Collateral

BFS 3001 S. Parkes

LENDING

UNIT 4

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Objectives: In this unit, the students
will do the following:

• Identify the advantages and

disadvantages of various forms of
security.

• Value the various forms of security.

• Assess the risk in security used as

collateral for a loan.
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 Collateral
Property, which is pledged as
security for the satisfaction of a debt.
Collateral is additional security for
performance of principal obligation.

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 Security
An obligation, pledge, mortgage, deposit,
lien, etc., given by a debtor in order to
assure the payment or performance of
his debt, by furnishing the creditor with a
resource to be used in case of failure in
the principal obligation.

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 OVERVIEW

Lending Institutions take security to

protect against risks, the risk of the
borrower dishonouring the agreement to
repay the liabilities. All exposures carry a
degree of risk and security is the tool
used by most lenders to protect against
the risk of default.

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 OVERVIEW

• Despite the use of security as a

measure of protection, institutions are
still faced with the losses arising from in
adequate security, inability to realize the
security, challenges by borrowers and
in some cases the reality that the
security offers absolutely no protection
whatsoever.
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Collateral - an asset pledged to
a lender

• Collateral is an asset pledged to a lender,

until the borrower pays back the debt.
• In case of default the lender has the right to
seize the collateral and sell it.
• Collateral serves to protect the lender against
risk; it screens potential borrowers and is an
incentive to respect the repayment obligation.

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 Collateral

• Depending on the nature of the assets, the

extent of physical possession and the relation
with the underlying debt claim, one
distinguishes broadly
– personal guarantees,
– assignment for security,
– debentures,
– pledging and
– mortgage.

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 Bank’s preference of
collateral
• Not all forms of collateral are equally
accepted by banks: their preference is
determined by:
– Present and anticipated transaction costs
in establishing and enforcing property
rights,
– the ease of liquidation and
– the position vis-à-vis other creditors in case
of insolvency.

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 Bank’s preference

• In principle, there is a close link between loan

size and the extent and quality of
collateralization:
• the larger a loan, the more the bank will be
inclined to require a form of collateral that:
– retains its value over time
– can be easily sold, taking into account the
respective transaction costs involved

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 Transaction costs

• Transaction costs in connection with

collateralization can be considerable.
Banks try to externalize some of these
transaction costs to the borrower or to
an intermediary; banks also seek to
compensate for insufficiently attractive
collateral by charging higher interest
rates, wherever that is possible..
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 preference of borrowers

• The preference of borrowers for some

form of collateral or another is
determined by:
– transaction costs,
– incidence on business activities
– social exposure

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 THE FUNCTIONS OF
COLLATERAL

• The lender has the right to demand

collateral: basically, collateral
serves the lenders' interests:
– Protection against risk
– Screening

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Protection against risk

• Collateral must limit a lender's losses by

giving the lender a protection against
the partial or total loss of resources.
• (in addition to the intrinsic capacity of
the financed activity to generate a
surplus).

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 Screening
• Collateral is also a screening device (next to a
number of other screening devices built into a loan
contract, for example the interest rate).
• The pledge in a collateral arrangement means that
the borrower could lose part of his property if he does
not pay back; the borrower has an interest in paying
back.
• The hesitation of a borrower to provide collateral
could signal to the bank that the borrower is fully
aware of the implications of making this pledge, and if
he does provide collateral, then he is likely to do
everything to avoid the loss of the pledged asset.

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 Testing for good security
• M.A.S.T
– Marketability – The asset should be able to be
sold easily
– Ascertainability of Value – it should be easy to
obtain a value for the asset.
– Simplicity of Title - it should be easy to ascertain
the legal owner of the security and, thus, the
person(s) who must execute the mortgage or
charge.
– Transferability of Title – it must be easy to transfer
title to the bank so that the asset can be sold if
required.
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 Very Little Money Indeed

• Value- it should be easy to obtain

a value;
• Legal mortgage - it should be possible to take
a legal mortgage;
• Marketability - the asset should be able to
be sold easily;
• Increase in value - the value of the asset
should rise during the period of the load.

