Loan Securities and Documentation PDF

Home About FIN367 Loan Securities and Documentation Sub-topic 2.4 Next Slide  FIN367 Introduction Security is a second way out that provides lender some assurance of fallback in the...

Home About FIN367 Loan Securities and Documentation Sub-topic 2.4 Next Slide  FIN367 Introduction Security is a second way out that provides lender some assurance of fallback in the event borrower fails to pay the loan. It is important to note that security does not mitigate the risk of default. It can only mitigate the risk of losses in the case of default. Credit officer should ensure that the adequacy of security value and the security-to-loan coverage ratio meets the lending bank’s credit policy and prudential requirements. In addition, the quality of the security is of equal importance. A good security must have: Stability in value Marketable with adequate liquidity Quantifiable / measurable Ease of transfer in terms of usage Ownership and physical movement Free from prior ranking claims/ encumbrances Allow the lender to enforce their right over the security legally.  FIN367 Collateral categories Collateral value that The lender should accurately determine the value of collateral at the time of granting the loan. The margin of financing cannot be too high. are depreciating E.g. vehicle, plant and machinery. Collateral value that The lender is required to periodically update the value. Incorporate a provision in their offer letter that allow lender to request for additional collateral in the event the security-to-loan coverage ratio falls below the minimum threshold level are fluctuating E.g. stocks, shares, bond, and other marketable securities Collateral value that The lender must ensure legal enforceability intact with fixed deposit remained under lien and not wrongly released to borrower are stable E.g. Fixed Deposit Collateral value that The Lender can engage professional valuer to periodically update the property value and advise on any adversity affecting the property value. are potentially The lender is required to create a security interest through the execution of security agreement between security provider and lender to ensure that a collateral is valid against third party claim. This is followed appreciating by perfecting the security interest through notifying the security interest to third party.  FIN367 Loan Agreement The loan agreement sets out the contractual and legal relationship between the lending bank and the borrower. It contains full details of the loan terms and This agreement has to be: conditions, the identity of the persons who are parties to the loan, the date of drafted properly with appropriate execution, and other requirements needed to safeguard the loan. clauses; signed by authorised signatories of The loan agreement, among other things, would contain the following major the bank and the borrower or its sections: officers; stamped with stamp duties paid; 1. Structure and terms of the loan facilities registered with appropriate 2. Conditions precedent regulatory agencies where required; 3. Conditions for drawdowns and 4. Continuing conditions kept safe by the lending bank’s securities department or in-house legal 5. Covenants and Credit control counsel. 6. Compliance and monitoring of covenants  FIN367 Loan Facilities: Structure and Terms This section will include a full description of the types of facilities, their amounts, and their availability for drawdown. It will also detail the interest rates charged on the loan, repayment schedules, the amount of repayment instalments, and security requirements. Conditions Precedent These are conditions imposed on the borrower by the bank, sometimes on the advice of solicitors, to be fulfilled prior to making the loan facilities available. Examples include the provision of a board of directors’ resolution accepting the loan facilities, the furnishing of documents of title, and disclosure to the lending bank of required business arrangements such as customers’ purchase contracts. Non-fulfilment of conditions precedent would prevent the loan from being made available for drawdown by the borrower. Conditions for Drawdown Some loan facilities have specific conditions for each drawdown from the available facilities. These conditions are designed to provide the lending bank some control over the use of funds from the loan. Each time a drawdown is required, the borrower will have to provide the bank with required information or seek the bank’s consent.  