A security interest is a term that refers to an interest that is created when someone who is in debt gives a creditor the legal right over a piece of property in the event that the debtor breaches the agreement between the two parties. In general the property offered in a security interest agreement is known as collateral property. Security interests are derived from general securities law.
It is important to note that the laws and regulations regarding security interests are covered by both state and federal laws. This means that the exact definition as to what constitutes a legal and enforceable security interest will depend on the laws of the jurisdiction in which the security interest is created.
An example of a common security interest is when an individual obtains a mortgage to buy a house, the house itself is often utilized as collateral in the loan. Then, if the purchaser fails to make the expected payments on the house, the bank can seize and take the house away from them. In these situations the bank is allowed to take the house because the bank has a security interest in the home if the purchaser does not meet their mortgage payment obligations.
How Is a Security Interest Created?
Once again, a security is defined as any proof of ownership or debt that has been assigned a value and may be sold by the party holding the security. Securities also come in many different forms including, but not limited to: stocks, bonds, options, loans, mortgages, treasury stocks, investment contracts, or fractional interests in oil, gas, or mineral rights.
As far as how a security interest is created that will once again depend on the type of security interest that is being created, as well as the laws of jurisdiction in which the security interest is being created. However, in general, a security interest is created by a written agreement that will need to include the following elements:
- Security Interest Language: First, there must be explicit language in the agreement executed between the two parties that expressly grants one party a security interest.
- In general, the language must be clear so there is no question that a security interest has been created;
- Authentication: The party granting the security interest must authenticate the agreement to show that it is legitimate, which is generally accomplished by including an original signature; and
- Description of the Collateral: Finally, the agreement must properly describe the collateral, either by specifically identifying it, describing its category, or otherwise reasonably identifying it.
- In general, it is best practice to include a significant amount of detail about the collateral so there is no confusion as to what collateral is being offered as security, as this helps to avoid later legal disputes.
- For example, if a vehicle is being offered as a security, then a description that provides the vehicle identification number (“VIN”) should be utilized, as that would be the best way of identifying the particular vehicle being offered as collateral.
The Federal Uniform Commercial Code (“UCC”) also provides laws and regulations concerning the enforceability and attachment of a security interest. Specifically, UCC § 9-203 provides that A security interest attaches to collateral when it becomes enforceable against the debtor with respect to the collateral, unless there is an agreement that expressly postpones the time of attachment.
Further, UCC § 9-203 provides that a security interest is enforceable against the debtor and other parties with respect to the collateral only if:
- Value has been given;
- The debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party; and
- One of the following conditions is met:
- The debtor has authenticated a security agreement that provides a description of the collateral;
- The collateral is not a certificated security and is in the possession of the secured party;
- The collateral is a certificated security in registered form and the security certificate has been delivered to the secured party; or
- The collateral is deposit accounts, electronic chattel paper, investment property, or letter-of-credit rights, and the secured party has control of the security pursuant to the debtor’s security agreement.
Additionally, there are also certain situations in which security interests are automatically created, such as when a lien is created. Depending on an individual’s state laws, a lien may be created automatically if they fail to pay for services.
Examples of common liens that are created automatically include failing to pay attorney’s fees and failing to pay a mechanic for completed repairs. However, even if a lien is to be created automatically, if the parties have an agreement about payment that is to the contrary, the written agreement will usually always control in any legal disputes.
If there is a question as to whether or not a security interest has been automatically created, or if there are any questions regarding whether a security interest has been formed and attached, then a local real estate attorney will be able to answer such questions.
How Are Security Interests Enforced?
Once again, a security interest is only enforceable after it attaches to the collateral. Attachment occurs when the following steps are completed:
- There is value given for the security interest;
- The debtor has rights in the property
- Importantly, an individual cannot create a security interest if they do not have any ownership to the property, such as attempting to put up someone else’s property as collateral; and
- There is evidence that the debtor intended to create a security interest.
Then, if the security has attached and the debtor defaults on the security agreement, the creditor can take legal action to enforce their security interest. In general, the following enforcement options are available to creditors:
- The creditor can take possession of the collateral put up as security and sell it.
- In the case of a mortgage scenario, upon the default of the homeowner, the bank may place the property in foreclosure and try to sell it at an auction or sheriff’s sale;
- After the creditor takes possession of the collateral and sells it, the creditor can then sue the debtor for a deficiency judgment, which is the difference between what they received for the collateral and the amount owed to the creditor; or
- The creditor can ignore the security interest and seek a judgment against the debtor for the full amount owed under the agreement.
It is important to note that if the collateral is taken and sold, the creditor is obligated to return any surplus from the sale to the debtor. For example, if the outstanding debt between the debtor and creditor is $100,000 and the collateral property sells for $110,000, then the debtor will be entitled to the $10,000 that was in excess of the amount owed from the sale.
What Happens When a Third-Party is Involved?
Third parties may also have an interest in the same collateral that is the subject of a security interest. This is because a piece of property may be given as collateral in multiple security agreements, such as loans. In these situations, courts will look at what is called “perfection” in order to determine the creditor’s rights to take the collateral after a default has occurred.
Importantly, different types of collateral have different requirements for perfection. Typically, a security interest is perfected after attachment and one or more of the following actions occurs:
- The creditor files a financing statement (Form UCC1) with the Secretary of State;
- The creditor takes possession the collateral; and/or
- The creditor takes control of the collateral.
In other words, the first party to properly perfect their security interest by putting all future parties on notice is generally at the top of the list to be paid if a default occurs and collateral property is sold. In some cases, security interests are automatically perfected when it attaches.
The general rules for priority when there are multiple creditors is:
- Among creditors with perfected security interests, the first to file or first to perfect has the highest priority;
- Perfected security interests have priority over unperfected security interests;
- Among unperfected security interests, the first to attach has priority; and
- Liens have priority over unperfected security interests.
Should I Contact an Attorney?
If you are having any issues involving security interests, you should immediately consult with an experienced property attorney. An experienced property attorney that handles securities cases will be able to help you understand your legal rights and options according to your state’s specific securities law and federal law.
As a creditor, an attorney will also be able to help you understand if the security interest is enforceable, and if you have perfected your interest. In addition, an attorney can also advise you about whether or not you have priority over other third parties. Finally, an attorney can also represent you in court, as necessary.
