It always starts so easy. Borrower comes in and wants to borrow money. Lenders want some form of collateral to secure (potentially) a loan and the Borrower happily agrees to provide, or pledge, collateral to secure a loan. Common examples are the Borrower pledging inventory, equipment or receivables (assuming of course there is no real estate to lien with a mortgage). Lender, either internally, or with outside counsel, prepares the necessary security agreement to document the pledge of collateral. This is generally the description of a secured transaction.

While there is generally a happy relationship between the Borrower and the Lender, and therefore no issues, problems frequently arise, however, when the Borrower goes bankrupt.

In bankruptcy, the Lender is now faced with having to deal with either a Chapter 7 Trustee or a Creditors’ Committee in a Chapter 11. Whether it is a Chapter 7 Trustee or a Creditors’ Committee, one of their first tasks is reviewing the loan documents and seeing if there is a way to challenge the effectiveness of the security arrangement.

Article 9 of the Uniform Commercial Code (UCC) covers secured transactions, in order for a creditor to become a secured party—that is, a party with a legal right to take possession of collateral in the event of the debtor’s failure to pay—the creditor must take special steps. These steps are known as attachment of a security interest and perfecting the security interest. Generally speaking, attachment requires that: (i) value be given for the security interest; (ii) the debtor has rights in the collateral (or power to transfer the collateral to a secured party); and (iii) the debtor “authenticates” a security agreement.

For purposes of attachment, the debtor must “authenticate” a security agreement. That is, the debtor must sign the agreement. (The UCC uses the term “authenticate” to include the possibility of electronic signatures.) Not only must the security agreement contain a clear statement that the debtor is granting the secured party a security interest in specified goods, but it must also provide a description of the collateral. Section 9-108 of the UCC indicates generally that a description of collateral is sufficient “if it reasonably identifies what is described.” While the description of collateral in a security agreement does not have to be finely detailed, the UCC prohibits descriptions of collateral that are “supergeneric,” such as “all the debtor’s assets” or “all the debtor’s personal property.” Tip:Knowing many times the Lender or its counsel is using a “form” security agreement, this is where and when the Lender needs to slow down and take the time to thoroughly proof the document – dot those i’s and cross those t’s.

The next big step in the secured transaction is “perfecting” the security agreement. The Lender wants to perfect its security interest in order to help assure that no other party, such as the Chapter 7 Trustee or Creditors’ Committee, will be able to claim the same collateral in the event that the debtor becomes insolvent. The Lender wants to properly perfect its security interest, as a secured party, to gain priority over other parties regarding the collateral.

How to specifically perfect a security interest will depend in part on the local jurisdiction where the collateral is located. However, generally speaking, the primary ways for a secured party to perfect a security interest are: (i) by filing a financing statement with the appropriate public office; (ii) by possessing the collateral; (iii) by “controlling” the collateral; or (iv) it’s done automatically upon attachment of the security interest. Of these four listed items, the first–filing a financing statement–is by far the most common and important to understand – and where Chapter 7 Trustees or Creditors’ Committees will go first and look for flaws.

The filing of a Financing Statement is the most common way to perfect a security interest for most types of collateral. The purpose of the financing statement, which is filed with a public office such as the Secretary of State, is to put other people on notice of the secured party’s security interest in the collateral. The UCC specifies what must be contained in a financing statement: (i) the name of the debtor; (ii) the name of the secured party; (iii) and an indication of the collateral.

The name of the debtor (borrower) – get it right! It is crucial that the name of the debtor be sufficiently specific and accurate because financing statements are filed under the debtor’s name. If the name on the statement is wrong, the statement will fail to provide adequate notice to others, and will not succeed in perfecting the security interest. Section 9-503 of the UCC provides various, more specific rules regarding the sufficiency of a debtor’s name on a financing statement. For example, if the debtor is a “registered organization,” which might mean a corporation or limited liability company organized under a particular state’s law, then the name on the financing statement must match the name of the debtor as registered with the state.

The name of the secured party – well, that is you the Lender and generally not an issue. Ah, but the description of the collateral. That is important! The rules for describing the collateral on the financing statement are largely the same as for the description of collateral on a security agreement (see above). However, unlike with a security agreement, on a financing statement it is acceptable to use a “supergeneric” description of collateral. A standard form, known as Form UCC-1, is widely used by secured parties to file a financing statement. While many financing statements must be filed with the Secretary of State, you should check your own state’s laws for more information. Tip: Again, take the time to thoroughly review the accuracy of the UCC-1 Financing Statement. Errors in the description of the collateral, or failing to list the collateral, can render the Financing Statement defective – which means you become an unsecured creditor.

Lastly, given that not all states have adopted all sections of the current model of the UCC, you should double check your own state’s commercial code for the most accurate information.