A secured transaction is created when a buyer or borrower (debtor) grants a seller or lender (creditor or secured party) a security interest in personal property (collateral). A security interest allows a creditor to repossess and sell the collateral if a debtor fails to pay a secured debt.
A secured transaction involves a sale on credit or lending money where a creditor is unwilling to accept the promise of a debtor to pay an obligation without some sort of collateral. The creditor (the secured party) requires the debtor to secure the obligation with collateral so that if the debtor does not pay as promised, the creditor can take the collateral, sell it, and apply the proceeds against the unpaid obligation of the debtor.
A security interest is an interest in personal property or fixtures that secures payment or performance of an obligation. Personal property is basically anything that is not real property. A fixture is personal property that has become so attached or adapted to real estate that it has lost its character as personal property and is deemed to be part of the real estate. An example would be a central air conditioning unit within a commercial building.
CREATION OF A SECURITY INTEREST
A security interest is said to attach at the time it becomes enforceable. There are three prerequisites to the attachment of a security interest:
- There must a security agreement;
- Value must be given; and
- The debtor must have rights in the collateral (for example, he must own it or be leasing the collateral).
A security interest is not enforceable unless the collateral is in the possession of the secured party; or the debtor has signed a security agreement that contains a description of the collateral, value has been given, and the debtor has rights in the collateral.
The agreement of the creditor and the debtor that the creditor shall have a security interest in the goods must be evidenced by a written security agreement unless the creditor retains what is known as a possessory security interest by taking possession of the collateral.
To be enforceable, a written security agreement must be signed by the debtor and reasonably describe the collateral. For example, a security agreement describing collateral as “Furniture as per attached listing,” but with no listing attached fails to sufficiently describe the collateral and therefore is not an enforceable security agreement.
The first prerequisite to the attachment of a security interest is that there must be a security agreement. The next prerequisite is that there must be value given. The giving of value normally takes place when the secured party lends money to the debtor or the debtor agrees to repay the obligation. In order for a security interest to attach, the debtor must have rights in the collateral which generally means the debtor either owns the collateral or has rights to possess the collateral such as in a leasing arrangement.
PURCHASE MONEY SECURITY INTEREST
A purchase money security interest secures the unpaid price for collateral or a loan used to buy the collateral.
THE NATURE AND CLASSIFICATION OF COLLATERAL
The UCC divides personal property or goods into different classes: consumer goods, equipment, inventory, general intangibles, farm products and fixtures.
As far as tangible personal property is concerned, the goods are classified by the debtor’s intended use. For example, a television set in the hands of a manufacturer or a retailer would be classified as inventory. However, if it were in a person’s hands who intended to use it at home, it would be a consumer good.
Goods are consumer goods if they are used or bought primarily for personal, family, or household use. An example would be the family’s television set.
Goods are classified as equipment if they are used or bought primarily for use in a business. For example, the computers at an office would be equipment.
Goods are classified as inventory if they are held by the debtor primarily for sale or lease to others. An example would be a television set bought by someone who sells televisions and appliances for a living. Also, raw materials used in manufacturing such as steel used to manufacture cars would be classified as inventory. Materials consumed in a business such as typing paper would be inventory.
General intangibles would be something like a promissory note which you held as collateral with regard to money you lent to another person.
Goods are farm products if they are crops or livestock or supplies used in farming operations.
A fixture is personal property that has become so attached or adapted to real estate that it has lost its character as personal property and is deemed to be part of the real estate (e.g., a central air conditioning unit within a commercial building).
A debtor may grant a security interest to secure future loans. This involves granting a security interest in property a debtor may acquire later. The security interest attaches when the future credit is given or when a debtor gets the property. Inventory of a dealer changes rapidly, and therefore any bank or finance company is going to expressly provide that the security interest will bind after acquired property. In other words, the security agreement will provide that the goods acquired after the initial loan will also be covered by the security interest. This is called a floating lien.
A secured transaction automatically covers proceeds from the collateral unless this is expressly excluded in the agreement. Proceeds include cash, checks, and accounts receivable arising from the sale of collateral. It would also include insurance proceeds in case the collateral was damaged such as in a fire. In such a situation, the financing company holding the security interest would have rights to the insurance proceeds.
