What is a Security Interest, and Why Should I Care?
This post explains what a security interest is, how it is used, and why it is significant.
A security interest is an interest in an asset that is intended to secure performance of an obligation. Typically, the obligation that is secured is payment of a debt.
Terminology: The person who owes money is called the debtor. The person to whom money is owed is the creditor.
Many of us grant a security interest when we buy a house. In exchange for providing money for the purchase, the lender receives a mortgage (or, in California, a deed of trust). This is a type of security interest.
Security Interest in Commercial Transactions
Commercial transactions, too, can include a grant of a security interest. For example, one of my clients provides sophisticated electronic devices to its customers, with the purchase price payable over time. The Installment Sale Agreement includes the following provision.
Buyer hereby grants to Seller a first-priority security interest in the Equipment and authorizes Seller to file UCC financing statements to perfect that security interest. As long as any amount remains payable by Buyer hereunder, Buyer will keep the Equipment free and clear of any other liens or encumbrances.
Notice the reference to a “first priority” security interest. This means (subject to “perfection”, discussed below) that if the Buyer fails to make payments and there are multiple creditors, Seller will have priority in reclaiming the Equipment (which is referred to as “collateral“).
Another client sold his business. The buyer paid part of the purchase price in cash, and signed a Secured Promissory Note for the balance. The Note included the following:
This Note is secured by a first priority security interest in the Acquired Assets and all derivatives thereof, and in all proceeds of the Acquired Assets and all derivatives thereof, (all of the foregoing the “Collateral”) which Borrower hereby grants to Lender. Upon request by Lender, Borrower shall execute, alone or with Lender, any financing statements or other documents that Lender deems appropriate for filing in any public offices.
Perfecting a Security Interest
Perfection is the process by which a security interest is made effective against third parties and retains its effectiveness if the borrower defaults.
Perfection is accomplished by filing a record with the appropriate governmental entity that identifies the debtor, the creditor, and the collateral.
For a home loan, the mortgage typically is recorded with the clerk of the county where the house is located.
For a commercial transaction, a UCC-1 financing statement typically is filed with one or more secretaries of state. The relevant states are likely to include the state where the debtor resides and any states where the collateral is located.
By creating a public record, the creditor establishes priority over other creditors with respect to the collateral.
Once the debt is paid in full, the creditor should file a release of the security interest so the debtor then will have clear title to the collateral.
In summary, any time goods having significant value are purchased using seller or third-party financing, the debtor should expect to grant, and the creditor should expect to receive, a security interest in the collateral.
Dana H. Shultz, Attorney at Law +1 510 547-0545 dana [at] danashultz [dot] com
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.