What Is A Security Interest?
There are a number of different types of security interest. Read more about what they are, how they operate, and how they affect your financial affairs here
It is not uncommon for people to use their property as leverage as a means of securing a loan or some kind of capital fundraising. It might be for personal use, or it may be for the purposes of business. This process will involve a security interest. A security interest is a legal right granted by a debtor to a creditor over the debtor’s property which enables the creditor to have recourse to the property if the debtor defaults in making payment or otherwise performing the secured obligations. Collateral is the more common term for this. It involves different types of proprietary interests. It can also involve more than just two parties. Factoring in creditor rights by way of a Deed of Priority is a concept you should read about in tandem with this.
Granting a security interest can be a calculated risk, but a risk nonetheless. Each situation is different and will depend largely on your own unique loan agreement. Accordingly, it is wise to know as much as you can about this process. As either a debtor (borrower) or creditor (lender), these loans can have broad outcomes. The first step is to learn some of terms you may read about and what they mean. We have outlined some of the different types of security interests and how they operate for you below.
Types of security interest
Any type of property can be a security interest. The law divides property into two classes. Firstly, personal property. Secondly, real property. Real property consists of land. Anything affixed to that land is also real property. Personal property, also known as personalty, includes anything other than real property. Within these two broad types, there are different ways that a security interest can form.
A legal mortgage occurs when the assets are conveyed to the secured party as security for the loan, but subject to a right to have the assets returned when the loan is repaid. Equity of redemption is the term for this right. The law protects this right. It does so by preventing a ‘clog’ on the equity of redemption. What this means is that as a debtor, provided you repay your debts, creditors must legally handover your property and forfeit that security interest. This is a nonpossessory type of security interest. This will arise by agreement only. For more information about mortgaging your property as a security interest, it may be worthwhile seeking the help of a property lawyer.
Usually, the mortgagee will have the same rights as they would have had under a normal legal mortgage, but the manner of enforcement is governed by the statute. This statute may vary between jurisdictions, and is much the same as a legal mortgage, but may differ in some slight ways as per the relevant legislative provisions.
An equitable mortgage can arise in two different ways. Firstly, as a legal mortgage which was never perfected by conveying the assets. Secondly, by specifically creating a mortgage as an equitable mortgage with no legal interest. Usually, an equitable mortgage has the same effect as a perfected legal mortgage except in two instances. Firstly, a later bona fide purchaser for value who did not have notice of the mortgage will cease this equitable interest.
Secondly, given the legal title to the mortgaged property is not actually vested in the secured party, it means that a further step is imposed in relation to the exercise of remedies such as foreclosure when trying to retain the security interest in the event of a debtors failure to pay. Even though it may arise through an imperfect conveyance, the will to agree to grant a security interest existed initially, and therefore equitable mortgages arise by way of agreement also.
Fixed equitable charge
A fixed equitable charge confers a right on the secured party (the creditor) to rely on or appropriate a particular asset in the event of the debtor’s default. This is enforced by either power of sale or appointment of a receiver. An equitable charge is also a nonpossessory form of security, and the beneficiary of the charge does not need to retain possession of the property.
Floating charges are similar in effect to fixed equitable charges once they finalise come the liquidation process. However, prior to that time, they ‘float’ and do not attach to any of the debtor’s assets. Therefore, the debtor or chargor remains free to deal with or dispose of them.
A pledge is a form of possessory security. Accordingly, the assets which are being pledged need to be physically delivered to the beneficiary of the pledge. Pledges are common in commercial contexts used in trading companies ( like commodity and goods trading). Stock held on pledge is an example of this. Another familiar example of this might be a pawnbroker who retains that physical property until such a time as the debt is paid.
Common law lien
A common law lien includes a right to retain physical possession of assets as security for the underlying obligations of the debtor. In the case of a possessory lien, the right is purely passive. The secured party or creditor has no right to sell the assets, but merely a right to refuse to return them until the debtor has paid. These arise as an operation of law and not by agreement.
Equitable law lien
These are liens that are imposed by the court in order to maintain a certain degree of fairness or equity in the situation surrounding the property. They usually arise when one person holds possession of property for another person. These are an operation by law and not by agreement.
Sometimes contracts can create legal liens. It operates in much the same way as it would under the common law basis. Accordingly, it forms by way of agreement and not through a court imposed legal function.
Hypothecation is a form of security interest whereby the underlying assets are pledged, not by delivery of the assets as in a normal pledge, but by delivery of a document or other evidence of title. These are quite uncommon. This form of security interest is possessory in nature, and operates by agreement only.
As you can see, the premise of mere collateral can become quite complicated pending the unique facts of any case. There are many things to consider when granting a security interest. Knowing these facts as both a creditor and a debtor is valuable. Protecting your interests is key to your business and financial success. If you are unsure about your situation, and have formed a security interest by way of agreement, it is recommended that you seek the advice of a contract lawyer. For further reading, the Australian Government Financial Security Authority also provides more information on its website.
Paul is an intern at Lawpath, and is currently studying a combined Arts/Laws degree with a major in criminology at Macquarie University. Paul has an interest in legal tech, which complements his broader interest in cyber crime/security and the way in which it is changing the world.