Security Interests in Personal Property

Copyright ©  2002  Regents of the University of Minnesota. All rights reserved.

Dealing with a borrower who has a solid reputation and who has demonstrated his ability to repay loans generally is the best protection a lender can have. But lenders typically require borrowers to pledge collateral to secure the loan. Lenders may accept real property or personal property as collateral. Another publication in this series, Mortgages and Contracts for Deed, discusses the use of real property as security for a loan. This publication considers some general concepts and identifies some potential problem areas that arise with the use of personal property such as livestock, machinery, equipment, and crops, as security for a loan.

The law governing the legal rights of lenders and borrowers who use personal property as collateral is contained in the Uniform Commercial Code (UCC). The UCC has been adopted in every state and governs virtually all such transactions. It does not apply to real estate transactions, however. It has greatly simplified the use of personal property as collateral by providing for a nationwide uniform set of rules. Significant revisions to the UCC have been enacted in Minnesota, effective July 1, 2001. This publication will discuss the rules applicable to the creation and perfection of security interests and priority security interests.

Creation of Security Interests

If a lender follows the rules of the UCC, he may acquire a "security interest" in the collateral. A security interest can be created in either of two situations:

1. When a farmer needs to borrow money but cannot obtain the funds unless some collateral is put up for the loan. Such funds may be needed to plant crops, acquire livestock, or obtain machinery. In such a case, the borrower may grant a lender a security interest in his personal property in order to obtain the necessary money.
2. When a farmer does not have sufficient funds to pay the full price of a desired purchase. In such a case, the seller may provide the necessary financing and retain an interest in the property. Such a security interest is referred to as a purchase money security interest. In some cases, Minnesota law provides suppliers with a lien on a farmer's crops or livestock which may function similarly to a security interest. Another publication in this series, Agricultural Liens in Minnesota, discusses the rules relating to those liens established by law for suppliers of goods and services to farmers.

In most cases, in order to give a lender a security interest, the borrower will sign a security agreement. For a security agreement to be valid, it need not be in writing so long as the security agreement is authenticated by the borrower. If the collateral is in the possession of the lender under an agreement with the debtor, no written security agreement is required. It is not necessary that the security agreement contain a detailed description of each item of collateral. For example, it is not necessary to include the serial number of a piece of particular farm machinery in order for that piece of machinery to be subject to the security agreement. The test of whether a description is valid is whether it reasonably identifies the collateral. The UCC sets forth various types of collateral such as inventory, farm products, and equipment. If a security agreement uses the collateral classifications of the UCC to describe the collateral, the security agreement will comply with the rules regarding description of the collateral. However, it is not permissible to use overly broad collateral descriptions such as "all personal property of the debtor."

Besides the required terms, the security agreement generally will have additional terms that deal with the borrower's right to sell the collateral. Most farm security agreements provide restrictions on the farmer's ability to sell the secured property. Some agreements may completely prohibit any sales without the written consent of the lender. Others may allow such sales subject to restrictions on how the buyer of the secured property is to pay the farmer, such as requiring that the lender's name appear on any checks issued in payment for such property.

Perfection of Security Interests

The security interest between the borrower and the lender is valid and enforceable once three requirements have been fulfilled: (1) the security agreement has been authenticated; (2) the lender has given value in exchange for the security interest; and (3) the borrower has property rights in the collateral.

If the lender wants the security interest to be valid against third parties such as another lender with a claim against the borrower, however, the lender must notify such parties of the lender's claim. When the collateral is in the possession of the lender, no additional steps may be required. In addition, it may be necessary for a secured party to obtain control of certain types of collateral such as deposit accounts in order to give notice of its interest in the debtor's property. This process of giving public notice of a security interest is called "perfection."

The usual method for perfecting a security interest is by filing a financing statement in the proper place. Under the former rules, the county recorder in the county in which the debtor resided was the proper place to file a financing statement to perfect a security interest in crops, farm products (crops, livestock, or supplies used or produced in farming operations and products of crops or livestock in their unmanufactured state), equipment used in farming operations, or accounts arising from the sale of any of these types of collateral. With other types of collateral, the financing statement was filed with the Minnesota Secretary of State.

