This article will explain each of these various definitions and their slightly different interpretations. To start, let’s look at the most universally accepted definition.
The Internal Revenue Code as administered by the Internal Revenue Service defines a lien as follows:
“A lien is a legal claim against your property to secure payment of your debt.”
Appears relatively simple at first. Note that it states a legal claim. To have a legal claim, the borrower must first sign a document granting this right to the lender/creditor. As defined in the first sentence at the start of this article, it states ‘A documented right …’ which supports the use of a legal claim. It is not necessarily true that the debtor has to sign a document to grant this right. Sometimes, the right is assigned by a judge via a legal process, more on this later in the legal section below. Since the IRS administers pretty much all business in the United States, its definition serves as the primary understanding of what this term means.
Other recognized authorities define a lien as follows:
- Federal Department of Commerce – defines a lien as a ‘security interest’, ‘… which is analogous to the lien a creditor puts on a car when making an auto loan’
- Supreme Court – ‘… a lien secures a claim against the debtor …’, 13-1421 BANK OF AMERICA, N.A. V. CAULKETT
- Webster’s Dictionary – a charge upon real or personal property for the satisfaction of some debt or duty ordinarily arising by operation of law
At first glance, this appears simple; the reality is much more complex. To understand the variations let’s first explore the use of the word in business, where is most commonly found.
A typical business relationship exists between those that provide funds or products to a user/buyer in the normal course of business activity. This relationship is commonly unsecured, meaning there is no formal document solidifying the relationship. This is routinely found with accounts payable. A company engages a subcontractor or a supplier to render a service or provide a product/raw material in exchange for financial reimbursement. This arrangement is informal and the subcontractor/supplier is at risk that he will not get paid. However, many subcontractors and suppliers want to reduce or eliminate this risk position. They do so by requiring the buyer to sign a document that places a lien on the service or product provided to the buyer. In effect, a formal relationship now exists between the buyer and provider of goods. The lien is the instrument (document) that secures the creditor.
Please be sure to understand the difference between secured and unsecured as used in business. Please read the following if you do not fully understand: Secure and Unsecure.
As the product or service gets more valuable for the provider or for the third-party financing the purchase, the documented rights become more important. A perfect example is a bank that provides financing for fixed asset purchases. Banks have the borrower sign a lien, sometimes called a security interest. Here the borrower is granting the bank the right to the property if the borrower fails to pay back the amount due.
Banks and other creditors use a vast array of documents to create the lien and then enforce the lien. The primary document that creates the lien is of course the actual note. The note will refer the reader to the security interest document which is a supporting document to the note. The security interest is more of a form that lists in detail the actual property that will become the collateral. Often this is the actual property purchased with the funds advanced by the bank. In addition, banks have the borrower sign another document which allows the bank to enforce the collection process without an official notice or due process. This is called a confession of judgement. Basically the borrower is allowing the lender to expedite the legal process and obtain the right to collect the property and sell this property to satisfy the balance of the principal, interest accrued, penalties, fines, legal and other fees related to the promissory note signed.
What the above illustrates is that it is rare to have a single document that represents the lien. Often it is comprised of multiple documents when read together encompass a lien, i.e. a legal claim to property. It is more convoluted than just a simple piece of paper that says there is a lien on the property.
Before going into the legal definition of a lien, I want to add a side note here related to liens. The term is customarily used with real estate and titled personal property such as automobiles, boats, heavy equipment, and legal rights (patents, trademarks etc.). It is also used with more expensive tools and office technology but requires more legal steps in order to ensure the ability of the lender to acquire the property to sell it in order to get their money back. It can be used with more generic assets such as receivables, inventory and other forms of liquid assets but here, the lender as to take a lot more legal steps in order to ensure the right to collect. The legal definition below will go into more detail.
Now the term ‘lien’ is going to get more complicated. There are going to be some twists and of course some exceptions. So let’s get started.
Above I mentioned that often a lien is placed on titled property. With real estate it is done with a mortgage note and the corresponding deed of trust. The deed of trust is the actual document that hands the right to the property to the lender in case of default. With transportation equipment, a lien is documented on the title paperwork. Here the lien is actually monitored by the state’s secretary or through the division/bureau of motor vehicles. Monitoring doesn’t mean the state collects the money nor sends notice to the debtor; it simply means that if the titled proper needs to change hands (a sale), the state will verify that the debt is paid before changing the title’s ownership name.
Notice with both forms of loans above (real estate and transportation), notice is given to the public stating the property has a lien on it and who the holder of this legal claim is. Deeds of Trust are filed with the local circuit courts at the county clerk’s office; transportation and heavy equipment is monitored by the state via the secretary of the respective state or through the state’s DMV/BMV.
With the above, the public is given notice that the property in question has a claim to it by a third-party creditor.
