Relationship Between Debt and Value of Collateral

Relationship between debt and value of collateral

A secured creditor has a vital interest in the relationship between the amount of the secured obligation and the value of the collateral that secures the obligation.

If there is only one creditor with a lien on property, that creditor is adequately secured (sometimes referred to as oversecured) if the value of all of the collateral securing the debt is greater than the amount of the obligation secured. For example, a creditor owed $100,000 with a lien on property worth $150,000 is adequately secured. In such a case, the owner of the collateral (usually, but not always, the person or entity obligated on the debt) is said to have equity in the property equal to the amount by which the value of the collateral exceeds the amount of the secured debt ($50,000 in our example). If there is only one creditor with a lien on property, that creditor is undersecured (sometimes referred to as underwater) if the value of all of the collateral securing the debt is less than the amount of the obligation secured and, in such a case, where the collateral is sold and the proceeds of sale are applied to satisfaction of the obligation, the remaining (unsatisfied) portion of the obligation is referred to as a deficiency. For example, a creditor owed $100,000 with a lien only on property worth $50,000 is undersecured and the deficiency will be $50,000. As to the deficiency, the creditor is, ipso facto, unsecured. However, in a variety of circumstances, anti-deficiency law restricts or prohibits the creditor from obtaining payment of the deficiency. Where a creditor, either by agreement or by applicable law, is prohibited from collecting a deficiency, the debt is said to be non-recourse (because there is no in personam liability of the debtor).

Often, more than one creditor has a lien on the same property. In such cases, with rare exceptions, such creditors do not share the value of the collateral upon the debtor's default. Rather, claims to collateral are ranked and one creditor's claim is given priority over the claim of another (or others). The creditor whose lien has highest priority can satisfy all of its claim from the collateral before the creditor with the next highest priority may satisfy any of its claim. Thus, a creditor whose lien is junior to the lien of another secured creditor may, at different times, be adequately secured, undersecured, or, totally unsecured, depending upon the value of the collateral, the amount of the debt secured by the senior lien(s), and the amount of the debt secured by the creditor's lien.

As more fully explained in Commentary.Allowed secured claims, an undersecured creditor is considered to have two claims against a debtor in bankruptcy: a secured claim equal to the value of the collateral and an unsecured claim for the deficiency.

Because of the more cumbersome and less certain process for collecting an unsecured claim, most consensual secured creditors, particularly institutional creditors, want to start and remain adequately secured. To accomplish this objective, they must:

(1) Know the fair market value of the collateral and predict the value that the collateral will have in the context of a distress sale, such as a foreclosure or bankruptcy sale (hence, the desirability of an appraisal);

(2) Predict the extent to which the value of the collateral is likely to appreciate (real property and some forms of personal property such as art), depreciate (any property), or be affected by changes in the market (e.g., inventory or intellectual property) and predict the rate of such change in value to the extent possible;

(3) Fully amortize the debt over a period shorter than the useful life of the collateral;

(4) Leave a margin for error by extending credit in an amount less than the estimated available value of the collateral (hence the requirement for a down payment leading to an initial loan to asset ratio of less than 1);

(5) Insist that the collateral is fully insured and that the secured party is named as loss payee in the insurance policy;

(6) Insist that the debtor properly maintain and care for the collateral and, in the case of personal property, not remove the collateral from a designated location without the prior consent of the creditor;

(7) Monitor the location and condition of the collateral.

In addition, if there are liens with higher priority encumbering the collateral, something that the creditor should discover through investigation and analysis prior to extending credit, the creditor wishing to be adequately secured must:

(8) Know the amounts of any debts secured by higher priority liens on the same collateral and the extent to which the amount of any such debts might increase either by virtue of further secured advances that could be made by the creditors with the higher priority liens or by virtue of the accumulation of earned but unpaid interest on the debt, late fees, or collection costs (including attorney's fees).

The value of the collateral is, obviously, critical to the creditor's calculations. However, value is shifting and elusive because property can be sold in a variety of contexts in each of which the amount of money received may differ. Thus, one cannot attribute a specific dollar value to collateral until it is actually sold. One can only estimate different potential values, relying, in many cases, on the expertise of appraisers, or, in some cases, upon widely distributed standard price quotations, such as those provided for automobiles in the Kelly Blue Book.

The greatest amount of money to be generated by a sale, typically referred to as "fair market value", occurs where the owner is willing but not obliged to sell in an open market where buyers are interested but not compelled to purchase. And, if the collateral is part of a going business (e.g. beds in a hotel), the amount apportionable to the beds from a sale of the entire business will be greater than if the beds are sold piecemeal.

Much less money will be realized in a "distress sale." The distress may be the owner's need to move, immediately. Or, the distress may result from a sheriff's sale under a writ of execution enforcing a judgment, from a foreclosure by a secured creditor, or from a sale by a bankruptcy trustee. The amount of money to be received in such forced sales is sometimes referred to as "liquidation value" or also, more particularly, as sheriff's sale value, foreclosure or Article 9 sale value, or bankruptcy value.