Secured transactions arise in everyday dealings, such as mortgage and car loans, and also in sophisticated commercial instruments. It is of paramount importance for creditors or debtors to understand their rights when entering into a security agreement.
What is a Security Interest?
A security interest is a creditor’s contractual right to property or assets to satisfy or secure a debt obligation. Article 9 of the Uniform Commercial Code (“UCC”) governs secured transactions.
Under the UCC, creditors can get security interests in: personal property; fixtures; accounts; chattel paper; payment intangibles; promissory notes; leases (including an option to buy a leased good, also called a Purchase Money Security Interest).
What is a Purchase Money Security Interest?
Purchase Money Security Interests are also called “conditional sales.” These are usually point of sale financing in which the seller finances the purchase and the buyer repays the financing in installments. If the buyer defaults, the seller repossesses the property. Title transfers to the buyer after full payment under the agreement. A purchase money security interest requires the seller not to charge a fee for exercising a purchase option unless it is nominal, i.e. a “no-brainer” cost.
If a secured creditor/lessor overcharges the debtor for the purchase option, the creditor may lose their security interest in the transaction. Overcharging may cause the purchase money security interest to convert into a lease transaction. Overcharging in this context is charging a price equal or greater than “the reasonably predictable fair market value of the goods at the time the option is to be performed.” UCC 1-203. However, in practice, anything more than “nominal” or “no-brainer” charge might put the security interest at risk. For example, a couch layaway transaction for a $300 couch could be a purchase money security interest for the financing creditor. However, if the creditor charged a $300 stocking fee in the purchase option, this would eliminate the creditor’s security interest. A normal stocking fee would preserve the interest. Creditors would be wise to consult with counsel to protect security interests in Purchase Money Security Interest transactions.
How do I create an enforceable security interest?
An enforceable security interest “attaches” to collateral, i.e. the collateral becomes at risk on a debt. This occurs when a creditor can take rights in collateral if a debtor defaults on repayment. If an agreement postpones the time of attachment, the security interest is not enforceable. Usually a security interest attaches when a debtor and creditor enter into a security agreement. Sometimes a creditor’s rights are not fully enforceable against other creditors unless it files a UCC financing statement (called “perfecting” its interest in the security).
Creditors must meet certain conditions for a security interest to be valid. First, a secured creditor must give value to a debtor. Second, a debtor must actually have rights in the collateral or the power to transfer rights in the collateral. Without this, the debtor can’t legally transfer rights to the secured creditor. Third, the debtor should “authenticate” a security agreement (e.g. by signing it) that describes the collateral or gives the secured creditor control over relevant collateral (for example deposit account funds, electronic chattel paper, investment property, letters of credit rights, and the like). If there is no security agreement, the secured party should actually take possession of the collateral. In the case of securities represented by certificates or registration documents (such as certificates of shares) the creditor can take possession of the relevant documents.
Creditors should consider risks in negotiating security interests. It is important that creditors describe collateral specifically enough to identify it. The phrase “all of the debtor’s assets,” for example, is too general (also called “supergeneral”) and this would not create a valid and enforceable security interest. It is also important for creditors to verify a debtor’s rights in the collateral or power to convey the security interests. Creditors should engage knowledgeable counsel to help ensure they obtain valid and enforceable interests in secured transactions.
Likewise, debtors may have potential arguments to invalidate asserted security agreements or interests, such as lack of specificity or lack of capacity to convey. Competent counsel can advise debtors regarding the enforceability of security interests.
How can I perfect my security interest?
“Perfection” of a security interest occurs when a security interest attaches to collateral (or is enforceable against collateral) AND the creditor meets requirements of UCC 9-310.
The most common way to perfect a security interest is to file a UCC financing statement. Some security interests can be perfected without a financing statement. These include interests perfected under UCC 9-308, 9-309, 9-311, 9-312, and 9-313. Examples of these include deposit accounts, chattel paper, documents and goods covered by documents, instruments (such as stand by letters of credit), investment properties; and letter of credit rights, purchase money security interests, sales of single accounts, sales of promissory notes, certain properties subject to statutes and regulations, goods subject to bailment, certificated securities, money, and property covered by title (such as cars and boats, etc.). You should consult with counsel regarding the appropriate method of perfecting any security interest.
