SHORT OVERVIEW OF SECURED TRANSACTIONS REFORM

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1 SHORT OVERVIEW OF SECURED TRANSACTIONS REFORM In partnership with

2 Typically, the secured transactions imply the contracts, under which the fulfillment of the borrower s obligations is guaranteed with the movable (assets); for example, the lender and the borrower may enter to the loan agreement and that agreement may be secured by the pledge of equipment. That deal is a simple example of secured transaction. WHY is the reform necessary? The reform focuses to those (primarily SMEs) with available movable collaterals, which are engaged in income generation for the owner (e.g. livestock is used for the income generation for the farmer, but might be pledged for the loan, as well). The successful implementation of the reform allows to solve the financial paradox [p.5, picture 1] (collateral gap) (i.e. the borrower with the movables (which brings income to the borrower) is unable to get the loan, while the borrower with the real estate is able to get the loan (but that real estate does not participate in the business (income generation)). Once the secured transactions reform is successfully implement-ted, more SME will have an access to the finance, their business will produce more progressively and that will affect the GDP size of the country. Additionally, the reform will have positive impact to the position of the country in Doing Business list [p.6, table 1] (as of today, Azerbaijan has only two positive answers to 12 questions in the list of relevant indicators). increased access to the finance Direct benefit of the reform reduction of the risks for the financial institutions (lenders) cheaper finance resources 1 P a g e

3 It is important to note that the reform will enable the broad use of the following movables finance products: HIRE PURCHASE OPERATING LEASE DEALER FINANCE FLOOR PLAN FINANCE PLANT & MACHINERY FINANCE FINANCE LEASING LEASEBACK MASTER ASSET FINANCE FACILITY Four Components from the Secured Transactions Law. 1) DOCUMENTATION OF THE SECURED TRANSACTIONS Documentation of the secured transactions should be simple. Secured transaction becomes forceful as soon as it is documented, as required by the effective law (Civil Code); Neither notarization of the agreements nor external appraisal of the movables is required to keep the documentation simple and cost-effective. Once the transaction is documented, the creditor becomes the secured creditor and obtains security interest in that movable This approach implies that equal legal regime is applied to all types of secured transactions, no matter whether it is the pledge, leasing or other type of secured transactions (in other words, the same rules are applicable for the documentation, publicizing, priority and enforcement with no matter what the kind of movable is). It is important that the security interests are allowed in connection with both tangible and intangible movables, and such rights are recognized in the products and proceeds of the movables. Furthermore, the security rights should be allowed both in the existing movables and the future movables (e.g. the accounts receivable, that will be paid in next month, or the equipment, that will be ready next month). The typical list if the movables for the secured transactions include cashes, deposit sums, accounts receivables, equipment, crop, fish farm, livestock and etc. 2 P a g e

4 In Azerbaijan, the movables which are subject to the registration in the official registries (cars, planes, ships, and etc.) are excluded from the scope of the reform. The secured creditor may describe the movables as indicated below: Specific asset Chocolate equipment, 10 kg per hour production, produced by Selmi in 2010 Categories of assets 25 laptops, Lenovo, produced in 2016, model T460s, or all inventory of the borrower 2) PUBLISIZING INFORMATION creditor will recognize movables as a reliable security, unless makes sure that this movable has not been used as a security for the favor of another creditor. Publicizing information implies the availability of the instruments for the secured creditor to notify other potential creditors about his interests in connection with the movables; that might be done via the collateral registry or other alternative ways (by possession or controlling the movable). Perfect collateral registry should be noticebased [the creditor s job is limited to fill in the notices and enter to the registry] and accessible via internet for everyone 24/7. The registry is a bulletin-board, which shows that certain movables have been pledged for the lender (contact details of the lender is available). The registry should allow the creditors to include the notices on the registration, amendments, and termination; should enable the borrowers or collateral providers to include their objections, and should provide the possibilities to make searches either via the borrower or via the collateral, if possible. The registry does not seek the supportive documents (agreements) and is not responsible for the correctness of the information. Possession (e.g., jewelry in safe) or control (e.g., deposit sum) is an alternative way to the registration, since those actions make a signal to other potential creditors about the existence of the secured interests in those movables. In other words, second creditor will not enter to the agreement with the debtor, unless the latter may deliver the jewelry physically. It is important to note that publicizing information does not affect the force of the agreement (i.e. it is not necessary to publicize information in order to have the agreement in force), but affects the priority, as described below. 3) PRIORITY RULES Priority rules should be clear for all players in advance. The potential creditor needs to better understand its place in the list of creditors. That is why the rules of the game should be clear for all potential creditors before they have documented the secured interests in the movables. 3 P a g e