FIN367 Continuing Conditions These conditions are designed to ensure the borrower maintains discipline and proper conduct over the use of the loan facilities throughout the loan period. On-going compliance with these continuing conditions will prevent the lending bank from calling an event of default. Covenants and Credit Control These covenants are credit control mechanisms and their effectiveness requires a clear understanding of their objectives and rationale. As the risk of a loan is borne by the lender until it is repaid, it is necessary to ensure that the borrower engages in good financial and business discipline throughout the loan duration. Covenants can be categorized as those having direct financial effects and those relating to general business continuity. Covenants are also referred to as restrictive and non-restrictive covenants, or negative and positive covenants. See: common covenants in business lending (tables in next slides) Compliance and Monitoring of Covenants The lending bank should not overburden the borrower with covenants that are irrelevant or do not contribute to protecting creditworthiness. Covenants that are difficult to comply with or hard to monitor should be avoided. Compliance check: Credit officer need to monitor compliance of the covenants imposed on borrower during yearly credit review.  FIN367 Common financial covenants in business loan Financial covenant agreement Description and objective Nature Minimum equity covenant A requirement imposed on the borrower to cover any losses Positive covenant with new capital injection within a specified period. Working capital maintenance The borrower is to ensure sufficient net current assets and Positive covenant prevent over reliance on current liabilities or engage in over-trading. Typically, a current ratio is specified, with an amount indicated. Sinking fund requirement This is a specific requirement for the borrower to create and Positive covenant maintain a specific fund for asset replacement or loan redemption. This is done to avoid future cash shortage Borrowing and debt restriction This covenant deters excessive borrowings and/or trade Negative covenant liabilities by the borrower and preserves the financial solvency. Dividend payment restriction A restriction to prevent excessive cash outflow which requires Negative covenant prior approval of the lending bank.  FIN367 Common general covenants in business loan General covenant agreement Description and objective Nature Valid licenses and trade The borrower has to renew all licenses, franchise agreements Positive covenant agreements and permits before the expiry dates. This is to ensure the business remains legally registered, and franchises are valid to continue viable operations. Insurance coverage All assets and key executives to be covered with adequate Positive covenant insurance and the policies assigned to the bank. Non-disposal of key assets of the The borrower shall not sell or transfer certain specified assets Restrictive covenant borrower such as landed assets without prior consent of the lending bank. The objective is to ensure important assets remain to support the business as well as protection for the creditor Restriction on investments outside Any investment outside the core activities is not allowed Restrictive covenant normal business operations without prior consent of the bank. This is to prevent aggressive investment practices that deplete cashflows while increasing risk. Restriction on change of business There shall be no change in majority shareholdings in the Restrictive covenant ownership company without prior consent of the lending bank. This restriction ensures the bank has the opportunity to assess the risk of any potential new party while capturing existing commitmen  FIN367 Property Security Land and properties are important form of security for lender. Two types of property Property with Issued Document of Title Property with No Issued Document of Title  FIN367 Property with Issued Document of Title Legal Charge as Security over Type of Land Title Property with Title Type of Legal Freehold Land Leasehold Land Tenancies Charge First Legal Charge First Party Charge Principal Charge and Second Legal and Third Party and Subsidiary Charge Charge Charge  FIN367 Property with Issued Document of Title For properties with title. They are governed by land laws such as National Land Code 1965 (only applicable in Peninsular Malaysia), Sarawak Land Code (Sarawak) and Sabah Land Ordinance (Sabah). Two type of land title: Freehold Land Land where the title is generally referred to as grant in perpetuity or freehold title. Freehold title vests in the individual and successor in title the land for an indefinite period. Leasehold Land A leasehold title vests in the owner and successor in title the leasehold land for periods such as 30, 60, or 99 years. Upon expiry, the title reverts to the state, unless the lease is renewed. Leasehold title only applicable under National Land Code in Peninsular Malaysia. There is a restriction in interest that restrict the transfer and charge without the prior written consent of state authority. In Peninsular Malaysia, a registered lease involves the letting of land for a term exceeding 3 years. In Sabah and Sarawak, a registered ‘Sub-Lease applies to land that is let for a term exceeding 1 year. Tenancies Tenancies need not be registered.  