Security interest
Encyclopedia
A security interest is a property interest created by agreement or by operation of law over assets to secure the performance of an obligation, usually the payment of a debt. It gives the beneficiary of the security interest certain preferential rights in the disposition of secured assets. Such rights vary according to the type of security interest, but in most cases, a holder of the security interest is entitled to seize, and usually sell, the property to discharge the debt that the security interest secures.
in case the debtor defaults on the obligation. If the debtor goes bankrupt, a secured creditor takes precedence over unsecured creditor in the distribution.
There are other reasons that people sometimes take security over assets. In shareholders' agreements involving two parties (such as a joint venture
), sometimes the shareholders will each charge their shares in favor of the other as security for the performance of their obligations under the agreement to prevent the other shareholder selling their shares to a third party. It is sometimes suggested that banks may take floating charge
s over companies by way of security - not so much for the security for payment of their own debts, but because this ensures that no other bank will, ordinarily, lend to the company, thereby almost granting a monopoly in favour of the bank holding the floating charge on lending to the company.
Some economists question the utility of security interests and secured lending generally. Proponents argue that secured interests lower the risk for the lender, and in turn allows the lender to charge lower interest, thereby lower the cost of capital for the borrower. Compare, for example, interest rates for a mortgage loan
and for a credit card
debt.
Detractors argue that creditors with security interests can destroy companies that are in financial difficulty, but which might still recover and be profitable. The secured lenders might get nervous and enforce the security early, repossessing key assets and forcing the company into bankruptcy. Further, the general principle of most insolvency regimes is that creditors should be treated equally (or pari passu
), and allowing secured creditors a preference to certain assets upsets the conceptual basis of an insolvency.
More sophisticated criticisms of security point out that although unsecured creditors will receive less on insolvency, they should be able to compensate by charging a higher interest rate. However, since many unsecured creditors are unable to adjust their "interest rates" upwards (tort claimants, employees), the company benefits from a cheaper rate of credit, to the detriment of these non-adjusting creditors. There is thus a transfer of value from these parties to secured borrowers.
Most insolvency law allows mutual debts to be set-off
, allowing certain creditors (those who also owe money to the insolvent debtor) a pre-preferential position. In some countries, "involuntary" creditors (such as tort
victims) also have preferential status, and in others environmental claims have special preferred rights for cleanup costs.
The most frequently used criticism of secured lending is that, if secured creditors are allowed to seize and sell key assets, a liquidator or bankruptcy trustee loses the ability to sell off the business as a going concern
, and may be forced to sell the business on a break-up basis. This may mean realising a much smaller return for the unsecured creditors, and will invariably mean that all the employees will be made redundant.
For this reason, many jurisdictions restrict the ability of secured creditors to enforce their rights in a bankruptcy. In the U.S., the Chapter 11
creditor protection, which completely prevents enforcement of security interests, aims at keeping enterprises running at the expense of creditors' rights, and is often heavily criticised for that reason. In the United Kingdom
, an administration order
has a similar effect, but are less expansive in scope and restriction in terms of creditors rights. European systems are often touted as being pro-creditor, but many European jurisdictions also impose restrictions upon time limits that must be observed before secured creditors can enforce their rights. The most draconian jurisdictions in favour of creditor's rights tend to be in offshore financial centres, who hope that, by having a legal system heavily biased towards secured creditors, they will encourage banks to lend at cheaper rates to offshore structures, and thus in turn encourage business to use them to obtain cheaper funds.
and in common law
jurisdictions derived from English law, there are eight types of proprietary security interests: (1) 'true' legal mortgage; (2) equitable mortgage; (3) statutory mortgage; (4) fixed equitable charge, or bill of sale; (5) floating equitable charge; (6) pledge, or pawn; (7) legal lien; (8) equitable lien; and (9) hypothecation, or trust receipt.
Security interests at common law are either possessory or non-possessory, depending upon whether the secured party actually needs to take possession of the collateral). Alternatively, they arise by agreement between the parties (usually by executing a security agreement), or by operation of law.
The following discussion of the types of security interest principally concerns English law. English law on security interests has been followed in most common law
countries, and most common law countries have similar property statutes regulating the common law rules.
and real property
. Real property is the land, the buildings affixed to it and the rights that go with the land. Personal property is defined as any property other than real property.
". The law has historically taken a dim view of provisions which might impede this right to have the assets reconveyed (referred to as being a "clog" on the equity of redemption), although the position has become more relaxed in recent years in relation to sophisticated financial transactions.
References to "true" legal mortgages mean mortgages by the traditional common law method of transfer subject to a proviso in this manner, and references are usually made in contradistinction to either equitable mortgages or statutory mortgages. True legal mortgages are relatively rare in modern commerce, outside of occasionally with respect to shares
in companies
. In England, true legal mortgages of land have been abolished in favour of statutory mortgages.
