SECURED TRANSACTIONS

The Uniform Commercial Code provides the legal framework that governs commercial business transactions. The UCC’s eleven articles set out the laws on “the sales of goods, leases, negotiable instruments, bank deposits, funds transfers, letter of credit, bulk transfers, bulk sales, warehouse receipts, bills of lading, investment securities and secured transactions.”[1] In this course, we’ll cover secured transactions. In the opening module, we’ll define secured transactions, discuss the parties to a secured transaction, cover what it means to “attach” a security interest and explain how to attach a security interest.

A security interest is “an interest in certain assets which secures payment or performance of an obligation.” In a secured transaction, the borrower grants a security interest over its assets in favor of the lender to secure repayment of a loan or debt and possibly other performance obligations to the lender.[2]

There are two types of security interests: possessory and non-possessory.  With a possessory security interest, the secured party has possession of the collateral. With a non-possessory security interest, the debtor maintains possession of the collateral. Most security interests are non-possessory because a debtor usually wants to use the property being used as collateral.[3] For example, car loans would usually be pointless if the debtor didn’t get to keep the car while the loan was being paid off.

Since the widespread enactment of the UCC in the 1960s, the law governing most secured transactions is found in its Article 9. All 50 states, the District of Columbia and United States territories have enacted it. Some states have enacted it exactly as promulgated by the Uniform Law Commission, while others have made changes to suit their needs and goals.[4] Some states have gone beyond what Article 9 provides and have added additional layers of protection for consumer transactions, which are those entered into primarily for personal, family or household purposes.

Article 9 “governs security interests and applies to any transaction that creates a security interest in personal property,” including goods, inventory, equipment, accounts, documents and instruments.[5] Article 9 applies broadly to transactions “that create a security interest in personal property or fixtures by contract.”[6] Article 9 also applies to other transactions such as agricultural liens, consignments and sales of accounts or promissory notes.

Article 9 also governs the law of consignments. A consignment, which is similar to a secured transaction, occurs where the owner of goods relinquishes possession to a seller, who then sells the goods to the buyer.[7] Consignments are common when owners give unique goods such as antiques, oriental rugs, used furniture, art works and the like, to professional sellers such as brokers or auction houses. The owner is the secured party and the sales outlet fills the role of debtor. This ensures that the seller’s own creditors cannot treat the consigned goods as inventory because they really belong to someone else. Say, for example, Sue owns a classic painting. She gives it to Jim’s auction house, to sell it on her behalf in exchange for a commission. Because Sue keeps a security interest in the painting, if Jim gets sued personally, the painting would not ordinarily be vulnerable to Jim’s creditors.

Secured Transactions Parties and Key Definitions

Property rights are often described as “a bundle of sticks.” Each “stick” represents a different aspect of ownership and total and complete ownership, free from all other claims and encumbrances, is the compilation of all possible sticks. A renter or lessee, for example, may have the “sticks” that represent the rights to use and possess the property, but not “sticks” representing the right to sell or re-let the property or the right to keep it beyond the term of the rental or lease.  An owner, however, has more sticks. Someone with complete ownership in perpetuity (in the context of real property, this is referred to as a “fee simple absolute”) has all the sticks, which includes the right to sell it, lend it, rent it out, use it and leverage it.

Entering into a secured transaction is like a debtor giving a stick – representing the encumbrance – to the secured party.  As long as the secured party holds that stick, the debtor’s ownership rights are diminished. The lender now has that stick, which is called a security interest. Secured transactions exist in a variety of forms. The common denominator is that they give security interest in property, which is now referred to as the “collateral.” Both tangible and intangible personal property may be identified as collateral in a secured transaction. Examples of tangible collateral include:

  • consumer goods, which are goods used or bought for use primarily for personal use, such as automobiles or jewelry;
  • equipment, meaning goods used by a business that aren’t normally sold by the business, such as chairs, desks, computers, restaurant kitchen equipment and manufacturing machines;
  • inventory, which means goods held for sale by a business, such as the hammers and drills on the shelves of a hardware store;
  • farm products, which are goods unique to farming operations and include crops, livestock, feed, agriculture products and fertilizer;
  • fixtures, which means property that is affixed to buildings so that they are sometimes considered real property, such as the built-in brick oven in a pizza shop; and
  • computer software.

