Security

Another way of contractual protection for creditors is the possibility to obtain security in the form of a proprietary claim over the assets of the borrower to secure payment of the debt.⁵³² Security, as covenants, restricts the borrower’s freedom of action in order to minimize the risk of transactions that would reduce the wealth of the firm, and thus prejudice creditor’s interests.

However, between the two mechanisms there are substantial differences, which are best observed when the borrower defaults. In contrast to rights granted to the creditor pursuant to a covenant,⁵³³ the holder of a security acquires possession of the debtor’s assets when the debtor fails to repay the debt and may realize them in order to extract the amount of money lent to the borrower. Thus, with the security interest, the creditor is granted proprietary rights and the security is “self-enforcing”.⁵³⁴ Covenants are not self-enforcing, since it has to be proved first that there is a breach of covenants, and second and most importantly, in the presence of a covenants breach, the party imposing it may not satisfy her claim against the debtor neither on a particular asset nor on the business of the debtor as a whole.

1. Reasons for taking security

The compelling reasons for a creditor to obtain security rest on a number of privileges granted to the secured to protect his claim from devaluing and to reduce financial exposure.⁵³⁵ Thus, in insolvency proceedings, the security holder will have priority over unsecured creditors as well as over other secured creditors who rank junior to him.⁵³⁶ Holding a security over the assets of the debtor allows the creditor to actively take measures to enforce such security when the debtor defaults on the repayment. Whether the security is a fixed or floating charge,⁵³⁷ the result is that when the creditor chooses to realise the security, the assets under the charge are no longer those of the debtor firm.⁵³⁸ Moreover, obtaining security affords the creditor a certain measure of control of the business of the debtor firm, similar to that granted pursuant to covenants. This allocation of control is of increased relevance when the debtor is facing financial difficulties and

p. 257 ff.

532 Davies, Principles of Modern Company Law, p. 815.

533 Some authors consider covenants and securities as substitutes. Bebchuk/Fried, Yale Law Journal, 1996, 857, p. 878.

534 Armour, Center for Business Research Working Papers, 2008, 1, p. 4.

535 LoPucki, Virginia Law Review, 1994, 1887, pp. 1921-2; Keay, Modern Law Review, 2003, 665, p. 687;

Servatius, Gläubigereinfluß durch Covenants, p. 61.

536 Davies, Principles of Modern Company Law, p. 818; Finch, Modern Law Review, 1999, 633, p. 637.

537 For instance, in the United Kingdom.

538 Davies, Principles of Modern Company Law, p. 822.

the risk of default lingers. In such a situation, allocating control over the enforcement efforts to those creditors who are best placed to maximise the value of the firm is essential to prevent ineffective enforcement efforts by dispersed creditors, who on a “race to collect”⁵³⁹ may achieve a suboptimal result and probably worse, liquidate a debtor who is more valuable as a going concern. Additionally, the creditor could be in the position even to prohibit the debtor from issuing additional debt which would rank senior to him ⁵⁴⁰ and thus maintain its priority in rights vis-à-vis other creditors.

2. Benefits and costs

On a different perspective, debtors as well stand to benefit from granting security to creditors.

Thus, granting security lowers⁵⁴¹ the aggregate cost in a lending transaction by signalling⁵⁴² a lower pre-loan risk of default.⁵⁴³ A lower pre-loan risk of default translates into lower interest rates and therefore, also lowers the costs of capital for the debtor.⁵⁴⁴ Additionally, when obtaining security for the loan, the creditor will tend to narrow its monitoring focus to the asset that constitutes the security in order to increase its monitoring efficiency.⁵⁴⁵ Narrowing the monitoring focus helps to establish monitoring routines, which reduce the overall costs of monitoring for the creditor,⁵⁴⁶ and that in turn lowers also the cost of capital for the borrower.

However, this is the case when the security interest is on a specific asset or groups of assets, but not when the security is a floating charge and thus the whole business of the debtor is relevant for the creditor. Nevertheless, also this kind of security interest provides benefits for both, debtor and creditor. As it will be explained in the subsequent chapters, this form of security interest encourages creditors and debtors to engage in a kind of relationship which is characterised by an intensive flow of “soft” information from the debtor to the creditor, longer duration of the relationship and more intensive monitoring by the creditor. This kind of relationship, known also

539 Armour, Center for Business Research Working Papers, 2008, 1, p. 4.

540 Davies, Principles of Modern Company Law, p. 818. In more detail about the powers of a security holder see Mann, Harward Law Review, 1997, 625, p. 638 ff.

541 The ways how a creditor may reduce pre-loan risk perception were briefly discussed above.

542 However, the signalling theory does not always stand, especially in the case of larger borrowers with good credit rating. Keay, Modern Law Review, 2003, 665, p. 687.

