What Is a Security Agreement? The Different Types of Security Agreements
At some point, most new businesses and many ongoing concerns have the need for additional working capital. A common way to do that is through a public or private offering of stock, but that requires giving up an interest in the business. Many businesses and business owners opt, instead, to borrow the necessary capital to expand. In such a transaction, though, the lender wants some assurances of payment in the event the business should encounter economic challenges or even close down. That’s the function of secured transactions and security agreements.
What Is a Security Agreement?
A security agreement is a legal document, essentially a contract, wherein a borrower pledges certain assets as collateral in exchange for receiving a loan (aka “financing”). The security agreement creates a “security interest,” which means the creditor has certain legal rights in the event the borrower defaults (doesn’t pay) on the loan. Typically, those rights include the ability to seize the property pledged as collateral and either keep it or sell it to recover the amount of financing extended to the debtor.
What Is a Secured Transaction?
Any commercial deal or transaction where the debtor pledges collateral in exchange for a loan is considered a secured transaction. If you’ve ever had a car note or mortgage, you’ve engaged in a secured transaction. In those situations, the house or car is the collateral, and if you fail to make your regular payments, the lender can take steps to repossess your car or foreclose on your house in order to get back the funds they loaned you.
Most secured transactions, other than mortgages, are governed by the provisions of Article 9 of the Uniform Commercial Code (UCC). Article 9, which has been adopted in whole or in part in all 50 states, applies to security interests in movable property (vehicles and equipment, for example), intangible property (such as copyrights, trademarks, and patents), and fixtures. Article 9 does not cover security interests in real property; those are governed by state mortgage laws.
Under Article 9, a security interest becomes enforceable as soon as it “attaches” to the collateral. Attachment has three prerequisites:
- The person pledging the collateral must have the right or power to do so (i.e., they must own the collateral or have some other legal right to pledge it).
- The party to whom the collateral is pledged must convey something of value to the other party (the debtor); typically, this is the money being loaned.
- The debtor must put a security agreement in place that sufficiently describes the collateral.
It’s non uncommon for a business to pledge the same collateral in exchange for financing from more than one source. In such a situation, disputes can arise regarding which security interest has first right to the collateral in the event of default. In general, under Article 9, to have priority over other creditors, a claimant must have “perfected” the security interest. While some types of security interests are automatically perfected upon creation, most require that the creditor take additional legal measures, which typically involve filing a financing statement (known as a UCC-1) with the proper state office.
What Terms Are Typically Included in Security Agreements?
At a minimum, a valid and enforceable security agreement requires the following terms:
- identification of the parties involved,
- description of the collateral, and
- a statement that the debtor is pledging the collateral as security for a specific transaction.
Other provisions that often appear in security agreements include:
- Warranties or covenants—Often, a security agreement will include language requiring the property owner to maintain the collateral or notify the creditor of any damage to or change in the value of the collateral.
- The priority of the secured interest—When there are multiple secured parties financing a transaction or expansion, it’s common for the security agreement to identify the order in which each party has a right to the collateral.
- Default—Security agreements often include detailed descriptions of what constitutes default and when a secured party has the right to seize the collateral.
- Remedies—Agreements often specify the different legal courses of action a creditor can pursue upon default.