Perfection of a Security Interest - Module 2 of 5

Module 2-Perfection of a Security Interest

Perfection Overview

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.[1]

Article 9 provides three mechanisms for a creditor to perfect her security interest: file a financing statement, possession and control.[2]  Furthermore, certain security interests are perfected automatically, and other state laws can sometimes provide alternate paths to perfection.[3]

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.[4] 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.[5]  

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.[6]

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.[7]  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.[8] 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.[9]  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.[10] 

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.[11]  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.[12] 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.[13]

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.[14]  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.[15]  

Special filing systems are in place for certain kinds of collateral governed solely or concurrently by other bodies of law.[16]  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:[17]

·         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.[18]  Most banks and lenders simply add a short permission provision to their standard loan applications to obtain that consent.

Providing the correct debtor name is an important section of a financing statement.[19]  Errors in debtor’s names can easily make a financing statement “seriously misleading” and therefore ineffective.[20] 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.[21]  A secured party must use the full legal name of the debtor.[22] 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.[23] 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.[24]  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[25] 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 financing statement.   

The UCC-3 is an amendment[26] 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.[27]  Furthermore, a UCC-3 form can be filed to terminate[28] 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.[29]  If the secured party misses that window and fails to file a UCC-3 to continue the security interest, the perfection lapses.[30]  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 in line.

A UCC-5[31] 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 possession.

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 similar reasons.

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:[32] 

·         deposit accounts, such as checking or savings accounts[33];

·         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.[34] 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.[35]

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.

Automatic Perfection

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.[36] 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.[37] It is considered perfected automatically except when it is inventory or equipment.[38] 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

            Finally, 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.[39] 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.