A lender’s checklist for debt collection

Lenders frequently seek collateral from their borrowers to increase the probability of repayment. In a secured transaction, a lender has the ability to dispose of a borrower’s (debtor’s) assets to satisfy a secured obligation. A security interest is created only when proper steps are taken. A security interest in a debtor’s assets is created upon “attachment.” If a security interest in collateral is properly attached, the collateral can be used to repay the debt. But what happens if the debtor subsequently sells the collateral to a different party — or if another creditor subsequently claims a security interest in the same collateral?

To ensure that no other parties, such as other creditors or even a bankruptcy trustee, in the case of insolvency of the debtor, can lay claim to the collateral, the lender’s security interest must also be “perfected.”

The steps for attaching and perfecting security interests can be complicated, but must be followed precisely. Here are some to consider.

Attachment is the first step in creating a security interest. Once a security interest has attached, it is enforceable against the debtor. A security interest attaches when: 1) value has been given by the secured party; 2) the debtor has rights in the collateral; and 3) the secured party has been granted a security interest in the collateral.

A secured party can give value in many ways. The value given by a secured party is usually obvious. For example, a lender gives value to a debtor when it loans money to the debtor in connection with a security agreement. A business seller may give value to a business purchaser by transferring title to the business assets in exchange for a security interest in those assets to secure repayment of a carry back promissory note.

A security interest may only attach to collateral in which the debtor has rights. The debtor’s rights may be created by owning the property prior to the secured transaction or by purchasing the collateral as part of the secured transaction, such as where a loan is obtained to purchase items that will serve as the collateral. However, a security interest will not attach if the debtor has no right to the collateral to be secured.

There is no particular form required for a security agreement. Similarly, no specific language need be used in a security agreement. However, language expressing that the debtor intends to grant a security interest to the secured party is mandatory. For example, language such as “the debtor hereby grants and conveys a security interest in the following collateral to the secured party” is sufficient grant language. Without these “magic words,” a security interest may be ineffective.

In addition to the express grant of a security interest, the security agreement must be “authenticated” (signed) by the debtor, and the agreement must describe the collateral. A reasonable description of the collateral is all that is required, but generic descriptions such as “all assets” or “all personal property” are overly broad and unacceptable. Attorneys will typically identify collateral by listing the applicable defined classes of collateral described in the Uniform Commercial Code.

When a security interest has attached, the lender has a claim to the collateral as to the debtor.

However to state a priority claim to the collateral over third parties, the security interest must also be perfected. A perfected security interest gives a lender priority over other parties regarding the collateral. For example, a lender with a perfected security interest has a superior interest over subsequent judgment creditors or bankruptcy trustees.

There are several ways to perfect a security interest. The two most common methods are perfection by filing, and perfection by possession. It should be noted, however, that in many cases, a security interest in particular collateral can only be perfected in one way – you should consult your attorney.

The most common method of perfection is by filing a financing statement, frequently referred to as a UCC-1. A financing statement must include: 1.) the name and address of the debtor, or the owner of the collateral if different from the debtor; 2.) the debtor’s signature; 3.) the name and address of the secured party; and 4.) a description of the collateral.

UCC-1 forms are widely available from the local UCC filing office (in Nevada that is typically the Secretary of State’s office).

Where to file can be tricky. Security interests in an individual’s assets are generally perfected by filing in the state of the debtor’s residence, while security interests in an entity’s assets are generally perfected by filing in the jurisdiction of the debtor’s organization.

So even though a corporation may do business in Nevada, if it was formed elsewhere, the secured party may need to file in another state to perfect.

As an alternative to perfection by filing, a secured party may perfect by possession. For example, if a loan is made and secured by certain farming equipment, and the lender and debtor agree that the lender may take possession of the equipment until repayment of the loan, the lender has a perfected security interest as of the time he/she takes possession of the farm equipment. In the example given here, no financing statement need be filed. However, perfection by possession is lost if the lender returns the secured collateral to the debtor.

As a lender, you may feel that you have adequately preserved the ability to recover payment from the debtor. However, troubles arise when third parties claim an interest in collateral, or when the debtor becomes insolvent and enters bankruptcy.

Perfecting a security interest puts the rest of the world on notice that you have a security interest in the collateral at issue. As a result, you have priority over unsecured creditors and subsequent lien creditors. If your security interest remains unperfected, you are running the risk that another creditor, even one with a claim arising later in time than yours, may be able to claim a superior interest in your collateral.

Joshua Woodbury is an associate with Woodburn and Wedge. He practices primarily in the areas of civil litigation and employment law.