AFM231 Chapter Notes - Chapter 26: Unsecured Creditor, Secured Creditor, Forklift
18 May 2018
School
Department
Course
Professor
Chapter 26- the legal aspects of credit
Business law in practice
• Bill and Martha of Hometown Hardware Ltd has become concerned about rumours that a big-box
store will soon be arriving near them
• How to stay competitive? Expand and offer a broader range of supplies
• Bill’s ofidet i his ustoes’ loalt if the a otai the sae age of poduts fo
Hometown as in the big-box store
• At the same time, Bill is concerned about the recent slowdown in housing construction.
• $250,000 expansion cost. They hope to borrow this amount from the bank
INTRODUCTION TO DEBT AND CREDIT
• Hometown will be both a borrower or debtor, and a lender or creditor
• E.g. he the u supplies, it’s euied to pa ioie ithi 3 das- making it a debtor
• E.g. when it sells lumber to its commercial customers- they are a creditor
• Credit is a contractual relationship, with the lender agreeing to lend money in exchange for a
promise by the borrower to repay the loan, usually with interest and within a certain time frame
• All the fundamental principles of contract law apply
• Addition legal regulations and principles specific to credit
• Credit can be either secured or unsecured
• Secured credit means the creditor has an interest in all or some of the property of the debtor in
order to secure payment of the debt
• Unsecured credit means that the creditor has only a contractual right to receive payment from the
debtor
• Does’t hae a iteest i the popet of the deto that it a efoe i the eet of
default by the debtor
• When Hometown agrees to pay supplier in 30 days or when customers agree to pay Hometown, this
is known as a trade credit which is unsecured
• If the debtor fails to pay on time, the creditor may have to sue
• May not getting paid if debtor has limited financial resources
• Important to exercise good judgement when deciding whether to extend credit
• Riskier if the supplier and customer are in different countries
• A letter of credit is a itte poise a ue’s ak to selle’s ak to pa the selle
when specified conditions are met. This helps the international problem
• A business can also raise capital by borrowing
• These credit arrangements are more secure to the lender
• E.g. Hometown applies to the bank for $250,000 loan, the bank will require extensive
documents to support the loan application
• The bank will consider two criteria:
• . Hoeto’s fiaial health- the likelihood the expansion will succeed and
Hometown paying the loan within a reasonable time period
• 2. Investigate the security that Hometown can provide- so they know that
Hometown can pay up regardless of the success of the expansion
find more resources at oneclass.com
find more resources at oneclass.com
• In addition, the lender will also consider the state of the economy, the particular
industry in which the debtor carries on business, whether personal guarantees are
available, and the state of the credit markets generally
• The lender will set the interest rate at a level that corresponds to the riskiness of the
loan
• If lender ad ooe agee, the’ll go ito credit/loan agreement, which include repayment terms,
interest, security, fees, and the events of default (failure by the debtor to make required payments
on a loan or to fulfill its other obligations under the credit agreement)
• In most cases, the legal and other fees of the lender must be paid by the borrower
METHODS USED TO REDUCE RISK IN CREDIT TRANSACTIONS
• 1. Creditors should employ good credit policies and procedures
• E.g. haig detos fill out edit appliatios ad hekig detos’ edit efeee
• 2. Ceditos hage the stutue of a tasatio so that it’s ot a edit aageet at all
• E.g. a supplier of equipment may choose to lease the equipment rather than sell it so the
supplier retains the ownership of the equipment
• 3. Collateral – property to which a creditor takes a iteest as seuit fo a ooe’s poise to
repay a loan
• 4. Creditors may ask for assurances from other people that the debt will be repaid – obtain a
guarantee from another creditworthy person
• 5. Include terms in credit agreements which require debtors to carry on business in accordance with
specific requirements
• E.g. require the debtor to refrain from making significant capital expenditures or allowing
certain financial ratios to fall below limits
THE CREDIT OR LOAN AGREEMENT
• With trade credit- the agreement can be verbal
• In the case of a large debt financing, the credit agreement is typically called a loan agreement and is
much more comprehensive and carefully negotiated
