The division of debt between “secured” and “unsecured” is very important because it determines what bankruptcy can do for you. “Secured debt” is a creditor's claim that is secured by a lien of some type in your property, either by your agreement or involuntarily such as with a court judgment or taxes. A secured creditor can generally foreclose upon or repossess the property that secures the debt in the event that the debt is not paid.
If you decide to file bankruptcy, you will have the option to either surrender the collateral secured with a lien against property you own and be released from liability on the debt, or retain the collateral by reaffirming your contracts with secured creditors or by redeeming the collateral by paying the creditor the fair market value of the property you want to keep in one lump sum payment. You can choose to retain certain property and repay the debt in installments, and surrender other property without paying for it. For example, if you have a home mortgage and two car loans, you can keep the house and one car, and surrender the second car without payment. If you have several leases or contracts, you can reject some contracts or leases, surrender the property, pay nothing on the rejected contracts, and assume other contract or leases and maintain the contract payments.
Unsecured debt is not tied to any type of property, leaving the creditor without any opportunity to repossess or foreclose upon your property. Most unsecured debts can be completely eliminated in a Chapter 7 bankruptcy proceeding.
Some secured debts are familiar: mortgages, equity lines of credit and vehicle and equipment loans. These are all liens created by agreement between you and the creditor in some sort of recognizable legal agreement. There are several other kinds of debt that are secured by liens on property, sometimes without you even realizing it.
Contractual Security Interests
As a condition to getting a loan, a borrower is sometimes required to offer up assets as “security” (or “collateral”). The borrower signs a security agreement giving the lender the power to foreclose on the assets if a borrower defaults on the loan.
Examples of assets in which lenders will take a security interest include:
- Office furnishings
- Inventory and proceeds from sales
- Accounts receivable
- Patents, copyrights, trademarks and other intellectual property rights
“Choses in action” (potential rights that have not yet matured, such as a claim in a lawsuit)
- Commercial real estate
- Residential real estate
- Interests in leases
- Options to purchase
- Fixtures (improvements such as built-in cabinets that started out as personal property before becoming a part of real property)
Depending on the type of asset, there are different requirements for creating a security interest. With personal property, for example, the security agreement itself may be enough to create a security interest in collateral that is described in the agreement. Rules vary greatly from state to state.
A lender will generally want its security interest to have priority over other creditors.
With personal property, the lender files what is called a “UCC-1 form” with the Secretary of State in the state where the collateral is located (and sometimes with local counties or townships, as well). This public record puts other creditors on notice that there is a lien on the assets that will have priority over any other security interests given on the same collateral.
Blanket Security Interests
This is the term in most secured bank or SBA loans by which the borrower gives the lender a security interest in all of the borrower's personal property: the lien “blankets” all the borrower's assets. (“Personal” here means everything but real estate, not “personal” as opposed to “business” assets.) Even things like accounts receivable and intellectual property can be covered by a blanket security interest. The agreement may also give the creditor a lien in assets purchased after the security agreement is signed.
Since the borrower agreed to give the lender a security interest in the property described in the security agreement, the lien can't be avoided on the grounds it impairs an exemption. In Chapter 11 or Chapter 13, the lien may be “stripped down” to the value of the property at the time the bankruptcy is filed.
Since a lender has rights in the items themselves and in any profit from their sale, you may not be free to sell the asset and pocket the profits or even spend the profits paying other business debts. Spending the profits without the lender's permission may be a form of fraud creating a debt you can't get rid of in bankruptcy.
Purchase Money Security Interests
These security interests are lien rights that the seller takes in purchased goods when the seller finances the purchase. The lien can be created by a specific written agreement or may arise when the item is financed on the seller's revolving credit or store credit card. This kind of lien does not have to be recorded through the usual filing of a Uniform Commercial Code (UCC) financing statement.
The usual retail store credit plans give the seller a security interest in the goods purchased. But if you buy the same goods using credit provided by a lender other than the seller (such as Visa or MasterCard), you get clear title to the goods. Even if you discharge your liability on the credit card through bankruptcy, the goods charged to the card are yours, free and clear of any security interest in favor of the seller or the credit card issuer.
In theory, even if you discharge a debt secured by a purchase money security interest through bankruptcy, the seller still has the right to reclaim the goods. They retain their lien rights and can sue you to repossess the collateral in State Court after your bankruptcy Creditors with purchase money security interests in goods with lower value almost never file a lawsuit to enforce their interest in the goods. They are not really interested in the goods. They rely on the debtor's fear of repossession to “encourage” debtors to pay for things with little present market value. Because of this, it is usually possible to negotiate with the creditors to lower the principal balance owed on the debt and reduce or eliminate the interest charged on the account.
Usually a judgment does not, in and of itself, give the judgment creditor a lien. The creditor must usually take the additional step of “perfecting” a lien by filing or recording the judgment with the designated government agency to create a lien on the judgment debtor's property.
State law determines how judgment liens are perfected. Texas requires judgment liens to be perfected by filing an abstract of judgment in the County Clerk's office. You may obtain a report of liens on file with the Secretary of State to know which liens are perfected, and the seniority of each lien. Liens filed first have priority.
In bankruptcy planning, it's important to know if judgment liens have been perfected, as secured debts are totaled separately from unsecured debts in calculating your eligibility for Chapter 13 bankruptcy. With a Chapter 13 proceeding, these debts can be “stripped down” to the value of the assets on which the lien is filed. Judicial liens that impair a debtor's exemptions may be avoided in a bankruptcy proceeding.
Liens survive bankruptcy discharges
In a Chapter 7 case, even if a secured debt is discharged, a “lien” against property will survive the bankruptcy. This means that the creditor can never attempt to recover the debt as a personal liability of the debtor. However, after bankruptcy, if the debt is not paid, the creditor can enforce the lien by repossessing the property, selling it, and applying the proceeds to satisfy the debt. In a Chapter 13 case, secured creditor's claims against property you want to keep are normally satisfied and the creditor must release the lien upon the conclusion of the case.