Small business security

Security, term in economics and finance with two meanings: something given by a borrower to a lender to secure a loan, that is, something that the lender will be able to sell and recover monies owed if the borrower defaults on repaying the loan; or a share in the equity of a business.

Securities were originally the documents that proved ownership on property or rights to income that could be used as security for a loan. Today, the term small business security is generally taken to refer to interest-bearing shares or bonds traded on the capital or money markets.

The past two decades have seen substantial growth in securitization, as companies have increasingly opted to raise finance through the securities market rather than through a loan from a bank or other financial intermediary. As a result the securities market has become remarkably diverse and sophisticated. Banks may have lost some of their traditional loan small business security, but they welcome the fact that the risk of lending is now spread among a wider range of suppliers of funds, and they now make money from arranging the issue of securities.

As securitization has grown, so too has the market for what are called derivatives. These are effectively assets derived from other assets; for example, an option to buy a share at a certain price at any time up to a specific date in the future. In this instance, two markets operate: one for the original asset and one for the derived asset. Those who trade in options are in effect betting on the price of the share of which they have purchased an option to buy; if the share price goes up by more than the cost of the option, they can realize a profit. In theory there could be derivatives of derivatives, such as an option to buy an option to buy a share. In practice, there are real worries that too much concentration on derivatives undermines the market for the original securities.

Types of securities

1. LAND AND BUILDINGS AS SECURITY ( Real Estate) - Bankers do not generally lend against land and buildings or against securities relating there to. The reasons are:

a. Legal title. It is very difficult to satisfy oneself with regard to the ownership of property. The banker is likely to land himself in litigation if he disposes of the security to recover his money. The law relating to succession and transfer of immovable property is very complicated and the banker will be courting trouble if he accepts land as security.

b. Valuation Difficulty. The valuation of land and buildings is very difficult. Several factors will have to be taken into account when valuing property.

c. Difficulty in Selling. It is very difficult to sell property. It may be valuable in itself, but when put up for sale, it may fetch much less than its real value. For this reason, if a banker lends against land and buildings, he will be locking up his funds.

d. Expenses. The expenses for affecting the legal mortgage are heavy.

e. Legal Hurdles. In some states, restrictions are imposed on the transfer of property in the land. For instance, the Punjab Land Alienation Act forbids the transfer of land is non-cultivators.

Precautions. If, however the banker decides to lend against land, he must take the following precautions:

1. He must satisfy himself with regard to the title of the property.

2. He should obtain legal advice before granting the loan.

3. He must take a legal mortgage. The deed should be registered.

4. He should obtain a non-encumbrance certificate from the Registrars office.

5. He must ensure that the borrower is financially sound and the purpose for which money is borrowed is sound.

6. The property should be properly valued.

7. The property must be fully insured.

Legal and Equitable Mortgage. A mortgage is defined as the transfer of an interest in specific immovable property for the purpose of securing the payment of money advanced or to be advanced by way of loan, an existing or future debt, or the performance of an engagement which may give rise to a pecuniary liability.

Legal mortgage is the transfer by deed of the legal estate in land subject to the mortgagors for the payment of money due or to become due to the person who takes the security. When a loan of money is secured by the deposit of title deeds it is known as an equitable mortgage, because in such a case no legal transfer of property takes place. In India equitable mortgages are restricted to the cities of Kolkata, Chennai and Mumbai.

As between two equitable mortgages, a prior mortgage takes precedence over a subsequent one. Similarly, as between two legal mortgages, a prior mortgage takes precedence over a subsequent mortgage. But as between a legal and equitable mortgage, the legal mortgage takes precedence over an equitable mortgage, whatever may be the dates on which they are made.

We may discuss the problems involved in accepting agricultural lands and a building standing on a lease hold land where the lease is to expire shortly.

(a) Agricultural lands. These are not suitable securities as cover for a Banks advances. The amounts advanced against such securities are comparatively small. They are not very popular with the bankers for the following reasons:

1. Legal Hindrances -There are legal or customary hindrances to their transfer. Some checks are imposed by legal enactments.

