collateral assignment of security interest

§ 9-203. ATTACHMENT AND ENFORCEABILITY OF SECURITY INTEREST; PROCEEDS; SUPPORTING OBLIGATIONS; FORMAL REQUISITES.

(a) [Attachment.]

A security interest attaches to collateral when it becomes enforceable against the debtor with respect to the collateral, unless an agreement expressly postpones the time of attachment.

(b) [Enforceability.]

Except as otherwise provided in subsections (c) through (i), a security interest is enforceable against the debtor and third parties with respect to the collateral only if :

(1) value has been given;

(2) the debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party ; and

(3) one of the following conditions is met:

(A) the debtor has authenticated a security agreement that provides a description of the collateral and, if the security interest covers timber to be cut, a description of the land concerned;

(B) the collateral is not a certificated security and is in the possession of the secured party under Section 9-313 pursuant to the debtor 's security agreement;

(C) the collateral is a certificated security in registered form and the security certificate has been delivered to the secured party under Section 8-301 pursuant to the debtor 's security agreement; or

(D) the collateral is deposit accounts , electronic chattel paper , investment property , or letter-of-credit rights , and the secured party has control under Section 9-104 , 9-105 , 9-106 , or 9-107 pursuant to the debtor 's security agreement.

(c) [Other UCC provisions.]

Subsection (b) is subject to Section 4-210 on the security interest of a collecting bank , Section 5-118 on the security interest of a letter-of-credit issuer or nominated person, Section 9-110 on a security interest arising under Article 2 or 2A, and Section 9-206 on security interests in investment property .

(d) [When person becomes bound by another person's security agreement.]

A person becomes bound as debtor by a security agreement entered into by another person if, by operation of law other than this article or by contract:

(1) the security agreement becomes effective to create a security interest in the person's property; or

(2) the person becomes generally obligated for the obligations of the other person, including the obligation secured under the security agreement, and acquires or succeeds to all or substantially all of the assets of the other person.

(e) [Effect of new debtor becoming bound.]

If a new debtor becomes bound as debtor by a security agreement entered into by another person:

(1) the agreement satisfies subsection (b)(3) with respect to existing or after-acquired property of the new debtor to the extent the property is described in the agreement; and

(2) another agreement is not necessary to make a security interest in the property enforceable.

(f) [Proceeds and supporting obligations.]

The attachment of a security interest in collateral gives the secured party the rights to proceeds provided by Section 9-315 and is also attachment of a security interest in a supporting obligation for the collateral.

(g) [Lien securing right to payment.]

The attachment of a security interest in a right to payment or performance secured by a security interest or other lien on personal or real property is also attachment of a security interest in the security interest, mortgage , or other lien.

(h) [Security entitlement carried in securities account.]

The attachment of a security interest in a securities account is also attachment of a security interest in the security entitlements carried in the securities account.

(i) [Commodity contracts carried in commodity account.]

The attachment of a security interest in a commodity account is also attachment of a security interest in the commodity contracts carried in the commodity account.

Collateral Assignment

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A collateral assignment involves granting a security interest in the asset or property to a lender. It is a lawful arrangement where the borrower promises an asset or property to the lender to guarantee the debt repayment or meet a financial obligation. Moreover, in a collateral assignment, the borrower maintains asset ownership, the lender holds the security interest, and the lender has the right to seize and sell the asset in event of default. This blog post will discuss a collateral assignment, its purpose, essential considerations, and more.

Key Purposes of a Collateral Assignment

Collateral assignment concerns allocating a property's ownership privileges, or a specific interest, to a lender as loan collateral. The lender retains a security interest in the asset until the borrower entirely settles the loan. If the borrower defaults on loan settlement, the lender can seize and market the collateral to recover the unpaid debt. Below are the key purposes of a collateral assignment.

• Enhanced Lender Protection: The primary purpose of the collateral assignment is to provide lenders with an added layer of security and assurance. Also, by maintaining a claim on the borrower's properties, lenders lower their risk and improve the probability of loan settlement. In case of default, the lender can sell the collateral to recover the unpaid balance. This security authorizes lenders to offer loans with lower interest rates, as the threat associated with the loan is reduced.
• Favorable Loan Terms: Collateral assignment allows borrowers to access financing on more favorable terms than unsecured loans . However, the terms of the loan will vary depending on the borrower’s creditworthiness and the value of the collateral. Generally, lenders are more willing to extend larger loan amounts and lower interest rates when they have collateral to fall back on. The presence of collateral reassures lenders that they have a viable means of recouping their investment, even in case of default. This increased confidence often leads to more competitive loan offers for borrowers.
• Unlocking Asset Value: Collateral assignment enables borrowers to leverage the value of their assets, even if those assets are not readily convertible into cash. For instance, a business owner with valuable machinery can assign it as collateral to secure a business loan. This arrangement allows the borrower to continue utilizing the asset for operational purposes while accessing the necessary funds for expansion or working capital. Collateral assignment, thus, enables the efficient allocation of resources. However, the collateral will still be considered in determining the loan amount and terms.
• Access to Higher Loan Amounts: When borrowers promise collateral against a loan, lenders can present greater loan amounts than for other unsecured loans. The worth of the collateral serves as a reassurance to lenders that they can recover their investment even if the borrower fails to settle the loan. Therefore, borrowers can obtain higher loans to finance important endeavors such as purchasing property, starting a business, or funding major projects.
• Diversification of Collateral: Collateral assignment offers flexibility for borrowers by allowing them to diversify their collateral base. While real estate is commonly used as collateral, borrowers can utilize other valuable assets such as investment portfolios, life insurance policies, or valuable personal belongings. This diversification allows borrowers to access financing without limiting themselves to a single asset, thereby preserving their financial flexibility.

