Security Interests

Loans are part of many businesses, and business leaders try to make sure that any loans they make are paid back in full. A secured transaction is one in which a debtor puts up their personal property, usually through a security agreement, to guarantee that they will pay a debt to a creditor. In contrast, in an unsecured transaction, the debtor promises to pay but does not offer any collateral, property used to secure a loan with the understanding that its owner will forfeit it in the event of default, as backing for the loan. Article 9 of the Uniform Commercial Code (UCC), which is a group of uniform laws that regulate business and commercial transactions, governs secured transactions in almost every jurisdiction of the United States.

A security agreement is a contract that shows intent to provide a security interest to the lender, discusses the rights between parties, shows that there is an agreement between the parties, defines default, and explains how the secured party will collect. In other words, the security agreement protects the lender's interest by allowing the lender to take and sell some of the borrower's property if the borrower stops making payments. This significantly reduces the lender's risk. The collateral used to create a secured transaction must be personal property and not real property. Real property refers to land and everything attached to it, such as buildings, crops, and mineral rights. All property that is not real property is personal property, whether it is tangible or intangible. Tangible property is personal property that can be touched and moved, such as books, furniture, and computers. Intangible property is personal property that does not have a physical form but is usually represented by a written document. Stocks, bonds, trademarks, and patents are all examples of intangible property. A semi-intangible, also called a quasi-good, is an intangible right of the debtor that is embodied in a tangible form. This means that the underlying asset owned by the debtor is intangible but can be represented in some tangible form, usually by a formal document, such as investment properties or letters of credit rights. Creditors have rights in the event a debtor uses the same collateral to back many loans that they now cannot pay. Secured creditors have rights to specific properties that the debtor put up as collateral. To give the creditor the right to collect that collateral, the security interest must attach in accordance with Article 9. Attachment occurs when:

1. the creditor gives something of value in exchange for the security interest

2. the debtor actually owns the collateral and has the legal right to transfer it to someone else

3. the debtor either signs the security agreement or hands over the collateral

Attachment is important for creditors because it provides them with an enforceable security interest, meaning that if the debtor does not pay, the lender can use the collateral to recoup any loss. For example, Ben goes to First Bank in hopes of obtaining a personal loan to fund a family vacation. Ben offers the title to his car as collateral for the loan. Ben proves that he owns the car free of any claim and that he has the right to transfer the ownership. First Bank and Ben set forth the terms of their agreement in writing, and Ben hands over the title to his vehicle to First Bank. First Bank's security interest attached because Ben (1) gave his vehicle, something of value, in exchange for the loan; (2) owns the vehicle and has the legal right to transfer the vehicle to someone else; and (3) gave First Bank the title to the vehicle. This means that First Bank now has an enforceable security interest against Ben if he fails to satisfy the loan requirements. However, to ensure that First Bank has priority in the event that Ben becomes insolvent, First Bank should ensure that its security interest is perfected to prevent claims of higher-priority security interests in the vehicle title from other creditors. Perfection ensures that no other party, including another creditor or bankruptcy trustee, may claim the collateral if the debtor loses all their money. A trustee is given control of administration of property with the legal obligation to use it solely for the intended purpose. A bankruptcy trustee is specifically appointed to represent a debtor's estate in the bankruptcy proceeding. A creditor can achieve perfection by filing a financing statement in the required public office, by actually possessing the collateral, by controlling the collateral, or by having a financial document called a purchase-money security interest.

A purchase-money security interest (PMSI) creates a security interest even if the parties do not sign a security agreement. A PMSI is created when a debtor receives credit from the creditor to buy goods and those goods serve as collateral to protect the creditor's interest. Article 9 of the UCC defines a purchase-money collateral as "goods or software that secures a purchase-money obligation incurred with respect to that collateral." Article 9 defines goods as items such as consumer goods, crops, fixtures, equipment, inventory, and livestock. Therefore, stocks, bonds, client lists, copyrights, or trademarks cannot be collateral for a PMSI, as they are not classified as either goods or software. Article 9 provides specific requirements to create a PMSI. First, the secured party must give new value, which means an old debt cannot satisfy this requirement. Second, the new value must allow the debtor to buy goods or software. Article 9 defines goods as "all things that are moveable when a security interest attaches." Creditors usually satisfy the second requirement by paying the vendor of the goods directly rather than giving the money to the debtor to pay the vendor. If the debtor defaults, then the creditor has the right to repossess the goods.

In business it is common for a PMSI to be created in inventory and equipment. However, different rules apply. For example, a creditor may take a security interest in the goods part of an inventory that are being sold to another party. This is common when the bank loans a company money to purchase goods (inventory) that the company then sells to the public. In this case Article 9 has two main requirements for this security interest to create a PMSI. First, the security interest must be perfected at the time the debtor receives the goods. Second, the filer of the security agreement must provide a detailed written notice to any other creditors that have an interest in the debtor's inventory at least five days before the debtor receives the goods. In contrast, when the creditor takes a security interest in noninventory collateral, such as equipment, the creditor does not have to notify other parties. A PMSI in consumer goods perfects automatically, without the need to file any documents.

For example, suppose First Bank took possession of the title of Ben's vehicle; as a result, its security interest automatically perfected when it attached. This is because perfection can be achieved by actually possessing the collateral that is subject to the loan in question. Even though the actual collateral is Ben's vehicle, the title of his vehicle has the same effect because it would be impractical for Ben to physically give First Bank his vehicle. On the other hand, assume First Bank did not take physical possession of the title to Ben's vehicle. First Bank could achieve perfection by filing a financing statement, usually with the applicable secretary of state's office. In this instance, First Bank is not in physical possession of anything that would put other creditors on notice that it has a security interest in Ben's vehicle. However, other creditors are put on notice with the filing of the financing statement.