Default

     Default by the debtor is an act or omission by the debtor or obligor that triggers the rights of a secured party. See, e.g., U.C.C. 9-601(a). In both the real and personal property context, the triggering acts or omissions are not specified by statute but are left to the agreement of the parties, subject to background rules of contract law such as those governing interpretation, waiver, estoppel, mistake, fraud, or unconscionability. The most common default is the obligor's failure to make a payment when due.   However, as we see in Problem.Default, failure to make a payment may not always constitute default.  In addition to failure to pay, the parties typically specify a variety of other potential kinds of default.  Examine our sample security agreement for some illustrations.

     Enabling a secured creditor to forcibly control and liquidate collateral in the event of default is the primary function of the legal rules governing secured debt (both the non-uniform real property rules and the rules of U.C.C. Article 9).  But the secured creditor will not always act in cases of default, particularly if it is not concerned about the general financial strength of the debtor or the debtor's willingness to pay the debt.  Moreover, even where the secured creditor wishes to act, forced control and liquidation is almost invariably the last resort for dealing with a debtor's default.  Empirical evidence gathered and analyzed by law professor Ronald Mann confirms anecdotal evidence about the infrequent use of force as a response to default.  R.Mann, Strategy and Force in the Liquidation of Secured Debt, 96 Mich. L. Rev. 159 (1997).   His study included a sample of distressed commercial loans, secured by real property, made by a large national life insurance company.  In that sample, the insurance company took control of the collateral, either through foreclosure or a deed in lieu of foreclosure, in six cases (only 32% of the sample), and in each case it suffered significant losses, ranging from a 42% loss ($3.5 million on an $8.5 million loan) to a 100% loss ($6 million on a $6 million loan).  Id. at 210 n.16.    In many cases of default in payment, the insurance company allowed the debtor to remain in possession after negotiating a "workout."  Id. at 208-09.  Workouts are common responses to default because they frequently will net the secured creditor greater recovery on the debt than forcible control and litigation.  Workouts take a variety of different forms depending upon the circumstances of the individual case.  Workouts may involve payment concessions by the creditor, including reduction in the principal amount owing, an extension of time to pay, or an adjustment of interest rate, and may also involve immediate or prompt partial payments or other contributions by the debtor.

     As in the case of real property secured loans, forcible control and liquidation of personal property collateral is generally the last resort.  In Professor Mann's study of a sample of twenty-three distressed commercial loans held by a finance company and another sample of twenty-eight distressed commercial loans held by a bank, secured by inventory, accounts, or equipment, there was but one case of repossession of collateral and even in that case the collateral was ultimately returned to the debtor.  There was, therefore, not a single case of forced liquidation of collateral in his samples of personal property secured commercial loans.  R.Mann, Strategy and Force in the Liquidation of Secured Debt, 96 Mich. L. Rev. 159, 177, 190-91 (1997).  Instead, the secured lenders would leave the debtor in possession of collateral with the expectation and the general result that the debtor would either refinance the debt with another lender or pay the debt either in the ordinary course of business or through its own sale of the collateral.  Those secured lenders expected that forced control and liquidation through exercise of Article 9 remedies would result in a greater loss to the bank.  One bank officer remarked:  "'[A] decision to go out and get the collateral is a decision not to get paid in full.'"  Id. at 191.   Mann concluded:  "As long as the bank does not go out and get the collateral, the bank has a substantial chance of being paid in full through one of several reasonably likely courses of events:  a sale of the business, a refinancing of the loan by another lender, or continued operation of the business long enough to defray the outstanding balance of the debt."  Id. at 191.

     Professor Mann did not gather empirical evidence concerning loans secured by residential real property or consumer goods, but suggested that foreclosure on residential real property or automobiles may be more common both because of the liquidity of those assets and because of the increased transaction costs associated with negotiating a workout with a consumer borrower.  Id. at 237-32.

     Where the secured creditor wants to exercise its rights to forcibly control and liquidate collateral, a wide variety of possibilities--remedies for the creditor and rights of the obligor and debtor-- confront the parties.  If the underlying contract so provides, the secured creditor may notify the obligor that the debt is accelerated and the entire sum is immediately due and payable. The secured creditor may consider repossessing tangible personal property collateral, collecting receivables, foreclosure, suit on the debt, or pursuit of any guarantors of the debt or collection on any letters of credit issued in connection with the debt.

     The obligor may seek to invoke any available rights to reinstate the debt (i.e. de-accelerate the debt), may seek to redeem the collateral from the lien (either before or, in some cases involving real property, after foreclosure), may resist collection of any deficiency, or may invoke the protections of federal bankruptcy law, including an automatic stay that in most cases will temporarily stop the secured creditor in its tracks.

     Our materials concerning default and bankruptcy explore each of these possibilities.