Secured Transactions Flashcards
Overview
Secured transactions is about collateral. When businesses get loans from banks,
the banks often ask for personal property (“collateral”) to secure the loans. If the businesses default on the loans, the banks can recover some of their money by selling the collateral. Secured transaction law, which is contained in Article 9 of the Uniform Commercial Code, protects the banks’ rights to the collateral.
Of course, the parties in Secured Transactions questions are not always businesses and banks. Sometimes individual people and other institutions that provide credit are involved. But Secured Transactions law focuses on businesses and the institutions that lend to them, so those are the parties that tend to appear in exam questions.
Under Article 9, a creditor must take two steps to gain the full protection of secured transactions law:
1. Attach a security interest to the collateral, and
2. Perfect the security interest.
The majority of secured transactions essay questions focus on these two steps.
Attachment
Attaching a security interest simply means creating a valid security interest in collateral.
The most common way to attach a security interest is with a signed security agreement.
The security agreement is a written agreement that certain personal property will serve as collateral, usually for a loan.
To be valid,
(1) the security agreement must describe the collateral,
(2) the party offering the collateral must have rights in it (that is, they must own it or have some other legal rights in it), and
(3) the party gaining the security interest (usually a bank or merchant) must give value in exchange for the security interest.
For example, if a bank gives a loan to a borrower, the loan is value. But if you try to give your friend a security interest in your lawn mower as a gift (an awfully strange gift), that does not create a valid security interest because your friend did not give you value in exchange for it.
There are also two ways for a security interest to attach to collateral without a security agreement:
- Possession, and
- Control
If the party that wants the security interest has actual possession of the collateral, no written security agreement is required for a security interest to attach. So, if you borrow $200 from your friend and you agree to let your friend take your lawn mower until you can pay the money back, your friend’s security interest attached to the collateral (that is, the lawn mower) and there is no need for a written agreement.
Security agreements in a few types of collateral can become attached by control. For example, if a business has a deposit account (a regular bank account) at a bank, and that bank loans the business some money, the bank has control over the collateral because the collateral is an account at that bank.
To be valid, security agreements must:
To be valid,
(1) the security agreement must describe the collateral,
(2) the party offering the collateral must have rights in it (that is, they must own it or have some other legal rights in it), and
(3) the party gaining the security interest (usually a bank or merchant) must give value in exchange for the security interest.
For example, if a bank gives a loan to a borrower, the loan is value. But if you try to give your friend a security interest in your lawn mower as a gift (an awfully strange gift), that does not create a valid security interest because your friend did not give you value in exchange for it.
2 ways for a security interest to attach to collateral without a security agreement:
There are also two ways for a security interest to attach to collateral without a security agreement:
- Possession, and
- Control
If the party that wants the security interest has actual possession of the collateral, no written security agreement is required for a security interest to attach. So, if you borrow $200 from your friend and you agree to let your friend take your lawn mower until you can pay the money back, your friend’s security interest attached to the collateral (that is, the lawn mower) and there is no need for a written agreement.
Security agreements in a few types of collateral can become attached by control. For example, if a business has a deposit account (a regular bank account) at a bank, and that bank loans the business some money, the bank has control over the collateral because the collateral is an account at that bank.
Perfection
Step two of gaining the maximum protection of secured transactions law is perfection. By perfecting a security interest, the holder of the security interest puts the world
on notice that the security interest exists. When done properly, a perfected security interest will be superior to most (but not all) interests others might have in the collateral. In other words, if the business defaults on the loan, the bank will be first in line to auction off the business’s collateral and recover the balance of the loan.
Most security interests are perfected when the holder of the security interest files a financing statement at a central filing location in the state where the debtor is located. The financing statement is a simple document that identifies the debtor and the creditor and describes the collateral.
