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 than 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.
More sophisticated criticisms of security point to the fact that although unsecured creditors will receive less on insolvency, they should be able to compensate by charging a higher interest rate. However, since many unsecured creditors are unable to adjust their "interest rates" upwards (tort claimants, employees etc), the company benefits from a cheaper overall level of credit, to the detriment of these non-adjusting creditors. There is thus a transfer of value from these parties to secured borrowers.
Most systems of insolvency law allow mutual debts to be set-off, allowing certain creditors (those who also owe money to the insolvent debtor) a pre-preferential position. In some countries, "involuntary" creditors (such as tort victims) also have preferential status, and in others environmental claims have special preferred rights for cleanup costs.
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.
Traditionally security interests in common law can be divided either of two ways.
In practice, some security interests can arise either by operation of law or by agreement, and so the preferred categorisation is between possessory and non-possessory security interests.
For simplicity, the discussion of the various forms of security interest that follows is principally based upon the English law position. This has been followed in most common law countries, and most common law countries have similar property statutes regulating the common law rules.
Security may be any type of property. The law divides anything that is capable of being owned into two classes: personal property and real property. Real property is the land, the buildings affixed to it and the rights that go with the land. Personal property often has been defined as anything capable of ownership, which is not real property.
A legal mortgage arises when the assets are conveyed to the secured party as security for the obligations, but subject to a right to have the assets reconveyed when the obligations are performed. This right is referred to as the "equity of redemption". The law has historically taken a dim view of provisions which might impede this right to have the assets reconveyed (referred to as being a "clog" on the equity of redemption), although the position has become more relaxed in recent years in relation to sophisticated financial transactions.
References to "true" legal mortgages mean mortgages by the traditional common law method of transfer subject to a proviso in this manner, and references are usually made in contradistinction to either equitable mortgages or statutory mortgages. True legal mortgages are relatively rare in modern commerce, outside of occasionally with respect to shares in companies. In England, true legal mortgages of land have been abolished in favour of statutory mortgages.
To complete a legal mortgage it is normally necessary that title to the assets is conveyed into the name of the secured party such that the secured party (or its nominee) becomes the legal titleholder to the asset. If a legal mortgage is not completed in this manner it will normally take effect as an equitable mortgage. Because of the requirement to transfer title, it is not possible to take a legal mortgage over future property, or to take more than one legal mortgage over the same assets. However, mortgages (legal and equitable) are non-possessory security interests. Normally the party granting the mortgage (the mortgagor) will remain in possession of the mortgaged asset.
The holder of a legal mortgage has three primary remedies in the event that there is a default on the secured obligations: they can foreclose on the assets, they can sell the assets or they can appoint a receiver over the assets. The holder of a mortgage can also usually sue upon the covenant to pay which appears in most mortgage instruments. There are a range of other remedies available to the holder of a mortgage, but they relate predominantly to land, and accordingly have been superseded by statute, and they are rarely exercised in practice in relation to other assets. The beneficiary of a mortgage (the mortgagee) is entitled to pursue all of its remedies concurrently or consecutively.
Foreclosure is rarely exercised as a remedy. In order to exercise the remedy of foreclosure the secured party needs to make an application to the court, and the order is made in two stages (nisi and absolut), making the process slow and cumbersome. Courts are historically reluctant to grant orders for foreclosure, and will often instead order a judicial sale. If the asset is worth more than the secured obligations, the secured party will normally have to account for the surplus. Even if a court makes a decree absolut and orders foreclosure, the court retains an absolute discretion to reopen the foreclosure after the making of the order, although this would not affect the title of any third party purchaser.
The holder of a legal mortgage also has a power of sale over the assets. Every mortgage contains an implied power of sale. This implied power exists even if the mortgage is not under seal. All mortgages which are made by way of deed also ordinarily contain a power of sale implied by statute, but the exercise of the statutory power is limited by the terms of the statute. Neither implied power of sale requires a court order, although the court can usually also order a judicial sale. The secured party has a duty to get the best price reasonably obtainable, however, this does not require the sale to be conducted in any particular fashion (ie. by auction or sealed bids). What the best price reasonably obtainable will be will depend upon the market available for the assets and related considerations. The sale must be a true sale - a mortgagee cannot sell to himself, either alone or with others, even for fair value; such a sale may be restrained or set aside or ignored. However, if the court orders a sale pursuant to statute, the mortgagee may be expressly permitted to buy.
The third remedy is to appoint a receiver. Technically the right to appoint a receiver can arise two different ways - under the terms of the mortgage instrument, and (where the mortgage instrument is executed as a deed) by statute.
In England, a third remedy, "appropriation" may exist under The Financial Collateral Arrangements (No.2) Regulations 2003 where the assets subject to the mortgage are 'financial collateral' and the mortgage instrument provides that the regulations apply. Appropriation is a means whereby the mortgagee can take title to the assets, but must account to the mortgagor for their fair market value (which must be specified in the mortgage instrument), but without the need to obtain any court order.
