Introduction
For many
small business owners, taking on debt in the form of a loan plays a big role in
getting the business started or keeping the business running.[1] In many of
these cases, the borrower, or debtor, is asked by the lender, or creditor, to
put up some sort of property, called collateral, to “secure” the loan.[2] This is
known as a “secured” transaction.
Although seemingly straightforward, entering into this type of
relationship gives the lender certain rights, the most prominent being the
right to repossess the collateral if the borrower defaults on the loan. Because
a “secured” creditor has such a right, it is important for a potential debtor
to understand how a secured transaction works and the consequences of defaulting on a secured
loan so they can take all factors into consideration when considering this type
of financing.
When a business owner is being asked to provide collateral for a loan, they are providing a “security interest” on their property. This security interest gives the lender a legal claim, or lien, against the property until the loan is paid off.[3]
Formalities for a
Security Interest
Under Michigan law, there are generally three requirements for the attachment of a security interest that are relevant for small business owners: (1) value must have been given by both sides, (2) the debtor must owns or have rights in the collateral, and (3) the debtor has “authenticated,” or signed,[4] a security agreement that provides a description of the collateral.[5] Although the timing of each requirement does not matter, each requirement must be met in order for the security interest to “attach” to the collateral and become enforceable against the debtor.[6] Each of the three requirements are discussed in further detail below.
Value
Most small
businesses are likely to look for simpler types of financing arrangements such
as term loans, lines of credit, and equipment or inventory financing. In the
vast majority of these situations, the debtor takes on some sort of obligation,
such as to pay the debt. In making such a promise, the debtor provides value.
Similarly, in most security agreements, the creditor has typically agreed to
lend money or has sold property to the debtor on credit, which is also
sufficient to meet the value requirement. Because of how these transactions
usually go, this first prong is usually met fairly easily.
Rights in the
Collateral
The second
requirement requires that the debtor have rights in whatever collateral is
being granted to secure the loan. In most scenarios, the debtor owns the
property, which is a legal right. As such, this prong is also likely to be
fulfilled. Generally, issues with regards to this requirement relates to the
time at which a security interest actually becomes enforceable against the
collateral. For example, when a debtor grants a security interest on a piece of
machinery that they plan on purchasing in the future, the security interest is
unenforceable until the instant that the debtor actually purchases and acquires
a right in the machine.
Authenticated Security
Agreement
The third
requirement states that a debtor must have “authenticated” a security
agreement.[7] Under state
law, “authentication” merely refers to a signed writing.[8]
Thus, as long as the debtor has agreed to the transaction in some sort of
signed agreement, this third prong is also met.
In the majority of cases, a secured transaction will be agreed to on a “security agreement.” Although each security agreement may be different, a typical security agreement provides for (1) the grant of a security interest, (2) a description of the collateral, and (3) the obligations that the collateral secures, such as a loan. In addition, many security agreements also include other provisions that the lender feels are important. These additional provisions may include, but are not limited to: (1) defining default under the contract, (2) specifying the creditor’s rights on default, and (3) impose other obligations on the debtor, such keeping the collateral housed in a certain location or requiring that the collateral be insured. As such, it is important to understand the exact obligations you are signing up for before you sign the security agreement.
What can a Secured
Creditor Do?
The largest
benefit that a security interest provides for a creditor is the ability to
bypass courts and sheriffs by exercising their right to “self-help
repossession.”[9] In doing
so, creditors may repossess the collateral themselves or outsource to
specialized repossession agencies. Depending on the provisions in the security
agreement, the debtor may even be required to surrender the collateral upon
default.
While
secured creditors are able to exercise self-help repossession rights, the law
limits what they can do. A secured creditor may only repossess collateral if it
does so without a “breach of the peace.”[10]
Unfortunately, there is significant dispute over what actions constitute a
breach of the peace. However, a few generalizations can be made. The mere
presence of a police officer during a repossession is insufficient to
constitute a breach of the peace and invalidate the repossession.[11] However,
if the police officer intervenes and provides active assistance to the
repossessor, the debtor may have a stronger case for breach of the peace.[12] In any
case, if the debtor feels as if they have been subject to behavior that rises
to this level, they should consult an attorney.
A potential debtor may question
why they would ever grant a security interest when secured creditors have such
powerful rights. In a nutshell, offering collateral for a loan may be a good
way to get a lower interest rate, due to the reduction in riskiness for the
lender or, in some circumstances, get access to any credit at all. However, a
potential debtor that is looking at an unsecured versus a secured loan must
consider whether the benefits of a secured loan are worth giving the lender
additional rights, namely the ability to dictate terms of default and repossess
the collateral upon default.
By Frank Huang
[1] New
NFIB Survey: Small Business Owners Concerned with High Interest Rates, NFIB (Dec. 27, 2023), https://www.nfib.com/content/press-release/economy/new-nfib-survey-small-business-owners-concerned-with-high-interest-rates/#:~:text=Financing%20Concerns%3A,from%20July%202023%20(58%25).
[2] See
Heywood Fleisig, Secured Transactions:
Power of Collateral, Fin. & Dev.,
Jun. 1996, at 45 (stating that about half of the credit offered in the US is
secured).
[3] 11 U.S.C. § 101(37) (defining a lien as a
“charge against or interest in property to secure payment of a debt or
performance of an obligation”).
[4] Mich. Comp. Law § 440.9102(1)(g)(i).
[5] Mich. Comp. Law § 440.9203(2); see also id. § 440.9203(c)(i), (ii) (describing alternatives to the third
prong).
[6] Id.
§ 440.9203(1), (2).
[7] Id.
§ 440.9203(2)(c)(i).
[8] Id. §
440.9102(1)(g)(i).
[9] Id.
§ 440.9609(1)(a). The statute also allows the secured creditor to render
the equipment unusable on the debtor’s premise, id. § 440.9609(1)(b).
[10] Id.
§ 440.9609(2).
[11] Hensley v. Gassman, 693 F.3d 681 (6th
Cir. 2012).
[12] See,
e.g., Cochran v. Gilliam, 656 F.3d 300 (6th Cir. 2011); Anderson
v. City of Oak Park, 2014 WL 4192754 (E.D. Mich. 2014)