543 Mann, Harward Law Review, 1997, 625, p. 638.

544 In the cases of debt capital, the signalling effect is even stronger when the debtor agrees to contribute additionally to the equity capital of the company before creditor supply debt capital. Servatius, Gläubigereinfluß durch Covenants, p. 55 ff.

545 When the creditor has a charge on a particular asset, he will focus his whole attention of that asset and ignore other assets. See also the arguments by Levmore, Yale Law Journal, 1982, 49, on the monitoring of ‘focal points’.

546 Brinkmann, European Company and Financial Law Review, 2008, 249, p. 250.

as “relationship lending” provides observable benefits as regards a more effective protection of creditors. These benefits are analysed in more details in Chapter 8.

However, on the downside, both parties are faced with costs. For the creditor, there is no protection that provides full protection. Obtaining security as a means to ensure the payment of the debt is not a perfect protection. Reasons vary. The information and negotiation costs for closing a security may be excessive given the financial risk that might be involved.⁵⁴⁷ Creditors face sometimes difficulties to determine the value of the asset, which is charged with a security.⁵⁴⁸ Asking for expert valuations to determine the value of the asset could be costly and thus lower profit margins for creditors.⁵⁴⁹ As in the case of financial covenants, the complexity of the transaction presents smaller creditors with difficulties related to the lack of expertise, financial or legal, needed to close the arrangement.⁵⁵⁰

In a long-term debt relationship the value of the asset could change substantially making the renegotiation of debt contract necessary in order to obtain additional security, should the asset decrease in value. However, this will require the parties to incur transaction costs. Moreover, start-up companies might have less fixed assets and more non-fixed or immaterial assets, whose value is difficult to determine and who retain value when the firm is a going-concern value rather than when they are liquidated individually.⁵⁵¹ Additionally, the creditor faces also the risk that his evaluation of the debtor’s risk of default is totally wrong and has been underestimated, in which case the security will be only of little comfort. However, the wish of lenders to lend money at no risk does not reflect the reality of the lending business. Without the existence of the credit risk, a good part of the credit markets would also disappear⁵⁵² and the creditors need the borrowers and the risk that they bring with them for simple reason that without the borrowers, also the lenders would not exist.

On the debtor’s side, the granting of security is not a desired action,⁵⁵³ and sometimes not even necessary. On an evaluation of literature, it results that the strongest debtors or larger companies

547 Finch, Modern Law Review, 1999, 633, p. 638.

548 Servatius, Gläubigereinfluß durch Covenants, p. 61.

549 Ibid., p.61 ff; Keay, Modern Law Review, 2003, 665, p. 687.

550 Finch, Modern Law Review, 1999, 633, p. 638.

551 Thießen, Zeitschrift für Bankrecht und Bankwirtschaft, 1996, 19, pp. 20-21.

552 Servatius, Gläubigereinfluß durch Covenants, p. 62.

553 Costs such as information costs and costs for the administration of the loan increase the overall cost of capital.Mann, Harward Law Review, 1997, 625, p. 659 ff.

with good credit ratings do not secure their debt.⁵⁵⁴ It seems that these borrowers are not in need of signalling the market of their strength or ability to pay. Their financial credentials are sufficiently good as to justify even putting pressure on the creditors to either lend them or they will go elsewhere for capital.⁵⁵⁵ The situation is different though with smaller or junior firms lacking the financial credentials to obtain credit without issuing security. For these types of firms, borrowing could result with higher costs because they might not possess sufficient security, and as a result might have to accept higher interest rates as a compensation of the credit risk.⁵⁵⁶ Especially larger borrowers, who accept to grant securities, could be faced with burden related to information costs, which includes all efforts spent to gather pre-loan information, and costs for the administration of the loan, which come in the form of reduced operational flexibility to invest its own assets in ways most profitable.⁵⁵⁷

Similarly to the covenants, security charges on the debtor’s assets could grant creditors considerable control over the business decisions of the borrower. As in the case of lender liability referred to above, creditors might find themselves in a position similar to shadow directors and thus risk being held liable for being the alter ego of the debtor company by controlling as a matter of fact the business decisions of the debtor or by obtaining an exclusive right to supply the debtor with further credit.⁵⁵⁸

3. Impact of security on creditor’s monitoring incentives

This risk as well as other burdens, which a creditor could face when it chooses to secure its debt could well have repercussions on the adequacy of monitoring efforts that creditors are willing to expend. As already introduced above, when deciding whether to extend credit and if yes, at what interest rate, a given creditor will also estimate the amount and difficulty of monitoring she would have to carry out to avoid debtor’s misbehaviour. One the reasons why creditors choose to be secured is also the simple fact that by taking an asset as security for the repayment of the debt, the creditor can narrow the focus of its monitoring efforts to the performance of the asset taken as security.⁵⁵⁹ From an economic point of view, this is efficient for the creditor. The

