The Attachment of Security Interests
If someone is seeking to obtain a security interest, they hope to enforce their interest against some type of property (collateral) if their debt is not paid. In order for them to enforce the security interest, it must first attach to some collateral. Attachment is a process whereby if certain elements are met, the security interest will be enforceable against the collateral to which it has attached. A security interest is enforceable against the debtor with respect to the collateral only if three elements are met:
- Value has been given;
- The debtor has rights in the collateral;
- There is some type of security agreement and an evidentiary basis:
- The debtor has authenticated a security agreement that provides a description of the collateral;
- If it is not a certificated security and it is in possession of the secured party pursuant to debtor’s security agreement;
- If it is a certificated security in registered form and delivered to secured party pursuant to the debtor’s security agreement;
- If a secured party has control pursuant to the debtor’s security agreement.
Has Value Been Given?
In order for a security interest to attach, value must be given. Generally, it will be value given by the secured party but the value given doesn’t necessarily have to go to the debtor (who is simply the person who pledges the collateral). Value can broadly be defined as any consideration used to support a contract. For example, a party may be willing to take a security interest for total or partial satisfaction of a pre-existing claim. The satisfaction of the pre-existing claim could be considered value. In some instances, a binding agreement to extend credit or the extension of immediately available credit can be considered value. Chances are if it would be adequate consideration for a contract, it could be value such that this element is met.
Does the Debtor Have Rights in the Collateral?
A debtor cannot grant a security interest in something they do not own or have rights in. Whether or not the debtor has sufficient rights in the collateral often goes beyond secured transactions into sales and property law. It’s best to consult with a business lawyer regarding this element of attachment. Rights in collateral can be full or partial. If you have full ownership of something, you can give someone a security interest in the entire thing. If you have partial rights, such as a leasehold, you can only give a security interest in the amount of rights you have. In certain instances, you can have less than full rights but the power to grant full rights. For example, pursuant to sales law, a person with voidable title, such as after a fraudulent purchase of goods, can transfer good title to a purchaser for value and can transfer full rights in certain instances. Given the definition of purchaser, a secured party qualifies as a purchaser in most cases but it’s not always clear. Since the buyer has voidable title but can grant good title to a purchaser they should be able to grant a full security interest.
Is There a Security Agreement with Sufficient Evidentiary Basis?
The last element of attachment is that there must be an agreement and some evidentiary basis. The strongest and clearest evidentiary basis is an authenticated security agreement that adequately describes the collateral. With a security agreement, we also need the debtor’s signature or other authentication on a record that says this is the debtor’s collateral given to the secured party for the purposes of securing a loan. The record is often a written contract but does not have to be written on paper. Even electronic records theoretically count as long as the record is stored and retrievable.
Either way, debtors have to authenticate the security agreements to fall under the first category. We want the person who owns the stuff to authenticate the security agreement and not just the person who owes the money. The key with authentication is a present intent to adopt or accept a record and associate with the record in whatever format. We’re looking for the type of authentication that shows that you are identifying yourself and accepting it as your own.
The security agreement must contain an adequate description of the collateral. A description of collateral is usually sufficient whether or not it is specific if it reasonably identifies what is described. Identification is reasonable if it describes something by category or type or any method that is objectively determinable.
A super generic description of collateral will not work in the security agreement, however, because it has to be somewhat specific. You need to have a skilled business lawyer draft the language to ensure the collateral is described.
Obviously, money can be collateral and value in it of itself. Aside from money, under commercial law, there are common categories of property that are referenced when we talk about collateral description.
Goods include tangible personal property, all things movable at the time the security interest attaches, things beyond movable things such as fixtures, standing timber, unborn young and crops and software embedded in goods as long as it is not standalone. There are four subcategories that are mutually exclusive which means you can only be in one category at a time. You characterize goods based on their principal use in the hands of the debtor.
- Inventory – Includes stuff that is held for sale or lease, stuff furnished under contracts for service such as a plumber bringing raw materials to fix the pipes and works in progress or goods used up such as pencils, papers or gas.
- Equipment – Catch all categories when it doesn’t qualify for the other three categories and also encompasses traditional equipment such as forklifts or tractors.
- Consumer Goods – Used or bought for use primarily for personal or family household use.
- Farm Products – This is related to people engaged in farming operations and can include crops, livestock or supplies used such as fertilizer or goods produced in the course of farming operation.
Rights to Payment
The right to receive money in the future used as collateral for a new loan.
- Chattel Paper – A right to payment that is stated in a record with two elements. The record evidences the monetary obligation in the security interest or lease. There also has to be a security interest or lease granted. E.g. Promissory note with security interest involved.
- Instruments – Negotiable instruments fall into this category or any other writing that evidences a right to payment of a monetary obligation that is not itself a security interest or lease and is of the type that, in the ordinary course of business, is transferred by delivery with any necessary endorsement. E.g. Promissory note or check.
- Accounts – Right to payment of monetary obligation for goods sold or services rendered not embodied in any writing and not including rights to be repaid a loan of money. E.g. Someone mows your lawn and you pay at the end of the week.
