A car loan is the most familiar UCC secured transaction. When you borrow money to buy a car, you sign at least two pieces of paper. One is the promissory note. This is the contract between you and the bank, where you agree to repay the loan at a certain interest rate with monthly payments. If you default on this “contract” or “promissory note,” the bank can file suit against you personally. The bank can obtain a judgment against you, which will enable them to attach your personal assets, garnish your wages, etc.
When placing the car loan, you also sign a “security agreement.” This security agreement gives the bank a “Security Interest” in the “Collateral” or “Security Property” (the car). The security agreement gives the bank the right to go against the collateral (car) if you default. The bank can repossess the collateral and can resell it to get payment on the loan. If the sale of the collateral is insufficient to repay the loan, the bank still has the right to sue you on the promissory note for any deficiency.
In the typical secured transaction, the lender has two avenues to obtain payment: (1) a claim against the borrower personally, which will eventually enable the lender to go against all of the borrower’s assets, and (2) a claim against the collateral or secured property.
Obviously, the existence of two avenues gives the lender a greater chance of recovery. The lender’s risk of non-collection is lower, thereby enabling the lender to offer lower rates. Thus, secured loans are usually cheaper for the borrower.
Secured creditors will usually have the same rights as a general unsecured creditor and will also have the first claim against the security property. A second creditor may file suit against the debtor unbeknownst to the secured creditor. The second creditor could obtain a judgment against the debtor and attach all of the debtor’s assets, including the security property. However, even though the secured creditor has not filed suit against the debtor and has not yet obtained a judgment, he or she will still have the first right to the security property. If the second creditor takes the debtor’s property to a judicial sale, the secured creditor will receive all of the proceeds from the security property up to the amount of the loan. A secured creditor, therefore, is not too concerned with the “race to the court house.”
Conversely, unsecured creditors are in a race to obtain a judgment. The first judgment creditor to attach the debtor’s assets will have priority over later judgment creditors. A secured creditor, however, already has a first priority lien in the security property, even without filing suit.
Bankruptcy ends the race to the courthouse. All creditors are forbidden from racing to get judgment liens or otherwise improving their position once a petition for bankruptcy is filed. Once a petition is filed, general unsecured creditors will never be able to secure the amount owed to them, by judgment or otherwise. However, the secured creditor’s lien on property survives the bankruptcy.
The practical result of most bankruptcies is that all secured creditors get some or all of their money while general unsecured creditors get nothing. Security interests become most important, therefore, upon the debtor’s insolvency or bankruptcy.
When can the typical material supplier take advantage of a security interest? At what point in the typical credit transaction will the supplier have the opportunity to obtain security?
In practice, UCC security interests will often be unavailable to contractors or material suppliers. Customers often are unwilling to grant security interests for open account credit, and competition from other vendors most likely will keep you from requiring them. However, do not forget about security interests as a possibility, for they should be kept in your arsenal of credit management tools. You will often be faced with marginal customers whom you should turn away. A security interest may allow you to increase sales by accepting customers you would otherwise turn away. Ask the customer what business or personal assets are available to provide security. It will not hurt to ask this question of a customer to whom you would otherwise refuse to sell.
A contractor or material supplier can offer incentives to the debtor to provide security. The seller can offer its best credit terms, lower service charges or an increased discount in exchange for a security interest. The seller can offer these incentives because the seller’s costs of doing business and risk of non-collection have been reduced. These risks are a part of the margin figured into every seller’s price. Just as you can provide your best prices and terms to your longstanding creditworthy customers, you can do the same for a marginal customer providing you with good security.
Lower costs benefit the buyer who provides security; this idea should be “sold” to the customer in this fashion. A security interest in equipment or accounts receivable will not impact the customer’s daily business as long as the terms of the credit agreement are met. The customer can still use the equipment or accounts receivable, but will be getting better prices on its material purchases month after month. This can add up to a great deal of savings with no cost to the customer.
You should continue to consider security interests throughout the life of your customer account, such as when the customer desires a higher credit limit or other accommodation. A customer is most likely to grant a security interest when the customer is in default. Most contractors are very dependent on their material suppliers to continue in business. If they cannot get materials, they cannot finish their projects—and cannot get their needed cash flow. Contractors are eternal optimists. They always believe that if they can finish the current project and obtain a new project, they will be able to “turn it around.” This is an opportunity for you to obtain security for a pre-existing debt, discussed below, even if this customer was unwilling to provide security earlier.
When a lender provides the funds to a buyer for the purchase of goods, the lender can obtain a “purchase money security interest.” In the typical heavy equipment sale, the excavating subcontractor purchasing heavy equipment needs to borrow money for the purchase. The seller of the heavy equipment, or the bank, lends money to the excavating subcontractor to purchase the equipment. The heavy equipment seller, or the bank, will “retain” a purchase money security interest. If the excavating subcontractor grants a lien on this equipment at any later time, after its purchase, the security interest will not be a purchase money security interest.
