What is security?

Security is an essential form of protection for lenders. It refers to a right given by a borrower to a lender that typically entitles the lender to take control of some (or all) of the borrower’s assets if the borrower fails to repay the loan as agreed. Under such circumstances, the lender can then try to sell enough of those assets to repay itself. A borrower will usually have to offer security to persuade a lender to lend, or to persuade a lender to charge a lower interest rate on the loan (in recognition that there is a lower risk of that lender not ultimately receiving back its money in full). 

• When a lender takes control of a borrower’s assets, this is known as the lender “enforcing” its security, i.e. invoking the pre-agreed right to sell the asset(s) and retain some or all of the proceeds. There still exists a risk that an asset over which security is taken will decrease in value, meaning a lender might not be able to fully recoup the money loaned even if it sells that asset. Lenders may therefore take security over assets that are collectively worth more than the loan. 
• If a lender invokes its right to sell the relevant asset(s), it must however return any excess proceeds to the borrower once it has recouped the amount it is owed. Note that a lender can only invoke its right to sell the borrower’s assets if pre-agreed circumstances arise, most notably if the borrower defaults on the terms of the loan (e.g. fails to make an interest payment to the lender on time).

Over which assets can security be taken?

Security can be taken over a variety of assets. A purchaser of a home gives a lender a mortgage (this is a type of security) over his or her house in exchange for a loan. In simple terms, if that purchaser fails to repay the lender as agreed, the mortgage (security) entitles the lender to sell the house and repay itself out of the sale proceeds. 

In larger commercial transactions, there may be multiple lenders that collectively provide a loan (a “syndicated” loan), and the amounts lent may be in the hundreds of millions rather than the hundreds of thousands. However, the basic premise is the same. 

Syndicated loan: where borrowers need to raise large amounts of money, lenders may “syndicate” (i.e. group together) and collectively provide the required capital (hence the term “syndicated loan”). Doing so enables lenders to spread the risk and collectively lend amounts that each individual lender may be prohibited from lending by their internal credit committees. Each lender will then receive a share of the interest payments.

Borrowers in commercial transactions will typically be companies that own a wide range of assets. Lenders will usually take security over one or more of these assets (as they would over a house when lending to the purchaser of a home). These assets typically include factories, machinery and stock. 

However, lenders can take security over a much wider range of assets, for instance: cash the borrower has in its company bank accounts; money the borrower is owed but has not yet received from its customers (this money is referred to as “book debts”); work in progress (i.e. products that have not yet been fully manufactured); the borrower’s intellectual property rights; and shares the borrower owns in other companies (e.g. shares in its subsidiaries).

Types of security

There are various types of security, for instance “fixed charges” and “floating charges”. This section provides a simplified overview of how different types of security (also known as “charges”) can operate, although you are unlikely to be expected to discuss the concepts outlined in any real detail in an interview. However, understanding the basic principles can help if you end up interning in a banking/debt finance-related team at a commercial law firm. 

Fixed charge / mortgage: if a loan has not been repaid in accordance with the agreed terms, a fixed charge (or mortgage) may give a lender the legal right to claim and sell the secured assets in order to recover the funds loaned out. A borrower cannot usually sell assets that are subject to fixed charges without the lender’s consent, so fixed charges will not usually be suitable for assets such as stock (which businesses need to be able to freely sell in order to generate profit). Note that mortgages and fixed charges are not identical in all respects. However, discussion of the differences (which relate to the transfer of ownership) is beyond the scope of this course.

Secured assets: assets over which the borrower has granted security to the lender. For example, when a bank lends money to the purchaser of a house, the house is typically the secured asset. 

Floating charge: floating charges operate in a similar manner to fixed charges, but are different in that the assets over which floating charges are taken can be freely sold unless the floating charge “crystallises”. The parties can agree in advance the circumstances under which a floating charge will “crystallise” and these circumstances will usually include the borrower becoming insolvent (i.e. bankrupt). This ability to freely sell assets makes floating charges more suitable for assets over which it would be commercially impractical for a borrower to relinquish control to the lender (e.g. stock or cash held in a current account). For example, if a borrower relinquished control of its stock to a lender, it would be unable to sell that stock without receiving permission from the lender each time a customer requested to buy that stock. A floating charge offers less protection for lenders however. This is because floating charge holders will not be repaid in the event of insolvency until certain other parties (such as fixed charge holders, the liquidator and unpaid employees) have been repaid in full. This often means that there is little left for floating charge holders after borrowers have progressed through the insolvency process.

