Lending Overview

What Net Lawman says about lending:

"Lending money - what you should record in an agreement

If ever there was a contract which should be put into writing it is a contract to lend money. 

The circumstances of common transactions vary widely. Usually, an agreement is put in place by the lender, since it is his or her capital at risk, so this article considers what should be important to him or her.

Formal lending that a bank might undertake, such as a normal house mortgage or a corporate bond is outside the scope of this article.

Looking at less formal transactions, you might wish to lend to:

• your child, to buy a house

• a friend to engage in a new business, or get him out of personal financial trouble

• a business colleague in a business you jointly operate (such as lending him capital for his joint investment in the business)

• someone you know less well, for a good return on your money

We cannot emphasise enough how important it is to record the amount and terms of any loan in a written agreement.

If your borrower is someone you don't know well, who offers you a good rate of interest for an amount that is otherwise sitting in a bank account not earning interest, you need to set down every possible consideration, so that you have confidence that you really are “agreed” on possible point.

If you are lending to someone you know very well - perhaps a friend or even one of your children, then it is just important to record the terms in writing. If you don't, you can be sure that, between you, you will fail to consider some important element, upon which later you will find you have different views - and that is before you even begin to consider the terms where you have different recollections. The reason to have a written record might be to keep your relationship strong rather than to be a document that you want to enforce.

What your agreement should consider

The agreement you choose (or rather the terms that you include in it) will depend on:

• how far you trust the borrower to repay on time

• what confidence you have in the ability of the borrower to repay

• how you assess the chances of change for the worse in the affairs of the borrower

• how important it is to you to be repaid in specific terms - or at all

• how important it is to you to obtain the best rate of interest

Whether your loan is to someone close to home or at arm’s length, the main terms to consider are:

• how much money does the borrower require, and will this be enough to satisfy his or her full requirement for why he or she needs the money

• at what rate of interest and upon what other terms are you prepared to lend

• what information do you want up front, to satisfy yourself, or your business partners that the proposition is viable

• what security or third party guarantee can be provided and how tight do you want to make it

• what information do you require from time to time to stay satisfied that the borrower is solvent and that you will be first in line when the time for repayment arrives

• what will happen, in detail, if the borrower is unable to repay

Security

The question of security is worth deeper consideration. The three most common forms of security, in order of preference, are:

• traceable securities (such as public company shares) or intellectual property that can be sold

• a promise by a third party to pay or make good if the debtor fails - a personal guarantee

• goods given in security - usually plant or machinery that is difficult to move

Of course, most borrowers are not in a position to offer you the perfect security. If they were, they would probably be borrowing from a bank and not from you or your company. The main criteria to take into account in choosing security (if you have a choice) are:

• value in an open market sale

• liquidity - the ease with which they can be sold

• value to the borrower

Value

Obviously, security does not “secure” your cash loan unless the value you would receive on selling it is at least equal to the amount lent, plus accumulated interest and expenses.

Of course, you could imitate the position taken by a bank and ask for a “fixed and floating” charge. You would not take such a charge from an individual because it amounts to a personal guarantee, which is far easier to document and subsequently claim. But if the borrower is a company then an “F&F” gives you all the security you can obtain. What it amounts to is a charge on all the assets of the borrower, whether they are fixed assets such as cars or plant or office furniture, or floating assets which change constantly such as stock for sale of materials for manufacture.

We do not recommend a floating charge for use by individuals or small company lenders because there may be difficulties in proving ownership and right to sell. We recomment that you stay with specific assets that are easy to sell. If you must have floating assets, you should choose goods that are identifiable and that do not turn over too often, such as beef cows, rather than nuts and bolts.

Liquidity

Liquidity means not merely how easy it is to sell, but all things in connection with the sale.

Most lenders fail to assess the difficulties in liquidation certain types of security.

Ask yourself how you would go about selling a potato cleaning and sorting plant and how long it would take to make the sale.Compare that with a share transfer form (and certificate) for the sale of 100,000 shares in a FTSE 100 company.

There is a tendency for a borrower to offer as security the goods he intends to buy with the loan. This may seem neat, but it is not logical. If the borrower has better security, we recommend that you ask for it.

Value to the borrower

It is best to take security that is also of great value to the borrower. You may be able to sell security assets for only a small sum, but if they are worth far more to the borrower, then his effort to repay the loan will be correspondingly greater.

Other Issues

Lending to a close relative

Your money is at risk any time you fail to provide a proper agreement with appropriate safeguards. If you do not wish to tie down the borrower (for any reason) then you increase your risk.

We don't believe that we should sell documents that might fail to protect you. So if you want an agreement for this situation, we suggest you buy one our template documents then remove whatever provisions are not suitable.

Real property (buildings and land) as security

Real property is not as liquid as many financial assets, but certainly better than fixed plant. Such a security is of course usually called a mortgage or charge.

You need a solicitor to prepare and register a mortgage (preservation of the monopoly) so we do not sell template documents for this purpose.

Taking title deeds as security

Before country wide land registration, real property could be taken as security by physical possession of the title deeds, without which the borrower could not deal with the property in any way, and which could form the basis of an application to court for the lender to sell the property. Today, that does not work.

To take a land certificate as informal security is a non starter, for technical reasons we shall not here explain.

What about promissory notes?

Historically, a promissory note was useful as a means of recording money debts between people who trusted each other to pay.

Cheques now perform that function more efficiently.

The main problem with promissory notes today is that it is far easier than it was 200 years ago for the debtor to persuade a court that he has a good reason not to honor the note. In other words, the note may not tell the full and up-to-date story of the financial relationship.

Please note that the information provided on this page:

• Does not provide a complete or authoritative statement of the law;
• Does not constitute legal advice by Net Lawman;
• Does not create a contractual relationship;
• Does not form part of any other advice, whether paid or free."

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