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Lending Money

Who should read this Fact Sheet?

Everyone about to lend money to someone will want to know that they have the best chance of being repaid, or if should the loan go bad, that they can recover the maximum amount possible.

If the loan is not properly documented or if adequate security is not taken or properly registered, there is a chance that only some of the money lent (if any) will be recovered. Protecting yourself against a loan going bad is not an expensive or time consuming exercise, particularly when compared to the loss of the money lent. However, it is something that must be done properly to be effective.

How do lenders protect themselves?

Firstly satisfy yourself that the borrower (and the monies) will not disappear once the money has been lent. You should only deal with an established person or business. Secondly, you will want to assure yourself that the borrower has the capacity to repay the loan. You should get your accountant to look over the borrower's records or business plan.

There are three steps that should be considered before the money is handed over. You should:

1. prepare proper documentation of the loan;
2. obtain adequate security; and
3. obtain guarantees and securities from third parties.

Why prepare documentation?

Without proper documentation, you may not be able to prove that the monies were lent, under what conditions they would be repayable, or what interest and other terms were applicable. You are relying on the good faith of the borrower (or their trustee or liquidator) and being able to convince a court that what you say is correct. Documentation creates certainty.

Are securities and guarantees necessary?

Necessary? No. Recommended? Yes. Think of securities and guarantees as insurance. You hope that the loan is repaid as expected, and that preparing the documentation, securities and guarantees is a waste of time and money. But, if the loan goes bad, these may be the only way of getting your money back.

You may not be able to obtain securities and guarantees, but they should be requested. If you do not obtain security, the loan will be unsecured and your rights will be limited if the borrower goes bankrupt or is wound up - you will be in the same position as all other unsecured creditors. Without a guarantee from another party, you will be left solely with your rights in the borrower's estate with no avenue of obtaining payment from anyone else.

What documentation should be prepared?

1. The loan itself should be fully documented. The loan agreement should include the amount lent and the repayment provisions; it should deal with interest and other charges; it should detail what are breaches of the agreement, your rights if a breach occurs and other matters. Most importantly, it should include dispute resolution provisions, who should pay the costs of this process, and provisions dealing with your rights to exercise any security or guarantees held.

2. Any security over assets should be documented, as most securities are invalid or unenforceable if not in writing. There are also registration considerations (mentioned below) as some securities will be invalid if not registered, particularly securities over assets owned by a company or under Bills of Sale. The security documentation should detail all of the assets covered by the security, the powers to exercise the security over those assets and the powers of any person appointed over those assets.

3. A guarantee must be in writing to be enforceable. Guarantees should be prepared by lawyers as they need to have certain clauses and be explained to the guarantor before they are signed.

We recommend that a solicitor prepare all of these documents. Most solicitors will have these documents as precedents.

SECURITIES

What is a security?

A security is a right over an asset that allows the holder of the security to sell that asset to satisfy an outstanding debt.

They are generally known as mortgages, though different forms of security have different names. The common point is that an asset (something of value) is pledged to support the repayment of a loan and the security will be able to be exercised under certain conditions. The asset secured does not have to be owned by the borrower. A third party may give a security over one of their assets to support a loan.

Why are some charges Fixed or Floating or both?

Whether a charge is Fixed or Floating depends on what type of asset it covers. Charges can be both Fixed and Floating over different types of assets, but will have to say so in the documentation.

A fixed charge covers a specific asset like a house, land, a piece of machinery, etc. The asset can be specifically and individually identified and will sometimes be listed in the charge documentation. In this way there can be no dispute as to what asset is charged to secure a debt. Usually the asset will not change during the life of the charge, or if it does, that the outgoing asset will be released from the charge and will be replaced by new asset.

A floating charge covers classes of assets that naturally change from time to time. Floating charges secure assets like trade debtors, cash at bank and stock. As a business must retain the ability to deal with these assets to trade, the charge can be not specific to a particular asset. This charge '"floats" above the class of asset while it is constantly changing. When a breach occurs, the charge falls and captures the particular assets (debtors, stock etc.) held at that time - hence a "floating" charge. After activation, the floating charge can be considered fixed on those particular assets.

What is a registrable security?

This is a security of whatever form or name that is required to be registered with an authority under to the provisions of various Acts. An unregistered registrable security may not be enforceable. Lenders will need to check the asset secured, the type of security and the entity that owns the asset to determine whether it should be registered.

Should the security be registered?