2. Legal Mortgage Very Expensive - In mortgaging lands, heavy expenses are to be incurred by the customer. The customer may find it difficult to meet them.

3. Difficulties Regarding Customers Title - This is an important reason. It becomes very difficulty to find out the title of the customer. The law relating to this subject is very complicated. Moreover proper enquiries must be made about the existing encumbrances on the property. Otherwise the banker will be put to trouble.

4. Security rigid - It is very difficult to realize lands. Hence the banker cannot think of locking up his capital for a long time. This is particularly a disadvantage to commercial banks, which depend mostly on current deposits.

5. Changing Land Tenures - A banker should note the land tenures in the states, their changes and the incidents attached to them. The value of land depends upon the land tenure. However, a banker can give loans only after taking legal advice.

6. Problems in Valuation - There is difficulty in valuation of land. The banker has to depend upon valuations reports of expert surveyors and engineers for deciding margin, depreciation and other factors.

7. Legal formalities for selling in mortgaged land - There will be delay in realization of security when the mortgagor, fails to pay the amount. This is due to several legal formalities.

(b) Building standing on a Lease-Hold Land where the Lease is to Expire Shortly. Generally it is not safe for a banker to give advances on the security of immovable properties such as Land, Building. Hence he must be very cautions. Where the building standing on a lease-hold land is given as security, the banker must look to the terms and unexpired period of the lease. If the lease is to expire shortly, he must also see to the prospect of renewal of the Lease and the terms on which it can be affected. Otherwise the value of the property tends to decrease. This asset is not very popular with the bankers as cover for advances.

Before advancing money against such assets, the banker should note the terms of the lease very carefully, particularly about transfer and under leasing. Some leases insist on prior permission of the lesser for transfer. In such a case, the banker should take the written permission of the lesser for transfer. He should examine the receipts small business security for payment of ground rent particularly for the last rent due and other charges. He must take a stamped declaration of absolute ownership. He should get the property valued by a competent surveyor. He must keep an adequate margin. He should also note the nature of the locality and situation. The property must be insured and revalued periodically.

2. ADVANCES AGAINST GOODS - Goods are a popular form of security for bank advances. Nearly two-thirds of advances by banks are against goods. The goods may be food articles, industrial raw materials, manufactured goods and minerals or plantation products. At one time there was a prejudice against bank lending on the security of goods and documents of title to goods. But the prejudice is now worn off. It is usual to find banks in large towns and commercial centers granting loans on the security of goods and documents of title to goods. Goods are generally stored in godowns.

Reasons for the Wider Acceptance of Goods as Security In several towns of India, bankers find it difficult to obtain stock exchange and other types of more suitable security. Where the alternative is to have goods as security or no security at all, it is natural for banks to accept goods as security, for the banker has some thing tangible to fall back upon in case of default by the borrower. It has been found that goods have the following merits as security.

1. Easy to Sell - Goods are easy to sell. They can more easily be sold than certain other forms of security such as land and buildings. Some commodities enjoy a ready market throughout the year. As the demand is wide regular and steady, the banker experiences no difficulty in selling the goods and realizing his money in case of default.

2. Small fluctuations in Prices - In the case of goods which are necessaries of life the risk of fluctuations in prices is small. In the case of paddy, wheat, cotton and sugar the prices are remarkably steady. But there are wide fluctuations in the prices of luxury goods and those that depend upon the tastes and fashions of people Bankers do not accept as security goods whose prices are subject to heavy fluctuations.

3. Value Ascertainable -The value of goods can more easily be ascertained. Wholesale prices are published regularly in newspapers and are broadcast over the radio. The valuation is easier than in the case of fixed assets like land and buildings.

4. Short Period Loans - Usually advance against goods are for short periods on account of their seasonal character. These advances may be renewed after the period of the loan.

Risks - But this kind of security has the following drawbacks.

1. Deterioration in Quality/Weight - Goods or produce stored for considerable periods are liable to deteriorate, or lose in weight. All the goods may not be durable goods. The value of security diminishes with the passage of time. It is difficult for the banker, ascertain the value of the security from time to time.

