Security interest

Overview

In law and finance, a security interest is a legal right that a secured party has over secured assets. Security interests most often arise where a debtor grants an interest over collateral to a creditor to secure the loan, such that the creditor will have enforceable rights in the event of the debtor's default or non-performance. In the event that the debtor is unable to perform their contractual obligations, the secured creditor may not only sue the debtor for contractual damages or recovery of debt, but may also enforce their proprietary rights over the assets (e.g. by seizure and sale) and obtain priority over unsecured and subordinate creditors in the event of insolvency. The most common security interest is the mortgage, which often involves a creditor bank securing an interest in a debtor homeowner's land for the payment of a loan used to finance the purchase of the home. Although most security interests are created by agreement between the parties, it is also possible for a security interest to arise automatically by operation of law.

English common law

Almost every legal jurisdiction today recognises security interests, generally security interests in rem (proprietary or real) and interests in personam (personal), although the laws relating to taking and enforcing security vary greatly by country and legal system. Security interests in common law jurisdictions originate in the common-law courts and the courts of chancery. Historically, only the Court of Chancery recognised security interests over both land and moveable property, whereas the common law courts recognised two kinds of security interests, only over moveable or personal property: liens and pledges. The creation of equitable security interests often originated in the concepts of unconscionability and fraud. As such, the modern doctrine of the mortgage originates in the law of equity. Prior to the enactment of the Law of Property Act 1925, mortgages over land could only arise where the borrower or mortgagor transferred their entire estate (or, alternatively, demise a lease) to the creditor or mortgagee, with only a contractual agreement that the mortgagee would return the estate once all payments had been made. The courts of equity, nonetheless, recognised that the mortgagor had not merely a contractual interest in the property but a proprietary one known as the equity of redemption, such that the mortgagor could redeem the property in equity even if he could no longer do so under the terms of contract. The language of "foreclosure" of mortgage originates from the equity, with the mortgagee retaining the eventual ability to "foreclose the prospect of redemption". By the mid-20th century, mortgages over land began to be recognised as legal, often statutory, interests rather than equitable ones, although a distinct category of equitable mortgages had also emerged in English law. Equity also recognised the security interest of the charge as being able to be created over any form of property, including land.

Reception in the United States

In the late 1940s, the United States legal community arrived at a consensus that the traditional common law distinctions were obsolete and served no useful purpose. They tended to generate too much unnecessary litigation about whether the creditor had selected the correct type of security interest. There was a growing recognition that the different types of security interests had developed only because of case-specific historical reasons. The result was Article 9 of the Uniform Commercial Code (UCC), which regulates security interests in personal property (as opposed to real property) and establishes a unified concept of a security interest as a right in a debtor's property that secures payment or performance of an obligation. Article 9 was subsequently enacted, although not entirely without variations, by the 50 states, District of Columbia, and most territories. If the debtor defaults (and does not file for bankruptcy), the UCC offers the creditor the choice of either suing the debtor in court or conducting a disposition by either public or private sale. UCC dispositions are designed to be held by private parties without any judicial involvement, although the debtor and other secured creditors of the debtor have the right to sue the creditor conducting the disposition if it is not conducted in a "commercially reasonable" fashion to maximize proceeds from the sale of the collateral. Article 9 is limited in scope to personal property and fixtures (i.e., personal property attached to real property). Security interests in real property continue to be governed by non-uniform laws (in the form of statutory law or case law or both) which vary dramatically from state to state. In a slight majority of states, the deed of trust is the primary instrument for taking a security interest in real property, while the mortgage is used in the remainder. The Uniform Law Commission's attempt during the 1970s to encourage the enactment of uniform land transaction laws was a catastrophic failure.

Influence of the UCC internationally

The UCC Article 9 inspired the enactment of the Personal Property Security Acts throughout Canada during the 1990s. After, international development experts recognized in the mid-1990s that reform of the law of security interests contributed to the economic prosperity of both Canada and United States in enabling businesses to finance growth through forms of secured lending which simply did not exist elsewhere. The International Monetary Fund, the World Bank, and other international lenders began to encourage other countries to follow Canada's example as part of the structural adjustment process (a consultation process often required as a condition of their loans). Over the next three decades, the Canadian PPSAs inspired developments in Australia, New Zealand, Vanuatu, Papua New Guinea, the Jersey, the Samoa, and the Jamaica. In 2002, the Organization of American States promulgated the Model Inter-American Law on Secured Transactions, in response to a rapidly growing body of empirical evidence that the chronic failure of Latin America's legal systems to support modern asset-based financing is a primary reason for the region's economic instability. The OAS Model Law attempted to import many of the best parts of UCC Article 9 into the Latin American civil law sphere, but with extensive revisions for that region's unique problems. The OAS Model Law has been enacted to some extent in several countries, including Mexico (2000, 2003, and 2010), Peru (2006), Guatemala (2007), and Honduras (2009). To date, only Honduras has been able to fully enact and actually implement the OAS Model Law in the sense of unifying security interests and making them easily visible on a public registry.

