Understanding Article Nine of the UCC – Security Interests
November 1, 2022
In this Surety Today Blog post we will discuss Article 9 of the Uniform Commercial Code (“UCC”). Article 9 covers security interests in all personal property whether tangible or intangible. We will discuss what security interests are, what is required for perfection and the priorities afforded security interests.
Section 9-109 of the UCC defines the scope of Article 9 and identifies what is included and also lists what is not included. The primary innovation of Article 9 is that it establishes a uniform and orderly method for obtaining a security interest in collateral by standardizing the forms, process and procedures. This standardization allows for greater certainty in one’s security interest and greater ability to search for and locate other interests that may exist in the debtor you are dealing with.
Article 9, like other UCC titles, is laid out with a number of subtitles. It begins with a subtitle addressing general provisions and definitions, the next subtitle deals with effectiveness of security agreements and attachment, the largest subtitle in Article 9, not surprisingly, deals with perfection and priority. That subtitle is followed by subtitles addressing the rights of third parties, the filing requirements and procedures and finally default.
First, let’s look at security interests and perfection. These issues are relevant for a surety claims handler in the event you are filing your own security interests (not recommended) or in the event you need to evaluate other security interests to see if they are valid and entitled to a higher priority than your security interest or other rights.
The first concept to discuss is the “security agreement.” A security agreement is a written document that conveys a security interest. UCC § 1-201(35) defines a “Security Interest” as “an interest in personal property or fixtures that secures payment or performance of an obligation.” In the context of suretyship, the security agreement is usually found in the Indemnity Agreement. Although the security agreement is sometimes an elaborate document negotiated between the debtor and creditor, it can be as informal and as simple as a single page or paragraph. There is no magic form or format.
The primary purpose of a “security agreement” is to show, to an objective observer, that the debtor intended to transfer an interest in personal property as a security to a creditor. A security agreement must contain a description of the collateral. UCC § 9-108 requires that the description of the collateral provide “reasonable identification” of the property. Examples of what is considered to be reasonable identification include identification of the collateral by specific listing, category, by type of the collateral defined in the UCC, by quantity, computational formulas or other procedures, as long as the identity of the collateral is “objectively determinable.” Section 9-108(c) states that “super generic” descriptions such as “all the debtor’s assets” or “all the debtor’s property” do not reasonably identify the collateral for purposes of a security agreement.
The next concept to discuss is “attachment.” For a security interest to be enforceable it must “attach” to the collateral. UCC § 9-203 sets forth the requirements for attachment and enforceability of security interests. In general: (1) the creditor must give value, (2) the debtor must have rights in the collateral, and (3) there must be a security agreement or other action indicating an intent to convey a security interest. Once the security interest has “attached,” it is effective between the debtor and the creditor.
This brings us to the next concept – “Perfection.” Perfection is the step necessary to place the world on notice that a creditor has an interest in the collateral. Perfection is also necessary to give a creditor priority with respect to other creditors over the same collateral. Typically, perfection is achieved by filing a document called a “financing statement,” sometimes referred to as a “UCC 1.” The financing statement must identify the debtor, the creditor, and the collateral against which the creditor has a claim. Unlike Security Agreements, the financing statement only needs to provide an “indication of the collateral” that is covered. Section 9-504 of the UCC states that a financing statement may use the super generic identification of collateral such as “all assets” or “all personal property,” which is directly contrary to the security agreements, which do not allow that. So, the UCC adopts the approach of “Notice Filing” which only requires a simple record with a limited amount of information for notice purposes. An interested party must then inquire further to obtain the details of the secured transaction and collateral covered. The financing statement need not be signed by the debtor and will be effective for five years after filing.
There are different methods of perfecting. You can always file a UCC-1. Every single time, it will not hurt you to file a financing statement. That is always permissible. But, a UCC-1 is not the correct form of perfection for several asset categories and your interest will not be protected if you do not perfect properly.
The other categories of assets where the UCC requires something more than a UCC-1 includes assets like cash, negotiable instruments, which include promissory notes, drafts and checks. These forms of assets require “possession” of the collateral in order to perfect your security interest. Possession is also required for chattel paper, which is the combination of a promissory note and a security agreement, such as what you would find if you were financing the purchase of furniture in a retail transaction for example.