Examples of intangible collateral, or property that cannot be seen our touched,

include the following:

  • accounts receivable, which are typically unsecured obligations owed to the person for goods supplied or services rendered;
  • chattel paper, which references obligations that facilitate smaller secured transactions and are most commonly seen with furniture, jewelry, electronics and similar consumer goods;
  • deposit accounts, such as bank savings or checking accounts; and
  • investment property, including stocks, bonds and similar types of property traded on a securities exchange.

A debtor is the party who takes the loan and provides the security interest on the collateral. A creditor, who can be secured or unsecured, is the lender or seller. One purpose of a secured transaction is to make it easier for a secured creditor to collect a debt, as compared to the rights of an unsecured creditor. We can appreciate the importance of secured transactions by comparing the situation of the two different parties should a debtor default.

The unsecured creditor to whom a debtor owes an obligation is limited in the remedies available if the debtor defaults. The unsecured creditor can’t seize the debtor’s property to satisfy the debt unless and until he obtains a judgment and initiates collections proceedings. This can take months or years and is very expensive. Moreover, many personal property items are exempt from collection actions to satisfy unsecured debts. While rules vary by state, courts are exceptionally unlikely to allow a moderately-valued car or the like to be seized to satisfy an unsecured debt.[8]

A secured creditor or secured party, on the other hand, holds an interest in the collateral that the secured creditor may enforce to use the property to satisfy her claim should the debtor default. A bank with a security interest in a car can repossess it without resorting to lawsuits on the underlying debts and collections actions. In fact, self-help repossession without any due process is often allowed.[9]

Attachment of a Security Interest

            To create an enforceable security interest, there must be attachment, which means that the security interest is made effective, usually by the loan agreement.[10] There are three requirements for attachment of a security interest. The order of satisfaction for these requirements doesn’t matter, but attachment will not occur until all three are complete.

            The first element is that the creditor must give the debtor value, which can be a service, cash loan or access to a line of credit. Value can also come in the form of forbearance on a pre-existing debt. This value requirement ensures that all secured transactions are exchanges. Second, the debtor must have rights in the collateral. This means ownership or at least the power to transfer rights in the collateral. In its simplest sense, the requirement that the debtor must have rights in the collateral before the security interest can attach follows intuitively from the idea that “you can’t transfer what you don’t own.“[11] Finally, the debtor must agree to grant the secured party a security interest. This can take the form of a security agreement signed by both the debtor and the secured party.[12]

Security Agreement

A written security agreement must describe the collateral and be authenticated by the debtor to create a security interest.[13] A security agreement is not a public document and so is privately held, typically by the lender. It need not be filed in any recording office. To accomplish its essential purpose, a security agreement doesn’t have to be “wordy” or complicated. For example, a legally adequate security agreement could be:

“I, Debtor, grant a security interest in my 2018 Chevrolet Cruze to First Bank.”

Language that affirmatively grants a security interest is key. Secured parties will typically draft complex and detailed forms that govern the security relationship and provide as many rights and remedies to collect on the debt as possible.

A security agreement reflects the concept that security interests are always created voluntarily and with the consent of the debtor; never by implication or force.  It is important that the security agreement sufficiently describes the collateral so that it is clear what the newly created security interest will apply to.[14] Something like “my 2018 Chevrolet Cruze” is sufficient (as long as I own only one 2018 Chevrolet Cruze). You do not have to include, say, the VIN number or more formal legal description.