Contemporary reforms

The first major attempt to bring the benefits of UCC Article 9 to civil law jurisdictions was launched by the European Bank for Reconstruction and Development in 1992, which resulted in the EBRD Model Law for Secured Transactions in 1994. However, the EBRD Model Law's approach to the entire subject differed radically from UCC Article 9, and it was also quite limited. For example, it did not have provisions for purchase money security interests. Nearly all Central and Eastern European countries undertook reform of their secured transactions laws in the 1990s and 2000s, although most of them either came up with ad hoc indigenous solutions or followed the EBRD Model Law to some extent. Only Albania, Kosovo, and Montenegro attempted to closely follow the UCC Article 9 approach. Separately, after the issue of secured transactions reform was recommended to the United Nations Commission on International Trade Law in 2000 by the Secretary-General, UNCITRAL eventually prepared a Legislative Guide on Secured Transactions as a recommendation to all countries, which ended up structured as a "political compromise" between "sharply divergent" legal systems. The Legislative Guide did not conform to Article 9's terminology or structure. On December 11, 2008, the Guide was subsequently endorsed by the 67th plenary meeting of the United Nations General Assembly in Resolution 63/121, which took effect January 15, 2009.

Doctrine

Security interests arise from situations involving a secured party (for example, a creditor) and secured property, which is often collateral for a loan made to a debtor. They can be created either by agreement or imposed by courts upon the operation of law. The Oxford English Dictionary defines security in law as "property, etc., deposited or pledged by or on behalf of a person as a guarantee of the payment of a debt, and liable to forfeit in the event of default", noting further that the term security in financial markets is derived from the concept of a security interest as a "means of being or making secure":Originally: a document held by a creditor as a guarantee of the right to payment, or attesting ownership of property, stock, bonds, etc.; (hence) the financial asset represented by such a document. Also (originally and chiefly U.S.): such a document issued to investors to finance a business venture.

Rationale

Security interests allow a creditor to have rights against the debtor in the event of default of an obligation or insolvency, beyond the rights they may usually have. In particular, security interests can give the creditor proprietary rights over the debtor's property as well as priority in the event that the creditor becomes insolvent. Security interests also have a number of microeconomic effects, particularly in commercial secured lending contexts. Depending on the terms of the security agreement, they may allow one creditor to ensure that no other bank would lend to the debtor as a result of the scope of the charge, resulting in a form of anticompetitive practice. Some economists have also questioned the general notion of different creditors having different priorities and repossession, which they believe places too much potentially destructive power in the hands of creditors while also violating the conceptual purpose of insolvency as a pari passu process. Although unsecured creditors will receive less on insolvency, and despite the fact that they should theoretically be able to compensate by charging a higher interest rate, many unsecured creditors (such as tort claimants and employees) are unable to adjust their "interest rates" upwards, thus allowing the company to benefit from a cheaper rate of credit, to the detriment of these non-secured creditors. For this reason, many jurisdictions restrict the ability of secured creditors to enforce their rights in a bankruptcy. In the US, the Chapter 11 creditor protection, which completely prevents enforcement of security interests, aims at keeping 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 is 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.

Perfection

Perfection of security interests means different things to lawyers in different jurisdictions.

in English law, perfection has no defined statutory or judicial meaning, but academics have pressed the view that it refers to the attachment of the security interest to the underlying asset. Others have argued cogently that attachment is a separate legal concept, and that perfection refers to any steps required to ensure that the security interest is enforceable against third parties. in American law, perfection is generally taken to refer to any steps required to ensure that the security interest remains enforceable against other creditors or other parties, including a bankruptcy trustee in the case of the debtor's bankruptcy.

Remedies

Where a security agreement has created both a proprietary and personal right, the security holder may seek to enforce either or both rights against the secured party, which may entail a number of different remedies, including possession, sale, foreclosure, the appointment of a receiver, and appropriation.

Types

Securities can be categorised in a number of ways: possessory and nonpossessory; consensual and by operation of law; proprietary and personal; and legal and equitable.

Mortgage

The most common form of security interest is the mortgage, which is defined differently across contexts and jurisdictions. The word "mort-gage" comes from the French term meaning "dead pledge", and is in distinction to the "living pledge" whereby the party who benefits from the security interest was expected to take possession of the mortgaged property, and work it to generate a profit; such security interests fell into disuse centuries ago. In a lay, non-technical sense, a mortgage arises where the creditor acquires a security interest over the debtor's land, such that payment for the loan is secured by the mortgage, and upon default the creditor (or mortagee) can seize and sell the property of the debtor (or mortgagor). Historically, the mortgage originates in the Court of Chancery, particularly in the equity of redemption, which arose where the debtor conveyed their assets (typically land) to the creditor as security for a loan, with a contractual agreement allowing for a right of redemption. Such a method of creating a mortgage, however, is largely deprecated across common-law jurisdictions, which have developed more sophisticated statutory mortgage regimes. English law continues to recognise the equity of redemption through the doctrine of equitable mortgage, which may arise in a number of situations, including where parties contract to a mortgage but end up failing to eventually validly execute the mortgage; where an existing mortgagor, having only the equity of redemption, wants to grant a second mortgage; or where the mortgagor only has an equitable interest, for example, as a beneficiary of a trust. Generally, upon default, remedies available to the mortgagee include foreclosure, sale of the assets, and the appointment of a receiver. In a strict, technical, historical legal sense, foreclosure refers to the extinguishing of the equity of redemption. Depending on the jurisdiction, mortgagees may have different powers and duties in selling assets in relation to being able to sell the assets without the intervention of the court or selling the assets in a specific manner or according to specific rules and standards.

Pledge

In Roman law, a pledge, or pignus, was a type of contract where the debtor would give physical possession to the creditor as security for a debt. As the creditor has possession but no ownership, he could not use, sell, or alter the property but only had recourse upon default. Pledges in common law jurisdictions operate in much the same way.