If your business has taken out a loan, you might be familiar with a security interest. Many lenders require businesses, especially newer ones, to promise collateral to get a loan. This requirement allows the lender to take the collateral if the business doesn't make the required loan payments. When collateral is offered in exchange for something (like a loan), you've created a "secured transaction" where the lender has a security interest in the collateral.
Article 9 of the Uniform Commercial Code (UCC) provides rules for secured transactions, including how a security interest can attach and be perfected. Here we'll look at both attachment and perfection of security interests.
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A secured transaction is a loan or purchase that's secured by collateral. Collateral is anything the debtor agrees to give up if they can't make the required payments on the loan or purchase. Generally, a secured transaction involves:
Common secured transactions include a bank loaning a business money so the business can buy inventory, or a company selling a business equipment on credit. In these transactions, you'd have the following roles:
Most likely, the inventory or equipment will be at least part of the collateral. But the lender or selling company might require the business to offer something else as collateral.
Attachment of a security interest. Under the UCC, in order for a creditor to become a secured party—that is, a party with a legal right to take possession of the collateral if the debtor fails to pay—the creditor must take special steps (discussed below). These steps are known as "attachment of a security interest."
Perfecting a security interest. Moreover, in order for a secured party to more fully ensure its legal rights if other parties are asserting an interest in the same piece of collateral, the secured party must take additional steps (discussed later). These additional steps are known as "perfecting a security interest."
A creditor has a security interest in collateral—and becomes a secured party—if and when a security interest "attaches." Under the UCC, a security interest generally doesn't attach unless three basic requirements are met:
Let's briefly look at each of these requirements.
A secured transaction is a contract between the debtor and the secured party. Like most contracts, there must be an exchange of consideration between the parties. In other words, there must be an exchange of value.
In the case of secured transactions, the value given by the secured party is usually obvious. For example, a bank gives value to a debtor when it loans money to the debtor to buy inventory. Similarly, a seller gives value to a debtor when it sells the equipment to the debtor.
For the debtor's part, they give the secured party a security interest in the collateral.
A business might have rights in collateral either by:
Owning the collateral prior to the transaction. When a business already owns certain property, it should be clear that the business has rights in that property, and can use it as collateral. For example, if the business uses its real estate as collateral, it should have a corresponding deed. If the business wants to use its vehicle as collateral, it should have a bill of sale and title to the vehicle.
Purchasing the collateral as part of the transaction. In other cases, a business will buy items (materials, inventory, machinery, and so on) on credit and want to use those same items as collateral. In such cases, the business will sign a conditional sales contract—which is also considered a security agreement. Under UCC sales rules, the contract will give the business the necessary rights in the purchased items to use as collateral. (Note: The alternative option of having the "power to transfer" the collateral often involves relatively unusual circumstances and isn't covered here.)
For purposes of attachment, the debtor must "authenticate" a security agreement. In other words, the debtor must sign the written agreement that gives the secured party an interest in the collateral. (The UCC uses the term "authenticate" to include the possibility of electronic signatures.)
A security agreement normally will contain a clear statement that the debtor is granting the secured party a security interest in specified goods. The agreement also must provide a description of the collateral. Section 9-108 of the UCC says that, generally, a description of collateral is acceptable if the description reasonably identifies the collateral.
The same section then goes on to provide a half-dozen different possibilities for a reasonable identification, such as:
(U.C.C. § 9-108(b).)
While the description of collateral in a security agreement might not need to be finely detailed, the UCC prohibits descriptions of collateral that are "supergeneric," such as "all the debtor's assets" or "all the debtor's personal property."
The three requirements to attach a security interest apply to the most common types of collateral, such as equipment, inventory, and even payments due under a contract. However, for certain less common types of collateral, the requirements relating to an authenticated security agreement can vary.
A secured party perfects a security interest to help assure that no other party—such as another creditor or a bankruptcy trustee—will be able to claim the same collateral if the debtor becomes insolvent. By perfecting its security interest, a secured party seeks to gain priority over other parties regarding the collateral.
The precise details of how to perfect a security interest depend in part on the local jurisdiction where the collateral is located. However, generally speaking, the primary ways for a secured party to perfect a security interest are:
Of these four listed items, the first—filing a financing statement—is by far the most common and important to understand.
Security interests for most types of collateral are usually perfected by filing a document simply called a "financing statement." You'll usually file this form with the secretary of state or other public office. The purpose of the financing statement is to put other people on notice of the secured party's security interest in the collateral.
The UCC specifies what must be contained in a financing statement:
Name of the debtor. Regarding the first of these items, it's important that the name of the debtor be sufficiently specific and accurate because financing statements are filed under the debtor's name. If the name on the statement is wrong, the statement will fail to provide adequate notice to others, and will not succeed in perfecting the security interest.
Section 9-503 of the UCC provides various, more specific rules about how to specifically identify the debtor on a financing statement. For example, if the debtor is a "registered organization"—which might mean a state-registered corporation or limited liability company—then the name on the financing statement must match the name the debtor registers with the state.
Name of the secured party. The second required item on the statement, the name of the secured party, is generally a straightforward matter. Since the secured party is completing the form, there's less chance of error. If the secured party is an individual, they should use their legal name. If they're a registered company, the secured party should use the same name they have registered with their state.
