Collateral Valuation: Credit Risk: Enforcement of Security Interest

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Earlier we discussed the creation and perfection of security interest in collateral. In this post we will look at the methods used for enforcing security interest when a default event or breach of security agreement occurs and how the proceeds recovered from collateral are applied.

Enforcement of Security Interest

After a default event occurs, such as a breach in the terms and conditions of a security agreement by the borrower or the borrower not making loan repayments within the grace period, the secured party may notify the borrower to make the payment or perform according the agreed terms. The secured party can then take a reasonable commercial collection action (e.g. filing a money suit, repossession, foreclosure) to collect the collateral and sell it. The expenses for collecting/ recovery including any attorney fees may be recovered from the collection amount.

The collateral may be sold, leased or disposed of in either a public or private sale provided that it is commercially reasonable, i.e. a private sale would be encouraged it the proceeds realized were higher than what could be obtained in a public sale. Once the collateral is sold the proceeds are applied against:

  1. The cost of collecting the collateral and disposing of it and may include attorney fees and legal expenses depending on the jurisdiction/ country and/ or terms and conditions of the security agreement.
  2. The outstanding obligation of the borrower against the senior secured party, including principal, interest, financial charges and other unpaid charges provided for within the security agreement.
  3. The claims of those subordinated to the senior secured party provided that these parties provide an authenticated notice and proof to the senior party to complete the distribution of proceeds
  4. Residual rights, if any

Any surplus proceeds will be paid back to the borrower. In the event that the proceeds do not cover the outstanding debt of the lender the debtor would usually be required to cover the deficiency unless the security agreement explicitly releases or waives the borrower from this condition.

We have reviewed what enforcement of security interest in collateral means. In the next post we will look at how security interest is terminated or extinguished.