PERFECTION OF SECURED TRANSACTIONS
When a security interest in property is superior to other interests and claims to the property, it is said to be perfected. In other words, to secure protection against third parties’ claims to the collateral, the secured party must perfect the security interest. This is generally done by filing a financing statement in the proper governmental office. In many states, the proper governmental office in which to file UCC-1 Financing Statements (UCC-1) is the office of the state’s secretary of state.
PERFECTION BY CREDITOR’S POSSESSION
Loans may be secured by a pledge where the creditor takes possession of the collateral like shares of stock. Perfection of the security interest takes place upon taking possession. If the collateral is tangible personal property, the creditor has the alternative of perfecting the security interest by taking possession of the collateral or filing a UCC-For example, Adam borrowed $500.00 from Betty. He orally agreed that Betty should have a security interest in certain equipment that was in his backyard. There was nothing in writing, and no filing of any UCC-1 was made. Nine days later, Adam agreed that Betty should take possession of the equipment until he repaid the loan. Betty took possession of the equipment. What kind of interest did Betty have in the equipment? When Betty took possession of the collateral, she acquired a perfected security interest. The perfection dated from the time she took possession. The fact that possession was taken eliminated the need for a written security agreement. The taking of possession also gave her perfection without the necessity of filing a UCC-1. Therefore, the security interest of Betty became perfected at the moment Betty took possession of the collateral.
PERFECTION FOR CONSUMER GOODS
If the collateral is consumer goods, the creditor does not have to file a UCC-1 or take possession of the goods in order to perfect a purchase money security interest in the goods because this type of an interest is perfected as soon as it attaches (automatic perfection). A creditor who sells goods to a consumer on credit and retains a security interest has a purchase money security interest.
Smith sells a refrigerator to Bob on credit and obtains a proper security agreement so that the refrigerator may serve as collateral for the payment of the amount due. Does Smith have a perfected purchase money security interest? Smith does have a perfected purchase money security interest since credit was advanced to enable Bob to purchase the consumer goods.
In an ordinary credit sale of consumer goods, no filing of a UCC-1 is required in order to perfect the secured party’s interest. Consumer credit sales are treated differently from secured credit sales of inventory since, for most consumer transactions, the amount involved would not warrant the expense of preparing and filing a UCC-1. However, if no UCC-1 Financing Statement is filed, a resale by the consumer buyer to another consumer will destroy the seller’s security interest if the second purchaser does not have knowledge of the security interest of the seller. For example, a consumer buys a refrigerator under an installment contract and the appliance store retains a security interest in the refrigerator. The appliance store does not file a financing statement. The consumer later on sells the refrigerator to a neighbor who is unaware of the prior security interest. The neighbor will take free of the security interest of the appliance store. However, if the seller of consumer goods does file a financing statement, he has priority over a subsequent purchaser even if the purchaser does not have actual knowledge of the seller’s security interest.
PERFECTION FOR MOTOR VEHICLES In most States, a security interest in non-inventory collateral for which a certificate of title is issued (like a car) can be perfected only by having the lien stated on the certificate of title.
PERFECTION BY FILING A FINANCING STATEMENT
A financing statement is a different instrument from the security agreement. The financing statement must be signed by the debtor and give the address of the secured party. It also must give the address of the debtor and contain a statement indicating the kinds or describing the items of collateral. A security agreement may be filed as a financing statement if it contains the information necessary for a financing statement.
The financing statement does not set forth the terms of the agreement between the parties. This is done in the security agreement. The financing statement gives notice to the world that the secured creditor has a security interest in the collateral described in the statement.
Filing of the financing statement is usually required to perfect the creditor’s interest in inventory or the proceeds. An exception is made when a statute requires the security interest to be designated on the title certificate issued for the property – e.g., title certificate of an automobile. A security interest in a car that is inventory (e.g., held for sale by Acme Chevrolet) is perfected by filing under the UCC. However, a privately-owned car is generally protected by a notation on the title certificate.
Place of Filing
The UCC gives each State the option to describe where financing statements will be filed. Local filing would be in the county of residence or place of business of the debtor. Central filing would be a principal office in the State Capitol. Dual filing would be a combination of both local and central filing. Dual filing would mean that the financing statement must be filed both at the secretary of state’s office and at the office in the county where real property records are kept. The place of filing sometimes depends upon the type of collateral (equipment, inventory, farm products) and whether or not the debtor has more than one place of business in the State.
Defective Filing
If the filing of the UCC-1 is defective because the information in the statement is seriously misleading or filing is made in the wrong county or office, the filing fails to perfect the security interest. This means that other creditors who have liens on the collateral may have a right to the collateral that is superior to that of the secured creditor. A Trustee in Bankruptcy also may have a right superior to the original secured creditor if the filing is defective.
