Banks and Security Lending: A Discussion

Introduction

One of the major operations of banks in contemporary society is lending. This is whereby the bank makes money available to the public for various purposes in the form of loans. The borrower approaches the bank for a loan to finance various activities. These may include the purchase of an asset such as a car, land, machinery, or a house among others. In other circumstances, the borrower may take out the loan to finance another debt from a previous lender.

The banks may lend money to differing clients. These may include organizations, governments, and businesses among others. The loan may also be advanced to individual members of the public as personal loans.

There are various considerations carried out by the bank before processing or approving a loan request from a potential borrower. These may include the creditworthiness of the borrower, whereby those who have defaulted on loans before are avoided by the banks. The bank may also assess the use that the potential borrower intends to put the borrowed money into. This is also aimed at assessing the risk of the money that is borrowed, or the likelihood of the borrower to default.

Money lending by the banks is attended by a myriad of risks, ranging from the failure of the borrower to clear off the loan, and the rise in interest rates or inflation within the period that the loan is to be repaid. Out of these, loan default by the borrowers is the major risk facing banks wishing to avail funds to the public.

There are various reasons why a borrower may default on a loan. Some of the causes of defaults are within the control of the borrower, while others are without their control. A case in point is when the business in which the borrower had plowed all the money is affected by a natural calamity such as an earthquake or floods. Given that the borrower intended to clear off the loan using the proceeds from the business, interference with this source of income will affect their ability to pay off the loan negatively. The assets of the borrower, according to, are wiped out. They are made incapable of restarting their business soon enough to clear the loan. These are unavoidable causes of loan defaults. However, as earlier indicated, there are also causes of loan defaults that are avoidable, which are within the borrower’s control. A case in point is when the borrower puts the money into the wrong or unintended use. This is for example using money borrowed and intended for business on personal effects such as house furniture.

In an ideal situation, all the borrowers are expected to repay their loans to the bank. However, this is not the case in the real world. Some borrowers will repay their loans, while others, for one reason or the other, may default on payments. This affects the well-being of the lending institution or individual. This is despite the fact that some of the reasons causing the borrower to default may be genuine, such as a natural catastrophe.

In lieu of this, banks and other financial institutions that are involved in the process of lending money have found it necessary to put in place norms and procedures which they undertake before they release the money to the borrower, may it be an individual or a business. As earlier stated, the lender goes through the credit proposal brought before them by the potential borrower. This is in order to check for the viability and feasibility of the proposal. Each of the loan requests submitted to the bank is evaluated on an individual basis, given the fact that the potential borrowers are unique in their ability to pay or put the money to good use.

One of the precautions that are taken by the bank to safeguard against non-payment is obtaining security from the potential borrower. Security may take various forms, ranging from intangible to tangible assets. Tangible assets include land, car, house, and ushers. On the other hand, intangible assets or securities may be the borrower’s payslips (salary for the employed borrowers), bonds, and stocks (Veneziano, 2011).

Several issues surround the securities aspect of money lending by banks. For example, there are legislations that govern the conduct of both the borrower and the lender regarding the security of collateral provided. Such legislations are for example those prohibiting the borrower from using the security on another loan, the remedies of secured creditors, and such others. Also included in such legislation includes various provisions on how the security will be treated should the borrower be declared bankrupt before they have cleared the loan (Getzler & Payne, 2008).

In this paper, the author is going to analyse the notion of banks’ taking of security over assets in the lending process. The nature of security in this context, as well as the various forms of securities available to the bank, will also be analysed. The author will integrate relevant decided cases in this field in the process of analysis. The scenarios when a bank’s security may come under threat of postponement to the rights of other creditors will also be analysed. In this case, the author will additionally look at the mechanisms that the bank may utilize to avert the loss of security in such an instance.

