Unsecured Lending: a Worked Example

Security gives a lender three things: a place in the queue, control over a sale, and the power to act without going to court. Holding a charge, a bank can usually appoint a receiver and sell. Without one, it has none of those. It must demand payment and, if that fails, sue for judgment or apply to put the company into liquidation, in the same position as any other ordinary creditor. In a liquidation it files a claim and waits.

It also has no say over who gets ahead of it. An unsecured lender can search the PPSR in New Zealand or Australia, or the register of charges at Companies House in the UK, but it cannot stop what appears there later, except by contract. A bank agrees to this because a large borrower with several banks will not usually give any of them security, because the documents are simpler and cheaper, and because the borrower remains free to manage its assets. The bank takes a different protection.

The first is a negative pledge, a promise not to grant security over assets to others, usually with baskets for ordinary items such as asset finance. The second is financial covenants, designed to bring the bank to the table while the business can still pay. The third is a pari passu undertaking that the debt will rank at least equally with other unsecured debt. The fourth is guarantees from the operating subsidiaries, often backed by a test requiring guarantors to represent a set share of group earnings or assets, because debt at a holding company otherwise ranks behind the creditors of the subsidiaries that hold the business. That problem is structural subordination.

All of these are contractual. A breach gives the lender a default and the right to act on it, and possibly a claim against the borrower. It generally does not give the lender the priority it would have had with a charge. The recovery follows from the ranking:

A listed maker of electrical switchgear, constructed for this page like every figure in it, borrows US$80m unsecured from its banks. It fails. Its assets realise US$65m, including US$15m from machinery on which an asset financier holds security for US$15m. Costs are US$5m and employee and other priority claims US$5m. Trade and other unsecured creditors are owed US$25m. Three versions of the same failure:

The first column shows what the ranking costs: trade creditors share in the US$40m and take US$9.5m of it. The bank's loss is US$49.5m rather than US$40m. The second column is the case a negative pledge is meant to prevent. In it, the group borrowed a further US$30m on a charge shortly before failing and spent the money trading. The unsecured banks' recovery drops by about three-quarters. They may have had a default to call, but they cannot undo a registered charge simply by showing a breach of the promise. The third column assumes the banks had taken all-asset security, in which case the trade creditors receive nothing here, leaving aside the UK reservation described below. The order and amounts belong to the example, and real outcomes turn on the nature of the assets.

Small-business loans are often advertised as unsecured when an owner's personal guarantee stands behind them. That is accurate in one sense: no asset of the company is charged. But the lender has a claim on someone else's assets, and the owner's position is very different from that of a shareholder in a listed group. A guarantee is a promise, and it ranks as an unsecured claim against the guarantor unless the guarantor has also granted security.

The line between secured and unsecured is also less clean than it sounds. A secured creditor whose security falls short can claim the shortfall as an unsecured creditor. In the UK, a set portion of what would otherwise go to a floating charge holder is reserved for unsecured creditors under section 176A of the Insolvency Act 1986, subject to exceptions. And ahead of an unsecured lender stand the costs and the priority claims the law sets in each market, including employees and, in New Zealand and the UK, some tax debts.

DEFINED IN ONE PARAGRAPH → · THE RECOVERY WATERFALL → · WHAT YOUR BANK HOLDS AS SECURITY →

A desk reviewing an unsecured loan reads the first way out harder because the second way out is thin. The questions are about the things that would have to go wrong and how early the covenants would show it. It reads the negative pledge carve-outs line by line, since each one is room for someone to get ahead, and it checks where in the group the debt and the assets sit. It watches for any lender taking security, on the register and in the notes to the accounts.

The decision to lend unsecured can also be reversed in part. Some corporate agreements include a springing feature that requires security if ratings or ratios fall below agreed levels, and a lender may take security as the price of a waiver. In a bank's own numbers, lending without security shows up in the loss it expects, and so in the margin and capital it allocates. Those factors are why an unsecured loan tends to be priced above a secured one for the same company.