Any seller of goods on credit has the opportunity to request a purchase money security interest. The principle advantage of a purchase money security interest is that this interest will have a special priority over other security interests in the same property, if special rules are followed. The UCC favors a seller who lends money to make a sale, because the debtor/buyer would not have the goods if the seller had not extended credit to buy them. Therefore, the UCC gives the seller/lender first priority in the goods sold.
A purchase money security interest will work best for a seller of durable goods, which the buyer will retain for a long period of time. The heavy equipment seller is a good example. A supplier of groceries to a restaurant will not be as interested in a purchase money security interest, because the goods are quickly resold or deteriorate in value as they age. A construction materials supplier usually has this same problem. The lumber supplied to a carpentry contractor will soon be resold to the homebuilder and incorporated into the real property. The homebuilder will usually require the carpentry subcontractor to convey the lumber “free of liens” and “free of any security interest.”
For these reasons, the construction material supplier may prefer other security options, such as mechanic’s lien rights. However, it may still be possible to obtain a purchase money security interest in construction materials, which will continue as a security interest in the debtor’s proceeds of sale. The carpentry subcontractor is allowed to convey the lumber to the homebuilder free of liens. The lumber supplier, who has a purchase money security interest, now has a security interest in the cash received by the carpentry subcontractor from the homebuilder. The cash proceeds will quickly be commingled with the carpentry subcontractor’s other funds, so “tracing” can become a problem. The lumber supplier then will have to show where the money for the lumber went. The carpentry subcontractor should use the funds promptly to pay the lumber supplier, payroll and other vendors. A security interest in proceeds, therefore, may not be long lived.
A material supplier never knows when a bankruptcy will hit a customer. If a bankruptcy hits soon after a sale, a purchase money security interest in materials sold, with a continuing interest in proceeds, may provide the material supplier security for a recent sale. The material supplier will be a secured creditor for at least those recent sales, instead of joining the ranks of totally unsecured creditors.
A lender can request a security interest in any of the debtor’s property. All assets of the debtor/customer are candidates for security. The best possibilities for UCC security interests will probably be in equipment or accounts receivable of the debtor. A security interest in real estate is also possible, although this would not be a UCC security interest.
A materials supplier can require a continuing security interest for an ongoing line of credit. A supplier can require a security interest upon the opening of the account or later as a condition to continue the account or increase the credit limit. This most likely will work when the customer is very dependent on one supplier to continue its business. It should always be considered as a possibility, especially with a marginal customer. If faced with a customer you would normally disqualify on credit grounds, consider a security interest. This is an opportunity to increase sales that would otherwise be turned away.
There will come a time that your customer needs you very badly. They may have exceeded their credit limit or may be in default of the credit agreement. They may need additional materials to complete a project, and they will be unable to get paid on the project until it is completed. You may already have threatened legal action.
There comes a time that you must “cut off” a customer. There is no point in throwing good money after bad. This presents an age-old problem, however. If you cut the customer off, he will not be able to finish the project and cannot obtain the funds to pay you. Also, if you refuse to ship, the customer may get angry and stop payments altogether.
This situation creates a tremendous opportunity to obtain security for new shipments and to obtain security for the existing debt. Because this customer needs you badly, the customer may be willing to provide the security he would not consider when he opened the account. Now, you have an opportunity to “work with the customer,” get through credit problems and dramatically improve your own position.
Even if you are about to “go legal” on the customer, you should consider a security interest. A customer may plead with you not to file a mechanic’s lien or file suit. You can agree to do this in exchange for other adequate security. It is worthwhile to do this, even if it means waiting longer for payment or extending additional credit. If you continue to push the customer legally, it will probably take months to obtain a judgment. Many other creditors will be “racing you to the court house.” It is very much worth your while to offer incentives to the borrower to provide security. Other creditors obtaining judgment liens months from now will have an inferior interest in the same property in which you obtain a security interest now.
The best possibility for security in these situations is accounts receivable. How often has a debtor told you that you will be paid as soon as they collect on a particular project? It is advantageous to take a debtor at his word. This is the fastest way to find out whether the debtor means what he says. Suggest that the debtor grant a security interest in that single receivable. The debtor has told you that the receivable is your money. What does it hurt to put that in writing? You probably don’t even have to file a financing statement to perfect this security interest if it is not a significant part of the outstanding accounts of the debtor. A simple letter identifying the collateral, stating that the debtor “assigns” this receivable to you or grants you a security interest in it, and signed by the debtor will probably be sufficient. If 90 days pass without a bankruptcy, you are a secured creditor. In the appendices is an example of a simple assignment of accounts receivable.