Direct security is typically collateral that can be used to secure a loan. Securities can be broadly divided into two distinct types: asset securities and collateral securities.
Asset security represents ownership interest held by shareholders in an enterprise, realized in the form of shares of capital stock. Holders of equity securities are generally not entitled to regular payments, although equity securities often pay out dividends. However, they can profit from capital gains while selling the securities. Equity securities provide the holder with some control over the business through voting rights.
Types of Direct Security
There are three major types of direct securities:
Real estate assets (e.g., land, residential, or commercial properties), tangible non-current assets (e.g., machinery and equipment), cash, securities, and inventory can serve as security. Intangible assets, such as any intellectual property rights, patents, and distribution agreements, can also be taken as security.
How to Secure a Position Using Assets
Fixed and floating charges are the ways of securing a position by a financial institution.
A fixed charge is attached to a certain item of an organization’s property, plant, and equipment (PP&E). The lender owns the legal rights to a specific asset that was pledged as security for a loan, which means that the borrower cannot sell the asset without the lender’s consent. Real estate properties are usually subject to a fixed charge.
A floating charge attaches to a general class of assets rather than a particular asset. It allows the borrower to trade its assets during the ordinary course of business. The floating charge will be fixed if the borrower becomes insolvent or defaults on its loan repayments. If it happens, the borrower gives up its legal right over the pledged asset.
There are two ways that direct security can be pledged to the lender:
The first way is through a general security agreement (GSA), and the second is by identifying and assigning specific collateral. It serves as protection for the lender. Using specific collateral means assigning specific assets or pledging the assets to the lender so that if the borrower goes bankrupt, the lender will repossess the ownership of the pledged asset.
All assets are pledged as security to the lender in case of the general security agreement, and in case of a default, the lender can seize all the borrower’s assets.
Indirect Security vs. Direct Security
Indirect security represents the security of a loan that is not directly related to assets pledged against the loan by a borrower being a part of direct securities. The two common types of indirect security are:
The most common type of indirect security is a guarantee. In other words, a third party, called a guarantor, takes responsibility for any debt outstanding that has not been repaid by the borrower because of its default. Such a responsibility is documented in writing as evidence of the fact.
There are three common types of guarantees:
Joint and several
A personal guarantee is used in case a guarantor is an individual. If a borrower goes bankrupt and is no longer able to service debt, then the guarantor (the individual) will need to cover the unpaid outstanding debt. It also means that the lender may pursue the guarantor’s assets.
A corporate guarantee is used when the guarantor is a company. Corporate guarantees are common when companies are related through ownership. For example, a corporate parent enterprise can be asked to provide a corporate guarantee for loans provided to a subsidiary company that is owned by the parent.
Finally, joint and several guarantees are utilized when there are several guarantors. Any and all guarantors may be pursued to repay the debt of the defaulted borrower. Joint and several guarantees are common when lending to groups of companies with shared ownership.
Personal, corporate, and joint and several guarantees come in several versions. For example, personal and corporate guarantees can be unlimited or limited.
Unlimited guarantees obligate the guarantor to repay the full amount of the outstanding loan if the borrower went bankrupt, whereas limited guarantees are used for a particular dollar amount of a borrower’s obligation, meaning the guarantor will need to repay a certain amount that can be less than the loan amount originally taken by the borrower.
2. Letter of comfort
A letter of comfort is another form of indirect security. It is a letter given by a third party (a parent company) to help secure debt financing for a borrower. Importantly, it is a weaker form of reassurance in comparison to guarantees.
Letters of comfort are non-binding and can be thought of as letters of recommendation. They do not require any legal obligation.
For example, a letter of comfort can include something like: “The parent company will be responsible for the business of the subsidiary or the borrower, in a way as to meet all liabilities under the loan agreement.” It does not mention a guarantee, which is why it is a weaker reassurance guarantee.
To conclude, direct securities are those that a borrower directly uses as a pledge against the loan, whereas indirect securities are securities provided by a third-party (a guarantor) that will take responsibility for the loan repayment should the borrower default on it.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:
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