FIN367 Legal Charge as Security over Property with Title A registered legal charge/ legal mortgage is the best security over land because in the event of loan default, the charge (lender) is entitled to enforce the security by foreclosure as provided by National Land Code (NLC) in order to recover the loan advanced by the charge. Memorandum of Charge is the instrument to create a charge over property with title. It is known as Form 16A under NLC. To ensure the legal charge is valid against claim from other creditors, It must be properly executed, attested by parties authorized by land law, stamped on ad-valorem basis within 30 days from date of execution and presented for registration within 30 days from date of creation. A charge is normally presented for registration together with memorandum of transfer for the reason that the ownership of property must be transferred to the purchaser first before they can create a charge favoring the Bank. Prior to presenting the charge for registration, lender is advisable to conduct a final land search to ensure there are no private caveat, Registrar caveat or prohibiting order have been filed and registered that may led to the registration of charge being rejected.  FIN367 Legal Charge as Security over Property with Title (Cont.) The date and time as entered into the presentation book at the land office is the effective date of registration of charger, which conferred indefeasible title and interest on the charge, which is good against all other conflicting claims. In addition to the registration of charge at the land office, it is important for lender to take note of registration of charge at Company Commission of Malaysia (CCM) if the charger is a company. Under Company Act, a legal charge must be registered with CCM within 30 days of execution failing which the charge is invalid and lender would lose its priority of claim against other creditors.  FIN367 Creation and Perfection of Memorandum of Charge  FIN367 Type of Legal Charge A charge is a transaction whereby the registered owner of a land or a lease conveys the legal interest to another for repayment of a debt. The owner of the land is called Chargor. The party (usually the lender) to which the land is charged is called Chargee. i. First Legal Charge and Second Legal Charge First Legal Charge – Upon registration, the first legal charge would create an encumbrance on the land which prevents any further dealings without consent of the First Chargee. Second Legal Charge – It is permissible to create more than one charge by the some Chargee or different Chargee subject to consent of the First Chargee. In the event the land is foreclosed, the rights of subsequent charger shall rank after the First Chargee i.e. proceeds from sales of land will be paid to the First Chargee before subsequent charge. ii. First Party Charge and Third Party Charge First Party Charge – it is where the borrower and owner/Chargor are the same party. Third Party Charge – it is taken where the borrower and owner/Chargor are different party. iii. Principal Charge and Subsidiary Charge The different between Principal and Subsidiary Charge is in the stamping of the charge instrument. Principal Charge – it is the charge where the ad valorem stamp duty is paid based on the amount stated in the memorandum of charge.  FIN367 Property with No Issued Document of Title Legal Assignment Procedure to as Security over Reduce Risks in an Property without Assignment Title Loan Agreement Original Copy of Lodgment of Loan Agreement Documentation of Deed of Receipt and Deed of Sales and Private Caveat cum Assignment Power of Attorney Loan Agreement and Reassignment Assignment Purchase against the Mater (LACA) cum Assignment (R&R) (LADA) Agreement (SPA) Title  FIN367 Property with No Issued Document of Title Property without title usually involves multi-density dwellings such as apartments, condominiums, townhouses and gated communities. These properties are governed by Strata Title (Amendment) Act 2007 where the property developer or land proprietor is responsible to apply for subdivision of the land and the issuance and transfer of strata titles to individual owners of the multi-density development.  FIN367 Legal Assignment as Security over Property without Title An absolute Assignment is a contract in writing where the assignor/owner of property/borrower assign all his rights, title and interest in the property under the Sales and Purchase Agreement to the assignee/lender as security for a loan extended by the lender of the borrower. i. Loan Agreement Cum Assignment (LACA) It involves first party where purchaser and borrower are the same party. It is to be stamped on ad-valorem basis. ii. Loan Agreement and Deed of Assignment (LADA) It involves third party where purchaser and borrower are different party. iii. Power of Attorney (PA) LACA and LADA contains valid PA, which must be registered at High Court which gives the Assignee/lender the right to enforce remedy under the LACA/LADA upon default by borrower of right and power to sell, assign and deal with the property under assignment. In the event of default, the assignee bank can sell the assigned property by way of private treaty or public auction to settle the  FIN367 Procedure to Reduce Risks in an Assignment i. Documentation of Loan Agreement Cum For sub-sales of property involving assignor and new purchaser, an express Assignment Notice in Writing must be given to the Developer for the Deed of Assignment to take effect. ii. Original Copy of Sales and Purchase For effective enforcement of LACA, lender must ensure