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p. 9 of 22 BACK | NEXT Introduction List of Participants Welcoming Remarks Emerging Trends and Issues in Legal and Judicial Reform in Development Bank Legal Frameworks for Private Sector Development in the Asia Pacific Region Legal Frameworks for Private Sector Development of Infrastructure in the Asia Pacific Region Collateral Security Reforms Panel Presentations and Discussion Governance: Sound Development Management Strengthening Judicial Institutions Training of Government Lawyers and Judges Lessons Learned: Legal Reform and Technical Assistance 1960-95 Panel Representation and Discussion An Introduction to Project DIAL Concluding Remarks Country Statements

Roundtable Meeting of Chief Justices and Ministers of Justice

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Collateral Security Reforms

Richard Eyre
Assistant General Counsel
Office of the General Counsel
Asian Development Bank

I. Introduction

Compared to the other topics we are discussing today, the development and strengthening of collateral security (or secured transactions as it is now usually referred to) may at first strike this audience as a fairly specialized, even narrow area for discussion. For purposes of this discussion, collateral security or secured transactions, means a legal interest held by a creditor in personal property owned by a debtor or a third party which entitles the creditor upon failure of the debtor to pay or perform an obligation to take possession of the property and to sell it in order to satisfy the obligation.

In the Bank's view, developing a country's legal and regulatory framework to enable the creation, perfection and enforcement of security interests is crucial if the banking and financial system of that country is to be capable of meeting the demands of a fully functioning market economy. The absence of an adequate legal and regulatory framework acts as a major impediment to the use of various categories of property as credit and effectively cuts off, or severely limits, access to credit for a large segment of the populace. In our member countries in transition, a major constraint to funding of private sector infrastructure projects is the inability to take a valid and binding charge over assets and in particular the revenue stream. In many member countries, it has affected the growth of small and medium enterprises. In economies where land, livestock, standing crops, equipment and inventory cannot be effectively used as security for credit, then either the potential borrower is frozen out of the formal market or must pay higher unsecured interest rates. In addition, it prevents the extension of long-term lending. These all impact negatively on productivity and results in a loss in GDP.

In a private lending institution, the first question any loan officer is taught to ask is "how do I get my money back?" Broadly speaking, borrowers have offered two answers to that question: in one model - akin to "sovereign lending" - they offer an unsecured promise to pay; in the other, they offer some kind of collateral that can be seized and sold by the lender in the event that the borrower fails to pay. In developed countries, movable property (livestock, machines, inventory, equipment, standing crops) can represent as much as one-third of the capital stock and one-half of investment. Where borrowers cannot use this property as collateral for loans, they face higher interest rates when borrowing for such capital, they invest less and, consequently, have less capital per worker and less output per person. Although it will vary from country to country, the loss of GDP in one study was estimated between 5 and 10 percent of GDP. There are, of course, economic and other explanations that impact on the efficient allocation and cost of credit, from macroeconomic instability to directed credit and even high collateral registration fees.

II. Collateral and lending

Why does a lender believe a borrower will repay? One proof of sincerity is collateral: placing property at risk such that the lender can seize it if the borrower fails to pay. Taking security reduces risk and the cost of lending and contributes to sound banking practices, as it involves a systematic objective analysis of information on the borrower. The power of collateral to increase the amount that a creditor is willing to offer can be seen in most lending institutions. For example, CIBC Bank in Canada charges 18 percent on its unsecured credit card loans, 7.2 percent for a five-year car loan secured by the car, and only 5.2 percent for a loan secured by a first charge on a house for a term of up to 25 years. Private lenders in the Philippines and throughout the region behave in exactly the same way. Collateral reduces the cost of borrowing. In Viet Nam, where the laws and registration system are not yet in place, the extension of credit is severely constrained, interest rates do not adequately reflect risk, and maximum rates are determined by the government. (Imagine the economic consequences in the U.S. and Canada if tomorrow it was impossible to use a car as security for a car loan.)

III. Legal and Regulatory Barriers to Using Movable Property as Collateral

Yet despite the importance of collateral in increasing loan size and reducing risk and, thereby, interest rates, important legal and regulatory barriers make movable property nearly useless as collateral in many of our borrowing member countries. There are three legal and regulatory issues of key economic importance and
they concern:

the creation of security interests
the perfection of security interests
the enforcement of security interests

These are abstract notions. For a practitioner, it is easiest to understand them with an example: these cows (Figure 1) are identical, but one lives in the State of Kansas in the United States and the other in Country X in Asia. In Country X, no private bank would take cattle or livestock as collateral for a loan; however, in the State of Kansas, cattle are the best collateral for a loan. Moreover, this is not the only practice of private banks but the view of the bank examiners. In Kansas, good banks have "cattle paper" and risk banks have "exposure to real estate"; in Country X, even though banks are also closely regulated, bank examiners do not accept cattle as collateral for secured loans. How can such a difference exist?

First, because it is difficult to create a security interest in cattle in Country X. Suppose a bank lends against 100 cattle worth $200,000. The law calls for enumeration of property - a "pledge" against cattle. In an extreme and obviously unworkable case, this would require the cattle being transferred to a separate holding pen, or it would mean naming the individual cattle or identifying them by serial number. However, specific identification makes monitoring the loan very expensive for the bank, as the loan officer must ensure that his bank's particular 100 cattle are in the farmer's field; a different 100 cattle would not secure the loan. By contrast, in the United States or Canada a binding agreement can be written secured by a floating security interest in "$200,000 in cattle".