Collateral descriptions are among the most frequent sources of error in a security agreement. The most common issues with such an agreement are:

  • inconsistencies between or among the loan documents and financing statements;
  • the use of “defined” terms in the financing statement or its schedules that, in fact, are not defined in the security agreement;
  • the incorrect incorporation of UCC definitions.

The UCC establishes that any description of personal property in a security agreement is sufficient if it “reasonably identifies what is described.”[15] Many form security agreements drafted by banks include long lists of every possible category of collateral to ensure that they capture everything.  Depending on the circumstances, attaching photographs of goods or detailed charts of individual assets might be a good way to define the collateral concerned.  The standard is whether the description identifies the collateral in a way that is “objectively determinable.”[16]

An overly broad description, such as “all assets” or “all personal property” is an insufficient collateral description in a security agreement.[17] The purpose of the description of the collateral remains “evidentiary,” such that overly broad descriptions, other than by UCC category or type, may be legally inadequate. Additionally, a description of certain categories of collateral, such as commercial tort claims, requires greater specificity than a description of something like farm products.

For example, Ohio Revised Code Section 1309.108 stipulates that any description of personal or real property is sufficient if it reasonably identifies what is described. Reasonableness is a fact-specific determination. To reasonably identify the collateral, the law states that the parties must be able to identify the collateral by specific listing, category, type of collateral, quantity, computational or allocational formula or procedure or any other method if the identity of the collateral is objectively determinable. Finally, Ohio’s law prohibits the description of collateral in the security agreement as “all the debtor’s assets” or “all the debtor’s personal property, or other words of similar import,” as they don’t reasonably identify the collateral.[18] Where available, descriptions of each piece of equipment by title, manufacturer, identification or serial number and so on are appropriate. Books, records, sales logs, patents and so on should be described in reasonable detail. Summary descriptions may also not be reasonable.

To be sure that a description is legally adequate, the granting clauses of the security agreement should refer to the appropriate UCC “categories” of collateral, specifically pointing out whether the collateral is an account, commercial tort claim, a consumer good, or fixture, for example. Security agreements for commercial transactions, especially if they are not purchase money security instruments, often include two additional and important provisions.  An after-acquired property clause enables the security interest to stretch and encompass property that the debtor does not yet have but which fits within the categorical description of collateral in the security agreement.[19]  The best example of this is for business inventory, which constantly turns over.  Without an after-acquired property clause, the security interest captures only that collateral which the debtor owns at the time of attachment. This clause can allow the security interest to attach to inventory acquired after the agreement.

A future advances clause anticipates that the secured party may extend additional credit to the debtor after the first loan.[20]  If that occurs, the security interest relates back to the original transaction. This provides the benefits priority among creditors. For example, assume a debtor opens a credit line, secured by her house, with First Bank on February 1, and immediately withdraws $10,000 of a maximum $30,000 credit line. On March 1, she withdraws another $10,000. If the agreement had a future advances clause, the entire $20,000 would be considered to have been secured as of February 1, and thus may have priority over another debt that arose on February 15.

Possession and control are suitable alternatives to a signed security agreement; possession for tangible collateral such as cars and art works, and control for intangible collateral, such as bank deposits or business interests.[21]  Possession and control show the debtor’s intent to grant the security interest and define the collateral.  If a debtor gives a gold watch to a pawn shop to secure a pawn loan, for example, that shows intent to encumber the property.

Financing Statement

A financing statement is another key document in a secured transaction. This is typically filed with a public office such as a state’s Secretary of State and so is a public document.

The financing statement must provide:

  • the name of the debtor;
  • the name of the secured party; and
  • an indication of the collateral.[22]

Section 9-503 of the UCC defines the sufficiency of a debtor’s name on a financing statement. For instance, if the debtor is a “registered organization,” such as a corporation or limited liability company organized under a state’s law, then the name on the financing statement must match the name of the debtor as registered with the state.

