Jul 16, 2019
Written By: Leah Eisenberg, of counsel, Foley & Lardner LLP
Loans and other debts generally fall under two categories: unsecured debt and secured debt. As will be discussed below, there is a significant divide when it comes to the treatment of a secured creditor versus an unsecured creditor in a bankruptcy proceeding.
Unsecured debt has no collateral or security to back the debt upon default or non-payment. Thus, upon a borrower’s default, the lender/creditor must commence a lawsuit against the borrower to collect on any outstanding amounts owed. Unsecured debt is generally issued based upon the borrower’s reliability, credit history and creditworthiness and contractual promise to repay the debt. Examples of unsecured debt include unsecured lines of credit, an unsecured bond and credit card debt. Because the unsecured debt has no property or security to backstop the debt, where repayment is based on reliability and creditworthiness of the borrower, it is riskier and thus generally carries a higher interest rate.
In contrast, secured debts are secured or backed by property or security, often called collateral, in addition to the borrower’s promise to pay. The secured party obtains a lien in this collateral, where, upon default or non-payment, the lender/creditor can look to repossess such property or security to satisfy any outstanding amounts under the applicable agreement. Because a lien creates leverage and reduces risk as to the lender’s ability to receive repayment, the secured creditor generally offers lower interest rates.
In legal terms, in a secured transaction, the lender is granted a lien on specific, identifiable property of the borrower. If the collateral is personal property, Article 9 of the Uniform Commercial Code governs the terms of the transaction and the lien is called a “security interest.” A lien can encumber both tangible and intangible property, such as intellectual property and accounts receivable, as well as after-acquired property.
If the collateral is real property, applicable state real property laws govern, and the lien is called a mortgage or deed of trust.
Thus, the main difference between secured and unsecured claims is the existence (or absence) of collateral that serves as a backing to the underlying loan or debt in the event of a default or non-payment by the borrower.
Whether a claim is secured or unsecured becomes more critical in the context of a borrower’s bankruptcy proceeding. The Bankruptcy Code contains its own waterfall provisions governing how claims are satisfied in bankruptcy cases. After the payment of administrative claims in a bankruptcy proceeding, holders of secured claims are generally paid first from available assets of a debtor’s estate, whereas unsecured claims are generally paid next in the waterfall if there are funds available, and equity claims are paid last. If there are insufficient funds available to satisfy all unsecured claims in full, holders of unsecured claims will receive their pro-rata share of available estate assets, or, if there are no funds or assets available, will not receive any distribution.
Additionally, a secured creditor has the right to repossess and sell the collateral, but it must seek relief from the Bankruptcy Code’s automatic stay to do so, which requires the filing of a motion with the Bankruptcy Court. An unsecured creditor in a bankruptcy proceeding has no claim against specific property of the borrower. Such unsecured creditor will file with the Bankruptcy Court what is called a “proof of claim”, which memorializes the outstanding debt.
Moreover, in a bankruptcy scenario, a secured creditor whose collateral is worth more than the amount of its claim is deemed “over-secured”, where a secured creditor whose collateral is less than the amount of its claim is deemed “under-secured.” This is significant in the context of a bankruptcy proceeding, as an under-secured creditor will hold two claims against the borrower: a secured claim in the amount of the value of the collateral and an unsecured claim for the remaining balance of its claims (also called a “deficiency claim”).
Due to the unique nature of each borrower, it is difficult to predict what, if anything, unsecured creditors will receive in a bankruptcy case as all debtors and cases are unique. What such holder does know is that the repayment of its debt in full is riskier simply based upon the Bankruptcy Code’s distribution waterfall provisions, where unsecured claims are generally last to be satisfied, if at all. In contrast, a secured creditor has more protection by virtue of its rights in the collateral, the ability to look to the collateral to satisfy its claims (after seeking relief from the automatic stay) and the Bankruptcy Code’s waterfall provisions providing for the satisfaction of secured claims prior to unsecured claims.
Leah Eisenberg is of counsel and a bankruptcy and restructuring attorney with Foley & Lardner LLP. Leah’s practice focuses on counseling clients in default, restructuring, bankruptcy, and corporate trust matters, with an emphasis on indenture trustee, creditors’ committee, and other creditor representations. Recent representations include serving as counsel to the Creditor’s Committee for GST AutoLeather, East Orange General Hospital, and Cengage Learning.