2. Risks of Fraud - There are the risks of fraud. For instance if an advance is secured by bags of paddy, not all the bags may contain paddy. Some of them may be filled up with hush. It may be difficult for the banker to examine the contents of all the bags. Again, all the bags may not contain the same quality of the product.

3. Difficulty in Valuation -Valuation is difficult unless the banker possesses considerable experience. It may be difficult to differentiate between different varieties of the commodity.

4. Price Fluctuations - Some kinds of produce are subject to great fluctuations in prices. In the present context when prices are rising almost ever month, the danger may not be great.

5. Difficulty in Selling - It may be difficult to dispose of large quantities of produce at a single place. The costs of transport to other places may be prohibitive.

6. Absence of Warehouses - Absence of public warehouses is another difficulty. Private godowns do not possess equal security and there is the danger of the goods being removed after being given as security. Moreover proper storage may not be possible in private godowns.

PRECAUTIONS

1. The banker must make sure that the borrower is honest and thoroughly reliable. The banker has to reply on his past experience to judge the creditworthiness of the customer. This precaution is very important because of the possibilities of fraud that are available to a dishonest borrower. Moreover the customer himself must have sufficient experience in the line. Otherwise he may be himself deceived.

2. The banker must see the purpose of the loan. He can safely lend where the stocks have been acquired for preparing them for the market, for instance husking paddy or ginning cotton. He can also advance for storing the produce so as to ensure steady supplies or for moving the produce from the field to the market. Such loans are self liquidating in character since the customer can repay the advance from the sale proceeds of the processed commodities.

3. The banker must examine whether the commodity a good market, whether its prices are liable to wide fluctuations. Necessaries of use are ideal forms of security from this point of view. The commodity offered must be fresh stock. If old stock is offered it should be seen that it is in a good condition. Some commodities like paddy may gain in value if stored for a long time. But many commodities lose their value with the passage of time.

4. The banker must see that the storage conditions of the commodity. Offered as security are adequate and proper. He should keep a godown register and note all particulars in it. Goods offered for security must be stored in proper godowns. Godowns must be well protected against fire, floods theft. In the case of hypothecation of goods, the borrower should give an undertaking that he will allow inspection of godown and stock register as and when desired. In the case of pledge, the godown should be locked by banker. A name plate that the goods are pledged with a particular banker must be prominently displayed. Goods are to be changed by way of pledge or hypothecation.

5. The banker must be well acquainted with the type of goods accepted as security. Also he must be acquainted with the market for such commodities. This knowledge will enable him to keep proper margins for the advances.

6. The banker must insist on the goods being insured against theft and fire.

7. The banker must be careful in valuing the goods. He should satisfy himself both as to quantity and price. For this he should acquire sufficient experience in the kind of goods that are usually offered as security.

8. The banker must take possession of the goods, either actual or constructive. In the case of constructive delivery the key of the godown is handed over to the banker. He may permit the goods to be used for processing or manufacturing. But he retains his charge over the goods. The name plate of the banker must be prominently exhibited on the godown to indicate that the goods are pledged with the banker. He must make periodical inspection of the godowns.

9. The banker should be careful in realizing the stocks, when it is permitted against part payment of the loan. All deliveries must be sanctioned by the manager through delivery orders.

10. The banker should keep a proper margin to provide for fluctuations in prices. When prices fall he should reduce the loan or ask for further security.

11. The banker must appoint honest and trustworthy persons as godown keepers.

3. ADVANCES AGAINST DOCUMENTS OF TITLE TO GOODS

Advances are made by bankers against documents of title to goods. A document of title to goods is a proof of the possession of goods by the holder of the document. He can either take delivery of the goods or transfer then by indorsing on the document. The person who possesses the document is recognized by law as possessing the goods themselves. It is necessary to distinguish between documents which give title to the goods named therein and those that are merely receipts acknowledging that the goods have been received in the warehouse. Bills of lading, dock warrants, and war house keepers warrants belong to the first category and ware house keepers receipts and delivery orders belong to the second.

