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“Try and Be Careful When You Step out in the World,” said Your Mother

“Make sure you, take care!” All these are the words that drop similar to fragile butterflies, unbidden from the lips regarding almost every mama on the planet around the actual period her young adults happen to be of sufficient age to go away from residence and next associate within the freeways as well as byways with other older people as if these children, also, were altogether entirely grown. Mothers hope to convey a hard and also defensive gloss to hide their son’s or daughter’s lack of life experience, and also worse yet, their lack of comprehending, their malfunction to learn that they’ll not ever be 100% safe and sound. The various actions of others, if not their very own, possess the heartbreaking potential to be able to render terrible and unforeseen injuries, also injuries that could call for, inside a dreadful and complicated world, the help of a good traumatic brain injury lawyer.

Right now there it is, organized bare as well as bald, the terror belonging to the out there unknown, of the possible, of all that is bad. It will be that which most of us read about daily in the headlines of reports stories that unexpectedly happen to others. It is usually merely other individuals which need a personal injury lawyer to characterize all the liberties of merely one harmed rife with the hopes involving some sordid profit due to the fact that, at this point, is all the gain left to be had in this once vivid dream involving everyday life turned to become this nightmare. It really is fear’s underbelly which usually slithers below the light, stunning butterfly thoughts said lightly, so lightly, but with a caring mother’s significant purpose: “You should, be careful out there.”

Safeguards of Creditors

INTRODUCTION:

This essay seeks to find out that in present day loan transactions what measures can ensure the repayments; and how effective they are. The essay looks at the customary way of protection: the security _ by way of mortgage and charge; the nontraditional and smart ways that have evolved with the passage of time: quasi-security _ retention of title, hire purchase and sale and lease back arrangements; and other safeguards like contractual covenants etc. Each of these measures of protection, except the covenants, has been discussed in proportion of their importance, particularly, for those who effectively fund companies. Thus the main focus remains on the banks.

CREDITORS’ PROTECTION:

Banks, individual or syndicates, are the entities that effectively fund companies and their operations. They receive deposits on one hand and advance these deposits as loans on the other; and thus make profits. However this process is very delicate, as if enough loans are not granted, little profit would be earned; and if too much loans are granted, ready cash may not suffice to satisfy the demands of the depositors. They have to keep a balance and focus equally on liquidity as well as profitability (1). In such a situation, they cannot afford to lose huge amounts of money advanced as loans. As long as a business, funded by the banks, continues working smoothly, every one associated with that business is benefited in one way or the other. But when it is unable to work anymore or defaults in discharging its liabilities, it goes bankrupt. In the event of bankruptcy these liabilities are paid out of the proceeds of sale of its assets.Creditors’ claims normally are more in value than the assets of the bankrupt. In such a situation a creditor needs to be in an advantageous position to realize his claims ahead of others. This, typically, can be done by being a secured creditor: who holds some security and is paid off ahead of the other creditors who don’t hold any securities. Banks, usually, while granting loans, obtain security and personal guarantee in addition to the other precautions to safeguard themselves in the event of such unfortunate happenings. Following are the ways to safeguard the position of the lending banks:

SECURITY (Collateral):

Security is an asset which a lender holds for money he has lent. “Under the Insolvency Act 1986 (the Act), security is defined by section 248 as ‘any mortgage, charge, lien or other security’. This definition is taken to mean that the rights the creditor have are proprietary in character. The proprietary interest in the debtor’s assets allows the creditor to realize the secured assets to discharge the debtor’s obligation to the creditor” (2). Generally, securities include stocks, shares, debentures, bonds, instruments creating or acknowledging indebtedness, warrants and options (3). More typical term for a security against a debt is ‘collateral’. The document granting collateral or any other charge is called ‘debenture’. “Under the terms of a debenture, the secured creditor will usually have the power, upon default by the company, either to enter into possession of the assets and sell them to pay off the secured debt or to appoint a receiver with the power to manage and sell the company’s business as a going concern to raise the money”(4).That is why the collateral is granted as a routine for obtaining loans throughout the world; and it is the most common feature of commerce in every country (5). However, for financially strong companies, particularly the public corporations, secured loan is not usually an attractive option (6). That is why “large unsecured overdrafts are quite common for established companies” (7). But in most of the cases security is a common feature, as the secured credit is the “principal means of financing’ for ongoing ventures as well as expansion purposes (8). Security or Collateral, documented as debenture, is secured, usually, by way of mortgage or charge. Both these terms are sometimes used interchangeably, as every mortgage implies a charge, though every charge is not necessarily a mortgage.