5 The primary rules of the priority are as follows: The creditors, which have publicized information via the registration or other alternative ways will prevail the creditors, which have not publicized information; Among the creditors, which have publicized information via the registration or other alternative ways in connection with the same movable, the calendar subsequence of the action (i.e., the moment of the registration, possession control commencement) will be taken into account with some exceptions. As an example to the exception, the priority of the financier of the movables might be referred provided that the notice is entered to the registry within 5 days from the date of the purchase. Let s look at these priority rules in the scenario, as described below: Company A (the seller) sold the equipment to the borrower on February 1, 2016 and the borrower is obliged to pay the prices within 2 years. The borrower pledged that equipment to the Company B (bank) and received a loan on February 3, 2016 (Company B registered its security right on February 3, 2016). Company A entered the notice to the registry on February 4, 2016 and registered its secured interest. The borrower pledged that equipment to the Company C (bank) on March 1, 2016 and did not register its security rights. Once the borrower is in default, the priority among three companies will be defined as follows: A B 1 C 2 3 Company A will be first, since it is the financier of that equipment and registered its security rights within 5 days from the purchase date. Company B will be second, since it has registered its security rights and company C did not register its security rights. Company C will be last, given that it did not register it security rights. 4) EFFICIENT ENFORCEMENT Efficient enforcement procedures are vital. If any secured creditor faces the delays and inefficient sale of the movable, that creditor will no longer view the movables as the reliable security. For example, if the creditor took two tons of vegetables as a collateral, it can t wait long in order to sell it in case of default. That said, it is really important the movables of the defaulted borrowers (collateral providers) should be sold in a quick and effective way; for such purposes, the creditors should have the opportunities to sell the movables or to take them into ownership in the manner, as stated in the draft law. 4 P a g e

6 The specific procedures should be applied if the movables are accounts receivables or deposit sums. The secured creditors should be allowed to sell the security themselves with the market price, if the movables are in possession of the creditor. The objection of the borrower should not stop the sale procedures, provided that the secured creditor should be ready to cover the damage, caused to the debtor and/or collateral provider due to the breaches in the sale procedures. Role of government agencies as the secured creditors in relation to the collateral registry. The potential creditor is interested to make sure that no other creditor has created the security interest in connection with that exact movable, and it does not matter whether the security interest is created by the private company (or individuals) or the state bodies (e.g., in response to the tax debts, the tax authorities may recognize the movables as the security). Ideally, the state bodies (tax, customs, social protection agencies, and etc.) should be required to enter the notices to the registry along with the private sector. The state bodies also benefits, since the registration of their secured interests informs other creditors, and the latter do not claim the movables, in connection to which the state bodies have secured interests. Picture 1. Illustration of mismatch between assets owned by companies and collateral required. Capital Stock of Firms 22% 44% 34% Land/Real estate Accounts receivable Vehicles/machinery/equipment Collateral Taken by FIs 27% 73% Movable property Land/ Real estate 5 P a g e

7 Table 1. Indicators 1. Does an integrated or unified legal framework for secured transactions that extends to the creation, publicity and enforcement of functional equivalents to security interests in movable assets exist in the economy? 2. Does the law allow businesses to grant a non possessory security right in a single category of movable assets, without requiring a specific description of collateral? 3. Does the law allow businesses to grant a non possessory security right in substantially all of its assets, without requiring a specific description of collateral? 4. May a security right extend to future or after-acquired assets, and may it extend automatically to the products, proceeds or replacements of the original assets? 5. Is a general description of debts and obligations permitted in collateral agreements; can all types of debts and obligations be secured between parties; and can the collateral agreement include a maximum amount for which the assets are encumbered? 6. Is a collateral registry in operation for both incorporated and non-incorporated entities, that is unified geographically and by asset type, with an electronic database indexed by debtor's name? 7. Does a notice-based collateral registry exist in which all functional equivalents can be registered? 8. Does a modern collateral registry exist in which registrations, amendments, cancellations and searches can be performed online by any interested third party? 9. Are secured creditors paid first (i.e. before tax claims and employee claims) when a debtor defaults outside an insolvency procedure? 10. Are secured creditors paid first (i.e. before tax claims and employee claims) when a business is liquidated? 11. Are secured creditors subject to an automatic stay on enforcement when a debtor enters a court-supervised reorganization procedure? Does the law protect secured creditors rights by providing clear grounds for relief from the stay and/or sets a time limit for it? 12. Does the law allow parties to agree on out of court enforcement at the time a security interest is created? Does the law allow the secured creditor to sell the collateral through public auction and private tender, as well as, for the secured creditor to keep the asset in satisfaction of the debt? Answers Yes Yes Publication developed by WBG-IFC F&M GP ACAFI Project 6 P a g e