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A Short Series on Security Interests for Credit Managers

Part 1: BASICS

Many people misunderstand the use of security interests and their enforcement. While the subject is much too broad to cover completely here, there are some highlights we can hit.

A security interest is a lien in personal property. "Personal property" means anything other than real estate. It does not mean just the customer's (debtor's) clothes or her coin collection. Equipment is an example of personal property. On the other hand, a mortgage (or deed of trust) or a judgment lien will create a lien on real property.

Security interests are governed by Article 9 of the Uniform Commercial Code (UCC), which has been adopted in every state. Although many states have varying versions, there are basic uniform provisions. To have a security interest, there must be (1) an agreement in writing (signed by the customer) granting a security interest, (2) the debtor (customer) must have rights in the collateral, and (3) the secured party must have given "value" in exchange for the security interest. When these three things are present, a security interest "attaches" to the property. There are, as you may guess, thousands of decisions about whether each of these requirements was met in any given case.

Often, there will be language in the contract or the sales slip that grants the security interest. These situations may be as mundane as the grant of a security interest to the retailer for the refrigerator you buy on credit or as complicated as the grant of a security interest to you in the specialized equipment a vendor is building for you and for which you have made a substantial down payment.

Usually, the issue of the existence of a security interest only comes up when the debtor (the one who owes the money) is in default. Other times it becomes an issue if someone else wants to take a security interest and wants to make sure there are no prior liens. In either case, the first question is whether there is a security interest. If there is, then the debtor and the secured party (creditor) are bound by it. The more important question, however, may be whether the interest is "perfected" so it is good against other, third parties.

Perfection is the concept of making the lien good against other people so they cannot get rights in the property higher than the party with the perfected lien. Next week, more about perfection.

Part 2: THE PERFECTED SECURITY INTEREST

As we saw last time, perfection is the concept of making a lien good against other people so they cannot get rights in the property higher than the party with the perfected lien. It is one thing to create a security interest with your customer. It is another to have it enforceable against third parties.

Most of the ways of perfecting security interests come from the idea of giving notice to third parties that the lien exists. In some situations, if a third party is aware of the lien (has actual notice), it will be good against that third party. The UCC is specific about how security interests are perfected in certain types of property. If the UCC requires a certain type of perfection, other types will not work.

Some liens require no special steps for perfection. Some security interests in consumer goods that are in the hands of the consumer are automatically perfected. The security interest you granted in the refrigerator you bought on credit requires no further act to have it perfected.

The next simplest form of perfection is perfection by possession. A security interest in almost any type of personal property can be perfected by the secured party actually holding the goods. When a bank takes jewelry as security for a loan, it may actually take the items into its possession and store them. Since the bank holds the goods and they are not in the possession of the debtor, any third party attempting to take a security interest in the items would be on notice that there is something unusual about the transaction. Typically, one who is in a position to pledge collateral has possession of the collateral.

Property for which the state issues a certificate of title (generally vehicles) has security interests perfected by notation on the title itself. States will have a system of recording an encumbrance on the state records, and it may be printed on the certificate of title, so anyone looking at or searching the title will see the lien. Contrasted with that, however, are vehicles that are held for resale. Those are considered inventory (or something else) and need to have another type of perfection.

The most prevalent form of perfection is perfection by filing. Much more on that next week.

Part 3: PERFECTION BY FILING

While this could be the title of a manual on manicures (sorry, I couldn't resist), it is about the most frequent type of security interest perfection.

Each state has a system of recording "financing statements" (not financial statements) that are used to give notice to the world. Just as judgments and real estate transactions are recorded somewhere to allow access by the public, so, too, are financing statements. The idea is that a system of recording contributes to the smooth flow of commerce. Everyone knows that the UCC requires filing to perfect certain types of security interest and that the UCC-1 forms (financing statements) are filed with a particular office where they can be searched. Simple enough? Anyone who deals with the UCC knows that things are rarely that simple.

Article 9 of the UCC underwent a major revision in 2001, with every state adopting the revisions and making them effective, generally, by July 1, 2001. A few states had delayed effective dates, but by January 1, 2002, all were effective.

Under former Article 9, one of the non-uniformities was that each state got to decide where the UCC-1 forms need to be filed. Some states had simple, central filing. Some had dual filing. Some had dual filing, sometimes.

Under new Article 9, the most important change is that the financing statement is generally filed where the debtor (customer) is "located." For corporations and other registered entities, the "location" is the state of registration of the entity. A Delaware corporation doing business (and having assets) only in Pennsylvania is "located" in Delaware. A sole proprietorship will be located where the principal resides, regardless of where it does business.

All states are now central filing states. That is, the financing statements are filed with the Secretary of State. There may still be local filing for fixtures (relating to real estate).

So, let's look at a simple, typical transaction under former Article 9 and under Revised Article 9. You sell equipment on credit to a customer who only has one location, in Pittsburgh, Pennsylvania. That customer is a Rhode Island corporation. Customer signs an agreement granting you a security interest in that equipment. Under Revised Article 9 (R9), the customer no longer has to sign UCC-1 forms. These forms are filed without a signature. Under former Article 9, you would have needed the signature and had to file the financing statements with the Secretary of the Commonwealth of Pennsylvania, since the property is located in PA. You would also have needed to file with the Prothonotary (Clerk) of the Court of Common Pleas of Allegheny County, since the customer operated only in one county in PA. Now, under R9, that is all different. Since the customer is a Rhode Island corporation, you only need to file the financing statement in Rhode Island! Once those filings are accomplished, you would have a perfected security interest in the identified equipment. And, as we have seen, that gives you a lien good against third parties.

Unfortunately, there are a number of things that can go wrong with that simple scenario, which we will cover next time.

