Creditors come in two basic types: secured and unsecured. Although the amount of the debt may be the same, the remedies available to the creditor are very different. Secured creditors have a claim against a specific asset, whereas unsecured creditors do not.
Secured creditor vs. unsecured creditor
Creditors can be unsecured or secured. An unsecured creditor (also called a general creditor) has a general claim against a debtor. This claim is not secured by any particular asset of the debtor. An unsecured creditor has the weakest claim, which may go unpaid in a bankruptcy proceeding.
An unsecured creditor may become a secured creditor after a lawsuit and judgment. A secured creditor, who has an interest (referred to as a lien) on a particular asset, can use the court system to seize the asset and to satisfy the debt. This clearly presents a significant risk for the business owner.
A lien is a security interest or legal claim against property that is used as collateral to satisfy a debt. In other words, liens enable creditors to assert their rights over property. Unless the debtor is prudent and has taken measures to safeguard their assets, there is a risk that the creditors can seize assets and take the debtor’s wealth. In order to know if your assets are at risk, it is imperative that you have an understanding of the different types of liens you may encounter as a small business owner:
- Consensual liens
- Purchase-money security liens
- Non-purchase-money security liens
- Statutory liens
- Mechanic's liens / tax liens
- Judgment liens
Once we discuss the different types of liens, we'll then examine how creditors might seek to get your assets through these types of liens, and what you can do as a small business owner, to maximize your protection against those creditors. The strategies outlined will address a broad spectrum of topics, from forms of property ownership to structuring debt to minimizing exposure.
Consensual liens are voluntary
As the name implies, consensual liens are those to which you voluntarily consent, as a result of a loan or other advance of credit. The property purchased secures the buyer's obligation to pay for the property. One common example of a consensual lien is the residential mortgage: a home buyer consents to a bank taking a security interest in the home when a mortgage is obtained. Similarly, a security interest also is created when a car dealer arranges financing for a car buyer. There are two broad classes of consensual liens:
- Purchase-money security interest liens. Here, the creditor extends credit to the debtor specifically for the purchase of the property that secures the debt. Examples of a purchase-money security interest lien include a first mortgage on a home, a car loan, and situations in which the seller finances the purchase of property, such as furniture, through a credit agreement.
- Non-purchase-money security interest liens. Here, the debtor puts up property he or she already owns as collateral for a loan. The loan proceeds are then used to pay expenses (or perhaps to buy other property). Examples of a non-purchase-money security interest lien include a second mortgage (or refinancing of a mortgage) on a home or a loan used to pay operating expenses with previously owned office equipment put up as collateral.
Both types of consensual liens are usually non-possessory. This means that the creditor does not take or retain possession of the property. Rather, the debtor takes, or retains, possession of the property.
However, it's possible for either type of consensual lien to be possessory. In that case, the creditor takes possession of the collateral. A loan from a pawnbroker, for example, usually would create a possessory, non-purchase-money security interest lien in the collateral.
While this seems very straightforward, the type of debt can have a large impact on the creditor's rights if a debtor defaults. The rules vary from state to state, but characteristics of a debt are critical to understanding if assets are to be protected. Issues include:
- Who is holding the property that secures the debt? Is it the debtor or the creditor? In a car loan, the debtor has possession of the property. When a loan is obtained from a pawnshop, the creditor has possession of the property securing the loan.
- Was the debt incurred to purchase property or not? For example, a first mortgage loan is a purchase money loan since the proceeds were used to purchase a residence. In contrast, a refinancing loan is not a purchase money loan. The homeowner already owned the property.
- What is the nature of the property to which the lien is attached? This is often the essential inquiry when it comes to asset protection. The states, as well as the federal government, have a wide variety of laws relating to what assets are protected from creditors and how they are protected. The primary mechanism for protecting selected assets is a concept called exemptions. In essence, the law may declare that certain property simply cannot be seized by a creditor.
The other common types of liens are statutory liens and judgment liens.
Statutory liens arise by operation of law
In addition to consensual liens, there are many different types of liens that creditors can use to get at your assets to satisfy a debt. In certain circumstances, creditors obtain security interests by the operation of state (or federal) laws and not by the consent of or a security agreement with the debtor. Examples of statutory liens include:
- Mechanic's liens. This type of lien arises when a contractor or mechanic performs work on property and is not paid. Mechanic lien examples include a contractor who installs a furnace in a home or an auto mechanic who performs repairs to a car. This lien is a security interest in the property. If the owner tries to sell the property, the debtor will have a secured interest in the portion of the proceeds needed to pay the debt. In addition, having a mechanic's lien can delay or prevent the sale of real property until the debt is satisfied and the lien is released.
- Tax liens. This type of lien is placed against property by the local, state, or federal government, as authorized by statute, for delinquent taxes, including property, income, and estate taxes.
Judgment liens arise as a result of a lawsuit
Of the three types of liens (consensual, statutory, and judgment), the judgment lien is the most dangerous form, but one which the informed business owner may be able to eliminate. A judicial lien is created when a court grants a creditor an interest in the debtor's property, after a court judgment. Judgment liens can arise in a wide variety of circumstances — basically, any incident that can land you in court can end up generating a judgment lien.
For example, if you are driving negligently and injure someone in an accident, the injured person may sue for damages. To the extent that your insurance doesn't cover the judgment, a judicial lien may be placed against your property to secure payment of the claim to the injured party. A plaintiff who obtains a monetary judgment is termed a "judgment creditor". The defendant becomes a "judgment debtor". The judgment in the lawsuit provides the basis for the lien.
If the debt is not paid, the judgment creditor can then seek to enforce (or execute) the judgment. This can be accomplished by garnishing wages, seizing a bank account, or placing a lien against the debtor's property. The lien is the first step by the judgment creditor in a process that will culminate in a sale of the attached property, to satisfy the judgment debt.
A judgment lien is any lien placed on the defendant's assets as a result of a court judgment. If a lien were placed on a home, the judgment creditor could then seek to foreclose on the property, in the same way a mortgage holder such as a bank could foreclose if it were not paid. In this section, the term "judgment lien" is used in its strictest sense: a lien attributed to a court judgment, where the court judgment itself is the basis for the lien.
An example would be a plaintiff who is awarded a monetary judgment against a defendant in a lawsuit based on negligence, and who then is granted an order of attachment against the debtor's property. In contrast, this definition excludes a judgment based on a pre-existing lien (i.e., a prior consensual lien or statutory lien). Thus, for example, this definition would exclude a judgment in a mortgage foreclosure. This distinction is critically important in discerning what types of liens against exempt property can be eliminated.
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