If it is a registrable charge, Yes. Some legislation requires that a security be registered to be enforceable in some circumstances. The best known of these are charges over many types of assets owned by a company that require registration with the Australian Securities & Investments Commission. Section 262 of the Corporations Act sets out the charges that require registration. Bills of Sale also need to be registered to be enforceable in some circumstances.

Lenders should seek Legal Advice on this point.

PERSONAL GUARANTEES

Should lenders get a personal guarantee?

Lenders do not need a personal guarantee, but it is desirable, particularly if the borrower is a company. If the directors are not prepared to guarantee the repayment of the loan, they must not have great hope that the company will be able to do so. They want you to take the financial risk, while they make their profits. Guarantees may be obtained from anyone. They do not have to be officers of a company or related to the borrower. The guarantee allows you to seek payment from another party if the borrower defaults.

We recommend that a solicitor prepare the guarantee documentation and be present while it is being signed by the guarantor. Guarantees may be challenged if they are not properly executed or explained to the guarantors.

Will a guarantee ensure repayment?

No. If the guarantor has no assets or means of repaying the loan themselves, the guarantee may be worthless. Some background examination of the guarantor should be undertaken before giving the loan based on such a guarantee. If the guarantor resists this checking, you should become suspicious. You may also seek security over some of the guarantor's assets, as the guarantee will only make you an unsecured creditor of the guarantor.

OTHER CONSIDERATIONS

What if I cannot get a security or a guarantee?

If the borrower will not or can not give security, and the people behind the borrower will not give guarantees, think twice about lending the money. You are putting your money at risk. How much risk you are willing to take is the decision that you alone have to make. Making a loan without security or guarantees is sometimes very risky.

Other considerations

Think about these points before making a loan.

(a) Make sure that the entire arrangement (loan, guarantees and security) is in writing and executed by all of the relevant parties before money is handed over.
(b) Make sure that you keep the complete executed originals. Usually a number of originals will be executed - one for each party.
(c) Determine whether guarantees from the individuals or other entities behind the borrower should be sought.
(d) Check that the asset(s) being offered as security actually exist(s).
(e) Check who actually owns the asset(s) that is being charged. Is it the entity that is offering the charge over the asset?
(f) Check whether the charge requires registration and who is to register it.
(g) Check whether there another charge that has a higher priority over the asset than your charge.
(h) Check whether the asset(s) secured is worth more than the debt - on a forced sale basis as this is how a security holder will be selling it. Should further security be sought to cover any shortfall?
(k) Check the rights for enforcement of any security or guarantee. Are these set out clearly in the documentation and do they make sense? Do they create unnecessary hurdles before you can exercise your rights?

How do I enforce my security?

Details of what enforcement steps have to be taken and when can they be taken will need to form part of the security documents. It is important that these documents clearly state what is a breach of the loan, the time periods for notice of and rectification of the breach, and the action that may be taken to enforce the security.

The action taken will greatly depend on the type of asset that is secured. Recovery may be as simple as having the asset collected and sold at auction. If the security is over a business, the business may have to be maintained while being sold. There is also the decision of who can, or should, take that action. The documentation should provide the alternatives. The main choices are:

(a) to take the action yourself (be a Mortgagee in Possession), or
(b) to appoint an agent (commonly called an Agent for the Mortgagee in Possession).

You can also appoint Receivers or Receivers and Managers. The security documents will have to provide for all of these alternatives, but they are standard in most securities.

Who should pay for setting up the loan?

Accountants and solicitors will charge you a fee for the documents and in undertaking any searches that are required prior to giving the loan. The cost should be paid by the borrower, by way of an application fee. If the borrower can not or will not pay the costs of setting up and documenting the loan properly, you should question whether you should make the loan.

Why are you making this loan?

One last matter to consider is why you are lending the money. Generally a loan is made for one of two reasons:

(1) to help out someone in a time of need; or
(2) as a commercial venture to earn interest.

Should these loans be treated differently? We believe not.

Helping someone out in a time of need may be noble, but if they are in a time of need, their financial position is probably doubtful. If that is the case, you need to protect your money. If the loan is made with a view to earn interest, then all proper documentation and security precautions should be taken as a matter of good business practice.

Too many people make too many loans to too many borrowers without considering the possibility that the loan may go bad. If it does go bad, they generally join a long list of other creditors and wonder why they cannot get their money back.

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

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Last Updated: 20.2.2008