To complete a legal mortgage it is normally necessary that title to the assets is conveyed into the name of the secured party such that the secured party (or its nominee) becomes the legal titleholder to the asset. If a legal mortgage is not completed in this manner it will normally take effect as an equitable mortgage. Because of the requirement to transfer title, it is not possible to take a legal mortgage over future property, or to take more than one legal mortgage over the same assets. However, mortgages (legal and equitable) are non-possessory security interests. Normally the party granting the mortgage (the mortgagor) will remain in possession of the mortgaged asset.
The holder of a legal mortgage has three primary remedies in the event that there is a default on the secured obligations: they can foreclose on the assets, they can sell the assets or they can appoint a receiver over the assets. The holder of a mortgage can also usually sue upon the covenant to pay which appears in most mortgage instruments. There are a range of other remedies available to the holder of a mortgage, but they relate predominantly to land, and accordingly have been superseded by statute, and they are rarely exercised in practice in relation to other assets. The beneficiary of a mortgage (the mortgagee) is entitled to pursue all of its remedies concurrently or consecutively.
Foreclosure is rarely exercised as a remedy. To execute foreclosure, the secured party needs to petition the court, and the order is made in two stages (nisi and absolut), making the process slow and cumbersome. Courts are historically reluctant to grant orders for foreclosure, and will often instead order a judicial sale. If the asset is worth more than the secured obligations, the secured party will normally have to account for the surplus. Even if a court makes a decree absolut and orders foreclosure, the court retains an absolute discretion to reopen the foreclosure after the making of the order, although this would not affect the title of any third party purchaser.
The holder of a legal mortgage also has a power of sale over the assets. Every mortgage contains an implied power of sale. This implied power exists even if the mortgage is not under seal. All mortgages which are made by way of deed also ordinarily contain a power of sale implied by statute, but the exercise of the statutory power is limited by the terms of the statute. Neither implied power of sale requires a court order, although the court can usually also order a judicial sale. The secured party has a duty to get the best price reasonably obtainable, however, this does not require the sale to be conducted in any particular fashion (i.e. by auction or sealed bids). What the best price reasonably obtainable will be will depend upon the market available for the assets and related considerations. The sale must be a true sale - a mortgagee cannot sell to himself, either alone or with others, even for fair value; such a sale may be restrained or set aside or ignored. However, if the court orders a sale pursuant to statute, the mortgagee may be expressly permitted to buy.
The third remedy is to appoint a receiver. Technically the right to appoint a receiver can arise two different ways - under the terms of the mortgage instrument, and (where the mortgage instrument is executed as a deed) by statute.
In England, a third remedy, "appropriation" may exist under The Financial Collateral Arrangements (No.2) Regulations 2003 where the assets subject to the mortgage are 'financial collateral' and the mortgage instrument provides that the regulations apply. Appropriation is a means whereby the mortgagee can take title to the assets, but must account to the mortgagor for their fair market value (which must be specified in the mortgage instrument), but without the need to obtain any court order.
If the mortgagee takes possession then under the common law they owe strict duties to the mortgagor to safeguard the value of the property (although the terms of the mortgage instrument will usually limit this obligation). However, the common law rules relate principally to physical property, and there is a shortage of authority as to how they might apply to taking "possession" of rights, such as shares. Nonetheless, a mortgagee is well advised to remain respectful of their duty to preserve the value of the mortgaged property both for their own interests and under their potential liability to the mortgagor.
Under the laws of some jurisdictions, a mere deposit of title documents can give rise to an equitable mortgage. With respect to land this has now been abolished in England, although in many jurisdictions company shares can still be mortgaged by deposit of share certificates in this manner.
Generally speaking, an equitable mortgage has the same effect as a perfected legal mortgage except in two respects. Firstly, being an equitable right, it will be extinguished by a bona fide purchaser for value who did not have notice of the mortgage. Secondly, because the legal title to the mortgaged property is not actually vested in the secured party, it means that a necessary additional step is imposed in relation to the exercise of remedies such as foreclosure (although in the recent case of Alfa Telecom Turkey Limited v Cukurova Finance International Limited HCVAP 2007/027, heard in the Eastern Caribbean Court of Appeal as to matters of English law (and so currently subject to appeal to the Privy Council
), it was held that an equitable mortgagee could enforce security over financial collateral (in this case shares) by informing the interested mortgagor and other interested parties of the fact without first taking possession of shares or having his ownership interest recorded in the register.
An equitable charge is also a non-possessory form of security, and the beneficiary of the charge (the chargee) does not need to retain possession of the charged property.
Where security equivalent to a charge is given by a natural person (as opposed to a corporate entity) it is usually expressed to be a bill of sale
, and is regulated under applicable bills of sale legislation. Difficulties with the Bills of Sale Acts in Ireland, England and Wales have made it virtually impossible for individuals to create floating charges.
The pledgee has a common law power of sale in the event of a default on the secured obligations which arises if the secured obligations are not satisfied by the agreed time (or, in default of agreement, within a reasonable period of time). If the power of sale is exercised, then the holder of the pledge must account to the pledgor for any surplus after payment of the secured obligations.
