To understand the importance of security interests, it is first important to understand the legal process involved when a lender does not have a security interest (i.e., is unsecured) in relation to the borrower. If a lender makes an unsecured loan and the debtor defaults, the lender must sue in court and obtain a judgment. However, this judgment by itself is worth nothing: suitable only for framing. Since the debt is unsecured, there is no specific property backing the debt, so the unsecured lender must obtain a writ of execution, which allows the local sheriff or federal marshal to seize upon any property of the debtor’s that can be found. If the debtor has filed for bankruptcy, the creditor will likely end up with nothing. As you can imagine, trying to recover on a bad unsecured debt can be an expensive, time-consuming and often fruitless exercise in frustration for the unsecured creditor.
Consequently, a lender will often require a debtor to agree to the creation of a security interest in order to protect that creditor. The security interest is the right of the lender to sell specific property in order to satisfy the debt should the borrower default. One of the most common security interests is found in a mortgage for real estate, but is also regularly seen in personal property transactions, both tangible and intangible. Tangible personal property includes cars, motorcycles, kitchen appliances and pretty much any movable physical property you can imagine. Intangible personal property includes things like accounts receivable, securities, and promissory notes. Generally speaking, the law of secured transactions is governed by Article 9 of the Uniform Commercial Code.
As a lender, making sure your debt is secured through the proper creation of a security interest often only gives you minimal protection. This is because the property referenced as collateral in the security interest may have been used by the borrower as collateral for other debts as well. In the case of a mortgaged real estate property, you will often see many secured interests: a first mortgage, a second mortgage, a security interest in a fixture such as a swimming pool or a garage, or perhaps a judgment lien from a lawsuit the debtor lost. As a lender, understanding your relative priority against other secured interests in a specific property and maximizing your place in that pecking order will sometimes make all the difference between getting something rather than nothing out of a bad debt. That process of enforcing your security interest against other creditors is known as perfection. Perfection involves putting the rest of the world on notice that you have an interest in the debtor’s asset. Continue reading