How to Attach and Perfect Your Security

Interest in Collateral
Learn about secured transactions and how to obtain legal
priority to collateral.
by David M. Steingold, Contributing Author

Secured transactions are loans or purchases that are secured by collateral. Article 9 of the
Uniform Commercial Code (UCC) contains hundreds of rules for how these types of loans and
purchases are handled. Here well look at just a few key terms and principles. Additional Nolo
articles on secured transactions contain more details.

A Basic Example

It is not necessarily easy to understand how the basic elements of a secured transaction, such as
collateral (also known as security), debtors, secured parties, and security interests, fit together.
However, the following simple example should provide at least a little illumination.

Stefan is the president and CEO of a small company that makes specialized parts for cargo ships.
He has just signed an agreement to supply parts to a major ship manufacturer. The deal
ultimately will be very profitable. However, to meet his obligations to the ship manufacturer,
Stefans company needs new machinery and a lot of raw materials, and currently his company
doesnt have enough money to buy either of these things.

So, Stefans company buys the necessary new machinery (which the UCC calls equipment) on
credit from Machines, Inc. As a key part of the deal, Machines, Inc. requires Stefan to provide
collateral (or security). More specifically, Machines, Inc. requires that Stefan give it the legal
right to repossess the new equipment if Stefan fails to keep up the payments.

For the raw materials (which the UCC calls inventory), Stefan goes to State Bank to get a loan.
As with Stefans deal with Machines, Inc., the deal with State Bank includes a requirement that
Stefans company provide collateral (security) for the loan. More specifically, State Bank
requires Stefan to provide the bank with the legal right to repossess the raw materials
(inventory), as well as the legal right to take any payment due under the contract with the ship
manufacturer, if Stefans company fails to repay the loan.

In this example:

Stefans company is the debtor

Machines, Inc. and State Bank are creditors (and, more specifically, secured parties); and

the machinery, materials, and contract payments are collateral (or security).
Machines, Inc.s legal right to repossess the new machinery constitutes Machines, Incs security
interest in the equipment collateral. State Banks legal rights to the raw materials and payments
constitute the banks security interest in the inventory and other collateral. (Note that collateral
need not be limited to physical property, and may include, a businesss accounts receivable.)

This example covers some of the key elements of a secured transaction, including a loan or
purchase, collateral, a debtor, secured parties, and security interests. However, a secured
transaction also involves other necessary elements, including a security agreement, attachment
of the security interest, perfection of the security interest, and, potentially, prioritization of
creditors. Each of the latter elements is reviewed briefly below, and more fully in separate Nolo
articles.

Attachment of a Security Interest

Under the UCC, a security interest is not createdor, in the language of the UCC, does not
attachunless certain basic requirements are met. In simplest form, the requirements are that:

value be given for the security interest

the debtor has rights in the collateral or power to transfer the collateral to a secured party;
and
the debtor authenticates a security agreement.

These requirements apply to the most common types of collateral, including those listed in our
example above. However, for certain less common types of collateral, the requirements relating
to an authenticated security agreement may vary.

In our example, Stefans company receives value for Machines, Inc.s security interest in the
form of new equipment, and receives value for State Banks security interest in the form of the
money loaned by the bank. Stefan, as president and CEO of his company, has rights in the
collateral. Finally, both Machines, Inc. and State Bank will present security agreements to Stefan
for his signature. (A signature is one form of authenticating a security agreement; in the UCC,
authenticate covers not only traditional signatures but also electronic signatures.)

Perfecting a Security Interest

A basic purpose of a secured transaction is to give a lender or seller some potential remedy in the
event that the borrower or buyerthe debtoris unable to pay whats owed. More particularly,
in situations where the debtor is insolvent, the secured party can take possession of the agreed-
upon collateral. While this idea may work reasonably well when there is only one secured party,
matters are more complicated where there are several loans or purchases, several secured parties
and, potentially, a bankruptcy trustee. When multiple creditors and a bankruptcy trustee are
involved, and there is not enough money or property to pay all the creditors in full, the creditors,
along with the trustee, all may try to take possession of the same collateral, leading to disputes.

Perfection of a security interest is intended to help avoid competing claims to collateral. Under
the UCC, a basic security interest involves attachment, which is discussed in the preceding
section. However, attachment alone will not work to resolve a dispute between multiple creditors
and a bankruptcy trustee. Instead, secured parties must also perfect their security interests.
Perfection of a security interest gives a secured party priority over other creditors or a
bankruptcy trustee.

A secured party often perfects an interest in collateral by filing a document known simply as a
financing statement. The purpose of the financing statement is to put any other potential creditors
or other interested parties on notice regarding the filers interest in the collateral listed on the
statement. In many cases, the secured party will work from a widely-available preprinted form,
known as Form UCC-1, to complete the financing statement. You can easily find a sample UCC-
1 online. Once completed, the statement is filed with an appropriate local government office.
(Other methods of perfection are also laid out in the UCC but are not covered in this overview
article.)