Steps to Execute a Collateral Assignment

A collateral assignment is a financial procedure that involves utilizing an asset as security for a loan or other responsibilities. Below are the essential steps involved in the collateral assignment process.

• Assess the Need for Collateral Assignment. The initial step in collateral assignment is determining whether collateral is necessary. Lenders or creditors may require collateral to mitigate the risk of default or ensure repayment. Evaluating the value and marketability of the proposed collateral is crucial to ascertain if it meets the lender's requirements.
• Select Appropriate Collateral. The next step involves choosing a suitable asset for collateral assignment. Common classifications of collateral comprise stocks, real estate, bonds, cash deposits, and other valuable assets. The collateral's value should be sufficient to cover the loan amount or the obligation being secured.
• Understand Lawful and Regulatory Requirements. Before proceeding with collateral assignment, it is essential to comprehend the lawful and regulatory provisions specific to the jurisdiction where the transaction happens. Collateral assignment laws can vary, so seeking advice from legal professionals experienced in this area is advisable to ensure compliance.
• Negotiate Provisions. Once the collateral is recognized, the collateral assignment provisions must be negotiated among the concerned parties. It includes specifying the loan amount, interest rates, repayment terms, and any further duties or limitations associated with the collateral assignment.
• Prepare the Collateral Assignment Agreement. The collateral assignment agreement is a lawful document that typically includes details about the collateral, the loan or obligation being secured, and the rights and responsibilities of both parties. It is highly advised to engage the services of a legal specialist to prepare or review the contract.
• Enforce the Collateral Assignment Agreement. After completing the collateral assignment agreement, it must be executed by all involved parties. This step ensures that all necessary signatures are obtained and copies of the agreement are distributed to each individual for record-keeping objectives.
• Notify Relevant Parties. To ensure proper recognition and recording of the collateral assignment, it is important to notify all relevant parties. It may involve informing the lender or creditor, the custodian or holder of the collateral, and any other pertinent stakeholders. Sufficient documentation and communication will help prevent potential disputes or misunderstandings.
• Record the Collateral Assignment. Depending on the nature of the collateral, it may be necessary to record the collateral assignment with the appropriate government authority or registry. This step provides public notice of the assignment and establishes priority rights in case of multiple claims on the same collateral. Seeking guidance from legal professionals or relevant authorities can determine if recording the collateral assignment is required.
• Monitor and Maintain the Collateral. Throughout the collateral assignment term, it is crucial to monitor and maintain the value and condition of the collateral. This includes ensuring insurance coverage, property maintenance, and compliance with any ongoing obligations associated with the collateral. Regular communication between all parties involved is essential to address concerns or issues promptly.
• Terminate the Collateral Assignment. Once the loan or obligation secured by the collateral is fully satisfied, the collateral assignment can be terminated. This involves releasing the collateral from the assignment, updating relevant records, and notifying all parties involved. It is important to follow proper procedures to ensure the appropriate handling of the legal and financial aspects of the termination.

Benjamin W.

Key Terms for Collateral Assignments

• Security Interest: It is the legal right granted to a lender over the assigned collateral to protect their interests in case of borrower default.
• Collateral Valuation: The process of determining the worth or market value of the assigned collateral to assess its adequacy in securing the loan.
• Release of Collateral: The action taken by a lender to relinquish its claim over the assigned collateral after the borrower has fulfilled the loan obligations.
• Subordination Agreement : A legal document that establishes the priority of multiple creditors' claims over the same collateral, typically in the case of refinancing or additional loans.
• Lien : A legal claim or encumbrance on a property or asset, typically created through a collateral assignment, that allows a lender to seize and sell the collateral to recover the loan amount.

Final Thoughts on Collateral Assignments

A collateral assignment is a valuable instrument for borrowers and lenders in securing loans or obligations. It offers borrowers access to profitable terms and more extensive loan amounts while reducing the risk for lenders. Nevertheless, it is essential for borrowers to thoughtfully assess the terms and threats associated with collateral assignment before proceeding. Seeking professional guidance and understanding the contract can help ensure a successful and beneficial financial arrangement for all parties involved.