MORTGAGE:

It is ‘an interest in property created as a form of security for a loan or payment of a debt and terminated on payment of the loan or debt’ (9). Mortgage is the most typical form of loan security. Through a mortgage, the title of the secured property is transferred in the name of the creditor (mortgagee), which is transferred back to the debtor (mortgager) when the loan is paid off. The most common fixed charge securities created by companies are legal mortgages over land (10). In the event of default in payment by the debtor, the creditor is entitled to realize his money by sale of the mortgaged property. Thus, a mortgage ensures the repayment of loan of the creditor at the end of the mortgaged period or in the event of bankruptcy.

CHARGE:

A charge is also ‘an interest in company property created in favour of a creditor (e.g. as a debenture holder) to secure the amount owing’ (11). It is different from mortgage in the sense that it does not require transfer of title like a mortgage. ‘It merely gives the chargee the right to have the charged assets realized in order to pay off the debt’ (12). As a result, a charge is a security that gives rise to the priority of the holder over unsecured creditors. A charge can either be a fixed charge or a floating charge. Every charge is a result of contract between the parties. A fixed charged is associated with specific assets and limits the debtor’s free dealing with such assets. These can be intangible assets, like shares in other companies (13). It, being a fixed security, is enforced prior to all other classes of creditors (14).On the other hand, a floating charge floats over all the assets of the debtor. It usually is suitable in case of those assets the value of which fluctuates, like stocks, cash, shares, book debts etc. It allows the debtor to use the charged assets freely until the event of default or bankruptcy. The floating charge is desirable sometimes because the specific assets lose their value through market fluctuation or depreciation. In that case collateral may not continue to be of sufficient value equivalent to the amount of loan. That is why in certain cases floating charge is preferred by the creditors. However, in case of bankruptcy, not only the fixed charge holders, but the preferential creditors get priority over the floating charge holders in the order of payment (15). Thus, a floating charge, though necessary in certain situations, does not make its holder a secured creditor in the true sense. But certainly his position is better than that of the unsecured creditors.

The Customary Safeguard:

‘Secured creditors are, as a matter of policy, immune from the loss.’ (16) While in liquidation the creditors could get only a small percentage of their claims, (17) 75 per cent creditors could get nothing, and only 2 per cent could recover their full amount; (18) banks’ rate of recovery remained as high as 77 per cent as compared to the 27 per cent of the preferential creditors.(19) In globalized financial system, many companies’ assets and creditors are spread over more than one jurisdiction.’European Union, too, is to have an internal financial market “with open access to banks’ and financial institutions’ operation in member countries” (20). On the other hand, “The fragility of the financial system, built as it is on confidence, can mean that there is a real possibility of systemic risk spreading throughout the system.” (21) In such a situation, banks, like every creditor, get the best security (22) _ though, the security is merely a contingency measure, otherwise primarily, banks loan against feasibility and cash flow (23). Still in case of any unfortunate event like default or insolvency of the debtor, it is only the security that can be the best safeguard for a creditor. Collaterals by way of mortgage or charge are the most reliable and customary safeguards available to the creditors. But there are certain other measures that can be taken by the creditors to ensure secure repayment of their loans.

QUASI SECURITIES:

Credit is granted on four major grounds: by getting a security, without any security (an unsecured loan), by having guarantee of a third party or by making use of a sale as a security arrangement. (24) These security-by-sales arrangements provide a reasonable level of security to the person who advances money, but in most cases he is not a typical creditor. These transactions, not being typical loans, cannot be described to be made on the basis of security; instead they are said to be made for quasi securities. Hereunder are the most common types of quasi-security:

RETENTION OF TITLE:

