Alternatives for Securing Your Loans or Investments
We often advise clients who want to loan money or participate in an investment to “get adequate security” for their investment. The purpose of getting additional security for your loan is so that you have something else that you can go after if the loan goes south.
Ordinarily, if your loan is “unsecured,” it generally means that if the investment tanks, then your only remedy would be to sue the debtor and go through the potentially expensive process of litigation in hopes that you can get a judgment against the debtor, and perhaps most importantly, that the debtor will then have assets from which you can collect.
In our experience, if a debtor has defaulted on your investment, they are likely experiencing financial issues as a whole, and will unlikely have assets for you to recover from even if you prevail in your lawsuit. Moreover, a debtor having financial issues and/or without assets is a likely candidate for bankruptcy, and for those reasons, investors who are reduced to having to resort to the court system to remedy a failed investment are often just throwing good money after bad.
In general, real estate with sufficient equity to secure the investment is the best form of security for the primary reasons that real estate is immovable, and there is a well established public record for recording and determining rights and priorities to real estate.
However, if securing your investment with real estate is not an option, that does not mean your investment must be unsecured. In fact, virtually any type of property or asset can serve as collateral for an investment. Unlike real estate, the process and laws for securing your investment using “personal property” as collateral will depend on the type of property as well as the applicable state, local, and sometimes federal law that apply. Examples of personal property that can serve as collateral for your loan include the following:
- Interests in Inventory, Equipment, or Fixtures – If you are lending to a business and that business has assets, those assets could likely serve as security for your loan. In general, this would require an additional “security” agreement which specifically identifies the assets that are being offered as security for the loan, which then must be “perfected” usually by filing a UCC-1 Financing Statement with the Secretary of State for the state where the business is located. This procedure is most often used by banks and other financing companies for business loans that are not secured by real estate. The benefit is, like real estate, the office of the Secretary of State serves as a central resource where anyone can access to determine the existence of liens against the assets of a business and the priority of those liens.
- Interests in Stock or interests in LLCs – If the debtor owns interests in his/her own corporation or LLC, the interest in the corporation or LLC could serve as security for a loan. This is most often accomplished by a “pledge” agreement whereby the debtor offers his/her interests in the corporation or LLC as collateral for the loan. One drawback for stock or LLC interests is, unlike real estate or other asset classes, there is no central resource like a recorders’ office or secretary of state for determining if there are competing or priority claims against privately held interests in businesses. In addition, a pledge agreement doesn’t mean much if the entity itself has no assets and so adequate due diligence on the entity that is being pledged is essential.
- Interests in publicly traded securities and securities accounts – Interests in stocks or other securities held by a brokerage can also serve as collateral for a loan. Usually, this is achieved by having the parties to the loan enter into an agreement with a third party custodian that holds the account (sometimes called a securities intermediary) which provides that upon a default on the loan, the third party custodian will deliver the asset to the creditor without further consent by the debtor.
- Interests in Intellectual Property – Interests in Trademarks, Patents, Copyrights, and even Trade Secrets can serve a security for a loan, although the procedures for perfecting these interests in intellectual property will differ and it is often difficult to place a value on intellectual property for purposes of determining whether the value is adequate for the loan.
- Interests in Tangible Personal Property – Virtually any item of personal property of value (such as jewelry, equipment, vehicles, etc.) can serve as security for a loan. Usually this would entail delivering the property to a third party who holds the asset similar to an escrow or consignment subject to performance of the terms of the loan. For assets which ownership is evidenced by some certificate of title, there may be a department or organization which provides for registering your lien (e.g. the Department of Motor Vehicles).
Securing your loan or investment with personal property is just one part of the due diligence that you should be performing when considering any particular investment. As this article demonstrates, the documents and procedures necessary to document, establish and perfect these secured transactions may vary widely and so you want to make sure that you follow the correct legal procedures and that your security documents are properly drafted so ensure that your loan or investment is, indeed, secure.