Flyover 1 - Granting

Welcome back to secured transactions. Now we're going to talk about the granting of security interests, that is, how does a creditor get a security interest in a piece of personal property or multiple pieces of personal property that it can then enforce if the debtor defaults on the loan from the creditor? Default simply means that the debtor does not pay as it was supposed to under the terms of the loan.

Remember that security interests are given by the people and businesses who take out loans to the creditor extending them the loan. The giving of the security interest is done through a written document of some form called a security agreement.

Attachment

Security interests cannot be granted orally. For a security interest to be enforceable, it must attach. Attachment makes a security interest enforceable against particular pieces of personal property called collateral upon the debtor's default on the loan secured by that property. As a preview, the next lesson details how the secured creditor enforces an attached security interest to get value from the collateral upon default.

Three Requirements

For security interest to attach, three requirements must be met. First, value must have been given by the creditor; second, the debtor must have rights in the collateral that can be transferred to the secured party; third, the debtor must have authenticated a security agreement that provides a description of the collateral, or the secure party must have taken possession of the collateral pursuant to the security agreement. Let's take each of these requirements in turn.

1. Value

First, in most instances, the secured creditor will have given the debtor value. The value is the extension of credit, that is, the loan. The first requirement is value given.

2. Collateral

The second requirement is collateral that the debtor has rights in. In most instances, the debtor will have rights in the collateral that will be subject to the security interest.

The debtor will simply own the piece of property. For instance, the debtor will own equipment, a bank account, accounts receivable, or inventory that is the collateral. If you encounter a question about enforceability of a security interest, the first two of the three requirements typically will be met. Value will have been given, and the debtor will have rights in the collateral.

3. Security Agreement

The third requirement is a written security agreement with a collateral description, or that the creditor has possession of the collateral as provided in the security agreement. Questions about enforceability usually turn on the third requirement. Notice that both alternatives require a security agreement.

The first alternative is that the debtor authenticated a security agreement that provides a description of the collateral. Authenticate means signing in some way. The debtor can sign with a pen or electronically, or even through email with a signature block in it. In short, the debtor must sign the security agreement.

Collateral Description

The security agreement also must include a collateral description. There are a handful of standards for what is required for the collateral description. Article 9 provides that the description must reasonably identify the collateral. This is a low standard, but not a nonexistent standard. The description cannot simply list all assets or all property of the debtor.

These super generic descriptions are not sufficient. The description also cannot list commercial tort claims or consumer goods. Besides providing that the description must reasonably identify the collateral, Article 9 also provides guidance for what descriptions are sufficient. Most importantly, listing collateral by categories defined in the UCC is sufficient.

The most common types of collateral that are defined by the UCC are accounts, deposit accounts, goods, equipment, and inventory. Remember that accounts are accounts receivable, and deposit accounts are what are commonly known as bank accounts.

After-Acquired Property Clauses

The collateral description may do more than simply list collateral, such that it is reasonably identified. It also may include language that provides the creditor with a security interest in collateral that was not present when the debtor initially extended the security interest.

For example, assume that a creditor wants to take a security interest in all the debtor's equipment. After the granting and attachment of the security interest, the debtor might purchase more equipment.

That additional equipment is called after-acquired property. Does the creditor's security interest attach to that later-purchased equipment? The answer depends on the type of collateral and the language in the security agreement's collateral description.

For a creditor's security interest to attach to after-acquired property, the primary rule is that the collateral description must specifically state that the security interest attaches to that property. It does so by using words similar to "all after-acquired goods" or " all after-acquired equipment."

To continue with our example, for the creditor's security interest to attach to later-purchased equipment, the collateral description would need to include words similar to "equipment and all after-acquired equipment."

There are two types of collateral for which a creditor's security interest automatically attaches to the after-acquired property. They are accounts and inventory, both of which are defined by Article 9.

If the security agreement's collateral description states that it covers accounts or inventory, all after-acquired accounts and all after-acquired inventory is included as the creditor's collateral. To reiterate, for all collateral that is not accounts or inventory, the security agreement's collateral description must state that it extends to after-acquired property of that type.

If you encounter a question on the exam that includes facts about a debtor buying more property after the granting of a security interest, that's a clue to think about the security agreement's collateral description and whether it must include words like "after-acquired."

Proceeds

In addition to acquiring new property, sometimes a debtor may sell the secured creditor's collateral to a third party, and the debtor will receive something in return. For example, a debtor business may sell inventory and receive cash. The creditor, of course, will want a security interest to attach to new property owned by the debtor. This new property is called proceeds.

Proceeds are defined as whatever is received from the sale of collateral, whatever is collected on collateral, and rights arising out of the collateral. To ensure that a creditor's security interest attaches to proceeds, the secured creditor often includes language in the collateral description that provides so.

For example, the collateral description will read, "all inventory, including after-acquired inventory, and all proceeds therefrom." Although such language often is included in collateral descriptions, it is not necessary under Article 9. Article 9 provides that the creditor's security interest automatically attaches to proceeds of its collateral.

Returning to our example, if the debtor sells his inventory and a creditor had a security interest in the inventory, the creditor's security interest automatically attaches to the cash that the debtor receives for the inventory, that is, a secured creditor can value trace to proceeds of its collateral.

If you encounter a question on the exam with facts about the debtor selling or disposing of collateral, remember that the creditor's security interest attaches to proceeds regardless of whether the collateral description mentions proceeds.

As a final summary, the third of three requirements for attachment is an authenticated security agreement that includes a collateral description. The text of the collateral description most often is the issue. The description must reasonably identify collateral and cannot be super generic.

If the secured creditor wants to have an interest in after-acquired property, it must include words to that effect in the description, unless the property is accounts or inventory. The security interest automatically attaches to proceeds of collateral. That takes care of the one alternative for the third requirement for attachment.

Possession

Moving on to the second alternative, which is that the secured creditor has possession of the collateral as provided in the security agreement. There are a couple of types of property that a creditor typically will take possession of. They are deposit accounts, which are bank accounts, and promissory notes, which are documents in which one party promises to pay a sum of money to another party. Notice that both of these items are not physical personal property.

Secured creditors will often possess non-physical personal property. Occasionally, a secured creditor will possess physical personal property, such as goods. For this aspect of attachment, remember that if a creditor has possession of the collateral, they have fulfilled one of the three requirements for attachment of a security interest.

Again, the three requirements for attachment are value given by the creditor, the debtor has rights in the collateral, and there is a security agreement with a sufficient collateral description, or the creditor has possession of the collateral.