In case, a bank finances a company to purchase some machinery, raw material or any other item, it may require retaining of the title of such items with itself unless the full amount loaned for the purchase is paid off. ‘Retention of title clause’ in an agreement, normally, defends such items from any claims by other secured or preferential creditors (25), in case of insolvency of the debtor, as long as this item is recognizable (26). However if such an item is processed and loses its identity before the insolvency proceedings start, then the title cannot be retained (27). In that case, the title holder will have to be among other unsecured creditors. This type of security is typical for trade creditors.However, a bank can benefit from this method in certain cases; although banks, in case of other creditors, have expressed disapproval of retention of title. (28) ‘Surveys suggest that majority of suppliers employ such clauses in their conditions of sales’ (29). But they can only bear a fruit if the user of these clauses are not affected by the complex, time-consuming and expensive legal proceedings involving a number of other secured and unsecured creditors. Critics usually do not find the retention of title clause as useful as it seems on the face of it: ‘the device fails, at the end of long and legally uncertain day, to deliver real protection to the quasi-secured creditor.’ (30) It, however, remains equally effective in liquidation, administrative receivership, administration and voluntary arrangement, in the event of insolvency of the debtor. (31)

HIRE PURCHASE:

This is another mode of securitization that is a sale arrangement of the face of it but in fact operates as a security device. It is a method of buying goods in which the buyer advances a small amount as deposit to the seller and takes the possession of the goods (and not the title), as a bailee. The balance price is paid in periodical installments over a longer period of time. When the price is fully paid off, the ownership is transferred to the buyer. During this period from taking possession till getting ownership, if the buyer defaults in payments, the seller can exercise his right to take the goods back being the real owner. This is something like ‘retention of title’. This method is generally used by the small and medium businesses and the trade creditors. But it can be used by the banks to advance loan in cash while converting it into kind _ by purchasing the required equipment or land etc for the debtor _ and retaining the title until the debt is paid off. However, a property purchased mainly for credit purposes, _ which originally meant for some different use by the original owner _ sometimes, may not be one easily disposable. In such a case, the creditor may have to sell it at a lower price to save expense of resources on looking after it. Still it is a better option to safeguard the interests of the creditor. That is why there has been a rise in number in this type of arrangements in recent years (32).

SALE AND LEASE BACK:

This is another way for a person or company to secure money by sale of an asset to a bank or lender. But the sale agreement includes the condition that the same asset would be leased back to the seller for certain period of time on agreed terms and condition. Thus the seller secures required amount without losing the right to use that asset, whereas the buyer gets the ownership in lieu of the amount paid; and thus gets secured. This type of agreement despite not being a security offers more than sufficient security; and falls under the category of quasi security. This is said to be a lower-cost method by the creditors to achieve priority in insolvent regimes (33).This can reasonably safeguard the position of the creditors. Quasi Securities are quite an interest phenomenon. They are not securities in the true sense of the word; however they provide security to a creditor at the level of an original security. All of these arrangements _ of apparent sale for the purpose of security _ are well-liked by the lenders (buyers) and the debtors (sellers). But certain critics look at them from a different angle. To them, these seem to be tools of the so-called secured creditors and the debtors to grab the assets of companies leaving nothing for other classes of creditors in case of bankruptcy. Thus, this phenomenon looks like another aspect of ‘bankruptcy Darwinism’ (34). And if these types of arrangements continue, some critics predict more losses for the other classes of creditors: ‘If, however, the debtor looks to quasi security and shifts its asset patterns so as rely more heavily on the use of assets that are leased or subject to hire purchase agreements, retention of title or other sale-based security devices, the protection offered to the secured creditor will be diminished. Fewer assets will enter the insolvent estate in the scenario involving heavy reliance on quasi-security and the holder of, say, a floating charge, will have a call on a slimmer body of assets.’ (35) Anyway, quasi securities are good safeguards for the creditors.Continued as SAFEGUARDS OF CREDITORS – II

Safeguards of Creditors

Continued from SAFEGUARDS OF CREDITORS – I

OTHER SAFEGUARDS: Since the grant of a loan is a contract, it provides all those remedies to a creditor, in case of default by the debtor, which can be available to each party to a contract against the other party in the event of breach of contract. Thus the measures mentioned above or below are in fact the ones, in addition to those provided by a contract. In a loan agreement, the creditor is the primary stake holder. Therefore, he can get as many assurances as possible through the loan agreement itself. Some such most common safeguard measures, besides the security, are the following:

