One of the most important ways a lender can mitigate the risk of not being repaid is by taking security from the borrower, any guarantors or from other entities in the borrower group, giving it rights over specified assets. But when a borrower defaults, the lender must consider whether that security can be enforced and, if so, how.
This article brings together a number of concepts considered elsewhere in our A–Z of Banking and Finance series – you’ll find those articles linked throughout.
What is security enforcement?
Security enforcement is the legal and practical process through which a lender exercises its rights over specified assets, typically following a borrower’s default and the lender’s subsequent acceleration of a loan.
The enforcement rights available to the lender depend on the:
- Nature of the secured assets
- Type of security taken
- Terms of the document creating the security interest
- Availability of any common law or statutory remedies
The terms of the transaction documents usually provide the lender with the right to take control of and sell the secured assets in order to apply the proceeds in repayment of the amounts outstanding. Where the lender has the benefit of a floating charge over all, or substantially all of the assets of a security provider, its rights may extend to being entitled to commence an insolvency process in respect of the security provider.
When can security be enforced?
In most cases the terms of the relevant loan agreement and security documents (and, if applicable, any documentation governing the relationship between financial creditors, such as an intercreditor agreement) will determine when a lender can enforce its security. Enforcement rights will typically arise upon an event of default, but the lender will then need to satisfy certain conditions before it can exercise those rights. For example, the lender may need to:
- Establish that the event of default is continuing
- Declare the outstanding debt due and payable (and give notice of this to the borrower)
- Issue a demand for payment to the borrower
- Comply with any notice, demand or other procedural requirements set out in the loan and security documents
The lender must be careful not to waive any of its rights to take any enforcement steps.
Even where the lender is entitled to enforce its security, it may choose not to do so immediately or at all. Whether enforcement is appropriate will depend on the circumstances of the default and the lender’s preferred strategy for recovering the amounts owed.
How can a lender enforce its security?
As mentioned above, the methods of enforcement available will also depend on the:
- Type of security held
- Nature of the secured assets
- Terms of the relevant document creating the security interest
- Availability under common law or statute of other enforcement remedies
In most cases, the lender will prefer to rely on express powers of enforcement set out in the transaction documents, as these are almost always broader in scope and subject to fewer conditions than those arising under statute or from common law.
In the case of a fixed charge or a mortgage, a lender may have a range of enforcement remedies available, including taking possession of the secured assets, selling assets, selling the assets and applying the proceeds towards repayment of the secured liabilities, or appointing a receiver to do so. The availability of other remedies will depend on the nature of the asset secured: for example, where security is over rights under a contract, the lender may be entitled to require the counterparty to make payment to the lender rather than the security provider.
A floating charge will usually crystallise automatically on the occurrence of insolvency related events or on notice from the lender to the security provider following the occurrence of an event of default. At and from the moment of “crystallisation” the security interest attaches to the assets within its scope such that the security provider can no longer continue to deal with the assets. The lender can then seek to realise those assets in the same way that it would for assets subject to a fixed charge.
In addition, the holder of a ‘qualifying floating charge’ (which is a floating charge or charges over all or substantially all of the security provider’s assets) may also be entitled to appoint an administrator to the security provider without the involvement of the court. For more on the distinction between fixed and floating security, see F is for fixed and floating charges.
What if there is more than one financial secured creditor?
Where there is more than one secured financial creditor, there will often be an agreement between the creditors which regulates when security can be enforced, and how the proceeds of enforcement are to be distributed. We discussed these types of agreements in I is for Intercreditor agreement. Where an intercreditor agreement is in place, a lender that wishes to enforce the security will need to do so in compliance with its terms, which may require giving notice to the other parties or only being entitled to enforce after the lapse of prescribed notice periods.
Enforcement and insolvency
The commencement of certain types of insolvency proceedings in respect of the security provider may limit a lender’s ability to enforce its security. For example, where a company enters administration, the resulting moratorium prohibits the enforcement of security granted by it unless the administrator consents or the court gives permission (or the security interest is a specific kind known as a ‘financial collateral arrangement’). And where a company obtains a Part A1 moratorium (a process designed to give a short period of breathing space to a distressed company), the lender will need court permission to crystallise any floating charge granted by the company. But where a company enters liquidation (is being “wound-up”), no such restriction on security enforcement arises.
What should lenders check before enforcement?
Before taking enforcement action, a lender should consider both the effectiveness of its security and any factors which may affect its ability to enforce. Key considerations include:
- Validity and perfection: has the security been validly created and perfected, including registration where required?
- Scope of the security: which assets are covered, and what rights does the lender have in respect of them?
- Competing security: do other creditors hold security over the same assets and, if so, how do the respective interests rank?
- Procedural requirements: are any notices, demands, consents or other steps required before enforcement can take place?
- Intercreditor arrangements: is the lender’s ability to enforce subject to any restrictions or controls agreed with other creditors?
- Insolvency restrictions: is there a moratorium or other insolvency-related restriction which prevents or limits enforcement?
