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Understanding Contracts: How do Security Interests work?

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Contracts are at the heart of business. At their simplest, contracts are the formalized agreement between two (or more) parties spelling out what each party is required to do and what benefit they’re expecting to get in return. But what happens when one party doesn’t — or can’t — hold up their end of the contract? The remedy a party has usually depends on what kind of contract is at issue and what remedies the contract allows for. (See: The Most Common Lawsuits Filed Against Small Business Owners: Breach of Contract)

One common form of contract is a loan agreement. The typical American adult enters into dozens of loan agreements in their lifetime, often without realizing it. A lender will lend money to a borrower in exchange for repayment of that money together with some rate of interest. The borrower will be expected to make regular payments until the debt is paid in full. Mortgages, car loans, credit cards, and merchant financing are all common forms of debt backed by loan agreements.

Loans can take two different forms — secured and unsecured. A secured loan is a loan that is backed by property, typically owned by the debtor, that the lender can repossess if the debtor fails to pay. When you receive a loan to buy your home, that is a common example of a secured loan because, if you fail to pay, the lender can repossess the home and sell it to pay off (or at least pay down) the debt. The same is true of car loans. Unsecured loans are just as the name suggests — they’re loans that aren’t backed by any property. If the borrower defaults, the lender has no specific property it can repossess.

How do I secure a loan?

Many people think that securing a loan just involves saying it in the contract — for example, by saying something like “Debtor pledges his home as collateral to secure the loan”. As is the case with all other contract-related issues, the process isn’t nearly that simple. You may have heard of the “Uniform Commercial Code”, often shortened to the “UCC” — a legal framework written to provide some uniformity to contract law. One of the many things the UCC does is prescribe how a creditor can secure its interest in property put up as collateral by a debtor and how it can perfect that security interest — meaning no other lenders or creditors can take a higher priority competing security interest in the property. Once a security interest is perfected, other creditors may also take a security interest in the same property, but their interest would be subordinate to the perfected interest. A common example of this is a second mortgage on a home. If the debtor defaults on that second mortgage, the lender could repossess and sell the house — but the primary mortgage lender would need to be paid first before the second mortgage holder would recover anything.

Unfortunately, contrary to the stated goal of uniformity at the heart of the UCC, each state has revised and adopted its own version of the UCC. This means that what works in one state may or may not work in another. States also typically have additional laws that deal with certain kinds of property — such as real estate/real property — that aren’t covered by the UCC. The end result is that what works in one state doesn’t work in another, so it’s important to have a good attorney in whatever state the property is located in to help you secure your interest in it.

General Rules

Generally speaking, how to take and perfect a security interest in property depends on what kind of property you’re dealing with.

Property TypeHow to Perfect
Real Property (houses, land, etc.)A mortgage (alternatively, a “deed of trust” in some states) made out by the debtor and filed with the clerk of the county in which the property resides
Motor vehicles (cars, boats)A lien placed on the vehicle of title and recorded with the Motor Vehicle Department
Shares of stockTaking physical possession of the certificated shares
Units of an LLC (non-securitized)Filing a UCC-1 Financing Statement against the LLC units
Units of an LLC (securitized)Taking physical possession of the certificated LLC units
Most other assets of a businessFiling a UCC-1 Financing Statement with the State UCC Office

If a security interest isn’t perfected, does that mean it doesn’t exist?

This is a surprisingly common question, and the answer is, as is often the case with legal questions, “it depends”. Many security interests need not be perfected to be effective, but, unless a security interest is perfected, some other creditor can take a subsequent security interest, perfect it, and have priority despite their security interest being newer. A perfected security interest is generally better than a senior security interest (with a few exceptions, of course).

That said, some security interests are only effective if they’re properly evidenced. This is, in part, a requirement to make sure the debtor understands what they’re pledging as collateral, and in part to make sure other would-be creditors are given notice of existing liens. (See: UCC Lien Search in Business Acquisition) For example, including “Debtor pledges his home as collateral to secure the loan” in a loan agreement itself isn’t enough to secure an interest in real property. One needs a validly executed mortgage, made by the debtor and owner of the real property, for the security interest to be exist. Most states require the mortgage also be filed to be effective — with a few exceptions.

Conclusion

Creating and perfecting security interests is no small matter — especially when multiple states are involved. Mortgages, in particular, are complex legal documents and should only be prepared by licensed, qualified attorneys or other practitioners in the state in which the property resides. Those attorneys are responsible for knowing the laws of that state and the ‘ins’ and ‘outs’ of the UCC and real property laws. If you’re entering into a contract that involves security interest, reach out to a qualified contracts attorney today, and remember: a little law now saves a lot later!

Law 4 Small Business, P.C. (L4SB). A Slingshot company.

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