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 REASONS FOR TAKING
SECURITY
• Alternate source of repayment-the essential
feature face secured alone is that the Boren
and gives the lender the right to resort to the
security to obtain prepayment in the event of
default
• To compel the borrower to honour his
obligations to the institution and ensure due
performance of the contract i.e. it reduces the
risk of nonpayment to the lender.

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 CHARACTERISTIC OF
GOOD SECURITY

• Taking security means acquiring

equitable for legal rights over and
assets pledged as security. Some
assets are more suited as security
because of certain characteristics that
makes them more attractive to the
lender.

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 These are as follows:

• The these are valuation

• Marketability
• Salability
• Capable of retaining the valley overtime
• Ease of identification
• Ease of realization

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 TAKING COMPANY
SECURITIES

Documents to be perused:
• Certificate of Incorporation
– This is evidence that the Company is
incorporated as a limited liability
company under the Companies Act.
– Used to check the correct name of the
Company and the address of the
Registered Office.

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 The Memorandum of
Association
• This is used to ascertain the objects of the
Company and to ensure that the company
has the power to borrow and give security
including a guarantee if it is not a trading
Company.
• (Note that trading Companies have an implied
power to borrow). The purpose for which the
security is to be given must fall within the
objects of the Company.

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Articles of Association

• This is used to ascertain the power of the

Directors and whether they have the power to
charge securities for borrowing and the limit if
any of such amounts that can be borrowed.
• It also indicates who is empowered to sign on
the company’s behalf and to ensure that the
Director’s are acting within their delegated
authority.

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 Articles of
Incorporation
• Under the new Companies Act the
Articles of Incorporation replaces both
the Memorandum of Association and
the Articles of Association the
company can do any thing it desires but
can list the objects which it is precluded
from doing. Removing the impact of
Ultra Vires.
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 Commercial Justification

• The borrowing should be examined to

ensure that it is being done for the
benefit of the company and is done in
the best interest of the company.

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The following questions will help
and should be asked prior to
commitment by the Institution.
1. Does the company have the power in its
memorandum to borrow?
2. Is there any limitation on the amount?
3. Is the purpose of the borrowing consistent
with the objects of the company as stated in
its memorandum?
4. Is there commercial justification? In other
words is the borrowing for the benefit of the
company, any resemblance that it could be
for the personal benefit of Directors should
be investigated.
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5. How and by whom can the power be
exercised as per the Articles?
6. Is there any limitation on the amount
that can be borrowed?
7. Was there a meeting of Directors in
accordance with the Articles and was
the appropriate resolution passed?

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Steps to be followed in respect
of Company Securities:

• Search must be conducted at the Registrar

of Companies.
• Registration of the charge must take place
within (21) days of its creation at the
Registrar of Companies.
• Prior charges must be ascertained
• The Directors guarantees should be taken
except when this is not necessary e.g.
where the advance is fully cash secured.

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• Registration must take place at other
relevant statutory bodies e.g. at the Island
Record Office.
• Must be entered on the charges register at
the registered office of the company.
• The reliance placed of the search at the
Registrar of Companies must be measured.

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 Types of Securities

• DEBENTURES
• LAND AS SECURITY
• STOCK AND SHARES AS SECURITY
• GUARANTEES
• LIFE INSURANCE POLICIES AS SECURITY
• BILL OF SALE
• LETTER OF SET –OFF
• ASSIGNMENTS / HYPOTHECATION
• LAWYERS UNDERTAKING
• SPECIALIST SECURITIES
– Agricultural Charges

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 DEBENTURES

• Technically any document

acknowledging indebtedness is a
debenture, but the term is used
generally to mean an instrument sealed
by a limited company, which makes
provision for the repayment of a sum of
money at some future time.

