Without security, a loan agreement is, for all intents and purposes, a lengthy and well-dressed IOU.
No-one likes feeling insecure
Without security, a loan agreement is, for all intents and purposes, a lengthy and well-dressed IOU. This is because, in the event of a default, a lender will be required to instigate legal proceedings to recover their losses. On the other hand, if effective security is provided the lender may be able to take immediate steps to secure assets and recover all or some of their losses. Where a loan is unsecured, recovery can be a slow and expensive process requiring. If the borrower is an individual, the lender must first obtain a court judgment in their favour and then instigate bankruptcy proceedings. Or, where the borrower is a company, the lender must seek to wind up the company following the service of a statutory demand. In either case, there is no guarantee that there will be sufficient assets available at the end of the process to repay the lender all that they are owed.
Big house, nice car – they’re good for it. Or are they?
Individuals that appear to be of substantial net worth can insulate their assets from their liabilities by the use of corporate structures and trusts. Therefore, while taking a personal guarantee from a director may incentivise repayment (depending on the individual’s personal view of being made a bankrupt), it may not result in the recovery of substantial assets if everything of value is owned by the individual’s partner, or held in a family trust.
What is the value of security?
The value of taking security for a loan is threefold.
1. Financial security
From a purely financial standpoint, the value of the property that is provided as security should exceed the amount owed plus a buffer to allow for interest, costs of recovery and a reduction in the value of the property due to market forces. The amount of the buffer will depend on the nature of the asset being offered as security, but generally the smaller the buffer, the higher the risk to the lender. A lender who is at high risk should charge a higher rate of interest, as compensation for its risk.
2. Preservation of the borrower’s assets
Where a lender has effective security over an asset, this can prevent the owner of that asset from selling, mortgaging or otherwise putting that asset beyond the reach of the lender without the lender’s consent. Often it is the case that a business is worth more than the sum of all of its assets, therefore if a lender has security over all of the business’s assets it can prevent the value of the business from being stripped by a piecemeal sale of assets by the borrower. It will also prevent those assets from being offered to another financier as security for further borrowings without the lender’s consent.
3. Incentivises repayment
Effective security can also prevent what is often referred to as ‘moral hazard’. If an individual’s personal assets are not at risk, are they going to do everything that is necessary to ensure that the loan is repaid? Or will they try and walk away when the going gets a bit tough? On the other hand, if everything that a borrower has spent years building up, including their family home, is at risk, the borrower is likely to use all their efforts to ensure that the loan is repaid.
Ok – I will take their firstborn child as security!
Careful consideration needs to be given to the nature of the security that is taken as it can have unintended side effects. If you take their firstborn child, you could get caught for their childcare, schooling and university fees before you see a return!
Where money is being lent to fund the development of land, a lender may find themselves having to complete the development in order to recover their money. As a lender, do you really want to expose further funds to a project that has gone bad? An alternative would be to require the borrower to give security over other assets which may enable the lender to recover their losses without the hassle, delay and cost of completing the development itself.
Alright then – I will tie the borrower’s hands and feet instead
It is in both the lender’s and borrower’s interest that the loan is repaid in accordance with its terms: the lender recovering their outlay and interest without the delay, cost and risk of having to take enforcement action and the borrower enjoying the fruits of whatever the loan was used to fund. It is important to be aware that there is a risk that the taking of some security may in itself have an adverse effect on the viability of the borrower’s business and consequently their ability to repay the loan.
Take for example where money is being lent to a manufacturing company to finance the purchase of a piece of equipment. If the lender takes as security a General Security Agreement securing all of the assets of the company this may restrict the company from obtaining an overdraft to fund its ongoing business. On the other hand, a Specific Security Agreement may be more appropriate.
It’s a short-term loan, and I’ll need the money back quickly
Consideration should also be given to the difficulty of turning an asset seized by the lender into cash. For example, specific notices and time periods need to be complied with for the sale of a house under a power of sale in a mortgage. Issues can also arise where finance is being provided for specialised equipment, which may have limited resale value.
The security for the loan should be addressed as early as possible in the negotiations to ensure that the lender can make all necessary enquiries before committing to lending any funds.
John Morrissey is a Senior Associate with Meyer Vandenberg with over 17 years’ experience in commercial property acquisition, development, realisation and finance who has worked both in private practice and as in-house counsel for a European bank during the Global Financial Crisis.
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