# The Legal Environment of Business, v. 1.0

by Don Mayer, Daniel M. Warner, George J. Siedel, and Jethro K. Lieberman

## 11.1 Introduction to Secured Transactions

### Learning Objectives

1. Recognize, most generally, the two methods by which debtors’ obligations may be secured.
2. Know the source of law for personal property security.
3. Understand the meaning of security interest and other terminology necessary to discuss the issues.
4. Know what property is subject to the security interest.
5. Understand how the security interest is created—”attached”—and perfected.

## The Problem of Security

Creditors want assurances that they will be repaid by the debtor. An oral promise to pay is no security at all, and—as it is oral—it is difficult to prove. A signature loanA loan for which no collateral is pledged. is merely a written promise by the debtor to repay, but the creditor stuck holding a promissory note with a signature loan only—while he may sue a defaulting debtor—will get nothing if the debtor is insolvent. Again, that’s no security at all. Real security for the creditor comes in two forms: by agreement with the debtor or by operation of law without an agreement.

## By Agreement with the Debtor

Security obtained through agreement comes in three major types: (1) personal property security (the most common form of security); (2) suretyship—the willingness of a third party to pay if the primarily obligated party does not; and (3) mortgage of real estate.

## By Operation of Law

Security obtained through operation of law is known as a lienAn encumbrance upon property to secure payment.. Derived from the French for “string” or “tie,” a lien is the legal hold that a creditor has over the property of another in order to secure payment or discharge an obligation.

In this chapter, we take up security interests in personal property and suretyship. In the next chapter, we look at mortgages and nonconsensual liens.

## Basics of Secured Transactions

The law of secured transactions consists of five principal components: (1) the nature of property that can be the subject of a security interest; (2) the methods of creating the security interest; (3) the perfection of the security interest against claims of others; (4) priorities among secured and unsecured creditors—that is, who will be entitled to the secured property if more than one person asserts a legal right to it; and (5) the rights of creditors when the debtor defaults. After considering the source of the law and some key terminology, we examine each of these components in turn.

Here is the simplest (and most common) scenario: Debtor borrows money or obtains credit from Creditor, signs a note and security agreement putting up collateral, and promises to pay the debt or, upon Debtor’s default, let Creditor (secured party) take possession of (repossess) the collateral and sell it. Figure 11.1 "The Grasping Hand" illustrates this scenario—the grasping hand is Creditor’s reach for the collateral, but the hand will not close around the collateral and take it (repossess) unless Debtor defaults.

Figure 11.1 The Grasping Hand

## Source of Law

Article 9 of the Uniform Commercial Code (UCC) governs security interests in personal property. The UCC defines the scope of the article (here slightly truncated):Uniform Commercial Code, Section 9-109.

This chapter applies to the following:

1. A transaction, regardless of its form, that creates a security interest in personal property or fixtures by contract;
2. An agricultural lien;
3. A sale of accounts, chattel paper, payment intangibles, or promissory notes;
4. A consignment…

## Definitions

As always, it is necessary to review some definitions so that communication on the topic at hand is possible. The secured transaction always involves a debtor, a secured party, a security agreement, a security interest, and collateral.

Article 9 applies to any transaction “that creates a security interest.” The UCC in Section 1-201(35) defines security interestRight in personal property to secure payment or performance of an obligation. as “an interest in personal property or fixtures which secures payment or performance of an obligation.”

Security agreementAgreement that grants a security interest. is “an agreement that creates or provides for a security interest.” It is the contract that sets up the debtor’s duties and the creditor’s rights in event the debtor defaults.Uniform Commercial Code, Section 9-102(a)(73).

CollateralProperty given as security for a debt. “means the property subject to a security interest or agricultural lien.”Uniform Commercial Code, Section 9-102(12).