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 Debenture

• The debenture may be a security for all

sums owing by the company to the
chargee or it may be limited in the
amount it secures. These are known as
‘all monies’ debentures and ‘fixed sum’
debentures respectively.

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 ADVANTAGES OF A
DEBENTURE AS A SECURITY

1. Captures assets subsequently acquired by

the company.
2. Prevent the company from charging its
assets to another institution thus giving the
lender control over the company’s
borrowings.
3. Gives the lender a fixed charge over the
fixed assets.
4. Provides a specific equitable charge over
any real property, which the company might
acquire at any time in the future.
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 ADVANTAGES OF A
DEBENTURE AS A SECURITY

5. Creates an ‘effective and comprehensive’ security

which can cover the entire undertaking of a
company, while leaving the company and its
officers free to deal with those assets in ordinary
day-to-day affairs and business.
6. Security is all embracing and has the attraction that
in the necessary circumstances a receiver can be
appointed to take immediate control of the
business, and to continue trading, if appropriate.
7. Unsecured non-preferential creditors have no
rights.

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 DISADVANTAGES OF A
DEBENTURE AS A SECURITY

1. The lender has no control over floating

assets.
2. The lender must appoint a receiver to
convert the charge from a floating one to a
fixed charge.
3. The assets caught under the floating charge
can disappear.
4. Losses can reduce the value of the floating
charges before the lender is aware of such
losses.

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 DISADVANTAGES OF A
DEBENTURE AS A SECURITY

5. The order of priority of payments to

preferential creditors may render the
debenture of no value to the institution.
6. Floating charge will be invalid where it is
given within twelve months of the
commencement of the winding up of the
company or the presentation of a petition for
winding up of the company.
7. Preferential creditors such as PAYE, GCT,
etc must be paid in priority to the holder of
the floating charge.

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 DISADVANTAGES OF A
DEBENTURE AS A SECURITY

8. The company may create a fixed or

equitable charge subsequently over the
assets, which have been charged by way of
the floating charge, and the fixed charge
holder would have priority over the floating
charge.
9. An accurate valuation of a floating charge is
difficult.
10. Action by creditors – Creditors who receives
court judgment and seeks to enforce .
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 DISADVANTAGES OF A
DEBENTURE AS A SECURITY

11. Retention of title – where a supplier of

goods to the company retains the title to
those goods until they are paid for even
though it appears in the balance sheet they
are owned by some one else.
12. Costs – before appointing a receiver legal
advice is required and the cost of the
receiver

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 LAND AS SECURITY

Land or real property has always represented good

security for lenders due to the following:
• Land is immovable; the borrower therefore cannot
hide the security from the lender.
• Land and real property tend to appreciate in value,
this is especially so in the cases of residential
properties.
• The lender’s charge if taken by way of a legal
mortgage offers certain protection to the lender.
• The state – backed Certificate of Title is evidence
of ownership.
• Easily valued/salability is good.

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 LAND

• The lender’s charge if taken by way of a

legal mortgage offers certain protection
to the lender.
• The state – backed Certificate of Title is
evidence of ownership.
• Easily valued/salability is good.

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ADVANTAGES OF LAND AS A
SECURITY

• In normal times land and property tend

to be stable in value, even though short-
term variations occur, and over the
longer period appreciation of prices in
line with inflation is seen.
• Unlike other securities land can always
be used productively.

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 DISADVANTAGES OF LAND
AS A SECURITY

• Property is not an easy security to realize,

especially if it’s a domestic home, occupied
by the mortgagor and his family. Resort to
court is then usually necessary, in order to
obtain a possession order.
• When possession is obtained, it is necessary
to find a purchaser and vacant property can
deteriorate rapidly if the market is not
buoyant.

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 DISADVANTAGES OF LAND
AS A SECURITY

• Estate agent cost and legal costs will need to

be incurred in realizing the security and these
though recoverable under the terms of the
charge, will mean that the forced sale value
of the property will almost certainly be less
than the open market value placed on the
property in happier times.
• T o value a property can be a difficult
exercise, except where it is a domestic
house, similar in size and location to others,
which have changed hands recently.