- Payment Intangibles – This is the catchall for right to payments and usually seen with a right to be repaid a loan of money that’s not an instrument. E.g. Someone owes you money and you pledge the right to be paid as collateral but there is no promissory note.
Accounts held at a bank (i.e. checking or savings accounts) can be described collateral but this does not include investment accounts.
Documents and General Intangibles
Certain documents can be described collateral. For example, when you put goods in a warehouse, they should give you a bill of lading. Bills of ladings are considered documents under this definition. If the collateral doesn’t fit any category is a general intangible (i.e. Justice Beiber tickets).
Other Attachment Issues
Attachment is a fundamental concept in security interests but it can become quite complicated depending on the facts and circumstances of any particular case.
Sometimes security interests need to account for future advances of value without a separate security agreement being executed each time. A security agreement can say that the collateral secures the initial advance and all future advances. In such cases, The original security agreement will apply not only to the first but subsequent advances of value. While this is possible, there are several requirements. For one, It has to be put in the agreement for the future advances to be secured by the original collateral. If it is at all ambiguous, you could have a dispute regarding the intent of the parties.
Composite Document Rule
You can take a collection of documents and maybe read them together to find the authenticated security agreement requirement has been met. You are looking for some evidence that shows the authentication of a document with the collateral or a reference to the collateral contemporaneously but too much attenuation threatens the rule.You can always make the argument that there is evidence of intent to create the security agreement and a specific description of the collateral.
After Acquired Property Clauses
A security agreement can include a clause that covers after-acquired property in which case the security interest would attach to property acquired after the agreement in certain occasions. If there is language such as “Now and hereafter-acquired or “existing now and hereafter,” it might be an after acquired property clause. If the security agreement is silent as to after-acquired collateral we treat it as a matter of contractual interpretation based on intent. A majority of jurisdictions follow the so-called Filtercorp Rule (Majority Rule). This rule states that For the types of collateral that are cyclical or designed to be bought and sold on a regular basis (inventory and accounts). May be rebutted with evidence that after-acquired was never contemplated. If the agreement does not say, then we presume that an after-acquired collateral clause is applies.
Possession Or Control Of Collateral Pursuant To Security Agreement
Possession or control of the collateral can be used to show the security agreement exists.For collateral that is not a certificated security (capable of being possessed), if it’s put into possession of the secured party pursuant to a security agreement the security interest has attached and a writing or a signature is not needed. Must have dominion over the collateral to show that evidence that the agreement exists. Things that are physical goods and can be delivered possession must be transferred. With intangible collateral, control must be transferred pursuant to a security agreement, oral or written. Security agreement can be oral.
Stock Certificates Attached by Delivery/Control
Certificated securities are pieces of paper or certificates representing a security in a registered form. Delivery and attachment occur when possession is transferred pursuant to a security agreement.
Proceeds are acquired upon the sale lease license or exchange or other disposition of collateral. If the security interest attaches to the collateral, the security interest automatically attaches to identifiable proceeds. Examples include: If the collateral is an account, payments to the account are proceeds.If it is stock, dividends are proceeds. Claims arising out of the collateral such as a breach of contract claim, breach of warranty claim (the claim and recovery), or insurance money are proceeds.
With proceeds, you should consider the Lowest Intermediate Balance Rule. Courts have determined to what extent a secured party can claim a security interest in the stuff in a comingled bank account because proceeds may no longer be identifiable. Proceeds sink to the bottom and the non-proceeds money comes out of the top but when non-proceeds money is gone, proceeds are used and are not replenished with new money coming in.
Sales of Collateral
A security interest in collateral continues notwithstanding a disposition of collateral unless the secured party authorizes the disposition free and clear of the security interest.
Sometimes collateral changes forms when commingled with other collateral and when you unite them together, you lose the individual identity of each thing. Any attached security interest to the components attaches automatically to the final goods that result. E.g. If you have a security interest in the inventory that includes materials such as eggs you do not need to specify “cake” because it automatically attaches.
These are goods that are commingled with other goods but in such a way that the original identity is not lost. A security interest continues in collateral that becomes an accession. E.g. If you have a security interest in a motor that is used in a tractor you can separate the motor so it is an accession. You do not have a security interest in the tractor but the security interest continues in the motor.
We assume that the lender is taking the security interest in these items.
- Proceeds: You don’t need proceeds in a security agreement because the security interest attaches automatically.
- Certain Investment Property: If the security agreement says something like a securities account, everything in that account qualifies because the security interest attaches to the account and everything that it contains.
- Rights in the Secured Obligation: Usually we will have an account or a right to receive payment in addition to a guarantee or a mortgage which is included in a security interest automatically.
Contact A Business Attorney to Discuss Your Business
There’s certainly quite a few more important aspects when it comes to the attachment of security interests. It often depends on the type of business you are in and the unique facts and circumstances of your case. If you’d like to find out more and have a business lawyer from our team provide more narrowly tailored insight based on your business, give us a call today at 419-469-5002.
Chris Sawan is both a licensed attorney and a CPA which allows him to provide exceptional service to bankruptcy clients in Toledo, Ohio.
Dennis Sawan is a licensed attorney with a robust background interfacing with Courts making him a valuable asset for bankruptcy clients in Toledo, Ohio.
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