Legalese – Taking security

Introduction

Lenders have a range of options available to them when taking security. The article summarises the most common types of security available under English law, namely a lien, pledge, charge and mortgage. These are naturally applicable in relation to assets located in England, however, as many of the principles of English law have been imported by other jurisdictions, the concepts are often widely understood.

Lien

A lien generally refers to a very specific type of security interest founded in the right to retain (but not sell) property until a debt or other obligation is discharged – once possession is lost, the lien is released. A lien can arise from the operation of law (a common law lien), in equity, or can exist as a matter of contract (a contractual lien). Unlike other security interests, importantly, a lien holder does not have an automatic right to sell the assets.

Pledge

A pledge is the transfer of the possession of an asset to the creditor as a way of security in respect of a certain debt, while the ownership of such asset remains with the debtor. The creditor may, on a default, sell the pledged asset in order to have its debt repaid. Before selling the asset though, the creditor needs to send a notice to the debtor.

Charge

For obvious reasons lenders will not want to take possession of assets and nor will a borrower want to lose control of them, especially if they are used in the day-to-day running of its business. Instead, lenders typically want to take security by obtaining rights over specific assets of a borrower as security for a loan. Although the term “charge” is a term widely used for all kinds of security interest, it is in fact an agreement between two or more parties where one party (the chargor) grants security over an asset to another (the chargee), without transferring either the possession or the ownership of such asset (comparing a lien or pledge). This agreement sets out that upon the failure of the chargor to comply with an obligation, the chargee will be allowed to use the asset to have its debt repaid.

Charges can be fixed or floating. A fixed charge immediately attaches to the charged asset – an object of a fixed charge needs to be capable of being ascertained and defined (for example, shares of a company). The essential characteristic of a fixed charge is that it gives the lender control over the charged asset; it will give the lender the right to prevent the chargor from disposing of the asset without the lender’s consent, sell the asset if the chargor defaults under the loan, require the chargor to maintain the asset while it remains in the chargor’s possession and claim the proceeds of sale of the charged asset in priority to other creditors.

A floating charge exists over a pool of unspecified assets. Unlike the assets encumbered by a fixed charge, the assets under a floating charge are not capable of being ascertained other than generally. A floating charge can crystallise over all the assets which are subject to the floating charge or just some of them if the lender so decides (this is relatively rare). Crystallisation generally occurs at common law in circumstances such as a winding up order being made, appointment of a receiver, administrative receiver or administrator over some or all of the chargor’s assets or if the chargor ceases to carry on business. As these events only take effect once a chargor is in financial difficulty, the charge document can specify other circumstances which will cause the floating charge to crystallise, such as, upon notice from the lender if it believes that the secured assets are in jeopardy.

Where possible, a lender will attempt to ensure its charges are fixed as this generally puts the lender ahead of preferential creditors, rather than floating, which would put the lender behind them.

Mortgage

A mortgage is widely accepted as the most secure and comprehensive form of security as it involves the transfer of the ownership of an asset for the purposes of securing a debt. Upon the discharge of the payment obligation the asset is returned to the previous owner. Therefore, the transfer of the property enables the creditor (the mortgagee) to maintain control over it and prevents the debtor (the mortgagor) from disposing of such property (though the right to use the asset in certain restricted ways typically remains with the mortgagor).

There are two types of mortgage: legal mortgage and equitable mortgage. A legal mortgage transfers the legal title of the asset to the creditor and prevents the debtor from dealing with such asset. As an aside, a legal mortgage over land does not transfer the legal estate of this land, but it puts the creditor in the same position of someone to whom a lease of 3,000 years was granted, according to the provisions of the Law of Property Act 1925 Act. The form of creation of a legal mortgage over land is by means of the execution of a deed whereas for the creation of a legal mortgage over chattels a valid agreement between the parties and the intention to create a legal mortgage are sufficient.

An equitable mortgage transfers the beneficial interest in the asset to the creditor but the legal ownership of such asset remains with the debtor. The equitable mortgage commonly arises when the formalities required for the creation of a legal mortgage have not been complied with or the parties have entered into an agreement to create a future legal mortgage over the asset in question or the property to be mortgaged is recognised only in equity (for example, the common law does not recognise the transferability of many intangible assets which would be required for a legal mortgage).