What is Security in a Loan Agreement?

Summary

• Security in a loan agreement gives the lender special rights over the borrower’s assets, allowing them to sell those assets and recover the loan amount without court proceedings if the borrower defaults, making secured lending less risky and more efficient for lenders.
• The three main types of security are charges (including fixed and floating charges), mortgages, and pledges, with the appropriate type depending on the nature of the borrower’s assets, whilst guarantees, comfort letters, negative pledges, and indemnities function similarly to security but do not provide the same legal protections.
• Security is only practically effective if the value of the secured assets is at least equal to the loan amount, as a lender enforcing against under-valued security will likely be unable to recover the full amount owed.
• This article is a guide to security in secured loan agreements for businesses in the UK, explaining what security is, the main types available, and the practical considerations for borrowers and lenders entering into secured lending arrangements.
• LegalVision is a commercial law firm that specialises in advising clients on commercial finance and loan agreements.

Tips for Businesses

Review the security provisions in any loan agreement carefully before signing to understand which assets are being secured and the lender’s enforcement rights if you default. Ensure the value of assets offered as security is sufficient to cover the full loan amount plus interest, as under-valued security may not adequately protect the lender and could affect your ability to obtain the loan on favourable terms. Seek legal advice before entering into any secured lending arrangement to understand the implications of granting security over your company’s assets, particularly where fixed or floating charges over all assets are involved.

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On this page

• Understanding Loan Agreements
• What is Security? 
• Types of Security 
• What is the Difference Between a Fixed Charge and a Floating Charge?
• Practical Considerations
• Key Takeaways 
• Frequently Asked Questions

If your company is looking to get a loan from a bank, you may have come across the term “security”. Security is a legal interest that provides lenders with an efficient means to recover the money they lent. If you breach the terms of a loan agreement, the lender could use their broad powers to recover their money. This article will explain the legal concept of security in a secured loan agreement. 

Understanding Loan Agreements

At its most basic level, a loan is a form of contract. A contract is a legally binding agreement between two or more parties, where each party promises to enter into an obligation to obtain a benefit from the other party. A legal obligation means that if one party does not uphold their end of the agreement, you can go to court and ask them to enforce such an obligation. 

In a loan agreement, where the borrower has breached a term of the loan, the lender usually seeks a “debt action”, which is an order by a court telling the borrower to repay the amount. However, if the borrower has run out of money, this can undermine the lender’s ability to retrieve the money they lent. 

Lenders can minimise the risk of this occurring by obtaining a security interest. 

What is Security? 

Banks tend to loan money to companies only if they agree that the bank has the right to claim the company’s assets and sell them to recover the loan amount. That is to say, if the borrower cannot repay the loan amount and therefore breaches the loan terms, the bank still has recourse to recover the amount. 

If the borrower defaults on the loan, the lender can “enforce” against their security. This usually means they will sell the property and use the proceeds of the sale to pay themselves back. Additionally, having security in an asset enables lenders to avoid filing court claims to recover its money. This saves time and expense and incentivises the bank to make secured loans. 

Types of Security 

A lender can obtain three main types of security in the borrower’s property. These types of security include:

• charges, which are commonly referred to as fixed and floating charges; 
• mortgages; and 
• pledges. 

The distinction between these three kinds of security is quite technical. Ultimately, the kind of security a bank takes depends on the borrower’s assets. 

There are also other kinds of agreements that function like security but are not secure from a legal perspective. These include:

• guarantees; 
• comfort letters; 
• negative pledges; and 
• indemnities. 

What is the Difference Between a Fixed Charge and a Floating Charge?

Charges are the most common form of security taken by lenders over a company’s assets. There are two types: fixed charges and floating charges.

A fixed charge attaches to a specific asset at the time it is created. The borrower cannot sell or dispose of that asset without the lender’s consent. Fixed charges are typically taken over land, buildings, and high-value equipment.

A floating charge, by contrast, hovers over a class of assets that changes from time to time, such as stock or trade debtors. The borrower can continue to deal with those assets in the ordinary course of business. However, if the borrower defaults, the floating charge “crystallises” and attaches to whatever assets are in that class at that point in time.

Lenders prefer fixed charges because they provide greater certainty and priority. However, floating charges are useful where the borrower’s assets are constantly changing and a fixed charge would be impractical. In practice, most secured loan agreements include both a fixed charge over key assets and a floating charge over the remaining assets. Together, these are known as an “all assets” debenture.

Companies must register charges at Companies House within 21 days of creation, or they will be void against a liquidator or creditor.

Practical Considerations

In practice, a security is only adequate if the value of the secured property is at least as valuable as the loan amount. 

To illustrate this point, suppose your company obtains a £100,000 loan. The total value of all of your company’s assets was £500,000. If the bank takes security over all of the company’s assets, it should have no problem recovering its £100,000 (plus interest). 

Alternatively, if the bank obtained security in property valued less than the £100,000 loan, it will likely be out of pocket if it enforces against its security. 

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Key Takeaways 

A loan is a contractual agreement where the borrower promises to repay the loan amount according to the loan’s terms and conditions. Sometimes, the borrower cannot fulfil their obligations because they have run out of money. This makes lending risky because the bank may not be repaid. To avoid this, most bank loans are secured, meaning the bank gets special rights to the company’s property. If the company faces financial difficulties, these rights usually require the company to sell the secured property to repay the bank before anyone else. 

If you need help understanding your loan agreement, LegalVision provides ongoing legal support for all businesses through our fixed-fee legal membership. Our experienced commercial lawyers help businesses manage contracts, employment law, disputes, intellectual property, and more, with unlimited access to specialist lawyers for a fixed monthly fee. To learn more about LegalVision’s legal membership, call 0808 196 8584 or visit our membership page.

Frequently Asked Questions