Traditionally, lenders and credit sellers have felt pretty good about their position as a “secured creditor” in the bankruptcy context, particularly when their security interest in the consumer/debtor’s collateral is a purchase money security interest. Recall that a purchase money security interest (PMSI) is a status that arises by operation of law. The status arises when the consumer purchases the goods that become the collateral from the credit seller, or the proceeds of a lender’s loan are used to acquire the goods from the seller. A PMSI generally assures creditors that their interest in the collateral will enjoy certain advantages and priorities over other creditors. See Back to Basics, Continued—What does “perfection” and “priority” of a security interest mean?

Why is this important in a bankruptcy context?

If a creditor’s security interest is a PMSI then the creditor is “automatically” perfected without the necessity to make a UCC or other filing. More importantly in this context, the creditor’s position in the debtor’s collateral with respect to the debtor, the Trustee and other creditors is advanced by this priority standing.

But, of course, that is not the end of the story.

If the value of the collateral has severely diminished by the time of the debtor’s filing bankruptcy, then the status of being a purchase money secured creditor may dwindle along with that collateral value. My understanding of bankruptcy procedure is that a secured claim is only effective up to the current fair market value of the collateral. So seriously diminished value can ultimately result in a secured claim being reclassified as unsecured. This technique is used by debtors and their counsel by means of a “motion to reclassify proof of claim as unsecured.” If that’s the fact, then that’s the fact. Alas, chalk this one up to the cost of doing business.

This point though, supports the lender’s position that it is entitled to review its collateral position in connection with any future refinancing of the debt. That is, anytime that a loan is refinanced by a lender, the lender should take a hard look at the value of the goods that are to serve as collateral for the refinanced loan. The collateral value that supported the original loan, is unlikely to support the refinanced loan.

Please Note: This is the two hundred-forty-eighth blog in a series of Back to Basics blogs, in which relevant and resourceful information can be easily accessed by clicking Dentons - Consumer Finance Report. To receive weekly insights to your email from the Consumer Finance Report blog, subscribe here.