Let’s take an example. A debtor is struggling and seeks money from several sources. Bank A provides a loan on an unsecured basis. Bank B provides a loan containing a lien on assets which is not perfected. Bank C loans money, taking a perfected security interest in collateral through either possession or properly filed financing statement and security agreement.
The debtor runs into financial problems and starts defaulting on loans. Trade creditors are typically unsecured. Trade creditors file suits quickly because they know they must move swiftly. This typically has a domino effect. In other words, once trade creditors start filing their collection lawsuits, secured creditors move in in order to protect their collateral.
In the circumstance described above, bank A provided a loan on an unsecured basis so it is basically in the same situation as the trade creditors. Should the debtor’s business fail completely, trade creditors usually receive less than $.10 on the dollar and bank A will find itself in that position, typically. Therefore, being an unsecured creditor is very dangerous. The only reason trade creditors are unsecured is because of competition. If a trade creditor were to try and seek a security interest in its collateral, the debtor would simply go down the street and purchase goods from another vender, particularly if those goods were commodities, which are easy to find.
Bank B loaned money and a security agreement was attached but was not perfected. Therefore, a security agreement is valid as between the bank and the debtor, but not valid as protection against third parties. Bank three did perfect. Therefore, if bank A, bank B and bank C start to move in on the collateral at the same time, bank C wins. A perfected creditor is going to have superior collateral rights to a creditor who has only attached a security interest, which is the situation with bank B. Bank A, as indicated above, is just another unsecured creditor with no rights against assets of the debtor absent a legal judgment.
In a worst case scenario, the debtor files for bankruptcy. Bank A and Bank B are both out of luck. They are being treated as unsecured creditors and unsecured creditors typically get less than $.10 on the dollar in bankruptcy liquidations.Bank C, by way of contrast, gets to foreclose on its collateral in most circumstances and at least will recover some money, depending on the value of the collateral it secured. If the collateral is worth the full amount of the loan, bank three will be made whole. Banks A and B will, as stated, be walking away with less than $.10 on the dollar.
In order to appreciate the difference between the secured positions of Bank B and Bank C, the following discussion is offered. Bank B attached, but did not perfect its interest as a secured creditor, whereas Bank C attached and perfected. Attaching and perfecting are separate concepts, and both are necessary to attain the highest status of becoming a truly secured creditor.
To attach, the parties simply prepare and sign a security agreement, which is a document describing the collateral and pledging the collateral as security to the debt. It should be noted while we normally consider the security agreement to be written, and electronic version is perfectly acceptable in most jurisdictions.
Perfection, under the Uniform Commercial Code occurs in commercial transactions where the lien is filed with the appropriate authorities; typically the Secretary of State in the state where the debtor transacts business and sometimes a copy is filed within the local county (a political sub-division of the state) where the property is located. Simply put, the filing is the action which creates perfection of the lien.
The filing process is very inexpensive and there are forms readily available. These forms are typically referred to as “UCC 1” forms or “Financing Statements”. Lenders who choose to do business with a particular debtor will search the public records to find evidence of other secured creditors. A search through the records of the Secretary of State will turn up all filed financing statements. A creditor can then be aware of persons or businesses which have taken a lien on collateral. These same public record searches also show any tax liens filed against a debtor. A creditor can then be guided accordingly in making a decision as to whether to lend money or not. For example, if you are loaning money, you need to know whether your debtor has other secured creditors or tax liens having liens on the same property you are about to take as collateral!
It is extremely valuable to be a perfected secured creditor! This is particularly true if you are a lender. Lenders deal exclusively in money. They don’t provide a product; they simply are in business to loan money and recover it back plus interest in order to make a profit. Therefore, it is extremely important for lenders to loan money on a secured basis.
Manufacturers, to the contrary, take more risk in terms of providing goods to their customers on open account terms, which means on an unsecured basis. Presumably, the manufacturer has a sufficient profit that it can absorb certain losses each year for maybe 2% or 3% of its customers failing to pay/filing for bankruptcy. In a situation where a manufacturer is operating on a very tight profit margin or, where a manufacturer provides “big ticket items”, very expensive milling machines or robots, a manufacturer in this category would be foolish to continue to do business with debtors who were “marginal” without taking a security interest in the products that it sells.
Whether a lender or a manufacturer, or any other position in the “chain” of commerce, it pays to be a perfected secured creditor!