We talk a lot about the importance of taking collateral to secure the repayment of loans. Securing repayment by taking collateral is as old as lending itself. I have previously written about the limitations imposed by the Federal Trade Commission on the types of collateral that may be taken. That blog is available by clicking here. But what is the significance of “perfecting” a security interest in collateral? And what about “priority?”

Perfection is a concept that was introduced into consumer lending with the advent of the Uniform Commercial Code in the 1960's. The Uniform Commercial Code (”UCC”) is a uniform body of law adopted now in all of the states of the USA. Article 9A of that uniform law gives the rules for how and when loans may be secured by personal property, how priorities in the collateral are established and governed, and what happens in the event of default in the underlying loan.

So, what do we mean by perfection? Perfection is the concept of completing the claim of a security interest in the subject collateral. Taking the security interest by contract language alone does not complete the job. The law requires that in order for the security interest in the collateral to be fully effective to secure the debt, perfection of the security interest must also occur. And, once that occurs, then the creditor's claim of a security interest in the collateral is firmly established—well almost.

The method of perfection of a security interest depends on the type of collateral taken. A security interest in most personal property is perfected by filing a form UCC-1 in the designated office of state government—in Alabama, that is the Office of the Secretary of State. However, for certificated collateral such as cars, trucks and motorcycles, the security interest is perfected by noting the fact of the security interest on the vehicle's certificate of title. This is often accomplished through the Department of Motor Vehicles or Department of Revenue in a state.

Once “perfected” a creditor is then in a position to claim or repossess the collateral securing the loan if a customer defaults. There are many other rules set forth in the UCC regulating the collection process. And that brings us to the “priority” rules.

The priority of competing security interests in the same collateral is often a significant issue in pursuit of the collateral in the event of default. Generally speaking, a “first in time, first in right” rule applies to determine priority. That is, the first creditor to perfect a security interest, will have first priority rights in the collateral.

I have written about the alternative of purchasing non-filing insurance in lieu of perfection. See here. Either perfecting a security interest or purchasing non-filing insurance is an important step in making certain that a creditor's security interest is indeed just that—secure.

Practice Pointer: Make certain that when a security interest is claimed in collateral, it is perfected. And note that just because a security interest is perfected does not mean that the creditor has a priority claim to the collateral.

Please note: This is the forty-sixth blog in a series of Back to Basics blogs, in which relevant and resourceful information can be easily accessed by clicking here.