Many companies routinely make loans or otherwise extend credit to other businesses or individuals. Often the company making the loan will want some collateral from the borrower to secure repayment of the loan. How do you, as the lender, obtain a valid security interest in the collateral, and how is that security interest protected and enforced?
If your company routinely makes loans or otherwise extends credit to other businesses or individuals, you, as the lender, will obtain from the borrower a promise to repay in exchange for the loan or extension of credit. If the borrower fails to repay the loan as promised, you can sue to enforce the promise. But what if the borrower simply doesn't have the means to repay the loan? After all, most businesses and business owners would pay you back if they had the money to do so. Therefore, you should protect yourself by requiring your extension of credit to be backed by some type of collateral, whether real property (i.e., land) or personal property (i.e., anything other than land such as computers, vehicles, or accounts receivable). In the event of the borrower's default on the promise to repay, you can exercise your rights in the collateral in addition to (or instead of) suing the borrower on the promise to repay. The collateral, therefore, provides a second remedy to you as the lender. You want to make sure your claim on the collateral is effective not only as against the borrower, but also against all other creditors of the borrower who are likely to be scrambling to get paid at the same time you are.
The Uniform Commercial Code
The Uniform Commercial Code ("UCC") has been adopted in North Carolina as Chapter 25 of the North Carolina General Statutes. Article 9 of the UCC governs the creation and enforcement of security interests in personal property. (The creation and enforcement of security interests in real property encompass an entire body of law itself and will not be discussed in this article.) Most, if not all, states have adopted some form of the UCC.
How Are Security Interests Created?
In general, to acquire a security interest in collateral, you must obtain a written agreement signed by the owner of the collateral ("Grantor") wherein the Grantor grants you a security interest in the collateral. This document is called a "security agreement." The security agreement must specifically identify the collateral. The security agreement may be included in the same document as the borrower's promise to repay. However, the Grantor may or may not be the same person or business as the borrower. For example, a parent company may agree to use some of its property as collateral for an advance of credit to one of its subsidiaries, or the person who owns a limited liability company may pledge personally-owned property as collateral for the company's debts and credit lines. You should satisfy yourself that the Grantor is in fact the owner of the collateral or otherwise has sufficient rights in the collateral to grant a valid security interest in it. The promise to repay (signed by the borrower) and the security agreement (signed by the Grantor) are separate and distinct obligations.
Is Your Security Interest Enforceable?
So now you have advanced money and obtained a security agreement giving you "dibs" on some property. But what if the Grantor previously granted a security interest in the same collateral to someone else? What if the Grantor subsequently grants a security interest in the collateral to someone else? How can you determine the "priority" of your interest in the collateral and protect that priority against claims by third parties?
Unless your security agreement specifically provides otherwise, your security interest "attaches" to the collateral (i.e., the collateral becomes subject to the security interest) when it becomes enforceable against the Grantor. This generally happens when both the money is loaned (or credit is extended) and the security agreement is signed by the Grantor. Once the security interest attaches, you may exercise your rights in the collateral relative to the Grantor, but only upon the borrower's default in the payment of its underlying debt to you.
Even so, enforceability against the Grantor does not mean you can enforce your rights in the collateral against anyone else (in most instances, another lender) who has a security interest in the same collateral. The priority of competing security interests in the same collateral depends on the order of "perfection" of the security interests. "Perfection" is the process by which third parties other than you, the borrower, and, if separate, the Grantor are put on notice of your security interest in the collateral. Security interests in different types of collateral may be perfected in different ways. For example, a security interest in a car can be perfected only by having your lien noted on the certificate of title. Security interests in other types of collateral, such as certificated stocks, would be perfected by you actually taking possession or control of the collateral (the stock certificate). Special rules also apply for perfecting security interests in intellectual property rights.
Most security interests, however, are perfected by filing what is called a "financing statement." In most states, including North Carolina, the financing statement is filed with a state-wide office such as the North Carolina Department of the Secretary of State (where financing statements are filed in North Carolina) and becomes effective when it is filed in the required office(s).
To be effective, your financing statement must identify the Grantor and you as the lender, and must sufficiently describe the collateral. The Grantor will be identified as the "debtor" even if the collateral is securing the loan of another person or entity. The idea is to give notice of the claim on the property, regardless of who the debtor is. The financing statement cannot give you, as the lender, any greater rights in the collateral than what is granted to you by the security agreement. The financing statement serves only to perfect the security interest by giving notice of your claim, not to define the scope of your claim or the amount of debt being secured.
The Grantor's name, as "debtor," must be accurately reflected on the financing statement. If the Grantor is a corporation or other registered organization, the financing statement must list the Grantor's name exactly as it appears in the records of the North Carolina Department of the Secretary of State. If the Grantor is an individual, the individual's full name should be listed, with particular attention given to proper spelling. In most states, financing statements are indexed under the name of the Grantor, and any errors in the Grantor's name will cause the financing statement to be improperly indexed. If the financing statement is not indexed under the Grantor's correct legal name, it may be deemed to not have been perfected at all because a third party would not find it in a search using the Grantor's correct name and, as result, you may lose your claim and rights to the property. (Your unperfected security interest which has attached will still be valid as against the Grantor, but not against third parties who have properly perfected their interests.)
The records of the North Carolina Department of the Secretary of State may be searched online to determine if any financing statements have been filed against a Grantor. You should thoroughly search the Secretary of State records for financing statements before taking a security interest in collateral to ensure the priority of your security interest. Then, you should file a financing statement as soon as possible to preserve the priority of your security interest.
How Long Is a Financing Statement Effective?
Your filed financing statement serves to perfect your underlying security interest for five years from the date you file it. You may extend the effectiveness for another five years by filing a "continuation statement" within six months before the expiration of the initial five-year period. Your financing statement may be continued in this manner indefinitely by filing successive continuation statements until the underlying debt is paid in full. However, if your financing statement is permitted to lapse without filing a continuation statement, the financing statement ceases to be effective, and any security interest that previously was perfected by the financing statement becomes unperfected and loses its priority. Upon payment in full of the underlying debt, you should file a "termination statement" terminating the effectiveness of the financing statement.
What if the Borrower Defaults on the Loan?
If the borrower defaults, you may enforce your security interest in the collateral and exercise your rights as provided in the security agreement and under Article 9 of the UCC. Generally, you can take possession of the collateral from the Grantor if the Grantor surrenders the collateral or if such possession can be taken peacefully. Otherwise, you must sue to obtain possession. Once you obtain possession of the collateral, you may dispose of it in a commercially reasonable manner after proper notification to the Grantor and any other party entitled to notice. Following disposition of the collateral, the proceeds must be applied to the underlying debt, with any surplus being paid to the Grantor. If the proceeds from disposition of the collateral are insufficient to pay the balance on the debt, the borrower generally will remain liable to you for any such deficiency.
Companies and businesses that routinely make loans and extend credit should consider taking collateral to secure the repayment of the debt. If you take personal property as collateral, you should understand the process for obtaining, perfecting, and enforcing your security interest in the collateral. This requires careful consideration of the terms of the security agreement between you and the debtor or owner of the collateral and of your financing statement, as numerous pitfalls await the unwary.
© 2021 Ward and Smith, P.A.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.