If the mortgagee takes possession then under the common law they owe strict duties to the mortgagor to safeguard the value of the property (although the terms of the mortgage instrument will usually limit this obligation). However, the common law rules relate principally to physical property, and there is a shortage of authority as to how they might apply to taking "possession" of rights, such as shares. Nonetheless, a mortgagee is well advised to remain respectful of their duty to preserve the value of the mortgaged property both for their own interests and under their potential liability to the mortgagor.
An equitable mortgage can arise in two different ways - either as a legal mortgage which was never perfected by conveying the underlying assets, or by specifically creating a mortgage as an equitable mortgage. A mortgage over equitable rights (such as a beneficiary's interests under a trust) will necessarily exist in equity only in any event.
Under the laws of some jurisdictions, a mere deposit of title documents can give rise to an equitable mortgage. With respect to land this has now been abolished in England, although in many jurisdictions company shares can still be mortgaged by deposit of share certificates in this manner.
Generally speaking, an equitable mortgage has the same effect as a perfected legal mortgage except in two respects. Firstly, being an equitable right, it will be extinguished by a bona fide purchaser for value who did not have notice of the mortgage. Secondly, because the legal title to the mortgaged property is not actually vested in the secured party, it means that a necessary additional step is imposed in relation to the exercise of remedies such as foreclosure (although in the recent case of Alfa Telecom Turkey Limited v Cukurova Finance International Limited HCVAP 2007/027, heard in the Eastern Caribbean Court of Appeal as to matters of English law (and so currently subject to appeal to the Privy Counsel), it was held that an equitable mortgagee could enforce security over financial collateral (in this case shares) by informing the interested mortgagor and other interested parties of the fact without first taking possession of shares or having his ownership interest recorded in the register.
Many jurisdictions permit specific assets to be mortgaged without transferring title to the assets to the mortgagee. Principally, statutory mortgages relate to land, registered aircraft and registered ships. Generally speaking, the mortgagee will have the same rights as they would have had under a traditional true legal mortgage, but the manner of enforcement is usually regulated by the statute.
A fixed equitable charge confers a right on the secured party to look to (or appropriate) a particular asset in the event of the debtor's default, which is enforceable by either power of sale or appointment of a receiver. It is probably the most common form of security taken over assets. Technically, a charge (or a "mere" charge) cannot include the power to enforce without judicial intervention, as it does not include the transfer of a property proprietary interest in the charged asset. If a charge includes this right (such as private sale by a receiver), it is really an equitable mortgage (sometimes called charge by way of mortgage). Since little turns on this distinction, the term "charge" is often used to include an equitable mortgage.
An equitable charge is also a non-possessory form of security, and the beneficiary of the charge (the chargee) does not need to retain possession of the charged property.
Where security equivalent to a charge is given by a natural person (as opposed to a corporate entity) it is usually expressed to be a bill of sale, and is regulated under applicable bills of sale legislation. Difficulties with the Bills of Sale Acts in Ireland, England and Wales have made it virtually impossible for individuals to create floating charges.
Floating charges are similar in effect to fixed equitable charges once they crystallise (usually upon the commencement of liquidation proceedings against the chargor), but prior to that they "float" and do not attach to any of the chargor's assets, and the chargor remains free to deal with or dispose of them.
A pledge (also sometimes called a pawn) is a form of possessory security, and accordingly, the assets which are being pledged need to be physically delivered to the beneficiary of the pledge (the pledgee). Pledges are rarely used in commercial contexts, but are still used by pawnbrokers, which, contrary to their old world image, remain a regulated credit industry.
The pledgee has a common law power of sale in the event of a default on the secured obligations which arises if the secured obligations are not satisfied by the agreed time (or, in default of agreement, within a reasonable period of time). If the power of sale is exercised, then the holder of the pledge must account to the pledgor for any surplus after payment of the secured obligations.
A pledge does not confer a right to appoint a receiver or foreclose. If the holder of pledge sells or disposes of the pledged assets when not entitled to do so, they may be liable in conversion to the pledgor.
A legal lien, in most common law systems, is a right to retain physical possession of tangible assets as security for the underlying obligations. It is a form of possessory security, and possession of the assets must be transferred to (and maintained by) the secured party. The right is purely passive; the secured party (the lienee) has no right to sell the assets - merely a right to refuse to return them until paid.
Most legal liens arise as a matter of law (mostly by common law, but also by statute), however, it is possible to create a legal lien by contract. The courts have confirmed that it is possible to also give the secured party a power of sale in such a contract, but case law on such a power is limited and it is difficult to know what limitations and duties would be imposed on the exercise of such a power.
Equitable liens are slightly amorphous forms of security interest that only arise by operation of law in certain circumstances. Academically it has been noted that there seems to be no real unifying principle behind the circumstances that give rise to them.
