Introduction To Taking Security

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1 Memoranda on legal and business issues and concerns for multiple industry and business communities Introduction To Taking Security Lina Lau & Terrence Choo Boon Liang Rajah & Tann 4 Battery Road #26-01 Bank of China Building Singapore Tel: Fax: eoasis@sg.rajahandtann.com Website:

2 Introduction To Taking Security PURPOSE OF TAKING SECURITY A financier taking security for an advance is concerned to see that if the debtor's assets are insufficient to meet the claims of all his creditors, the financier will at least be able to look to his security to obtain total or partial payment. The general rule in winding up is that all creditors are treated equally. Having security, however, allows the lender to avoid equal treatment by taking a privileged status over certain assets, thereby obtaining a priority over unsecured creditors. Alternatively, another purpose of taking security is to obtain rights against a third party who will be responsible if the debtor defaults. SECURITY INTEREST / BASIC PROPERTY CONCEPTS Nature Of Security Interest A security interest is a right given to one party in the asset of another party, to secure the payment or performance by that other party or by a third party. A security interest: arises from a transaction intended as security or in some cases by law; and is a right in rem. Real Vs Personal A security interest creates real rights in an asset as opposed to personal rights to an asset. A purely personal claim to delivery or transfer of an asset does not survive the debtor's bankruptcy but becomes converted into a right to prove for a dividend in the debtor's estate in competition with other creditors. By contrast, a security interest is a right in rem and in principle the secured creditor is entitled to remove the asset from the general body of creditors. Page 1

3 For Example: Real Personal Bankrupt Loan on $1 secured by Contract for sale and purchase of apple apple for $1 Secured Creditor Unsecured Creditor (iii) (iv) (v) SC advanced $1 to B on security of B's apple. B agrees to sell the apple to UC for $1. B takes the $1 from UC with the intention of repaying SC so that SC will release the apple. However, before he can do so, he becomes a bankrupt. SC, as secured creditor, has rights against the apple (real). He can sell it to recover the $1. As far as the apple is concerned, SC has managed to obtain priority over the other creditors of B. UC has no security. His rights are against B (personal) for failure to deliver the apple. For that, UC should have no problem getting judgment for $1. UC will prove in the bankruptcy of B and will be treated like any other unsecured creditor. After all the other assets of B are sold, UC will share pro rata with the other unsecured creditors of B. The $1 that UC paid will become part of the pool of B's assets to be distributed among all of B's creditors. TYPES OF SECURITY INTERESTS Pledge Nature Of Pledge A pledge arises when a creditor takes possession of the debtor's asset as security until payment for the debt. Possession Possession is crucial to a pledge also serves to prevent fraud. Possession can take the form of: actual possession of the assets eg as in the case of pawnshops; or Page 2

4 possession of documents of title to the assets, eg bills of lading. Constructive possession is possible Examples of constructive delivery are: when a pledgor hands over the key to his warehouse to a pledgee; delivery to the bank of the documents of title which constitute the symbol of the goods. Realising A Pledge The power of a pledgee includes implied power of sale upon default. Rights Of A Pledgor The pledgor retains the general ownership. At any time before the pledgee exercises the power of sale, the pledgor has the common law right to redeem. Rights Of A Pledgee The pledgee's interest goes beyond a mere right to detain the asset. It encompasses the following: the right to use the asset at his own risk so long as this will not impair it; to sell his interest as pledgee or assign it by way of gift; to deliver the assets to another for safe keeping; to sub-pledge the asset on the same conditions as he holds it and for a debt no greater than his own; and to sell the asset in the event of default in payment by the pledgor (but must exercise reasonable care in sale, appropriate proceeds to debt owing and account to pledgor for surplus). Duties Of Pledgee The duties of a pledgee are as follows: duty to take care of the goods but the care demanded is merely ordinary care; and Page 3

5 duty to arrange for a prudent sale (The Odessa [1916] 1 AC 145). What Can Be Pledged Since a pledge depends on possession, an asset is not pledgeable unless it is reducible to possession. Theoretically, it may be possible to have a pledge of land but in practice pledges are confined to goods and to documentary intangibles, that is, documents embodying title to goods, money or securities such that the right to these assets is vested in the holder of the document for the time being and can be transferred by delivery of the document with any necessary indorsement (ie the obligor's delivery or payment obligation is owed not to the original obligee as such but to whoever is the holder of the document and presents it for delivery or payment). The class of documentary intangibles is not closed, as it is liable to expansion through mercantile usage. Examples of documentary intangibles include: bills of lading; negotiable instruments (eg bills of exchange, cheques, promissory notes and treasury bills); negotiable securities (eg bearer shares, share warrants, bearer bonds, debentures and negotiable certificates of deposit); and documents of title to goods (eg warehouse and dock warrants or receipts which by statute or custom are negotiable). Disadvantages Of A Pledge The following are the disadvantages of a pledge: storage costs for creditor; loss of use by debtor; and assets such as goods that are perishable. Lien A lien is defined as a right in one man to retain that which is rightfully and continuously in his possession but belonging to another until the present and accrued claims of the person in possession are satisfied. Put simply, it entitles a person who has done work for another to detain goods in his possession and belonging to that other until charges for the work have been paid. Page 4