To effectively address the objectives above, the paper will be structured into several sections. Each of these sections will deal with a particular issue regarding bank lending and security. The author will start by looking at the general overview of the nature of security, where the importance of this function in bank lending will be assessed. This will be followed by a discourse on the forms of security interests as defined by law. Here, legal mortgage, equitable mortgage among others will be addressed. The third segment of the paper will deal with the negative pledge, and how they affect the relationship between the bank and the borrower. This will be followed by a discourse on registration requirements under section 262 of the Corporations Act. The remedies for secured creditors will also be addressed in a subsequent section of the paper, followed by an analysis of the problems on the enforcement of these remedies. Finally, the author will look at the issue of financial distress of companies and subordination.

Nature of Security

An Overview

Various scholars have defined security within the context of bank lending and borrowing variously. The various definitions are informed by the individual scholar’s philosophical orientation and the school of thought they subscribe to.

However, generally speaking, security can be conceptualized as an asset of any kind or description, and which possesses some specified qualities that can be possessed by the lender in the event that the borrower or debtor fails to pay the borrowed amount. Among the qualities that the asset acting as security should possess includes monetary value, which should be equal to or higher than the amount of money lent. The asset, when possessed in case of a default by the borrower, is used to recover the loan. The lending bank may sell off the asset or dispose of it in such a way that the bank recovers the money lent and interest that may have accrued.

The desire of the bank in lending out money is to ensure that the borrower repays off the loan plus all the interests that may have accrued. This is one of the major reasons why the bank finds it important to secure the loan. To ensure that the interest plus the principal amount is recovered, the bank will usually create a charge against the asset that may have been financed by the loan that the borrower took from the bank. For example, a charge may be created against the house that the borrower financed with the money that they borrowed from the bank.

There are two types of securities that are available to the banks in the event of securing a loan. These are primary and collateral securities, and they refer to different circumstances during the lending process.

Primary Security

This is the form of asset that is directly formed out of the finance provided by the bank. A case in point is when a bank provides an individual borrower with the funds to buy a house. In this case, the house becomes the primary security for the bank loan. To secure the loan provided by the bank in such a case, a charge is created against the asset so financed. The charge that is created in such a case provides the bank with legal authority to dispose of the asset should the borrower default on the payments. The proceeds from this disposal are used to offset the defaulted loan.

The problem with primary security is the fact that the value of this security may depreciate, especially in cases of negative market developments. This is for example when the prices of a house in a given locality fall due to adverse developments in the locality. In such a case, the risk to the bank is aggravated, given the fact that the primary security may not be able to liquidate the loan. This realization creates the need for collateral security.

Collateral Security

This is specific additional security over the primary security that the lending bank obtains with the intention of securing the loan.¹⁷ In the scenario given above of the house financed by the bank, the lending bank may decide to obtain collateral security in addition to it. The bank may opt to take the land around the house as additional security to the loan that was granted to purchase the house. The major purpose of this form of security is to offset the risks attending the primary security as stated above.

The two above are not the only form of security for loans though. For example, a borrower can provide personal security for the loan. When a bank obtains personal security for a loan, it has a legal authority to proceed against the borrower and their personal estate, and apply the proceeds to the recovery of the loan if the borrower defaults.

Proper security acquired by the bank greatly reduces the likelihood of having the loan defaulted. When, despite all of the precautions taken by the lending institution, the borrower defaults, the loss that the bank stands to accrue is reduced a great deal.

Why Take Security?

As already indicated in this paper, there are several reasons that make the bank take security for a loan granted.

Reduces Likelihoods of Defaults

One of the major reasons for securing a loan is to ensure that the likelihood of the borrower defaulting on the loan is minimised. The fact that the borrower has used an asset that is valuable to them as collateral means that they will try their best to repay the loan, and to avoid defaulting.²⁰ This is given the fact that they are aware if they default, the bank has legal authority to repossess their assets. This being the case, defaulting becomes very unattractive to them.

In Case of a Default, the Loss to the Bank is Reduced

There are instances where, despite all their efforts to meet their pledge and clear their loan, the borrower defaults on the loan. This is for example due to unavoidable and unforeseeable events such as fire, floods, and earthquakes among others. The ability of the borrower to clear the loan in such circumstances becomes hard, and they are likely to default on the loan.

