03. secured transactions

The question

A creditor who lends money or supplies goods on credit faces the risk that the debtor will not pay, and that, if the debtor becomes insolvent, the creditor will recover little or nothing, ranking merely as one unsecured creditor among many who share the debtor's insufficient assets. The law allows the creditor to improve its position by taking security, a right over the debtor's property that the creditor may resort to if the debt is not paid. This sub-unit examines the law of secured transactions, asking what security is, what forms it takes, and how the law resolves competition among those who claim the same asset. The answer draws directly on the distinction between real and personal rights examined in Course 1, for the essence of security is the conversion of the creditor's mere personal claim into a right in the debtor's property.

The security interest and its purpose

A secured transaction is a transaction in which a debtor grants a creditor a right over property to secure the performance of an obligation, and the right so granted is a security interest, a right in an asset, the collateral, that entitles the creditor, if the debtor defaults, to resort to the asset to satisfy the debt, characteristically by selling it and applying the proceeds to the debt. The creditor who holds a security interest is a secured creditor, and the purpose of the security interest is to protect the creditor against the debtor's default and, above all, against the debtor's insolvency.

The security interest connects directly to the distinction between real and personal rights examined in Course 1, and this connection is the key to its value. An unsecured creditor has only a personal right against the debtor, a right that the debtor pay, which avails against the debtor alone and which, on the debtor's insolvency, must compete with the personal rights of all the other unsecured creditors for a share of insufficient assets. A security interest, by contrast, is a real right in the collateral, a right in the asset itself that avails against the world, and it gives the secured creditor a claim to the collateral ahead of the unsecured creditors: on the debtor's insolvency, the secured creditor may resort to the collateral to satisfy its debt before the unsecured creditors share what remains. The security interest thus transforms the creditor's position from that of a mere claimant against the debtor into that of a holder of a right in the debtor's property, which is why creditors seek security and why the law of security is central to the extension of commercial credit.

Consider a lender who lends to a business and takes a security interest over the business's equipment as collateral. If the business pays the debt, the security interest is discharged and the equipment remains the borrower's. If the business defaults and becomes insolvent, the lender may resort to the equipment, selling it and applying the proceeds to the debt ahead of the business's unsecured creditors, who must share the remaining assets. The lender's security interest has given it a real right in the equipment that protects it against the borrower's insolvency. The example shows the security interest converting the creditor's personal claim into a real right that confers priority on insolvency.

The security interest is therefore a real right in the debtor's property, the collateral, granted to secure an obligation and entitling the creditor to resort to the property on default, and its purpose, achieved through the conversion of a personal claim into a real right, is to protect the creditor against the debtor's default and insolvency by giving it a claim to the collateral ahead of the unsecured creditors.

The principal forms of security

Security takes several forms, distinguished principally by whether the creditor takes possession of the collateral and by the kind of property over which the security is granted, and the forms are broadly common across the traditions though their names and details differ. The pledge is a form of security in which the debtor delivers possession of the collateral to the creditor, who holds it as security and may sell it on default; the pledge depends on the creditor's possession, and its limitation is that the debtor is deprived of the use of the asset while it is pledged, which makes the pledge suitable for assets the debtor does not need to use, such as goods or documents of title, but unsuitable for assets the debtor must continue to use in its business.

The mortgage and the charge are forms of security that do not depend on the creditor's possession, allowing the debtor to retain and use the collateral while the creditor holds security over it. A mortgage, in its general sense, is a security created by a transfer of an interest in the collateral to the creditor as security, subject to the debtor's right to have the interest restored on payment, while a charge is a security that gives the creditor a right to resort to the collateral on default without transferring an interest in it; the distinction between them, and the terminology, vary considerably among legal systems, but both allow security to be taken over property, including land and the assets of a business, without depriving the debtor of its use. These non-possessory securities are of the first importance in commerce, for they allow a business to raise credit on the security of assets it must continue to use, such as its premises, its equipment, and even its stock and receivables, the security following the assets while the business trades. Because the creditor does not have possession to signal its interest, these securities commonly depend on registration in a public register to make the creditor's interest known to others, a point the discussion of priority develops.

Imagine a business that wishes to borrow on the security of its premises and equipment, which it must continue to use. It cannot pledge them, for it cannot give up possession; instead it grants the lender a mortgage or charge over them, retaining their use while the lender holds security. Were the business instead to borrow on the security of goods it does not need to use, it might pledge them, delivering possession to the lender. The example shows the pledge depending on possession and the mortgage and charge allowing non-possessory security over assets the debtor continues to use.