A pledge does not confer a right to appoint a receiver or foreclose. If the holder of pledge sells or disposes of the pledged assets when not entitled to do so, they may be liable in conversion to the pledgor.
systems, is a right to retain physical possession of tangible assets as security for the underlying obligations. In some jurisdictions it is a form of possessory security, and possession of the assets must be transferred to (and maintained by) the secured party. The right is purely passive; the secured party (the lienee) has no right to sell the assets - merely a right to refuse to return them until paid. In the United States, a lien can be a non-possessory security interest. See the main article: lien for a discussion of the differences between the United States and other common law countries.
Most legal liens arise as a matter of law (mostly by common law, but also by statute), however, it is possible to create a legal lien by contract. The courts have confirmed that it is possible to also give the secured party a power of sale in such a contract, but case law on such a power is limited and it is difficult to know what limitations and duties would be imposed on the exercise of such a power.
An equitable lien takes effect essentially as an equitable charge, and they arise only in specified situations, (e.g. an unpaid vendor's lien in relation to property is an equitable lien; a maritime lien
is sometimes thought to be an equitable lien). It is sometimes argued that where the constitutional documents of a company provide that the company has a lien over its own shares, this take effect as an equitable lien, and if that analysis is correct, then it is probably the one exception to the rule that equitable liens arise by operation of law rather than by agreement.
ation, or "trust receipts" are relatively uncommon forms of security interest whereby the underlying assets are pledged, not by delivery of the assets as in a conventional pledge, but by delivery of a document or other evidence of title. Hypothecation is usually seen in relation to bottomry
(cf. bills of lading
), whereby the bill of lading is endorsed by the secured party, who, unless the security is redeemed, can claim the property by delivery of the bill.
".
Other obligations (i.e., recourse obligations) are backed by the full credit of the borrower. If the borrower defaults, then the creditor can force the obligor into bankruptcy and the creditors will divide all assets of the obligor.
Depending on the relative credit of the obligor, the quality of the asset, and the availability of a structure to separate the obligations of the asset from the obligations of the obligor, the interest rate charged on one may be higher or lower than the other.
With the Americanization of the world's legal profession, the second definition is becoming more frequently used commercially, and arguably is to be preferred, as the traditional English legal usage has little purpose except in relation to the comparatively rare true legal mortgage (very few other security interests require additional steps to attach to the asset, but security interests frequently require some form of registration to be enforceable on the chargor's insolvency).
arrangement, or execute undated transfer instruments. Whilst these techniques may provide protection for the secured party, they do not confer a proprietary interest in the assets which the arrangements relate to, and their effectiveness may be limited if the debtor goes into bankruptcy
.
It is also possible to replicate the effect of security by making an outright transfer of the asset, with a provision that the asset is re-transferred once the secured obligations are repaid. In some jurisdictions, these arrangements may be recharacterised
as the grant of a mortgage, but most jurisdictions tend to allow the parties freedom to characterise their transactions as they see fit. Common examples of this are financings using a stock loan or repo agreement
to collateralise the cash advance, and title transfer arrangements (for example, under the "Transfer" form English Law credit support annex to an ISDA Master Agreement (as distinguished from the other forms of CSA, which grant security)).
, under article 9 of the Uniform Commercial Code
which regulates security interests in personal property (as opposed to real property), a security interest is a right in a debtor
's property that secures payment or performance of an obligation.
A security interest is created by a security agreement, under which the debtor grants a security interest in the debtor's property as collateral
for a loan
or other obligation.
A security interest grants the holder a right to take a remedial action with respect to the property, upon occurrence of certain events, such as the non-payment of a loan. The creditor may take possession of such property in satisfaction of the underlying obligation. The holder will sell such property at a public auction
or through a private sale, and apply the proceeds to satisfy the underlying obligation. If the proceeds exceed the amount of the underlying obligation, the debtor is entitled to the excess. If the proceeds fall short, the holder of the security interest is entitled to a deficiency judgment whereby the holder can institute additional legal proceedings to recover the full amount unless it is a non-recourse debt like many mortgage loans in the United States.
In the U.S. the term "security interest" is often used interchangeably with "lien
". However, the term "lien" is more often associated with the collateral of real property than with of personal property.
A security interest is typically granted by a "security agreement". The security interest is established with respect to the property, if the debtor has an ownership interest in the property and the holder of the security interest conferred value to the debtor, such as giving a loan.
The holder may "perfect" the security interest to put third parties on notice thereof. Perfection is typically achieved by filing a financing statement with government, often the secretary of state located at a jurisdiction where a corporate debtor is incorporated. Perfection can also be obtained by possession of the collateral, if the collateral is tangible property.
Absent perfection, the holder of the security interest may have difficulty enforcing his rights in the collateral with regard to third parties, including a trustee in bankruptcy and other creditors who claim a security interest in the same collateral.
Rationale
A secured creditor takes a security interest to enforce its rights against collateralCollateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
in case the debtor defaults on the obligation. If the debtor goes bankrupt, a secured creditor takes precedence over unsecured creditor in the distribution.