Moreover, in Country X, the bank would have to worry about the borrower selling the cattle without notifying the bank. The U.S. or Canadian bank, however, would automatically get a continuing interest in the proceeds of the sale and could automatically attach whatever place the seller of the collateral had put the funds - a bank account or a tractor, for example.

Second, because it is difficult to perfect a security interest in Country X, for a lender to have confidence that collateral has value, the lender must be sure that there are no prior superior claims to the collateral. How, for example, does the lender even know that the collateral belongs to the person possessing it? Suppose the cattle were already securing a loan or had been purchased on credit? In Country X, it is extremely difficult to search the records for a record of whether there already exist prior claims against collateral. Pledges are filed in chronological order and require a sequential search of the entire registry to discover a prior pledge. (In other countries, there is no specific registry for such interests and discovery of a prior interest would require a search of each separate notarial registry in the country, or there may be no registries.)

Finally, and crucially, are the problems in repossessing and selling the collateral. In Country X, repossessing and selling collateral requires six months to two years as the lender must go through the courts, and there is considerable court congestion. In Kansas, one does not have to resort to courts as there are private rights of sale built into the law and it takes only one to five days!

IV. Better Solutions: Change the Law

The following possible solutions have emerged for government consideration:

Creation of security interests: change the law to permit the creation of a wide variety of security interests in a wide variety of property.

Perfection of security interests: create modern self-sustaining registries that are accessible, cheap and simple to use, and make public the records of the registries.

Enforcement of security interests: change the law to permit private parties to contract for non-judicial enforcement of debt contracts.

Reforming the framework for secured transactions: there are, of course, economic, financial and capital market reforms that are needed, but these require law reform. What are the legal remedies? Among the most important are improving the legal and regulatory framework for creation, perfection and enforcement of security interests.

ADB's strategy includes financial sector and capital market reforms and improving the underlying legal and regulatory framework and, in this regard, the Bank has provided loans and technical assistance in over 12 countries and is presently active in Mongolia and Viet Nam. The countries to which assistance has been provided include India, Lao PDR, Sri Lanka, Indonesia, Philippines, Maldives, Samoa, Cambodia, Thailand, Malaysia, and Kazakstan.

ADB technical assistance has also supported regional discussions and planning on credit and collateral security. A 1993 technical assistance supported a regional Symposium on Legal Issues in Debt Recovery, Credit and Security, focusing on problems of debt enforcement and recovery, particularly in public sector financial institutions.

We are currently involved in improving the legal framework and setting up a registration system in Viet Nam and Mongolia. Of significance also is a regional technical assistance program that will concern most of our borrowing member countries and will analyze the problems, gaps and issues involving secured transactions, including the options for reform and the costs involved. This will facilitate the Bank's country-specific lending and assistance program as well as donor coordination.

A specific current example of reforms taking place is in Viet Nam. Following policy dialogue between the ADB and the government, technical assistance was provided to assist in determining the options for reforming the financial sector. Following this assistance, the government requested the Bank to fund the reforms. At the same time, Viet Nam was carrying out various reforms, including the enactment in 1996 of a new Civil Code which provides the basic framework for secured financing.

The Bank in 1996 provided Viet Nam with a Financial Sector Program Loan that will help fund needed policy and legal reforms with the aim of developing a market-based system in the financial sector. Establishing the basic infrastructure to facilitate private sector participation in the financial sector requires various legal reforms. One condition to the release of the second tranche of the $90 million loan requires the government to issue comprehensive implementing regulations on collateral security. In addition, the government has undertaken to establish a registration system.

The Ministry of Justice is currently drafting the implementing decree on collateral security with assistance from the IMF and UNDP. ADB, working with the Ministry of Justice, is providing a $500,000 technical assistance grant to design a self-sustaining centralized national computerized registration system for secured transactions.

Phase I will look at registry design options and will assist in consensus building. While the Ministry of Justice of Viet Nam is fully capable of drafting an excellent decree, without the courts, notaries, lawyers, bankers, borrowers and policy- and decision-makers reaching a viable consensus on the direction of the collateral security reforms, the decree will never pass. Assuming consensus is reached, then detailed design of the registration system and extensive capacity building, including training of lawyers, bankers and relevant government officials will take place.

In the Canadian province of Quebec, which recently enacted a new civil code and established a new registration system, extensive retraining of the legal profession was not only deemed necessary, it was mandatory.

Following the completion of ADB technical assistance, Viet Nam will most likely seek loan and grant financing to establish the registration system.

Viet Nam will, as a result of these reforms, have in place the legal, regulatory framework and a modern registration system that will assist in the creation of a market-based financial sector. These reforms will help improve the terms of financing and will stimulate other reforms in areas such as leasing, insurance, company law, BOT project financing, credit rating agencies, and adoption of international accounting standards. Ultimately, it will provide the linkage to, and major impetus for, a domestic capital market - an area of reform that ADB has programmed for technical assistance in 1998.

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