When making a secured loan, the process of making sure your collateral is actually – legally – your collateral can be more difficult than expected or later determined. The steps are fairly simple, but the analysis and execution can be lacking for a number of technical reasons which can render your first priority lien a junior lien or gone all together if you are not careful.
There are numerous opportunities to mess up collateralizing things for a secured loan. This blog post will discuss personal property which has its own rules (as opposed to real property).
First, the down side. If a lien is not properly attached or perfected the lender runs the risk of either being subject to a later lien or all together unsecured if the borrower files bankruptcy. It’s a big deal.
There are two basic steps to create a lien. The first step is “attachment” the second step is “perfection”. Both are equally important but for different technical reasons. However, the underlying purpose of the exercise is also two-fold. 1 – Agree on what is being pledged and, 2 – let everyone else know.
When taking a pledge of collateral, the first deal a lender makes is with the borrower. This agreement is contained (usually) within the security agreement. This is the document, signed by the borrower, which identifies specifically what things are being pledged (hypothecated, etc.) as collateral.
The security agreement should either: specifically identify what is being pledged, or should enumerate the class of collateral by their defined terms in the applicable uniform commercial code.
The security agreement is the specifics of the agreement to pledge collateral by the borrower to the lender. (By the way, be sure the borrower actually is the owner of the collateral. One cannot pledge what one does not own).
There are many traps for the unwary in this process. The type of collateral pledged may be one of several defined collateral classes depending on how it is being used. Thus, taking a lien on equipment will not give a lender a lien if that equipment is being used as inventory.
Once a lender has properly attached the collateral the lender has a lien on the collateral as between the borrower and lender. BUT not third parties.
When taking a pledge of collateral, the second deal a lender makes is with everyone else. In short, once the lien is attached the lender needs to let everyone else know about the lien, otherwise it’s meaningless to third parties.
Different types of collateral require different types of perfection. The typical perfection method is filing a form with the secretary of state called a UCC1 form. Other methods are used for specific types of collateral, but that is beyond the scope of this article.
The secretary of state’s filing system provides a public forum which provides legal constructive notice of the filing. This means that if a UCC1 is filed everyone is on proper notice even if they never look at the filing.
The state of incorporation will determine which secretary of state needs to receive the lenders UCC1. After that, the next task is the technical compliance with the requirements of filing. More specifically, the lender needs to put the world on notice as to what the lender’s lien attaches to. If this is done successfully, then all third parties will be subordinate to the lien of the first lender.
To accomplish this, the lender needs to properly name the borrower by its formal legal name (no DBAs) and give reasonable notice of the collateral pledged.
A failure on either of these can cause a lender to loose priority or the lien all together. The formal legal name is easier to mess up than you think. With regard to the collateral, here is where determining exactly the character of collateral becomes important as well. If your security agreement says “equipment” but your UCC1 says “inventory” then there has not been proper perfection.
If perfection is not proper then there is no way to keep a third party from taking over a first position lien (assuming they attach and perfect properly) and, worse, if the borrower files bankruptcy ANY failure to attached or perfect will be attacked by the trustee and likely render a lien worthless.
There are, frankly, a number of ways to mess up this technical process. The mind frame to approach securing a loan is “this seems simple, but it’s actually quite complex”. Oftentimes, a misstep isn’t discovered until years later when it’s too late to remedy.
There is a significant amount more to talk about on the topic, but I wanted to give a brief overview of attachment and perfection. Email me if you have any good war stories on the topic; they tend to be very interesting.