There are other reasons that people sometimes take security over assets. In shareholders' agreements involving two parties (such as a joint venture
Joint venture
A joint venture is a business agreement in which parties agree to develop, for a finite time, a new entity and new assets by contributing equity. They exercise control over the enterprise and consequently share revenues, expenses and assets...
), sometimes the shareholders will each charge their shares in favor of the other as security for the performance of their obligations under the agreement to prevent the other shareholder selling their shares to a third party. It is sometimes suggested that banks may take floating charge
Floating charge
A floating charge is a security interest over a fund of changing assets of a company or a limited liability partnership , which 'floats' or 'hovers' until conversion into a fixed charge, at which point the charge attaches to specific assets...
s over companies by way of security - not so much for the security for payment of their own debts, but because this ensures that no other bank will, ordinarily, lend to the company, thereby almost granting a monopoly in favour of the bank holding the floating charge on lending to the company.
Some economists question the utility of security interests and secured lending generally. Proponents argue that secured interests lower the risk for the lender, and in turn allows the lender to charge lower interest, thereby lower the cost of capital for the borrower. Compare, for example, interest rates for a mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
and for a credit card
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
debt.
Detractors argue that creditors with security interests can destroy companies that are in financial difficulty, but which might still recover and be profitable. The secured lenders might get nervous and enforce the security early, repossessing key assets and forcing the company into bankruptcy. Further, the general principle of most insolvency regimes is that creditors should be treated equally (or pari passu
Pari passu
Pari passu is a Latin phrase that literally means "with an equal step" or "on equal footing." It is sometimes translated as "ranking equally", "hand-in-hand," "with equal force," or "moving together," and by extension, "fairly," "without partiality."...
), and allowing secured creditors a preference to certain assets upsets the conceptual basis of an insolvency.
More sophisticated criticisms of security point out that although unsecured creditors will receive less on insolvency, they should be able to compensate by charging a higher interest rate. However, since many unsecured creditors are unable to adjust their "interest rates" upwards (tort claimants, employees), the company benefits from a cheaper rate of credit, to the detriment of these non-adjusting creditors. There is thus a transfer of value from these parties to secured borrowers.
Most insolvency law allows mutual debts to be set-off
Set-off (law)
In law, a set-off is a statutory defense to the whole or to a portion of a plaintiff's claim. It had no existence under the English common law, being created by 2 Geo. II c. 22 for the relief of insolvent debtors, although set-off was recognized in equity...
, allowing certain creditors (those who also owe money to the insolvent debtor) a pre-preferential position. In some countries, "involuntary" creditors (such as tort
Tort
A tort, in common law jurisdictions, is a wrong that involves a breach of a civil duty owed to someone else. It is differentiated from a crime, which involves a breach of a duty owed to society in general...
victims) also have preferential status, and in others environmental claims have special preferred rights for cleanup costs.
The most frequently used criticism of secured lending is that, if secured creditors are allowed to seize and sell key assets, a liquidator or bankruptcy trustee loses the ability to sell off the business as a going concern
Going concern
A going concern is a business that functions without the threat of liquidation for the foreseeable future, usually regarded as at least within 12 months.-Definition of the 'going concern' concept:...
, and may be forced to sell the business on a break-up basis. This may mean realising a much smaller return for the unsecured creditors, and will invariably mean that all the employees will be made redundant.
For this reason, many jurisdictions restrict the ability of secured creditors to enforce their rights in a bankruptcy. In the U.S., the Chapter 11
Chapter 11, Title 11, United States Code
Chapter 11 is a chapter of the United States Bankruptcy Code, which permits reorganization under the bankruptcy laws of the United States. Chapter 11 bankruptcy is available to every business, whether organized as a corporation or sole proprietorship, and to individuals, although it is most...
creditor protection, which completely prevents enforcement of security interests, aims at keeping enterprises running at the expense of creditors' rights, and is often heavily criticised for that reason. In the United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
, an administration order
Administration (insolvency)
As a legal concept, administration is a procedure under the insolvency laws of a number of common law jurisdictions. It functions as a rescue mechanism for insolvent entities and allows them to carry on running their business. The process – an alternative to liquidation – is often known as going...
has a similar effect, but are less expansive in scope and restriction in terms of creditors rights. European systems are often touted as being pro-creditor, but many European jurisdictions also impose restrictions upon time limits that must be observed before secured creditors can enforce their rights. The most draconian jurisdictions in favour of creditor's rights tend to be in offshore financial centres, who hope that, by having a legal system heavily biased towards secured creditors, they will encourage banks to lend at cheaper rates to offshore structures, and thus in turn encourage business to use them to obtain cheaper funds.
Security
Under English lawEnglish law
English law is the legal system of England and Wales, and is the basis of common law legal systems used in most Commonwealth countries and the United States except Louisiana...
and in common law
Common law
Common law is law developed by judges through decisions of courts and similar tribunals rather than through legislative statutes or executive branch action...
jurisdictions derived from English law, there are eight types of proprietary security interests: (1) 'true' legal mortgage; (2) equitable mortgage; (3) statutory mortgage; (4) fixed equitable charge, or bill of sale; (5) floating equitable charge; (6) pledge, or pawn; (7) legal lien; (8) equitable lien; and (9) hypothecation, or trust receipt.