Benefits of security

Different types of security can give lenders different degrees of protection. For example, the type of security granted can determine the extent to which lenders are able to exert control over borrowers and their assets, as well as the order of priority between lenders that are seeking repayment in an insolvency situation.

Control

The type of security taken by a lender can dictate the extent to which that lender can control the borrower’s use of the secured assets. For instance, if Lender A takes a “fixed charge” over Borrower Z’s factory, the agreement will likely include terms that prohibit Borrower Z from:

1. Disposing of (selling) that factory without Lender A’s consent; and
2. Granting security over that factory to other lenders before Lender A has been fully repaid (the clause in an agreement setting out this prohibition is known as a “negative pledge” clause).

If instead Borrower Z grants Lender A a “floating charge” over its assets, Borrower Z will typically remain free to sell the secured assets unless and until certain pre-specified events occur (e.g. Borrower Z fails to make an interest payment to Lender A on time). 

Priority

The type of security taken by a lender can also dictate that lender’s ranking in the order of priority between all creditors:

• If Company A becomes insolvent, its assets will be liquidated (i.e. sold off in exchange for cash) so that the parties to which Company A owes money (Company A’s “creditors”) can be repaid. However, the value of an insolvent borrower’s remaining assets will typically be lower than the value of its existing debt obligations. Moreover, the borrower may have become insolvent whilst still owing money to multiple creditors. The law deals with such circumstances by setting out a system of priority between creditors. 
• If a lender has been granted security, this can ensure that it will be repaid (out of the proceeds from the sale of secured assets) in priority to other lenders that either do not have the benefit of security (“unsecured lenders”), or have security that ranks lower in priority. Lenders that have fixed charges over a borrower’s assets generally rank above lenders with floating charges, whilst lenders with no security will generally rank beneath lenders that do have some form of security. 
• Note that a company may be in possession of property that does not belong to it, such as machinery that is leased/borrowed or goods that have been supplied on terms that ensure those goods remain the supplier’s property until they have been paid for in full (e.g. through the use of retention of title clauses). Such items must be returned to their actual owners; they cannot be sold for the benefit of the insolvent company’s lenders.

By way of example, let’s assume that Lender A is owed £100,000 and has a fixed charge over Borrower Z’s assets; Lender B is owed £100,000 and has a floating charge over Borrower Z’s assets; and Lender C is owed £100,000 and has no security over Borrower Z’s assets. If Borrower Z becomes insolvent and only £150,000 remains after all its assets have been sold, Lender A will likely receive back it’s £100,000 in full; Lender B might receive back the remaining £50,000 (which covers at least some of the money it is owed); and Lender C will most likely receive back nothing, as unsecured creditors rank lower in the order of priority. 

Secured creditors: lenders that have been granted security over a borrower’s assets.

Unsecured creditors: lenders that do not have the benefit of security over any of a borrower's assets.

Note that this section provides an oversimplification of the rules governing security. There are other rules that affect the order of priority. Lenders can contractually agree an alternative order of priority between themselves (using “intercreditor” or “subordination” agreements), whilst a certain proportion of the assets subject to a floating charge may be set aside (“ring-fenced”) for unsecured creditors. Different forms of security may also be better suited to different types of assets. However, for the purposes of this course (i.e. interview and internship preparation), the detail in this section should be more than enough.

Issues with taking security

Taking security can be an expensive process, as it typically involves the drafting and negotiation of a number of documents (and therefore the involvement of a number of professional advisers). Moreover, certain types of security may not be recognised in other jurisdictions, for instance security involving trustees, although further consideration of this is outside of the scope of this course.

Some corporate borrowers may also be subject to restrictions that prevent them from granting security over their assets to lenders. These restrictions may be in the corporate borrower’s constitutional documents (the documents that set out what companies can and cannot do) or in agreements with other lenders (such agreements may include, for instance, a negative pledge clause, as discussed above). 

Certain types of security must also be registered. For example, fixed charges must be registered at Companies House within 21 days. Failure to register may mean that the security is void, which can have dire consequences for lenders (as they will therefore rank beneath secured creditors in the order of priority).