Perfection of a Security Interest - Module 2 of 5
Module 2-Perfection of a Security Interest
While granting a
security interest gives a creditor rights against the borrower to seize the
collateral property, perfecting a security interest gives the creditor
superior rights to other creditors. Perfecting a security interest puts the
world “on notice” of an encumbrance on collateral and it alerts future
creditors trying to collect against a debtor about another creditor that has a
superior security interest.
In this module, we’ll
explore the perfection of a security interest. We’ll expand on the purpose of
perfection and discuss the different means to perfect a security interest. The process of “perfecting”
a security interest is what provides a secured party rights that are superior
to certain other creditors. A
“perfected” security interest prevails over any other creditors who use
judicial process, such as judgments, to obtain liens on collateral and over
those with unperfected security interests.
Article 9 provides three mechanisms for a creditor to perfect her security interest: file a financing statement, possession and control. Furthermore, certain security interests are perfected automatically, and other state laws can sometimes provide alternate paths to perfection.
Perfection by Filing a Financing Statement
Let’s begin by looking at a creditor who perfects his security interest by filing a financing statement. Filing a financing statement, also known as a UCC-1 form, is an appropriate and acceptable means of perfecting security interests in all kinds of collateral. This method of perfection satisfies the basic purpose of incentivizing perfection: avoiding secret liens that may harm third-party purchasers of the collateral or creditors of the debtor.
The statement is a
single page fillable form that makes an otherwise complex lending and security
relationship easily comprehensible. Filing a financing statement provides notice to encourage further inquiry, but
it won’t necessarily reveal confidential or proprietary details regarding the
loan or the collateral. Filing a financing statement perfects a security
interest for five years.
Although a security
interest can’t be perfected until it has attached (such as through the loan
that establishes the interest), a creditor can pre-file a financing
statement before the loan closes. So long as the loan does eventually close,
thereby attaching the security interest, the perfection retroactively applies
as of the date of the pre-filing. Given the simplicity of filing the UCC-1,
many creditors file while negotiating, underwriting or documenting large sum or
complex commercial financing. The
creditor is staking out a place in line of security interest holders, in
anticipation of the closing of the loan.
When a creditor files a
financing statement, she tenders a form document and pays the applicable fee
for entry into a database of public record. If the security agreement
is between an individual creditor and an individual debtor, the creditor should
file the financing statement in the state where the debtor lives at the time
the security interest is created. State agencies, such as a secretary of state,
state corporation commission, or department of assessment and taxation,
regulate the process for filing financing statements and manage these
databases. Most UCC-1 filings are made
in central state filing offices.
If the debtor is a
registered entity, such as a corporation or LLC, it is deemed to be located in
whichever state it was formed. Many financing statements are filed in
Delaware because many businesses from around the country incorporate
there. Organizations with one place of
business are also “located” in that state even if incorporated in another
state, such as Delaware. If the debtor isn’t a
registered entity and has multiple places of business, the financing statement
must be filed where the organization’s primary executive offices are located.
Domicile, of course,
can be changed by moving. Moreover, some
collateral, such as client lists, trade secrets and other intellectual
property, is intangible and cannot be said to be in any physical place. Other
collateral, such as cars, are inherently mobile and likely to routinely travel
beyond state borders. Because the UCC is
a uniform body of law designed to function throughout the country and enable consistent
outcomes for parties in different states, a series of rules in section 9-307
resolves these complications. With all secured parties following the same
procedures, there is predictability and lenders can easily determine which
state’s records to search when evaluating a loan application as well as to
determine where to file if a secured loan is made.
The filing location may
also depend on the category of the collateral. If collateral is a fixture, then
a unique problem emerges because a fixture is a tangible, movable good that is installed
in real estate. Examples of fixtures include installed ovens, chandeliers and
central air conditioning units. UCC-1’s
for fixtures are filed in the land records office in the city or county where
the real property is located.
Special filing systems
are in place for certain kinds of collateral governed solely or concurrently by
other bodies of law. Notably, liens on motor vehicles are filed
with the local department of motor vehicles under transportation laws because
those offices handle car titling.
Similarly, departments of natural resources and the Coast Guard
administer vessel liens and the Federal Aviation Administration administers
aircraft liens. Likewise, the United
States Patent and Trademark Office handles patent and trademark
assignments. Each of these offices has
its own forms, fees and procedures for perfecting security interests in these collaterals.