When the bank has secured the loan, the loss that it suffers in case of such unavoidable default is mitigated. For example, the bank may repossess the security, dispose of it and use the proceeds to clear the loan. There are times when the value of the property may not be enough to cover the loan and the accrued interest on the same. However, the loss of interest is small compared to the loss that the bank may have suffered has the loan been unsecured. In such a case, the bank will have lost both the principal amount and the interest on the loan.²¹

Types of Security Interests

An Overview

Before looking at the various forms of security interests that are available to the bank in the process of lending money to the public, it is important to first look at what security interest is. A definition and overview of this phenomenon will help the reader to contextualise the discourse that will follow in this section.

Security interest is conceptualised as a form of property interest that is created when the lender and the potential borrower agree to negotiate on the loan application. It is created by legal operation on assets, and it is aimed at securing the performance of an obligation on the part of the borrower. The performance in this case is the borrower’s payment of the debt granted by the bank.

The security interest, according to Berger et al (2009), provides the bank with preferential rights regarding the disposition of the property that is so secured. These rights vary with regard to the form of security interest that is under consideration, as well as the kind of debt that the bank is lending the borrower.

When a bank takes a security interest when lending money to the individual or an organisation, it automatically becomes a secured creditor to the borrower. There are several benefits that come with being a secured creditor, and this is the major reason why banks prefer taking a security interest over assets. For instance, the bank has the legal right to take the collateral should the borrower default.

Types of Security Interests

Tyree and Everett & McCracken identify eight forms of proprietary security interests. These are as listed below:

1. ‘true’ legal mortgage
2. Equitable mortgage
3. Statutory mortgage
4. Fixed equitable charge, also referred to as bill of sale
5. Legal lien
6. Hypothecation, also known as trust receipt
7. Floating equitable charge
8. Equitable lien
9. Pledge, also known as pawn

In this section, the author will look at a few of these security interests. In looking at these forms of security interests, the author will also analyse the case of Toohey v. Gunther, a classical case when it comes to English law regarding security interests.

‘True’ Legal Mortgage

There are times when the secured assets are transferred to the secured party, or the lending bank, as borrower’s security for the obligation to pay the debt.³⁰ When this happens, and when it is subjected to a right on the part of the borrower to have the assets transferred back to them when the debt is settled, this is referred to as a legal mortgage. Finch refers to this right as the equity of redemption on the part of the borrower, ensuring that they get their assets back.

According to Tollers Solicitors, this is the most secure and comprehensive type of security that is available to the lending bank and it is thus the most preferred.³³ This is given the fact that the legal title of the asset is transferred to the lender, or the mortgage, and this ensures that the mortgagor is unable to deal with the asset so mortgaged when it is still subject to the mortgage.

A legal mortgage is only taken over assets that are already in existence, and owned by the mortgagor at the time of borrowing. This means that future property is exempted from this form of security. However, there are special circumstances where a mortgage can be drawn over future property. This is however referred to as equitable mortgage, where the mortgage becomes equitable mortgage over the said asset when it becomes to existence and owned by the mortgagor, or borrower.

There are several formalities that are undertaken in the process of creating a legal mortgage. When it is created over land as the preferred asset, it must be executed by the use of deed between the lender and the borrower. When the mortgage is to be created over chattels such as a factory and the equipment therein, it is not necessary to come up with formalities to effect the mortgage. This is provided the fact that the two parties have come to a valid agreement and share a mutual intention to create the legal mortgage. The latter can be provided for on the mortgage document, an indication of the agreement between the two parties.

Equitable Mortgage

An equitable mortgage, according to Tollers and Berger et al comes into existence under special circumstances. First, it may arise when the formalities that are needed to come up with a legal mortgage are non-existence, or one of the parties has failed to comply with them if they were in existence. Alternatively, an equitable mortgage can arise when the lender and the debtor have formally agreed to create a legal mortgage on a future asset. This is when the asset is not yet in existence, or is not owned by the mortgagor, but there are assurances that the asset will come into existence and will be owned by the mortgagor.

