Safeguards of Creditors

INTRODUCTION:

This essay seeks to find out that in present day loan transactions what measures can ensure the repayments; and how effective they are. The essay looks at the customary way of protection: the security _ by way of mortgage and charge; the nontraditional and smart ways that have evolved with the passage of time: quasi-security _ retention of title, hire buy and sale and lease back arrangements; and other safeguards like contractual covenants etc. Each of these measures of protection, except the covenants, has been discussed in proportion of their importance, particularly, for those who effectively fund companies. consequently the main focus remains on the edges.

CREDITORS’ PROTECTION:

edges, individual or syndicates, are the entities that effectively fund companies and their operations. They receive deposits on one hand and improvement these deposits as loans on the other; and consequently make profits. However this course of action is very delicate, as if enough loans are not granted, little profit would be earned; and if too much loans are granted, ready cash may not suffice to satisfy the demands of the depositors. They have to keep a balance and focus equally on liquidity in addition as profitability (1). In such a situation, they cannot provide to lose huge amounts of money progressive as loans. As long as a business, funded by the edges, continues working smoothly, every one associated with that business is benefited in one way or the other. But when it is unable to work anymore or defaults in discharging its limitations, it goes bankrupt. In the event of bankruptcy these limitations are paid out of the proceeds of sale of its assets.Creditors’ claims typically are more in value than the assets of the bankrupt. In such a situation a creditor needs to be in an advantageous position to realize his claims ahead of others. This, typically, can be done by being a secured creditor: who holds some security and is paid off ahead of the other creditors who don’t keep up any securities. edges, usually, while granting loans, acquire security and personal guarantee in addition to the other precautions to safeguard themselves in the event of such unfortunate happenings. Following are the ways to safeguard the position of the lending edges:

SECURITY (Collateral):

Security is an asset which a lender holds for money he has lent. “Under the Insolvency Act 1986 (the Act), security is defined by section 248 as ‘any mortgage, charge, lien or other security’. This definition is taken to average that the rights the creditor have are proprietary in character. The proprietary interest in the debtor’s assets allows the creditor to realize the secured assets to release the debtor’s obligation to the creditor” (2). Generally, securities include stocks, shares, debentures, bonds, instruments creating or acknowledging indebtedness, warrants and options (3). More typical term for a security against a debt is ‘collateral’. The document granting collateral or any other charge is called ‘debenture’. “Under the terms of a debenture, the secured creditor will usually have the strength, upon default by the company, either to go into into possession of the assets and sell them to pay off the secured debt or to appoint a receiver with the strength to manage and sell the company’s business as a going concern to raise the money”(4).That is why the collateral is granted as a routine for obtaining loans throughout the world; and it is the most shared characterize of commerce in every country (5). However, for financially strong companies, particularly the public corporations, secured loan is not usually an attractive option (6). That is why “large unsecured overdrafts are quite shared for established companies” (7). But in most of the situations security is a shared characterize, as the secured credit is the “principal method of financing’ for current ventures in addition as expansion purposes (8). Security or Collateral, proven as debenture, is secured, usually, by way of mortgage or charge. Both these terms are sometimes used interchangeably, as every mortgage implies a charge, though every charge is not necessarily a mortgage.

MORTGAGE:

It is ‘an interest in character produced as a form of security for a loan or payment of a debt and terminated on payment of the loan or debt’ (9). Mortgage is the most typical form of loan security. by a mortgage, the title of the secured character is transferred in the name of the creditor (mortgagee), which is transferred back to the debtor (mortgager) when the loan is paid off. The most shared fixed charge securities produced by companies are legal mortgages over land (10). In the event of default in payment by the debtor, the creditor is entitled to realize his money by sale of the mortgaged character. consequently, a mortgage ensures the repayment of loan of the creditor at the end of the mortgaged period or in the event of bankruptcy.

CHARGE:

A charge is also ‘an interest in company character produced in favour of a creditor (e.g. as a debenture holder) to obtain the amount owing’ (11). It is different from mortgage in the sense that it does not require move of title like a mortgage. ‘It merely gives the chargee the right to have the charged assets realized in order to pay off the debt’ (12). As a consequence, a charge is a security that gives rise to the priority of the holder over unsecured creditors. A charge can either be a fixed charge or a floating charge. Every charge is a consequence of contract between the parties. A fixed charged is associated with specific assets and limits the debtor’s free dealing with such assets. These can be intangible assets, like shares in other companies (13). It, being a fixed security, is enforced prior to all other classes of creditors (14).however, a floating charge floats over all the assets of the debtor. It usually is appropriate in case of those assets the value of which fluctuates, like stocks, cash, shares, book debts etc. It allows the debtor to use the charged assets freely until the event of default or bankruptcy. The floating charge is desirable sometimes because the specific assets lose their value by market fluctuation or depreciation. In that case collateral may not continue to be of sufficient value equivalent to the amount of loan. That is why in certain situations floating charge is preferred by the creditors. However, in case of bankruptcy, not only the fixed charge holders, but the preferential creditors get priority over the floating charge holders in the order of payment (15). consequently, a floating charge, though necessary in certain situations, does not make its holder a secured creditor in the true sense. But certainly his position is better than that of the unsecured creditors.

