Collateral: What is it and Why is it Important

Posted in Blog by on July 17th, 2017

By: Attorney Dianna M. Williams | Associate

Massachusetts-Understanding-collateral “Collateral” is defined by the Oxford Dictionary as: “Something pledged as security for repayment of a loan, to be forfeited in the event of a default.” The utility and importance of collateral in a loan or other business transaction cannot be stressed enough, as it provides a quick and relatively easy way to get paid if the obligor falls behind on his obligations.

There are many different forms of collateral, including a personal guaranty, a mortgage on real estate, an assignment of rents, a lien on a motor vehicle, a pledge of a liquor license and a security interest on personal property. This discussion will focus on two very common forms of collateral in Massachusetts- mortgages on real estate and security interests in personal property.

A mortgage is a device for providing security to a lender by creating a lien against a specific piece of real estate. Upon signing, the mortgage is effective between the borrower (“mortgagor”) and the lender (“mortgagee”). However, in order for a mortgage to be effective as to third parties, it must be recorded with the Registry of Deeds for the county in which the property is located. Once recorded, third parties are put ‘on notice’ of the lender’s interest in the real estate. In most instances, the lender’s interest will be junior to any previously recorded mortgages, liens and other interests in the property and superior to any subsequently recorded mortgages, liens and other interests in the property. As the saying goes, “first in time is first in right.”

A security agreement is a device for providing security to a lender by giving the lender an interest in personal property (“security interest”). This agreement will set forth which obligations the borrower is giving collateral as security for and what personal property the borrower (also called a “debtor”) is providing as that collateral.

A security interest can be obtained on all types of personal property, like consumer goods, inventory, equipment, farm products, documents, instruments, chattel paper, investment property, accounts, deposit accounts, and general intangibles, which is a broad category including patents, publication rights, copyrights, tradenames, licenses, partnership interests and more. A lender (also called a “secured party” or “creditor”) can obtain a security interest in a broad category of personal property, like all of the debtor’s inventory or equipment, or in a specific item of personal property, like a particular piece of machinery. Oftentimes, lenders will require a security interest in all business assets of a debtor when providing financing. When this is the case, it is important for the lender to obtain a detailed itemization of (and receive periodic updates on) the borrower’s personal property, so that it knows exactly what its collateral includes, can better determine the collateral’s value, and can more easily assemble and liquidate the collateral upon default.

Security interests are governed by Article 9 of the Uniform Commercial Code, which has been passed in whole or in part in every state in the country, including Massachusetts.

In order for a security interest in personal property to be enforceable against a debtor, the security interest must “attach” to collateral. A security interest attaches to collateral only if:

1. value has been given;
2. the debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party; and
3. one of the following conditions is met:
A. the debtor has signed a security agreement that provides a description of the collateral and, if the security interest covers timber to be cut, a description of the land concerned;
B. the collateral has been delivered to and/or is in the possession of the secured party (only for certain types of collateral); or
C. the secured party has control over the collateral (only for certain types of collateral).

A security interest in all business assets of a debtor typically “attaches” upon the debtor’s signing of a security agreement like the one mentioned above.

However, in order for a security interest in personal property to be enforceable against third parties, including other creditors of the debtor, it also has to be “perfected”. Security interests can be perfected in several different ways depending on the type of personal property (i.e. automatically upon attachment in some circumstances, by taking possession or control of the personal property, or by filing a financing statement). The most common way, and the way to perfect a security interest in all business assets of a debtor, is by filing a financing statement with the appropriate state’s filing office (i.e. the Secretary of State’s office). A financing statement is a form that can be obtained from the state’s filing office and filled out by the secured party or the debtor in conjunction with the security agreement.

An important question, when a secured party chooses to perfect its security interest by filing a financing statement, is where the financing statement should be filed. A financing statement must be filed in the state in which the debtor is “located”. In particular:

1. A debtor who is an individual is located at the individual’s principal residence;
2. A debtor that is an organization and has only one place of business is located at its place of business; and
3. A debtor that is an organization and has more than 1 place of business is located at its chief executive office.

This requirement can become tricky when a debtor conducts business in numerous locations. For example, if XYC Incorporated has twenty (20) offices located in Massachusetts and enters into a loan transaction with a lender in Massachusetts, through which it gives an all business asset security interest as collateral, but is incorporated under the laws of Delaware and has its main office there, the financing statement would need to be filed with the Secretary of State’s office in Delaware and not Massachusetts. Of course, there is no penalty for filing a financing statement in more than one state in these tougher situations in an abundance of caution.

Security interests that are perfected by filing a financing statement with the appropriate filing office are only effective for a period of five (5) years. In order to preserve its security interest and priority (i.e. place in line amongst other creditors), a creditor must file a continuation form with the filing office before each five (5) year anniversary. If a creditor fails to do so, it’s perfected security interest “lapses” and its financing statement is treated as if it was never filed.

A security interest continues in personal property even if it is sold or otherwise disposed of (unless the creditor specifically agrees otherwise). Additionally, if a piece of collateral is sold, the security interest attaches to its identifiable proceeds and is automatically perfected to the extent that the original collateral was perfected. This gives the secured party additional recourse against the debtor, which is helpful if the piece of collateral is no longer available.

If you have any questions or would like assistance in obtaining or recovering collateral in real estate or personal property, please call the attorneys at Wynn & Wynn, P.C., at 1.800.852.5211 or request a free consultation.

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