Why Take a Lien
When a Creditor lends money to a Debtor, the Creditor may wish to have a lien on some property or right owned by the Debtor in case the Debtor does not voluntarily repay the money. Such property or right is called “collateral”. If the Debtor does not voluntarily repay the loan, the Creditor may sell the collateral to produce money to repay the loan.
Why Perfect a Security Interest
How does a Creditor lien collateral and know its lien is valid against all other creditors and enforceable against the Debtor? The Creditor perfects its lien. Perfection is the process by which a Creditor announces to the world that it has a security interest in described property owned by the Debtor. When a Creditor receives a security interest in property of the Debtor, the Creditor has a right to sell that property in the event the Debtor does not repay the Creditor. However, it is possible for a Debtor to give a security interest in the same property to several Creditors unknown to those several Creditors. For example, Joe goes to Bank A for a loan. Joe grants Bank X a lien on equipment owned by Joe. The next day Joe goes to Bank B and borrows some more money and grants Bank B a lien on the same equipment. Each of Bank A and Bank B thinks it has an exclusive security interest on the same equipment.
How does the law establish priority to the equipment between Bank A and Bank B? Whichever of Bank A or Bank B first perfects its lien in the equipment has the first priority to its value. By being the Creditor first in time to perfect its security interest that Creditor establishes its right to the sales proceeds from the property against all other persons, including Bank B and Joe.
How To Perfect a Security Interest
The process of perfecting a security interest is governed by Article 9 of the Uniform Commercial Code (“UCC”). Under Article 9, a perfecting a security interest is a two step process. The steps can occur in either order. The two steps to perfecting a security interest are:
- Attachment: A security interest cannot be perfected until the interest has attached. For information on how to attach a security interest, see this article.
- The completion of one of the methods of perfection specifically set forth in Article 9. Although Article 9 provides a variety of methods, the most common method is by filing a financing statement – commonly referred to as a UCC-1 Financing Statement.
Perfection by Filing a UCC-1 Financing Statement
In order to perfect a security interest by filing a UCC-1 financing statement a Creditor, the Creditor must satisfy five requirements:
- Debtor Authorization: The Debtor must authorize the filing of a financing statement in writing. The filing can be authorized before or after it is filed.
- The Financing Statement Must Include the Debtor’s Name and Mailing Address: An error in the Debtor’s name is permissible only if the error is so minor that it doesn’t prevent a subsequent creditor from discovering the filing. Whether an error prevents a subsequent creditor from discovering the filing depends on the nature of the filing system used by the office in which the financing statement is filed.
- The Financing Statement Must include the Security Party’s (Creditor’s) Name and Mailing Address.
- The Financing Statement must describe the collateral. The financing statement must include a description of the collateral sufficient to put subsequent creditors on notice the collateral MAY already be the subject of a prior security agreement. The description can be very broad, such as “all equipment” or even “all assets.” A financing statement can include property currently owned by the Debtor as well as property the Debtor acquires in the future.
- The Financing Statement Must Be Filed in the Correct Location. Financing statements are ordinarily filed in the office of the Secretary of State of the debtor’s “home state.” If the debtor is an individual, the debtor’s home state is typically the debtor’s primary residence or domicile. If the debtor is a business entity, the debtor’s home state is its state of formation.
- If the collateral is related to real estate (such as crops), the financing statement should be filed in the county where a mortgage on the same real estate is required to be recorded and include a legal description of the real estate.
A security interest that is perfected by the filing of a financing statement is valid for five years. A Creditor can continue a perfected security interest beyond the five year period by filing a “continuation statement” in the six months before the lapse of the current financing statement. The debtor does NOT need to authorize a continuation statement.
Other Methods of Perfection
In addition to filing a financing statement, there are several alternative methods of perfecting a security interest. These are:
- Noting the Interest on the Title: If a security interest is taken in a motor vehicle which is required to be titled, the interest is perfected by noting the security interest on the certificate of title. This is done in the same manner as other changes to title under the law of the state in which the vehicle is titled.
- Taking Possession of the Collateral: A security interest in most tangible property can be perfected merely by taking control of it (which is also sufficient to attach the security interest). In the classic case, a Creditor will take an item of value, such as a watch or diamond, and hold it until the loan is repaid. Certain types of collateral, mainly non-tangible items such as bank accounts, accounts receivable, and intangible goods such as trademarks, cannot be perfected by possession. Furthermore, goods which have titles, such as vehicles, cannot be perfected by possession.
- Taking Control of the Collateral: Certain types of property, primarily the non-tangible goods described above, can be perfected by obtaining “control” over the goods. Collateral commonly perfected by control includes company bank accounts and investment property such as stocks, bonds, and brokerage accounts. Article 9 provides specific rules describing what actions constitute “control” over different types of collateral.
Automatic Perfection of Certain Interests: A loan to a consumer of consumer goods for the purchase of those consumer goods provides the lender with an automatic perfection of the lender’s security interest in those particular consumer goods. This type of loan and perfection is known as a purchase money security interest (“PMSI”). For more information on this type of loan, contact an experienced attorney.
Temporary Perfection of Certain Interests: Certain security interests are automatically perfected for a limited period of time, generally twenty days. Most notably, if collateral in which a Creditor has a perfected security interest is sold, the Creditor automatically receives a perfected security interest in the proceeds from that sale for twenty days.
Legal Disclaimer
This website provides information addressing legal topics of interest to the general reader. You should not consider this information designed or adequate to meet any of your particular legal needs, concerns or inquiries. You should consult with a lawyer licensed to practice law in the jurisdiction appropriate to your legal situation to assess your situation and provide you with appropriate legal advice.