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I provide comprehensive legal and business consulting services to entrepreneurs, startups and small businesses. My practice focuses on start-up foundations, business growth through contractual relationships and ventures, and business purchase and sales. Attorney with a demonstrated history of working in the corporate law industry and commercial litigation. Member of the Bar for the State of New York and United States Federal Courts for the Southern and Eastern Districts of New York, Southern and eastern District Bankruptcy Courts and the Second Circuit Court of Appeals. Skilled in business law, federal court commercial litigation, corporate governance and debt restructuring.

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As most people (at least in the banking world) know, a security interest is the granting of an interest in property to secure obligations, usually loan debt.  If the borrower defaults under its obligations, the bank can foreclose and take the collateral.

In general, there are two main issues in ensuring that a lender has an enforceable security interest.  The first concern is whether the bank has a property interest in the collateral and right to take the collateral/foreclose in the event of a default.  The second concern deals with the bank’s rights with respect to third parties— i.e. if more than one party has a security interest or other right to the collateral, who gets it?  Properly perfecting a security interest ensures that the lender has rights to the collateral vis-à-vis other creditors and third party purchasers according to a standard set of priority rules (which are beyond the scope of this post).  In addition, if a security interest is not properly perfected, it is subject to avoidance in a bankruptcy proceeding and the loan would become unsecured.

If a security interest is not properly perfected, it is subject to avoidance in a bankruptcy proceeding and the loan would become unsecured.

The general idea with perfection is that the lender must either have actual possession of, or control over, the collateral to put the “world on notice” that the lender has a security interest in collateral (such as by filing a UCC-1 Financing Statement with the Secretary of State).

A security interest in most types of collateral (e.g., furniture, accounts receivable, non-fixture equipment, etc.) can be perfected by filing a UCC-1 Financing Statement with the Secretary of State of the state in which the borrower is formed/incorporated (or principal residence if the borrower is an individual).  A Financing Statement filed with the Secretary of State must be renewed every five years by the filing of a UCC-3 Continuation Statement within the six month period before the expiration of that five-year period.

But, not all security interests can/should be perfected by filing a UCC-1 with the Secretary of State alone.  Below is a sampling of the perfection rules for some common and some less common types of collateral.  That being said, in most situations, you generally want to take a belt and suspenders approach — perfect by the proper method for the particular type of collateral, but also file a UCC-1 Financing Statement with the appropriate Secretary of State.

Real Estate Mortgages:

Although not strictly a “security interest” governed by the Uniform Commercial Code, a real estate mortgage often is a component of a secured loan transaction, thus it is worth mentioning in this post…  In order to perfect security in real estate, the original mortgage, duly executed, witnessed and acknowledged (i.e., notarized) must be recorded in the land records of the jurisdiction in which the real estate is located.  For example, in Connecticut, this is done by recording the mortgage with the town clerk; in New York, mortgages are recorded with the county clerk; in Massachusetts, mortgages are recorded with the registry of deeds (or registry district of the land court) for the county (or portion of the county) in which the land is located. 

Security interests in fixtures (generally, furniture or equipment that has been affixed to the building or the land) can be perfected in a few ways:

If the security interest in fixtures is taken in connection with a mortgage of the real estate to which the fixtures are attached, the mortgage generally will include language required to perfect the security interest in fixtures. If this is the case, recording the mortgage as described above also perfects the security interest in fixtures.

If there is no mortgage involved, you can record a UCC-1 Financing Statement in the land records of the jurisdiction where the real estate is located. (As with Secretary of State Filings, this must be renewed every five years).

A security interest in fixtures may also be perfected by filing a UCC-1 Financing Statement with the Secretary of State as with other general types of collateral discussed above. However, perfection of a security interest in fixtures by filing with the Secretary of State will be junior in priority to security interests perfected by filing in the land records. (Again, perfection by this method this must be renewed every five years).

In general, best practice is perfect a security interest in fixtures both with a filing in the land records (item 1 or 2 above) and by filing with the Secretary of State (item 3 above).

Motor Vehicles:

Perfection of security interests in motor vehicles is accomplished by having the interest noted on the certificate of title for the vehicle.  In Connecticut, for example, this requires filing an Application for Certificate of Title with the DMV.  Note that in Connecticut, if the filing with the DMV occurs within twenty days after the security interest/lien is created, the perfection usually will relate back to the date the security interest was first created.

Boats/Ships/Vessels:

For small vessels, (generally less than 26 feet), a security interest is perfected by filing with the DMV, as with motor vehicles.

For ships, a “preferred ship mortgage” is filed with the Coast Guard National Vessel Documentation Center in West Virginia.