Security interests at common law are either possessory or non-possessory, depending upon whether the secured party actually needs to take possession of the collateral). Alternatively, they arise by agreement between the parties (usually by executing a security agreement), or by operation of law.
The following discussion of the types of security interest principally concerns English law. English law on security interests has been followed in most common law
Common law
Common law is law developed by judges through decisions of courts and similar tribunals rather than through legislative statutes or executive branch action...
countries, and most common law countries have similar property statutes regulating the common law rules.
Types
Security interests may be taken on any type of property. The law divides property into two classes: personal propertyPersonal property
Personal property, roughly speaking, is private property that is moveable, as opposed to real property or real estate. In the common law systems personal property may also be called chattels or personalty. In the civil law systems personal property is often called movable property or movables - any...
and real property
Real property
In English Common Law, real property, real estate, realty, or immovable property is any subset of land that has been legally defined and the improvements to it made by human efforts: any buildings, machinery, wells, dams, ponds, mines, canals, roads, various property rights, and so forth...
. Real property is the land, the buildings affixed to it and the rights that go with the land. Personal property is defined as any property other than real property.
"True" legal mortgage
A legal mortgage arises when the assets are conveyed to the secured party as security for the obligations, but subject to a right to have the assets reconveyed when the obligations are performed. This right is referred to as the "equity of redemptionEquity of redemption
The equity of redemption refers to the right of a mortgagor in law to redeem his property once the liability secured by the mortgage has been discharged.-Overview:...
". The law has historically taken a dim view of provisions which might impede this right to have the assets reconveyed (referred to as being a "clog" on the equity of redemption), although the position has become more relaxed in recent years in relation to sophisticated financial transactions.
References to "true" legal mortgages mean mortgages by the traditional common law method of transfer subject to a proviso in this manner, and references are usually made in contradistinction to either equitable mortgages or statutory mortgages. True legal mortgages are relatively rare in modern commerce, outside of occasionally with respect to shares
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
in companies
Company
A company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...
. In England, true legal mortgages of land have been abolished in favour of statutory mortgages.
To complete a legal mortgage it is normally necessary that title to the assets is conveyed into the name of the secured party such that the secured party (or its nominee) becomes the legal titleholder to the asset. If a legal mortgage is not completed in this manner it will normally take effect as an equitable mortgage. Because of the requirement to transfer title, it is not possible to take a legal mortgage over future property, or to take more than one legal mortgage over the same assets. However, mortgages (legal and equitable) are non-possessory security interests. Normally the party granting the mortgage (the mortgagor) will remain in possession of the mortgaged asset.
The holder of a legal mortgage has three primary remedies in the event that there is a default on the secured obligations: they can foreclose on the assets, they can sell the assets or they can appoint a receiver over the assets. The holder of a mortgage can also usually sue upon the covenant to pay which appears in most mortgage instruments. There are a range of other remedies available to the holder of a mortgage, but they relate predominantly to land, and accordingly have been superseded by statute, and they are rarely exercised in practice in relation to other assets. The beneficiary of a mortgage (the mortgagee) is entitled to pursue all of its remedies concurrently or consecutively.
Foreclosure is rarely exercised as a remedy. To execute foreclosure, the secured party needs to petition the court, and the order is made in two stages (nisi and absolut), making the process slow and cumbersome. Courts are historically reluctant to grant orders for foreclosure, and will often instead order a judicial sale. If the asset is worth more than the secured obligations, the secured party will normally have to account for the surplus. Even if a court makes a decree absolut and orders foreclosure, the court retains an absolute discretion to reopen the foreclosure after the making of the order, although this would not affect the title of any third party purchaser.
The holder of a legal mortgage also has a power of sale over the assets. Every mortgage contains an implied power of sale. This implied power exists even if the mortgage is not under seal. All mortgages which are made by way of deed also ordinarily contain a power of sale implied by statute, but the exercise of the statutory power is limited by the terms of the statute. Neither implied power of sale requires a court order, although the court can usually also order a judicial sale. The secured party has a duty to get the best price reasonably obtainable, however, this does not require the sale to be conducted in any particular fashion (i.e. by auction or sealed bids). What the best price reasonably obtainable will be will depend upon the market available for the assets and related considerations. The sale must be a true sale - a mortgagee cannot sell to himself, either alone or with others, even for fair value; such a sale may be restrained or set aside or ignored. However, if the court orders a sale pursuant to statute, the mortgagee may be expressly permitted to buy.
The third remedy is to appoint a receiver. Technically the right to appoint a receiver can arise two different ways - under the terms of the mortgage instrument, and (where the mortgage instrument is executed as a deed) by statute.
In England, a third remedy, "appropriation" may exist under The Financial Collateral Arrangements (No.2) Regulations 2003 where the assets subject to the mortgage are 'financial collateral' and the mortgage instrument provides that the regulations apply. Appropriation is a means whereby the mortgagee can take title to the assets, but must account to the mortgagor for their fair market value (which must be specified in the mortgage instrument), but without the need to obtain any court order.
