Security Interests & UCC Article 9: An Overview

Security interests form the backbone of many financing transactions, providing a lender with protection for its investment while enabling a borrower to access capital. This article provides a high-level overview of this important financial mechanism.

Understanding the Basics

It’s important to first distinguish between similar-sounding terms:

• A security interest refers to an interest in assets that secure payment or performance of an obligation. Those assets are generally referred to as collateral.
• Securities, in contrast, represent ownership (stocks), creditor relationships (bonds), or rights to ownership (options).

In a secured lending transaction, a debtor (typically, a borrower) grants a security interest over specific assets (collateral) to a creditor (typically, a lender). This security interest ensures the debtor’s payment and/or performance of its obligations to the creditor.

Real-World Context

The most familiar example of a security interest is a mortgage. When purchasing a home, a buyer typically obtains a loan to purchase the home and gives its lender a security interest in the house itself to secure its obligation to the lender to repay the loan. Should the buyer fail to repay the loan, the lender can claim (i.e., foreclose on) the house to recover its investment.

This basic structure — where an asset secures a financial obligation — applies across various types of business financing transactions, and the fundamental relationship between the asset and the obligation remains consistent regardless of the type of assets serving as collateral or the type of financial obligation that collateral secures. The remainder of this article will focus on the documentation of secured lending transactions, the creation of security interests, and a lender’s remedies with respect thereto.

Essential Documentation

Two primary documents govern secured lending transactions:

1. Loan Agreement: The principal document establishing the financing terms between the lender and borrower and the other related obligations owed by the borrower to the lender.
2. Security Agreement: The document outlining the arrangement between the lender and any parties providing security (typically called grantors) for the obligations, detailing the collateral and the lender’s rights and remedies. More often than not, the borrower will act as a grantor along with certain of its affiliates, as discussed below.

Common Security Structures

All Assets Security

In this comprehensive approach to security, lenders require a complete security package covering substantially all assets of the borrower and, oftentimes, related entities such as the borrower’s parent companies and/or subsidiaries. In connection with providing the lender with a lien on substantially all of their assets as additional security for the borrower’s obligations, such parent companies and/or subsidiaries also typically serve as guarantors of the borrower’s obligations.

This approach provides maximum protection for lenders by casting a wide security net across a borrower’s organizational hierarchy.

Limited Security

In limited security arrangements, lenders take security over only specific assets or asset classes. For instance, a lender making a loan to enable a borrower to buy a large piece of equipment might look to just that piece of equipment to secure the borrower’s obligation to repay its loan. 

This approach focuses security on the most relevant assets rather than encumbering all business resources, and the purpose of the loan will often inform which assets serve as collateral.

Security Interests and UCC Article 9

The Uniform Commercial Code (UCC) represents a standardized set of commercial laws adopted by all states, though with some variations. Article 9 of the UCC specifically addresses security interests in personal property and fixtures — essentially any business assets except real estate. This framework creates consistency and predictability in secured transactions across state lines.

The Two-Step Process: Attachment and Perfection

For lenders to fully protect their interests and exercise their rights under the UCC, security interests must (i) attach and (ii) be perfected.

Attachment: Establishing the Basic Security Relationship

Attachment creates a security interest that a lender can enforce against a grantor. Three essential requirements must be met for a security interest to properly attach:

1. The lender and grantor must have a signed agreement that clearly describes both the collateral in which a security interest is being granted and the obligations being secured thereby;
2. The grantor must have rights in the collateral or authority to transfer rights; and
3. The lender must provide value (typically the loan itself) to the grantor.

Importantly, security agreements cannot use overly broad descriptions like “all assets” to satisfy the attachment requirement — Article 9 of the UCC requires specific identification of the collateral.

Perfection: Protecting Against Third Parties

While attachment establishes rights between the immediate parties (i.e., lender and grantor), perfection goes a step further and extends a lender’s protection against third parties — including other creditors and bankruptcy trustees. This critical step also determines priority when multiple creditors claim a security interest in the same collateral. Article 9 of the UCC sets forth the various ways in which a lender can perfect an attached security interest, and the proper avenue of perfection varies by the type of collateral in which the security interest is granted. 

Methods of perfection include:

• Filing a UCC financing statement (appropriate for most personal property types);
• Obtaining control of the collateral (necessary for deposit accounts);
• Taking possession of the collateral (for stock certificates or cash); and
• Automatic perfection upon attachment (applicable in certain specialized situations).

UCC financing statements expire five years after filing and must be continued via a UCC-3 continuation filing within six months before expiration. Other maintenance requirements relating to UCC financing statements apply when a grantor changes its name, the collateral perfected by such financing statement changes, or other circumstances change.

Priority: Who Gets Paid First?

When a borrower faces financial difficulties, priority rules determine the order in which creditors can claim assets and, thereby, have a means to be repaid for the obligations on which the borrower defaulted. Under the UCC:

• Perfected secured creditors outrank unperfected secured creditors (i.e., a creditor whose security interest has only attached);
• Among perfected secured creditors, priority typically follows the “first in time, first in right” principle (in other words, whichever secured creditor perfected its security interest first (i.e., by filing a UCC-1 financing statement) has priority over any secured creditors who subsequently file against the same collateral);
• If multiple perfection methods are possible, the “better” method (as determined by UCC rules) may prevail regardless of the timing of the secured creditor’s perfection; and
• Among unperfected secured creditors, earliest attachment determines priority.

Enforcement and Remedies

When a borrower defaults on its obligations, secured lenders may exercise various remedies under the UCC relating to their security interests, including:

• Collection: Directly collecting payments owed by third parties to the grantor to apply to the debt
• Disposition: Selling collateral and applying proceeds to the debt
• Retention: Keeping the collateral in full or partial satisfaction of the debt

All enforcement actions must be conducted in good faith, in a commercially reasonable manner, and with proper notice to the grantor.

Business Implications

It is important to remember that security interests may have significant implications for other transactions in which a business may look to engage. For example, in the context of an acquisition:

• Buyers must identify existing security interests in assets being acquired, as these encumbrances typically follow the assets.
• Sellers need to understand existing security interests on assets they intend to sell and whether the related secured lender will permit the transaction.

Releasing Security Interests

When the obligations owed to a secured lender have been fully satisfied, the security interest of the lender should be released. The loan agreement and/or security agreement may outline procedures for releasing collateral, which has two prongs: (i) release of the security interest itself and (ii) termination of the perfection of such security interest. A lender’s security interest is typically released in a payoff letter for the obligations satisfied. The method of termination of perfection varies by type of collateral — for example, UCC-1 financing statements are terminated by filing a UCC-3 termination statement, while perfection of a security interest in a corporation is terminated by returning the original stock certificates to the grantor.

In Summary

Security interests are crucial to the lending transaction market — they provide necessary protections to lenders, enabling lenders’ willingness to enter into loan transactions, which allow borrowers to gain access to capital for a variety of business needs. The structure provided by Article 9 of the UCC creates a system that facilitates business growth and opportunity for both lenders and borrowers by protecting the interests of all parties involved. Understanding these fundamental concepts helps both potential borrowers and lenders navigate financing discussions with greater confidence and clarity.

Facing questions about a financing transaction? Please contact Lauren K. Flamang, Megan K. Kelly, or another member of LP’s Financial Services & Restructuring group.