Security interests in aircrafts are perfected by filing an original, signed security agreement with the FAA Registry in Oklahoma City.  The security interest may also be registered with the International Registry in Dublin to be perfected under international law.

Patents and Trademarks:

Security interests in patents or trademarks should be perfected by filing the security agreement with the US Patent and Trademark Office and by filing a UCC-1 with the appropriate Secretary of State (and UCC-3 Continuation Statements as appropriate).  Note that a utility patent generally only lasts for twenty years, and once the patent expires, so does the security interest.  Trademarks can last indefinitely, provided the borrower continues to comply with relevant procedural requirements and does not abandon the use of the mark.

A caveat with patents: Parties have three months to file a notice of transfer with the US Patent and Trademark Office, which would have priority over subsequent transfers or security interests (even if the subsequent transfer is filed before the earlier transfer).  So it is important to do your due diligence and have other evidence or assurance that the borrower had not previously assigned the patent (or wait three months after filing to advance funds in reliance on the security interest).

A security interest in copyrights should be perfected by the filing of an Intellectual Property Security Agreement with the US Copyright Office and by filing a UCC-1 with the appropriate Secretary of State (and UCC-3 Continuation Statements as appropriate).  Note that a filing with the US Copyright Office cannot perfect a security interest in unregistered copyrights, so it is advisable to require your borrower to register all of its copyrights.  As with patents, copyrights only last for a limited period of time, but because that time period is significantly longer than the twenty-year patents, you generally will not need to worry about it in a loan context.  (Generally 70 years after author’s death; or 95 years after publication or 120 years after creation of works made for hire).

Deposit Accounts:

The only way to perfect an interest in a deposit account (i.e., a bank account) is through “control” (though a UCC-1 is often also filed with the Secretary of State).  Control may be obtained in one of three ways (four if New York law applies):

The lender obtains control if it is the bank in which the deposit account is maintained;

A lender may obtain control by entering into a deposit account control agreement executed by the lender, the borrower and the bank at which the account is maintained; or

The lender may obtain control if the lender (instead of the borrower) is the bank’s customer for the deposit account.

In New York, a lender can also obtain control if the name on the deposit account is the lender’s name or the name of the account indicates that the lender has a security interest in the account.

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Protecting your security interest in an llc membership interest: methods and considerations for perfecting.

By: Rochelle Hauser | September 18, 2018 Owning a Business

You have made the decision to provide financing, whether as a business owner or otherwise. Perhaps you are loaning money to a borrower, or selling a company you own and financing the purchase. You will likely require some type of collateral to secure repayment of the loan.

If your collateral includes a limited liability company (“LLC”) membership interest, there are important steps you need to follow to be sure you are protected in the transaction.

First, you need to review the organizational documents to determine whether the security interest in the membership interest is permitted. If not permitted, you need to obtain consent from the company and other members. Next, you will want to have a security agreement (often called a pledge agreement) granting you a security interest in the membership interest, signed by the borrower.

However, that’s only part of the process. You also need to “perfect” your security interest in the membership interest. Perfecting a security interest protects your rights in the collateral and determines your priority in relation to other creditors .

Perfection methods vary depending on the jurisdiction and the type of collateral. To determine the appropriate method to perfect your security interest in a membership interest, you must review the company’s organizational documents, as well as the Uniform Commercial Code (“UCC”) in the appropriate jurisdiction.

Methods for perfecting

General intangible : Most commonly, a membership interest in an LLC is considered a general intangible . To perfect a security interest in a general intangible, you must file a UCC-1 financing statement with the Secretary of State’s office in the state in which the individual resides, or in which the entity was formed, depending on whether the borrower is an individual or an entity.

Once you file the financing statement, your security interest is considered perfected. Generally, the timing of filing, among other factors, determines the order of priority among multiple secured parties, with the first to file having priority.

A financing statement lapses five years from the date of filing. If the loan will be longer than five years, you must file a UCC-3 continuation statement prior to the lapse date to maintain perfection. The continuation statement can be filed up to six months before the lapse date.

Security : An LLC, however, can elect to have its membership interests classified as securities under Article 8 of the UCC. Generally, the organizational documents must expressly state that the membership interests are to be treated as securities. Additionally, if the membership interests are certificated, they are also considered securities. As the secured party, you must review the organizational documents to determine whether the “opt in” language is included or the membership interests are certificated, to properly perfect your security interest.

If the membership interests are securities, then you perfect by taking possession or control of the securities – or both. If the membership interests are certificated, then you perfect by taking possession of the certificates and by taking control by having the security interest noted in the company’s records. If the membership interests are not certificated, then you perfect by taking control by entering into an agreement with the company that specifies the company will take instructions from you, the secured party, as well as having the security interest noted in the company’s records. In each case, the borrower will also give you an assignment of the membership interest so that you can transfer title if there is a default on the loan.

