#16806 - Secured Credit - Banking Law Notes

Overview

• Methods for securing repayment.

• Economic analysis of security interests.

• Fixed and floating charges.

• Financial collateral arrangements.

Methods for securing repayment

• Recall the Net Present Value (“NPV”) rule:

  • NPV = F₀ + E(F)/(1 + E(r_i)).

  • E(F) = ⁿ_j=1p_jF_j
    This is the weighted average of the all the possible payoffs that will be made by the borrower on the loan.

• How does the introduction of security affect our calculation?

  • The lender has recourse to the secured assets if the borrower is unable to meet its obligations in full.

    • But the lender can only access the secured assets to the extent that is necessary to satisfy the borrower’s obligations; it is not entitled to any excess in the proceeds above the amount is owed by the borrower.

  • This leads to an increase in E(F), and therefore a decrease in both variance and standard deviation.

• Personal security (by way of a personal guarantee):
  

  • The guarantee can be made either by the borrower’s shareholders, or the borrower’s subsidiaries.

  • The former is more commonly used in SMEs and family-run companies, whilst the latter is more commonly used in substantial public companies (because the cash flow generating assets are mostly held by the operating subsidiaries and no the parent itself).

• Proprietary security:
  

  • It is not based on a guarantor’s personal liability for the obligations of a third party.

  • Here, we are concerned with the possibility of dedicating the assets of the borrower (or of third parties, such as the borrower’s subsidiaries) to the repayment of the outstanding loan.

  • Security interests proper:

    • Certain formalities required for creation and enforcement.

    • Mandatory risk-and-reward structured.

    • Can be in the form of a pledge, a contractual lien, a mortgage, or an equitable charge.

  • Title-based finance:

    • This is based on a transfer of title rather than the registration any formal security interests. The secured party is accordingly entitled to exercise all the rights associated with ownership.

    • No formalities other than the transfer of title.

    • No mandatory enforcement rules.

    • Risk-and-reward structure subject to the parties’ autonomy.

    • Enormous flexibility.

    • All these advantages of title-based financing means that it may be more attractive to a lender than. But note the problem of recharacterisation (into a security interest proper): the court may hold that they parties have actually created a registrable charge (which must be registered within a certain time limit), and, because the parties have not done so, the security interest is therefore ineffective.

• Types of property:

  • Immovable property (i.e. real property or realty).

    • This includes chattels reals and leasehold interests.

  • Movable property (i.e. personal property). These may be:

    • Tangible (e.g. chattels, choses in possession, goods);

    • Intangible (e.g. choses in action);

    • Pure intangibles (e.g. receivables, intellectual property); or

    • Documentary intangibles (e.g. documents of title, negotiable instruments, investment securities).

Economics of security interests

• The intersection between law and economics:

  • This is the predominant approach in the US; most of the teaching looks at law and economics together instead of black-letter law alone.

• How else can a lender reduce risk if not by taking security?

  • By monitoring the borrower and the other lenders.

    • Why the borrower? So as to understand its financial situation.

    • Why other lenders? So as to ascertain if they are moving towards enforcement, and to secure for himself the “first mover advantage”.

    • The consequences: High monitoring costs + Enforcement by any single lender leads to a wave of enforcement by all other lenders that forces the borrower into insolvency.

  • By having collective insolvency proceedings.

  • By premature liquidation.

  • By not lending at all.

• The consequences of having security:

  • The situation without security:

    • No security = High monitoring costs, because risk-averse lenders must continuously monitor the borrower’s financial situation = High cost of credit = Reduced availability (and affordability) of credit.

  • How does the secured lending change this?

    • Reduction of monitoring costs by securing credit;

    • Reduced risk of default;

    • Reduced costs of borrowing;

    • Increased availability and affordability of credit;

    • More borrowing to finance public infrastructure projects; and

    • Society as a whole is thus better off.

• Consider: Are there any arguments against this? How can the use of secured credit also do a disservice to society as a whole?