Part 4: IMPERFECT PERFECTION

Last week, we used this simple example of perfection by filing:

You sell equipment on credit to a customer who only has one location, in Pittsburgh, Pennsylvania. That customer is a Rhode Island corporation. Customer signs an agreement granting you a security interest in that equipment. Under Revised Article 9 (R9), the customer no longer has to sign UCC-1 forms. These forms are filed without a signature. Under former Article 9, you would have needed the signature and had to file the financing statements with the Secretary of the Commonwealth of Pennsylvania, since the property is located in PA. You would also have needed to file with the Prothonotary (Clerk) of the Court of Common Pleas of Allegheny County, since the customer operated only in one county in PA. Now, under R9, that is all different. Since the customer is a Rhode Island corporation, you only need to file the financing statement in Rhode Island!

I said there were things that could go wrong. Let me highlight a few. The first has to do with the accuracy of the debtor's name. Anyone who has tried to collect an account knows how important it is to get the customer's name and legal composition right. It is critical here. If your customer is Bob Bernstein trading as Bob's Barrels (sole proprietorship), your filing should not be against "Bob's Barrels." Under R9, your filing is not "seriously misleading" if the filing office's computer search logic will find the filing. It is unlikely that a search for "Bernstein, Bob" would turn up a filing against "Bob's Barrels." In that event, your filing would not be good.

That is not the name of the owner of the equipment you sold. Someone searching for liens against Bob Bernstein would not find it if filed against Bob's Barrels. Likewise, if Bob was the sole shareholder of Bob's Barrels, Inc., you would not file against Bob Bernstein, since someone searching for Bob's Barrels, Inc., would not find it.
The other critical item under R9 is making sure of the "location" of the debtor, if a registered entity. You will need to verify the state of incorporation and get the entity number that the state issued. That number needs to be on the financing statement or it may be rejected by the filing office.

If you were selling inventory (a UCC defined term) instead of equipment, you could have a more serious problem. The UCC allows that a perfected filing against inventory can cover "after acquired" inventory. So, if Bob was in the business of retailing barrels and you sold him barrels, those barrels would become part of his inventory. Let's say that Local Bank previously loaned Bob working capital and that it has a perfected security interest in his inventory (along with everything else). Even if you have a purchase money security interest (where you provide the credit for the purchase), you may be junior to Local Bank, unless you have done some work in advance of delivering the barrels.

Without more work, as soon as Bob gets your barrels, the security interest of the bank attaches (grant of the security interest in writing, value given and now debtor has rights in the collateral). Without more work, the Bank now has a senior lien on your barrels and you may be in trouble.

The UCC provides a mechanism for you to give notice to a prior perfected security interest holder in inventory that you intend to ship and take a purchase money security interest in certain goods. If you do that, your lien can become the senior lien on your inventory. Let me give a story that pulls much of this together.

A number of years ago, there was a lawn tractor dealer in our area. Its physical address was in Westmoreland County Pennsylvania, which we will call Bob's, Inc. It used a mailing address of a Post Office Box in Monroeville (Allegheny County). It has pledged its entire inventory to a bank, who properly filed financing statements. A vendor intended to sell $400,000 of inventory to the dealer and searched the records of the State and Allegheny County for Bob's, Inc. of P.O. Box xxx, Monroeville. The search turned up nothing, since all of the other filings were using the physical address.

The vendor sold and shipped and did file UCC-1 forms in Allegheny County, with the Commonwealth, and in Westmoreland County. Bob's, Inc. later filed bankruptcy. Vendor lost its $400,000. Even though it was lucky enough to have filed in the right places, it did not give notice to the prior perfected lien holder that it was putting inventory in under a security interest. Thus, the bank's lien attached before the vendor's.

Next time, some simple steps to avoid problems when retaining (or taking) security interests.

Part 5: SOME SIMPLE STEPS TO BETTER SECURITY INTERESTS

In the past few issues, we have covered some of the basic rules of security interests, as well as some of the pitfalls. Here are some tips that will help your security interests succeed.

GET THE NAME RIGHT. There are so many ways available to make sure of the correct identity of your customer, that it is unforgivable to get it wrong. Start with the credit application. That should ask the right questions. Then it can be verified by several different resources that are available to you through your telephone or your computer. There are many services that can verify the registration status of fictitious or assumed names, corporation, partnerships and the like. Many are available through electronic services, usually for a nominal fee.

GET THE NAME RIGHT II. When typing the financing statements (UCC-1) forms, make sure you index the filing against the correct name. When in doubt, put the debtor's "real" name and the trade name. Remember, the filing puts the world on notice that you may hold an interest in the debtor's property. Check the filing fees. Is it worth spending an extra $50 to protect the credit?

CHECK FOR PRIOR FILINGS. Unless you are taking a purchase money security interest in something other than inventory , you should search to see if there are prior filed security interests. This, too, can be done by a number of means, ranging from walking into the filing office to calling any number of search firms to do the job for you. The cost is generally under $100 and will often also give you copies of the filing. Since many states are filing electronically, there are an increasing number of reliable electronic search services. Remember that there is a transition system that allows filing under Former Article 9 to be valid along with those under R9. For the time being, you need to search the proper filing officer(s) under both the former and revised law.

DETERMINE THE RIGHT PLACE FOR FILING. Is your customer a registered entity, like a corporation? If so, what is the state of incorporation and the registration number? If not, what is the proper location of the customer, which designates the proper place of filing?

ASK SOMEONE. Part of the benefit of reading things like this is to let you know that there are options out there. This is not a complete manual on the UCC, but it does tell you there are things that can be done. If you think there is a sale (or a credit) that you want to secure (even after the fact), this gives you some ideas. When in doubt, ask. Most collection agencies or lawyers will give you, without charge, an idea of what can be done. ASK!