A mistake that I often see inexperienced lenders make when making secured loans is that they do not take all the steps necessary to become a secured creditor. There are numerous traps for the unwary and people should be careful when documenting secured loans to make sure that they actually end up secured. It’s always hard having to tell a new client after reviewing their documents that they are unsecured because they didn’t follow some step or didn’t draft their documents properly.
Before diving into specifics of how to become a secured creditor on personal property, please note that the rules for securing real property (ie. real estate) are different. If you plan to take real property as collateral, the following is not entirely applicable to your situation.
Securing Collateral – A Two Step Process
One mistake that people often make in securing personal property is that they simply state that the loan agreement or promissory note is secured without doing anything further. Simply stating that a loan is secured is not enough to make it secured!
In order to become a secured party, one must (i) prepare a document which grants a security interest (which is the agreement between the parties) and (ii) also perfect on that security interest (which is the notice to the world of the security interest). Without both steps occurring, the lender will be unsecured.
Step 1 – Attachment
To grant a security interest in personal property, one must have a security agreement which contains (i) a statement granting the security interest and (ii) the description of the collateral. There is no specific requirement that the security agreement be a standalone document.
In order to properly grant a security interest, one must use language which explicitly grants the security interest. In order to properly describe the collateral, a lender must use language which reasonably identifies the collateral. One common mistake that people make in describing collateral is that they forget to include “proceeds” of the collateral as part of the description of the collateral. What occurs in such instances is that once the collateral is sold (assuming, for example, that the collateral is equipment), the money received is no longer part of the collateral pool and the lender is therefore unsecured as to that money unless the money itself is separately identified as collateral.
Step 2 – Perfection
To perfect a security interest, one generally files a UCC financing statement at the state level where the debtor lives or where the debtor was formed. Filing a financing statement does not perfect a security interest in all types of collateral, however. One should talk to an attorney to make sure that a UCC financing statement is appropriate for their needs. For instance, perfecting a lien on someone’s shares of stock requires physical possession of the stock certificates. Also, there are special rules for vehicles, boats, mobile homes, and aircraft.
If there’s one major point to take away, remember that becoming a secured creditor requires both the grant of security and the perfection of that security interest. Simply stating that you have a security interest in an agreement is not enough.
The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.