The economic consequences of obsolete systems for secured transactions

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Obsolete laws governing secured transactions make it difficult to use property as collateral, raising hurdles in each stage of the process-creation, priority, publicity, and enforcement of a security interest. Lawyers in countries considering reform of secured transactions systems are unlikely to know how different features of their law restrict the use of collateral and thus limit access to credit. Nor are other stakeholders likely to know that these limits on access to credit, often central to their policy and business concerns, stem from defects in the law. It is the job of task managers and project teams to explain how these defects limit access to credit-and to do so throughout the reform process, from justifying this reform against other possible financial sector reforms, to motivating government ministers and members of parliament.

This chapter sets out examples of legal problems in each stage of obsolete systems and outlines their economic consequences. For many readers the chapter may (necessarily) require the mastery of some new terms. While not daunting, this requirement does underscore the need for reform projects to have continual advice from a lawyer well versed in the operation of modern (or reformed) systems for secured transactions.

Creation: problems that exclude goods, agents, and transactions

Many legal systems place needless restrictions on creating security interests, excluding economically important property, agents, and transactions. Where such gaps exist, lenders cannot be sure that a secured transaction, such as a loan agreement using collateral (a security agreement), will be lawful and that a court will enforce it. Special statutes authorizing the creation of security interests in movable property may restrict the parties able to undertake the transaction, the nature of the transaction, and the type of property that can Page 24 serve as collateral. Under this fragmented approach a law may have limited application: Some laws may apply only to banks, registered businesses, consumers, microenterprises, or farmers. Some may apply only to pledges, leases, mortgages, trust agreements, or sales with retention of title. And some may apply only to cattle or mining equipment. The end result is that some loans cannot be secured with movable property, some property cannot secure a loan, and some borrowers and lenders cannot use some types of instruments or give or take a security interest in some types of property.

Limits on who can be a party to a security agreement

Unreformed systems place restrictions on who can be a party to a security agreement and thus limit who can lend and who can borrow. Sometimes such restrictions serve no public policy purpose, as when farmers cannot give a security interest in their property to merchants.1 Sometimes they undermine good public policy, as when a woman cannot sign a security agreement-or when only corporations can file security interests in the company registry, a restriction excluding most farmers, all microenterprises, and most small and medium-size ones (box 3.1). Sometimes they are side effects of apparently unrelated laws, as when laws set the minimum age for signing a contract above the age of many heads of household, particularly among the poor.

BOX 3.1 The intricacies of law can shut many out of the formal market

In Mexico a recent attempt to reform the system for secured transactions focused on the commercial pledge, prenda mercantil. Support for this work came from the agriculture divisions of the World Bank and the Inter-American Development Bank, signifying its perceived importance for farmers. But because small farmers do not qualify as commercial entities under Mexico's civil code, it is unclear whether they are bound by the commercial code. That leaves room for doubt that a commercial pledge signed by a farmer is legally valid, a legal risk that minimized the reform's effect on agriculture.

In Bangladesh, India, and Jamaica a company can give a security interest-a "charge"-against all its property, movable and immovable. But that charge must be filed in the company registry, which deals only with corporations (companies). This system for publicity of security interests thus excludes the sole proprietorships that make up the vast majority of enterprises in these countries-all microenterprises and many small and medium-size ones.

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Such restrictions sometimes affect a large share of the population, such as when all farmers cannot use collateral. And they sometimes have a disproportionate effect on groups targeted by donors, such as women or poor people. The greater the potential economic importance of the groups affected, the greater the economic impact of the limits on their access to credit.

Limits on coverage of goods and transactions

Traditional systems often limit the coverage of goods and transactions. Laws may exclude from the realm of collateral several types of assets-goods that do not yet exist, such as a future crop; goods that lack a title; intangible assets representing rights to other property, such as copyrights, air rights, or accounts receivable; or fixtures, movable property subsequently affixed to immovable property, such as a silo, an oven, an escalator, or a central air conditioning system. Some laws apply to pledges of a particular item, such as cattle. Others may limit or exclude transactions, such as a second-priority security interest (box 3.2).

This spotty coverage creates two economic problems. First, when assets cannot serve as collateral, the owners of those assets cannot get the benefit of

BOX 3.2 How to protect first-priority lenders while preserving competition

As borrowers accumulate equity-as they pay off a first creditor or as the value of an asset pledged as collateral increases-they might wish to finance a second-priority security interest with a competing lender. In Bangladesh, however, the law restricts security interests to one per item of collateral. And in Bolivia the pledge law does not void an agreement that requires the permission of the first-priority lender for the borrower to give a second-priority security interest to another creditor. These restrictions are aimed at strengthening the position of the first-priority creditor. But they do so at the cost of greatly restricting competition and giving the first-priority creditor monopoly power over the debtor. Moreover, under rules like these, financing methods such as second-mortgage home equity lines of credit cannot be developed. Modern systems void any agreements that include restrictions on granting other creditors a second-priority security interest and protect the first-priority creditor by giving that creditor power to control the sale of collateral, even if the debtor defaults on the loan of a lower-priority creditor. This rule protects the first-priority creditor without sacrificing competition among lenders.

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secured lending. Consider the consequences of laws in civil code countries that treat fixtures as part of the real estate to which they are attached and grant real estate mortgages "superpriority" to include any fixtures on the property: If a business operator wanting to finance a fixture owns the building, the operator must go to the expense of refinancing the entire mortgage. If the business operator rents the building, no lender will finance the fixture because the holder of the mortgage on the real estate would have first claim on the fixture (see the section in this chapter on limits on creating security interests in fixtures).

Moreover, these complex and arbitrary divisions can diminish the use of property as collateral simply by creating confusion about what is included under the law. In Nicaragua a law that permits taking a security interest in a future crop, for example, limits such interests to crops that will be harvested within 18 months. This excludes most forestry financing. Moreover, if a natural disaster should destroy this year's crop, the requirement limits continuation of the pledge in crop in the following years. Where such uncertainty exists, lenders know that a lawsuit may be needed to clarify matters if a borrower defaults. So lenders typically avoid such risks by giving little weight in the lending decision to property whose use as collateral is questionable.

Second, transaction costs rise when much time and effort must be devoted to determining whether the law permits taking a security interest in a particular...

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