Commercial finance offers important opportunities for brokers to expand their revenue stream. And in a market where many small to medium enterprises (SMEs) find it challenging to secure bank funding, the alternative finance (alt-fi) sector can be a ready source of funding, often with more rapid turnaround times.
However, in a bid to secure a lower rate for SMEs, brokers may unwittingly be putting their clients in a higher risk position than they realise.
Finance that comes with low interest rates can often be backed by considerable security. This has important practical implications for SMEs and business owners.
This guide outlines the key forms of security, what they mean for SMEs, and how brokers can continue to act in their clients’ best interests.
General Security Agreements
One of the first steps in any contract review is to see if it includes a General Security Agreement (GSA). This is a clause that confers a security interest to the lender. It matters because the type of security will not only affect the interest rate being charged, it can also have an important impact on the assets of the SME and of the business owners.
The GSA itself is not a registration of security. The lender will typically choose what to do with the security interest.
Registering a security on the PPSR
If the security interest is anything other than real property, the lender will register the security interest on the Personal Property Securities Register (PPSR).
The PPSR is a central, national online register operated by the Commonwealth government. Think of it as a public noticeboard that shows security interests in all forms of property other than real estate (if real property is offered as security it won’t appear on the PPSR).
A key point of the PPSR is that it allows priority over an asset to be assigned according to the date a security is registered. So by registering a security on the PPSR, the lender preserves their priority position against other lenders or suppliers if your client is made insolvent or is placed into administration.
Two main types of registrations
One type of security that can be registered on the PPSR is an “AllPAAP”. This gives the lender security over “all present and after-acquired property”. Put simply, the lender has security over everything your client owns now and any property acquired after the registration is made.
A second type of PPSR registration is a “Purchase Money Security Interest” (PMSI). This normally applies with equipment finance. It allows the lender to register a security against a specific piece of equipment (including motor vehicles) through an identifying serial number – such as a motor vehicle’s VIN. This means the lender has a charge against the equipment being financed rather than against the company.
The practical impact of these GSAs really only comes into effect when an SME defaults on a loan, or if the company is made insolvent, or is placed in administration. At this point, the registered security will show which creditors have priority over the various assets of the business.
What if real property is offered as security?
Where the SME owner also owns real estate, this asset may also be captured by a GSA. In this situation, the lender may lodge a caveat on the relevant land titles register notifying its security interest. While not technically a second mortgage, this will appear on the title deeds of the property, notifying of the lender’s claim over the property. This can impact the SME owner’s ability to sell the property in the future – at least until the caveat is removed.
More importantly, for the SME owner, who may think they are quarantining the business assets from personal assets, the family home could be the subject of a GSA. If a caveat comes into play because the business defaults, it can have a hugely negative impact on the entire family, not just the business.
Asking for a personal or director’s guarantee is standard practice for most commercial lenders, regardless of whether the loan is secured or unsecured. Most often the personal guarantee is general in nature rather than specifying security over an asset.
Whilst not technically considered security, your client should be aware that signing a personal guarantee ultimately means that they could become personally liable if the company is unable to re-pay the debt.
It’s common for businesses to have a GSA registered against them on the PPSR, often by a major bank. This means that the bank will be the first creditor to have access to the SME’s assets in the event of default, providing it has priority under the PPSR rules. Problems arise when other lenders lodge a GSA on the PPSR, leading to competing priorities for assets in the event of default.
Granting a security interest has wider ramifications than just in cases of default, though – it can impact an SME even when business is running smoothly. For example, inventory subject to a security interest may require consent from the secured party.
Secondly, pledging the GSA to a party who is not your senior financier can make it difficult to access additional finance facilities. Depending on the terms of the GSA, some security interests can also inhibit the SME from increasing facilities or advancing additional funds even with its existing senior secured financier.
Know what lies behind a low rate
It’s worth stressing that when SME finance comes with a GSA which can be registered on the PPSR or the ability to register a caveat on the land titles registers, the lender is in a much better position to offer more competitive rates.
Understandably, the prospect of a rate saving can be extremely attractive for SMEs, so it’s no surprise that security is often used by lenders as a way to lower repayment costs.
Nonetheless, SME owners need to understand that as a rule, the lower the rate, the lower the risk to the lender, often due to the greater value of the security provided. Equally, providing security can impact the ability of an SME to do business moving forward.
What action should brokers take?
The issue of GSAs and different types of security is a complex area of law. It is vital, though, that SME clients know what they are signing up for.
As a broker, the first step is to review the loan document and identify if it contains a security interest clause.
If it does, bring this to the attention of your client, and recommend that they seek independent legal advice.