554 Mann, Harward Law Review, 1997, 625, p.629; Finch, Modern Law Review, 1999, 633, p. 638.

555 Keay, Modern Law Review, 2003, 665, p.687; Mann, Harward Law Review, 1997, 625, p. 629.

556 Hence, the well-known statement: money is lent to those who don’t need it.

557 Mann, Harward Law Review, 1997, 625, p. 668.

558 Davies, Principles of Modern Company Law, p. 818.

559 Schwartz, Journal of Legal Studies, 1981, 1, p.10; Mann, Harward Law Review, 1997, 625, p. 650.

Taking a specific asset or class of assets as a security implies the presence of expert knowledge on the side of the secured creditor regarding the performance of that asset or its value in liquidation.

creditor does not need to monitor the entire business or assets of the debtor, rather only his security. In this aspect, the facilitation regarding monitoring efforts and costs brought about by the security is similar to the role played by the concept of legal personality in company law, whereby creditors of a company need not monitor the whole personal assets of a changing number of firm owners, but rather only the fluctuations in the assets of the company.⁵⁶⁰ When the assets that have been taken as security represent important assets⁵⁶¹ of the debtor, then monitoring them provides important signals about the financial stability of the debtor.⁵⁶² However, monitoring from secured creditors suffers from similar problems as in the case of the creditors who impose covenants as a means of protection their interests.⁵⁶³ Security reduces the costs of the secured creditor on the one side, but increases the costs to the unsecured creditor on the other. Thus the existence of security raises the expected costs of default for unsecured creditors because it reduces the debtor’s pool of assets to satisfy creditor’s claims in insolvency.⁵⁶⁴ This in turn forces unsecured creditors to monitor more intensively because they have no guarantee to hold on to if the debtor fails. As a result, they incur more costs. Seen from this perspective, one could dare say that the assumption that unsecured creditors benefit from the monitoring of secured creditors⁵⁶⁵ might not have a very firm foundation. Instead, the opposite could be true. Secured creditors would benefit from obtaining security from the debtor as well as from increased monitoring from the unsecured creditors. ⁵⁶⁶ This view presents a picture where security is taken only or mainly as a means to secure the claim of the creditor in default. Pursuant to this view, the creditor does not have strong incentives to monitor borrower’s performance, except when such monitoring is essential to guarantee her claim. There is however

560 Hansmann/Kraakman, Yale Law Journal, 2000, 387, pp. 309-405.

561 Levmore, Yale Law Journal, 1982, 49, considers these assets as ‘focal points’.

562 Ibid., p. 69.

563 Although, covenants could be used to control a broader range of inefficient behaviour by the debtor.

Bebchuk/Fried, Yale Law Journal, 1996, 857, p. 879.

564 Schwartz, Journal of Legal Studies, 1981, 1, p. 10. See also Brinkmann, European Company and Financial Law Review, 2008, 249, on the disadvantages faced by unsecured creditors when a debtor grants security rights to secured creditors.

565 Enriques/Macey, Cornell Law Review, 2001, 1165.

566 On the pattern of secured credit, benefits and burden to creditors and debtors, as well as problems with regard to the monitoring by secured creditors see Jackson/Kronman, Yale Law Journal, 1979, 1143;

Schwartz, Journal of Legal Studies, 1981, 1; Levmore, Yale Law Journal, 1982, 49; Goode, Canadian Business Law Journal, 1983-84, 53; Triantis, Virginia Law Review, 1994, 2155; Bebchuk/Fried, Yale Law Journal, 1996, 857; Mann, Harward Law Review, 1997, 625; Finch, Modern Law Review, 1999, 633; Keay, Modern Law Review, 2003, 665. For German literature see e.g. Dorndorf/Frank, Zeitschrift fur Wirtschaftsrecht, 1985, 65; Thießen, Zeitschrift für Bankrecht und Bankwirtschaft, 1996, 19; Merkt, Zeitschrift für Unternehmens- und Gesellschaftsrecht, 2004, 305; Servatius, Gläubigereinfluß durch Covenants; Giering, Risikobezogener Gläubigerschutz.

another perspective that present collateral not mainly as a means to guarantee repayment of the credit, but rather as a means to allocate priority rights to intervene and decide as regards reorganisation chances when a debtor is financially distressed.⁵⁶⁷ According to this view, creditors that are allocated seniority over other lenders by ways of security interest enjoy more bargaining power when the debtor firm is financial distressed. Because of this position, these creditors are more willing to intervene and engage in out-of-court reorganisations of distressed firms, as opposed to foreclosure,⁵⁶⁸ since they are certain of the benefits from a successful reorganisation. Hence, it is reasonable, on efficiency grounds, to grant security and thus also seniority to a single, well-informed creditor who has the incentives and the skills to monitor the debtor more effectively.⁵⁶⁹