What Is ‘Security’?
Security is an essential form of protection for lenders. When giving a loan, a lender may take ‘security’ over a borrower’s assets in order to increase its chances of receiving back its money in full if the borrower defaults on the loan (fails to repay the loan as agreed), thus making lenders feel more secure. A borrower will offer security to persuade a lender to lend, or to persuade a lender to charge lower interest rates on the loan (in recognition that there is a lower risk of that lender not receiving back the money lent in full). ‘Security’ in this context refers to a right given by a borrower to a lender. This right usually relates to some (or all) of the borrower’s assets, and typically entitles the lender to sell enough of those assets to repay itself if the borrower fails to repay the loan as agreed.
- When the lender takes such action, this is known as the lender ‘enforcing’ its security, i.e. invoking the pre-agreed right to sell the asset(s) and retain some or all of the proceeds. There still exists a risk that an asset over which security is taken will decrease in value to the extent that the secured lender would not fully recoup the money it is owed if the borrower defaults and that asset is sold. Lenders may therefore take security over assets worth more than the loan.
- If a lender invokes its right to sell the relevant asset(s), it must however return any excess proceeds to the borrower once it has recouped the amount it is owed. Note that the lender can only invoke its right to sell the borrower’s assets if pre-agreed circumstances arise, most notably if the borrower defaults on the terms of the loan (e.g. fails to make an interest payment to the lender on time).
Over Which Assets Can Security Be Taken?
Security can be taken over a variety of assets. A purchaser of a home gives a lender a mortgage (this is a type of security) over his or her house in exchange for a loan. In simple terms, if that purchaser fails to repay the lender as agreed, the mortgage (security) entitles the lender to sell the house and repay itself out of the sale proceeds. In larger commercial transactions, there may be multiple lenders that collectively provide a loan (a ‘syndicated’ loan), and the amounts lent may be in the hundreds of millions rather than the hundreds of thousands. However, the basic premise is the same.
- Syndicated Loan: where multiple banks work together to contribute funds in order to provide the required capital. The syndicate of banks share both interest payments from the borrower and risk. Syndicated loans are more viable where the borrower requires a large amount of capital, as these loans can be complicated and expensive to administer.
Borrowers in commercial transactions will typically be companies that own a wide range of assets. Lenders will usually take security over one or more of these assets (as they would over a house when lending to the purchaser of a home). These assets typically include factories, machinery and stock.
However, lenders can take security over a much wider range of assets, for instance: cash the borrower has in its company bank accounts; money the borrower is owed but has not yet received from its customers (this money is referred to as ‘book debts’); work in progress (i.e. products that have not yet been fully manufactured); the borrower’s intellectual property rights; and shares the borrower owns in other companies (e.g. shares in its subsidiaries).
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