Steps to Perfection: Security in a Time of Insolvency

Last week we had a brief overview of some bankruptcy issues and talked about the some of the risks presented by bankruptcy filings in these uncertain times. Today we are going to expand on ways to mitigate some of those risks when we aren’t in a position to demand and receive cash in exchange for goods.

The most important step to take to ensure you are protected against the risks of an insolvent customer is to attach and perfect a security interest in the goods sold to the customer. A security interest in the goods you sold on credit helps you to get paid first (before unsecured creditors, shareholders, and others, who often get nothing) in the event your customer enters bankruptcy.

Many companies are good at attaching a security interest to goods sold on credit by including terms that state the buyer grants the seller a security interest in the goods sold to secure the purchase price. If your sales agreements do not include such a provision you should work with a lawyer to make sure that they do.

An attached security interest on its own, however, has little effect in truly securing you as the seller (and more importantly, as creditor). In order to be effective, a security interest must be perfected. A perfected security interest gives notice to the world that you have a security interest in the particular goods so that others who may attempt to attach a security interest later know that they are behind you in priority.

Let’s drill down a bit deeper on the ideas of “attachment” and “perfection.”

Attachment

The Uniform Commercial Code (UCC) provides that “[a] security interest attaches to collateral when it becomes enforceable against the debtor with respect to the collateral . . . .” (UCC § 9-203). The debtor in this case is your customer. The UCC goes on to explain what it means for a security interest to become “enforceable.” (We have limited the text to be relevant for our purposes, because some very specific things, like descriptions of timber to be cut, simply don’t apply!)

Under the UCC, “a security interest is enforceable against the debtor and third parties with respect to the collateral only if:”

(1) value has been given

In this case, the goods sold in exchange for the promise to pay the purchase price in the future—for instance on net 30 terms—is value given.

(2) the debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party

Here, the debtor (your customer) gains the rights in the collateral and power to transfer rights when they receive the goods.

And finally, (3) one of the following conditions is met (only one is applicable for the purposes of this discussion):

(A) the debtor has authenticated a security agreement that provides a description of the collateral

A security agreement is any agreement that provides a security interest, for instance our sales agreement (with appropriate terms, as mentioned above). To authenticate the agreement, the debtor (customer) merely needs to sign it (or otherwise accept the record through electronic sound, symbol, or process). The security agreement must also provide a reasonably detailed description of the collateral. The part number, nomenclature, and quantity that appears on our documentation is an example of a reasonably detailed description.

Although verbose, the process of attaching a security interest is relatively straight forward and many or most of you may be doing it now. You should review the terms and conditions that appear on your quotes, confirmations, invoices, and other sales documents to be sure. If there are questions, remember to consult your attorney.

Perfection

Merely attaching a security interest, though, is not enough to protect you. In fact, an attached security interest without more provides little security indeed. In order to protect your interests, you must perfect the security interest. This gives notice to others that you have a security interest (in the form of a lien) against the goods. That way if they attempt to attach their own security interest to the goods or other assets to protect their extension of credit (for instance in the form of a loan), they know that they are behind you in order of priority with respect to those goods. (We’ll have more to say about priority in our next post—sometimes a previous secured lender like a bank may have priority for even newly acquired goods).

The exact details of perfecting a security interest are a matter of state law, but in general the primary method of perfecting a security interest is by filing a financing statement with the relevant public office—usually the Secretary of State. The UCC specifies the elements required in a financing statement in § 9-502:

  • The name of the debtor
  • The name of the secured party
  • An indication of the collateral

Typically, you can use as your financing statement a Form UCC-1, which is a standardized form that is widely available online, often via the very state agency with which it must be filed.

The most important thing to note in completing the financing statement is that the name of the debtor (your customer) must be precise. The UCC explains that it should be the name that is listed on the company’s most recently filed document in its jurisdiction of registration. (See UCC § 9-503). Put another way, the debtor name on the financing statement should be the most up-to-date name of the organization as filed in its state of incorporation. This level or precision is necessary because the financing statement is recorded under the debtor’s name and it must be of sufficient detail to put other potential secured parties on notice.

The secured party’s name is more straight forward (your company) and the indication of the collateral can be the same as appeared on the security agreement we discussed above, for instance, part number, nomenclature, and quantity.

The financing statement is generally filed where the debtor is incorporated, so make sure you are identifying the appropriate jurisdiction’s requirements. You can often kill two birds with one stone because the Secretary of State is typically where the financing statement is filed (and can be found) and you should also be going there to identify the correct name of the debtor for the financing statement anyway. As always, if you have any questions, you should consult an attorney.

As a secured creditor you can have confidence you will get paid (at least in part) even if a company becomes insolvent, because the liquidated assets of an insolvent company are first used to pay secured creditors. Specifically, the money raised from the liquidation of your secured goods is used to pay your security interest. This also applies to proceeds from those goods when the proceeds are directly identifiable. Creditors with no security are often left hoping for a share of what little is left after the secured creditors are paid.

Attaching and perfecting a security interest in goods sold is a valuable risk mitigation strategy. While it may not be as relevant when the economy is hot, when the economy gets rocky and the industry sees upheaval it is an important way to protect yourself against the unpredictability of the global aviation market.

One Response to Steps to Perfection: Security in a Time of Insolvency

  1. Pingback: First Position: Priority in Security Interests | ASA Web Log

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