Finally, an equitable mortgage can be created when the “…..property that is (intended) to be mortgaged is recognised as such only in equity…..”. This is for instance rights that are recognised under contracts, in other words the right of an individual, for example the lender, to enforce a debt against another individual, for example, the borrower.

Equitable Charge

In this form of charge, the lender who is a secured creditor has the legal authority to obtain a given asset owned by the debtor when the latter defaults on loan payments (Kennedy, 2010). The secured creditor can enforce this right by the use of the power of sale conferred on them by the law or by appointing a receiver who will act on their behalf as far as the asset is concerned. It is noted that this is the form of security that is common, and banks usually take it over the assets of the borrower.

This type of security interest is non-possessory, meaning that the charge, or the beneficiary of the equitable charge (in this case the lending bank), needs not take into possession the asset that is so charged. There are circumstances under which this form of security interest is referred to as a bill of sale. This is when an individual [who Tollers (2009) refers to as a “natural person”] provides a security that is equal to a charge. This form of charge is regulated under a different set of legislation, which Veneziano refers to as “bills of sale legislation”.

Floating Charge

This is another form of security interest that bears some resemblance to fixed equitable charges. The similarity is in the charge’s effect, and it is more evident when the fixed equitable charges are crystallised. The crystallisation takes place when the chargee, or the lender, initiates liquidation proceedings against the chargor, or the borrower.

The floating nature of this form of security interest is evident before the crystallisation. This is given the fact that the charge do not attach to any of the properties owned by the borrower. Unlike in the case of a legal mortgage, the borrower is at liberty to deal with or dispose the property before crystallisation. As such, the charges are merely ‘floating’, without any attachments to property.

Toohey v. Gunther: A Decided Case in Mortgage

This is one of the classical cases of security interest agreements in Australian law. This case was decided by the Australian high court in 1928. The facts of the case were that, Astby, who owned a hotel in Australia, used it as a mortgage in 1901. This is in an agreement he entered into with Tooth & Co., and the hotel was used to secure a loan. Additionally, the mortgage obtained a tie that was supposed to be in effect for a period of 34 years, ending in 1935. In this agreement, it was purported that the mortgagor’s successors in title were bound in it. The asset (the hotel) was subsequently sold by Gunther in the year 1926. However, the buyer, Toohey, refused to purchase the hotel when he realised that a tie was in existence. As a result of this, Gunther forfeited the deposit that had been made by Toohey. The latter felt that Gunther was in no position to forfeit the deposit, and the sale contract that was drawn should be rescinded. Toohey further claimed that the defendant had not shown a good title, and as such, they should return the money that the appellant has given them.

The court deliberated whether the agreement would have bound Toohey, and if he was bound, it was within his right to refute the title shown by Gunther. Other cases decided after this one has also supported this view. A tie that is attaching to licensed property such as the hotel by Gunther through a mortgage has the possibility of enduring beyond the redemption. A case in point is Abbot v. L.D. Northern and Co., a case under the jurisdiction of New Zealand courts.

Negative Pledge

According to Sykes, a negative pledge can be conceptualised as provision in a contract which is supposed to safeguard the property of one of the parties. One of the parties in the contract is prohibited by this clause to create any form of security interest on some assets that are named in the clause. For example, the clause may provide that the provider of the security, such as the borrower, is not allowed to create security interest out of the same property or asset that they have already used as a security by another lender.

These pledges are provided for in security documents that are drawn between the two parties. The aim is to safeguard the interests of the lender, or the beneficiary of the security interest. This is given the fact that, if the grantor of security interest happens to create another interest over the same asset, it may rank pari passu with the security of the original secured creditor, in this case the lending bank. Ranking pari passu means that the second security will compete with the first one, putting the initial beneficiary of the security interest at risk of losing their rights over the asset. Negative pledges provide the bank with the confidence of lending out money to corporations. This is given the fact that their interests are secured under the clause.