Under the current rules, effective July 1, 2001, all financing statements, including those covering agricultural collateral, will be filed in the central filing system operated by the Minnesota Secretary of State. This may be accomplished either by filing the financing statement directly with the Secretary of State's office or by filing with any of several satellite offices located in the county recorders' offices throughout the state of Minnesota.

The financing statement is a brief and relatively simple document. It must contain the name of both the debtor and the secured party. In addition, it must include an indication of the collateral. It need not be signed by the debtor. It is not necessary to provide a detailed description of the collateral in the financing statement. For example, the financing statement need not describe the land upon which crops are to be grown, or the number of head of livestock which are subject to a security interest. However, it is important that the holder of a security interest not describe the collateral too broadly in its financing statement. Filing a financing statement which contains a collateral description substantially broader than the security interest granted by the debtor will not be effective to perfect a security interest in the additional collateral. In addition, a secured party may be subject to claims for damages by a debtor who is damaged by an overly broad financing statement.

While a financing statement may use a very broad description of the property subject to a security interest, it is very important that the name of the debtor be accurate. The financing statement must generally set forth the debtor's legal name. In the case of a corporation or limited liability entity, the name of the debtor must correspond exactly with the name of the debtor as it appears in its organizational documents. For an individual debtor, it is preferred that the name of the debtor be the individual's legal name. Nicknames are not favored. In addition, trade names are not permitted.

A financing statement may be rejected if the financing statement form is completed incorrectly or if it is not clear from the face of the financing statement that the debtor is an individual or organization. Once filed, a financing statement need not be refiled for five years unless it is terminated before then.

A major exception to the perfection rules of the UCC applies to security interests in motor vehicles. To perfect a security interest in a motor vehicle for which a certificate of title has been issued, the lender must file appropriate documentation with the Minnesota Department of Public Safety. It is not sufficient for the lender to file a financing statement that covers a motor vehicle with the county recorder. If the lender has properly filed with the Department of Public Safety, the department will issue the certificate of title including the name of the secured party. A lien confirmation notice will be provided the secured party.

Priority of Security Interests

In many cases, two or more creditors may have security interests in the same collateral. In such a case, the question of who has the first claim to the collateral may arise. If one of the competing creditors has failed to file a financing statement, the holder of a perfected security interest will prevail. When two or more creditors file a financing statement covering the same collateral, the general rule under the UCC is that the first to file or otherwise perfect its security interest prevails, regardless of who actually loaned money first. It makes no difference whether the party who filed first knew when the money was advanced that another lender already had made a loan on the same collateral.

Despite this general rule, the priority of a perfected security interest in after-acquired property can be overcome by a purchase money security interest if certain procedures are followed. If the party who sells goods to the debtor, or finances the purchase of such goods, files a financing statement within 20 days from the time the borrower takes possession of the goods, his purchase money security interest will be given priority over the lender with an after-acquired property clause in his security agreement. A typical example of such a purchase money financing is the financing provided by the financing affiliates of farm machinery manufacturers. Often such financing is offered directly by agricultural equipment dealers.

A similar rule applies to purchase money security interests in livestock. A secured party who finances the debtor's purchase of livestock may obtain priority over a competing security interest if it provides the holder of the competing security interest notice of its intent to obtain such a purchase money security interest within six months of the debtor obtaining possession of the livestock and if the secured is perfected when the debtor obtains possession. However, this purchase money security interest may be subject to a agricultural liens provided by Minnesota law.

A second exception to the first to file or perfect rule is provided for agricultural liens. Minnesota law provides suppliers of goods and services to farm operators various liens for the value of the goods and services. Another publication in this series, Agricultural Liens in Minnesota, summarizes the rules applicable to these agricultural liens. However, it is important to note that such liens may have priority over a competing security interest if they are timely perfected by the agricultural lienholder.

