Secured Credit 101: Security and Perfection

Consumer secured lending is a commonplace part of many household budgets. Major purchases like homes and cars are almost always financed, while other consumer transactions, like the purchases of furniture, electronics, appliances, and HVAC equipment are sometimes financed. A lender will often seek to retain rights in collateral as additional assurance that the loan will be paid. Sometimes, a consumer will pledge property they already own as collateral to a new loan, such as a home equity line of credit. In the legal lingo, these are all "secured transactions" aiming to create secured debts.

There's a lot of different kinds of secured transactions, which vary greatly in the details. As one can imagine, there's a lot different between a mortgage on a new home and a lien on a clothes dryer. Nevertheless, there are two basic phases of a secured loan: (1) granting of a security interest, and (2) perfection of that security interest. Normally, the granting of a security interest is far more important to a consumer than perfection. As I will discuss below, bankruptcy makes both important considerations.

Granting of a Security Interest

Property becomes collateral by grant of a security interest. Exactly how this is done varies by type of property involved. But at the most basic level, there is an affirmative grant of rights in the property from the owner-borrower to lender. Absent granting of a security interest, there's no secured debt, no collateral, and no prospect of repossession. If a person is lent money to buy something, that does not automatically mean the lender has collateral. There has to be another aspect to the transaction.

Most secured lenders have the security interest down to a very precise process, but there are occasionally mistakes that result in a security interest ineffective against the borrower or anyone else.

Perfection of a Security Interest

Whereas granting of a security interest gives the lender rights against the owner-borrower to seize the collateral property, perfection is the process used to give the lender superior rights to other third parties. Once perfected, the creditor can enforce its security interest (i.e. repossess or foreclose) against certain future purchasers of the collateral. The creditor also gets first shot at the collateral's value, ahead of later creditors who obtain a security interest in the same property.

There's considerable variation on how security interests are perfected. Deeds of trust (a type of mortgage) are perfected by recording at the County Register of Deeds. Car loans are perfected by notation on the certificate of title. Some transactions in goods required a UCC-1 financing statement to be filed with the Secretary of State to obtain perfection, while others are automatically perfected upon grant of the security interest.

Perfection and Bankruptcy

The general rule is that perfection is not required for the security interest to be enforceable against the borrower. In bankruptcy, more parties than just the debtor-borrower and the lender are involved. Bankruptcy law allows the trustee to step ahead of a creditor with an unperfected security interest, and use the value of the property for all creditors.

When the debtor is giving up the property anyways, the lack of perfection affects who gets the value of the sold property. That can be good or bad from the debtor's perspective. If the debtor wants to keep the property, an unperfected lien in valuable property can lead to problems. When the property is lower in value, exemptions may be applicable to shield the value from creditors. In that case, the debtor benefits from the lack of perfection. If exemptions are inadequate, that means the trustee in chapter 7 will be interested in selling the property, and the debtor may need chapter 13 to protect the asset. This scenario will be discussed in more detail in a forthcoming post.

If a lender has not perfected prior to the filing of a bankruptcy petition, attempting to perfect the loan after the bankruptcy is filed will normally be a violation of the automatic stay.