Different Forms of Collateral

CHAPTER 7

DIFFERENT FORMS OF COLLATERAL

7.1 INTRODUCTION 3

7.2 MEANING OF COLLATERAL 3

7.3 GENERAL ASPECTS PERTAINING TO COLLATERAL 4

7.4 ACCEPTABLE AND NON-ACCEPTABLE COLLATERAL 6

7.5 GUARANTEES/ SURETYSHIPS 9

7.6 MORTGAGES OVER REAL PROPERTY 12

7.7 SECURITIES OVER CHATTELS 13

7.8 SECURITIES OVER CHOSES IN ACTION/ CESSIONS 14

7.9 OTHER FORMS OF COLLATERAL 18

7.10 SUMMARY 20

TEST YOUR KNOWLEDGE - THEORY 21

ESSAY QUESTIONS AND CASE STUDIES: CHAPTER 7 – DIFFERENT FORMS OF COLLATERAL 22

CHAPTER 7

DIFFERENT FORMS OF COLLATERAL

AIM

To provide learners with knowledge of the different forms of collateral that may be available to banks when loans are granted and aspects regarding the appropriateness of the collateral.

KEY CONCEPTS

Guarantee/suretyship Mortgage Chattels

Choses in action Cessions Retention money

LEARNING OUTCOMES

On completion of this chapter learners should be able to:

·  Explain the role of collateral in bank lending.

·  Discuss the characteristics of good collateral.

·  Name the general problems encountered with the realisation of collateral.

·  Discuss guarantees/suretyships in terms of :

- nature of guarantee/suretyship;

- guarantees/suretyships by individuals;

- guarantees/suretyships by companies;

- guarantees/suretyships by trusts;

- specific credit risks pertaining to suretyships.

·  Discuss the general characteristics of mortgages over real estate.

·  Distinguish and briefly explain the rights of mortgagers and mortgagees.

·  Briefly explain securities over physical chattels.

·  Explain the following securities over choses in action (types of cessions) in essence and the credit risks pertaining to each of them :

- book debts;

- bank deposits;

- insurance policies;

- loan accounts in companies;

- contract and retention money; and

- shares.

·  Explain the difference between taking loan accounts in companies as security and the subordination of loan accounts.

·  Discuss deposits of certificate of title and letters of comfort as forms of collateral as well as the credit risks pertaining to each of them.

·  Decide on the form/s of collateral to be obtained from a client, determine the realistic value of the collateral and evaluate the suitability of the collateral.

7.1 INTRODUCTION

A bank's primary function is to take funds on deposit from persons with surplus funds at their disposal and to lend out funds to persons requiring such funds for business or personal purposes.

It is of prime importance for a bank to constantly assess the financial position of prospective and existing borrowers in as prudent a manner as possible. If in its efforts to gain business a bank is too lenient in its assessment of clients' credit risk, it will incur a large proportion of defaulting clients. On the other hand if the bank is too stringent in its credit assessment it will lose business to its competitors.

Clearly, whenever money is advanced by a bank to a client, there is a certain amount of risk that the client may fail or, for some reason be unable to repay his debt. In the interest of investors (and shareholders), it is essential that every effort be made to minimise the possibility of the bank suffering a loss. The primary means by which this is achieved is by obtaining some form of collateral from the borrower to cover the debt in the event of default.

Please note that the terminology used and relevance of collateral referred to in this chapter may not necessarily be applicable in all countries. Legislation applying in different countries is not necessarily the same but the collateral types are generally common in nature. Therefore, the types of collateral will be described from a universal viewpoint without referring to specific country related legal implications that may emanate from it.

7.2 MEANING OF COLLATERAL

The term "collateral" means :

• The acquisition of rights over assets to support a borrower's personal undertaking to repay the debt. Failure by the borrower to repay the debt will result in the bank (creditor) exercising its rights in terms of the collateral.

• "Collateral" can also mean the acquisition of rights by the bank against certain third parties who have undertaken, (failing timeous performance on the part of the principal debtor), to fulfil the commitments of the principal debtor.

Obtaining acceptable collateral is a very important aspect in banking, and that is why negotiations with the client should commence right from the start. The decision to take collateral or not, cannot be isolated from the assessment of a credit application.

Collateral serves as insurance against unforeseen circumstances. The bank as lender requires some right over and above the basic contractual right to sue the client if repayment is not made according to the terms of the contract.

