As a business owner, you probably need access to credit. Some of your best options for obtaining credit probably involve securing your debt with collateral. This approach could help you obtain a lower interest rate, or credit in the first place.
If a creditor has security interest in your property, it will likely be outlined in a security agreement. This important contract should not be entered into without careful consideration, as a default could lead to harsh consequences. Below, we explore the essentials of security agreements along with several details you may not have considered.
Secured transactions are vital to growing a business. Nearly all individuals and organizations need to take on debt at some point, but getting creditors onboard can be a struggle. Security interest provides reassurance to the creditor, who is then more likely to provide much-needed funding for a given debtor. Additionally, the debtor is more likely to obtain a low interest rate if some form of collateral is available to the creditor. Security agreements play a central role in this arrangement by outlining the terms under which debt can be secured, and what will happen if the debtor defaults.
Security interest is largely regulated via Article 9 of the Uniform Commercial Code (UCC). This legislation provides uniformity across the lending industry while alerting both debtors and creditors to their rights. Over the years, Article 9 has become one of the code's most important elements. It applies to all transactions that create security interest in personal property.
At a minimum, a valid security agreement consists of a description of the collateral, a statement of the intention of providing security interest, and signatures from all parties involved. Most security agreements, however, go beyond these basic requirements. Many include covenants (or obligations of the debtor) and warranties (guarantees). Examples of covenants or warranties could include the following:
Once the security agreement is created, it should be attached. To be deemed 'secured,' the agreement should be perfected. These terms are outlined in detail below. Additionally, the agreement should be authenticated, ideally before a notary or witness (or both).
As mentioned earlier, a security agreement cannot be deemed valid if collateral is not adequately described. Specifically, descriptions of collateral should not be overly broad or generic. An overly broad description might involve a blanket description or invoke 'all assets' owned by the debtor.
In general, descriptions of collateral should "reasonably [identify] what is described.” In the UCC, examples of a reasonable description include:
The UCC acknowledges that description by type is not sufficient for commercial tort claims, commodity accounts, security entitlements, or consumer transactions.
A variety of tangible and intangible goods can be used as collateral. These include the following goods:
Some security agreements include a middle ground of sorts: indispensable paper. Not exactly tangible or intangible, this involves any paper that is absolutely necessary for securing the value of tangible goods.
Floating liens may also appear in security agreements. This type of security interest may not be in the debtor's possession at the time of the security agreement's creation. A floating lien may involve after-acquired property, proceeds from the collateral's disposition, or future advances.
Attachment is a critical process for completing security agreements and obtaining security interest. Only upon fulfilling attachment requirements does the creditor become a secured party. To achieve attachment, the following obligations must be met:
A commonly confused term, 'perfect' in the context of a security agreement does not mean that the document is free from errors. Rather, a 'perfected' security agreement ensures that a secured party can claim promised collateral in the event that the debtor declares bankruptcy.
The process of perfection is not required by law, but it remains an important step for those with security interest. Without perfection, it is impossible for secured parties to truly feel confident that the debtor's collateral is safe from other creditors.
Several methods can be used to perfect a security interest. Most debtors and creditors file financing statements, but some pursue alternatives. The main options for perfecting a security interest are outlined below.
The typical approach to perfecting a security interest involves filing a financing statement. Sometimes confused with the security agreement itself, the financing statement provides notice of a party's security interest in a debtor. This document can alert third parties, but it cannot be used as substitute for the actual security agreement.
Rules for financing statements vary somewhat from one state to the next. In general, however, all parties involved must be identified in the document. Additionally, the financing statement should clearly identify collateral. These objectives can typically be fulfilled by completing Form UCC-1 with the Secretary of State in your region.
Financing statements are sometimes filed prior to the security interest attachment. Creditors often prefer this approach, as it can prevent a lag between attachment and perfection.
While most parties prefer to perfect a security interest via filing Form UCC-1, it is also possible to achieve perfection if the secured party possesses the collateral. The exception: possession does not apply to intangible property, such as accounts receivable. Because many debtors prefer to continue using or possessing collateral, this approach is not common.
If the debtor consents, the creditor may achieve perfection by taking control of the collateral. For example, the secured party may take over the debtor's bank account and handle funds therein, assuming the debtor and bank both agree. Control as a means of perfection often occurs with securities and other forms of investment property.
In select cases, perfection can be achieved the moment the security interest is attached. Typically, this occurs in conjunction with a purchase money security interest (PMSI) in which the debtor either purchases the item on credit from the secured party or the debtor receives a loan from the bank (which acts as the secured party) to purchase an item from a seller.
Often, a secured party's primary desire in filing a UCC-1 financing statement is to establish priority over other secured parties. Without a financing statement, perfection of a secured interest does not necessarily grant the perfected party priority over other third parties. If proper perfection is not achieved, the creditor may be given the status of 'unsecured creditor' in the event of bankruptcy.
Generally, priority is granted to the first secured party to successfully file a financing statement. After this, other parties could be referred to as the "second secured party" or "third secured party."
While priority can typically be achieved by filing a financing statement before other parties, exceptions exist. These include statutory liens, federal tax liens, and prior filings. Hence, even with perfection via financing statement, it is possible that competing claims could take priority.
Security agreements may outline the conditions under which a loan is considered in default. Typically, default occurs when the debtor fails to make agreed-upon payments on time. However, other conditions may also be instated, such as the following:
Article 9 of the UCC provides a variety of remedies for creditors attempting to recover losses from defaulted loans or other transactions, including the following:
Collection is one of the most common remedies for secured loan defaults. It applies to many forms of liquid assets (such as chattel paper and accounts receivable) and some intangible assets. This is an attractive solution for secured parties, as it allows for quick retrieval of owed funds.
When collecting on a defaulted loan, the secured party must behave in a 'commercially reasonable manner.' Essentially, this means that the secured party must offer the obligor notice of the collection.
Repossession can be a powerful option, as the mere threat of it may convince an otherwise negligent debtor to comply with the terms of the loan. Furthermore, repossession allows the secured party to recoup at least a portion of the value lost on the investment. However, repossession is typically only a temporary solution, as it may force the secured party to take on duties such as maintenance of the repossessed items. The debtor can redeem the repossessed property by repaying the loan or otherwise fulfilling obligations to the secured party.
Disposition typically involves the sale or lease of the property held as collateral. This frequently occurs via public auction but could also involve a private sale. As with collection, the secured party must provide notice of the intent to dispose of the collateral.
Because default is such a grave risk, debtors should be thoroughly aware of their obligations upon entering into security agreements.
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