Different types of security can give lenders different degrees of protection, through: (1) enabling lenders to exert differing degrees of control over borrowers; and (2) giving lenders priority over borrowers’ assets if those borrowers become insolvent.
Control
- The type of security taken by a lender can dictate the extent to which that lender can control the borrower’s use of the secured assets.
- For instance, if Lender A takes a ‘fixed charge’ over Borrower Z’s factory, the agreement will likely include terms that prohibit Borrower Z from:
- Disposing of (selling) that factory without Lender A’s consent; and
- Granting security over that factory to other lenders before Lender A has been fully repaid (the clause in an agreement setting out this prohibition is known as a ‘negative pledge’ clause).
- If instead Borrower Z grants Lender A a ‘floating charge’ over its assets, Borrower Z will typically remain free to sell the secured assets unless and until certain pre-specified events occur (e.g. Borrower Z fails to make an interest payment to Lender A on time).
- Secured Assets: assets over which the borrower has granted security to the lender. For example, when a bank lends money to the purchaser of a house, the house is typically the ‘secured asset’.
Priority
- The type of security taken by a lender can also dictate that lender’s ranking in the order of priority.
- If Company A becomes insolvent, its assets will be liquidated (sold off to raise cash) so that the parties to which Company A owes money (Company A’s ‘creditors’) can be repaid. If Company A has borrowed from multiple lenders, all the lenders that are still owed money by Company A will want to be repaid. However, the assets remaining after a borrower becomes insolvent are typically insufficient to repay all the debts it owes. The law deals with such circumstances by setting out a system of priority between lenders.
- Security can ensure that lenders are repaid (out of the proceeds from the sale of the secured assets) in priority to other lenders that either do not have the benefit of security, or have security that ranks lower in priority. The type of security taken by a lender will dictate the extent to which it is given priority over other lenders. Lenders that have fixed charges over a borrower’s assets rank above lenders that have floating charges over a borrower’s assets, whilst lenders without security over a borrower’s assets will generally rank beneath lenders that do have some form of security.
- Note that a company may have possession of property that does not belong to it, such as machinery that is leased/borrowed or goods that have been supplied on terms that ensure those goods remain the supplier’s property until they have been paid for in full. These items must be returned to their actual owners; they cannot be sold for the benefit of the insolvent company’s lenders.
- By way of example, let’s assume that Lender A is owed £100,000 and has a fixed charge over Borrower Z’s assets; Lender B is owed £100,000 and has a floating charge over Borrower Z’s assets; and Lender C is owed £100,000 and has no security over Borrower Z’s assets. If Borrower Z becomes insolvent and only £150,000 remains after all its assets have been sold, Lender A will receive back it’s £100,000 in full; Lender B will receive back the remaining £50,000 (which covers at least some of the money it is owed); and Lender C will receive back nothing, as unsecured creditors rank lower in the order of priority.
- Secured Creditors: lenders that have been granted security over a borrower’s assets.
- Unsecured Creditors: lenders that do not have the benefit of security over any of a borrower’s assets.
Note that this section provides an oversimplification of the rules governing security. There are other rules that affect the order of priority. Lenders can contractually agree an alternative order of priority between themselves (using ‘intercreditor’ or ‘subordination’ agreements), whilst a certain proportion of the assets subject to a floating charge may be set aside (‘ring-fenced’) for unsecured creditors. Different forms of security may also be better suited to different types of assets. However, for the purposes of this handbook (i.e. interview and internship preparation), the detail in this section should be more than enough.
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By Jake Schogger - City Career Series