To negotiate for collateral after the finance has been granted is unsatisfactory as it could lead to friction with the client and result in losses for the bank. The preferential right of the bank in respect of the collateral can be put aside in the event of insolvency or the client can refuse to supply security afterwards. The collateral obtained from a client must therefore be legally in order and effective, prior to the funds being released to the client to prevent any of the abovementioned problems.

Apart from the aforementioned, the bank also attempts to obtain a greater degree of commitment from the client in respect of his exposure to the bank.

7.3 GENERAL ASPECTS PERTAINING TO COLLATERAL

The main objective when a banker takes collateral is to protect the bank against losses should the principal debtor default for any reason.

In this regard the following matters relating to the practical aspects of taking collateral for advances, must be considered :

7.3.1 Important sections of insolvency legislation

Legislation pertaining to insolvency, liquidation, and bankruptcy is not the same in different countries but bankers should keep the following aspects in mind when considering the collateral offered by clients:

• The possibility of collateral offered to the bank for existing debt exposure within a specified period before the sequestration of the client's estate or if the client’s liabilities exceeded his assets when the collateral was provided may be regarded as resulting in undue preference to the bank above other creditors. There are circumstances where the provision of collateral can be set aside by a court based on these issues.

7.3.2. Completion and signing of collateral documents

Clients should not be allowed, nor be asked, to sign any documents which are incomplete or in blank, even if the client becomes impatient, as the documents may be incorrectly completed afterwards and also to prevent any misunderstanding. There are circumstances where courts ruled that incomplete signed documents are regarded as invalid.

It should be noted that where handwriting occurs on a collateral document it should preferably be completed by the same person with the same pen, as a client who wishes to defend himself in any action by the bank against him, may state that part of the document was incomplete when it was signed by him.

In such circumstances the onus will be on the banker to prove that the document was completed before it was signed. This may be very difficult, particularly if action is taken several years after the document was signed and the witnesses are no longer available to testify.

7.3.3 Back dating

A banker should never backdate documents for any reason whatsoever. If the documents are required in a Court action by or against the bank, the bank may lose the case if it is proved that the documents were dated differently to the day they were signed.

7.3.4 Witnesses

A collateral document is not invalid merely because it was not attested to by two witnesses, except where it is a requirement by an act that a certain document be attested to by two witnesses, for example a last will and testament. The reason why it is important that collateral documents should be attested to by two witnesses, is that if the client or surety claims at a later stage that he never signed the collateral document, the two witnesses can testify in this regard. As such it is very important that the client or surety signs the documents in the presence of the witnesses. If the document is signed in the presence of one witness only and such witness may for some reason, not be available to testify in Court, the bank may lose its case.

7.3.5 Signing of documents under general power of attorney

Under a General Power of Attorney the agent is empowered to enter into most transactions on behalf of his principal. The agent may inter alia open a bank account, draw cheques, enter into contracts and supply collateral for overdraft facilities on behalf of the principal.

An inherent danger of a General Power of Attorney is that it is not addressed to anyone in particular and is revocable. A principal may wish to cancel the General Power of Attorney, but his agent may refuse to hand it back to him. The only way the principal can advise the outside world of such cancellation is to advertise in the newspapers that he has revoked the authority of his agent. Anyone accepting the signature of the agent after the publication of such a notice will do so to his detriment.

It is advisable for a banker to ask for a Power of Attorney to be addressed to the bank, and the principal should confirm to the bank that he will not cancel the Power of Attorney unless he has informed the bank of such action in writing.

The question that may arise is "What should a banker do if the agent wants to sign a guarantee on behalf of his principal in his own favour?". In terms of the General Power of Attorney he is legally entitled to do so, but it is advisable to insist on the principal signing the guarantee himself, or to obtain confirmation from the principal that such a transaction is authorised by him.

7.4 ACCEPTABLE AND NON-ACCEPTABLE COLLATERAL

7.4.1 Classification according to characteristics of good collateral

Collateral is normally classified by a bank in two broad categories, namely "approved" and "unapproved" collateral. The qualities of approved collateral are set out in the table below and are formulated as questions which can be asked when dealing with collateral

7.4.2 General problems with the realisation of collateral

Some general problems which may occur with the realisation of collateral are listed below :

• If another person has a better claim against the asset, due to the fact that the collateral (asset) does not belong to the client, the bank may not receive the full amount to settle the outstanding balance, when the asset is sold or disposed of.

• Where there is a delay in converting the asset to cash, the risk to the bank is increased due to the fact that :

- the value of the asset may drop significantly; and/or

- additional costs need to be incurred which will increase the outstanding balance of the debt.