Why Secured Transactions Are Important

Secured transactions form the backbone of a wide range of business dealings, including business loans, mortgages, and inventory financing. Because the stakes are often high and relatively minor oversights can have drastic consequences, lenders and borrowers should thoroughly understand how to form an enforceable security agreement that protects their legal rights.

What Is a Secured Transaction?

A secured transaction is an arrangement in which a buyer or borrower (known as the debtor) guarantees payment of an obligation by granting a security interest in property to the seller or lender (known as the secured party). Common examples include a residential mortgage secured by the home or a business loan secured by inventory.

In a secured transaction, the property pledged as security is known as collateral. There are two types of security interests: possessory and non-possessory. With a possessory security interest, the secured party assumes possession of the collateral. With a non-possessory security interest, the debtor maintains possession.

Chattel paper plays a key role in many secured transactions by documenting both the monetary obligation and the security interest in specific goods.

Security transactions are governed by Uniform Commercial Code (UCC) Article 9, along with state laws governing contracts. Article 9 of the UCC applies to commercial transactions involving a security interest in personal property, such as inventory, products, or fixtures. Except for Louisiana, most states have enacted the UCC with relatively few changes. Secured transactions involving real property, such as a mortgage, are governed by state law.

How Does a Secured Transaction Work?

Certain requirements must be satisfied in order for a security interest to be enforceable against the debtor and third parties. Below is a brief summary:

Security Interest

A security interest exists when there is collateral that guarantees a loan will be repaid.

Attachment

To create an enforceable security interest, there must be attachment, which means that the security interest is made effective. A valid attachment requires the following:

1. The creditor must give the debtor value, which can be a service, cash loan or access to a line of credit
2. The debtor must have rights in the collateral, such as ownership or the power to transfer rights in the collateral
3. The debtor must agree to grant the secured party a security interest, typically in the form of a security agreement signed by both the debtor and the secured party

Security Agreement

The UCC requires secured transactions to be memorialized in writing. At minimum, a written security agreement must describe the collateral and be authenticated by the debtor to create a security interest. A security agreement typically also includes a description of the obligation it secures, an identification of what constitutes a default, the rights of the creditor if the borrower defaults, the requirements of the debtor with respect to the care of and insurance maintained on the collateral, and any additional rights and obligations of the parties.

Commercial real estate law principles often overlap with secured transactions when property serves as collateral for business loans and development financing.

Financing Statement

The process of perfecting a security agreement allows the secured party to gain priority to the collateral over any third party, if the borrower defaults on the loan. In most cases, lenders will perfect a security agreement by filing a "financing statement," a form which details any personal property that is provided by the borrower as collateral for the loan.

By filing a financial statement with the Department of Treasury, the Secretary of State, or the office of a similar government official, a creditor puts the public on notice that the creditor has an interest in the property of a debtor. As long as it is properly filed, a financing statement establishes priority should the debtor default or declare bankruptcy, meaning that it places the named creditor's legal rights in the collateral above those of subsequent debtors or even innocent third-party purchasers.

Enforcement

If the debtor defaults, a secured lender can enforce its security interest. While the terms of the security agreement generally outline the details of the process, enforcement often involves the lender repossessing and selling the collateral to satisfy the debt.

How to Secure Transactions and Protect Your Interests

Secured transactions have a number of significant advantages. For lenders, they greatly reduce the risks. Generally, an unsecured creditor can't seize the debtor's property to satisfy a debt unless the debtor obtains a judgment and initiates collections proceedings, which can be a lengthy and expensive process.

Meanwhile, a secured lender can recoup the loan amount by taking the agreed-upon asset used as collateral and selling it. Additionally, a security interest is particularly beneficial in bankruptcy because secured creditors can collect their debts before creditors without a security interest.

Secured transactions also have benefits for borrowers. Most importantly, they allow borrowers to access credit that might not be available otherwise, especially for businesses or individuals with limited credit history. When you secure transactions with collateral, you often receive better interest rates and more favorable loan terms. Of course, because the debtor has pledged collateral, there is greater risk if a default occurs.

When businesses face financial challenges, understanding secured financing options can provide access to needed capital while managing risk appropriately.

Consult Scarinci Hollenbeck's Experienced Business Attorneys

Commercial loan transactions have grown increasingly complex in recent years, making it necessary to work with experienced counsel who can help guide you through the transaction. The attorneys of Scarinci Hollenbeck's Corporation Transactions & Business Group represent lenders and borrowers in both routine and complex secured transactions.

Whether drafting loan documents or enforcing a security interest, our team is committed to delivering practical and cost-effective legal services of the highest quality. Understanding how to properly structure and secure transactions is critical to protecting your financial interests and minimizing risk.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.