Repossession - Who Owns the Collateral?

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When Tom Sorley arranged financing for a new van for his home decorating business, the bank insisted that he execute a personal guarantee.

Less than a year later Tom and Audrey, his wife and business partner, were divorced. The court awarded Audrey the van, but at the same time ordered Tom to make the remaining payments. Tom continued to do so for some time, but when he could no longer single handedly keep Sorley Decorating in business, he was forced to default.

The bank was patient for awhile, but when the payments were not forthcoming from either Tom or Audrey, they had no alternative but to repossess the van. After the repossession, but before any sale or disposition, Tom filed a petition in bankruptcy under Chapter 13 of the Bankruptcy Code. Tom's counsel immediately requested that the van be returned to Tom. The bank, of course, refused. At this time Audrey bought a proceeding in the bankruptcy court asking the court to direct the bank to turn the van over to her. The bank argued before the court that when they repossessed the truck, they effectively became the owner and since ownership was transferred to the secured party, the van was really not subject to a turnover proceeding. Who's entitled to the van--the bank, Tom, or Audrey?

Prior to the enactment of the Uniform Commercial Code (UCC), common law provided that when a creditor repossessed collateral covered by a security agreement title normally passed directly to the creditor. The UCC changes that concept radically. When collateral is repossessed, title remains with the debtor until there is some formal disposition by the creditor in accordance with Code.

UCC Section 9-207 states:

A secured party must use reasonable care in the custody and preservation of collateral in his possession.
In the case of an instrument or chattel paper, reasonable care includes taking necessary steps to preserve rights against prior parties unless otherwise agreed.
A secured party is liable for any loss caused by his failure to meet any obligations imposed by the preceding subsection but does not lose his security interest.

That particular section clearly indicates that the creditor has a substantial obligation once he obtains possession of the property, that is, an obligation to provide reasonable care for the property. The section also allows the secured party, if he takes any action to preserve the collateral, to add his reasonable expenses to the secured obligation, which means that the secured obligation can increase even when the creditor has possession of the property.

UCC Section 1-102(3) states that the duty by the creditor to exercise reasonable care may not be disclaimed by agreement, although parties may remain free to determine by agreement, any manner of obligation not manifestly unreasonable. This seems to indicate that the debtor still has an interest in the property after the creditor repossesses it. The UCC also provides in Section 9-501 that a secured party who is in possession of the collateral has the rights and remedies and the duties provided for in Section 9-207.

If the creditor has obligations after he repossesses collateral, he cannot at the same time be the owner. If he were the owner, he would have no obligations to the debtor and his only duties would be to himself. Once he becomes owner of the property, there would be no right to increase the amount of the debt by any action other than through the security agreement, which has now become history by virtue of the fact that the creditor has become the owner.

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Lastly, if the secured party were the owner of the property, he should not be liable for any losses that were incurred by virtue of his failure to use reasonable care in the custody of the property. Creditors must understand that at the time they repossess, they do not have title to the property and significant and distinct obligations exist with regard to its maintenance. One case held that, where a bank permitted a car to remain on the street for an extended length of time, this inaction violated their duty of reasonable care even though they did not have possession of the car. The court held that it was constructive possession.

The creditor also the right to redeem the vehicle under Section 9-506:

"At any time before the secured party has disposed of collateral or entered into a contract for its disposition under Section 9-504 or before the obligation has been discharged under Section 9-505(2), the debtor or any other secured party may unless otherwise agreed in writing after default redeem the collateral by tendering fulfillment of all obligations secured by the collateral as well as the expenses reasonably incurred by the secured party in retaking, holding and preparing the collateral for disposition, and arranging for the sale and to the extent provided in the agreement and not prohibited by law, reasonable attorneys fees and legal expenses."

The right to redeem is certainly inconsistent with the right of ownership. Notwithstanding that these various sections of the code clearly spell out the fact that repossession does not give ownership to a creditor, some creditors are still under the incorrect assumption that once they acquire possession of the collateral, it is equivalent to ownership of the collateral.

A motor vehicle must be sold at a public or private sale in accordance with the provisions of the UCC and the provisions set forth in the security agreement itself. In those states where a certificate of title is needed, ownership cannot be transferred until there is a proper sale and a proper transfer. Any activity by the creditor which is inconsistent with the concept that the creditor is merely the caretaker and the custodian until such time as the property is placed at public or private sale in accordance with the provisions of the Code would necessarily expose the creditor to liability. In addition, the creditor must use reasonable care in the custody of the automobile which probably encompasses the idea of storing it in a secured placed with a certain reasonable degree of protection from the elements.

With collateral that needs special care due to its own nature, whether it be food or other types of material, the creditor is still under the same obligation to use reasonable care to protect the collateral. Consultation with counsel in certainly recommended.

Editor's Note: The above article originally appeared in the Credit & Collection Manager's Letter, a newsletter purchased by Credit Today in 2006. This article originally appeared prior to 2000.