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Collateral Valuation: Credit Risk: Security Interest – creation and perfection

Earlier we discussed collateral, collateral law and collateral valuation approaches. However for collateral to be effective the lender must have a security interest in it. This post discusses how security interest in collateral is created and perfected.

A security interest grants the lender the right to sell some property of the borrower in order to use the sales proceeds to settle the borrower’s outstanding debt. It ensures that the lender has the right over other creditors and in certain cases also against bankruptcy of the borrower to that particular property. However in order to be able to enforce a security interest against other creditors and in the event of the borrower’s bankruptcy the security interest would first need to be created and then perfected.

i. Creation of security interest

In order to create a security interest that is enforceable against the borrower the following requirements must be met:

  • The debtor must have rights in the collateral
  • The security agreement must be authenticated (e.g. signature) by the borrower
  • In the security agreement the lender must give value according to the amount that would cover, in full or part, the existing or future debt outstanding
  • The security agreement must describe the debt and the collateral used to secure it
  • It may contain other terms such as an inter-creditor agreement or a pari-passu charge

Creation alone cannot protect a lenders right or prior claim to the collateral against other creditors and secured parties who may also have an interest in the collateral. That is where perfection comes in.

ii. Perfection of Security Interest

The process of notifying everyone concerned of the lender’s creation of the security interest in a particular collateral asset and ensuring that his rights to prior claim are fully enforceable is known as having perfected the security interest.

There are four methods of perfecting security interest. These are:

  • filing financing statements containing the required information in the appropriate location
  • taking possession of the collateral (e.g. any tangible asset except those covered by certificates of title)
  • taking control of the collateral
  • other methods such as filing of certificates of title, public notice, etc.

In this post we have reviewed the methods of creating and perfecting security interest in collateral. We will look at the various aspects of collateral management next.