When one party (the “creditor”) lends money to another party (the “debtor”), the creditor often wants to receive collateral (a lien on something of value) at the same time the loan is made. If the debtor fails to repay the creditor or otherwise fails to comply with the terms of the loan, the creditor can then take the collateral from the debtor, sell it, and use the proceeds from the sale to satisfy the loan. The creditor’s interest in the collateral is called a “security interest”. If the collateral is personal property and not real estate, the rights of the creditor and obligations of the debtor are governed by Article 9 of the Uniform Commercial Code (“UCC”). If the collateral is real estate, the UCC does not govern; rather the security interest is referred to as a mortgage and is governed by each state’s mortgage foreclosure laws. The remainder of this article focuses on the rules addressing security interests in “personal property,” essentially all property other than real estate.
What Types of Collateral Can Be Secured?
A security interest can be given in almost any type of property in order to secure a loan. The most common types of collateral for businesses are inventory (goods held for sale and/or any goods consumed by the business, such as the wheat used by a baker to make bread), equipment (tangible goods owned by the business that are not inventory), accounts receivable, and deposit accounts (such as a company’s bank account). A security interest can not only be given in a company’s current assets, but also in any of the company’s future assets; such as accounts receivable created in the future. A security interest can also be given in any “proceed”; meaning any property received in exchange for the sale of the secured property. For example, if a creditor of a furniture store has a security interest in the furniture and proceeds, then the creditor has a right to collect the money from the sale of the furniture.
How to Create an Enforceable Security Interest
The creation of a valid security interest is called “attachment.” When a valid security interest is created, the creditor’s interest is said to have “attached.” A creditor whose security interest has not attached has no interest in the collateral. In order for a security interest to “attach,” three requirements must be satisfied:
- Both parties must agree for the creditor to receive a security interest. An agreement can be demonstrated in several ways. Two common methods of demonstrating such an agreement include (1) the creditor taking possession of the collateral and (2) the debtor signing an agreement, known as a “Security Agreement”, which adequately describes the collateral. The description of the collateral in a security agreement can be specific. For example by stating “Mazak Mulitplex Two Spindle, Dual Turret CNC Turning Center with Bar Loader, Manufacturer’s Serial Number 96-1234”. The description can be general, such as “all equipment.” However, the description cannot be so general that it fails to describe the property, such as “all of the debtor’s assets.”
- The creditor must give value. Most often value is given in the form of a loan. A creditor who has already lent money without taking collateral and now seeks to attach collateral to secure the loan is considered to have satisfied this requirement.
- The debtor must have rights in the collateral. This requirement is satisfied if the debtor is the owner of the collateral.
Consequences of Attachment of a Security Interest
Once a security interest attaches, if the debtor defaults on the debt, the creditor has the right to take the collateral from the debtor and sell it in accordance with the rules detailed in Article 9 of the UCC. However, attachment of a security interest does NOT give the creditor any rights against other creditors with validly attached security interests. In fact, a debtor can use the same collateral as security for as many loans as creditors will allow. For a creditor to be certain that its security interest in the collateral is superior to subsequent secured interests in the same collateral, the creditor must “perfect” its security interest. For information on how a creditor can perfect a security interest, see the article in this series entitled Perfecting a Security Interest.
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