that the Original SPA Agreement (SPA) between developer and first purchaser to be obtained as it is the proof of the assignor/ purchaser/ borrower’s title, right and interest in the property pending issuance of strata title / individual title. iii. Lodgment of Private Caveat against the The lodgment of Private Caveat is to prevent Developer from fraudulently Master Title deal with the property that affect the interest of purchasers and end-financier. It does not facilitate sub-division of master title and may delay the application for strata title. This is because developer needs to liaise with individual purchaser and/or their end financier to withdraw the private caveat before submitting application for subdivision into strata titles. iv. Deed of Receipt and Reassignment (R&R) A receipt and reassignment needs to be executed once the loan is settled by borrower. This is to ensure that the power of attorney which was created favoring the assignee bank is duly revoked. It also facilitates the reassignment of right, title and interest in the property from assignee bank to borrower/property owner.  FIN367 Documentation Process for Property with Title and Property without Title It is important for lender to familiarise themselves with the documentation process in order to mitigate risk arising from non-perfection of legal documentation and loss of security protection for lender. Lender needs to determine whether property to be financed is completed or under construction outright purchase from developer or sub-sales, and with or without document of title before they commence legal documentation.  FIN367 Property under Construction Stage For property under construction, it is important for lender to obtain written undertaking from developer through solicitor as follows:  FIN367 Completed Property under Sub-Sales For completed property under sub-sales, lender needs to obtain written undertaking from vendor to furnish original document of title and valid and registrable memorandum of transfer (for property with title) or Original Sales and Purchase Agreement and Deed of Assignment (for property without title) to the purchaser or its end-financier. Vendor is to refund the purchase price in the event the transfer or assignment cannot be effected/perfected for whatsoever reason. In addition, vendor needs to provide written confirmation on the settlement of differential sum between purchase price and loan sum. This is to prevent the risk of vendor rejecting the transfer of ownership due to non-settlement of balance purchase price by purchaser.  FIN367 Property under Redemption For property under redemption, it is important for purchaser and lender to verify the redemption amount owing to existing chargee bank /assignee bank prior to execution of Sales and Purchase Agreement. This is to ensure the purchase price is sufficient to settle the redemption sum. In addition, lender is required to lodge private caveat prior to the release of redemption sum. This is to mitigate the risk of discharge documents lost in transit after loan is disbursed rendering the lender (i.e. purchaser's end-financier) unsecured in loan exposure. If the property to be redeemed is a titled property, lender is to obtain redemption cum undertaking letter from the chargee bank. The chargee bank is to undertake to furnish the original document of title, duplicate charge, and discharge of charge upon receipt of full redemption sum, and undertaking to refund in the event the discharge of charge can be registered for certain reason.  FIN367 Property under Redemption (cont.) If property to be redeemed is without title, lender is to obtain redemption cum undertaking letter from the assignee bank. The assignee bank (vendor's bank) is to undertake to furnish the original Sales and Purchase Agreement (between developer and first purchaser), the Loan Agreement cum Assignment and Receipt and Reassignment upon receipt of full redemption sum, and undertaking to refund in the event the Receipt and Reassignment cannot be perfected for any reason whatsoever. In addition, a disclaimer letter is to be obtained from the Developer's Bank to exclude the units to be redeemed /redeemed from foreclosure proceeding, and to refund the redemption sum in the event discharge of charge (upon issuance of title) cannot be registered for any reason whatsoever.  FIN367 Other Security and Documentation There are other securities that can be considered as collateral such as: ✔ Fixed Deposit ✔ Stocks and Shares ✔ Unit Trust ✔ Insurance Policy ✔ Assets under Hire Purchase Financing ✔ Debenture Other Security and Documentation (Cont.) Fixed Deposit Stocks and Shares Fixed deposit (FD)is the most liquid and stable form of Stocks and Shares is another common class of security. Lender security taken by lender. Monies kept in a fixed deposit prefers to take shares of public listed companies (PLC) as they are account can be pledged as security for the repayment of a liquid, marketable and with ease of disposal. loan advanced to the depositor or to a third party. There are certain categories of shares that lenders are to avoid such as shares that are suspended, speculative, non-dividend