Let’s look at a sample financing statement provided by Texas’s Secretary of State. In this financing statement, the information that the creditor must provide includes:
· the debtor’s name and address;
· the secured party’s name and address; and
· a description of the collateral.
Historically, a debtor
had to sign a financing statement to indicate assent to perfecting a security
interest. With increased access to quick
credit and the automation of lending processes, that ceased to be
practical. The current requirement is
that the debtor express consent, in writing or electronically, for the secured
party to make the filing. Most banks and lenders simply add a short
permission provision to their standard loan applications to obtain that
Providing the correct
debtor name is an important section of a financing statement. Errors in debtor’s names can easily make a
financing statement “seriously misleading” and therefore ineffective. A state agency indexes
forms by debtor names in its database, which impacts how interested parties
search for existing records. Without proper naming and indexing, future
creditors may not find the creditor’s filing, rendering it ineffective for its
purpose: notice to future creditors. A secured party must use the full legal name
of the debtor.
If the debtor is a state-registered or chartered entity, such as a corporation
or LLC, the secured party must use the entity’s exact name in public records
with accurate punctuation and spacing. If the debtor is a
partnership, the financing statement should list all partners.
The secured party must also
ensure that he’s described the collateral in the financing statement in at
least as much detail as it’s described in the security agreement. For example,
if the security agreement says that the collateral is inventory, equipment and
accounts receivable, but the UCC-1 only says inventory and equipment, then the
secured party will not be perfected
in the debtor’s accounts receivable.
Unlike in security
agreements, where catch-all descriptions are discouraged, it is acceptable and,
in fact, preferable, to use a catch-all description like “all the debtor’s assets” or “all
the debtor’s personal property” when describing the collateral in the
financing statement. To ensure accuracy of the collateral
description in the financing statement, the creditor can copy and paste the
collateral description from the security agreement.
The UCC has also
created generic numbered forms to accomplish tasks related to perfecting a
security interest. For instance, a UCC-1Ad form is an addendum
form for those transactions that involve more than two debtors, more than one secured
party or otherwise more information than can be fit on the traditional UCC-1
The UCC-3 is an amendment form that a
creditor must file when information on the original financing statement becomes
outdated. An amendment can be filed in several situations. It should be used
when the debtor changes names or repays part of the debt, releasing some, but
not all, of the collateral subject to the security interest. Furthermore, a UCC-3 form can be filed to
the original financing statement when the debtor satisfies the debt or assigns
the security interest perfection to another party.
Finally, the UCC-3 is
used to extend the perfection obtained through a financing statement
through a process known as continuation. Filing a UCC-3 continuation
statement in the last six months before the expiration of the five-year term of
the security interest adds another five years to the perfected security
interest. If the secured party misses that window and
fails to file a UCC-3 to continue the security interest, the perfection lapses. While it is possible to file a new UCC-1 and
re-perfect, it will not relate back to the original, leaving the secured
party’s protection with a gap susceptible to other creditors stealing its place
A UCC-5 is filed when a secured party wants to correct an original filing. With proper care and attention to detail, most filers never need to fill out a UCC-5. When using any of the subsequent forms, including UCC-3’s, UCC-5’s and addenda, it is important to include a copy of the original UCC-1’s instrument or at least its recording number so that it is properly traceable in the database.
Perfection by Possession
A secured party who possesses the debtor’s collateral clearly signals to future creditors that the collateral is encumbered. A creditor can thus perfect a security interest by taking possession of any of the following types of collateral:
· tangible negotiable documents;
· goods like equipment, inventory and consumer goods;
· money; and
· tangible chattel paper, which is a writing that indicates that the holder is owed money and has a security interest in goods associated with the debt (such as a car’s title that indicates the car loan as a security interest).
A secured party can
establish possession either directly by having physical possession of the
collateral or through a third-party agent who acknowledges in an agreement that
he’s holding the collateral for the secured party’s benefit. When a creditor
perfects his security interest via possession, perfection occurs immediately.
