A security interest is created when someone who is in debt gives a creditor the legal right over certain property in the event the debtor breaches an agreement. Most of the time this occurs in a financial situation. The property is referred to as collateral.
A common example of a security interest is when someone obtains a mortgage to buy a house. If the purchaser fails to make the expected payments on the house, the bank can take the property away from them. In this situation, the bank has a security interest in the home if the purchaser does not meet their payment obligations.
How is a Security Interest Created?
Security interests can be granted in nearly any type of property, including presently owned and after-acquired property. A security interest is usually created by a written agreement that will need to include the following elements:
- Explicit Language: There must be language in the agreement that expressly grants someone a security interest. This language must be clear so there is no question that a security interest has been created.
- Authentication: The party granting the interest must authenticate the agreement to show that it is legitimate. This is usually accomplished by including an original signature.
- Description of the Collateral: The agreement must describe the collateral, either by specifically identifying it, describing its category or otherwise reasonably identifying it. It is the best practice to include more detail about the collateral so there is no confusion. This also helps avoid legal disputes down the road.
There are also certain situations where security interests are automatically created. A typical example of this is when a lien is created. Depending on your state’s laws, sometimes a lien will be automatic if you fail to pay for services.
Some examples are failing to pay attorney’s fees and failing to pay a mechanic for completed repairs. Regardless of this, if the parties have an agreement about payment that is to the contrary, the written agreement will usually always control any legal disputes. If you have a question about liens, contact a local real estate attorney to find out your state’s laws.
How are Security Interests Enforced?
A security interest is only enforceable after it attaches to the collateral. This occurs when the following steps are completed:
- There is value given for the security interest.
- The debtor has rights in the property. A person cannot create a security interest if they do not have any ownership to the property. For example, you cannot put your mother’s house up as collateral for your debt. You need to have some right to the property.
- There is evidence that the debtor intended to create a security interest. As noted above, this is usually evidenced by a written agreement between the parties.
If the debtor defaults on the agreement, the creditor can take legal action to enforce their security interest. The following enforcement options will generally be available:
- The creditor can take possession of the collateral and sell it;
- In the mortgage scenario, if the homeowner defaults and continues to stop making payments, oftentimes the bank will place the property in foreclosure and try to sell it at an auction or sheriff’s sale.
- After the creditor takes possession of the collateral and sells it, the creditor can sue the debtor for a deficiency judgment; or
- The creditor can ignore the security interest seek a judgment against the debtor for the amount owed under the agreement.
Keep in mind that if the collateral is taken and sold, the creditor will have to return any surplus from the sale to the debtor. For example, if the outstanding debt is $100,000 and the property sells for $110,000, the debtor will be entitled to the $10,000 excess from the sale.
What Happens When a Third-Party is Involved?
Third parties may have an interest in the same collateral that is the subject of a security interest. If so, courts will look at what is called "perfection" to determine the creditor’s rights to take the collateral after a default has occurred. Different types of collateral have different requirements for perfection. In general, a security interest is perfected after attachment and one or more of the following occurs:
- The creditor files a financing statement (Form UCC1) with the Secretary of State;
- The creditor takes possession the collateral; and/or
- The creditor takes control of the collateral.
Sometimes a security interest is automatically perfected when it attaches. This depends on the type of property and your state’s laws.
Next, a court will determine who has priority over the collateral. The general rules for priority when multiple creditors are involved are:
- Among creditors with perfected security interests, the first to file or first to perfect has priority;
- Perfected security interests have priority over unperfected security interests;
- Among unperfected security interests, the first to attach has priority; and
- Liens have priority over unperfected security interests.
Should I Contact an Attorney?
If you are a creditor who is trying to enforce a security interest, you should contact a local property attorney to evaluate for options. An attorney can let you know if the security interest is enforceable, and if you have perfected your interest. In addition, an attorney can advise you about whether you have priority over other third parties.
If you are the debtor and have questions about creating a security interest or a default, consulting an attorney would be your best course of action as well. These situations can be very complex and will require professional assistance to get the best possible outcome.