Risks in advancing money against documents of title to goods

If advances against goods are likely to prove dangerous for the banker, those against documents of title to goods are more likely to do so, because in addition to all the drawbacks which goods have as security, documents of title to goods have the following drawbacks:

1. The documents may be forged ones or the number of packages in the documents might have been altered. It is therefore necessary that advances against documents of title to goods must be made only to thoroughly honest and reliable persons.

2. The contents of the packages not correspond with the description of the goods as given in the documents. The shipping company or the railway company which undertakes to carry the goods does not assume any responsibility for the contents of the packages. As such the banker will have to remedy against the carrier if the packages contain worthless stuff, quite different from what they are stated to contain.

3. Most of the documents of title to goods are not negotiable instruments. The banker cannot get a good title if he receives them from persons who are not their real owners. However, since the documents are transferable the banker can accept them from the owners of goods of the transferees of the documents or mercantile agents in possession of the documents as agents.

4. Finally, an unpaid vendor may exercise his right of stoppage in transit and the banker may not be able to get the goods.

Precautions The following precautions must be taken by a banker when he makes advances against documents of title to goods:

1. The banker must ensure that the customer is an honest and trustworthy person, who besides has considerable experience in the goods he is dealing. This is necessary because the possibility of fraud is very great in the case of advances against documents of title to goods.

2. The banker must ascertain that the contents of the packages are as described in the document.

3. The banker must obtain all the copies of the bill of lading, which are made in sets of three. This is necessary because the shipping company is entitled to deliver the goods on the production of any copy of the bill of lading.

4. The banker should obtain the bill of lading endorsed in blank. In that case, the responsibility for paying the freight rests on the customer.

5. He must ensure that the goods are properly insured.

6. Where the banker agrees to deliver the documents of title of goods without receiving full payment, he should ask the customer to execute a trust deed, by which the customer is not paid off completely. If the customer, after executing the trust deed, does not make over the sale proceeds to the banker, he is liable for criminal breach of trust.

4. ADVANCES AGAINST STOCK EXCHANGE SECURITIES

The term stock exchange securities is used to cover the securities that are purchased and sold on the stock exchanges. These include

(1) securities issued by the central and state governments

(2) bonds issued by semi public bodies such as municipalities, port trusts, improvement trusts, and

(3) shares and debentures of industrial and commercial companies. Stock exchange securities form an excellent against which advances may be made by small business security. They are usually offered as security in large cities, where many of banks customers hold large blocks of securities. Government securities and semi government securities are called gilt edged securities. They are the safest securities because they are backed by the Government. Out of corporate securities, bankers prefer bonds/debentures to shares and preference shares to ordinary shares. This is because debentures have a priority over shares and preference shares have a priority over ordinary shares in payment in the event of liquidation of the company.

Precautions to be taken by the Bankers

1. Nature of Securities -The banker must see the mature of the securities with a view to satisfy himself about their marketability. He should not lend against the shares of a company, which are liable to sudden depreciation.

2. On partly paid shares - He should be careful in lending against partly paid shares. He may be called upon to pay the unpaid part of the shares, and further, even after the completion of the transaction he may be liable as a contributory shareholder in case the company fails within one year after the transfer of the shares back to the customer. The mere fact that the shares are partly paid need not cause the banker to reject them as security, when there is no possibility of the calls being made in the near future.

3. Maintain adequate margin - The banker should ascertain the correct value of the securities and keep a sufficient margin to guard against fluctuations of their value and to provide for the accumulation of the interest of the loan.

4. Mortgage deed and conditions - If the securities are offered as equitable mortgage, the banker should take a memorandum of deposit, which should set out the terms of the charge. The memorandum should specify the purpose for which the deposit of securities has been made. It should authorize the banker to sell the securities in case of the default if the customer or in case the value of the securities falls below a certain figure. It should also authorize the banker to debit the customers account with the amount he has to pay on partly paid shares.

