Properly securing your loan or credit advance: A secured transactions primer

Editor’s Note: Benjamin E. F. B. Waller is a member of the Financial Institutions and Litigation Sections and the Intellectual Property and Creditors’ Rights Practice Groups of Ward and Smith, P.A.

In exchange for lending money or extending credit, lenders will obtain from the borrower a promise to repay. If the borrower fails to repay the loan as promised, the lender can sue to enforce the promise. But what if the borrower simply doesn’t have the means to repay the loan? After all, the borrower probably would pay the loan if it had the money to do so. Most loans, therefore, are backed by some type of collateral, whether real property (i.e., land) or personal property (i.e., anything other than land such as computers, vehicles, or accounts receivable). In the event of a default on the promise to repay, the lender can exercise its rights in the collateral in addition to (or instead of) suing the borrower on the promise to repay. The collateral, therefore, provides a second remedy to the lender.

The Uniform Commercial Code

The Uniform Commercial Code (the "Code") is set forth in Chapter 25 of the North Carolina General Statutes. Article 9 of the Code concerns the creation and enforcement of security interests in personal property. (The creation and enforcement of security interests in real property encompasses an entire body of law itself and will not be discussed in this article.) Most, if not all, states have adopted some form of the Code.

How Are Security Interests Created?

In general, to acquire a security interest in collateral, you must obtain a written agreement signed by the owner of the collateral (the "Grantor") wherein the Grantor grants a security interest to you. This document is called a "security agreement." The security agreement must specifically identify the collateral. The security agreement may be included in the same document as the borrower’s promise to repay. However, the Grantor may or may not be the same as the borrower. You should satisfy yourself that the Grantor is in fact the owner of the collateral or otherwise has sufficient rights in the collateral to grant a valid security interest in it. The promise to repay (signed by the borrower) and the security agreement (signed by the Grantor) are separate and distinct obligations.

Is Your Security Interest Enforceable?

So now you have advanced money and obtained a security agreement. What if the Grantor previously granted a security interest in the same collateral to someone else? What if the Grantor subsequently grants a security interest to someone else? How can you determine and protect the priority of your security interest?

Unless your security agreement specifically provides otherwise, your security interest "attaches" to the collateral (i.e., the collateral becomes subject to the security interest) when it becomes enforceable against the Grantor. This generally happens when both the money is loaned (or credit is extended) and the security agreement is signed by the Grantor. Once the security interest attaches, you may exercise your rights in the collateral relative to the Grantor, but only upon the borrower’s default in the payment of the underlying debt.

Even so, enforceability against the Grantor does not mean you can enforce your rights in the collateral against anyone else (in most instances, another lender) who has a security interest in the same collateral. The priority of competing security interests in the same collateral depends on the order of "perfection" of the security interests. "Perfection" is the process by which third parties other than the lender, borrower, and Grantor are put on notice of the lender’s security interest in the collateral. Security interests in different types of collateral may be perfected in different ways. For example, a security interest in a car may be perfected only by having the lien noted on the certificate of title. Security interests in other types of collateral, such as certificated stocks, are perfected by the lender taking possession or control of the collateral (the stock certificate). Special rules also apply for perfecting security interests in intellectual property rights.

Most security interests, however, are perfected by filing what is called a "financing statement." In most states, including North Carolina, the financing statement is filed with the Secretary of State and becomes effective when it is filed in the required place(s). Some states, however, require filings with different or additional governmental entities.

To be effective, a financing statement must identify the Grantor and the lender, and must sufficiently describe the collateral. The financing statement cannot give you, as the lender, any greater rights in the collateral than what is granted to the lender by the security agreement. The financing statement serves only to perfect the security interest, not to define its scope.

The Grantor’s name must be accurately reflected on the financing statement. If the Grantor is a corporation or other registered organization, the financing statement must list the Grantor’s name exactly as it appears in the records of the North Carolina Secretary of State. If the Grantor is an individual, the individual’s full name should be listed, with particular attention given to proper spelling. In most states, financing statements are indexed under the name of the Grantor, and any errors in the Grantor’s name will cause the financing statement to be improperly indexed. If the financing statement is not indexed under the Grantor’s correct legal name, it may be deemed to not have been perfected because a third party would not find it in a search using the Grantor’s correct name, and, as result, you may lose the priority in your security interest. (The unperfected security interest which has attached is still valid as against the Grantor, but not against third parties who have properly perfected their interests.)

The records of the North Carolina Secretary of State may be searched online to determine if any financing statements have been filed against a Grantor. You should thoroughly search the Secretary of State records for financing statements before taking a security interest in collateral to ensure the priority of your security interest. You should file a financing statement as soon as possible to preserve the priority of your security interest.

For How Long Is a Financing Statement Effective?

A filed financing statement serves to perfect the underlying security interest for five years from the date of filing. This period may be extended for another five years by filing a "continuation statement" within six months before the expiration of the initial five-year period. A financing statement may be continued in this manner indefinitely by filing successive continuation statements until the underlying debt is paid in full. If a financing statement is permitted to lapse without filing a continuation statement, the financing statement ceases to be effective, and any security interest that previously was perfected by the financing statement becomes unperfected and loses its priority. Upon payment of the underlying debt in full, you should file a "termination statement" terminating the effectiveness of the financing statement.

What If the Borrower Defaults on the Loan?

If the borrower defaults on the underlying debt, you may enforce your security interest in the collateral and exercise your rights as provided in the security agreement and under Article 9 of the Code. Generally, you may take possession of the collateral from the Grantor if the Grantor surrenders the collateral or if such possession can be taken peacefully. Otherwise, you must sue to obtain possession. Once you obtain possession of the collateral, you may dispose of it in a commercially reasonable manner after proper notification to the Grantor and any other party entitled to notice. Following disposition of the collateral, the proceeds must be applied to the underlying debt, with any surplus being paid to the Grantor. If the proceeds from disposition of the collateral are insufficient to pay the balance on the debt, the borrower generally will remain liable for any such deficiency.

Conclusion

Companies that routinely make loans and extend credit should consider taking collateral to secure the repayment of the debt. If personal property is taken as collateral, these companies should understand the process for obtaining, perfecting, and enforcing their security interest in the collateral. This requires careful consideration of the terms of the security agreement and the financing statement, as numerous pitfalls await the unwary.

© 2008, Ward and Smith, P.A.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.