Other forms of collateral require “control” as the means of perfecting a security interest. Deposit accounts, including a savings account, checking account, or a similar account at a financial institution all require control. You often see in a commercial loan arrangement that the bank requires the debtor to keep all of their operating accounts within that bank so that they have that control.
As far as what the surety is looking for and the main assets that you would see with the principal, there is the “big three” and that is inventory, equipment and accounts receivable. Those are all going to be covered by the filing of a UCC-1. A surety may also frequently see payment intangibles and general intangibles, which may relate to different contract rights, that the principal has for an executory contract or funds for work performed. Another asset that might pop up in this commercial arena is a legal claim. For example, if a principal has a claim arising out of a project that may somehow be related, that is something a surety might have an interest in also. All of those are going to require the filing of a UCC-1 financing statement to achieve perfection.
PRIORITIES
Now let’s focus on priorities among various security interests and other types of liens. Because of the priority system, your security interest or your lien is only as good as your place in line. We are talking about situations where two creditors have an interest in the same exact collateral. I point that out because as noted above a UCC-1 is permitted to simply say “all of the debtor’s assets” or “all of the debtor’s personal property” so it may not be immediately obvious what a security interest is in when you do a basic public records search. You will get a good idea of who has the security interest, but you have to do a little bit more research to get a hold of competing security agreements and sort out whose interest is in what. So, assuming that we’re talking about that same collateral, there are a couple of different basic rules regarding priority.
Under § 9-322 if you have a perfected security interest and somebody else has an unperfected security interest, the perfected party wins. If you have two perfected security interests, the winner is whoever was first to perfect. The third rule is if you have two secured parties who have attached, but neither of whom has perfected, whoever attached first wins. Things can get a little more complicated under § 9-317, which addresses a conflict between an Article 9 creditor and a creditor arising under some other law, either a judgment creditor who is attempting to levy on collateral or a bankruptcy trustee, who is marshalling assets for the benefit of the estate. In these cases, in order to win as an Article 9 secured creditor against either of those outside parties, you need a signed security agreement with an adequate description of the collateral along with that perfection by filing a UCC-1 before the levy takes place or before the bankruptcy has been filed. Of course, in the bankruptcy context you will have to be aware of the 90 day preference period. If either an attachment or a perfection has occurred during the preference period, they may be subject to a preference action, which can undo the security interest, lien, attachment or judgment, in the absence of any of the bankruptcy defenses, like new value or ordinary course.
The last thing to consider in terms of priorities is the concept of the PMSI, which stands for purchase money security interest. The UCC treats the PMSI a little extra special. The concept of the PMSI is that the secured party enabled the debtor to obtain the collateral. This is what many of us have done when we have gone out to buy a car with financing. A special rule applies to the purchase money secured party because they have a 20-day grace period in order to file a UCC-1, and as long as they do that within 20 days of the debtor taking possession of the collateral, then they’re going to get a retroactive effect to the date of attachment and any other secured parties that happen to arise in the meantime get sort of bumped out by that. In addition, the purchase money rule offers some line-jumping priorities. So once a commercial entity has a floating lien, that is they’ve granted a security interest in all of their inventory, equipment and accounts now owned, hereafter acquired and forever obtained to some bank, they can still offer a security interest to a secured party that finances the purchase of new inventory or equipment and with a little bit of paperwork, they will get a super priority and jump in line ahead of that prior blanket perfected bank.
A caveat to our discussion of Article 9 of UCC is that while drafters of the UCC had every intent to make the UCC uniform, each jurisdiction that has adopted the UCC may have provided their own modifications to the provisions. Our general discussion does not account for such modifications. Further, our discussion is of a general nature, the UCC provisions can be extremely complex and detailed, and the devil is in the details as they say. So, one must refer to the UCC provisions in each jurisdiction.
*I would like to acknowledge and thank Professor Lisa Sparks, Esq., a former attorney with WCS for her contributions to the content of this blog post (she taught the UCC at the University of Baltimore School of Law).
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.