What is the practical value of personal property pledged as security for a loan? The Uniform Commercial Code theoretically allows debtors to pledge their interests in a wide variety of property as security for a debt, ranging from the common, like equipment, accounts, automobiles, and farm products, to the more esoteric, such as “general intangibles,” “chattel paper,” and “commercial tort claims.” Each of these categories of property rights may have value as collateral. But before relying on the theoretical value of the property, it is a good practice to consider the practical difficulties that may hinder collection or enforcement of the security interest in the event of a default.

If a business debtor pledges its interest in accounts receivable, for example, what will be required of the bank to collect those accounts if the debtor defaults? Most security agreements will require a debtor to, upon demand, provide account records, but the unique circumstances of each business may limit the effectiveness of such a provision.

A business that deals in goods or simple services may have relatively short payment terms requiring payment in 30 days or even less from its customers. If the bank’s agreement requires written demand for records and in turn the bank receives paper records (if the debtor responds at all), it’s likely the records will be stale by the time the bank can communicate to the account-debtors, and they likely will have already paid the bank’s debtor. Conversely, the accounts of a professional services firm may age longer before payment, but they may also be more difficult to collect because of the challenge of dealing with potentially confidential information or disputes over the quality of services. In both situations, the bank could benefit from requiring the business to provide, prior to default, a monthly report of account debtors, including names and amounts owed, to have a better understanding of the collectability of those accounts.

In short, remember to consider challenges that may arise when trying to foreclose on or liquidate personal property collateral in the context of the debtor, its industry, and its actual business practices. You may be able to implement terms or procedures that assist in collection, such as collecting serial numbers of non-titled assets, inspecting business locations to determine the location and nature of the collateral, and/or requiring regularly updated financial statements or access to electronic records. At the very least, the bank should appropriately account for collection challenges in determining the practical value it places on that collateral.

For more information, contact Joel Rische at 605-357-1259 or [email protected].

Davenport, Evans, Hurwitz & Smith, LLP, located in Sioux Falls, South Dakota, is one of the state’s largest law firms. The firm’s attorneys provide business and litigation counsel to individuals and corporate clients in a variety of practice areas. For more information about Davenport Evans, visit www.dehs.com