6 Except for certain specific instances, eg bankers' lien, the holder of the lien does not have the right of sale. Goods are usually delivered to a lienee for reasons other than as security, eg for storage or repair. A lien may be in the form of a general lien or a specific lien. General Lien A general lien will entitle a person in possession of the chattel to detain it as security until all the claims or accounts of the person in possession against the owner have been paid. General liens can be created from general usage or arise by contract between the parties. They have been established in favour of eg solicitors, bankers, factors, stockbrokers and insurance brokers. Special Lien A specific lien entitles the holder of the goods to retain the goods for which charges have been incurred until those charges have been paid eg warehouseman, repairer. Mortgage A mortgage is the transfer of ownership of an asset by way of security with the express or implied obligation to re-transfer ownership on the discharge of the mortgagor's obligations. Legal Mortgage The legal mortgage is the most secured and comprehensive security interest. It transfers legal title to the mortgagee and prevents the mortgagor from dealing with the securities while they are subject to the mortgage. Equitable Mortgage An equitable mortgage only transfers the beneficial interest in the securities to the mortgagee with the legal title remaining with the mortgagor. In general, an equitable mortgage will arise where: the formalities necessary to create a legal mortgage have not been completed; Page 5

7 the mortgagor's interest in the asset being mortgaged is itself an equitable interest; or the parties have merely entered into an agreement to create a legal mortgage in the future over the asset in question. Power Of Mortgagee If the mortgage is created by deed, the mortgagee has the power, under section 24 of the Conveyancing and Law of Property Act (Chapter 61) ( CLPA ) to: sell the mortgaged property; insure the mortgaged property; and appoint a receiver of the income of the mortgaged property. Usually, the requirements under the CLPA for the exercise of the mortgagee's powers are varied by the mortgage deed. Furthermore, the mortgage deed usually provides additional powers to the mortgagee, eg power to pay outgoings on the mortgaged property, and power to effect repairs. Charge A charge is an agreement whereby an interest in an asset is appropriated to the discharge of a liability or obligation. Unlike a mortgage, a charge does not transfer a legal or equitable interest in the asset to the chargee; it merely creates an encumbrance in favour of the chargee. Fixed Charge A fixed charge is one which attaches as soon as the charge has been created or the debtor has acquired rights in the asset to be charged. The effect of this is that the debtor cannot dispose of the asset free from the charge without the chargee's consent except by satisfying the indebtedness secured by the charge. In practice, fixed charges are commonly taken out on fixed assets that the company does not have to dispose of in the ordinary course of its business eg plant and machinery and intellectual property rights. A fixed charge can be taken over future property. Page 6

8 Floating Charge A floating charge is one which hovers over a designated class of assets in which the debtor has or will in the future acquire an interest. The debtor has the liberty to deal with any of the assets free from the charge so long as it remains floating. The underlying concept of a floating charge is that the company is free to manage and deal with a class of revolving assets in the ordinary course of business until an event occurs which entitles the creditor to intervene and assert his security rights over the assets then held or subsequently acquired by the company. The occurrence of such event is said to cause the charge to crystallise. The chargee's interest is thus in a changing fund of assets, not in any asset in particular, but when an event occurs which causes the charge to crystallise it attaches as a fixed security to all the assets then comprised in the fund and to any assets of the specified description subsequently acquired by the debtor. Generally, a floating charge has the following characteristics (Re Yorkshire Woolcombers' Association Ltd [1903] 2 Ch 284): there is security over a class of assets; the assets of that class change from time to time in the chargor's ordinary course of business; and the chargor is given freedom to deal with the assets in its ordinary course of business. Fixed Vs Floating Charge Advantages of Fixed Charge The creditor acquires immediate real rights over the asset which can only be cut off by a disposition to a bona fide purchaser for value without notice. By contrast, the disposition of an asset which is the subject of a floating charge will as a general rule, take effect free from the charge, whether the disposition be outright or by way of charge or mortgage. In the winding up of a company, a fixed charge has priority over preferred creditors whereas a floating charge ranks after the preferential creditors. Examples of preferred creditors are (a) costs of the liquidation; (b) employees' wages and salaries; and (c) retrenchment benefits. (iii) A floating charge given by an insolvent company within the twelve months prior to the onset of insolvency is void except as to new value. Page 7

9 Disadvantages of Fixed Charges A fixed charge is not appropriate for certain assets which a company would need to be able to dispose of in the ordinary course of its business, eg stock, receivables, cash. Advantages of Floating Charges Chargor has freedom to trade. Chargee has right to oppose appointment of judicial manager. Disadvantages of Floating Charges Weak priority position. Risk of winding up commencing within six months of creation (section 330 of the Companies Act (Chapter 50)). Section 330 of the Companies Act provides as follows: Effect of floating charge A floating charge on the undertaking or property of the company created within 6 months of the commencement of the winding up shall, unless it is proved that the company immediately after the creation of the charge was solvent, be invalid except to the amount of any cash paid to the company at the time of or subsequently to the creation of and in consideration for the charge together with interest on that amount at the rate of 5% per annum. Risk of disposal of assets by judicial manager: section 227H of the Companies Act provides as follows: Power to deal with charged property, etc. 227H. (1) The judicial manager of a company may dispose of or otherwise exercise his powers in relation to any property of the company which is subject to a security to which this subsection applies as if the property were not subject to the security. Page 8

10 (2) Subsection (1) applies to any security which, as created, was a floating charge and subsection (2) applies to any other security. Rajah & Tann is one of the largest law firms in Singapore. It is a full service firm and given its alliances, including US premier firm Weil, Gotshal & Manges, is able to tap into a number of countries. Rajah & Tann is firmly committed to the provision of high quality legal services. It places strong emphasis on promptness, accessibility and reliability in dealings with clients. At the same time, the firm strives towards a practical yet creative approach in dealing with business and commercial problems. The information contained in this newsletter is correct to the best of our knowledge and belief at the time of writing. Specific professional advice should be sought before any action is taken. In this regard, you may call the lawyer you normally deal with in Rajah & Tann or the Knowledge Management team at eoasis@sg.rajahandtann.com Rajah & Tann Knowledge Management. All rights reserved. Page 9