Note: You can also perfect by filing a UCC-1 financing statement. However, possession or control take priority over a UCC-1 filing, so they are better forms of protection.

Considerations after perfecting

After you have perfected your security interest, a company can amend its organizational documents to either opt in or opt out of Article 8, or to certificate or uncertificate its membership interests. If that occurs, the method of perfection could change, and your priority could be jeopardized.

As the secured party, you can protect your security interest as follows:

• Obtain a written commitment from the company that it will not alter the current status, whether it is opted in to or opted out of Article 8, until you are paid back your loan.
• Obtain a written commitment from the company that it will not change the membership interests from certificated to uncertificated, or vice versa, until you are paid back your loan.
• If the company has opted in to Article 8, request that the company provide certificates for its membership interests and then take possession of the certificates.
• Depending on the situation, you also may choose to file a financing statement, take possession of any certificates, and get the appropriate agreements and actions from the company.

Because of the complexity and varying factors involved in obtaining and perfecting a security interest, lenders should consider consulting with an attorney who can assist them with reviewing the organizational documents and properly obtaining and perfecting their security interest.

At Henson Efron, our attorneys have extensive experience assisting secured parties in protecting their collateral. If you’d like to learn more about how our experience and knowledge can help protect your business, please contact Henson Efron .

The purpose of this article is merely to provide general information and should not be construed as legal advice.

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What is a collateral assignment?

Rather than obtain funding of leases at lease origination , lessors often assign the lease payments and the leased assets to finance the leases after lease inception .  By back-leveraging , a lease funder makes a nonrecourse loan to the lease originator after inception of the lease that is secured by the collateral assignment of the leased asset to the funder and the lease payments as the means to service the debt .  As a collateral assignment, the lessor incurs a direct obligation to the lease funder for the loan while remaining the owner of the leased asset.  Since a collateral assignment usually requires lessee consent, lessors obtain the right to back- leverage leases at lease origination.

Back-Leveraging = Collateral Assignment after Lease Inception

Although the lessor retains ownership of the leased asset, a collaterally- assigned lease must be managed with the consent and approval of the assignees .  Moreover, a collateral assignment generally allows funders to share in and exercise rights of the lessor under the lease in their own name, which makes it necessary for the lessor to negotiate shared rights with the funders.  Shared rights , which are the rights of the lessor – as assignor – and the assignee that each exercises in its own name, typically include the right to receive notices and other documents from the lessee, to inspect the property interest , to enforce lessee compliance with certain covenants , to call upon the lessee for the payment of indemnities, and to seek recovery under the lessee’s liability insurance coverage.  Once the funding is repaid in full, the funder relinquishes the collateral assignment and the lessor again has full control over the asset.

In addition to shared rights and the terms of lessee consent, lease assignment provisions normally stipulate the level of assistance a lessee is to provide to a lessor, such as indemnification and insurance.  Moreover, the lease agreement will typically also contain a provision expressly providing to lessees the right to quiet enjoyment , which is the right of tenants and landlords to the continued undisturbed use and enjoyment of real property to be honored by the assignee should the real estate be collaterally-assigned.

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Taking a Security Interest in Insurance

How many of your business and corporate customers carry business interruption insurance? For those that do, what steps, if any, have you taken when extending credit to obtain a security interest in the borrower’s business interruption insurance policy or its property insurance?

A recent bankruptcy case, In re Montreal Main & Atlantic Railway Ltd., Debtor 1 underscores the importance of understanding the requirements of obtaining a security interest in an insurance policy. The Debtor had a $7.5 million business interruption policy. It sought a payment under the policy occasioned by a covered disaster. After reaching an accord with the trustee in bankruptcy, the insurance carrier agreed that 35% of the settlement amount would be paid to the Debtor with the remaining 65% going to the Debtor’s subsidiary.

Wheeling & Lake Erie Railway Company (“Wheeling”) had extended credit to the Debtor and had perfected a security interest in certain property of the Debtor. Wheeling claimed that under Maine law the policy proceeds came within the definition of an “account.”

After addressing Wheeling’s arguments and noting that there was no specific assignment of the insurance policy or its proceeds, the court held against Wheeling, stating that the assignment of an insurance policy and its proceeds is outside the provisions of Article 9 of the Uniform Commercial Code (“UCC”).

Section 4-9-109(d)(8) of the Colorado UCC provides that Article 9 does not apply to “a transfer of an interest in or an assignment of a claim under a policy of insurance other than an assignment by or to a health-care provider of a health-care insurance receivable and any subsequent assignment of the right to payment, but Sections 4-9-315 and 4-9-322 apply with respect to the proceeds and priorities in proceeds.” (Emphasis supplied.)

This case underscores the importance of understanding that generally one cannot perfect a security interest in an insurance policy or its proceeds by complying with the requirements of Article 9 of the UCC. When an insurance policy is part of your loan collateral, separate steps must be taken to perfect a security interest in the insurance policy. This may require a careful review of the policy’s terms and conditions.

