Secured transactions are an essential part of commercial law and many everyday transactions as well. In a secured transaction a borrower agrees that the lender (the secured party) may take property (“collateral”) owned by the borrower should the borrower default on the loan. In other words, the purpose of secured transactions is to secure a loan.
Secured interests are often required when a party borrows money, which means the loans must be securitized. Lenders often require more than just promises of repayment in order to extend credit to borrowers. The law of secured transactions deals with the collateral interests formed between a lender and borrower. The collateral interests secure the loan by allowing property to act as security for the borrower’s obligation to repay the loan.
A security interest is created by an agreement (“security agreement” also called a “debenture”) and arises when in exchange for a loan, a borrower agrees that the lender may take specific collateral owned by the borrower in the event of a default on the loan. Notably, a lender does not take a security interest in order to acquire the property, the collateral is simply a protection in case of a default. For example, if the borrower is unable to fulfill his obligation to make loan payments as agreed, then the lender may take possession of a specified security property.
In addition, a security interest assures the lender that if the debtor should go bankrupt (or “becomes insolvent”), the lender may be able to recover the value of the loan by taking possession of the specified collateral instead of receiving only a portion of the borrowers property after it is divided among all creditors.
Security agreements as contracts
Security agreements are contracts and so the law of secured transactions is generally considered to be a form of contract law. The law of secured transactions generally applies to any transaction, regardless of its form, that creates a security interest in personal property through a a contract. This includes sales of accounts, promissory notes, consignments, and various other security agreements.
Typically, a statute of frauds requires that security agreements be in writing unless the security is pledged. A pledged security agreement arises when the borrower transfers the collateral to the lender in exchange for a loan. To perfect a security agreement the filing of a public notice is usually required. This act of filing is generally known as perfection, which denotes the additional steps which must be taken in order to make the security effective against third parties and to ensure its effectiveness if the issuer goes bankrupt. In this context, the perfection of a security agreement allows a lender to gain priority to the collateral over any third party.
Taking security in the context of a loan
Pursuant to a loan transaction, a bank will generally take security over the assets and undertaking of the borrower in order to increase its chances of being repaid, even on the insolvency of the borrower. Therefore, in conjunction with entering into the loan agreement, the borrower will be required to enter into a debenture or security agreement, which is the document under which the borrower creates the security in favor of a bank for a loan. Such security typically includes creating a fixed charge over the fixed assets of the borrower (such as plants and machinery), which means that the borrower may not sell or do anything to devalue its assets without the bank’s consent and the bank has recourse to the assets if the borrower defaults on the loan.
In order to secure the remaining assets of the borrower which may fluctuate from time to time (such as its trading stock), the bank will also seek to take a floating charge over the whole undertaking of the borrower. A floating charge allows the borrower to deal with the charged assets in the ordinary course of business without the requirement of the bank’s consent. However, on the occurrence of certain events, such as a default under the loan agreement, the floating charge will crystallize, which means that it is converted to a fixed charge over the assets which it covers at that time, so the borrower will only be able to deal with such assets with the bank’s consent.
Other forms of security which the bank may hold include a mortgage over assets such as land or shares, which often grants the bank a right to sell on default; a pledge over assets capable of delivery such as bearer bonds, since this involves the bank taking physical possession of the asset; and an assignment of the borrower’s rights against third parties, such as book debts.
The bank will seek to ensure perfection of the security (i.e. to make it valid against third parties) by publicly registering the charges or security agreements. It will also seek to ensure that the charge ranks in priority to other charges, which it may achieve by the inclusion of a negative pledge, which is an undertaking by the borrower not to create any further security over its assets, in the debenture to prevent the borrower granting later fixed charges to third parties which take priority over the floating charge granted to the bank. Banks often create negative pledges by requiring the borrower to give covenants, or promises, including non-financial covenants, such as a negative pledge.
In addition to the security granted by the borrower, the bank may also seek a guarantee from the borrower’s parent company or other group company to act as third party support, which is an undertaking by the guarantor to answer for the borrower’s liabilities on its default. If the borrower’s parent refuses to provide a guarantee, it may give a comfort letter, which is usually not intended to be legally binding and is merely a statement of intention to maintain an interest in and support for a subsidiary and to ensure it is capable of fulfilling its obligations under the loan, which acts as reassurance to the bank.
Uniform Commercial Code – Article 9 Secured Transactions
assets: a person, business, or estate’s entire property. Comprises property of all kinds, including real and personal property. The assets acquired as a result of the sale will be transferred to the buyer on the completion date.
commitments: things pledged, obligations. Commitments to extend credit are agreements to lend provided there is no violation of any condition established in the contract.
creditor: one to whom a debt is owed by another. The debtor proposed to pay its creditors by selling its primary asset, a tract of land.
crystallise: to take definite or concrete form, e.g. when a floating charge becomes fixed. Under this provision, the floating charge crystallises if the borrower goes into liquidation or a receiver is appointed.
enforcement of security: collection of the debt by moving on the assets provided as security by the debtor. A receiver may be appointed to protect and recover secured assets where borrower is in default and enforcement of security is necessary.
fixed charge: a charge attached to specific assets which prohibits dealing with those assets without the creditor’s consent. Assets subject to a fixed charge cannot be sold without the bank’s consent.
floating charge: a continuing charge on assets which allows the grantor to deal with those assets freely. A major difference between a fixed charge and a floating charge is that assets can only be released from a fixed charge with the active consent of the lender.
loan agreement: the contract between borrower and lender which sets out the terms and conditions for the loan. Check that your loan agreement gives you this flexibility and try to avoid a prepayment penalty for paying off part of the loan early.
negative pledge: promise by the borrower not to place any further liens on its assets. Sometimes, the negative pledge is not absolute because it allows the borrower to place further liens on the security subject to the permission of the first creditor.
secured creditor: A person who holds a charge over the assets of a company or an individual and thereby gains priority over some or all other creditors on the winding up of the company or the individual’s bankruptcy. The only secured creditor was the bank, which had a charge over the company’s assets.
syndicated loan facility: usually the extension of a large amount of credit to one borrower by several banks under one agreement. Lundgren has signed a new syndicated loan facility with a syndicate of international banks for €800 million.
take security over: to place a charge over as security for the repayment of a debt. Mr Smith understood that in return for the provision of a revolving credit facility of €100,000, the bank would take security over two of his properties.
transaction: an agreement between a buyer and a seller to exchange an asset for payment. The most recent transaction he worked on was the acquisition by a multi-national company of a smaller competitor.
unsecured creditor: a creditor that does not hold security from the debtor, and does not rank as either a secured or preferential creditor in the liquidation of a company. The law firm was an unsecured creditor and, therefore, could only be paid on a pro rata basis after all secured creditors had been paid.