When purchasing consumer goods, consumers often (probably too often) pay some money upfront, and then promise to pay the remainder plus interest at a later time. By so doing, they become debtors. The creditors, in order to protect themselves against non-payment, will often require some form of guarantee for payment.
This guarantee is known as a security. A secured transaction is a transaction where the debt is secured by other property owned by the debtor. Article 9 of the UCC governs secured transactions in personal property. Personal property, broadly defined, is property that is not land or buildings. It includes fixtures (items that may become attached to buildings such as lighting fixtures), accounts, and even intellectual property such as patents.
As you may imagine, it's important to have an understanding of some new terminology.
- Security Interest. Article 9 of the UCC applies to any transaction that creates a security interest. The UCC defines a security interest as "an interest in personal property which secures payment or performance of an obligation."
- Security Agreement. An agreement/contract that creates or provides for a security interest.
- Collateral. The property that is subject to a security interest.
- Purchase Money Security Interest. Also known as a PMSI, this occurs when the debtor gets credit to buy consumer goods and the creditor takes a secured interest in those consumer goods.
- Debtor. A person who owes payment or other performance of a secured obligation.
- Secured Party. A creditor who has a security interest in the debtor's collateral.
- Financing Statement. Also known as a UCC-1, this is the form filed with the state to give public notice of the security agreement covering collateral in that state.
Creating a Security Interest
Put yourself in the shoes of a creditor. What keeps you up at night? The risk that those you lent money to will default and you get nothing back! And if the debtor defaults on the loan you have given, you worry about whether or not the debt can be satisfied through your repossession of the collateral and if you have priority over others who may have a security interest in the same collateral. By way of example, imagine that I decide to act on my deep-rooted desire to be a farmer. I make a request and you lend me $250,000 so that I can purchase this combine:
You likely have (valid) concerns about my ability to use this beast to make a profit on my farm, and if I can't make money, how are you going to get your quarter-of-a-million dollars back? If our agreement states that the combine is your collateral, that means that you can take possession of the combine and hope that you can sell it for the amount that I owe you. But what if I got another loan before I took your money, and pledged the combine as collateral to that person? As you see, I may have two loans, both of which use the combine as collateral. The creation and perfection of a security interest will solve these questions and concerns.
To create a security interest, the creditor must:
- Have a written security agreement that clearly describes the collateral and is signed by the debtor,
- Give something of value (usually money) to the debtor, and
- Allow the debtor to have "rights" (usually possession) in the collateral.
In our example above, we have an agreement that you will retain a security interest in the combine until I pay you back the $250,000 which fulfills the first requirement. You lend me money which I use to purchase the combine, fulfilling the second requirement. Finally, I have the rights of possession of the combine, meeting the third requirement. Once all of these requirements are met, the creditor's rights are said to "attach" to the collateral. Attachment gives the creditor an enforceable security interest in the collateral.
There is one notable exception to the requirements above. It occurs when the creditor keeps possession of the collateral. We will discuss this below.
Perfecting a Security Interest
Secured parties protect themselves from claims of other creditors through a priority process known as perfection. Perfection becomes important where a debtor uses the same collateral as security for loans from different creditors. In the example above, should you lend me $250,000 and another lends me $250,000, both with the combine as collateral, one party isn't going to be paid if I default on both loans and the combine is only worth $250,000. In such a situation, we look to see which creditor perfected their security interest to determine who has priority (who gets paid). If both creditors perfected, then we look to see who perfected first.
The most common way to perfect a security interest is by filing a financing statement, also known as a UCC-1. In Idaho, you can file this document online. To do so, go to the Idaho Secretary of State's website, click on Business Services, Business Filings, and finally the Uniform Commercial Code. From there, you can perform a UCC Search or file your UCC-1 online. The search function is vital because it allows you to search by names of parties or a description of the collateral.
A UCC-1 gives public notice that a security interest has been made. It must include the name and address of the debtor, the secured party, and a description of the collateral. This information is all vital, because assume again that I come to you asking for a loan of $250,000 to buy the John Deere combine. If you look me up by doing the UCC search on the Secretary of State's website, and see that I've already pledged that combine as collateral for another loan for $250,000, you will not lend me the money unless the combine is worth at least $500,000.
Filings are indexed by the name of the debtor so they can be discovered using the online system. The debtor may be a business or an individual. Currently, the UCC system on Idaho's Secretary of State's website is free. Check it out and do searches by the names of large businesses that you know. For example, I searched BYU-Idaho, and didn't come up with anything, but there were a number of filings for Simplot.
As a side note, I did find an active UCC form filed against someone named Brigham Young who apparently lives in Moscow, ID.
However, perfection can occur without the use of a financing statement/UCC-1. This is most commonly done by the creditor retaining possession of the collateral. This situation is known as a pledge. Imagine that you lend me the $250,000 so that I can buy the combine. You lend me the money, I pick up the combine, and then you take possession of it until I can pay you back. Obviously, this is a silly example because if you keep the combine, that does nothing for me. As a result, it's not very common.
A PMSI mentioned above is another example of perfection without the need of filing a UCC-1. It is created when a person buys consumer goods (items that are purchased primarily for personal purposes) on credit. An example could involve you buying a TV from Costco where Costco lends you the money to do so. These security agreements are perfected automatically.
When more than one party lends money on the same collateral, who has priority? The UCC lays out the following priority order:
- Perfected security interest versus unsecured creditors and unperfected security interest. When two or more parties have claim on the same collateral, a perfected secured interest has priority over the interests of most other parties.
- Conflicting perfected security interests. When two or more secured parties have perfected security interests in the same collateral, the first to perfect (by filing a UCC-1 or by taking possession of the collateral) will generally have priority.
- Conflicting unperfected security interests. When two conflicting security interests are unperfected, the first to attach (be created) has priority. This is known as the "first-in-time" rule.
What constitutes default can be difficult to define. As a result, the law encourages parties to define when default has occurred when they draft the security agreement/contract. Any breach of the agreement can constitute breach and result in default. The most common form of default occurs when the debtor fails to make payments (within a certain grace period) or when the debtor files for bankruptcy.
Article 9 of the UCC sets out the rights and remedies for secured parties. These rights are cumulative, so if one doesn't give the creditor full relief, he or she can use other methods as well.
The creditor or a security interest can take peaceful possession of the collateral without involving the courts or the sheriff's office. You've likely seen some crazy videos on YouTube from the repossession tv shows that were popular a number of years back. However, this example is more realistic. The general rule is that repossession must take place without any trespass onto land, assault/battery, or breaking and entering. After repossessing the collateral, the creditor can retain the property or sell it.
In the alternative, the creditor can seek the assistance of the courts by obtaining a judgment on the underlying debt followed by the seizure of the debtor’s property. Creditors may take possession of the collateral (usually with the assistance of the Sheriff’s department) and other property to cover the creditor’s damages.