NEGATIVE PLEDGE: The negative pledge clause is a “common feature of loan and security documentation”(38). It is an undertaking by the debtor not to allocate specific assets to another secured creditor. “By executing a negative pledge clause, the borrower promises that he will not grant any further rights which will give another creditor priority ahead of the lender to its assets, or, depending on the wording of the clause, that the original lender will be granted equal or equivalent rights.” (39) A negative pledge secures the interest of the creditor on one hand and put a ceiling on the borrower with regard to excessive liabilities on the other. It can also be included in case of a floating charge. However, practically, a negative pledge cannot restrict the grant of collateral by the debtor to another creditor absolutely. And if collateral is granted to a second creditor the first one can only seek remedy for breach of contract. However the collateral given to the second creditor would remain valid in the eyes of law. Even so, in secured loans negative pledge clause would prohibit second ranking security. (40) But, briefly, with very few and quite lengthy in process remedies, and without any proprietary interest of the lender, negative pledge clause can shield only a floating charge holder, to some extent, and this protection is not comprehensive(41).

GUARANTEE: It is a ‘second agreement’ (42), in addition to the primary loan agreement between the creditor and the debtor, by a third person who promises to perform the obligation of the borrower in case of his default. This third person, the guarantor, becomes responsible through the written guarantee to pay off the amount due as a loan if the borrower fails to do so. Though this is a contractual obligation, and needs a consideration for the guarantor, too, yet it strengthens the position of a creditor in case the debtor fails to pay the debt. Guarantee is also called quasi collateral.(43)

CONTRACTUAL COVENANTS: The loan agreement contains terms of the transaction on one hand and divide up the risks between the parties on the other. It, however, depends which party is stronger. If the debtor is sound enough, he may not agree to offer heavy securities to the creditor. But in such a case, the creditor would otherwise see few chances of default owing to the financial position of the debtor. If the debtor is weak financially, then a creditor may insist on covering up the risk by demanding appropriate securities. In any case, prior to making a loan agreement, a creditor must consider the risk analysis and go through the exercise of ‘due diligence’ by obtaining and analyzing certain information about the credibility of the borrower and feasibility of the transaction. If the creditor is careful and vigilant enough, at the time of the making the agreement, he can protect his position by incorporating necessary clauses as safeguards. The terms accepted by the debtor in addition to the normal ones, are called ‘contractual covenants’ ‘undertakings’ or ‘restrictive covenants’ (44).

Such covenants or undertakings by the debtor depend upon the mutual agreement of the parties. However, the main purpose of them is to secure the repayment of loan. Following are the common undertakings:

Prohibiting the change in nature of the business:

To ensure the proper utilization of the loan advanced, and avoid any adverse consequences of indulging into new kind of businesses by the debtor, a creditor may require him not to change the present nature of the business until the loan is paid off. Restriction on disposal of certain assets: A creditor apart from the negative pledge clause may require the debtor not to dispose off a particular assets in any manner whatsoever, until full repayment of the loan. This would minimize the risk of ending of the business without any assets to pay off the debtor, in the event of default or bankruptcy. Confining or limiting the creation of new debts: A business over-burdened by excessive debts is open to the risk of default or failure. A creditor would not like failure of any business funded by his loans.

This would result into a loss of his money, as well. Thus, he may require a debtor while granting a loan to restrain from having new debts, or at least, restrict to a certain level of further borrowing.

Barring or limiting the grant of dividend:

Keeping in view the weaker financial position of the debtor, a creditor may insist on inclusion of a clause in loan agreement which would make the debtor not to pay dividends to the shareholders or to limit such a payment up to certain level. This, again, would be a measure to ensure that without attaining a certain level of strength, the business would not be subject to further burdens.

Requiring a minimum net worth of the business:

A creditor may demand in loan agreement that if the net worth of the business drops down a certain limit, he would be at liberty to demand the acceleration in repayment of the loan. This is to avoid the expected threat to the money of the lender in case of a total failure of the business.

Limitation on use of the funds loaned:

The creditor may require the debtor not to spend the money lent on anything except for the purpose it is advanced. This is because the lender advances money keeping in view the viability of the business or project. He may not be sure about the outcome of expenditure on other areas or projects. Thus, to ensure the appropriate use and regular repayment of the loan, he may not agree to allow the debtor to spend it for some different purpose.