The principal forms of security are therefore the pledge, which depends on the creditor's possession of the collateral, and the mortgage and the charge, which secure the creditor without possession and so allow the debtor to retain and use the collateral, the non-possessory securities being of central importance in commerce because they permit a business to raise credit on assets it must continue to use.

Retention of title

A seller of goods on credit faces the particular risk that the buyer will take the goods and fail to pay, and the law allows the seller a distinctive means of security, the retention of title, by which the seller, in selling goods on credit, provides that ownership of the goods shall not pass to the buyer until the price is paid, so that the seller retains ownership as security for payment even after delivering the goods to the buyer. The retention of title connects to the analysis of the passing of property examined in the sale-of-goods module, for it is an exercise of the parties' freedom, noted there, to determine when property passes, used here to secure the price.

The device gives the seller a strong form of security, for the seller does not merely hold a security interest in goods the buyer owns but retains ownership of the goods themselves until paid; if the buyer fails to pay and becomes insolvent, the seller may, in principle, reclaim the goods as their owner, ahead of the buyer's other creditors, because the goods never became the buyer's property. The retention of title thus allows a seller to extend credit to a buyer while retaining the protection of ownership, and it is widely used by suppliers who sell goods on credit. Its operation is, however, subject to limits and complications that vary among the systems: the seller's retained ownership may be difficult to maintain once the goods are resold by the buyer, mixed with other goods, or used in manufacture, and the systems differ in how they treat a retention of title as against the buyer's other creditors and as against good-faith purchasers from the buyer, some treating it straightforwardly as retained ownership and others assimilating it in certain respects to a registered security interest. The seller relying on retention of title must therefore attend to what the governing law provides.

Consider a supplier who sells materials to a manufacturer on credit under a contract providing that title shall not pass until the price is paid. If the manufacturer fails to pay and becomes insolvent while the materials remain identifiable in its possession, the supplier may reclaim them as their owner, ahead of the manufacturer's other creditors. Had the materials been resold or consumed in manufacture, the supplier's position would be more complicated and would depend on the governing law's treatment of the retained title in those circumstances. The example shows retention of title securing the seller through retained ownership while its operation depends on what becomes of the goods.

Retention of title is therefore a means by which a seller secures the price of goods sold on credit by retaining ownership of the goods until they are paid for, a strong form of security resting on retained ownership rather than a security interest in the buyer's property, whose operation against the buyer's creditors and purchasers is subject to limits and complications that vary among the legal systems.

Priority among competing claims

Security would be of little value if a creditor could not know whether its security would prevail over the claims of others to the same asset, and the law accordingly governs priority, the order in which competing claims to the same collateral are satisfied. Where more than one creditor holds, or claims, a security interest in the same asset, or where a secured creditor's interest competes with that of a purchaser of the asset or with the claims of the debtor's general creditors, the rules of priority determine whose claim is satisfied first out of the asset.

Priority connects to the function of security and to the security of transactions that runs through the course, for the value of a security interest depends on its rank against competing claims, and a creditor takes security in order to obtain a high rank. The governing principle in most systems is that priority depends in large part on the time at which, and the manner in which, each interest was created and made public, with an interest that has been registered in a public register, or otherwise perfected, commonly ranking ahead of a later or unregistered interest; registration serves both to make the creditor's interest known to others who might deal with the asset and to fix the creditor's rank. The systems vary considerably in the detail of their priority rules and in the registers they maintain, and the modern tendency, reflected in international model laws on secured transactions, has been toward comprehensive systems of registration that determine priority by reference to a public record, reducing the uncertainty that competing secret interests would create. The reader should appreciate the centrality of priority to the law of security: a security interest is worth only as much as its priority, and the rules of priority, resting largely on registration, are what give the secured creditor the assurance that its security will prevail.

Suppose a business grants security over the same asset to two lenders in succession, and later becomes insolvent. Which lender is paid first out of the asset depends on the rules of priority, which in most systems will favour the lender whose interest was first registered or perfected, so that a lender who registers its interest secures its rank against a later or unregistered interest. A lender accordingly registers its security to establish and protect its priority. The example shows priority, resting on registration, determining which competing secured creditor is satisfied first.

Priority is therefore the order in which competing claims to the same collateral are satisfied, a matter on which the value of any security depends, governed in most systems by rules that turn largely on the time and manner in which each interest was created and made public, with registration in a public register commonly fixing the creditor's rank and giving the secured creditor the assurance that its security will prevail over competing claims.