Lending and Secured Transactions
Consumers and businesses routinely call on banks to lend them funds with which to purchase real estate, automobiles, equipment and other assets. Banks are typically happy to lend the funds so long as they believe they are adequately protected in the event of default. This protection is achieved through the execution of a promissory note in favor of the bank and, in many instances, the borrower’s granting the bank a security interest in an asset or assets owned by the borrower.
Where a borrower grants a bank a security interest in real estate, the security interest is referred to as a mortgage. Where a borrower grants a bank a security interest in personal property, the security interest is referred to as collateral. For example, when a consumer purchases an automobile with money loaned to the consumer by a bank, normally the bank will require that the automobile be used as collateral. Pursuant to its resulting security interest in the automobile, the bank can take possession of the automobile in the event the borrower defaults on the loan. The bank can then sell the automobile to offset all or part of its loss, and pursue the borrower for any deficiency.
Another common type of secured transaction in the small business context involves working capital. A small business owner will normally meet with his or her bank to discuss the current and anticipated financial needs of the business and to request a working capital loan. The better prepared the borrower is to respond to the lender’s questions concerning business conditions and the anticipated use of the loan proceeds, the more likely the borrower is to obtain the loan on favorable terms.
If the bank’s lending requirements are met, the bank will lend funds to the business contingent on the business’s granting the bank a security interest in either specified assets or all of the assets of the business (a “blanket security interest”). The security interest entitles the bank to take possession of the encumbered assets in the event the borrower defaults under the terms of the loan.
The Uniform Commercial Code (UCC) governs secured transactions. The UCC requires that the parties execute a financing statement, which explicitly grants the lender a security interest in the collateral. The lender must then “perfect” the security interest by filing the financing statement with a state government office. This filing constitutes public notice of the lender’s right to the collateral in the event of the borrower’s default. By virtue of this filing, the lender has priority over other creditors who do not have a security interest in the collateral or who subsequently file financing statements.
A potential problem can arise when a borrower sells a financed asset without using the sale proceeds to pay off the bank loan. Then the question arises whether the lender has a security interest in the sale proceeds. The UCC resolves this question in favor of lenders by taking the position that no reference to proceeds is necessary in the security agreement. Unless stated otherwise in the agreement, a security agreement gives the secured party the right to the proceeds. Similarly, a security agreement can provide that “after-acquired property” purchased with the proceeds of a sale is subject to the security interest. For questions about transactions under the Uniform Commercial Code, contact a business attorney.
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