Class 10 Secured Transactions Winter 2021 Priority Introduction

Class 10 Secured Transactions Winter 2021 Priority: Introduction Randal C. Picker James Parker Hall Distinguished Service Professor of Law The Law School The University of Chicago Copyright © 2001 -21 Randal C. Picker. All Rights Reserved.

Debtor Misbehavior and Insolvency n Two-Step Hypo u. Potential Investment: $30 required to undertake it u. Possible outcomes: w 99% of the time, money lost completely and no dollars generated w 1% of the time, $30 turns into $1000 n Does society want this investment to be made? December 13, 2021 2

Debtor Misbehavior and Insolvency n Depends, but … u. Need to make assumptions about risk-aversion: w Fear risk? w Neutral? w Prefer risk? December 13, 2021 3

Debtor Misbehavior and Insolvency n Depends, but … u. If risk neutral, don’t want the investment w Expected value of returns is. 99 x 0 +. 01 x 1000 = $10 w Better to just keep the $30 December 13, 2021 4

Debtor Misbehavior and Insolvency n Second Step: Embed Investment in Insolvent Firm u. Firm has creditors owed $100 and equity holders u. Firm has $30 in cash and the investment opportunity described above n The equity holders are in charge. Will they do the project? December 13, 2021 5

Debtor Misbehavior and Insolvency n Answer: Yes! u. Right now, with the $30 in cash, 100% of the time the equity holders will get nothing. u. The project converts that into a situation where they get nothing 99% of the time and a 1% chance at getting $900. December 13, 2021 6

Debtor Misbehavior and Insolvency n Controlling Debtor Misbehavior u. We need some sort of mechanism—control? —to make sure that debtors don’t undertake these types of investments u. They are playing with other people’s money and that will cause systematic losses to society December 13, 2021 7

Modigliani-Miller: The Irrelevance Theorem n Yogi Berra and the Pizza u. The size of the pie is independent of how many slices it is cut into u. Corporate capital structure is irrelevant for the value of the firm December 13, 2021 8

Modigliani-Miller: The Irrelevance Theorem n Intuition: Anything You Can Do I Can Do u. The key to theorem is that investors can replicate any debt/equity ratio created by the firm internally by externally creating a portfolio of stock of the pure-equity firm and, say, U. S. government bonds. December 13, 2021 9

The Key Idea u. If an all-equity firm could create market value by introducing debt into its capital structure—by issuing bonds and using the proceeds to buy back stock, for instance—investors in the firm could have done so by adding bonds to their investment portfolios. December 13, 2021 10

The Key Idea u. Any internal debt move could be matched (or offset) by an external debt move, and so investors should not be willing to pay any premium for internal efforts to create an optimal debt/equity ratio. u. The value of the firm is therefore independent of its capital structure. December 13, 2021 11

Hypo: $100 Investment Project Outcome Probability 50% $100 December 13, 2021 Project Value 12

Hypo: 2 nd Project Outcome Probability 49% 1% December 13, 2021 $100 X Project Value 13

Consequences of Project Choice n Society u. Project n 1 vs. Project 2 depends on the size of X Equity w Once $100 is in hand lenders have fixed payment, always prefer project 2 December 13, 2021 14

Consequences of Project Choice n Why Modigliani-Miller is “Wrong” u. Capital structure matters: it sets incentives for the use of assets December 13, 2021 15

Implications for Project Choice n The Need for Monitoring u. Debtor misbehavior means monitoring by creditors is required n Monitoring Consequences u. Controls debtor misbehavior u. But also makes possible deviations from pro rata n SI Allocates Monitoring Among Creditors December 13, 2021 16

Key Priority Contexts n Secured Creditor vs. u. Other secured creditor u. Pure unsecured creditor u. Lien creditor u. Other third parties, such as purchasers December 13, 2021 17

Case v. Foos Who has priority? SA: T&U FS: T&U 6/18/80 1966 FS: Farm EQ 9/82: $ 12/82: $ SA: T&U FS: T&U Sale of Tractor & Undercutter Rural December 13, 2021 Register Bank 2/83 Files New FS Assignment 11/24/82 Mistakenly Terminates FS Case 18

What Does this Mean n Says the Court u“Conversely, the record is clear that at the time of Foos’ purchase and through June 18, 1980, the Bank had no underlying security interest supporting its previously filed financing statement. [9‑ 308] contemplates the existence of a security agreement before a security interest is perfected. ” December 13, 2021 19

What Does this Mean n Says the Court u“Based upon these circumstances, we conclude Case had a perfected security interest in the tractor and undercutter from June 18, 1980, until its termination statement was filed on November 24, 1982, superior to any interest or claim asserted by the Bank. ” December 13, 2021 20

Holding: Pure Race Statute n Says the Court u“In short, this statute was intended to be and is a ‘pure race’ type statute. This means the secured creditor who wins the ‘race’ to the appropriate filing office has priority without regard to the prevailing creditor’s state of mind and knowledge. … December 13, 2021 21

Holding: Pure Race Statute n Says the Court u“Any other conclusion would cause confusion and uncertainty in commercial transactions, undoing the clarity and preciseness intended under Article 9 of the Code. ” December 13, 2021 22