What about the mid level types of assets? I’m referring to big tools, office technology (computers, copiers and phone systems), furniture etc. How does the public know there is a lien on the property? Well, another auxiliary tool used is called a Uniform Commercial Code statement. It is filed with the state’s secretary of state which gives the public notice that the property has a lien; it is called a UCC-1. Here a form is filled out by the creditor and signed by the debtor stating that certain property (very descriptive itemized list) has a claim by the lender.
For the more generic assets such as inventory, accounts receivable or other highly liquid assets; lenders use the UCC statement, direct communication with the involved parties, or physical control over the asset in question. A good example is a pawn shop. Here the borrower actually hands the collateral to the lender. The lender doesn’t need to take additional steps to collect on his loan amount.
All of the above forms of giving notice of a claim to the property is commonly referred to in law as ‘perfecting the claim’, i.e. making it legal. In effect, the creditor must give notice to the public via some venue to alert potential buyers of the asset that the lender has first rights to the proceeds.
Often, lenders lend the money without documenting a claim. This is common with unsecured loans or the lending of property, e.g. landlord/tenant relationship. How does the lender acquire a claim and give notice to the public?
Go back to the first sentence of this article, it states that a claim must be documented. To document a claim, the lender must obtain a judicial granting of this right. Basically, the lender seeks out a judgement in a court of law. Here, the lender requests a hearing in front of judge and sends notice to the borrower that there is a hearing. This request is often done in the lowest level of courts in the state, most states refer this as the District Court system. Here the judge listens to both parties, reviews the agreement between the parties and issues a decision. If the lender has done their job properly, the judge issues a judgement in favor of the lender. The borrower has the right to challenge this judgement, but it must be challenged in a higher court where it gets much more expensive.
The judgement is a documented claim to the property or money the borrower owes. If the borrower doesn’t challenge the lender, the lender may enforce the collection process by having the local sheriff enforce collection of property. For access to the borrower’s cash, the lender may seek out a writ of wage garnishment, an order by the court to the borrower’s employer to pay over certain sums from the employee’s wages to the creditor.
Again, note the importance of the documentation process in order to collect money from a borrower. It can get quite complicated as there are multiple variations of legal rules and procedures to collect value from a borrower. Naturally, the better the documentation up front, the easier it is in the long run to collect the loan amounts.
As mentioned above, states have their own definitions of the word lien. For example, look at the differences between several states below:
2872. A lien is a charge imposed in some mode other than by a transfer in trust upon specific property by which it is made security for the performance of an act.
Notice with California, the property is security. It doesn’t state that a document is required, but the actual creation of security is customarily done with a document of some sort.
44-1-2. Classification of liens–Definition of terms–General lien–Special lien. Liens are general or special. A general lien is one which the holder thereof is entitled to enforce as security for the performance of all the obligations or all of a particular class of obligations which exist in his favor against the owner of the property. A special lien is one which the holder thereof can enforce only as security for the performance of a particular act or obligation and of such obligations as may be incidental thereto.
In this state, a lien is subdivided into two separate groups of general or special.
§421. Lien defined.
A lien is a charge imposed upon specific property, by which it is made security for the performance of an act.
Again, note the word security. Oklahoma goes on to state the following:
§426. Lien created, how.
A lien is created:
1. By contract of the parties; or,
2. By operation of law.
Example number 1 is a document and number 2 is obviously documented via the court system.
Texas uses Code Section 1.201 of the Business and Commerce Code to define a lien under the definition for ‘Security’ as follows:
(35) “Security interest” means an interest in personal property or fixtures which secures payment or performance of an obligation. “Security interest” includes any interest of a consignor and a buyer of accounts, chattel paper, a payment intangible, or a promissory note in a transaction that is subject to Chapter 9. “Security interest” does not include the special property interest of a buyer of goods on identification of those goods to a contract for sale under Section 2.401, but a buyer may also acquire a “security interest” by complying with Chapter 9. Except as otherwise provided in Section 2.505, the right of a seller or lessor of goods under Chapter 2 or 2A to retain or acquire possession of the goods is not a “security interest,” but a seller or lessor may also acquire a “security interest” by complying with Chapter 9. The retention or reservation of title by a seller of goods notwithstanding shipment or delivery to the buyer under Section 2.401 is limited in effect to a reservation of a “security interest.” Whether a transaction in the form of a lease creates a security interest is determined pursuant to Section 1.203.
Notice the various exceptions to the fundamental rule.
Summary – Lien Definitions
The term ‘lien’ is defined in general as a documented claim to property of a borrower of money. Its definition gets broader related to business usage as several legal matters come into play. Overall, it is most important for a business owner/manager to understand the term related to their state’s definition. It can and does get complicated; but if one follows the law and uses reasonable actions, a business owner can properly document and reduce risk related to lending money and borrowing money. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.