How to Make a Secured Loan

A secured loan, if properly put in place, is backed by the assets of the borrower. This means that if the borrower does not make a payment on the loan or otherwise defaults, the lender can sell the secured assets and apply the proceeds towards the outstanding loan amount. It also means that if the company becomes insolvent, the secured lender will generally take priority over unsecured creditors and be protected up to the value of the secured assets.

There are three basic types of security interest that a lender can take to protect against the borrower’s failure to repay a loan:
  • a pledge over shares in or an asset of a company
  • a charge over the company’s assets
  • a mortgage over the company’s assets

With a pledge, the borrower delivers physical possession of the secured asset to the lender, but ownership of the asset remains with the borrower. If the borrower defaults on the loan, then the lender can sell the pledged asset after giving proper notice to the borrower. By its nature, only items of property that can be delivered (including title to property and share certificates) can be pledged.

In most commercial situations, neither the lender nor the borrower will want the lender to take physical control over the secured asset. This is because the lender will not want to be responsible for maintaining the asset, and the borrower will want to use the asset in the operation of its business. Both a charge and a mortgage gives the lender a security interest in an asset without requiring possession, so these forms of security are much more common than a pledge.

The main difference between a charge and a mortgage is who owns the secured property. In the case of a charge, the borrower grants the lender an equitable interest in the secured asset, but there is no transfer of ownership. With a mortgage, ownership of the secured asset is transferred to the lender until the loan has been repaid, in which case it is transferred back to the borrower.

Generally, any property capable of being transferred can be secured by way of a charge or mortgage. This includes existing assets such as land, goods, and intangibles (including accounts receivable, goodwill, intellectual property, and contractual benefits). It also includes future assets of the same type which are acquired after the security interest has been granted.

There are two types of charges: fixed and floating. For a charge to be considered a fixed charge, (i) the asset must be readily ascertainable and definite, and (ii) the lender must have control over the asset. Fixed charges can be granted by anyone, including companies, partnerships, and individuals.

A floating charge covers a class of assets belonging to the borrower which changes in composition during the ordinary course of business. For example, a lender may take a floating charge in the borrower’s inventory, stock in trade and book debts as these all change on a day to day basis. So through a combination of fixed and floating charges, it is possible for a lender to take some form of charge over nearly all of the borrower’s assets. A floating charge can be best described as a security that ‘hovers’ over a company’s assets without attaching to it. As the company’s assets are not fixed with a charge per se, the company can deal with the assets as it sees fit. However, if an event of default occurs, the floating charge ‘crystallizes’ and attaches to the assets. In so doing, it then becomes a fixed charge.

The question remains, however, as to the priority a particular charge will take over other creditors if the borrower becomes insolvent. The holder of a fixed charge is in the best position, because it will be paid before all preferential and unsecured creditors of the company. In contrast, the holder of a floating charge stands behind the fixed charge holders and the preferential creditors.

Unlike a charge, a legal mortgage involves the transfer of title to an asset for the purpose of securing a loan. This comes with the understanding that the lender is obligated to transfer title back to the borrower once the loan is repaid.

Because the lender actually owns the asset while holding a legal mortgage, it can (i) easily prevent the asset from being transferred, and (ii) readily act on the security interest if an event of default occurs. In addition, possession of the secured asset is not required. As a result of all this, a legal mortgage is considered the strongest form of security interest.

If it is not possible to take a legal mortgage over an asset, such as in a case where the borrower has not yet obtained legal title but has beneficial ownership of the asset, the lender may be able to obtain an equitable mortgage. While a legal mortgage transfers legal title to the lender and prevents the borrower from dealing with the mortgaged asset while it is subject to the mortgage, an equitable mortgage involves the transfer of beneficial title in an asset.

Any form of security interest—whether a pledge, charge, or mortgage—needs to be properly “perfected” before it is valid vis-à-vis the borrower and the borrower’s creditors. Depending on the type of security interest and the type of asset involved, one or more of the following is necessary to perfect:
  • A signed agreement
  • Possession of the asset
  • Registration of the security interest
  • Notice of the security interest to third parties

The signed agreement granting a security interest may consist of an individual pledge, charge or mortgage document. However, in the case of a loan to a company secured by all of the company’s assets, the security interests are normally contained in a Debenture (a form of combined fixed and floating charge) that is signed by the borrower and lender at the time the Loan Agreement is entered into.

The Loan Agreement sets out the commercial terms of the financing, such as the amount of the loan, the interest rate, and payment dates. The borrower will also make certain representations and warranties related to the company, as well as covenant to take, and refrain from taking, certain actions. Finally, the Loan Agreement will specify the events of default that will allow the lender to demand immediate repayment of the loan.

The Debenture acts in tandem with the Loan Agreement by granting specific security interests to the lender over the assets of the borrower and detailing what powers and rights the lender has to enforce the security interests if the loan becomes due and is not repaid. The principal terms and clauses found in most Debentures will include:
  • Grant of security / charging provisions
  • Liability of the borrower
  • Covenant to pay
  • Representations and warranties
  • Covenants of the borrower
  • Powers of the lender
  • Enforcement
  • Costs and indemnity
  • Release

The security interests granted by the borrower to the lender in the Loan Agreement will be tailored to the particular situation and will specify the exact assets to be secured and the type of security interest granted with respect to each asset. The lender will want to take a fixed charge and/or a legal mortgage over every asset possible, and a floating charge and/or equitable mortgage over all other assets.
The “liability of the borrower” provision describes the debts owed to the lender under the Loan Agreement, and the “covenant to pay” is the borrower’s agreement to pay the lender on demand when those debts become due. Failure to pay after a valid demand triggers the lender’s right to enforce the security interests granted under the Debenture.

The representations and warranties contained in a Debenture act in concert with those contained in the Loan Agreement, and ensure as much as possible that the borrower both owns (or has specified rights in) the assets subject to the security interests that are the subject of the Debenture, and has the right to grant those security interests. A breach of the representations and warranties will result in an event of default under both the Debenture and the Loan Agreement, giving the lender the right to accelerate the loan and refuse to fund any further draw-downs.

In general, the covenants contained in a Debenture require the borrower to maintain the value of the assets subject to the security interests and not do anything that puts those assets or security interests at risk. However, because the borrower will want to conduct its business in the ordinary course using many of those assets without having to obtain the permission of the lender, it will want to negotiate as much flexibility as possible with respect to the covenants.

The “powers of the lender” and “enforcement” sections specify in detail under what circumstances the Lender will be able to act on the security interest and the powers that it will have in doing so. In general, they state that the holder of the charge or mortgage will be granted the right to take possession of the assets and sell them to satisfy the loan if the borrower fails to make a payment when due, otherwise defaults the loan, or breaches the terms of the Debenture. The enforcement provisions also give the lender the right to appoint a receiver to administer the sale of the assets, and describe in details the powers that the receiver will have in doing so.

However, in order to have the right to enforce a charge or mortgage, the security interest must be properly created and perfected.

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