With the persistence of a sputtering economy, secured lenders are leaving no stone unturned in their hunt for collateral security from borrowers and guarantors alike. This search for more collateral has resulted in a renewed interest in taking investment property collateral, including stocks, bonds, and mutual funds. It can often be quite difficult for the secured creditor to decipher the precise type of investment property being offered as collateral security. This brings new risks as the requirements for perfection of a security interest in investment property differ based on the type of investment property. Mutual funds, in particular, are unusual in that perfection requires control from the issuer of the mutual fund, not the securities broker.
Mutual fund investors own a share of the mix of underlying investment property (i.e. stocks and bonds) held by the mutual fund. Mutual funds come in the form of open-end funds and closed-end funds. Open-end funds have no limit on the number of shares to be issued. When a new investor wants to purchase shares of the mutual fund, the fund simply buys more of the underlying investment property, pro-rata, to cover the shares purchased by the investor. Upon sale, the shares are redeemed and the applicable amount of the underlying investments are sold. With a closed-end fund, however, which is far less common, a set number of shares are issued and then those shares are traded on the open market. Nearly all mutual funds are uncertificated.
Both types of mutual funds are “securities” as defined in Article 8 of the UCC (8-103(b)). As an uncertificated security, perfection of a security interest granted in a mutual fund requires control or filing, which control being the highest and best form of perfection (9-312(a); 9-314). Control under Article 9 of the UCC may be achieved by transferring the property into the name of the secured creditor on the books of the issuer, or else by the issuer acknowledging in a control agreement that it will comply with instructions as to the mutual fund without further consent by the debtor, even though the debtor remains the registered owner of the mutual fund. In both cases, it is the issuer of the mutual fund that must give control to the secured creditor. This differs from most securities scenarios where the securities broker that holds the investment account may grant control of the account.
In short, a secured lender should seek the advice of knowledgeable counsel each time it takes investment property as collateral in order to determine the precise type of investment property and the steps necessary for perfection of the security interest. Absent careful evaluation, secured creditors could find themselves facing unperfected security interests with very little chance of recovery on that collateral.