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September 27, 2010 • Issue 10:09:02

Four things to know about security interests

By Sarah Weston
Jaffe, Raitt, Heuer & Weiss PC

You've seen the language in merchant agreements, but do you know what taking a security interest in collateral really means? What are security interests, how do they protect you and how do you recoup on the underlying collateral?

This article will provide answers to your questions and tips on how to effectively use security interests.

1. What is a security interest anyway?

Generally, a security interest is a lien created by an agreement between a debtor and a creditor. Usually a security interest is created to ensure a debtor actually repays a debt or fulfills some other obligation.

In the electronic payments world, you might be familiar with taking a security interest in POS terminals, inventory or funds in a merchant's settlement account. But how does taking a security interest in this collateral actually help you? The answer depends on several variables.

2. How can security interests protect you?

If the debtor (in this case, a merchant) defaults under the terms of its agreement and can't pay the amounts it owes, a secured creditor (the party holding the security interest) has a better chance of being reimbursed for its losses by selling the collateral and paying itself back. Even better, obtaining a security interest is relatively cheap.

But, of course, there has to be a catch. While obtaining a security interest may be inexpensive, you must take several precise steps to make sure a security interest is effective against third parties.

For example, if a merchant gives you a security interest in collateral, you are immediately a secured creditor as between you and the merchant. Between you and third parties, however, additional steps must be taken.

This concept is called "perfection" and your security interests must be "perfected" for you to secure your place in line before third parties that obtain later liens on the property.

3. How can you perfect a security interest?

How to perfect a security interest depends on the type of property you are trying to take a security interest in. For example, security interests in tangible personal property (such as POS terminals) may be perfected by the debtor authenticating (signing) a security agreement (such as one contained in a typical merchant agreement) that describes the collateral and then filing a financing statement in the merchant's location.

The cost of filing a financing statement is nominal; however, a handful of states collect taxes upon the filing of financing statements based on the amount of the debt being secured.

Business entities are located in the state where the merchant is organized, which may or may not be where the merchant has an office or where the collateral is located. So make sure you know the merchant's state of organization if the merchant has several locations.

Security interests in promissory notes may be perfected by taking physical possession of the note.

If the security interest covers funds in a deposit account (for example, a merchant's settlement account that is held at the merchant's bank), the secured party must perfect its security interest by taking "control" of such an account.

In other words, to perfect a security interest in funds held in a merchant's settlement account, you must also enter into an "Account Control Agreement" with the merchant's financial institution, pursuant to the terms of a security agreement with the merchant.

This agreement provides that the merchant's bank must comply with your instructions regarding disposition of the funds in the account without requiring any further consent from the merchant.

4. You have a perfected security interest - now what?

So you have a properly perfected security interest in the merchant's collateral and the merchant is in default. What do you do? The first thing to do is check the language in the applicable agreement under which the merchant has defaulted and make sure you comply with its terms.

It should have language that states your rights and obligations, as well as the merchant's rights and obligations, upon default.

You could be required to give the merchant notice of default in a specific manner, to a specific address, or be required to give the merchant a period to cure the default without penalty.

Next, have your attorney perform a lien search to find out if other creditors have liens on the collateral. This information will help you determine what actions to take next. This search is quick and usually inexpensive. If you perfect your security interests before other creditors, all other creditors of the merchant must get in line behind you and wait until you are reimbursed before they get their crack at the merchant's collateral.

Watch out for an especially sneaky type of security interest called a Purchase Money Security Interest (PMSI). A PMSI is a lien taken by a secured party at the moment the debtor purchases goods.

In some cases, even if you were the first secured party to perfect your security interest in the merchant's collateral, a secured party holding a PMSI lien might end up as the first paid.

For example, if another secured party files and perfects a PMSI after you (even if that secured party knows about your first-in-line security interest) the PMSI secured party - after following proper notice - is able to take cuts ahead of you because of the type of security interest taken.

If you are the secured party with first priority over other secured parties, you should be in a position to foreclose on the collateral and sell it, then apply the proceeds of that sale to repay yourself for the amounts you are owed.

If the collateral you are looking to sell is tangible property, such as terminals, your security agreement should include a right to make a claim against the merchant and demand to take immediate possession of the collateral upon the merchant's default.

This process can be arduous if the merchant has many locations but relatively simple if the merchant has few locations and is willing to cooperate. Your attorney can assist you with the foreclosure and sale of the property.

If you have a lien on funds in a settlement account that is perfected by an Account Control Agreement, you will need to provide instructions to the applicable financial institution with regard to the funds in the account, up to the amount of the debt owed to you.

Consult your attorney if you are concerned

If you have concerns about supplying services or goods to a merchant who is financially unstable or a startup without a strong financial history, there are ways to minimize your risk. Talk to your attorney about taking a security interest in their terminals, inventory or funds in their settlement account and make sure you are perfected.

That way, if things do go sour down the road, you won't be the party left holding the bag. end of article

The recommendations herein are general suggestions; they are not a substitute for legal advice. For specific information, consult experienced legal counsel. Sarah Weston is an attorney at Jaffe, Raitt, Heuer & Weiss PC and advises businesses on contract and regulatory issues in the merchant acquiring, stored value, automated clearing house and payment systems industries. You can reach her at 248-351-3000 or at sweston@jaffelaw.com.

The Green Sheet Inc. is now a proud affiliate of Bankcard Life, a premier community that provides industry-leading training and resources for payment professionals. Click here for more information.

Notice to readers: These are archived articles. Contact names or information may be out of date. We regret any inconvenience.

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