Secured transactions are loans or purchases that are secured by collateral. Article 9 of the Uniform Commercial Code (UCC) contains hundreds of rules for how these types of loans and purchases are handled. Here we'll look at just a few key terms and principles. Additional Nolo articles on secured transactions contain more details.
A Basic Example
It is not necessarily easy to understand how the basic elements of a secured transaction, such as collateral (also known as "security"), debtors, secured parties, and security interests, fit together. However, the following simple example should provide at least a little illumination.
Stefan is the president and CEO of a small company that makes specialized parts for cargo ships. He has just signed an agreement to supply parts to a major ship manufacturer. The deal ultimately will be very profitable. However, to meet his obligations to the ship manufacturer, Stefan's company needs new machinery and a lot of raw materials, and currently his company doesn't have enough money to buy either of these things.
So, Stefan's company buys the necessary new machinery (which the UCC calls "equipment") on credit from Machines, Inc. As a key part of the deal, Machines, Inc. requires Stefan to provide collateral (or "security"). More specifically, Machines, Inc. requires that Stefan give it the legal right to repossess the new equipment if Stefan fails to keep up the payments.
For the raw materials (which the UCC calls "inventory"), Stefan goes to State Bank to get a loan. As with Stefan's deal with Machines, Inc., the deal with State Bank includes a requirement that Stefan's company provide collateral (security) for the loan. More specifically, State Bank requires Stefan to provide the bank with the legal right to repossess the raw materials (inventory), as well as the legal right to take any payment due under the contract with the ship manufacturer, if Stefan's company fails to repay the loan.
In this example:
Machines, Inc.'s legal right to repossess the new machinery constitutes Machines, Inc's security interest in the equipment collateral. State Bank's legal rights to the raw materials and payments constitute the bank's security interest in the inventory and other collateral. (Note that collateral need not be limited to physical property, and may include, a business's accounts receivable.)
This example covers some of the key elements of a secured transaction, including a loan or purchase, collateral, a debtor, secured parties, and security interests. However, a secured transaction also involves other necessary elements, including a security agreement, "attachment" of the security interest, "perfection" of the security interest, and, potentially, prioritization of creditors. Each of the latter elements is reviewed briefly below, and more fully in separate Nolo articles.
Attachment of a Security Interest
Under the UCC, a security interest is not created—or, in the language of the UCC, does not "attach"—unless certain basic requirements are met. In simplest form, the requirements are that:
These requirements apply to the most common types of collateral, including those listed in our example above. However, for certain less common types of collateral, the requirements relating to an authenticated security agreement may vary.
In our example, Stefan's company receives value for Machines, Inc.'s security interest in the form of new equipment, and receives value for State Bank's security interest in the form of the money loaned by the bank. Stefan, as president and CEO of his company, has rights in the collateral. Finally, both Machines, Inc. and State Bank will present security agreements to Stefan for his signature. (A signature is one form of "authenticating" a security agreement; in the UCC, "authenticate" covers not only traditional signatures but also electronic signatures.)
Perfecting a Security Interest
A basic purpose of a secured transaction is to give a lender or seller some potential remedy in the event that the borrower or buyer—the debtor—is unable to pay what's owed. More particularly, in situations where the debtor is insolvent, the secured party can take possession of the agreed-upon collateral. While this idea may work reasonably well when there is only one secured party, matters are more complicated where there are several loans or purchases, several secured parties—and, potentially, a bankruptcy trustee. When multiple creditors and a bankruptcy trustee are involved, and there is not enough money or property to pay all the creditors in full, the creditors, along with the trustee, all may try to take possession of the same collateral, leading to disputes.
"Perfection" of a security interest is intended to help avoid competing claims to collateral. Under the UCC, a basic security interest involves "attachment," which is discussed in the preceding section. However, attachment alone will not work to resolve a dispute between multiple creditors and a bankruptcy trustee. Instead, secured parties must also perfect their security interests. Perfection of a security interest gives a secured party priority over other creditors or a bankruptcy trustee.
A secured party often perfects an interest in collateral by filing a document known simply as a financing statement. The purpose of the financing statement is to put any other potential creditors or other interested parties on notice regarding the filer's interest in the collateral listed on the statement. In many cases, the secured party will work from a widely-available preprinted form, known as Form UCC-1, to complete the financing statement. You can easily find a sample UCC-1 online. Once completed, the statement is filed with an appropriate local government office. (Other methods of perfection are also laid out in the UCC but are not covered in this overview article.)
In our example above, both Machines, Inc. and State Bank will likely file financing statements with appropriate local government offices as soon as possible after Stefan signs the necessary documents to perfect their security interests in the relevant collateral. (In fact, a creditor, like Machines, Inc., may even choose to file a financing statement before a security agreement is signed.)
Priority of Creditors
The UCC's rules for prioritization of creditors are vast and complex. They depend on many factors, such as:
For immediate purposes, we'll simply state that, generally speaking, when there are secured parties with competing claims for the same collateral, it is usually the secured party that first perfected its interest in the collateral—for example, by being the first to file a Form UCC-1—that will have legal priority to the collateral.
In our above example, if Machines, Inc. files the necessary UCC-1 to perfect its security interest in the new equipment, but then, at a later time, another creditor files a UCC-1 covering the same equipment, Machines, Inc. should have a priority interest over that other creditor in the event that Stefan's company goes bankrupt.
This article is based on the current version of the model Uniform Commercial Code (UCC). However, not all states have adopted all sections of the current model UCC. Moreover, the model UCC specifically leaves it to individual states to determine the precise wording of certain sections. Therefore, you should always check your own state's commercial code for the most accurate information.