How does a creditor get “priority” over other creditors in enforcing a security interests?
Sometimes multiple creditors have legal interests or rights in the same secured collateral. If a debtor sells, exchanges, leases, licenses, or otherwise disposes of collateral on account of one creditor, other creditors may continue to have rights or interests. These rights can be in the collateral or any money or value the debtor receives from the transaction. This means that creditors can have “priority” which is the term for when one creditor’s interests are paid before another’s. Secured creditors have priority based on when they perfect their security interest. Often this is determined by looking at when creditors filed UCC financing statements. A perfected security interest has priority over an unperfected interest. Moreover, purchase money security interests take priority over all competing interests if the creditor files a financing statement no later than twenty (20) days after the debtor receives the collateral. Therefore, creditors should perfect their interests to ensure priority over potential third party creditors.
A purchaser who buys collateral with attached security interests can sometimes purchase the collateral free and clear of liens, i.e. erasing the secured creditor’s rights. For example, a buyer who does not know about the security interests at the time of purchase can purchase free and clear of liens if those interests are unperfected. Therefore, a creditor with an unperfected interest risks losing the unperfected security interest to a good faith buyer of the collateral. Also, purchasers who buy property in the ordinary course of business (like a retail purchase) can purchase free and clear of liens even if they know about a perfected security interest. For example, a chainsaw purchased from a hardware store cannot be repossessed by a secured creditor of the store. On the other hand, a non-retail item, like a back-office computer used for hardware store accounting, could be repossessed by a secured creditor of the hardware store from the buyer.
What happens to a security interest if a debtor sells secured collateral?
When a debtor sells secured collateral, the creditor’s security interest in the collateral attaches to the proceeds, i.e. the money the debtor receives. If the creditor perfected its interest in the collateral, the perfected interest in the proceeds generally becomes unperfected after twenty (20) days (i.e. on the twenty-first day) unless it would be expected to continue (for example in the proceeds of sold inventory). If the proceeds are cash, creditors can avoid losing perfected status by ensuring that the cash proceeds are “identifiable” (e.g. checks and deposit accounts). If the proceeds are collateral, where possible, creditors should perfect the interest in the new collateral with a financing statement or by another applicable method.
How should I legally enforce a security interest?
Creditors enforce their security interest when debtors default on the security agreement. The UCC does not define “default.” Usually the security agreement defines what is a default in a given transaction.
If a debtor defaults, a creditor can take possession of the collateral covered by the defaulted security agreement, so long as it does so without “breaching the peace.” For example, when authorized, a creditor could tow a car from the debtor’s driveway, but the creditor likely cannot break into the debtor’s garage to take the car.
Creditors are at risk of litigation if they do not dispose of or sell collateral in a “commercially reasonable” way. This is a frequent source of debtor-creditor litigation. A best practice for creditors is to notify interested parties before selling or disposing of collateral. Litigation can occur if the sale price of the collateral is less than the debt, as debtor may still owe the creditor for the difference after the sale. Conversely, where the sale results in a surplus, creditors must remit the excess to the debtor. Laws on this vary from state to state, or type of asset, and creditors and debtors should consult counsel to advise on these issues.
In litigation over disposal of collateral, debtors have the initial burden of proof of showing that a creditor did not dispose of the property in a commercially reasonable manner. “In hindsight” arguments that a creditor theoretically could have gotten more money generally will not satisfy this burden. Courts only investigate whether at the time the creditor’s sale or disposition was commercially reasonable.
A debtor who successfully sues a creditor for commercially unreasonable disposition of collateral may be eligible for statutory damages under the UCC. In actions involving consumer goods, a debtor may recover a ten percent (10%) service charge and ten percent (10%) of the amount the creditor received. Statutory damages are meant to deter creditors from taking advantage of insolvent debtors and may result in debtors receiving more than their actual loss. Debtors and creditors should note that agreements by debtors to waive their statutory damage rights are unenforceable under the UCC.
Secured transactions range from the simple to the very complex. Legal issues may arise when debtors and creditors enter into secured contracts, when creditors obtain security interests, in the perfection of interests, sale of collateral or post-sale litigation. Debtors and creditors should consult competent counsel regarding their rights and obligations as to these secured transaction issues.
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