Security Agreements Part 2: How to Protect Yourself

Sparks Law | October 15th, 2014

MG_4844Jumping right in, continuing from our last article:

What Constitutes Default?

As you might expect, this is another very important section in any security agreement. Put simply, it states what acts or omissions put the borrower “in default,” allowing the lender to go after the secured property with a lawsuit.

Obviously, some sort of late payment on the loan will constitute default, but it is important that both parties negotiate this section so that they’re comfortable with its terms. Not to harp on the LegalZoom / online documents too much, but I’ve seen companies download ones that would put the borrower in default immediately for any late payment, no matter how quickly the borrower remedies their mistake. If you’ll recall from last week’s article, defaulting on a loan allows the lender to take everything listed in the secured property section of the security agreement.

Given the severe consequences that are triggered by being in default, it’s important to negotiate deadlines and leniency on payments in this section. For example, if the loan is to be repaid on a monthly schedule, a leniency period of 2 weeks after the payment becomes due is common.

It’s also important to specify what does and doesn’t constitute default. Be as specific as possible here. Let’s say that your company took a $30,000 dollar loan in return for monthly payments and 5% of your profits for the first year. This all sounds well and good, but what exactly are your “profits?” Is it gross income, before overhead expenses or are “profits” calculated with certain overhead expenses—employee payroll, rent, utility bills—subtracted first? What if the definition of profits is sufficiently delineated, but your accountant makes a minor mistake in the calculation – does that trigger default for purposes of the security agreement?

These are all important questions and contingencies that both parties should be considering and accounting for in their security agreement.

 

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Filing a Record of the Security Agreement

Just like real estate deeds, security agreements should be recorded at state offices and made available to the public. Recording a security agreement—filing / registering it with the state—does a number of things for both parties involved. It becomes important if the secured property (which we discussed above) has multiple people creditors going after it.

Most states have a first to file system, where the creditor who records their security interest at the local state office first, will get to take the secured property first and up to the point that the loan is repaid. Only then can the other creditors take the remaining secured property. (For example, if you owe the creditor $4,000 but they get $5,000 for selling your car, they can only take the $4,000. The next creditor in line would get the remaining $1,000.)

Therefore, it is important for everyone entering into a security agreement to check with the local state agency to see if any of the secured property is already claimed in any way by another creditor (lender).

To stick with the watch example that we used last week, if my friend gave me his Rolex as collateral for letting him borrow my $5,000 car for a week, and he wrecks the car, I would have a claim for the Rolex watch. However, if the watch is already listed as collateral on another security agreement, and that agreement has been recorded (filed) at the local state office, my claim for the watch (as a creditor) would be secondary to the lender specified on the recorded document; I could only take the watch if the first lender’s loan was repaid first. Our system of recording security agreements is really a way to protect lenders. Because all recorded (filed) security agreements are public information, everyone has an opportunity to see what the borrower has previously promised as collateral.

Wrap

Security agreements are quite common for business owners, and can be used at all stages of their business’s life. It is very important that all parties, the business owners and the lenders themselves, understand the ins and outs of security agreements, and discuss the specifics with their attorneys before signing anything. Doing otherwise can indeed risk a great deal—all of your personal assets; everything you own! Get it right on the front-end so that you don’t have to lose your savings to court costs and contingencies down the road.

Jonathan Sparks is the principal attorney at Sparks Law. He helps small to medium sized companies with their legal issues, general counsel and registered agent services.

– Jonathan Sparks, Esq.

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