1 59 Bankr. Ct. Dec. 101, 63 UCC Rep. Serv. 2nd 461.

Sherman & Howard L.L.C. has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation and does not create an attorney-client relationship between any reader and the Firm.

©2015 Sherman & Howard L.L.C.                                                                                     November 6, 2015

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LLC Membership Interests as Collateral

It is not uncommon for lenders to take a security interest in a business owner’s ownership interest in the corporation, LLC, limited partnership or other entity as collateral for a loan to the business. For the most part, the transactions are documented through a standard pledge or assignment (the “assignment agreement”) of the stock or other evidence of ownership. While such an approach may be acceptable when the interests of a corporation are pledged, when the collateral is an interest in an LLC, savvy lenders will make sure that they use an enhanced form of assignment agreement and perhaps obtain the consents (and necessary waivers) from the other LLC members.

An enhanced form of assignment agreement is called for because an LLC has one distinct advantage over other entity forms. Under Maryland law, a judgment against an LLC member can only be enforced by imposing a charging order against the member’s interest. This is a court order requiring the LLC to pay the creditor the debtor member’s share of LLC distributions. In this respect, a charging order is akin to a wage garnishment, except it is against the member’s distributions rather than against wages.  The lender who simply obtains an assignment of a membership interest in an LLC gets no right to attach the member’s LLC interest or be admitted as a voting member . The lender cannot, therefore, participate in company management, force a sale of company assets or distribution of profits, or inspect company books.

In contrast, shares of a corporation’s stock are freely transferable absent contrary provisions in a shareholder agreement. Consequently, a lender with a security interest can typically exercise all of the associated rights of a stockholder. Upon obtaining the shares, the lender acquires the right to inspect corporate books and records and to vote on the election and removal of directors. If the shares represent a controlling interest, the lender could actually replace all the directors and officers and take over control of the corporation. Depending on the circumstances, the lender may also have the right to seek involuntary dissolution or place the corporation in receivership.

To optimize the collateral value of an LLC membership interest, lenders will want to be sure that they, as assignees, can be admitted, automatically, as full voting members of the company once they obtain ownership of the membership interest (a complex process in and of itself). Lenders will also want to scrutinize the LLC operating agreement to see if it contains provisions that either permit the company to acquire a member’s interest for a discounted value in the event of the member’s personal bankruptcy or that limit profit distributions either by making them discretionary rather than mandatory, or by restricting distributions to insolvent members. Finally, the operating agreement should be reviewed so that the lender understands any restrictions that may be placed upon the rights of an assignee who assumes a member’s interest. If such provisions are included in the operating agreement, they should be addressed in the assignment agreement as part of the negotiations over the assignment of the LLC membership interest so as to preserve the creditor’s rights and the value of charging orders.

Savvy lenders know that the LLC is the optimal form of entity for insulating company assets from owners’ personal creditors. Hence, they are the lenders that will carefully review the LLC organizational documents and only take LLC interests as collateral using an enhanced form of assignment agreement.

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• Life Insurance
• Definitions

What Is a Collateral Assignment of Life Insurance?

Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University.

A collateral assignment of life insurance is a conditional assignment appointing a lender as an assignee of a policy. Essentially, the lender has a claim to some or all of the death benefit until the loan is repaid. The death benefit is used as collateral for a loan.

The advantage to using a collateral assignee over naming the lender as a beneficiary is that you can specify that the lender is only entitled to a certain amount, namely the amount of the outstanding loan. That would allow your beneficiaries still be entitled to any remaining death benefit.

Lenders commonly require that life insurance serve as collateral for a business loan to guarantee repayment if the borrower dies or defaults. They may even require you to get a life insurance policy to be approved for a business loan.

Key Takeaways

• The borrower of a business loan using life insurance as collateral must be the policy owner, who may or may not be the insured.
• The collateral assignment helps you avoid naming a lender as a beneficiary.
• The collateral assignment may be against all or part of the policy's value.
• If any amount of the death benefit remains after the lender is paid, it is distributed to beneficiaries.
• Once the loan is fully repaid, the life insurance policy is no longer used as collateral.

How a Collateral Assignment of Life Insurance Works

Collateral assignments make sure the lender gets paid only what they are due. The borrower must be the owner of the policy, but they do not have to be the insured person. And the policy must remain current for the life of the loan, with the policy owner continuing to pay all premiums . You can use either term or whole life insurance policy as collateral, but the death benefit must meet the lender's terms.

A permanent life insurance policy with a cash value allows the lender access to the cash value to use as loan payment if the borrower defaults. Many lenders don't accept term life insurance policies as collateral because they do not accumulate cash value.

Alternately, the policy owner's access to the cash value is restricted to protect the collateral. If the loan is repaid before the borrower's death, the assignment is removed, and the lender is no longer the beneficiary of the death benefit.