Sykes and Law Commission of England and Wales [LCEW] holds the view that these form of clauses are common in contemporary unsecured commercial loan agreements. The aim is to make sure that a debtor who has taken out an unsecured loan is prohibited from taking out another loan in the future with a different bank and securing this with the specified property. If the debtor happens to do this, the interests of the original lender will be put at risk. This is given the fact that the new lender will have first call on the specified assets when the borrower happens to default on the loans.

Registration Requirements for Securities and Charges

Overview

Banks are always lending to corporations and other forms of companies. This lending needs security, just like any other form of lending to individuals or otherwise. It is noted that the bank needs to properly register the securities that they are creating over assets that are held by a company. This is to ensure that the securities are enforceable against liquidators and administrators in the event of a default.

The requirements for this registration are to be found in the Corporations Act section 262. When a security is not registered, it is ranked below others which are registered when it comes to prioritising. When a liquidator or an external administrator is appointed under the law, it is noted that the securities that are not registered are likely to be disregarded, putting the lending bank at a disadvantage.

Requirements for Registration

The following are the charges that are required to be registered under section 262:

1. A floating charge that is drawn on a property or undertaking held by the corporation. This includes even charges drawn on parts of properties
2. Also, a charge that is drawn over a share capital that is uncalled should also be registered
3. A charge drawn on a call on shares which are made but which have not been paid
4. The banks should also register a charge that is drawn on a personal chattel. This includes future chattel, but does not hold for a ship that is registered under the Australian legislation on title to ships
5. The banks should also register a charge made on goodwill, patent, trademark copyright or such others
6. A charge on a book debt should also be registered under the Australian Corporations Act, section 262
7. A security that can be marketed, and which the bank has created a charge, also needs to have such a charge registered.
8. Charge on crop and on an instrument that can be negotiated but which is not a marketable security as provided for above

Remedies of Secured Creditors

Overview

There are several remedies that a secured creditor may resort to when a debtor defaults on a loan. However, it is noted that the creditor can only enforce against the borrower the rights and remedies that are contained in the security agreement that they signed before the loan was granted.

Remedies for a Secured Creditor

The following are just some of the remedies for a secured creditor. It is noted that the list below is not in any way exhaustive.

Mortgage

When the security is a mortgage, the lender has the following option:

Foreclosure

This is whereby the bank or any other secured lender repossesses the mortgaged asset and disposes of it, through selling or otherwise, to recover the borrowed amount. To carry out this remedy, the lender usually engages the services of a lawyer, who will initiate the foreclosure process. The mortgaged asset is valued to assess its market worth.

If the worth of the property fails to meet the money that the mortgagor owes the bank, the lawyer for the bank may request the court to make the debtor meet the shortfall.

Repossession of a Security through the Courts

The secured creditor may also seek the intervention of the court in repossessing the security. This is referred to as replevin, which may take two forms.

Exparte Replevin

This is when the lender repossesses the asset without giving notice to the borrower. This form of repossession is not common in most jurisdictions. It is provided for in special circumstances, given that many jurisdictions require that the borrower be notified of the intention to repossess. This is for example in special circumstances where the security agreement provides for the creditor to take such an action.

Ordinary Replevin

This is whereby the debtor is notified by the creditor before repossession. It starts by having the creditor making a formal complaint to the courts.

In a nutshell, the remedy of the creditor is executed through the courts. The creditor has the option of informing the debtor, or repossessing the security without any notice given. This is in accordance with the provisions of the law and the security agreement between the two parties.

Problems of Enforcement

Overview

It is a fact beyond doubt that a secured creditor is better placed when it comes to recovering their money. The security means that the risk of shortfalls and losses are greatly reduced. However, there are several challenges that the secured creditor encounters when they are trying to carry out the remedies they are entitled to.

Problems of Enforcement

The following are some of the challenges that secured creditors face when they are trying to repossess assets secured or to execute the remedies they are entitled to:

Debtor is a Protected Species

It is noted that the debtor in most jurisdictions is protected under the law. There are rights and privileges that they enjoy, and which should not be violated by the creditor. As such, as much as the secured creditor has the right to repossess the security, there are legal provisions that tie their hands down, reducing their options in recovering their investment. It is noted that the debtor is a protected species under the law.

