Introduction
Availability of credit and at competitive prices are major factors that promote the growth of businesses. Two of the main problems that face Ghana’s small and medium-scale enterprises are the unavailability of credit and the cost of credit. A critical look at this problem reveals that it is not primarily unavailability but rather, the conditions for accessing available credit that most entities are unable to meet. In particular, the requirements for businesses to provide comfort to financial institutions on their ability to repay the loan and acceptable collateral as a fallback measure in the event that they are unable to repay.
This article by Ferdinand D. Adadzi and Akosua K. Akowuah of pan-African business law firm AB & David Africa, takes a look at the issues relating particularly to collateral arrangements from both the perspective of borrowers and lenders.
Funding of Businesses
Businesses require capital for their operations to generate income. Capital is provided in two main ways – through the resources of the business owner or by borrowing from relatives, friends, business associates or financial institutions. Financial institutions lend money to make money. Two factors primarily determine the ability of businesses to obtain credit from financial institutions – first, the legal capacity of the entity and second, its creditworthiness.
For a business to be credit worthy, it must demonstrate its ability to repay the loan given. It can do this by showing that there are potential future receivables that will be available to repay the loan. A business must demonstrate that:
(a) it is able to undertake its required business activities (either produce the products or render the services for which is has been set up);
(b) it has potential consumers or clients ready to take and pay for the products or services (sometimes providing evidence of secure commitments from consumers or clients); or
(c) the income is sufficient to sustain its operations and repay the loan taken.
Lenders will look at the whole business cycle of the entity to conclude on the above factors. Assessing the operations of the business including its potential income is, therefore, key to the ability of the business to secure credit. This will also include looking at the borrower’s previous financial statements to determine the past financial performance of the business. In spite of the borrower’s ability to meet the above conditions, there are events that could happen in the future which may affect the above factors. Lenders, therefore, want a fallback measure to recover loans where such future events occur. This introduces the issue of collateral. Typically, if lenders are assured of the above position, the issue of collateral may not arise.
Collateral
Collateral generally covers fallback guarantees and securities available to a lender in the event the borrower defaults in repaying the loan as agreed under the loan agreement. Collateral or security interest may generally cover:
(a) personal guarantee of owners (shareholders) or directors of the company, relatives/friends or business associates;
(b) charges over the assets of the borrower which can include mortgage granted over landed property, charges over vehicles, equipment and machinery, receivables, proceeds and accounts, rights under various contractual documents, etc;
(c) mortgages or charges over property of owners (shareholders) or directors;
(d) pledge over shares of the borrower (if a company);
(e) pledge of assets;
(f) deposit of title documents;
(g) provision of bills of exchange including post-dated cheques, promissory notes, etc.
Collateral is a fallback measure. Lenders do not grant a loan primarily with a view to enforce the fallback measure (collateral). Lenders must, therefore, require and obtain any of the above collateral only after assessing that there are potential risks to the operations of the business which may affect the future receivables that will be used for the repayment of the loan.
Over-collateralization
Imagine you have a house valued at Ghc150,000. You have applied to the bank for a loan of GHc10,000 for your company and the bank has requested the house as collateral. In addition, the bank has asked that you provide a personal guarantee in the event the company is unable to pay. Then, for good measure, the bank has asked that you pledge your shares in the company as collateral. This situation is the over-collateralization situation. Another example may be where on an application for a personal car loan, the financial institution requires a guarantee from your employer, your salary to be passed through the financial institution with charge over the account, a charge over the car, assigning proceeds from comprehensive insurance over the car, and taking life insurance with proceeds assigned to the financial institution. This is after the usual requirement for the borrower to pay upfront 10 to 25% of the cost of the car. The situation can be compared to intending to kill a fly with a sledge-hammer. From the borrower’s perspective, that is problematic. The issue of over-collateralization has been one of the silent factors discouraging businesses from accessing credit.
Whilst financial institutions may see it as fully underwriting all possible risk, this adds to the cost of credit particularly since the security documents must be stamped and perfected. The cost of stamping is 0.5% of the secured amount for the principal security, and 0.25% of the secured amount for each additional security. It does not matter if all the security are included in the same document. This must be a problem for the financial institution itself as it makes the institution less competitive. Such cost, together with the interest charged, processing and other applicable fees make the cost of obtaining a loan prohibitive for businesses. This feeds into the narrative of high cost of lending. In order to be competitive, financial institutions must be mindful of the type of security and number of securities to take as a fallback position in the event of default of the borrower. A number of ways are suggested below for consideration by financial institutions.
Avoiding over-collateralization
Any of the suggestions below must be implemented within the context of assessing the potential risks that the collateral is to cover. In order to avoid over-collateralization, the following can be implemented:
1. It is not in all cases that a financial institution must request for a collateral. Lenders must assess the creditworthiness of businesses who require loans. Collateral will not be necessary if a business is able to sufficiently demonstrate to a lender that it is able to repay.
2. Avoid multiple securities which add no additional value. If the value of one security is enough to settle the loan plus interest, stick to one. What is important for financial institutions is that, the value of the collateral is 120% of the value of the loan granted.
3. There is no need to take separate security interests over many assets which essentially are related without any added value. For example, taking a charge over assets of the company and at the same time, taking a pledge of all the shares of the company from its shareholder. There is a direct relationship between assets and value of shares.
4. In case of multiple securities, cap the secured amount relating to each security. An asset valued at Ghc10,000 should not be stated to secure a loan of GHc150,000. The secured amount and the loan amount need not be the same. This will reduce the costs associated with lending, particularly, stamp duty cost.
5. There is no need to take security over assets and another security over the proceeds from the assets. The new Borrowers and Lenders Act has statutorily provided that a security interest in collateral automatically extends to its proceeds. Consequently, doing so will only lead to additional stamp duty cost with no commensurate benefit.
6. Administration under the new Corporate Insolvency and Restructuring Act now provides a viable option for a creditor to recover a loan amount. Administration allows creditors together with the administrator to restructure an insolvent business to continue as a going concern in order to settle its liabilities. This option should be explored in the event of default.
The suggestions above are not exhaustive and must be implemented within the specific context of the risk exposure the financial institution intends to cover.
Conclusion
It is important for businesses, especially small and medium-scale enterprises, to always assess the cost of borrowing prior to entering into any financial transaction. A business must check its financial health and ensure that repayment of loans will not have the potential to cripple the business. Where security is required, the business must ensure that the security provided is commensurate with the loan amount plus interest. As much as possible, businesses should attempt to negotiate fair collateral packages rather than settling for over-collateralized loans out of desperation for a loan. Financial institutions should have policies on requirements for collateral and nature of security to take. This will feed into the competitiveness of financial institutions.
Many businesses require financing for growth and financial institutions also need to provide these credit facilities in order to grow. Although lending and borrowing may seem like an everyday transaction and fairly straight forward, it is particularly important for lenders to aim at reducing credit cost while providing financing to businesses. This will make loans more accessible for all types of businesses and will ultimately contribute to business and financial growth for both lenders and borrowers. A win-win for all.
About Ferdinand D. Adadzi: Ferdinand D Adadzi is a Partner, with the Banking & Finance Practice Group of AB & David Africa. He is based in the Accra office and works with the firm’s Africa Finance Team which looks at the finance sector across sub-Saharan Africa. Ferdinand is also a lecturer at the GIMPA Faculty Law.
About Akosua Akowuah: Akosua Akowuah is an Associate Partner with the Banking & Finance Practice Group of AB & David Africa. She has advised many international financiers – Development Financial Institutions and Commercial Banks – and national banks on loan transactions and security arrangements in Ghana.
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