If the mortgagee takes possession then under the common law they owe strict duties to the mortgagor to safeguard the value of the property (although the terms of the mortgage instrument will usually limit this obligation). However, the common law rules relate principally to physical property, and there is a shortage of authority as to how they might apply to taking "possession" of rights, such as shares. Nonetheless, a mortgagee is well advised to remain respectful of their duty to preserve the value of the mortgaged property both for their own interests and under their potential liability to the mortgagor.
Equitable mortgage
An equitable mortgage can arise in two different ways – either as a legal mortgage which was never perfected by conveying the underlying assets, or by specifically creating a mortgage as an equitable mortgage. A mortgage over equitable rights (such as a beneficiary's interests under a trust) will necessarily exist in equity only in any event.Under the laws of some jurisdictions, a mere deposit of title documents can give rise to an equitable mortgage. With respect to land this has now been abolished in England, although in many jurisdictions company shares can still be mortgaged by deposit of share certificates in this manner.
Generally speaking, an equitable mortgage has the same effect as a perfected legal mortgage except in two respects. Firstly, being an equitable right, it will be extinguished by a bona fide purchaser for value who did not have notice of the mortgage. Secondly, because the legal title to the mortgaged property is not actually vested in the secured party, it means that a necessary additional step is imposed in relation to the exercise of remedies such as foreclosure (although in the recent case of Alfa Telecom Turkey Limited v Cukurova Finance International Limited HCVAP 2007/027, heard in the Eastern Caribbean Court of Appeal as to matters of English law (and so currently subject to appeal to the Privy Council
Judicial Committee of the Privy Council
The Judicial Committee of the Privy Council is one of the highest courts in the United Kingdom. Established by the Judicial Committee Act 1833 to hear appeals formerly heard by the King in Council The Judicial Committee of the Privy Council (JCPC) is one of the highest courts in the United...
), it was held that an equitable mortgagee could enforce security over financial collateral (in this case shares) by informing the interested mortgagor and other interested parties of the fact without first taking possession of shares or having his ownership interest recorded in the register.
Statutory mortgage
Many jurisdictions permit specific assets to be mortgaged without transferring title to the assets to the mortgagee. Principally, statutory mortgages relate to land, registered aircraft and registered ships. Generally speaking, the mortgagee will have the same rights as they would have had under a traditional true legal mortgage, but the manner of enforcement is usually regulated by the statute.Equitable charge
A fixed equitable charge confers a right on the secured party to look to (or appropriate) a particular asset in the event of the debtor's default, which is enforceable by either power of sale or appointment of a receiver. It is probably the most common form of security taken over assets. Technically, a charge (or a "mere" charge) cannot include the power to enforce without judicial intervention, as it does not include the transfer of a property proprietary interest in the charged asset. If a charge includes this right (such as private sale by a receiver), it is really an equitable mortgage (sometimes called charge by way of mortgage). Since little turns on this distinction, the term "charge" is often used to include an equitable mortgage.An equitable charge is also a non-possessory form of security, and the beneficiary of the charge (the chargee) does not need to retain possession of the charged property.
Where security equivalent to a charge is given by a natural person (as opposed to a corporate entity) it is usually expressed to be a bill of sale
Bill of sale
A bill of sale is a legal document made by a 'seller' to a purchaser, reporting that on a specific date, at a specific locality, and for a particular sum of money or other "value received", the seller sold to the purchaser a specific item of personal, or parcel of real, property of which he had...
, and is regulated under applicable bills of sale legislation. Difficulties with the Bills of Sale Acts in Ireland, England and Wales have made it virtually impossible for individuals to create floating charges.
Floating charge
Floating charges are similar in effect to fixed equitable charges once they crystallise (usually upon the commencement of liquidation proceedings against the chargor), but prior to that they "float" and do not attach to any of the chargor's assets, and the chargor remains free to deal with or dispose of them.Pledge
A pledge (also sometimes called a pawn) is a form of possessory security, and accordingly, the assets which are being pledged need to be physically delivered to the beneficiary of the pledge (the pledgee). Pledges are rarely used in commercial contexts, but are still used by pawnbrokers, which, contrary to their old world image, remain a regulated credit industry.The pledgee has a common law power of sale in the event of a default on the secured obligations which arises if the secured obligations are not satisfied by the agreed time (or, in default of agreement, within a reasonable period of time). If the power of sale is exercised, then the holder of the pledge must account to the pledgor for any surplus after payment of the secured obligations.
A pledge does not confer a right to appoint a receiver or foreclose. If the holder of pledge sells or disposes of the pledged assets when not entitled to do so, they may be liable in conversion to the pledgor.
Legal lien
A legal lien, in most common lawCommon law
Common law is law developed by judges through decisions of courts and similar tribunals rather than through legislative statutes or executive branch action...
systems, is a right to retain physical possession of tangible assets as security for the underlying obligations. In some jurisdictions it is a form of possessory security, and possession of the assets must be transferred to (and maintained by) the secured party. The right is purely passive; the secured party (the lienee) has no right to sell the assets - merely a right to refuse to return them until paid. In the United States, a lien can be a non-possessory security interest. See the main article: lien for a discussion of the differences between the United States and other common law countries.