In our example above, both Machines, Inc. and State Bank will likely file financing statements
with appropriate local government offices as soon as possible after Stefan signs the necessary
documents to perfect their security interests in the relevant collateral. (In fact, a creditor, like
Machines, Inc., may even choose to file a financing statement before a security agreement is
signed.)

Priority of Creditors

The UCCs rules for prioritization of creditors are vast and complex. They depend on many
factors, such as:

who the creditors are (a secured party, a so-called lien creditor, a buyer of the collateral)
what kind of security interest is involved (a so-called purchase-money security interest, a
security interest in property acquired by the debtor after attachment and filing of a UCC-
1); and
what kind of collateral is involved (equipment, inventory, consumer goods).

For immediate purposes, well simply state that, generally speaking, when there are secured
parties with competing claims for the same collateral, it is usually the secured party that first
perfected its interest in the collateralfor example, by being the first to file a Form UCC-1
that will have legal priority to the collateral.

In our above example, if Machines, Inc. files the necessary UCC-1 to perfect its security interest
in the new equipment, but then, at a later time, another creditor files a UCC-1 covering the same
equipment, Machines, Inc. should have a priority interest over that other creditor in the event that
Stefans company goes bankrupt.

Final Note

This article is based on the current version of the model Uniform Commercial Code (UCC).
However, not all states have adopted all sections of the current model UCC. Moreover, the model
UCC specifically leaves it to individual states to determine the precise wording of certain
sections. Therefore, you should always check your own states commercial code for the most
accurate information.

How to Attach and Perfect a Security Interest

Under the UCC
Learn the rules about how to attach and perfect a security
interest under the UCC.
by Stephen Fishman, J.D.

A secured transaction is a loan or purchase that is secured by collateral. It involves a borrower

or buyer, technically known as the debtor, and a lender or seller, technically known as a creditor,
and more specifically known as a secured party. Common secured transactions include a bank
loaning a business money so the business can buy inventory, or a company selling a
business equipment on credit. In these transactions, the business is the debtor, the bank or the
selling company is the creditor, and, most likely, the inventory or equipment will be at least part
of the collateral.

Under Article 9 of the Uniform Commercial Code (UCC), which covers secured transactions, in
order for a creditor to become a secured partythat is, a party with a legal right to take
possession of collateral in the event of the debtors failure to paythe creditor must take special
steps. These steps are known asattachment of a security interest. Moreover, in order for a secured
party to more fully ensure its legal rights in the event that other parties are asserting an interest in
the same piece of collateral, the secured party must take additional steps. These additional steps
are known as perfecting a security interest. Here well look at both attachment and perfection of
security interests.

Attachment

A creditor has a security interest in collateral, and becomes a secured party, if and when a
security interest attaches. Under the UCC, a security interest generally does not attach unless
three basic requirements are met. In simplest form, the requirements are that:

value be given for the security interest

the debtor has rights in the collateral (or power to transfer the collateral to a secured
party); and
the debtor authenticates a security agreement.

Lets briefly look at each of these requirements.

Value. A secured transaction is a contract between the debtor and the secured party. Like most
contracts, there must be an exchange of consideration between the parties. In other words, there
must be an exchange of value. In the case of secured transactions, the value given by the secured
party is usually obvious. For example, a bank gives value to a debtor when, in conjunction with a
security agreement, it loans money to the debtor to buy inventory. Similarly, a seller gives value
to a debtor when, in conjunction with a security agreement, it sells equipment to the debtor.

Debtors rights in collateral. A business may have rights in collateral either by owning the
collateral prior to the secured transaction or by purchasing the collateral as part of a secured
transaction. When a business already owns certain property, it should be clear that the business
has rights in that property, and can use it as collateral. In other cases, a business will buy items
(materials, inventory, machinery and so on) on credit and want to use those same items as
collateral. In such cases, the business will sign a conditional sales contract, which is also
considered a security agreement, and which, under UCC sales rules, will give the business the
necessary rights in the purchased items to use them as collateral. (Note: the alternative option of
having the power to transfer the collateral often involves relatively unusual circumstances and
is not covered here.)

Security agreement. For purposes of attachment, the debtor must authenticate a security
agreement. In other words, the debtor must sign the agreement. (The UCC uses the term
authenticate to include the possibility of electronic signatures.) A security agreement normally
will contain a clear statement that the debtor is granting the secured party a security interest in
specified goods. The agreement also must provide a description of the collateral. Section 9-108
of the UCC indicates generally that a description of collateral is sufficient if it reasonably
identifies what is described. The same section then goes on to provide a half-dozen different
possibilities for a reasonable identification, such a specific listing, a category, or a
quantity. While the description of collateral in a security agreement may not need to be finely
detailed, the UCC prohibits descriptions of collateral that are supergeneric, such as all the
debtors assets or all the debtors personal property.

The UCC recognizes that some security agreements are quite complex, and, therefore, has
various special rules regarding certain possible agreement terms. To take just one example, a
security agreement may include a clause that the collateral is to include property that the debtor
acquires after the agreement is signed. For the most part, the UCC allows parties to use after-
acquired property as collateral; however, the UCC does not allow after-acquired consumer
goods to serve as collateral.

