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When borrowing money from a lender, many businesses encounter a document known as a security agreement. Security agreements are contracts that assign to the lender a security interest in certain assets or property offered as collateral on the loan. Lenders use security agreements to mitigate the risk of default; the security interest allows the lender to seize and liquidate any stated collateral if the borrower defaults on the loan.
A security agreement will typically contain several different sections. While the details will vary depending on the parties and the circumstances, some basic aspects of the arrangement will always be addressed. The first section encountered is typically the recitals. Recitals describe the transaction broadly, naming the parties, their legal status, and their intent in executing the security agreement. In this section the person receiving a security interest will give something of value, the debtor will transfer an interest in the collateral to the secured party (the party receiving the security interest), and the debtor will describe the collateral and authenticate the agreement.
The next section encountered is usually the definitions section. Since security agreements are typically just one in a series of loan documents packaged together on a loan, they may borrow definitions from the master agreement or other documents. However, this is not always the case so it is important to assume there may be differences and review the definitions. In this section the parties also choose which state’s Commercial Code will apply (if there is a multi-state context), which can impact the meaning and enforceability of the agreement. Generally, everything in this section is negotiable, so it is in each party’s interest to bargain heavily to reach satisfactory terms.
An important next section is the representations, warranties, and covenants about the debtor. This section will confirm information that the secured party will need to perfect its security interest by filing a financing statement. For the party making the loan and taking the security interest (the secured party), perfection is the last formal step needed to consummate and validate the security interest. The representations, warranties, and covenants are designed to facilitate the perfection process. In this section the secured party will often seek to compel the debtor to provide notice of any change of legal name, place of business, type of entity change (e.g. LLC converting to a corporation) or jurisdiction changes.
Next come the representations and warranties regarding the collateral. Here, the debtor pledges that it has sufficient rights in the collateral to give the secured party a valid security interest. This section will address what, if any, type of encumbrances on the collateral are permitted. The secured party might request a promise that the debtor has complied with all applicable laws including labor and environmental laws. On the debtor’s side, the goal is to limit the scope and reach of representations and warranties, in order to minimize its exposure profile.
Another important section that will come near the end of the agreement is the remedies section. This section will provide the secured party with three options after default. The secured party will be allowed to sell the collateral, negotiate a full or partial foreclosure with the debtor, or collect from third parties to satisfy the debt. This section is often not negotiated much since the remedies section is the primary place for the parties to set forth remediation rights.
The agreement will also contain notice provisions and provisions setting forth conditions that must be fulfilled prior to and after closing. Special attention must be paid to the details because failure to adhere to agreed conditions could result in forfeiture or other loss to the business.