Legal Insight: Security Agreements
One of the most important aspects of commerce is getting paid—promptly and in full. Security agreements are under-utilized devices that sellers can use to enforce their rights if buyers default on their obligations. (To clarify, here “security” refers to collateral, not stock or protection.)
Obviously, parties expect payment when they sell personal property, such as inventory or equipment. If they receive immediate, full payment, their concerns with regard to payment are over. Oftentimes, buyers pay a portion of the price upfront and the balance in installments. When sellers extend financing, customers become debtors. The buyer may sign a promissory note or credit agreement. When a small company buys an item, the seller may require an individual to sign a personal guarantee in case the company defaults. Still, the creditor is unsecured. If the debtor declares bankruptcy, an unsecured creditor may end up with little or nothing. Secured creditors are protected.
Security interests are governed by Article 9 of the Uniform Commercial Code (UCC). Every U.S. state has adopted it as law. A debtor uses a security agreement to give a secured party an interest in collateral. Article 9 covers using goods and intangible property as collateral. Real estate interests are governed by different laws. If (1) there is a security agreement, (2) the secured party gives value, and (3) the debtor has the power to transfer the collateral, a security interest “attaches” to the property and the proceeds if the collateral is sold, transferred, or an insurer pays a claim for its loss.
The secured creditor must “perfect” its security interest in order to assert priority over most third parties, including junior secured creditors, unsecured creditors, and a bankruptcy trustee. Usually, the secured party must file a financing statement that identifies the debtor, secured party, and collateral. The financing statement is filed in the state where the property is located. Usually, they are filed with the state’s Secretary of State. (Security agreements are signed, but not filed, by the debtor. Financing statements are filed, but not signed, by the secured party.)
There is a complex set of rules governing priority among multiple secured creditors. To obtain the highest priority possible, secured parties should perfect their interest as soon as possible. In fact, a secured party can pre-file before it extends credit, even though the security interest won’t attach until the three steps above are satisfied.
Financing statements are part of the public record. If a party decides to buy a large asset (for example, a purchase from someone other than a manufacturer or retailer of that equipment), buyer’s counsel should conduct a UCC search to see if there is a lien on the property. A financing statement would alert the prospective buyer to investigate further. It is possible the lien was satisfied. Before buying an asset, however, a buyer should make sure that it will receive clean title.
The tremendous power of a security agreement becomes clear when a debtor defaults. Upon default, the secured party can foreclose upon and repossess the collateral without going to court. Of course, the secured party can choose to work with the debtor. When owed money though, a creditor should prefer the option to be generous and fair-minded rather than being forced to depend on the integrity and promptness of a distressed debtor who may become hostile.
The secured party can require the debtor to make the collateral available in a convenient place for repossession. If the debtor doesn’t surrender it, the secured party has a right to self-help so long as it doesn’t “breach the peace.” Essentially, the creditor cannot break in or use violence. If self-help fails, the secured party must go to court, which involves some cost. If the security interest is valid and perfected, the secured party should prevail. After repossession, the secured party can sell the collateral in a commercially reasonable sale and apply the cash proceeds to the outstanding debt and fees incurred. Then, it must pay the surplus to junior creditors or the debtor if anything remains.
Security interests can be used for a variety of transactions, albeit the process described above may be worthwhile only with regard to relatively valuable transactions. Nevertheless, when default occurs, security interests make all the difference.
Editor’s note: This column does not constitute legal advice.
Bryan L. Berson, Esq. is an attorney and mediator at The Berson Firm, P.C., a commercial and civil law firm specializing in business law, real estate, mediation and litigation. His e-mail is email@example.com. Connect with The Berson Firm on Facebook and Bryan on LinkedIn.