Access to Credit Pt. 3: Legal framework for Secured Transaction Reform

Without any doubt there is a type of global consensus on a couple things regarding Micro, Small, and Medium-sized enterprises (MSMEs). Firstly, there appears to be no disagreement about the essential role that MSMEs play in both developed and developing economies, as global estimates say that roughly two out of every three jobs are provided by MSMEs. The second, and somewhat paradoxical, point is that MSMEs face significant challenges, chief among which is the access to finance constraint.
Cross country studies have empirically shown that MSMEs are the primary sources of job growth. For example, according to Ayyagari, Demirguc-Kunt, and Maksimovic (2011, p. 11), across income groups in the 85 countries that they found to have had a net positive job creation, “the job creation share for firms with less than 20 employees (Small enterprises) ranges from 39.84% in high income countries to 58.34% in low income countries.”

While the initial phases of this discussion seek to look at the use of movable assets as a potential solution to the credit gap from a broad perspective, it is useful to point out at this juncture that the World Bank classifies Belize as an “Upper-Middle-Income” country—an income group for which the aforementioned study finds that Small (less than 20 employees) and Medium-sized businesses (20-99 employees) contributed more than 72 percent of the net job creation.
Nonetheless, MSMEs worldwide face significant credit constraints, with organizations such as the International Finance Corporation (IFC, 2013) stating that “MSMEs in developing countries face an estimated financing gap of USD $2.1 to $2.6 trillion”. Again, with a glance towards Belize, IFC (2014) suggests that there’s an approximate USD $1 billion credit gap for Belizean MSMEs.

Legal Prerequisites for STR
With the above in tow, we once again return to where we had left off in last week’s “Strictly Business”: providing a look at the general legal framework necessary for secured transaction reform (STR) which could allow for movable assets (equipment, inventories, livestock, accounts receivables, etc)—which, on average, makes up about two-thirds of the assets owned by MSMEs—to be used as collateral.
Of the eight principles, around which STR revolves, this column has since looked at “Scope and Uniformity of security mechanisms”, and the inclusion of “After-acquired property as collateral” (see previous articles at EDCwire.com). This week, we take a look at the principles of “proceeds as collateral”, establishment of adequate notification system (public registry), “inclusion of future advances”, “protection of debtors via purchase money security mechanisms”, “Buyers in Ordinary Course,” and “effective enforcement”.

Proceeds as Collateral
For STR to be successful, any jurisdiction seeking to utilize this approach as a solution to their respective MSME financing gap would need to be able to allow security interests to continue as collateral, even if the original asset is sold by the debtor. Such a legal consideration becomes conspicuously necessary in the case of inventories or agricultural commodities (crops, livestock) being used as collateral.
While some jurisdictions may already have laws that allow creditors to reserve their right to make a valid claim on proceeds from the sale, exchange or other disposition of the original asset used as collateral, the full benefits and flexibility of such legal infrastructure may be limited by the lack of a robust collateral (public) registry system.

Public Registry
Within the context of the “Proceeds” principle, it becomes evident that the legal framework must allow for a notification system that alerts “third parties” to the existence of any valid claim by another creditor. Therefore, “if notice is not provided, or is ineffective, subsequent purchasers or lenders may believe that debtors’ goods are free of encumbrances. Failure to make available notice may lead unwary third parties to purchase or lend against the collateral” (IFC, 2014).
When the security arrangement is possessory, such a registry may not be an imperative given the creditors’ ability to hold the property itself; however, the movable assets option usually requires debtors to retain possession of the assets. Therefore, in these non-possessory cases, the need for such a public registry becomes vital.

Purchase Money Mechanism
Generally speaking, a purchase money security interest (PMSI) arises in acquisition financing scenarios, in which the funds obtained by a borrower are used to purchase a particular asset (equipment, motor vehicle, etc). Fundamentally, in the case of default by the debtor, a PMSI allows creditors to repossess those assets that were purchased with the borrowed funds.

Beyond PMSI’s inherent benefits by way of encouraging lenders to finance MSMEs’ acquisition of equipment or inventories, such a system also provides a workable solution to the potential priority dispute that could emerge due to the “After-Acquired Property” principle—which allows for the extension of security interests in cases where the originally encumbered property to assets is replaced.
That said, “if a debtor is able to procure additional financing for a new line of goods, notwithstanding the prior interest, the PMSI provides a new creditor with protection over previous secured creditors with respect to the financed goods” (IFC, 2014). However, both in the case of the “After-Acquired Property” framework and that of PMSI, the role of a public registry must be underscored.

Future Advances
The modern secured transaction framework also calls for the ability for creditors to be able to extend “future funds without sacrificing” their priority as creditors with relation to “the collateral used to secure the original and future extension of funds” (IFC, 2014).

Buyers in Ordinary Course
Given the relatively “long reach” afforded to creditor protection under some of the principles discussed above, at some point someone is likely to ask the question: does this affect anyone who happens to purchase a product that was used as collateral. For example, should a customer who buys goods from a retailer be concerned that a creditor could come and lay a valid claim on his new purchase, given that the retailer’s inventory was used as collateral? The “Buyers in Ordinary Course” principle suggests that the legal infrastructure to support any modern secured transaction system should protect consumers from such any such eventuality.

Therefore, the law must allow for purchases by any buyer in “the ordinary course of business” to be free of any security interest created by the seller, even if the buyer was aware that a security interest existed prior to his or her purchase of the product. Given that inventories and equipment make up approximately 44 percent of the average small businesses assets, this protection to consumers becomes paramount.

Effective Enforcement
On a final and virtually unavoidable note, for any system, especially a secured transactions system, to function there must be mechanisms for “quick and effective methods of execution on the collateral”. The point here is simply this: creditors, in the event of a debtor’s default, should have access to adequate, official means for them to repossess collateral so as to “satisfy an outstanding deficiency on a loan.”
Moreover, the cost of such enforcement should be low. According to the European Bank for Reconstruction and Development (EBRD), “A person granting credit will usually ensure that all costs connected with the credit are passed on to the debtor. High costs of security will be reflected in the price for credit and will diminish the efficiency of the credit market”.

Looking Ahead
The last three installments of EDC’s “Strictly Business” has raised this issue in a general sense, so as to lay a broad-based foundation for any future discussion on the implementation secured transactions reform. As this article reminds, the role of MSMEs is indispensible. However, there appears to be a global phenomenon in which small businesses continue to have constrained access to credit, a factor that ironically slows the growth of a sector that empirical evidence repeatedly shows to be most critical in providing jobs, reducing poverty, and contributing to economic growth.
The importance of MSMEs is equally important here in Belize as it is in other developing countries. Therefore, looking ahead, future “Strictly Business” articles will look more closely at this issue and its potential remedies from a more local perspective.

About the EDC
The Economic Development Council (EDC) serves as the principal liaison body between the public and private sectors, and is designed to advocate for, plan, and coordinate the institutionalization of policy reforms that engender the business-and investment-friendly environment that is suitable for Belize’s private sector development and overall economic growth. The EDC executes its function by maintaining constant and open communication with both sectors via its technical unit, the Public-Private Sector Dialogue, which is housed in the Office of the Prime Minister.

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