A secured creditor is someone who holds a security interest in the property of a debtor. Becoming a secured party involves writing a specific type of contract called a security agreement and then filing a UCC-1 Financing Statement with your state's corporate authority, often the Secretary of State or the Bureau of Corporations. A security interest is the legal term used to describe your right to collateral property, or proceeds from the sale of that property, if the debt isn't repaid.
Write It and Sign It
A security agreement doesn't require any particular words or phrasing. However, there are a few prerequisites. The agreement must be authenticated by the debtor with a signature or its electronic equivalent, and the agreement must adequately describe the property the debtor offers as collateral.
For example, assume Sam loans a sum of money to Doug, but he doesn't trust that Doug will be able to pay him back. To secure Doug's obligation to repay Sam, Sam requires Doug to grant him a security interest in the brand new high definition TV Doug paid cash for a couple of weeks ago. Sam's security interest in the TV means that if Doug does not repay Sam, Sam can take Doug's TV or force a sale of Doug's TV and receive the money for it. This only works if Doug owns the TV outright, otherwise the financing company has the right to seize it for non-payment. In this case, the completed security agreement could simply describe the collateral as "Doug's brand new brand name high definition television located in his living room at his address."
Who Owes What to Whom?
Spell out the penalty for failing to pay, and outline a repayment schedule in the security agreement. While this is not strictly required by law, it's a smart step to take. It will clearly indicate both parties' obligations to one another, and protects the secured party if the debtor challenges the agreement in court. In the example with Doug and Sam, the agreement might read "Doug agrees to pay Sam $100 each month, payable on the 15th of each month, until the loan is repaid. If Doug fails to make a payment, Sam has the right to demand the entire amount due. If Doug cannot pay the entire amount due, Sam has the right to exercise his rights as a secured party under this agreement."
A Note About Mortgages
A mortgage is a type of security interest that is placed on real estate. We think of mortgages as coming from banks and financial institutions (and they do), but a private mortgage is actually one of the more common types of security interest created between an individual and someone who is not a traditional mortgage lender. Since the debtor is putting a big-ticket item – his home – on the line if things go wrong, it is especially important to document a loan and to document it well. If the borrower defaults on the loan payments, the remedy is foreclosure, which is a more complicated issue than regular repossession and often takes far more steps, including a lawsuit in some states.
Perfecting the Lien to Enforce Against Other Creditors
Financing statements are forms used to provide notice to other potential creditors that a security exists as collateral of a debtor, or in other words it's a warning that the property has already been used as collateral. The form is called a UCC-1 Financing Statement. It is available online or at your state's government agency, typically the Secretary of State, responsible for business registrations and UCC filings. With the loan example above, Sam would prepare a UCC-1 indicating he has a security agreement with Doug and that he has a security interest in Doug's high definition TV. Sam would complete the UCC-1 financing statement and file it with the appropriate state agency.
To give notice to all other potential creditors and protect your interest from anyone else making a claim on the collateral, you must file the financing statement. You must pay a filing fee, which varies by state. Our friend Sam is technically a secured creditor as soon as Doug signs the security agreement. However, filing a financing statement puts all other creditors on notice that Sam has a security interest in Doug's TV. Therefore, if Doug goes bankrupt and can't pay his debts, Sam will have first dibs on the TV before other creditors. This is called perfection of the security interest, and without perfection, your lien is no good as to a creditor who comes later and liens the same property because he didn't know about your agreement.