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 DISADVANTAGES OF LAND
AS A SECURITY

• It is particularly hard to value commercial

property, such as factories and offices.
• If a tenancy is created after the banks
mortgage, this can have a detrimental effect
upon the valuation of the security.
• Land is expensive to mortgage, as legal cost
are invariably incurred and registration fees at
the titles office.

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 STOCK AND SHARES AS
SECURITY
• Security can be taken by an instruction in the
form of registered stock or shares in a
company, usually in a listed company. To
take a legal charge/mortgage over stock and
shares means that the borrower must transfer
his shares to be registered in the name of the
lender or his nominee as a registered
shareholder until charge/mortgage is
discharged.

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ADVANTAGES OF STOCK AND
SHARES AS SECURITY

• It is fairly easy to take a charge over

these forms of security, particularly as
an equitable charge by means of
memorandum of deposit.
• Obtaining a valuation is easy because
up-to-date prices are publicly available.
• The security can be easily realized if the
customer defaults.

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ADVANTAGES OF STOCK AND
SHARES AS SECURITY

• Fairly common type of security lodged by

private customers to secure borrowings.
• Can be handled quickly and cheaply with a
minimum of formalities and banks have
standard printed transfer forms ready in their
branches so that registered securities can be
transferred out of the holders name and into
the banks name thus effecting a legal
mortgage.

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ADVANTAGES OF STOCK AND
SHARES AS SECURITY

• They are fully negotiable instruments,

and the bank can therefore technically
obtain a bearer title as mortgage.
• These bearer bonds can readily be
sold, if required, without the co-
operation of the customer

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ADVANTAGES OF STOCK AND
SHARES AS SECURITY

• Security steps are few and it is not necessary

for the bank to instruct a lawyer to investigate
the holder’s title to the security.
• Valuation for listed companies can be made
quickly- but the shares in unlisted companies
may pose difficulty to value the security
realistically, and problems may arise in
realizing the shares, should the customer fail
to repay.

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 DISADVANTAGES OF STOCK
AND SHARES AS SECURITY

• The value may fluctuate enormously so

institutions try to make sure that there is
a wide margin between the value of the
security and the amount lent.
• If a company restructures its shares for
example by a rights issue, there may be
problems, which could affect the
security.
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 DISADVANTAGES OF STOCK
AND SHARES AS SECURITY

• If there is a prior equitable interest in

existence at the time the bank takes it
as security, and in that event the earlier
interest will take precedence over the
bank’s charge. (Coleman v. London
County and Westminster Bank Ltd
(1916)

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 GUARANTEES

• Guarantees are referred as indirect forms of

security as it is used to secure the obligations
of some one other than the person getting the
loan facilities.
• A guarantee from a lending institution’s
position is a promise to be jointly and
severally liable for the debt of another person
or to perform some other legal obligation of
another.

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 GUARANTEES

• The person to whom the promise is

made i.e. the lending Institution, is
called the creditor, the person who
makes the promise is the guarantor or
surety and the person whose
obligations are guaranteed. (i.e. the
borrower), the principal debtor

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 ADVANTAGES OF
GUARANTEES AS SECURITY
• Guarantee is the easiest security to complete,
as the formalities associated with it are the
least.
• Less risk of technical irregularity, although
special care must be applied when taking
Guarantee from a limited company.
• Bank is normally able to take legal action
against a guarantor as soon as demand has
been made on him and he has failed to pay.
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 ADVANTAGES OF
GUARANTEES AS SECURITY

• Demand can be made on the guarantor

without calling upon the principal debtor.
• A guarantee is worth as much as the
person who has given it, but can be
supported by other security, and where
this is so the bank is in a much safer
position.