TTYN (1 of 3) Caterpillar Financial? : Ver. 1 S Coal 2006: $10 K lent, SA: EQ, FS: EQ Peabody 2008: $10 K lent, SA: EQ, FS: EQ Cat FSC December 13, 2021 2005: $10 K lent, SA: EQ, FS: EQ PNB 15 K in EQ: Who has priority? 23

TTYN (2 of 3) Caterpillar Financial? : Ver. 2 S Coal Peabody 2008: $10 K lent, SA: EQ, FS: EQ Subordination in favor of PNB 2006: $10 K lent, SA: EQ, FS: EQ Cat FSC December 13, 2021 2005: $10 K lent, SA: EQ, FS: EQ PNB 15 K in EQ: Who has priority? 24

TTYN (3 of 3) Caterpillar Financial? : Ver. 3 S Coal Peabody 2008: $20 K lent, SA: EQ, FS: EQ Subordination in favor of PNB 2006: $10 K lent, SA: EQ, FS: EQ Cat FSC December 13, 2021 2005: $10 K lent, SA: EQ, FS: EQ PNB 15 K in EQ: Who has priority? 25

Ver. 1 Answer n 9 -322(a)(1) Priority Scheme u. Priority dates from earlier of first to file or perfect u. Peabody first, Cat second, PNB third n Value Split u$10 K December 13, 2021 to Peabody, $5 K to Cat, $0 to PNB 26

Ver. 2 Answer n 9 -322(a)(1) Priority Scheme u. Priority dates from earlier of first to file or perfect u. Peabody first, Cat second, PNB third n Value Split u. SIs: $10 K to Peabody, $5 K to Cat, $0 to PNB u. Peabody sends $10 K to PNB under the subordination December 13, 2021 27

Ver. 3 Answer n 9 -322(a)(1) Priority Scheme u. Priority dates from earlier of first to file or perfect u. Peabody first, Cat second, PNB third n Value Split u. SIs: $10 K to Peabody, $5 K to Cat, $0 to PNB u. Peabody sends $10 K to PNB under the subordination December 13, 2021 28

Ver. 3 Answer n Key Points u. Do not let PNB assert right to full $15 K based on $20 K debt u. Subordination agreement is private contractual right between two creditors but doesn’t alter SI priority scheme December 13, 2021 29

TTYN (1 of 2) Caterpillar Financial? : Ver. 4 S Coal Peabody 2008: $20 K lent, SA: EQ, FS: EQ Subordination and Appoint Peabody as Collateral Agent 2006: $10 K lent, SA: EQ, FS: EQ Cat FSC December 13, 2021 2005: $10 K lent, SA: EQ, FS: EQ PNB 15 K in EQ: Who has priority? 30

TTYN (2 of 2) Caterpillar Financial? : Ver. 5 S Coal Peabody 2008: $20 K lent, SA: EQ, FS: EQ Subordination in favor of PNB 2006: $10 K lent, SA: EQ, FS: EQ Cat FSC December 13, 2021 2005: $10 K lent, SA: EQ, FS: EQ PNB 2007: Asset Transfer SPV 15 K in EQ: Who has priority? 31

Ver. 4 Answer n Key Points u. This is another look at the ex post collateral agent question u. Probably won’t work but remember Oak Rock and wait to see Fretz December 13, 2021 32

Ver. 5 Answer n 9 -203 Rights in the Collateral Issue u. What rights does S Coal have in the collateral after transfer? How should PNB respond? n Missing Issues u. Survival of Peabody and Cat SIs on transfer to SPV (9 -315, 9 -320) u. Cat purchase money security interest (PMSI) December 13, 2021 33

Ver. 5 Answer n But on this hypo u. PNB is out of the money as to its SI, if any, anyhow, assuming that Cat and Peabody SI’s survive the 2007 transfers as they likely will u. PNB can collect from Peabody on the contractual subordination December 13, 2021 34

Ver. 5 Answer n But on this hypo u. SIs: $10 K to Peabody, $5 K to Cat, $0 to PNB u. Peabody sends $10 K to PNB under the subordination December 13, 2021 35

TTYN 4 -6: Mixed Financing Statements and Priority Corp 1/1/79 SA: Equipment FS: Equipment 2/1/79 SA: Equipment FS: Equipment Finco December 13, 2021 Bank 1/1 Who has priority? Bank’s FS 12/1/83 – New FS Filed 1/1/84 – Original Lapses 36

4 -6: Answer n This is Hilyard December 13, 2021 37

Hilyard Drilling 4/25/79 Hilyard 6/14/83 SA: AR FS: AR Worthen December 13, 2021 SA: AR FS: AR After 5 Yrs: Lapsed FS NBC 7/8/83 FS: AR 4/28/83 Letter: “We acknowledge their first lien and would be happy to do so in writing so that it is clear to everyone that our lien is junior to theirs. ” 1/25/85 Hilyard Files Ch 11 Who has priority? 38

9 -308(c) n (c) [Continuous perfection; perfection by different methods. ] u. A security interest or agricultural lien is perfected continuously if it is originally perfected by one method under this article and is later perfected by another method under this article, without an intermediate period when it was unperfected. December 13, 2021 39

9 -322(a)(1) Conflicting perfected security interests and agricultural liens rank according to priority in time of filing or perfection n Priority dates from the earlier of the time a filing covering the collateral is first made or the security interest or agricultural lien is first perfected, if there is no period thereafter when there is neither filing nor perfection n December 13, 2021 40