Insurance companies must be notified of the collateral assignment of a policy. However, other than their obligation to meet the terms of the contract, they are not involved in the agreement.

Example of Collateral Assignment of Life Insurance

For example, say you have a business plan for a floral shop and need a $50,000 loan to get started. When you apply for the loan, the bank says you must have collateral in the form of a life insurance policy to back it up. You have a whole life insurance policy with a cash value of $65,000 and a death benefit of $300,000, which the bank accepts as collateral.

So, you then designate the bank as the policy's assignee until you repay the $50,000 loan. That way, the bank can ensure it will be repaid the funds it lent you, even if you died. In this case, because the cash value and death benefit is more than what you owe the lender, your beneficiaries would still inherit money.

Alternatives to Collateral Assignment of Life Insurance

Using a collateral assignment to secure a business loan can help you access the funds you need to start or grow your business. However, you would be at risk of losing your life insurance policy if you defaulted on the loan, meaning your beneficiaries may not receive the money you'd planned for them to inherit.

Consult with a financial advisor to discuss whether a collateral assignment or one of these alternatives may be most appropriate for your financial situation.

Life insurance loan (policy loan) : If you already have a life insurance policy with a cash value, you can likely borrow against it. Policy loans are not taxed and have less stringent requirements such as no credit or income checks. However, this option would not work if you do not already have a permanent life insurance policy because the cash value component takes time to build.

Surrendering your policy : You can also surrender your policy to access any cash value you've built up. However, your beneficiaries would no longer receive a death benefit.

Other loan types : Finally, you can apply for other loans, such as a personal loan, that do not require life insurance as collateral. You could use loans that rely on other types of collateral, such as a home equity loan that uses your home equity.

What Are the Benefits of Collateral Assignment of Life Insurance?

A collateral assignment of a life insurance policy may be required if you need a business loan. Lenders typically require life insurance as collateral for business loans because they guarantee repayment if the borrower dies. A policy with cash value can guarantee repayment if the borrower defaults.

What Kind of Life Insurance Can Be Used for Collateral?

You can typically use any type of life insurance policy as collateral for a business loan, depending on the lender's requirements. A permanent life insurance policy with a cash value allows the lender a source of funds to use if the borrower defaults. Some lenders may not accept term life insurance policies, which have no cash value. The lender will typically require the death benefit be a certain amount, depending on your loan size.

Is Collateral Assignment of Life Insurance Irrevocable?

A collateral assignment of life insurance is irrevocable. So, the policyholder may not use the cash value of a life insurance policy dedicated toward collateral for a loan until that loan has been repaid.

What is the Difference Between an Assignment and a Collateral Assignment?

With an absolute assignment , the entire ownership of the policy would be transferred to the assignee, or the lender. Then, the lender would be entitled to the full death benefit. With a collateral assignment, the lender is only entitled to the balance of the outstanding loan.

The Bottom Line

If you are applying for life insurance to secure your own business loan, remember you do not need to make the lender the beneficiary. Instead you can use a collateral assignment. Consult a financial advisor or insurance broker who can walk you through the process and explain its pros and cons as they apply to your situation.

Progressive. " Collateral Assignment of Life Insurance ."

Fidelity Life. " What Is a Collateral Assignment of a Life Insurance Policy? "

Kansas Legislative Research Department. " Collateral Assignment of Life Insurance Proceeds ."

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Secured lenders often look to the borrower's or guarantor's rights under insurance policies to improve their collateral position. Obtaining a collateral interest in a business interruption insurance policy may protect a lender who is dependent upon the ongoing cash flow of its borrower for debt service. Obtaining an assignment of an interest in a life insurance policy of the borrower's owner or a principal guarantor protects the lender against economic effect of the sudden loss of a member of the borrower's team essential to its success.

Despite its importance to many commercial loan transactions, the law governing lien interests in insurance is non-uniform. Since 1945, matters relating to insurance have been left to each state. 1 More importantly, all but two states have excluded liens in insurance policies from Article 9 of the Uniform Commercial Code ("UCC"). 2 Because of this exclusion, concepts of creation, perfection 3 and priority of liens taken by lenders in insurance policies are wholly dependent upon the forum and the terms of the particular insurance policy involved. Nonetheless, in the context of a bankruptcy proceeding, these concepts are essential to determining the extent of a lender's secured claim under section 506 of the United States Bankruptcy Code 4 ("Code") and to determining when a lien is perfected under Code section 547(e)(1)(B) for avoidable preference purposes.

How, then, does a lender create and perfect its interest in policies of insurance? Because of the exclusion of insurance from the ambit of the UCC, it is clear that execution and delivery by the debtor of a security agreement covering general intangibles and filing a financing statement will not create an enforceable lien. 5 An important first step is to examine the policy to make sure that all of the elements required by the insurer for the creation of a valid lien are complied with.

