Business Law

Security Interests - The Basics

As a condition to getting a loan, a business is usually required to offer up assets as "security" (or "collateral"). The borrower signs a security agreement giving the lender the power to foreclose on the assets if the business defaults on the loan.

Examples of business assets in which lenders will take a security interest include:

  • Personal property:
    • Equipment
    • Vehicles
    • Office furnishings
    • Inventory and proceeds from sales
    • Accounts receivable
    • Stocks
    • Crops
    • Patents, copyrights, trademarks and other intellectual property rights
    • "Choses in action" ( potential rights that have not yet matured, such as a claim in a lawsuit)

  • Real property:
    • Commercial real estate
    • Interests in leases
    • Options to purchase

  • Fixtures (improvements such as built-in cabinets that started out as personal property before becoming a part of real property)

Depending on the type of asset, there are different requirements for creating a security interest. With personal property, for example, the security agreement itself may be enough to create a security interest in collateral that is described in the agreement. Rules vary greatly from state to state.

In a business setting, a lender will want its security interest to have priority over other creditors, meaning that the asset will be used to pay the lender's claim first, should the borrower default.

With personal property, the lender files what's called a "UCC-1 form" with the Secretary of State in the state where the collateral is located (and sometimes with local counties or townships, as well). This public record puts other creditors on notice that there is a lien on the assets that will have priority over any other security interests given on the same collateral.

With real property, lenders will insist on a mortgage or a deed of trust. The lender records this document in the county or township where the real property is located. In most cases, the first document to be recorded has priority over documents that are recorded later.

Restrictions in Loan Agreements

Loan agreements may contain restrictions on actions that the business can take. These provisions can:

  • Restrict the assumption of additional indebtedness
  • Limit the payment of dividends
  • Restrict acquisitions, mergers and other changes in control
  • Regulate the disposition of assets, and
  • Restrict deviation from certain financial benchmarks such as net worth or revenues

These restrictions are intended to give some sort of assurance to the lender that the loan will be repaid as agreed.

Tax Liens

If the business fails to pay its federal tax, the tax, together with interest, penalties, and costs, will be a lien in favor of the United States on all of the business' property, both real and personal. A lien is a charge, security or encumbrance on property. The tax lien also attaches to the business' exempt property and to all property the business acquires after the time the lien arises.

The basic principle used in deciding the priority of competing liens is ''first in time, first in right.'' Thus, if the Internal Revenue Service's tax lien arises first, it will take priority over subsequent liens even if it is not filed. There are four broad exceptions to the general ''first in time, first in right'' doctrine. The general tax lien must be filed first in order to prevail over:

  • Purchasers
  • Holders of security interests
  • Mechanic's lien holders, and
  • Judgment lien creditors

Questions for Your Attorney

  • What does a security agreement give the lender the right to do if the borrower defaults on its loan?
  • In what kind of personal property can a lender take a security interest?
  • Can a loan agreement restrict any actions of the business that borrowed the money?
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