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Lending and Secured Transactions

Individuals and businesses regularly ask banks to lend funds to buy real estate, vehicles, equipment, and inventory. Lenders will lend funds if they deem they are sufficiently sheltered in the event of borrower default. Lenders protect themselves by requiring the borrower to execute a promissory note in favor of the lender. The borrower often has to grant the lender a security interest in collateral.

If the security interest is in real estate, the security interest is a mortgage. If the security interest is in personal property, the security interest is collateral. When an individual buys a vehicle using money loaned by a bank, the bank will usually require the vehicle to be collateral. According to the resulting security interest in the vehicle, the bank can take possession of the vehicle if the borrower defaults on the loan. The bank will sell the vehicle in an effort to offset as much of its loss as possible and try to recover from the borrower for any deficiency.

Another secured transaction in the small-business arena involves working capital. A small-business owner will meet with the bank to discuss current and anticipated financial needs of the business and to apply for a working capital loan. The better the borrower can respond to the lender’s questions about concerning business conditions and the proposed use of the loan proceeds, the more likely the borrower is to receive favorable terms. If the lending requirements are met, the bank will lend funds to the business—contingent on the business granting the bank a security interest in either specified assets or all of the assets of the business, which is a blanket security interest. The security interest entitles the bank to take possession of the encumbered assets if the borrower defaults under the terms and conditions of the loan.

The Uniform Commercial Code, administered by the Secretary of State, governs secured transactions. The Code requires the parties to execute a financing statement, which expressly grants the lender a security interest in the collateral.

The lender must then file the security interest in the form of the financing statement with the Secretary of State. This filing constitutes public notice of the lender’s right to the collateral if the borrower defaults. Because of the operation of this filing-notice, the lender takes priority over other creditors who cannot prove a security interest in the collateral or who file financing statements after the lender.

Problems can come up when a borrower sells a financed asset and does not use the proceeds to settle the loan. The issue arises when the lender has a security interest in the proceeds. The Code resolves this issue in favor of lenders by stating that no reference to proceeds is required in the security agreement to give the lender such interest. Unless modified by agreement, the security agreement gives the secured party the right to the proceeds. A security agreement can provide that property acquired after the purchase with the proceeds of a sale is subject to the security interest.

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