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 ADVANTAGES OF
GUARANTEES AS SECURITY
• Whether a guarantee is supported or not, a
guarantee is a third-party security and so it
can be ignored when proving a debt in the
estate of the principal debtor, the borrower.
• When a bank is lending to a limited company
it is particularly desirable to take personal
guarantees from the directors, for in this way
it makes them more personally associated
with the need for the company to repay the
bank.

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 DISADVANTAGES OF
GUARANTEES AS SECURITY
 Guarantees are difficult to realize – no
third party will be happy at having to pay
monies to meet another’s obligations.
• Negative publicity may arise out of a
case of the bank suing a guarantor

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 DISADVANTAGES OF
GUARANTEES AS SECURITY
 Legal proceedings are frequently
necessary to encourage a guarantor to
face up to his obligations and to meet
his liabilities and this means that cost
and lengthy litigation can be incurred
and during this time the guarantor might
be in a position to move his assets
beyond the reach of the bank.
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 BILL OF SALE

• Bills of sale can be used for individual

borrowings especial for consumer loans or for
company borrowings especially for consumer
loans or for company borrowings. In the case
of consumer loans this falls under the Hire
Purchase Act while loans on fixtures and
equipment, machinery etc. not of a
consuming nature comes under the Bills of
Sale Act.

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 BILL OF SALE

• There are dangers associated with this

type of security and the lender should
be aware of these:
– Difficulty in locating the item charged
under the Bill of Sale.
– Items are usually of a depreciating nature
– Difficulty in identifying the items charged
with certainty – risk of the lender
becoming liable for conversion

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 BILL OF SALE

– Existence of prior charges unknown to

the lender
– Loss of the item and inadequate or no
compensation from insurers.
– Insurers paying directly to borrower
instead of the bank.
– High cost of realization.

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 BILL OF SALE

• Restrictions in repossession of the

item if it falls under the Higher
Purchase Act.
• Restricted marketability especially in
cases of specialized equipment.
• Lack of Salability.

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 SPECIALIST SECURITIES

• Agricultural Charges
– Security over farming stock and other
agricultural assets.
• Cheap and easy to execute
• Affected by natural occurrences and other
market forces.

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 Agricultural Charges

In assessing agricultural loans one must

determine whether the proposed borrowing
can be repaid on the basis of:
• The story being put forward by the farmer;

• What the situation for the lender will be if

things go unexpectedly wrong, as they
undoubtedly can in a business like farming
which can be heavily affected by outside
factors, such as adverse weather conditions.

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 LETTER OF SET -OFF

• Gives the institution the right to set off a

credit balance against a debit balance,
there are prerequisites that must be
met, before the institution can proceed
to exercise its right to set-off.

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 Certainty of the
amount
• This means that the institution must be
able to clearly ascertain the sums
before they can proceed to set-off. In
other words, the institution cannot set-
off if the debt cannot be quantified with
certainty. Example in the case of
contingent liabilities.

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Between the Same Parties

• Before set-off can take place, the debt

due and the account in credit must be
between the same parties.

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 In the Same Right

• Before set off can be exercised the account

must be held in the same right. Example: An
Attorney's client account cannot be set-off
against the Attorney's personal liability.
Clearly the institution cannot exercise it's right
of set-off in these circumstances since the
accounts are not held in the same right, as an
account designated" client account" is
sufficient to put the institution on notice that
the funds in the account does not belong to
the Attorney.

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 AUTOMATIC RIGHT OF
SET-OFF
• In the following instances, there is an
automatic right of set-off.
• Upon the institution having notice of the death
of its customer
• Upon the customer being declared mentally
incapacitated
• Upon the receipt of a Garnishee Order or
Summons.
• Upon notice of bankruptcy.

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LIFE INSURANCE POLICIES
AS SECURITY

• Life policies are simple and cheap to

charge, and when a legal mortgage has
been taken they are readily realizable.
• Provided premiums are paid when they
are due, the bank can expect the
surrender value of a life policy to
increase steadily during the time it is
lodged with it.
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LIFE INSURANCE POLICIES

• If the premium is not paid there is a risk

that the policy might lapse, but in most
instances the life insurance company
will give notice to the assignee before
cancellation and it is more usual, in fact,
in those circumstances for an automatic
loan to come into operation and for the
surrender value to be reduced by the
amount of the unpaid premium.
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LIFE INSURANCE POLICIES

• The policy has a readily ascertainable

value in the form of a cash figure, which
can be obtained upon surrender, which
makes the security so attractive.