  • The “zero sum game” analysis:

    • The reduction in monitoring costs for secured lenders may actually be offset by the increase in monitoring costs for unsecured lenders.

  • Might the use of secured lending actually be inefficient?

    • Judgment proof vis-a-vis “involuntary creditors” (e.g. tort victims):
      E.g. A subsidiary company engages in secured borrowing. The victims of unintentional torts committed by the subsidiary (this is particularly pertinent if the subsidiary frequently engages in risky businesses such as mining or power generation) cannot access the subsidiary assets, because they have already been pledged to the lender, and neither can they access the subsidiary’s cash flow, because that is channelled to its parent by way of dividends.

    • Risk externalisation:
      Causing the “involuntary creditors” to bear the losses that result from the unintentional torts committed by the company.

    • Excessive risk-taking:
      This also incentivises the subsidiary’s management to adopt lower (and cheaper) levels of safety standards, because the tort victims cannot access the company’s assets or cash flow anyway.

• The optimum structure for secured lending:

  • The debtor is interested in having:

    • The debt being as cheap as possible;

    • Control of the assets being used as security; and

    • Protection against creditor opportunism.

  • The creditor is interested in having:

    • Strong incentives for the debtor to repay;

    • Inexpensive, quick, and flexible enforcement mechanisms;

    • Keeping any overvalue, because it is also the creditor bears the risk of any undervalue (in that, if the collateral turns out to be worth less than the nominal value of the claim, it is he who must bear the loss).

  • Third parties are interested in having:

    • Publicity, because their risk assessment takes into account existing security interests of the borrower’s assets, and they are hence interested in those pre-existing security interests being made public;

    • The ranking of their security interests being the same as the existing security interests; and

    • Outward reliance.

  • Formalities upon creation:

    • Increased costs (of publicising the creation of security interests) VS The ability of third parties to rely outwardly on the existing security interests over the borrower’s assets. This problem is usually solved by the use of some sort of registration system.

    • Registration and priority.

    • All types of assets can be used to secure all types of debts.

  • Duration:

    • The debtor can continue to use the asset (to generate cash flow).

    • Some element of fungibility (i.e. mutual interchangeability of the assets being used as collateral).

    • To use the same asset repeatedly as collateral.

  • Enforcement:

    • Prompt, inexpensive, and realisation of the market value (or something that is reasonably close to the market value).

    • There should be clearly defined events of default that is subject to judicial review, so as to protect against creditor opportunism.

    • There should also be a flexible risk and reward structure.

Fixed and floating charges

• The types of security interests:

  • Possessory:

    • Common law pledge = A form of bailment, where the lender gives up possession of the collateral to the buyer. But this is of very little use in commercial transactions, because the lending bank has no use for the borrower’s machinery and that machinery will simply be taking up space in the bank’s office, whilst the borrower himself needs to assets to continue generating cash flows.

    • Contractual lien= Where the lender finds himself in possession of the collateral for some reason that is unrelated to the lending, but he is nevertheless able to enforce its security and sell the collateral should the borrower fail to repay the loan.

  • Non-possessory:

    • Mortgage (legal or equitable).

    • Equitable charge (fixed or floating) = An agreement supported by valuable consideration to appropriate valuable assets to secure the borrower’s discharge of his indebtedness. This is really the most important security interest for the purpose of secured lending. Floating charges hover over some fungible pool of assets, and only crystallise upon the occurrence of some specified event.

• Attachment, Enforcement, and Perfection.

• Attachment:

  • This requires:

    • An agreement between the borrower and the lender that identifies the asset to be used as collateral;

    • The collateral is used to secure a current obligation of the borrower; and

    • The debtor must have a power to dispose of the collateral.

  • In the case of a floating charge, there must be:

    • An agreement manifesting an intention to charge present and future assets with the borrower continuing to have the freedom to deal with the assets in the ordinary course of business;

    • An immediate security over a changing fund of assets; and

    • The charge becomes a fixed charge upon crystallisation.

• Enforcement:

  • This is usually tied to the events of...