Calling for certain information:

The creditor may require the debtor, either as a condition precedent to the agreement or after the loan is advanced, to provide certain information to the creditor so as to keep him informed of the affairs of the business relevant to the financial status of the debtor. This is again a safeguard on the part of the creditor to keep him vigilant about the fate of his money.

Monitoring:

In certain situations, a creditor may demand a permanent role of monitoring the affairs of the debtor. This, usually, happens where the position of the debtor is quite weaker or the problems being faced by the company are attributed to the poor management.(45) In case of any breach the creditor may stop further payments of loan installments, if any, and may demand acceleration of repayment to secure the debt. “It will be necessary for the creditors to incur expenditure in gathering and analyzing information about the debtor’s actions and financial performance. This monitoring will ensure that defaults are detected as and when they occur” (46) ‘Monitoring’, ‘Contractual covenants’, ‘undertakings’ or ‘restrictive covenants’, being contractual in nature, creates only contractual obligations and thus do not provide, in themselves, an effective cover for the interests of the creditor. However, in addition to the security and other safeguard measures, they are capable of promising a reasonable protection to the creditor.

In addition to the above mentioned possible safeguards, following can be useful in peculiar circumstances.

SET OFF:

Set off is ‘the deduction of monies owed against sums due to be paid’ (47). Set off is a way to satisfy mutual claims by two parties, by deducting the smaller amount out of the bigger one. It may not be a usual case for a bank that in the event of insolvency a debtor would have a claim against the creditor as well. But if it is the case, then a creditor can reduce a claim against itself, by the debtor company (or the liquidator), by deducting its own claim. However, for those who fund companies it is seldom the case. Thus, the option of set off can only be partially useful in certain circumstances; otherwise in case of lending banks it does not provide any protection.

FACTORING:

Factoring is an option for a creditor of selling out the receivables to other companies at a lower value. These companies, called factors, are specialized in debt recovery, and they make money from the differences of the amounts paid to the creditor and that recovered from the debtor. Factoring is useful, particularly, for recovery from the trade debtors, to save the creditor from cash flow problem. It helps in getting something, not the full amount, from the dead debts. In case of big loans, however, this option can only be used as a last resort; which can bring only limited outcome for protection of the lenders.

INSURANCE:

A creditor, besides other safeguards, can opt for an insurance of the amount advanced through a loan agreement. This is not a free cover, neither it brings interest, instead it demands payment; still if an insurance provides cover for a risk of loss of a huge amount of loan, in case of default of payment by the debtor, or in the event of insolvency. However, in case of availability of appropriate security, it would not add much to the safety of the money advanced. Nonetheless, a creditor may weigh the cost of insurance in comparison with the risk covered and decide accordingly. PROTECTION _ That Creditors Need: In the forgoing paragraphs we have had a look at different ways to safeguard the lenders.

It can be observed that none of them is perfect. Some of them, like covenants, are only capable of creating contractual obligations, which are not sufficient to safeguard the position of the creditors. The others, particularly, the quasi-securities are suitable mostly for small and medium businesses. The lenders of big, sometimes syndicated, loans can not rely fully on these measures. However, in peculiar situations, creditors of the companies may like to blend their securities with these measures to enhance the level of protection. But, the most reliable safeguard for the creditors _ though not perfect _ remains a proper security. Only by putting themselves at the position of secured creditor, the lenders can have a maximum level of protection for their position. Nevertheless, the security, in spite of being the best, is not necessarily a perfect safeguard. Sometimes it may not provide cent per cent protection to the creditors. And this is inter alia because of the lack of information available to them about debtor companies’ indebtedness.

There are suggestions to improve the systems more and more _ like maintenance of a new register of ‘security interests’ (48). All the same, a total protection seems to be something too ambitious, as a quest for perfection (49) always remains a fantasy. CONCLUSION: Debt financing is a common feature of today’s commercial life. It works well for executing big projects with help of finances acquired as loans. But the problem of protection of the interests of the creditors could not be solved perfectly. Only by being a secured creditor, a lender can ensure the maximum level of protection, which in case of resourceful and well equipped lenders like banks goes up to 77 per cent: a reasonably high rate of recovery, but not completely successful. However, this level of protection attained through taking securities can be improved by adding certain other measures, where applicable, like quasi-securities: retention of title, hire purchase and sale and lease back agreement; contractual covenants and others