An equitable lien takes effect essentially as an equitable charge, and they arise only in specified situations, (e.g. an unpaid vendor's lien in relation to property is an equitable lien; a maritime lien is sometimes thought to be an equitable lien). It is sometimes argued that where the constitutional documents of a company provide that the company has a lien over its own shares, this take effect as an equitable lien, and if that analysis is correct, then it is probably the one exception to the rule that equitable liens arise by operation of law rather than by agreement.
Hypothecation, or "trust receipts" are relatively uncommon forms of security interest whereby the underlying assets are pledged, not by delivery of the assets as in a conventional pledge, but by delivery of a document or other evidence of title. Hypothecation is usually seen in relation to bills of lading, whereby the bill of lading is endorsed by the secured party, who, unless the security is redeemed, can claim the property by delivery of the bill.
Some obligations are backed only by a security interest against specific designated property, and liability for repayment of the debt is limited to the property itself, with no further claim against the obligor. These are referred to as "nonrecourse obligations".
Other obligations (i.e., recourse obligations) are backed by the full credit of the borrower. If the borrower defaults, then the creditor can force the obligor into bankruptcy and the creditors will divide all assets of the obligor.
Depending on the relative credit of the obligor, the quality of the asset, and the availability of a structure to separate the obligations of the asset from the obligations of the obligor, the interest rate charged on one may be higher or lower than the other.
Perfection of security interests means different things to lawyers in different jurisdictions.
With the Americanization of the world's legal profession, the second definition is becoming more frequently used commercially, and arguably is to be preferred, as the traditional English legal usage has little purpose except in relation to the comparatively rare true legal mortgage (very few other security interests require additional steps to attach to the asset, but security interests frequently require some form of registration to be enforceable on the chargor's insolvency).
There are a number of other arrangements which parties can put in place which have the effect of conferring security in a commercial sense, but do not actually create a proprietary security interest in the assets. For example, it is possible to grant a power of attorney or conditional option in favour of the secured party relating to the subject matter, or to utilise a retention of title arrangement, or execute undated transfer instruments. Whilst these techniques may provide protection for the secured party, they do not confer a proprietary interest in the assets which the arrangements relate to, and their effectiveness may be limited if the debtor goes into bankruptcy.
It is also possible to replicate the effect of security by making an outright transfer of the asset, with a provision that the asset is re-transferred once the secured obligations are repaid. In some jurisdictions, these arrangements may be recharacterised as the grant of a mortgage, but most jurisdictions tend to allow the parties freedom to characterise their transactions as they see fit. Common examples of this are financings using a stock loan or repo agreement to collateralise the cash advance, and title transfer arrangements (for example, under the "Transfer" form English Law credit support annex to an ISDA Master Agreement (as distinguished from the other forms of CSA, which grant security)).
In the United States, under Article 9 of the Uniform Commercial Code, a security interest is a proprietary right in a debtor's property that secures payment or performance of an obligation. A security interest is created by a security agreement, under which the debtor grants a security interest in the debtor's property as collateral for a loan or other obligation.
A security interest grants the holder thereof a right to take remedial action with respect to the property that is subject to the security interest upon the occurrence of certain events -- the classic example being the non-payment of a loan. The holder may take possession of such property in satisfaction of the underlying obligation, or, more common, the holder will sell such property (either by means of public auction or private transfer) and apply the proceeds of such sale to the underlying obligation. To the extent that the proceeds of the sale exceed the amount of the underlying obligation, the debtor is entitled to the excess; and, to the extent that the proceeds of the sale do not exceed the amount of the underlying obligation, the holder of the security interest is entitled to a deficiency judgment pursuant to which the holder can institute additional legal proceedings aimed at recovering the full amount of the underlying obligation from the debtor.
In the U.S. the term "security interest" is often used interchangeably with "lien"; that being said, the term "lien" is more often associated with real property collateral than with personal property collateral.
Security interests in most types of personal property are governed in the United States by Article 9 of the Uniform Commercial Code. A security interest is typically granted by a contract called a "security agreement". Upon execution of such contract by the debtor, the security interest exists with respect to the property in question assuming that the debtor has an ownership interest or ownership-like interest therein and assuming that some form of value has been conferred by the holder of the security interest to the debtor (such as a loan). Also, upon execution of such contract, the security interest becomes enforceable between the holder thereof and debtor; however, in order for the rights of the holder of the security interest to become enforceable against third parties, the holder must "perfect" the security interest. Perfection is typically achieved by filing a document called a "financing statement" with a governmental authority (often, the secretary of state in which a corporate debtor is incorporated -- although there are various rules applicable to natural persons and certain types of corporate debtors), however, perfection can also be obtained by taking possession of the collateral in question (assuming the collateral in question is tangible property). Absent "perfection", the holder of the security interest will not be able to enforce its rights in the collateral vis-á-vis third parties, such as other creditors who claim a security interest in the same collateral or a trustee in bankruptcy.