Indication of the collateral. Finally, as to the third item, the rules for indication of collateral on the financing statement are largely the same as for the description of collateral on a security agreement (see above). However, unlike with a security agreement, on a financing statement, it is acceptable to use a "supergeneric" description of the collateral.
A standard form, known as Form UCC-1, is widely used by secured parties to file a financing statement. You can easily find a sample UCC-1 online—usually on your secretary of state's website. While many financing statements must be filed with the secretary of state, you should check your own state's laws for more information.
As a final point, be aware that a financing statement can be, and sometimes is, filed before a security interest has attached. Creditors file early in anticipation of creating a security interest to make sure that the interest is perfected immediately upon attachment.
As a secured party, you can perfect your security interest in some types of collateral by possessing it. The types of collateral where the security interest can be perfected by possession are:
However, so-called "intangible" collateral, such as accounts receivable, can't be perfected by possession. Possessing intangible collateral doesn't usually equate to possessing anything of value or that can be redeemed.
While "possession" isn't directly defined by the UCC in this context, it does appear to include possession not only by the secured party but also by an agent of the secured party.
Under the UCC, a secured party can perfect their security interest in certain collateral by controlling that collateral. The types of collateral that can be perfected by control include:
The meaning of "control" can vary depending on which type of collateral is involved. For example, a secured party might have control of a deposit account if the bank, the debtor, and the secured party have all agreed that the secured party can handle the funds in that account "without further consent by the debtor." (U.C.C. § 9-104.)
As another example, a secured party has control over investment property, such as securities (shares of stock or the like), if the property is delivered to the secured party, and, if necessary, endorsed (signed) to the secured party.
The most important type of security interest that's perfected immediately upon attachment is what's known as a "purchase-money security interest (PMSI) in consumer goods."
A PMSI generally involves either:
When the debtor in one of these circumstances is buying consumer goods—goods to be used for personal or household purposes—the secured party (seller or bank) doesn't need to file a financing statement to perfect the security interest.
Not all security interests in PMSIs are automatically perfected. Note that, while it might not be necessary to file a financing statement, not all security interests in PMSIs in consumer goods are perfected upon attachment. For example, some laws about certificates of title (such as for cars) require that a security interest be indicated on the certificate in order for the interest to be perfected.
Automatic perfection applies to other collateral. Finally, be aware that under the UCC, perfection occurs automatically upon attachment for about a dozen other relatively unusual types of collateral. For more information, check UCC Section 9-309.
Having covered the main ways to perfect a security interest, it's important to note that there could be situations where a secured party with a perfected security interest might not have priority. In that case, the secured party would have their interest subordinated (or come second) to some other party. However, in most cases, perfecting a security interest provides very substantial protection of that interest.
The world of secured transactions is a complex one. With so much terminology to learn and relationships to understand, it can be hard to keep everything straight. You can refer to our frequently asked questions for quick answers to common questions.
Yes and no. A security interest is a type of lien. A lien is a creditor's legal claim to a debtor's property. Liens can be voluntary or involuntary. A security interest is a voluntary lien. With a security interest, the debtor has agreed to give the creditor (or secured party) an interest in their collateral (their property). So the creditor has a lien against the collateral.
But a lien can be involuntary—and therefore, not a security interest. For example, if a business doesn't pay its federal taxes, the IRS can put a tax lien on the business's property without the business's consent. So, the IRS would have an interest in the business's property and the ability to act on this interest and take the property to satisfy the tax debt.
Liens and security interests are often used interchangeably. Usually, people refer to voluntary liens as security interests and involuntary liens—like judgments and tax liens—as liens. Also, liens are more commonly related to real property.
Security interests can be possessory and non-possessory. A possessory security interest is one where the secured party has possession of the collateral; a non-possessory security interest is one where the debtor has possession of the collateral.
Non-possessory security interests are much more common because the debtor usually already owns and continues to possess the collateral or purchases and comes to possess the collateral during the secured transaction. Moreover, the debtor doesn't get much benefit if they don't possess the collateral—particularly if the collateral includes inventory, vehicles, equipment, and real estate.
A security interest that hasn't been perfected is an unperfected security interest. A secured party has an unperfected security interest when they haven't satisfied one of the ways to perfect their security interest—including filing a financing statement, possessing or controlling the collateral, or qualifying for automatic perfection.
A perfected security interest is preferred to an unperfected security interest because perfecting a security interest gives the secured party more protection, namely, priority over other creditors.
When there are multiple interests in the same piece of collateral (such as other creditors having a security interest in the collateral), a perfected security interest will give that secured party priority over the other creditors who have unperfected security interests. So, a secured party with a perfected security interest can claim the collateral over a secured party with an unperfected security interest.
All states have adopted Article 9 of the UCC. However, states might use different wording in their laws or follow different precedent when applying these rules. You should always check your own state's commercial code for the most accurate information.
However, these state laws can get pretty dense and confusing. If you need help interpreting specific laws or need guidance on your specific situation, consider talking to a business attorney. They can advise you on your rights in the collateral, draft a security agreement, and help you perfect your security interest.