Most legal liens arise as a matter of law (mostly by common law, but also by statute), however, it is possible to create a legal lien by contract. The courts have confirmed that it is possible to also give the secured party a power of sale in such a contract, but case law on such a power is limited and it is difficult to know what limitations and duties would be imposed on the exercise of such a power.
Equitable lien
Equitable liens are slightly amorphous forms of security interest that only arise by operation of law in certain circumstances. Academically it has been noted that there seems to be no real unifying principle behind the circumstances that give rise to them.An equitable lien takes effect essentially as an equitable charge, and they arise only in specified situations, (e.g. an unpaid vendor's lien in relation to property is an equitable lien; a maritime lien
Maritime lien
A maritime lien in admiralty law is a privileged claim upon maritime property, such as a ship, in respect of services rendered to, or the injuries caused by that property. In common law, a lien is the right of the creditor to retain the properties of his debtor until the debt is paid.It is a...
is sometimes thought to be an equitable lien). It is sometimes argued that where the constitutional documents of a company provide that the company has a lien over its own shares, this take effect as an equitable lien, and if that analysis is correct, then it is probably the one exception to the rule that equitable liens arise by operation of law rather than by agreement.
Hypothecation
HypothecHypothec
Hypothec is a mortgage in Roman and Scots law, in other words, a legal right over a debtor's property that however remains in the debtor's possession....
ation, or "trust receipts" are relatively uncommon forms of security interest whereby the underlying assets are pledged, not by delivery of the assets as in a conventional pledge, but by delivery of a document or other evidence of title. Hypothecation is usually seen in relation to bottomry
Bottomry
A bottomry, or bottomage, is when the master of a ship borrows money upon the bottom or keel of it, so as to forfeit the ship itself to the creditor, if the money is not paid at the time appointed with interest at the ship's safe return....
(cf. bills of lading
Bill of lading
A bill of lading is a document issued by a carrier to a shipper, acknowledging that specified goods have been received on board as cargo for conveyance to a named place for delivery to the consignee who is usually identified...
), whereby the bill of lading is endorsed by the secured party, who, unless the security is redeemed, can claim the property by delivery of the bill.
Security interest vs. general obligation
Some obligations are backed only by a security interest against specific designated property, and liability for repayment of the debt is limited to the property itself, with no further claim against the obligor. These are referred to as "nonrecourse obligationsNonrecourse debt
Non-recourse debt or a non-recourse loan is a secured loan that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the...
".
Other obligations (i.e., recourse obligations) are backed by the full credit of the borrower. If the borrower defaults, then the creditor can force the obligor into bankruptcy and the creditors will divide all assets of the obligor.
Depending on the relative credit of the obligor, the quality of the asset, and the availability of a structure to separate the obligations of the asset from the obligations of the obligor, the interest rate charged on one may be higher or lower than the other.
Perfection
Perfection of security interests means different things to lawyers in different jurisdictions.- in English lawEnglish lawEnglish law is the legal system of England and Wales, and is the basis of common law legal systems used in most Commonwealth countries and the United States except Louisiana...
, perfection has no defined statutory or judicial meaning, but academics have pressed the view that it refers to the attachment of the security interest to the underlying asset. Others have argued cogently that attachment is a separate legal concept, and that perfection refers to any steps required to ensure that the security interest is enforceable against third parties. - in American law, perfection is generally taken to refer to any steps required to ensure that the security interest remains enforceable on the debtor's bankruptcyBankruptcyBankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
.
With the Americanization of the world's legal profession, the second definition is becoming more frequently used commercially, and arguably is to be preferred, as the traditional English legal usage has little purpose except in relation to the comparatively rare true legal mortgage (very few other security interests require additional steps to attach to the asset, but security interests frequently require some form of registration to be enforceable on the chargor's insolvency).
"Quasi-security"
There are a number of other arrangements which parties can put in place which have the effect of conferring security in a commercial sense, but do not actually create a proprietary security interest in the assets. For example, it is possible to grant a power of attorney or conditional option in favour of the secured party relating to the subject matter, or to utilise a retention of titleTitle retention clause
A retention of title clause is a provision in a contract for the sale of goods that the title to the goods remains vested in the seller until certain obligations are fulfilled by the buyer.-Purpose:The main purposes of retention of title clauses are to ensure that where goods are supplied...
arrangement, or execute undated transfer instruments. Whilst these techniques may provide protection for the secured party, they do not confer a proprietary interest in the assets which the arrangements relate to, and their effectiveness may be limited if the debtor goes into bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
.
