Security Agreements what They’re all about

A security agreement is a written document by which a borrower or guarantor pledges some type of personal property in order to induce a lender to enter into a financial transaction. Personal property includes things like cars, shares of stock, inventory, etc. It is a legal agreement and as such is governed by state laws known commonly as the Uniform Commercial Code and specifically, by Article 9. Article 9 has dozens of provisions most of which the consumer has little interest in.

As a consumer, there are two basic reasons to execute a security agreement. The first reason is that the consumer wants to buy a product and finance the purchase by borrowing money from a lender. Much like a home buyer giving a mortgage to the lender, the consumer buying a car, television or computer on credit executes a security agreement in favor of the lender. The second reason a consumer would commonly execute a security agreement is to borrow money from a lender when the lender requires the borrower to pledge personal property to secure the loan. This is also a common reason for a commercial borrower to give a security agreement. In the consumer setting, getting a so called “title loan” is a common example of this type of secured transaction. In that instance, the borrower will pledge the title to his or her vehicle to the lender in exchange for the lender’s willingness to loan money to the borrower. In the commercial setting, a borrower may pledge his business inventory or accounts receivable to a lender.

There are a few basic issues that borrowers should keep in mind. First, a secured lender that does not take possession of the secured property will file the security agreement in the office designated by state law for the recording of security agreements. This is often the state’s Secretary of State’s office or a county’s probate court clerk’s office. These records are often easily searchable by other lenders. This means that if you try to give the same property as collateral for more than one obligation, the second lender will likely detect this. It should be pointed out that in some commercial transactions, it is fairly common to have two or more lenders securing their transactions with the same property or inventory where the total amount of all of the loans is less than the value of the collateral. This creates issues of priority and there are plenty of priority rules and issues for the lawyers to haggle over.

Second, during the term of the secured transaction, the borrower is limited in what he or she may do with the property. For example, the borrower would not be allowed to sell the property without paying off the debt secured by the property. Leasing or renting the property to a third party would typically be prohibited as well. Further, many security agreements require the borrower to maintain insurance on the property so that if the property were destroyed, the lender could recover the value of the collateral to pay off the debt.

Third, beware of force placed insurance. If the borrower fails to maintain insurance on the pledged collateral, the lender will often have the right under the security agreement to purchase what is commonly known as force placed insurance and can force you to pay the premiums for the insurance. Force placed insurance is very expensive compared to what borrowers can buy on their own. More importantly though, force placed insurance only protects the lender’s interest in the property, not the borrowers. For example, if the borrower owes the lender $10,000 that is secured by a piece of machinery worth $20,000, force placed insurance pays the lender the $10,000 and the borrower gets nothing.

Fourth, it is quite common for a secured lender to sell, or “assign,” its rights to the borrower’s property to another company. In that case, the new company steps into the shoes of the original secured party.

Fifth, and here’s where it gets (mildly) interesting, a secured lender has certain rights in the event that the borrower defaults on the agreement. There are several ways that a borrower can default. The most common way is to fail to make payments as agreed. Other ways include failing to maintain insurance, allowing the property to go to waste, or using the property for illegal purposes. If the borrower defaults on the agreement with the lender, the lender may take possession of the collateral in possession of the borrower (think “Repo Man”). Once the lender has possession of the collateral, the lender may then dispose of the collateral through any “reasonable” manner in order to offset the amount of the debt.

Let me just tell you right now, what the lender thinks is reasonable will never seem that way to the borrower. In the common example of the vehicle repossession, the wholesale value of the vehicle is often much less than the amount owing on the debt. On top of that, all of the expenses incurred in the repossession and auction are paid off the top, then accrued interest and late charges and whatever is left is applied to the principal balance owed. This means that in 99% of repossessions leading to sales, the borrower will still owe a deficiency which is the difference between the principal amount owing on the debt and the amount applied to the debt after expenses, interest and late charges were paid. Even though the lender took the collateral back from you, the lender can still collect the deficiency not only from the borrower, but also from any co-signers as well.

There are a few consumer protections built into the system. First, the lender must notify the borrower of the proposed sale so that the borrower can attempt to redeem the property before it is disposed of. In order to redeem, the borrower must typically bring the debt current with the lender by paying all late and current payments, accrued interest and late charges. Second, the lender’s sale must be commercially reasonable. They cannot sell a brand new car for $10, for example. In reality though, as long as the lender sells for something close to the wholesale value of the vehicle, the borrower has virtually no chance of successfully contesting the reasonableness of the sale.

Secured transactions are a very common in modern life. If you buy things on credit, you are entering into a secured transaction. Just remember, what you buy is not really “yours” until you pay off the debt. Also remember that repossession is never the end of the story. You and your cosigner are still on the hook even after the collateral has been repossessed.