LOSS OF PERFECTION
Perfection by possession is lost if a creditor returns the collateral to the debtor. Regarding consumer goods, perfection may be lost by resale of the goods by the consumer to another consumer if the buyer purchases the goods without knowledge of the perfection.
The filing of a financing statement is effective for five years. At the conclusion of five years, the perfection of the security interest terminates unless a continuation statement has been filed. The continuation statement is merely a statement by the secured party that identifies the original financing statement by its file number and declares that it is still effective. The state’s secretary of state’s office generally approves pre-printed forms.
In most cases, perfection is lost if collateral is removed to another state unless a creditor files a financing statement in the new state within four months after removal. Regarding motor vehicles, perfection is lost if a new title is issued and the lien is not stated on the title.
TERMINATION STATEMENT
Once the debt has been paid, the debtor has the right to require the creditor or the creditor’s assignee to send the debtor a termination statement which states that the security interest is no longer claimed under a specified financing statement. The debtor then may present this statement to the filing officer who marks his record that the financing statement is terminated.
SECURED PARTY VS. UNSECURED PARTY
If there are two security interests, one perfected and one not perfected, the perfected security interests prevails, i.e., is able to seize the collateral subject to the security interest and sell it to recover the amount due on the secured loan or secured sale.
PERFECTED SECURED PARTY VS. PERFECTED SECURED PARTY
If you have two perfected security interests, the first to be perfected (e.g. filed) prevails. A perfected purchase money security interest in inventory prevails over other creditors (even prior perfected liens) if the purchase money security interest is perfected before a debtor receives the collateral and notice is given to prior secured parties before the debtor receives possession of the goods. For example, suppose a bank has a perfected lien on the inventory of a pet store. If a supplier sells reptiles to the store on credit, taking a security interest on the reptiles, the supplier’s security interest would have priority if the supplier files his financing statement before the store gets the reptiles and notifies the bank of the security interest before the store receives the reptiles.
If the collateral is not inventory (such as equipment), the purchase money secured creditor will prevail if a financing statement is filed within ten days after the debtor takes possession of the collateral. For example, Tenth National Bank (TNB) makes a loan to Smith and files a financing statement covering all of Smith’s copying equipment, including after-acquired equipment. Later, XYZ Copiers, Inc, sells a copier to Smith on a retail installment contract and takes a security interest in the copier. XYZ Copiers’ security interest is superior to TNB’s security interest as long as Copiers files its financing statement within ten days of Smith’s receipt of the copier.
SECURED PARTY VS. BUYER OF COLLATERAL FROM DEBTOR
What if the debtor sells collateral which is subject to a security interest? If the security interest is not perfected and the buyer takes title without knowledge of the security interest, the buyer takes free of the security interest. If the security interest was perfected, the buyer takes title subject to the security interest unless the goods being sold is inventory. Purchase of inventory by a buyer in the ordinary course of business destroys the security interest, and the buyer takes free of any security interest.
RIGHTS OF PARTIES AFTER DEFAULT
When a debtor defaults on an obligation in a secured transaction, the secured party has certain rights under UCC with respect to enforcing his claim against the collateral. These rights can be specified by the security agreement itself. The UCC also provides for procedures that the secured party can follow in the event the security agreement does not itself provide for all necessary procedures.
In the event of default, the secured party is entitled to take the collateral from the debtor. Self-help repossession is when the secured party simply goes and takes the collateral himself. This is allowed if it can be done without causing a breach of the peace. In other words, if the debtor will allow the secured party to take the collateral without the debtor causing any trouble, self-help repossession is lawful. If taking the collateral cannot be done without causing a breach of the peace, the secured party must use court action. The secured party must go to court and get the court to order the collateral to be seized and sold pursuant to the security agreement and the UCC.
The secured party may sell the collateral at either a private sale or a public sale providing this is done in a commercially reasonable manner. Notice of the sale of the collateral has to be given, and the debtor has the right to redeem the collateral prior to its sale. Proceeds from the sale of collateral are applied first to the expenses incurred by the secured party in seizing the collateral and making the sale. Next, the proceeds are used to pay the outstanding indebtedness. Next, the proceeds are used to pay any indebtedness owed to any other secured party. Finally, if there is any money left, it is to be paid to the debtor.