It is also possible to replicate the effect of security by making an outright transfer of the asset, with a provision that the asset is re-transferred once the secured obligations are repaid. In some jurisdictions, these arrangements may be recharacterised
Recharacterisation
Recharacterization in law means the treatment of a certain course of conduct in a different manner to which the participants describe it....
as the grant of a mortgage, but most jurisdictions tend to allow the parties freedom to characterise their transactions as they see fit. Common examples of this are financings using a stock loan or repo agreement
Repurchase agreement
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...
to collateralise the cash advance, and title transfer arrangements (for example, under the "Transfer" form English Law credit support annex to an ISDA Master Agreement (as distinguished from the other forms of CSA, which grant security)).
United States – the U.C.C.
In the United StatesUnited States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, under article 9 of the Uniform Commercial Code
Uniform Commercial Code
The Uniform Commercial Code , first published in 1952, is one of a number of uniform acts that have been promulgated in conjunction with efforts to harmonize the law of sales and other commercial transactions in all 50 states within the United States of America.The goal of harmonizing state law is...
which regulates security interests in personal property (as opposed to real property), a security interest is a right in a debtor
Debtor
A debtor is an entity that owes a debt to someone else. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor...
's property that secures payment or performance of an obligation.
A security interest is created by a security agreement, under which the debtor grants a security interest in the debtor's property as collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
for a loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
or other obligation.
A security interest grants the holder a right to take a remedial action with respect to the property, upon occurrence of certain events, such as the non-payment of a loan. The creditor may take possession of such property in satisfaction of the underlying obligation. The holder will sell such property at a public auction
Public auction
A public auction is an auction held on behalf of a government in which the property to be auctioned is either property owned by the government, or property which is sold under the authority of a court of law or a government agency with similar authority....
or through a private sale, and apply the proceeds to satisfy the underlying obligation. If the proceeds exceed the amount of the underlying obligation, the debtor is entitled to the excess. If the proceeds fall short, the holder of the security interest is entitled to a deficiency judgment whereby the holder can institute additional legal proceedings to recover the full amount unless it is a non-recourse debt like many mortgage loans in the United States.
In the U.S. the term "security interest" is often used interchangeably with "lien
Lien
In law, a lien is a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation...
". However, the term "lien" is more often associated with the collateral of real property than with of personal property.
A security interest is typically granted by a "security agreement". The security interest is established with respect to the property, if the debtor has an ownership interest in the property and the holder of the security interest conferred value to the debtor, such as giving a loan.
The holder may "perfect" the security interest to put third parties on notice thereof. Perfection is typically achieved by filing a financing statement with government, often the secretary of state located at a jurisdiction where a corporate debtor is incorporated. Perfection can also be obtained by possession of the collateral, if the collateral is tangible property.
Absent perfection, the holder of the security interest may have difficulty enforcing his rights in the collateral with regard to third parties, including a trustee in bankruptcy and other creditors who claim a security interest in the same collateral.
See also
- CollateralCollateral (finance)In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
- DebentureDebentureA debenture is a document that either creates a debt or acknowledges it. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. In some countries the term is used interchangeably with bond, loan stock or note...
- Floating chargeFloating chargeA floating charge is a security interest over a fund of changing assets of a company or a limited liability partnership , which 'floats' or 'hovers' until conversion into a fixed charge, at which point the charge attaches to specific assets...
- HypothecHypothecHypothec is a mortgage in Roman and Scots law, in other words, a legal right over a debtor's property that however remains in the debtor's possession....
- HypothecationHypothecationHypothecation is the practice where a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral, but it is "hypothetically" controlled by the creditor in that he has the right to seize possession if the borrower defaults...
- LienLienIn law, a lien is a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation...
- Maritime Lien
- Mortgage law
- Negative pledgeNegative pledgeNegative pledge is a provision in a contract which prohibits a party to the contract from creating any security interests over certain property specified in the provision....
- Nonrecourse debtNonrecourse debtNon-recourse debt or a non-recourse loan is a secured loan that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the...
- Perfection (law)Perfection (law)In law, perfection relates to the additional steps required to be taken in relation to a security interest in order to make it effective against third parties and/or to retain its effectiveness in the event of default by the grantor of the security interest...
- PledgePledge (law)A pledge is a bailment or deposit of personal property to a creditor to secure repayment for some debt or engagement, The term is also used to denote the property which constitutes the security....
- Quistclose trustQuistclose trustBarclays Bank Ltd v Quistclose Investments Ltd [1970] AC 567 is a leading property, unjust enrichment and trusts case, which invented a new species of proprietary interest...
- Second lien financing
- Secured transactionSecured transactionGenerally, a secured transaction is a loan or a credit transaction in which the lender acquires a security interest in collateral owned by the borrower and is entitled to foreclose on or repossess the collateral in the event of the borrower's default. The terms of the relationship are governed by a...
- Tacking (law)Tacking (law)Tacking is a legal concept arising under the common law relating to competing priorities between two or more security interests arising over the same asset. The concept is best illustrated by way of example....
- Uniform Commercial CodeUniform Commercial CodeThe Uniform Commercial Code , first published in 1952, is one of a number of uniform acts that have been promulgated in conjunction with efforts to harmonize the law of sales and other commercial transactions in all 50 states within the United States of America.The goal of harmonizing state law is...