Purchase-money security interestThe security interest held by the seller of collateral to secure payment of all or part of the price. (PMSI) is the simplest form of security interest. Section 9-103(a) of the UCC defines “purchase-money collateral” as “goods or software that secures a purchase-money obligation with respect to that collateral.” A PMSI arises where the debtor gets credit to buy goods and the creditor takes a secured interest in those goods. Suppose you want to buy a big hardbound textbook on credit at your college bookstore. The manager refuses to extend you credit outright but says she will take back a PMSI. In other words, she will retain a security interest in the book itself, and if you don’t pay, you’ll have to return the book; it will be repossessed. Contrast this situation with a counteroffer you might make: because she tells you not to mark up the book (in the event that she has to repossess it if you default), you would rather give her some other collateral to hold—for example, your gold college signet ring. Her security interest in the ring is not a PMSI but a pledge; a PMSI must be an interest in the particular goods purchased. A PMSI would also be created if you borrowed money to buy the book and gave the lender a security interest in the book.

Whether a transaction is a lease or a PMSI is an issue that frequently arises. The answer depends on the facts of each case. However, a security interest is created if (1) the lessee is obligated to continue payments for the term of the lease; (2) the lessee cannot terminate the obligation; and (3) one of several economic tests, which are listed in UCC Section 1-201 (37), is met. For example, one of the economic tests is that “the lessee has an option to become owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement.”

## Chattel Paper

Chattel is another word for goods. Chattel paper is a record (paper or electronic) that demonstrates both “a monetary obligation and a security interest either in certain goods or in a lease on certain goods.”Uniform Commercial Code, Section 9-102(11). The paper represents a valuable asset and can itself be used as collateral. For example, Creditor Car Company sells David Debtor an automobile and takes back a note and security agreement (this is a purchase-money security agreement; the note and security agreement is chattel paper). The chattel paper is not yet collateral; the automobile is. Now, though, Creditor Car Company buys a new hydraulic lift from Lift Co., and grants Lift Co. a security interest in Debtor’s chattel paper to secure Creditor Car’s debt to Lift Co. The chattel paper is now collateral. Chattel paper can be tangible (actual paper) or electronic.

## Documents

This category includes documents of title—bills of lading and warehouse receipts are examples.

## Instruments

An “instrument” here is “a negotiable instrument (checks, drafts, notes, certificates of deposit) or any other writing that evidences a right to the payment of a monetary obligation, is not itself a security agreement or lease, and is of a type that in the ordinary course of business is transferred by delivery with any necessary indorsement or assignment.” “Instrument” does not include (i) investment property, (ii) letters of credit, or (iii) writings that evidence a right to payment arising out of the use of a credit or charge card or information contained on or for use with the card.Uniform Commercial Code, Section 9-102(a)(47).

## Investment Property

This includes securities (stock, bonds), security accounts, commodity accounts, and commodity contracts.Uniform Commercial Code, Section 9-102(a)(49). Securities may be certified (represented by a certificate) or uncertified (not represented by a certificate).Uniform Commercial Code, Section 8-102(a)(4) and (a)(18).

## Other Types of Collateral

Among possible other types of collateral that may be used as security is the floating lienA lien that is expanded to cover any additional property that is acquired by the debtor while the debt is outstanding.. This is a security interest in property that was not in the possession of the debtor when the security agreement was executed. The floating lien creates an interest that floats on the river of present and future collateral and proceeds held by—most often—the business debtor. It is especially useful in loans to businesses that sell their collateralized inventory. Without the floating lien, the lender would find its collateral steadily depleted as the borrowing business sells its products to its customers. Pretty soon, there’d be no security at all. The floating lien includes the following:

• After-acquired property. This is property that the debtor acquires after the original deal was set up. It allows the secured party to enhance his security as the debtor (obligor) acquires more property subject to collateralization.
• Sale proceeds. These are proceeds from the disposition of the collateral. Carl Creditor takes a secured interest in Deborah Debtor’s sailboat. She sells the boat and buys a garden tractor. The secured interest attaches to the garden tractor.
• Future advances. Here the security agreement calls for the collateral to stand for both present and future advances of credit without any additional paperwork.

Here are examples of future advances: