By Fred Aarons[1]
A sound legal and institutional framework is critical to maximize the economic potential of movable assets so that they could be used as collateral instruments.
It has been demonstrated that effective legal systems grant two fundamental rights to a creditor to reduce the risk that a loan will not be repaid, namely: (i) the right to recover the outstanding amount of a debt; and (ii) in case of default by the debtor, the right to recover the value of assets serving as collateral and to apply that value to any unpaid balance. However, a significant number of developing countries lacks an integrated legal framework for secured credit transactions and movable collateral registries that could facilitate access to finance and improve creditworthiness of private firms.
In a significant number of developing countries, there is no integrated or unified legal framework in the economy for secured transactions that extends to the creation, publicity and enforcement of functional equivalents to security interests in movable assets. There is no collateral registry in operation for both incorporated and non-incorporated entities that is unified geographically and by asset type with electronic database indexed by debtor’s name. Such limitations result usually in banks and financial institutions not having access to borrowers’ credit information online, while it takes an extensive recovery period and costs a significant portion of the value of the claim, and the average recovery rate is low on the dollar.
In order to promote viable and more efficient private sector businesses, it is important that governments focus their attention in the development and execution of several initiatives with the aim of providing a more enabling environment for businesses. These initiatives include establishing a modern and efficient secured transactions framework aimed at increasing the use of movable assets as collateral and establishing a modern collateral registry for all secured creditors.
I. Key aspects of a sound legal and operational framework
The ultimate purpose of a modern secured transactions system is to facilitate access to credit for all sectors and all types of economic factors, thereby contributing to the overall economic development of a country. Secured transactions systems based on international standards and best practices have increased the credit capital available in local economies. To achieve such purpose, governments in developing countries must consider reforms in their financial, legal and institutional frameworks to facilitate the efficient use of movable property as collateral.
International financial institutions provide ample support to governments in developing countries to improve credit access with the involvement of public and private sector entities, promoting a diverse array of institutional measures aimed at (i) establishing a legal framework for an integrated secured credit transactions system, (ii) establishing an operational secured credit transactions framework for movable and immovable collateral, (iii) increasing credit access in strategic economic sectors with special emphasis on Small and Medium Enterprises (SMEs), (iv) providing training to stakeholders on the functioning and benefits of the proposed integrated secured credit transactions system for movable and immovable collateral, and (v) establishing comparative metrics and performance indicators for the proposed secured credit transactions system. Such a policy undertaking must be fully aligned with the underlying country’s strategy, which in turn should address cross-cutting themes of climate change and gender challenges, while inter alia strengthening public sector institutions and governance; promoting private sector development; and fostering human development.
Upon deciding to implement a modern secure transactions system, governments in developing countries must build the necessary consensus among key private and public sector stakeholders to review the existing secured credit regulations applicable in such countries and align the proposed changes with UNCITRAL Legislative Guideline on secured credit transactions. In fact, it is desirable that ample discussions take place on the features and advantages of any prospective legislative initiative, and the applicable technical recommendations, to promote the consensus required to establish a comprehensive approach aimed at implementing a modern secured credit transactions framework. Past experiences have demonstrated that the approval of a legislative bill on secured credit transactions, aligned with the UNCITRAL Legislative Guideline on the subject matter, requires substantial political commitment and consensus building among the public and private sector entities due to the fact that the success of such legislative proposal hinges on the extent of the measures to be adopted regarding the legal secured credit transactions framework and the operation of an integrated registry for movable and immovable collateral. The active participation of key public and private sector entities in the building capacity process will contribute to achieve consensus among the stakeholders and promote sound public policies on a viable and modern secured credit transactions system, which in turn should prompt private sector development.
It is also of the essence that consensus building efforts take place among key public and private sector stakeholders about the design and implementation of an integrated web based electronic registry for movable collateral, which as part of the newly adopted secured credit transactions system should contribute to the implementation of a notice-based security interest framework in the underlying developing country. Any proposed integrated web based electronic registry should tend to unify the registration processes for movable collateral and align its activities with the registration processes available for immovable collateral. It is expected that the registries for both movable and immovable collateral provide third party access to registry information, promote expeditious enforcement of security rights within a user-friendly registry operations environment.
As part of the implementation of an integrated web based electronic registry for movable collateral, a strategic plan should be produced to include inter alia data storage, software and equipment layout, a manual of procedures for the registry operations and a registry’s user guide. Any policy oriented to promote a web-based registry for movable collateral must ensure that the requirements to establish a unified/integrated registry for movable and immovable collateral are appropriately incorporated in the proposed legislative initiative and additionally required regulations on secured credit transactions.
II. Key features of a modern secured transactions framework
A modern secured law ought to ensure that a security right may secure any type of obligation, whether present or future, determined and determinable, conditional or unconditional, fixed or fluctuating. A properly adopted modern secured transactions reform should incorporate all types of secured transactions into a single-security mechanism, without distinction among creditors. Secure rights must be based upon a claim to the possession of the collateral, not upon a claim of ownership or of title.
Accordingly, a sound secured transactions framework must include the following features, taking always into consideration the characteristics of the underlying developing countries in which the reforms will be implemented:
- A collateral registry must be in operation for both incorporated and non-incorporated entities, unified geographically and by asset type, with an electronic database indexed by debtor’s name.
- A notice-based collateral registry must be in place, in which all functional equivalents may be registered.
- An on-line registry must be in place, as oppose to a manual operated infrastructure.
- All security agreements that have the effect of creating a security interest in personal property should be treated in the same way under a unitary system of laws.
- All functional equivalents to security interests must be properly considered, including financial leases, factoring or assignment of accounts, sale and lease back, conditional sale or retention of title contracts and guarantee trusts.
- All types of assets may be used as collateral for secured transactions.
- All notices on security interests regarding sale of receivables or book debts should be registered and electronically available to third parties.
- Uniform asset treatment must be provided with regards to publicity and registration.
- Equal debtor requirements should be in place when perfecting security interests in equipment, irrespective of type of debtor and assets.
- Flexibility should be available to create collateral on fungible or comingled goods.
- Uniform treatment for after acquired collateral.
- A supplier and a financier may be also an “acquisition secured creditor”. Under a unitary concept of security interests, the supplier and financier should be treated in a similar way.
- While recognizing exceptions, the modern secured credit law should simplify priority rules by linking registration of notice of a security right with priority.
- A registered secured interest should continue in the hand of the buyer unless the secured creditor authorizes the sale free of the interest or the buyer acquires the collateral in the ordinary course of the seller’s business without actual knowledge that the sale violates a term of the agreement creating the security interest.
- Collateral on future assets should be permitted in a transparent manner from the outset of the transaction.
- Collateral on equipment must be permitted following the same basic rules, irrespective of the type of debtor.
- There should be special incentives to promote agricultural financing and the use of livestock and crops as collateral.
- Factoring must be included in a unitary secured transaction legislation.
- Mediation and conciliation proceedings should be implemented as an alternative mechanism to facilitate enforcement of secured rights.
- The length and costs of enforcement proceedings should establish priority rules among possible competing creditors.
- The order of payment among creditors should be based on a notice collateral registry.
III. Increased attention to SME markets and their activities to promote economic growth
SME business activities represent a substantial portion of developing countries’ economies. Therefore, it is advisable that the implementation of a modern secured credit framework be supported by a business promotion strategy for SMEs, which should include activities directed at promoting: (i) different types of lending products for SMEs with movable collateral and the involvement of public and private sector entities, (ii) a common credit scoring model for SMEs; (iii) management and financial capabilities training for eligible SMEs; and (iv) the use of mediation centers to solve disputes in secured credits executed by SMEs. In addition, it is critical to execute a plan aimed at (i) determining the sources of funds and amounts available for SMEs lending, (ii) establishing a reference guideline to improve access to credit information for SMEs, (iii) establishing eligibility criteria for SMEs credit access, (iv) coordinating workshops for eligible SMEs with the purpose of facilitating their meeting the operational, legal, management, financial criteria to access credit with movable collateral, (v) establishing a network between SMEs, on one hand, and public and private sector financing sources, on the other hand, with the purpose of making available the different types of lending products to SMEs. All these measures may be accompanied by pilot projects directed to (i) identifying SMEs that are eligible to participate in the pilot project, (ii) providing them with credit and managerial training, (iii) applying the credit scoring model to eligible SMEs, (iv) identifying the credit sources for SMEs financing, (v) matching the credit needs of the SMEs with available sources of financing, (vi) assisting in the negotiation and execution of the SMEs credits, (vii) following up with the SMEs to ensure timely repayment of their loans, (viii) providing the assistance of mediators in case disputes arise between SMEs and their lenders, and (ix) facilitating, on as a needed basis, the process of repossessing and selling of movable collateral in the secondary market to satisfy the repayment by SMEs of their loans.
As any properly implemented access to credit public policy, a successful reform on secured credit framework must include broad information dissemination and training directed to its potential users, with special emphasis on entrepreneurs of the SMEs market.
Considering that all undertaking has an impact on the economic growth. Thus, the law understood as the institutional aspects that regulate society, should have also a relevant effect on the economy in general, and specifically on a nation’s gross domestic product (GDP), on its per capita GDP or on the level of a country’s direct investment. Therefore, a sound and modern secured transactions framework, including both legal and operational features, is certainly conducive to institutional and social stability, and economic growth. As a result, governments in development countries should promote actions prompted by public-private partnerships with the purpose of strengthening business conditions and opening opportunities for private sector development. The implementation of a modern secured transactions framework is an alternative to be considered in developing countries as a tool to promote access to credit and sustainable economic growth!
[1] Fred Aarons (PhD) is an International consultant specialized in financial matters, private sector transactions and the promotion of regulatory and institutional capacity building conditions for private sector undertakings in developing countries. He has recently been involved in the analysis and design of regulatory and institutional capacity building proposals to promote secured credit frameworks and market-oriented financial alternatives for Small and Medium Enterprises focused on traditional and creative economic activities in Caribbean countries.