A financing statement follows the same collateral description requirements of a security agreement. Again, let’s return to the law in Ohio as an example. Ohio Revised Code Section 1309.506 establishes that a financing statement that “substantially” satisfies the requirements of the law is sufficient even if it has minor errors or omissions, unless the errors or omissions make the financing statement seriously misleading.[23] For example. a financing statement that fails to provide the debtor’s name is seriously misleading.

Another section, 504, provides that a financing statement sufficiently indicates the collateral if it indicates that it covers “all assets” or “all personal property.”[24] Accordingly, while the financing statement may repeat all the detail of the collateral in the security agreement, it can use far more generalized language such as “all business assets of the debtor.” The overarching purpose of the financing statement is to put other people on notice of the secured party’s security interest in the collateral. In our next module, we’ll turn to the idea of perfection, which establishes the priority for multiple creditor claims on a single item of collateral.

[1] Joy Tucker, “UCC Article 9 for Dummies,” National Association of Credit Management, (Sept. 21, 2017), https://nacm.org/nacm-blog/3114-ucc-article-9-for-dummies.

[2] “Security Interest,” Thomas Reuters Practical Law, (2018) https://uk.practicallaw.thomsonreuters.com/7-382-3812?transitionType=Default&contextData=(sc.Default)&firstPage=true&comp=pluk&bhcp=1.

[3] Brian Beers, “How Do Possessory and Non-possessory Liens Differ?,” Investopedia, (Sept. 5, 2018), https://www.investopedia.com/ask/answers/062415/what-difference-between-possessory-and-nonpossessory-lien.asp.

[4] “Uniform Commercial Code (UCC) Timeline,” CSC Global, https://www.cscglobal.com/service/cls/ucc-timeline (last visited Sept. 14, 2018).

[5] Joseph H. Flack, “Secured Transactions: Practical Things Every Business Lawyer Should Know About UCC Article 9,” American Bar Association, https://apps.americanbar.org/buslaw/committees/CL983500pub/newsletter/201103/flack.pdf (last visited Sept. 14, 2018).

[6] Unif. Comm. Code § 9-109(a) (2001).

[7] Unif. Comm. Code § 9-109(a)(4).

[8] See, e.g., “Current Dollar Amounts of Exemptions From Enforcement of Judgments,” Judicial Council of California, (April 1, 2016), http://www.courts.ca.gov/documents/ej156.pdf.

[9] Carolyn Carter, “Motor Vehicle Repossessions: Consumer Debt Advice From NCLC,” NCLC Digital Library, (June 4, 2018), https://library.nclc.org/motor-vehicle-repossessions-consumer-debt-advice-nclc.

[10] “UCC Article 9, Secured Transactions (1998) Summary,” Uniform Law Commission, http://www.uniformlaws.org/ActSummary.aspx?title=UCC%20Article%209,%20Secured%20Transactions%20 (1998) (last visited Sept. 14, 2018).

[11] Margit Livingston, “Rights in Collateral and Estoppel Under U.C.C. Article 9,” LexisNexis, (Oct. 8, 2008), https://www.lexisnexis.com/legalnewsroom/corporate/b/business/posts/rights-in-collateral-and-estoppel-under-u.c.c.-article-9.

[12] Unif. Comm. Code § 9-203(b).

[13] Unif. Comm. Code § 9-203(b).

[14] Unif. Comm. Code § 9-203(b)(3)(A).

[15] Unif. Comm. Code § 9-108(a).

[16] Unif. Comm. Code § 9-108(b)(6).

[17] Unif. Comm. Code § 9-108(c).

[18] Ohio Rev. Code Ann. § 1309.108.

[19] Unif. Comm. Code § 9-204(a).

[20] Unif. Comm. Code § 9-204(c).

[21] Unif. Comm. Code § 9-203(b)(3)(B)-(D).

[22] Unif. Comm. Code § 9-502.

[23] Ohio Rev. Code Ann. § 1309.506.

[24] Ohio Rev. Code Ann. § 1309.504.

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