Another way of securing equitable mortgage is by blank transfer. The customer signs the transfer document without mentioning the transferees name and without putting any date. The banker can get the shares transferred to his name by inserting his own name as the transferee. But he should get the shares transferred in his name before the first closure of the registrar of members after the date stamped on the transfer instrument by the prescribed authority if the shares are quoted securities, or if they are not quoted securities, within two months of such date. The danger of equitable charge is that it is defeated by a prior equitable mortgage or a subsequent legal charge. The borrower may obtain duplicate copies of the securities from the company stating that the original shares were lost.

5. Transfer of securities formalities -The banker should generally ask the securities to be transferred in his name. If they registered or inscribed securities he should get the transfer instrument signed by the customer and sent to the company or authority concerned. If they are negotiable and bearer securities, he can obtain the title by mere delivery, otherwise, there should be an endorsement and delivery.

6. Composite securities - The banker should not grant any advance against securities composite with other types of security.

7. Voting right - The banker should not exercise any voting rights in respect of securities pledged with it except with the approval of the Reserve Bank and in accordance with the directions issued by the Reserve Bank in this behalf.

5. ADVANCES AGAINST LIFE POLICIES

A life insurance contract is one by which the insurer in consideration of a certain premiums payable in a number of instalments undertakes to pay to the person for whose benefit the insurance is made, a certain sum of money on the expiry of a certain period or on the death of the insured, whichever is earlier. A life insurance policy may be a whole life policy, in which case the premium are payable throughout the life of the assured, or it may be an endowment policy, in which case premium are payable for a stated number of years or until the death of the insured whichever is earlier.

6. ADVANCES AGAINST BOOK DEBTS

At times the customers of a bank may seek an advance on the security of book debts which have become due or realizable in the near future. It means that the borrower will be assigned to the banker by the customer.

7. ADVANCES AGAINST SUPPLY BILLS

The Government or semi government departments and institutions purchase their requirements by inviting tenders. The contractor who quotes the lowest price gets the order for the supply of goods, articles, and materials gets the order. The quotation invited may relate to Government contract work also. The supplier or contractor prepares bills for goods supplied or work completed. Such bills are called supply bills. A supply bill is simply a document stating the amount due from the Government. It is neither drawn in the form of a bill of exchange nor is accompanied by a bill of exchange. It is not a negotiable instrument. The banker may grant loans to the contractor against the security of such supply bills.

8. ADVANCES AGAINST FIXED DEPOSIT RECEIPTS

A fixed deposit is made by a customer of the bank for a fixed period and the amount is repayable only after the expiry of that period. But the customer may borrow against the fixed deposit receipt if he wants the money before the expiry of the stipulated period. The rate of interest charged in such loans should be at least one percent above the rate of interest allowed on the deposit. Advances against fixed deposit receipts given by a banker constitute the safest form of lending, because the money is payable by the banker himself to the customer on maturity of that fixed deposit. The banker however should not made advances on the security of fixed deposits.

Where the fixed deposit is made in the names of two or more persons, advances should not be made to any one of them unless all the depositors authorize the bank to do so. All the depositors must sign the memorandum of pledge creating a lien in favor of the banker and give a valid discharge of the fixed deposit. Then only the banker appropriates the deposit against the loan. A note of the lien must be made in the fixed deposit register and also on the fixed deposit receipt. In no case should the advance be made to a minor. On the repayment of the loan the receipt is returned to the customer and the lien on the fixed deposit is cancelled. If the loan is not repaid before the maturity of the deposit, the amount of the deposit may be set off against any outstanding advance made on the security of the fixed deposit receipt.

9. DISCOUNTING OF BILLS OF EXCHANGE

A banker would prefer to grant accommodation to the customer by discounting the latters bills. The advantages of discounting bills are the following:

1. The banker can be definite that the bill discounted would be met on the due date. Dishonour of bills is very rare, as it harms the acceptors credit. The acceptor would normally meet his bill on the due date, failing which the banker can recover the money due there on from any of the parties there to.

2. There is absolutely no risk of the value of a bill declining since the amount of the bills is fixed.

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