The advantage of
perfecting a security interest by possession is that the debtor can’t damage
the collateral or take steps that could threaten the secured party’s rights
because the debtor doesn’t possess it. Note that pawn shops, who often lend
money that is secured by items left with the pawn brokers, typically perfect by
However, perfection by
possession isn’t always practical. For example, if the secured party has a
security interest in the debtor’s “equipment,” the secured party can’t possess
it because the debtor will need his equipment to operate his business. It’s
obviously impractical for the lender of a car loan to perfect by possession for
For example, assume Roger operates a bicycle shop. Roger and First Bank of America draft a security agreement where the bank would lend Roger $100,000 and in return, Bank of America acquires a security interest in all of Roger’s inventory and provides that it can seize the inventory if Roger defaults. First Bank does not file a financing statement with the secretary of state to perfect its security interest. Six months later, Roger obtains a $50,000 loan from Second Bank, also pledging his inventory as collateral under the same terms. As soon as Roger fails to repay the loan, Second Bank seizes the inventory under its agreement with Roger. Second Bank now has possession of the collateral and so has perfected its security interest. Since First Bank did not yet perfect, Second Bank has priority over First Bank, even though its loan was earlier. Since possession of collateral of an operating business is impractical, First Bank should have perfected by filing and should not have relied on seizing the inventory as a mechanism for perfection.
Perfection by Control
Perfecting a security
interest via control works to perfect security interests in intangible
collateral such as:
· deposit accounts, such as checking or savings accounts;
· investment property such as stocks or bonds; and
· letter-of-credit rights.
A secured party has “control”
over collateral like a deposit account if the collateral is in the secured
party’s name, or if the debtor, secured party, and the bank agree that the bank
will follow the secured party's instructions without the debtor’s consent. A secured party has
control over a deposit account even if the debtor retains the right to access
the account or continue depositing funds into the account.
The secured party who perfects his security interest by control assumes a position similar to the secured party who perfects his security interest by possession: he’s limited the debtor’s ability to use and dispose of the collateral. Perfection is achieved as soon as the creditor exercises the control. A secured party may also perfect a security interest in investment property such as a debtor’s certificated shares, such as stocks or bonds, via control. Obtaining control of a certificated security requires delivery of the certificate to the secured party together with either:
· an effective endorsement of the security to the secured party (either on the certificate or a separate stock power or similar form of assignment); or
· registration of the security in the name of the secured party.
Delivery is a requirement of control as to a certificated security and it occurs when the secured party gets possession of the certificate or another person gets possession of the certificate on behalf of the secured party or acknowledges that it acquired possession of the certificate on behalf of the secured party. Another person’s possession works only if the security is in registered form and has been indorsed to the secured party.
Certain types of collateral
are automatically perfected. This means that the secured party does not have to
file a financing statement, possess the collateral or exercise control over it
to perfect a security interest and have priority over other creditors.
For example, a purchase
money security interest in consumer goods is created when the secured party
extends credit to the debtor for the purpose of obtaining the collateral, or
financing the collateral purchase itself. Car loans and other loans
extended by sellers (or their financing companies) create purchase money
security interests. These are analogous to mortgage loans that finance real
estate purchases, though real estate loans are not governed by the UCC.
Purchase money security interests are “super-priority security interests” in consumer goods in favor of the creditor who has financed the purchase price of the consumer goods. It is considered perfected automatically except when it is inventory or equipment. Loans to finance inventory or equipment are not necessarily automatically perfected because it is expected that they will be used or sold.
Buyer in the Ordinary Course
we’ll note that although perfected security interests, and especially purchase
money security interests, have high priority, nobody has a higher priority than
a buyer in the ordinary course of business who buys the collateral without
knowledge of the security interest for personal use. This, for example,
protects shoppers at department stores. Otherwise, a bank with a security
interest in a department store coat would be able to repossess the coat from
its buyer. The disruption that would cause to commerce prompted the UCC to
protect the buyer in the ordinary course.
In our next module, we’ll examine priorities among security interests, including basic priorities, other special rules affecting purchase money security interests and priorities with security interests in fixtures.
 “Attachment: Your Security Interest Isn’t ‘Perfect’ Without It,” Baker Donelson, (May 1, 2011), https://www.bakerdonelson.com/Attachment--Your-Security-Interest-isnt-Perfect-Without-it-05-01-2011.