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 ADVANTAGES OF A LIFE
POLICY AS SECURITY
• Legal assignment of a policy can be
effected simply and a perfect title easily
established.
• Policies of the type accepted by the bank as
security have normally an increasing value
provided the premiums are paid.
• The security can be realized immediately if
the customer defaults.
• The policy proceeds are due immediately
the assured dies or upon earlier maturity.

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 DISADVANTAGES

• Since life policies are contracts of "uberrimae

fidei" (of the utmost good faith), non-
disclosure by the insured can enable the
insurer to avoid liability, also if the insurers
can prove that the assured failed to disclose
and did not act in utmost good faith. The
policy may also have exclusion of cover
clauses where the policyholder indulges
in dangerous activities. e.g. taking of drugs
etc.

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 DISADVANTAGES

• In Investment policies the value of such

policies is dependent on the
performance of the underlying
investments e.g. Real property, unit
trust etc. If these investments are not
profitable then the value of the policy
will diminish. A good example of this
took place in Jamaica in recent times.
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 DISADVANTAGES

• The policy's value is linked to the

policyholder's ability to keep up the
premiums. For the policy to be of value
the premiums must be paid as they fall
due.

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 ASSIGNMENTS /
HYPOTHECATION
• An assignment of a debt due from a
specified debtor or an assignment of the
benefits to be derived under a contract
can be of benefit in the right
circumstances. Where a charge is taken
over an existing specific debt or rights
under a contract, it will protect the bank
against a claim by a trustee in
bankruptcy to those monies.
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 ASSIGNMENTS /
HYPOTHECATION

• This type of security is easy to take

• Few formalities necessary in order to
perfect the security.
• Only covers debt rightly due to the
customer.
• Bank must give written notice to the
debtor

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 ASSIGNMENTS /
HYPOTHECATION
• Bank cannot sue debtor in its own name
and must rely on customer’s support if
any action is to be taken.
• Become the subject of counter claims
by the debtor
– Right of setoff
– Allege bad workmanship
– Or breach of contract

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 Legal Assignments:

• There are certain assignments, which are

commonly assigned to lenders, these include
the following:
• Assignment of contract proceeds (Present &
Future)
• Assignment of salary, bonus and other
benefits
• Assignment from the sale of agricultural
products e.g. sale of coffee to the Coffee
Industry Board, Bananas to The Banana
Board & Sugar.
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• The Following should be observed:
• Such assignments must be in writing and must state
the amount.
• Must be communicated to the person/ institution.
• The borrower must complete the assignment form
• Acknowledgement must be obtained from the
institution.
• Enquiries must be made if there are previous
assignments/ any rights of set off between the
borrower and the institution.
• It must be irrevocable

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 Assignments of Future
Debts under a contract:
1. Failure to perform
2. Damages that can become due as a result
of the actions/ or in actions of the
contractor
3. Delays
4. Assignments for Companies should be
registered at the Registrar of Companies

5. Inability of the principal to honor payments

to under the contract from bankruptcy.
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 HYPOTHECATION OF
CREDIT BALANCES

• The account must be held in the same

right
• A hold must be placed on the Account
• All parties to the account must complete
the hypothecation form
• Original Certificate of deposit must be
held by the institution

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 LAWYERS UNDERTAKING

• When a customer’s lawyer is acting for

him, and monies will be obtained and
become payable by the lawyer to the
customer, it is possible for the bank to
ensure that those funds come to the
bank by obtaining the customers
irrevocable authority in writing
addressed to the Lawyer, authorizing
him to pay monies to the bank..
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