paying and restricted under the individual bank's lending policies. Documentation: Documentation: The instrument creating the security interest is For PLC shares, lender can create legal mortgage through Memorandum of Deposit (MOD) and /or letter of set off. In Memorandum of Deposit (MOD), which gives the Bank the Power of addition, the original FD receipt is surrendered to the Bank Attorney to dispose the shares in the event of default. The legal to create a 'lien' over the FD receipt. ownership of shares is transferred outright to the Bank or their The letter of set off gives the Bank the right to set off the FD nominees through Central Depository System (CDS). proceeds to settle loan outstanding in the event of default. Private companies' shares are restricted from transferred to third MOD is stamped ad-valorem whilst letter of set is off at party under Company Act unless is empowered under Memorandum nominal fee of RM10. and Article of Association, and approved by the Board of Directors. If the deposit owner is a company, the MOD created over FD Therefore, an equitable mortgage is created over the private needs to be registered with Companies Commission of company shares through Memorandum of Deposit. This is Malaysia (CCM) through the filing of Form 34. The accompanied by lodgement of shares certificate with the Lender and registration serves as public notification of the Bank's legal blank presigned transfer form between borrower /shares owner and claim over the FD. lender. The legal ownership of the shares remains with borrower, who has the equitable rights to redeem the shares by full settlement of the outstanding loan. Other Security and Documentation (Cont.) Unit Trust Insurance Policy Unit trust is a collective investment scheme. The investors who invest in Lender can take life insurance policies as a form of security or credit them receive trust units that entitled them to dividend, bonuses and support, depending on the availability of cash or surrender value in the units distribution and proceeds from the disposal of investment. policy. Cash or surrender value is the cash amount that insurance company will pay on a given life insurance policy if the policy is cancelled prior to death or permanent disability of insured or before maturity. Endowment policy is taken by lender as security as they provide both saving and protection, and have a higher cash surrender value as compared to other life policy. Whole life policy (non-participating) and term life policy are usually taken as a credit support as these policies do not have cash surrender value and lender can only access to the insurance proceeds upon death or permanent disability of the insured and not upon default of the loan. Documentation: Documentation: Like stocks and shares, the instrument to create security interest is Lender can create a legal assignment with an endorsement over the Memorandum of Deposit (MOD) which gives the bank the power of insurance policy followed by written notification of the assignment to attorney to sell the unit trust upon default by borrower. the insurance company. A written notification on the assignment of In addition, transfer form is executed by borrower in favor of Bank or its insurance policy to be given to the insurer to establish a priority claim on nominees. Upon loan default, Bank will sell the unit trust to the Unit the policy monies, and ensure policy monies are paid directly to the Trust manager and sales proceeds will be credited to borrower’s account bank on maturity or upon claim. to settle the outstanding loan. The unit distribution continues to be credited to borrower's unit trust account to maintain collateral value. Upon full loan settlement, the trust units will be transferred by the lender to borrower followed by cancellation of MOD and endorsement on unit trust certificate. Other Security and Documentation (Cont.) Assets under Hire Purchase Financing Debenture For assets under hire purchase financing such as motor Debenture is defined as an instrument evidencing debts by a vehicle, etc. company. It is created as fixed charge over immovable assets (such as land, building) of a company and floating charge over movable assets (such as stocks, trade receivable, equipment) of a company. Documentation: Documentation: The instrument to create the security interest is Hire Purchase Debenture must be registered with Company Commission of Agreement, which is standardised by the Hire Purchase Act Malaysia (CCM) within 30 days of creation as notification of 1967. prior claim to third party. The event of default, as specified in The Hire Purchase Agreement is to be executed by borrower the debenture is upon the wind up of a company, cessation of and lender. Lender retains ownership of the assets but business or appointment of receiver by debenture holder. borrower/hirer can use the assets if they service the loan The floating charge will be crystallised upon event of default regularly. where the encumbered assets are frozen and no longer In the case of motor vehicle financing, ownership claim will be allowed to be transacted or moved without the lender's endorsed on the vehicle registration card by lender which approval. The bank can appoint an official receiver to take serves as notification to other party of lender's prior claim over borrower's business and sell the assets by way of private over the motor vehicle. treaty to settle the outstanding loan owing to the Bank. Upon default of two consecutive instalment payments, Notice of Intention for repossession will be issued to borrower, and the repossession by lender takes place after 21 days of the notice. The procedures for the repossession and subsequent disposal of assets must comply with the Hire Purchase Act.  