We’ve recently posted a few articles about security interests, and how they can be used work to mitigate or eliminate a business’s credit risk. I posted a brief general overview of security interests last week, and Seth followed up with a post describing UCC liens and how they create security interests for parties in circumstances where a mechanics lien is not available. In order to gain the advantages of a UCC lien, and the advantages of being a secured creditor are numerous, it is essential to craft a valid, binding, and appropriate security agreement.

What Is A Security Agreement?

A security agreement is a contract between the creditor and the debtor in a secured transaction that governs the rights of each party with respect to the secured property (collateral). Certain specific requirements are required for the security agreement to form the foundation for a valid security interest, namely 1) it must be signed, 2) it must clearly state that a security interest is intended, and 3) it must contain a sufficient description of the collateral subject to the security interest.

These three components of are mandatory requirements of proper security agreement, without them the creditor may not have a valid and enforceable security interest in the property subject to the agreement.

A security agreement does not need to be a complex legal document

While the content requirements are fairly stringent, the formal requirements are not. A security agreement does not need to be a complex legal document full of phrases that make little sense. As long as the content is there, the security agreement is likely valid. While the three requirements outlined above constitute the information that must be included for a proper security agreement, they may not constitute the information that should be included. A claimant may wish to include a clause specifically stating that a UCC financing statement may be filed with respect to the described collateral. This clause allows the UCC lien to be filed (perfected) without getting an additional signature from the debtor. Other information to be included on the document should be balanced between the information or restrictions that the creditor deems necessary or preferable, and concerns that the debtor would find the language too off-putting so as not to agree to grant the security interest in the first place. In practice, the creditor has more leverage in this situation and, provided the language is not truly too onerous, should be able to include most of the language desired in the security agreement.

Since a security agreement is a contract between the parties that governs the rights and responsibilities with respect to the collateral, any rule concerning the collateral should be included in the agreement. For example, a creditor may require the debtor to use or refrain from using the collateral in certain specific ways, require the collateral to be kept in a specific location, require the collateral to be kept insured, and so on.

Information Required For Proper Security Agreement

As outlined above, there are certain requirements necessary for a proper security agreement.

  1. Signature
  2. Statement that a security interest is intended
  3. A description of the collateral

Signature Required

A signature of the debtor, and the owner of the collateral if the owner is different party, must sign the security agreement in order for the security agreement to be effective. This is obviously important, and it is a strict rule. Special care should be taken to ensure that the name of the debtor (and owner if applicable) are correct – it is not unheard of for security agreements to be invalidated if the name of the debtor is not correct. While this seems to be obvious, and hard to get incorrect since the debtor must sign the document, it can be tricky. If the debtor is a corporation or other business entity, the actual name may be something different that the name under which they are doing business.

Security Interest Must Be Intended

The security agreement is a document that serves as the foundation of a security interest in property, and must be agreed to by the parties. Because of this, it may seem obvious that the grant of a security interest is intended by the parties to the document. This statement should be as specific as possible. While it is not necessarily true that exactly specific wording is required, it is easiest to comply with this requirement by including the language that the debtor “grants a security interest in” the property described in the agreement. This wording is sufficiently clear to confirm the intent of granting a security interest in the property.

Collateral Must Be Sufficiently Described

the property subject to the security agreement must be described sufficiently to identify it
Finally, the property subject to the security agreement must be described sufficiently to identify it. A complete a description as possible is the goal here. Clearly, the more descriptive the description, the better chance that the description is descriptive enough.  For vehicles and other similar equipment, a serial number or VIN would be sufficient to identify the property, although I would also include make, model, and year. For collateral such as inventory, it is likely that a general inventory list would be sufficient without further detail, but the further one strays from actual concrete descriptions of the actual property to be collateralized the more open the description is to challenge.

Security interests are very useful tools in mitigating or eliminating credit risks. For parties not entitled to involuntary liens, the filing of a UCC financing statement to perfect a voluntary lien may be a good option.