 Robert K. Weiler, “Basic of Creation and Perfection of Security Interests Under Article 9 of the Uniform Commercial Code,” Green Seifter, (Sept. 2006), https://bhlawpllc.com/wp-content/uploads/2014/04/CREATION-AND-PERFECTION-OF-SECURITY-INTERESTS-RKW1.pdf.
 Unif. Comm. Code § 9-310.
 D. Fenton Adams, “Sales of Personal Property as Secured Transactions Under Article 9 of theUniform Commercial Code,” 31 U. Ark. Little Rock L. Rev. 1, 16 (2008).
 Unif.Comm. Code § 9-515(a)
 Unif.Comm. Code § 9-502(d).
 Unif. Comm. Code §9-516(a).
 Unif. Comm. Code §9-307(b)(1).
 Unif. Comm. Code §9-501(a).
 Unif. Comm. Code § 9-307(e).
 Unif. Comm. Code § 9-307(b)(2)
 Unif. Comm. Code § 9-307(b).
 Unif. Comm. Code § 9-307.
 Unif. Comm. Code § 9-501(a)(1)(B); § 9-502(b).
 Unif. Comm. Code §§ 9-303, 9-311.
 "UCC Financing Statement,” Texas Secretary of State, (last visited Oct. 7, 2018).
 Unif.Comm. Code § 9-509(a).
 Unif. Comm. Code §§ 9-502 – 503.
 Unif.Comm. Code § 9-506(b).
 Unif. Comm. Code § 9-506.
 Unif.Comm. Code § 9-502.
 Unif. Comm. Code § 9-502.
 Unif.Comm. Code § 9-504.
 "UCC Financing Statement ADDENDUM,” Texas Secretary of State, https://www.sos.state.tx.us/ucc/forms/UCC1Ad.pdf (last visited Oct. 7, 2018).
 "UCC Financing Statement AMENDMENT,” Texas Secretary of State, https://www.sos.state.tx.us/ucc/forms/UCC3.pdf (last visited Oct. 7, 2018).
 Unif.Comm. Code § 9-512.
 Unif.Comm. Code § 9-513.
 Unif.Comm. Code § 9-515.
 Unif.Comm. Code § 9-510(c).
 "Information Statement,” Texas Secretary of State, https://www.sos.state.tx.us/ucc/forms/UCC5.pdf(last visited Oct. 7, 2018).
 Mark C. Winnings & Andrea M. Patton, “’Control’ Your Destiny: Perfecting a Security Interest in Deposit Accounts,” Lewis Rice LLC, Lexology, https://www.lexology.com/library/detail.aspx?g=9c0e484e-a3b6-44a5-b6cd-d261407df457 (last visited Oct. 7, 2018).
 Elaine Welle, “An Introduction to Revised Article 9 of The Uniform Commercial Code,” 1 Wyo. L. Rev. 555, 565 (2001).
 Lynn A. Soukup, “Equity Interests as Collateral,” American Bar Association at 15-16 (2011), http://apps.americanbar.org/dch/thedl.cfm?filename=/CL590044/relatedresources/2012LynnSoukupPLIOutlineEquityInterestsasCollateral.DOC.
 “Purchase Money Security Interests for Repetitive Sales,” Robison, Curphey & O’Connell, http://www.rcolaw.com/7599B1/assets/files/News/Purchase%20Money%20Security%20Interests%20for%20Repetitive%20Sales.pdf (last visited Oct. 12, 2018).
 Brian DiBenedetto & Marius Scherb, “Attention Sellers of Goods on Credit: A ‘Retention of Title’ is Not Sufficient Under U.S. Law, and the U.S. Equivalent is Changing,” Gibbons, (Oct. 2015), https://www.gibbonslaw.com/attention-sellers-of-goods-on-credit-a-retention-of-title-eigentumsvorbehalt-is-not-sufficient-under-us-law-and-the-us-equivalent-is-changing-10-01-20151/.
 Unif. Comm. Code § 9-309; see also Frank Peretore, Robert L. Hornby & Ryan O’Connor, “Purchase Money Security Interests – Nuances and Pitfalls,” Equipment Finance Advisor, (Nov. 18, 2014), http://www.equipmentfa.com/articles/3697/purchase-money-security-interests-nuances-and-pitfalls.