FIN367 Guarantee and Indemnity In the course of lending, lender may require further credit support in addition to tangible second way out. The credit support will obtain a moral commitment and financial support from a third party, or financial recourse to a third party in the event of loan default by borrower. There are several forms of credit support such as Guarantee, Indemnity, letter of undertaking, letter of awareness, letter of comfort and subordination of related party loan.  FIN367 Characteristic of Guarantee A guarantee is a legally binding contract under Contract Act 1950. It is an agreement by a guarantor to pay to the Bank in the event of borrower defaults. A guarantee involves existence of three (3) parties, namely, the guarantor, lender and borrower. The guarantor is a secondary debtor who undertakes to pay the loan in the event the primary debtor, borrower fails to pay. A guarantee must be provided by third party. Therefore, sole proprietor and partners who are primarily liable for the debts of the firm cannot guarantee the borrowings of the proprietorship or partnership. Lender may request for third party's guarantee either from an individual or corporate entity.  FIN367 Characteristic of Guarantee A guarantee is a legally binding contract under Contract Act 1950. It is an agreement by a guarantor to pay to the Bank in the event of borrower defaults. A guarantee involves existence of three (3) parties, namely, the guarantor, lender and borrower. The guarantor is a secondary debtor who undertakes to pay the loan in the event the primary debtor, borrower fails to pay. A guarantee must be provided by third party. Therefore, sole proprietor and partners who are primarily liable for the debts of the firm cannot guarantee the borrowings of the proprietorship or partnership. Lender may request for third party's guarantee either from an individual or corporate entity.  FIN367 Characteristic of Guarantee (cont.) A personal guarantee is usually provided by director and/or majority shareholder of a company in their personal capacity and shall remain valid even when the individual is no longer a director or shareholder in the company. The most common type of personal guarantee is Joint and Several Guarantee where the guarantors are jointly liable for the full amount of guarantee and lender is at liberty to recover the guarantee sum from any one of the guarantors. The guarantor who paid the full guarantee sum on behalf of other guarantors has the right to seek remedy from the remaining guarantors for their share of payment or losses. The discharge of one of the guarantors however, will not discharge the others. Lender usually obtain Corporate Guarantee from companies within a Corporate Group such as parent company, subsidiary and related company of common parent company. This is to be comply with section 133A of Company Act. It is important to note that corporate guarantee from non-related third party company is not allowed unless the company is a private exempt entity.  FIN367 Consideration for Guarantee The following considerations justify the need of a Guarantee as credit support: Borrower's debt servicing ratio is assessed to be beyond the lender's guideline. The loan tenor requested exceed the expected retirement age /economy lifespan of assets to be financed. The income reported by the applicant is of unstable in nature The income reported by the applicant cannot be substantiated as there is no proper document for verification  FIN367 Perfection and Enforcement of Guarantee A guarantee does not required attestation. However, lender is to ensure that a guarantee is properly witnessed in order to mitigate the risk of forgery. Unless it is specified as principal instrument, a Guarantee is usually stamped for nominal fee of RM10. The legal proceeding against Guarantor(s) involves obtaining judgment from the court, followed by enforcement of judgment as follows: Attachment of goods belonging to the guarantors by way of Writ of Seizure and Sales Attachment of land belonging to the guarantors by way of Prohibitory Order Garnishee proceeding to freeze the funds of guarantors with the Bank Judgment debtors summons against guarantors that are salaried workers with regular monthly remuneration Bankruptcy Order against guarantor that owed judgment debts of minimum RM50,000 Winding up petition against company (in the case of corporate guarantor)  FIN367 References ❑ Asian Banking School, Fundamentals of Credit., n/a, ISBN: n/a ❑ Asian Institute of Chartered Bankers, Certificate in Credit (CCR) Module, n/a, ISBN: n/a