In today’s complex business environments it is cruial to lend money for the economic development of the country and at the same time safeguarding the interests of the lenders. The macro economic variable or factor within the economy like the business ecosystem constantly requires additional capital to expand and deepen their business operational and executional activities. When the businesses workout exceptionally well, it consequentially, result in massive growth within the economy by increasing the empolyment opportunities, demand for raw materials and consumption, utilising the country’s resources to its optimum capacity, creating best in class infrastructure developmental activities to execute and improve the functioning of their business, positively impacting the GDP (Gross Domestic Product), increasing the imports, setting up and achieving elevating businesses & economic objectives and inturn, creating a stable, structured, efficient and growth oriented economy.
What Is A Security?
- Security as the word itself defines, is a financial asset which is used as a security/protection by the lender to safeguard the amount of loans advanced. It helps to recover the loan amount if the borrower defaults in repayments of the loan sanctioned. The key aim is to protect the lenders from the risk of losing the loan amount approved and there are safeguards put in place by financial institutions to ensure the repayment of loans and advances.
- In financial terms, security refers to an asset a borrower provides to a lender to secure a loan or credit facility. This financial asset backing or a financial instrument is a form of guarantee, significantly reducing the lender’s risk in case the borrower defaults on the loan repayment.
- Securities can be of different types, the two most common type of securities are primary security and collateral security.
- Primary security refers to the main asset the borrower provides to secure and safeguard the lender for the loan. It serves as the primary source of repayment in case of default.
- Collateral security acts as a secondary security, supplementing the primary security to mitigate/reduce the lender’s risk further. In the event of default, the bank has the right to claim the assets provided as security by the borrower to recover the outstanding debt. A collateral security is formed by the primary security along with the addition of some more security. It is created when the lender is not satisfied about the adequacy of the security and needs additional security to advance the loan .
What Is Primary Security?
- Primary security refers to the certain specific assets which are directly linked to the loan advanced. This security is directly pledged against the loan and safeguards the lender in case of default of repayment.
- Examples of primary security include assets directly financed by the loan. For instance, in the case of a housing loan, the property being financed (the house) serves as the primary security. Similarly, in a financing for an asset loan (plant & machinery), the asset being financed becomes the primary security.
- Example: A company in need of capital takes up a loan to finance a new machinery. The lender will pledge the machinery as a primary security in case of default of payment by the borrower. The machinery purchased acts as a direct security for the loan advanced.
What Is Collateral Security?
- It is an additional/ secondary security provided by the borrower to the lender along with the primary security to advance a potential loan. Collateral security is a secondary form of security, utilised when the primary security is inadequate to cover the entire loan amount in the event of borrower default.
- Collateral security consist of financial assets pledged by the borrower beyond the primary security to further secure the loan. For Example, in the case of a loan advanced for plant and machinery purchase, where the machinery serves as the primary security, a commercial land offered as additional security would be considered collateral security.
- Collateral security is an economic term widely used in the business ecosystem, refers to an asset that a lender accepts as security for a loan advanced. Collateral may take the form of real estate, assets, financial instruments or other kind of assets depending on the purpose of the loan.
- The collateral acts as a form of protection or security for the lender. That is, if the borrower under any circumstance, defaults the loan payments the lender can seize the collateral and sell it to recuperate some of its losses.
- Collateral security acts as a further additional layer of protection for the lender, providing further assurance against the risk of default by the borrower.
- The collateral maybe in the form of fixed charge or floating charge. Fixed charge is a charge levied on specific assets and a floating charge is an equitable charge.
- Example: A company wants to expand and diversify its business operational activities, build new offices and expand its presence hence, is in requirement of a financing of Rs.1 Crore from a financial institution. While the new office building you plan to purchase is the primary security for the loan, the lender also requires an additional assurance to advance the loan. As collateral/ secondary security, you pledge your existing commercial property, which you own outright, to secure the loan further. In this case, the office building represents the primary security, while the commercial property acts as collateral security.