Once a financing statement is properly filed, the security interest is perfected and
the world is considered to have notice of the security interest. For example, imagine Bank A gives Business One a loan, takes a security interest in all of Business One’s office furniture as collateral, and properly files a financing statement describing the office furniture. A month later, Bank B gives Business One a loan, also taking a security interest in the office furniture as collateral. If Business One defaults on both loans, Bank A will be able to use the value of the office furniture to recover some of its money. If there is nothing left to help Bank B recover, Bank B can’t complain. Bank B should have known about Bank A’s security interest because if Bank B had checked the records at the filing office, it would have found the financing statement.
There are some special perfection rules for certain types of collateral:
- Security interests in motor vehicles can be perfected only by a notation on the security interest on the vehicle’s title.
- Security interests in things attached to land (e.g., timber or fixtures) usually must be perfected with filing statements that describe the land and are filed in the county where the land is located.
- Security interests in most types of collateral can be perfected by possession by the party holding the security interest.
- Security interests in a few types of collateral (e.g., business deposit accounts) can be perfected by control.
- Purchase money security interests (discussed below) in consumer goods are automatically perfected.
Some special perfection rules for certain types of collateral:
There are some special perfection rules for certain types of collateral:
- Security interests in motor vehicles can be perfected only by a notation on the security interest on the vehicle’s title.
- Security interests in things attached to land (e.g., timber or fixtures) usually must be perfected with filing statements that describe the land and are filed in the county where the land is located.
- Security interests in most types of collateral can be perfected by possession by the party holding the security interest.
- Security interests in a few types of collateral (e.g., business deposit accounts) can be perfected by control.
- Purchase money security interests (discussed below) in consumer goods are automatically perfected.
Priority
The main issue in most secured transactions questions is the order of priority of the security interests. Two secured parties might both have loans secured by the same collateral. If the borrower defaults on both loans, the party with the highest priority security interest gets first dibs on the collateral. Here are the general rules:
- Perfected security interests have priority over unperfected security interests.
- Between two perfected security interests, the first to have been filed or perfected
has priority. - PMSIs (see below) have priority over non-PMSIs.
- Perfected security interests have priority over creditors in bankruptcy.
- A buyer in the ordinary course of business usually takes goods free of any security
interests (e.g., if a store gets a loan from a bank and gives the bank a security interest in its inventory of refrigerators, and then you buy a refrigerator from the store, the bank loses its security interest because you are a buyer in the ordinary course of business).
Categories of Collateral
Collateral is frequently described in security agreements and exam questions by category, so you must understand the categories. Here are the main ones:
- Consumer goods – goods used or bought for personal or household purposes
- Inventory – goods held for sale or lease and supplies/materials quickly used up in
business - Equipment – any physical goods other than consumer goods, inventory, or farm
products - Accounts – a right to payment (accounts receivable)
- Deposit accounts – a bank account
PURCHASE MONEY SECURITY INTERESTS
A purchase money security interest (PMSI) is a special type of security interest that gets higher than usual priority (see priority rules). A PMSI arises when the lender loans money to the borrower specifically for the buyer to purchase certain goods, and the lender takes a security interest in those goods.
For example, Lumber Mill owns a bunch of machines that saw wood. Bank 1 has a perfected security interest on all of Lumber Mill’s equipment (including these machines and any acquired in the future) due to an existing loan. Lumber Mill needs a new machine. Bank 2 gives Lumber Mill a loan to buy the new machine and takes a security interest in the new machine. Bank 2’s security interest is a PMSI and, therefore, Bank 2’s security interest has priority over Bank 1’s (even though Bank 1’s interest was perfected first).
RIGHTS ON DEFAULT
Generally, if a borrower defaults on a loan that is covered by a security interest, the secured party has a right to sell the collateral and use the funds from the sale to pay itself the amount remaining on the loan. Secured parties can simply take the collateral if they can do so peacefully. Or they can file an action in court to force a public sale of the collateral.
Original Use Test
Whatever the original intended at the time of purchase is going to control. This is relevant when talking about the special situation where a PMSI in consumer goods is automatically perfected.