Case law provides guidance (albeit conflicting) regarding how liens in insurance policies are created. Regarding life insurance, some courts hold that possession of the policy is required to create a lien interest, 6 while other courts hold that a policy cannot be pledged by possession. 7 In those jurisdictions where possession is not required or with respect to commercial insurance policies, execution and delivery of a collateral assignment of rights under the policy and notice to the insurer will likely be sufficient to create an interest in the policy. Commercial insurers often do not require a specific form of collateral assignment. With respect to life insurance policies, however, completion and delivery of collateral assignment forms provided by the insurer is often a prerequisite to a valid lien. A lender should pay particular attention to forms prepared by the insurance company to ensure that the lender is receiving the protections it seeks.

Regarding the sufficiency of notice, does notice to the debtor's insurance broker (but not the insurer directly) and receipt of a certificate of insurance showing the lender as an additional insured create an enforceable lien? Maybe—depending upon the effect of a certificate of insurance in the subject jurisdiction (which varies) and upon a court finding the broker is deemed to be an agent of the insurer with authority to bind it. Some courts have found a valid lien is created upon the execution of a collateral assignment of rights in the policy, even without notice to the insurer. 8 The one thing that is apparent is that the law is conflicting and muddled.

Nor are the rules with respect to priority of collateral interests any clearer. While a majority of courts follow the UCC's "first in time, first in right" precept, holding that senior priority of interests in a policy goes to the lender who first provides notice to the insurer, other courts rule that priority goes to first assignee regardless of notice to the insurer. These courts find that the notice requirement is for the benefit of the insurance company and not for third parties. 9

In any case, regarding commercial policies, to fully protect itself, the lender should not rely upon a certificate of insurance but instead should obtain from the insurer an endorsement to the policy providing that the lender is a loss payee and an additional insured under the policy. The endorsement should require the insurer to provide the lender with advance notice of cancellation and an opportunity to pay premiums due. The endorsement also should provide that the lender retains the right to receive a loss payment even if the lender has commenced a foreclosure or similar action to preclude a claim that the underlying debt is extinguished. In summary, the steps a lender should take to create and perfect a valid lien in insurance policies include:

• Reviewing the policy to determine the insurer's requirements for the creation of a valid lien.
• Having the debtor execute and deliver an appropriate assignment of life insurance as collateral (usually using the insurer's form), or a collateral assignment of rights in the debtor's commercial policy.
• Taking possession of the original life insurance policy in those states which require possession.
• Delivering notice of the collateral assignment to the insurer and receiving confirmation of receipt of the assignment.
• For commercial policies, obtaining an endorsement from the insurer naming the lender as an additional insured and loss payee.
• Ensuring that the endorsement requires the insurer to send advance notice of cancellation to the lender and permits the lender to pay premiums due, and provides that the lender is entitled to a loss payment even if foreclosure or similar proceedings are commenced.

Collateral interests in insurance policies often significantly enhance a lender's secured position, and having a valid interest in an insurance policy may be important in determining the extent of a lender's secured position, and therefore it's rights, in a bankruptcy proceeding. However, because liens in insurance are governed by state law and excluded from the UCC, there is no established, single set of ground rules for a lender to follow to create and perfect liens in the debtor's life or commercial insurance policies. Lenders must recognize this fact and carefully take the necessary steps to protect themselves.

If you have any questions on the topics discussed in this e-alert, please contact your Reinhart attorney or any member of Reinhart's Business Reorganization team .

1 See The McCarran-Ferguson Act of 1945 (15 U.S.C. § § 1011-1015). 2 See Cal. Com. Code § 9109 (including all types of insurance); La. Rev. Stat § 10:9-109(d)(8) (including life insurance). 3 "Perfection" is a concept arising under the UCC and is probably not appropriate when referring to liens in insurance policies. See Andrew Verstein, Bad Policy For Good Policies: Article 9's Insurance Exclusion, 17 Conn. Ins. L. J. 287, 309 (2011) (hereinafter "Verstein"). But see 11 U.S.C. § 547(e)(1)(B), which discusses perfection of interests in property for the purposes of preferences. 4 11 U.S.C §§ 101-1532. 5 See Wheeling & Lake Erie Ry. Co. v. Keach, 521 B.R. 703 (B.A.P. 1st Cir. 2014). 6 See In re Maplewood Poultry Co., 2 B.R. 550 (Bankr. D. Me. 1980) (applying New Jersey law). 7 See Metro. Life Ins. Co. v. Haack, 50 F. Supp. 55 (W.D. La. 1943) (applying Missouri law). 8 See Ketchikan Shipyard, Inc. v. Anchorage Nautical Tours, Inc. (In re Anchorage Nautical Tours, Inc.), 102 B.R. 741 (B.A.P. 9th Cir. 1989). 9 See generally, Verstein at 310-11.

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