A retailer asked me to review a security agreement that he was asked to sign as part of a deal from a mill giving him extended credit terms.

As we’ve noted in the past, a security agreement, if filed properly, gives the creditor, in this case the mill or its factor, rights in certain property owned by the debtor, in this case the dealer.

The rights given away are often very broad and, in certain cases, gives the creditor the right to reclaim the goods even by the use of some types of force.

When reviewing a security agreement it is most important to carefully read those clauses which state when the creditor’s rights arise with regard to enforcing the agreement.

While the most obvious of these clauses is, of course, triggered if the debtor fails to make the agreed payments, there are others in which one should also be aware.

Most of these agreements provide, in the event of a default by the buyer (debtor), the seller (creditor) may declare the entire balance due and payable immediately.

Once the seller has done this, in writing, the buyer no longer has the right to pay off the past due amount and continue on with the schedule of payments.

Instead, the agreement will say that the only way the debtor can keep the creditor from enforcing his rights in the collateral, including his right to reclaim, is to immediately pay off the entire balance.

Because of the harshness of this language it is important to note what is defined as a default under the agreement in addition to a missed payment.

One provision which is almost always found in a security agreement provides that the seller may declare a default and accelerate the note whenever he deems himself to be insecure even though the debtor has not actually missed any payment.

When may a creditor deem himself insecure? The Uniform Commercial Code (UCC) says: “A term providing that one party or his successor in interest may accelerate payment or his successor in interest may accelerate payment or performance or require collateral or additional collateral “at will” or “when he deems himself insecure” or in words of similar importance shall be construed to mean that he shall have power to do so only if he in good faith believes that the prospect of payment or performance is impaired. The burden of establishing lack of good faith is on the party against whom the power has been exercised.”

This clause applies to all loans or notes, whether or not secured, if the statement is included in the loan agreement. The purpose of putting this type of statement into a formal extended payment and security agreement is obvious.

Without it, a buyer could, conceivably, be forced to sit on its hands and watch a creditor slowly sell all its assets including it’s collateral, in the normal course of business so long as its note payments were made on time.

It would, in these cases, not have the power to stop the sale of the collateral until there was a default in the repayment schedule. By that time the seller might be out of luck.

Clauses of this type, providing for the acceleration of payments when the creditor deems himself insecure, although necessary to a lender, have a large potential for abuse. The seller in these cases merely has to tell the debtor he is insecure and he must, therefore, be immediately paid in full.

He does not, under the UCC, have to show why he is insecure but rather the burden is on the buyer to prove there is no reason for the insecurity. This would require a litigation and most likely a trial.

There are also other clauses contained in most security agreements which give the creditor the right to declare a default and accelerate the payments.

One of these might state that the failure of the debtor, “to do all things necessary to preserve and protect the value of the collateral,” constitutes a default. In line with this the simple failure to insure the collateral may also be deemed a default.

Other clauses will state a default occurs in the event of death, termination of existence, insolvency, business failure or with the commencement of any proceedings in bankruptcy.

Still other clauses may declare a default in the event anyone else obtains a judgment, for whatever reason or amount, against the buyer.

While these arguments are often necessary, especially when there is a long term payout, it is important that a buyer read and understand them before signing.

Although very few sellers or lenders will make any changes in these agreements, the buyer should, at the very least, understand the rights he’s giving away.