Security interest: rationale

Rationale

The principal purpose for taking a security interest over some assets is almost invariably to ensure that, if the debtor goes into bankruptcy, then the secured creditor can enforce its rights against the collateral rather than participating in the distribution to unsecured creditors in the bankruptcy, and thereby either get paid in full, or receive more in the way of payment that it would have as an unsecured creditor.

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 favour 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 charges 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.

Despite security interests being a firm feature of commercial law in almost every jurisdiction in the world, not all economists are certain of the benefit of security interests and secured lending generally. Proponents argue that by having security for a debt, this lowers the commercial risk for the lender, and in turn allows the lender to charge lower interest, thereby easing the cost of capital for business and consumers - compare for example the rates of interest that any high street bank charges for a mortgage loan and for a credit card debt. However, detractors argue that creditors having security over certain assets can destroy companies that are in financial difficulty, but which might still recover and be profitable, when the secured lenders get nervous and enforce their 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 in the lexicon), and allowing secured creditors a preference to certain assets upsets the conceptual basis of an insolvency.

But the most frequently used criticism of security and secured lending is that, if secured creditors are allowed to seize and sell key assets, then any 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 last reason, many jurisdictions restrict the ability of secured creditors to enforce their rights in a bankruptcy situation. In the U.S.A. the Chapter 11 creditor protection, which completely prevents enforcement of security interests, is specifically designed to try and keep 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.

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