Debtor Protection: The Case Study of Home Owner and Debtor Protection Act of 2010 in Scotland

Scotland provides for a classical analysis of debtor protection under the law. According to this act, all the repossession cases should be settled in court, meaning that exparte replevin is denied to the creditor. The creditor has to go through the courts, and it is the court that should approve the repossession of security.

The bank, or any lender who wishes to repossess, is required to prove to the court that they have tried other channels in recovering their debt to no avail. In other words, the secured creditor should prove that they have no option but to repossess the asset secured. The law further recognises that the home owner, or the ordinary debtor, may be intimidated by the court process during the repossession hearings. As such, there are provisions that the home owner have a legal representation in the court, and this greatly affects those secured creditors that would wish to repossess a debtor’s home.

Undue Influence

If it is proved in a court of law that “undue influence” was exercised by one party in the signing of the security agreement, the bank may be unable to repossess or execute the remedies it is entitled to. This is especially so if the debtor is able to prove that they were subject to undue influence from the bank. It is noted that undue influence exists where one party in an agreement exploited the other party, and if the exploiter happens to be the lender, the debtor may obtain a court injunction voiding the security agreement that they signed with the bank. For the security agreement to be annulled by the court, the debtor must be able to prove that they suffered negatively from the provisions of the agreement.

A case in point is that of Lloyds Bank Ltd v. Bundy, a court of appeal case in 1975. In this case the court found that the bank’s managers has exerted undue influence on the defendant, making him provide his only house as security to his son’s company. The bank wanted to repossess the defendant’s house, but the court found that the bank had no rights to do so. This is given the fact that the defendant was unduly influenced by the bank managers.

Another is National Westminster Bank v. Morgan in 1985, where the court found that a bank manager had unduly influenced Morgan’s wife into agreeing to sign for the house as a security to Morgan’s business. The bank manager did not advice the wife to get an independent advice regarding the matter.

In both cases above, it is noted that actions by the lender when drawing the security agreement are seminal in informing their right to remedy.

Unconscionable Conduct

Unconscionable conduct is said to have taken place when the terms and provisions of a contract are found to be very unfair to one party in the agreement. In the case of a security agreement, the terms may be unfair to either the lender or the borrower.

This is another challenge that faces a bank or any other lender in the process of executing their remedy. If the debtor is able to prove to the court that the security agreement is an unconscientious dealing, the court may negate the agreement, and grant the debtor the right to escape the agreement.

A case in point in Australia is that of Commercial Bank of Australia Ltd v. Amadio, which was decided in 1983. The facts of the case were that the Amadios, an elderly Italian couple, had secured debts accrued by their son’s business which was failing. The couple had poor command of the English language, which was used in the contract. The son misled them regarding the risks riding on the security agreement, and CBA failed to explain the same to the elderly couple. When the bank expressed the desire to repossess, the court ruled that the contract was unfavourable to the Amadios. Unconscionable dealing was established by the court, and the contract was voided.

Financial Distress of Companies and Debt Subordination

There are situations where a borrower is faced with huge debts that they are unable to clear. Financial distress is said to occur at such scenarios, when the debtor cannot repay debt due to financial instability.

A borrower facing financial distress may seek the protection of the courts. For example, they may file for bankruptcy, such that the lender is unable to repossess their properties.

In such a situation, the legal authorities may come up with subordination factors in settling the debts that are owed to the various creditors. In subordination, the various debts held by the financially distressed corporation are rated as either junior or senior. The latter, under which category secured debts usually fall, takes precedence over the former. This means that, in bankruptcy cases, the senior liabilities are paid first, or are prioritised over the junior ones.

Conclusion

This paper looked at various aspects of secured lending by banks in modern society. The nature of lending, the types of security interests that are available for a lending bank, negative pledge among other issues were addressed in this paper. It was revealed that despite having secured their money, banks and other lenders face risks of losing their security in the event of the debtor defaulting. The various causes of this challenge and the various remedies for the same were identified.

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