Special Problems for Farmers and Their Lenders

Secured parties who obtain security interests in farm products receive special treatment under the UCC. In addition, the very nature of a farming operation raises special problems for agricultural lenders and their customers.

Farmers may participate in any number of farm programs. Many of these programs result in direct payments to them from the government. These rights to payment may be a source of security for the agricultural lender. Such payments may be covered by a proper security interest in crops or in general intangibles, a catch-all category of collateral under the UCC. Most courts which have addressed the question have determined that government program payments are included in this classification.

Once a lender obtains a security interest under the UCC, it is a durable lien. By means of an after-acquired property clause, a lender may be given a security interest in property that will be obtained or acquired after the signing of the security agreement. Thus, livestock, crops, or other goods acquired by the farmer in the future may be included as collateral for the present loan. In addition, the UCC allows the parties to agree that future advances of money may be given when needed without making a new agreement. Such provisions are important as a lender who has been granted a security interest in all crops, including crops to be grown at a future date, will possess a security interest in crops that are planted and harvested in later years even though the lender may not have financed the planting and harvesting of such crops. It is not necessary for a farmer to sign a new security agreement or for the lender to file a new financing statement for each crop year.

Besides covering property that may come into existence at a later date, the security interest under the UCC remains intact even though the collateral itself may change through the stages of production. A lien on crops continues as the crop matures in the field, is harvested, and is stored. A lien on livestock, including all after-acquired livestock, creates a valid security interest in offspring, whether or not they were conceived at the time the agreement was signed. Finally, the security interest of a lender extends to proceeds of the collateral. Thus, if a farmer sells farm products, the lien holder is entitled to the sales proceeds by virtue of his security interest in the farm products themselves.

If a farmer sells farm products, the purchaser of such products takes them free of a prior perfected security interest in the products themselves that is created by the farmer unless the lender has filed second notice called an effective financing statement with the Minnesota Secretary of State under the provisions of a federal statute. If the lender complies with the federal act, and the farmer sells the crops without the permission of the lender, the lender can sue either the farmer or the purchaser of farm products to either repossess the goods or get damages for the farmer's unauthorized sale.

Conclusion

The rules of the UCC with respect to security interests in personal property are of critical importance for the farm operator and lender alike. The farmer must be aware of the significance of each of the documents he is asked to sign. The lender must take all steps necessary to obtain a perfected security interest in the collateral that has been promised for the loan. Once a perfected security interest has been obtained, it remains in place until terminated by the lender or until five years pass.

To order publications in this series, contact the University of Minnesota Extension Service Extension Store, 405 Coffey Hall, 1420 Eckles Avenue, St. Paul, MN 55108-6069, e-mail: mailto@umn.edu or credit card orders at 800-876-8636 or 612-624-4900 (local calls). Titles include:

• Agricultural Liens in Minnesota (FO-07682)
• Security Interests in Personal Property (FO-7292)
• Mortgages and Contracts for Deed (FO-07293)
• Termination of Contracts for Deed (FS-07294)
• Bankruptcy: Chapter 7 Liquidations (FO-07295)
• Bankruptcy: Chapter 11 Reorganizations (FS-07296)
• Mortgage Foreclosures (FO-07297)
• Termination of Security Interests in Personal Property (FO-7298)
• Rights of Unsecured Creditors (FO-07299)
• Tax Considerations in Liquidations and Reorganizations (FO-07300)
• Bankruptcy: Chapter 12 Reorganizations (FO-07301)
• Agricultural Production Contracts (FO-07302)
• Financing the Farm Operation (FS-02589)
• Contracts, Notes and Guaranties (FS-02590)
• Farm Leases (FS-02593)
• Bankruptcy: The Last Resort (FO-02598)

The sixteen publications are also available as a package:
Farm Legal Series (PC-07291).

This publication is designed to provide accurate information in regard to the subject matter covered. It is published with the understanding that the authors and the University of Minnesota are not engaged in rendering legal, accounting or their professional services. If legal advice or other professional assistance is required, the services of a competent professional should be sought.

Produced by Communication and Educational Technology Services, University of Minnesota Extension.

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