The three requirements of: giving value, debtor rights in the collateral, and an authenticated
security agreement apply to the most common types of collateral, such as equipment, inventory
and even payments due under a contract. However, for certain less common types of collateral,
the requirements relating to an authenticated security agreement may vary.

Perfection

A secured party perfects a security interest in order to help assure that no other party, such as
another creditor or a bankruptcy trustee, will be able to claim the same collateral in the event that
the debtor becomes insolvent. By perfecting its security interest, a secured party seeks to
gain priority over other parties regarding the collateral.
The precise details of how to perfect a security interest depend in part on the local jurisdiction
where the collateral is located. However, generally speaking, the primary ways for a secured
party to perfect a security interest are:

Related Ads

by filing a financing statement with the appropriate public office

by possessing the collateral

by controlling the collateral; or

it's done automatically upon attachment of the security interest.

Of these four listed items, the first--filing a financing statement--is by far the most common and
important to understand.

Financing statement. Security interests for most types of collateral are usually perfected by
filing a document known simply as a financing statement. The purpose of the financing
statement, which is filed with a public office such as the Secretary of State, is to put other people
on notice of the secured partys security interest in the collateral. The UCC specifies what must
be contained in a financing statement:

the name of the debtor

the name of the secured party; and

an indication of the collateral.

Regarding the first of these items, it is important that the name of the debtor be sufficiently
specific and accurate, because financing statements are filed under the debtors name. If the
name on the statement is wrong, the statement will fail to provide adequate notice to others, and
will not succeed in perfecting the security interest. Section 9-503 of the UCC provides various,
more specific rules regarding the sufficiency of a debtors name on a financing statement. For
example, if the debtor is a registered organization, which might mean a corporation or limited
liability company organized under a particular states law, then the name on the financing
statement must match the name of the debtor as registered with the state. The second required
item on the statement, the name of the secured party, is generally a straightforward matter.
Finally, as to the third item, the rules for indication of collateral on the financing statement are
largely the same as for the description of collateral on a security agreement (see above).
However, unlike with a security agreement, on a financing statement it is acceptable to use a
supergeneric description of collateral.

A standard form, known as Form UCC-1, is widely used by secured parties to file a financing
statement. You can easily find a sample UCC-1 online. While many financing statements must be
filed with the Secretary of State, you should check your own states laws for more information.
As a final point, be aware that a financing statement can be, and sometimes is, filed before a
security interest has attached; creditors do this in anticipation of creating a security interest, in
order to make sure that the interest is perfected immediately upon attachment.
Possession. A security interest in many types of collateral, including negotiable documents,
goods, instruments, money, or tangible chattel paper, may be perfected by the secured party
possessing the collateral. However, so-called intangible collateral, such as accounts receivable,
cannot be perfected by possession. While possession is not directly defined by the UCC in this
context, it does appear to include possession not only by the secured party but also by an agent of
the secured party.

Control. The UCC states that, A security interest in investment property, deposit accounts,
letter-of-credit rights, or electronic chattel paper may be perfected by control of the
collateral . . . . The meaning of control can vary depending on which type of collateral is
involved. For example, a secured party may have control of a deposit account if the bank, the
debtor and the secured party have all agreed that the secured party may handle the funds in that
account without further consent by the debtor. As another example, a secured party has control
over investment property, such as securities (shares of stock or the like), if the property is
delivered to the secured party, and, if necessary, endorsed (signed) to the secured party.

Automatically upon attachment. The most important type of security interest that is perfected
immediately upon attachment is what is known as a purchase-money security interest (PMSI) in
consumer goods. A PMSI generally involves either: (1) a debtor buying an item on credit from a
seller where the seller will be the secured party; or (2) a debtor using a loan from a bank directly
to buy an item from a seller, where the bank will be the secured party. When the debtor in one of
these circumstances is buying consumer goods, the secured party (seller or bank) does not need
to file a financing statement in order to perfect the security interest. Note, however, that, while it
may not be necessary to file a financing statement, not all security interests in PMSIs in
consumer goods are perfected upon attachment. For example, some statutes governing
certificates of title, such as for cars, require that a security interest be indicated on the certificate
in order for the interest to be perfected. Finally, be aware that the UCC states that perfection
occurs automatically upon attachment for about a dozen other relatively unusual types of
collateral. (For more information, check UCC Section 9-309.)

Having covered the main ways to perfect a security interest, it is important to note that there may
be situations where a secured party with a perfected security interest would still have that interest
subordinated to some other party. However, in most cases, perfecting a security interest provides
very substantial protection of that interest.

Final Note

This article is based on the current version of the model Uniform Commercial Code (UCC).
However, not all states have adopted all sections of the current model UCC. Moreover, the model
UCC specifically leaves it to individual states to determine the precise wording of certain
sections. Therefore, you should always check your own states commercial code for the most
accurate information.