SECURED TRANSACTIONS
WALSH
FALL 2011
COURSE DESCRIPTION: This course is about the legal and economic logic of the institutions used in market economies to enable vendors and lenders, as well as non-consensual and judgment creditors, to secure the performance of obligations due by their debtors. It will primarily examine security over movable property (personal property) although passing reference will be made to security over immovable property (real property). The concept of security explored in this course includes not just hypothecs in the strict sense but also other mechanisms such as conditional ownership, leases, trusts, and assignments by which a debtor’s assets can be deployed to secure a credit obligation. The course will focus on the sometimes different solutions to the same policy and doctrinal issues arrived at by the different units that make up Canada, most notably as between Quebec’s civil law tradition and the statutory (Personal Property Security Acts) and common law framework of the other provinces and three territories. Passing reference will also be made to federal laws that relate directly or peripherally to secured transactions as well as to international and foreign developments.
What is a Secured Transaction?
A secured transaction is a business arrangement by which a buyer or borrower gives collateral to the seller or lender to guarantee performance of an obligation, for example repayment of a loan (Black’s Law Dictionary)
Collateral is property offered by the debtor to back up the money he owes to the creditor
o This property is what the CR can seize if the DB doesn’t pay the $$ back
o The CR has no actual interest in the property itself àà they want its liquidated value as an alternative form of repayment of the loan
Advantages and Disadvantages of Allowing Security Interests
Why does the law allow secured lending? See the Armour article below.
o Lower risk situation created by the presence of security means secured creditors will charge a lower interest
rate for the loan
§§ This also partially explains why debtors grant creditors security àà to get the lower rate
§§ Debtors also grant security because they might not get the loan without doing so
o Increase in the amount of credit available in the marketplace
Advantages of security to creditor:
o 1. Priority: the law respects the property right given to the creditor and gives them the first claim to the value
of the liquidated asset
o 2. Increase in the likelihood of repayment
o 3. Gives creditor control and knowledge over their debtor’s asset
§§ Unsecured creditors are to a certain extent dependent upon the secured creditor to monitor the debtor
Disadvantages of security:
o Once a debtor grants security to one creditor, all other unsecured creditors are going to raise their interest rates
because their loans are now higher risk (is this true?)
John Armour, “The Law and Economics Debate About Secured Lending”
Thesis: secured credit is socially beneficial and such benefits outweigh any social costs
What does secured credit do?
Essence of the institution of secured credit: a rule that one creditor is entitled to claim control over/ priority to payment from an asset as opposed to an open-ended set of other parties
Confers on the lender 2 entitlements:
o 1. Control of the collateral
§§ If debtor not in default, control is negative (veto powers)
§§ If debtor in default, control is positive (to seize and liquidate the collateral)
§§ That is, the control rights are what economists call ‘state contingent’, because their extent is contingent on whether the debtor continues to meet their obligations under the loan.
o 2. Priority of payment out of the proceeds of sale of collateral
From the point of view of the secured creditor, a grant of security lowers default risk. All other things being equal, a creditor may therefore be expected to offer a debtor more advantageous terms—for example, a reduced interest rate— when lending on a secured rather than an unsecured basis. However, the priority accorded to a secured creditor means that unsecured creditors will now fare worse in insolvency. They may therefore be expected to demand terms that are correspondingly less advantageous for the debtor—for example, an increased interest rate.
The early literature on secured credit viewed these stylised facts as giving rise to a ‘puzzle’ over why debtors grant security: if the effect of security on a debtor’s aggregate cost of capital is neutral (secured creditors reduce rates, unsecured creditors increase them)
But from the debtor’s point of view, there is no difference in the consequences of default as between secured and unsecured borrowing: in either case, the debtor’s assets will be seized by creditors. The benefit of being a
secured creditor under such circumstances is not vis-à-vis the debtor, but against other creditors—the secured
creditor has priority as regards repayment.
Theories of Security
Economic Signalling Theory: A debtor who offers security to a creditor signals to them their seriousness about repaying, their creditworthiness àà not borne out by empirical evidence
Economic Monitoring Theory: the grant of security is a promise/bond by debtor not to engage in practices harmful to creditors’ interests, and creditor can check up on this (“agency costs”)
o This reduces the probability of default, and increases the value of all creditors’ claims
Redistribution Theory: by borrowing on a secured basis, the debtor obtains a lower interest rate – by failing to adjust their rates in response to this increased risk, the debtor’s unsecured creditors bear the cost of this lower interest rate
o This theory is not supported empirically – likely the benefits of security (i.e. increased monitoring) outweigh the costs
Domestic Laws and Secured Credit
Clearly, the institution of secured credit must be facilitated by a country’s legal system in order to function. The essence of the institution is a rule whereby one creditor is entitled to claim control and/or priority to payment from an asset as regards an open-ended set of other parties.
Legal facilitation of non-possessory security and general security interests (over entirety of debtor’s assets) will increase the availability of finance, reduce risk of default (greater oversight)
Stronger enforcement rights stimulate lending at lower interest rates also
Subordinating some of the secured creditor’s claims to unsecured creditors’ claims will reduce the use of that type of security right
Informing Third Parties
All jurisdictions have a mechanism for bringing the existence of security rights to the attention of other creditors
àà if they don’t publicize adequately, security right will not be enforced
Three strategies to reduce search costs of subsequent creditors:
o 1.
ecret lien” – gives the insolvent debtor the opportunity to avoid their creditors by making up a prior security interest in favour of someone else
§§ So unless SC takes possession of the property given in security, the transaction was deemed to be fraudulent
o Ratio: need to take possession of security for security interest to be valid.
This philosophy dictated the CML on secured lending until the Industrial Revolution (200 years)
o Need for non-possessory secured financing arose because the collateral the industrialists had to offer were the machines they needed for their business to run and make money
o So the legislature intervened and created public registries: publication rebutted the presumption of fraud attending non-possessory financing transactions
None of this ever happened in Germany – non-possessory financing wasn’t prohibited
o So no equivalent need for Legislature to establish a registry
o So CVL in Germany has a Nemo Dat system
In North America, legislatures have always been committed to registration
o Why? Settler societies – more anonymous market and mobile society (less trust).
§§ Immovables: security is always over a certain parcel of land (indexed in reference to the asset). Land
must be registered.
§§ Movables: registries index everything to the name of the debtor not the item.
Sources of the Law on Secured Transactions
1. Personal Property Security Acts (common law provinces/territories)
o Brought into force starting in 1975 (ON) and ending in 2001 (Nunavut/PEI)
o Model for PPSAs was Article 9 of the UCC (1972)
§§ Grant Gilmore came up with organizing idea of Art. 9: the concept of the “security interest” àà unifies
the proliferation of different types of security interests into one functional definition subject to a uniform body of rules
§§ This functional concept of security is replicated in the PPSAs to replace the huge variety of security
interests that had come to be recognized in the common law
o Registry systems are at the heart of the PPSAs
2. Civil Code of Quebec (Quebec)
o Quebec also recognized a number of individual security interests àà “numerus clausus”
§§ Was complex: came to be at competitive disadvantage for interjurisdictional transactions
o In 1994, CCQ was reformed and the hypothec became the principal security device in CCQ
§§ Hypothec: legal right over a debtor’s property that nevertheless remains in the debtor’s possession
§§ Governs both moveable and immovable security interests
o Complication: other Titles in CCQ recognize different security interests (trust, SWAROR)
§§ So if a security interest comes in a form other than a hypothec, have to go to a different part of the Code
to find the rules applicable to that transaction