The Customary Safeguard:

‘Secured creditors are, as a matter of policy, immune from the loss.’ (16) While in liquidation the creditors could get only a small percentage of their claims, (17) 75 per cent creditors could get nothing, and only 2 per cent could retrieve their complete amount; (18) edges’ rate of recovery remained as high as 77 per cent as compared to the 27 per cent of the preferential creditors.(19) In globalized financial system, many companies’ assets and creditors are spread over more than one jurisdiction.’European Union, too, is to have an internal financial market “with open access to edges’ and financial institutions’ operation in member countries” (20). however, “The fragility of the financial system, built as it is on confidence, can average that there is a real possibility of systemic risk spreading throughout the system.” (21) In such a situation, edges, like every creditor, get the best security (22) _ though, the security is merely a contingency measure, otherwise chiefly, edges loan against feasibility and cash flow (23). nevertheless in case of any unfortunate event like default or insolvency of the debtor, it is only the security that can be the best safeguard for a creditor. Collaterals by way of mortgage or charge are the most reliable and customary safeguards obtainable to the creditors. But there are certain other measures that can be taken by the creditors to ensure obtain repayment of their loans.

QUASI SECURITIES:

Credit is granted on four major grounds: by getting a security, without any security (an unsecured loan), by having guarantee of a third party or by making use of a sale as a security arrangement. (24) These security-by-sales arrangements provide a reasonable level of security to the person who advances money, but in most situations he is not a typical creditor. These transactions, not being typical loans, cannot be described to be made on the basis of security; instead they are said to be made for quasi securities. Hereunder are the most shared types of quasi-security:

RETENTION OF TITLE:

In case, a bank finances a company to buy some machinery, raw material or any other item, it may require retaining of the title of such items with itself unless the complete amount loaned for the buy is paid off. ‘Retention of title clause’ in an agreement, typically, defends such items from any claims by other secured or preferential creditors (25), in case of insolvency of the debtor, as long as this item is recognizable (26). However if such an item is processed and loses its identity before the insolvency proceedings start, then the title cannot be retained (27). In that case, the title holder will have to be among other unsecured creditors. This kind of security is typical for trade creditors.However, a bank can assistance from this method in certain situations; although edges, in case of other creditors, have expressed disapproval of retention of title. (28) ‘Surveys suggest that majority of suppliers use such clauses in their conditions of sales’ (29). But they can only bear a fruit if the user of these clauses are not affected by the complicate, time-consuming and expensive legal proceedings involving a number of other secured and unsecured creditors. Critics usually do not find the retention of title clause as useful as it seems on the confront of it: ‘the device fails, at the end of long and legally uncertain day, to deliver real protection to the quasi-secured creditor.’ (30) It, however, remains equally effective in liquidation, administrative receivership, administration and voluntary arrangement, in the event of insolvency of the debtor. (31)

HIRE buy:

This is another mode of securitization that is a sale arrangement of the confront of it but in fact operates as a security device. It is a method of buying goods in which the buyer advances a small amount as place to the seller and takes the possession of the goods (and not the title), as a bailee. The balance price is paid in periodical installments over a longer period of time. When the price is fully paid off, the ownership is transferred to the buyer. During this period from taking possession till getting ownership, if the buyer defaults in payments, the seller can exercise his right to take the goods back being the real owner. This is something like ‘retention of title’. This method is generally used by the small and medium businesses and the trade creditors. But it can be used by the edges to improvement loan in cash while converting it into kind _ by purchasing the required equipment or land etc for the debtor _ and retaining the title until the debt is paid off. However, a character purchased mainly for credit purposes, _ which originally meant for some different use by the original owner _ sometimes, may not be one easily disposable. In such a case, the creditor may have to sell it at a lower price to save expense of resources on looking after it. nevertheless it is a better option to safeguard the interests of the creditor. That is why there has been a rise in number in this kind of arrangements in recent years (32).

SALE AND LEASE BACK:

This is another way for a person or company to obtain money by sale of an asset to a bank or lender. But the sale agreement includes the condition that the same asset would be leased back to the seller for certain period of time on agreed terms and condition. consequently the seller secures required amount without losing the right to use that asset, while the buyer gets the ownership in lieu of the amount paid; and consequently gets secured. This kind of agreement despite not being a security offers more than sufficient security; and falls under the category of quasi security. This is said to be a lower-cost method by the creditors to unprotected to priority in insolvent regimes (33).This can reasonably safeguard the position of the creditors. Quasi Securities are quite an interest occurrence. They are not securities in the true sense of the information; however they provide security to a creditor at the level of an original security. All of these arrangements _ of apparent sale for the purpose of security _ are well-liked by the lenders (buyers) and the debtors (sellers). But certain critics look at them from a different angle. To them, these seem to be tools of the so-called secured creditors and the debtors to grab the assets of companies leaving nothing for other classes of creditors in case of bankruptcy. consequently, this occurrence looks like another aspect of ‘bankruptcy Darwinism’ (34). And if these types of arrangements continue, some critics predict more losses for the other classes of creditors: ‘If, however, the debtor looks to quasi security and shifts its asset patterns so as rely more heavily on the use of assets that are leased or unprotected to hire buy agreements, retention of title or other sale-based security devices, the protection offered to the secured creditor will be reduced. Fewer assets will go into the insolvent estate in the scenario involving heavy reliance on quasi-security and the holder of, say, a floating charge, will have a call on a slimmer body of assets.’ (35) Anyway, quasi securities are good safeguards for the creditors.Continued as SAFEGUARDS OF CREDITORS – II

REFERENCES:

1. Dewett, K K (1984) Modern Economic Theory 21st ed, New Delhi: Shyam Lal Charitable Trust, p 449

2. Keay, A. R. & Walton P. (2003) Insolvency Law: Corporate and Personal, Harlow: Pearson Longman p 425
3. Paul C & Montagu G (2003) Banking and Capital Markets Companion, London: Cavendish Publishing,p2

4. Keay, A. R. & Walton P. op cit p 53

5. Mistelis, L ‘The EBRD Modern Law on Secured Transactions and its Impact of Collateral Law Reform in Central and Eastern Europe and the Former Soviet Union” (1998) 5 Parker School Journal of East European Law 455 at 456-7, as in McCormack, Gerard (2004) Secured Credit under English and American Law, Cambridge: Cambridge University Press, p 16

6. Mann, Ronald J (1997) “Explaining the Pattern of Secured Credit” Harvard Law Review 110 Harv L Rev 674
7. Ministry of Development , New Zealand (2004) ;Current New Zealand Law in Context of Rescue; obtainable at visited on 05-08-2005

8. Scott, R (1994) ‘The Politics of Article 9’, 80 Va L Rev 1783 at 1784-5, as in McCormack, G op cit p 5
9. Oxford Dictionary of Law, 5th ed. (2003) Elizabeth A Martin, Ed., Oxford: Oxford University Press

10. Finch V (1999) ;Security, Insolvency and Risk: Who Pays the Price?” in Modern Law Review, Vol 62, No. 5 pp 633-670, at p 639
11. ibid
12. Keay, A. R. & Walton P. op cit p 55
13. Finch V op cit p 639
14. Dine, J (2001) Company law 4th ed. Basingstoke: Palgrave, p 347
15. s. 175 Insolvency Act, 1986
16. Keay, A (2001) “Balancing Interests in Bankruptcy Law” in shared Law World Review 206-235 p 211

17. Keay, A (1998) “Preferences in Liquidation Law: A Time for a Change” in Company Financial and Insolvency Law Review, Vol 2 1998 198-216, p 216
18. “Eighth Survey of Company Insolvency” (1997-8), by Society of Practitioners of Insolvency, p 20; see generally Milman, D & Mond, D (1999) Security and Corporate Rescue, London: Hodgsons; as in McCormack, G op cit p 7
19. Franks, J and Sussman, O (2000) “The Cycle of Corporate Distress, Rescue and Dissolution: A Study of Small and Medium Size UK Companies” obtainable at http://facultyresearch.london.edu/docs/306.pdf > visited on 10-08-2005
20. Clarke, W M (2004) How the City of London Works London: Sweet & Maxwell 6th Ed p 122
21. Campbell, Andrew and Cartwright, Peter (2002) edges in Crisis: The Legal Response, Aldershot: Ashgate Publishing Company, p 7
22. Salomon v. A. Salomon & Co ; [1897] AC 22 at 52
23. British Bankers’ Association (BBA) as referred to in, McCormack, G op cit p 10
24. Finch V op cit p 634
25. Keay, A. R. & Walton P. op cit p 431
26. Hendy Lennox (Industrial Engines) Ltd v Grahame Puttick Ltd ([1984] 1 WLR 485) as quoted by Keay, A. R. & Walton P. ibid p 432
27. Borden (UK) Ltd v Scottish Timber Products Ltd ([1981] Ch 25), as quoted by Keay, A. R. & Walton P. ibid p 433

28. Milman, D and Durrant, C. (1999) Corporate insolvency: law and practice, London: Sweet & Maxwell, Ch 9
29.Finch V op cit p 636
30. Ibid p 649
31. Keay, A. R. & Walton P. op cit pp 433-4
32. Finch V op cit 636

33. Jackson T & Kronman (1979) “Secured Financing And Pirorites Among Creditors” 88 Yale LJ 1143, as referred to in Finch op cit p 652
34. Gross, Karen (1994) “Taking Community Interests into Account in Bankruptcy: An Essay; Washington University Law Quarterly Vol. 72 pp 1031-1048 at p 1040

35. Finch V op cit p 648

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