• If the ak deides to gat Hoeto the loa, it’ll usuall poide a letter of commitment to
Hometown, which will set out in a summary manner the basic terms on which the lender is prepared
to make the loan. It may include:
• Amount of the loan and how it will be disbursed
• Rate of interest- floating or fixed
• Repayment terms- frequency
• Term of the loan and conditions for renewal
• Conditions that must be satisfied before the loan is made (e.g. guarantees, appraisals)
• And much more
• The borrow is free to try and negotiate the terms set in this letter of commitment
• Once the letter of commitment is signed, the lender will prepare a more formal loan agreement
which will cover all of the terms and conditions set out in the letter and will often by accompanied
by other agreements such as a mortgage, security agreement, or personal guarantee
find more resources at oneclass.com
find more resources at oneclass.com
SECURITY
• Collateral can be either real property which is accomplished through a mortgage, or personal
property
• The taking of security is normally covered by a separate security agreement
• Lenders will often try to match their security to the use of the loan proceeds
• E.g. if Hometown borrows money in order to buy a new equipment, the security for the loan
may be the equipment itself
• The most attractive collateral are assets that are the most liquid
• If the ak deides to led oe to fiae the plaed epasio, it’ll euie a general security
agreement, which will include as collateral all the personal property assets currently held by
Hometown, as well as all after-acquired property, which are assets that are acquired by Hometown
during the term of the loan.
• Some assets used as collateral are intended to be retained by the debtor
• E.g. if Hometown buys a forklift for use in its warehouse, the forklift is available as a security
for its entire life
• Other assets such as inventory and A/R are meant to circulate through the business on a regular
basis
• The security agreement will allow Hometown to sell inventory in the ordinary course of its business,
but probably will prohibit Hometown from selling the forklift while the loan is outstanding
• Also, require Hometown to have adequate insurance on the forklift to protect the value of
those assets as collateral
• Lender will typically require security in an amount that exceeds the amount borrowed because
when and if the borrower default, their assets when liquidated at that point may be much less than
the point of when the agreement is created
PERSONAL PROPERTY SECURITY LEGISLATION
• The personal property security system allows lenders to grant credit, knowing where they will stand
with respect to the collateral in the event of default by the debtor.
• The legislation (Personal property security act PPSA) has common concepts in all provinces:
• Attachment
• Perfection
• Registration
• Priorities
• Remedies
• PPSA applies to every transaction that in substance creates a security interest -an interest in
personal property that is intended to secure payment or performance of an obligation (usually a
debt)
• The PPSA also applies to some transactions that are not intended as security, such as lease for a
term of more than one year, commercial consignments, and absolute assignments (transfers) of
accounts (e.g. A/R)
Attachment
• Occurs when three conditions are satisfied
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Expand and offer a broader range of supplies: bill"s (cid:272)o(cid:374)fide(cid:374)t i(cid:374) his (cid:272)usto(cid:373)e(cid:396)s" lo(cid:455)alt(cid:455) if the(cid:455) (cid:272)a(cid:374) o(cid:271)tai(cid:374) the sa(cid:373)e (cid:396)a(cid:374)ge of p(cid:396)odu(cid:272)ts f(cid:396)o(cid:373) Hometown as in the big-box store: at the same time, bill is concerned about the recent slowdown in housing construction, ,000 expansion cost. They hope to borrow this amount from the bank. Important to exercise good judgement when deciding whether to extend credit when specified conditions are met. This helps the international problem: a business can also raise capital by borrowing, these credit arrangements are more secure to the lender, e. g. Hometown applies to the bank for ,000 loan, the bank will require extensive documents to support the loan application: the bank will consider two criteria, (cid:1005). Ho(cid:373)eto(cid:449)(cid:374)"s fi(cid:374)a(cid:374)(cid:272)ial health- the likelihood the expansion will succeed and. Hometown paying the loan within a reasonable time period: 2. Investigate the security that hometown can provide- so they know that.
