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Understanding Security Accounts in Banking Systems: Perfecting Your Security Interest

In today's complex financial landscape, understanding how to properly secure and perfect your security interest in collateral is more important than ever. This is particularly true when it comes to security accounts and deposit accounts in the banking system.   The Uniform Commercial Code (UCC) provides the foundation for much of the law governing secured transactions, including perfection of security interests in deposit accounts and securities accounts. However, navigating the nuances of the UCC and applying it to real-world situations can be challenging. In this article, we'll explore some of the key concepts and best practices for perfecting your security interest in these types of collateral.

Attachment and Perfection

The first step in creating an effective security interest is attachment. For a security interest to attach and be enforceable against the debtor, the debtor must have rights in the collateral, the secured party must give value, and there must be a security agreement authenticated by the debtor that sufficiently describes the collateral.

Once the security interest has attached, the next step is perfection. Perfection is what makes the security interest effective against third parties and ensures that it will survive a bankruptcy filing. For deposit accounts, the only way to perfect a security interest is through control. For securities accounts, perfection can be achieved through either control or filing a UCC financing statement, but control will trump filing in a priority dispute.

Control Agreements

The primary way to perfect a security interest in a deposit account or securities account is through a control agreement. A control agreement is a three-party agreement among the debtor, the secured party, and the bank or securities intermediary that maintains the account.

The key provision in a control agreement is language stating that the bank or intermediary will comply with instructions from the secured party directing disposition of the funds or securities in the account, without further consent of the debtor. This gives the secured party effective control over the account.

It's important to note that the secured party does not need to actually exercise this control on day one. The agreement can provide that the debtor is allowed to transact in the account until the occurrence of an event of default or other triggering event. At that point, the secured party can give notice to the bank or intermediary to stop complying with the debtor's instructions. What matters for perfection is that the secured party has the ability to take control when needed.

Priority and Preferences

Perfecting your security interest through control not only makes it effective against the debtor and third parties, but also establishes your priority relative to other secured creditors. A secured party perfected through control will have priority over a secured party perfected only through filing, regardless of the timing of the filing.

If there are multiple secured parties perfected through control, priority will go to the first to obtain control. The only exception is for the security intermediary itself - if the intermediary has a security interest in the account, that will always have priority over the secured party's interest.

One important thing to keep in mind is the risk of preferential transfers in bankruptcy. If a security interest is perfected more than 30 days after attachment, or if perfection lapses at any point and is not cured within 30 days, the perfection will not relate back to the original attachment date. This means that if the debtor files for bankruptcy within 90 days, the security interest could be avoided as a preferential transfer.

To guard against this risk, it's crucial to ensure that all steps for perfection, including control agreements, are completed as soon as possible after closing a transaction. Don't let perfection of security interests in deposit accounts and securities accounts linger as "post-closing" items.

Practical Considerations in Control Agreements

When negotiating and drafting control agreements, there are a number of important provisions and practical points to consider beyond just the basic "magic language" required for perfection.

One is the standard of care imposed on the bank or intermediary. Secured parties will want the highest standard possible, while banks will want to limit their liability to gross negligence or willful misconduct. The exact language is often heavily negotiated, but in general, banks' forms will prevail on this point.

Another is how quickly the bank or intermediary must act on the secured party's instructions once an event of default occurs. Secured parties will want immediate action, while banks will want a "reasonable" time to act. It's important to push for a specific, and short, outside time limit. The agreement should also be clear that even if the bank has a window of time to act, it cannot follow the debtor's instructions once the notice is received.

Access to information about activity in the account is also key. Secured parties should insist on the right to obtain statements and online access to monitor the account. This visibility helps the secured party identify any unusual activity that could signal fraud or an impending bankruptcy filing.

Finally, in syndicated or multi-lender deals with multiple layers of debt, thought needs to be given to how control and perfection will work for the different classes when the deal closes and in an eventual bankruptcy. The first lien lender may need to act as gratuitous agent for the second lien lender's perfection until the first lien is satisfied. The control agreement should spell out these mechanics so all secured parties can be assured of continuous perfection.

Deposit Accounts vs. Securities Accounts

While many of the concepts and practices around control and perfection are similar for deposit accounts and securities accounts, there are some key differences to be aware of.

One is how the UCC handles the downstream recipients of funds from these accounts. For deposit accounts, a transferee takes funds free and clear of any security interest in the deposit account unless they are actually colluding with the debtor to violate the security agreement. For securities accounts, the rules provide even broader protections for transferees who give value and don't have actual knowledge of an adverse claim. The policy behind both of these rules is to ensure the free flow of funds and securities in commerce.

Another difference is how the accounts are actually held and what property is being encumbered. With a securities account, the financial assets held in the account are the collateral. But the debtor doesn't hold those financial assets directly. Instead, the debtor holds a securities entitlement, which is a bundle of rights against the intermediary with respect to the underlying financial assets. The nuances of the indirect holding system under UCC Article 8 must be understood.

With deposit accounts, the collateral analysis is more straightforward - the collateral is the debtor's rights in the account itself. But with deposit accounts, you must pay particular attention to how cash moves through the account and whether your security interest continues in identifiable cash proceeds. Comingling of cash in a deposit account can destroy your perfected status.

Conclusion

Perfecting security interests in deposit accounts and securities accounts requires careful navigation of the UCC's requirements and a number of practical considerations. Closing a deal is only the start - to ensure that your security interest will stand up in a future bankruptcy or against competing creditors, perfection must be done properly and promptly.

Control agreements are the key, and they must be drafted thoughtfully to protect the secured party's interests. Understanding the differences between deposit accounts and securities accounts, and how the rules operate in a multi-lender scenario, is also critical.

While much of the law around security interests and perfection traces back to the fundamentals of attachment, the specific rules for these types of collateral can be complex. An experienced attorney should be engaged when completing any secured loan transaction.