COLLATERAL SECURITY = PRIMARY SECURITY + SECONDARY SECURITY (SOME ADDITIONAL SECURITY)
Types of Collateral Security:
- Land and buildings
- Goods
- Documents of title of goods
- Shares
- Term deposit
- Gold
Importance of Collateral Security:
Collateral security is a unique form of requirement for certain specific loan situations, primarily performed to safeguard the lenders and manage their risks associated with the advancement of loans. Loans relating to the financing of capital assets like purchase of land and building, machinery, equipment, home loans are typically backed by these assets itself which serve as a primary security.
The need of collateral security comes into picture when financing cash loans. In cash financing, where the borrower’s default could lead to asset liquidation, collateral security in the form of immovable property provides an additional layer of protection for lenders, ensuring loan security and repayment even in critical situations.
Issue of Debentures As A collateral Security:
What Is A Debenture?
When the ownership capital of the company is not sufficient enough to carry out the business activities the company needs to borrow capital in the form of creditorship securities to supplement its owned capital.
Debentures are one of the primary and principal sources of raising borrowed capital to meet its short term, long term and medium term financial requirements.
Debentures are also known as creditorship securities. It is a financial instrument issued in order to raise long-term finance.
They are one of the primary sources of raising borrowed capital. Debentures have acquired a significant position in the financial structure of the organisations.
The term debenture has come from the latin word ‘debere’ which means to ‘owe’.
Under the existing definition, debenture includes debenture stock, debenture means a document which either creates or acknowledges debt. Generally, debenture constitutes a lien on some property of company but there may be a debenture without such lien.
Sec 2(30) of the Companies Act 2013, only states that, ‘the word debenture includes debenture stock, bonds and other instruments of the company evidencing a debt, whether constituting a charge on the assets of the company or not’.
Palmer defines: “ A debenture is an instrument under seal evidencing debt, the essence of it being admission of indebtedness”.
Topham defines: “ A debenture is a document given by a company as evidence of debt to the holder, usually arising out of loan and most commonly secured by charge”.
It is a debt tool, finance raised through debentures is considered as a loan. Is an acknowledgement from the company that it has taken a loan from the public. Debentures are issued by analysing the creditworthiness of the company.
A debenture is an instrument of debt executed by the company acknowledging its obligation to repay the sum at a specified rate and also carrying a fixed rate of interest.
Debentures are the borrowed capital of the company. The people holding debentures are known as debenture holders. A Trust Deed is executed when debentures are issued to protect the interest of the debenture holders.
Features:
- Debenture is an evidence of debt by company that it owes specified sum of money to the holder of the debenture.
- The face value of debenture normally carries high denomination.
- The principal amount of debenture is repaired on maturity date.
- Debenture holders have a priority in repayment over the other claimants of company.
- A fixed rate of interest is paid to debenture holders, whether, the company makes profit or not.
- Debenture holder is a creditor of the company.
- Generally, secured by a fixed or floating charge on assets of the company.
- Debentures can be easily transferred through the instrument of transfer.
Issue of Debentures As A Collateral Security:
When a company is in need to raise capital for its expansion and furtherance of its business activities it takes a loan from a bank or other financial institution. The company raising the additional capital needs to maintain a security as a collateral.
Collateral security means a secondary security in addition to the principal or primary security. The need to create a collateral security arises from the banks or the potential financial institutions (lenders) when they are not satisfied enough about the adequacy of the amount pledged and further needs an additional security to advance the loan amount.
The potential loan advancing bank or financial institution to whom the debentures are issues as collateral security will not be entitled to any interest on such debentures. They are only entitled to get interest on the original value of the principal advanced by them.
The mechanism of issuing financial instruments as a collateral security is that, if under any circumstances, a default is made either on the payment of the periodical interest or the repayment of the principal debt amount, the lender will be in a position to first realise the debt from the principal security. However, if the entire amount of debt (Principal + Interest) is not realised from the principal security, lender/creditor will use the collateral security, by claiming all the rights of a debentureholder.
As soon as the company pays the final installment of loan and makes the settlement, it can take its debentures back.
