Safeguards of Creditors – II

Safeguards of Creditors – II


OTHER SAFEGUARDS: Since the grant of a loan is a contract, it provides all those remedies to a creditor, in case of default by the debtor, which can be obtainable to each party to a contract against the other party in the event of breach of contract. consequently the measures mentioned above or below are in fact the ones, in addition to those provided by a contract. In a loan agreement, the creditor is the dominant stake holder. consequently, he can get as many assurances as possible by the loan agreement itself. Some such most shared safeguard measures, besides the security, are the following:

NEGATIVE potential: The negative potential clause is a shared characterize of loan and security documentation(38). It is an undertaking by the debtor not to allocate specific assets to another secured creditor. By executing a negative potential clause, the borrower promises that he will not grant any further rights which will give another creditor priority ahead of the lender to its assets, or, depending on the wording of the clause, that the original lender will be granted equal or equivalent rights. (39) A negative potential secures the interest of the creditor on one hand and put a ceiling on the borrower with regard to excessive limitations on the other. It can also be included in case of a floating charge. However, nearly, a negative potential cannot restrict the grant of collateral by the debtor to another creditor absolutely. And if collateral is granted to a second creditor the first one can only seek cure for breach of contract. However the collateral given to the second creditor would keep valid in the eyes of law. already so, in secured loans negative potential clause would prohibit second ranking security. (40) But, briefly, with very few and quite lengthy in course of action remedies, and without any proprietary interest of the lender, negative potential clause can protect only a floating charge holder, to some extent, and this protection is not comprehensive(41).

GUARANTEE: It is a second agreement (42), in addition to the dominant loan agreement between the creditor and the debtor, by a third person who promises to perform the obligation of the borrower in case of his default. This third person, the guarantor, becomes responsible by the written guarantee to pay off the amount due as a loan if the borrower fails to do so. Though this is a contractual obligation, and needs a consideration for the guarantor, too, in addition it strengthens the position of a creditor in case the debtor fails to pay the debt. Guarantee is also called quasi collateral.(43)

CONTRACTUAL COVENANTS: The loan agreement contains terms of the transaction on one hand and divide up the risks between the parties on the other. It, however, depends which party is stronger. If the debtor is sound enough, he may not agree to offer heavy securities to the creditor. But in such a case, the creditor would otherwise see few chances of default owing to the financial position of the debtor. If the debtor is ineffective financially, then a creditor may insist on covering up the risk by demanding appropriate securities. In any case, prior to making a loan agreement, a creditor must consider the risk examination and go by the exercise of due diligence by obtaining and analyzing certain information about the credibility of the borrower and feasibility of the transaction. If the creditor is careful and vigilant enough, at the time of the making the agreement, he can protect his position by incorporating necessary clauses as safeguards. The terms accepted by the debtor in addition to the normal ones, are called contractual covenants undertakings or restrictive covenants (44).

Such covenants or undertakings by the debtor depend upon the mutual agreement of the parties. However, the main purpose of them is to obtain the repayment of loan. Following are the shared undertakings:

Prohibiting the change in character of the business:

To ensure the proper utilization of the loan progressive, and avoid any negative consequences of indulging into new kind of businesses by the debtor, a creditor may require him not to change the present character of the business until the loan is paid off. Restriction on disposal of certain assets: A creditor except the negative potential clause may require the debtor not to dispose off a particular assets in any manner whatsoever, until complete repayment of the loan. This would minimize the risk of ending of the business without any assets to pay off the debtor, in the event of default or bankruptcy. Confining or limiting the creation of new debts: A business over-burdened by excessive debts is open to the risk of default or failure. A creditor would not like failure of any business funded by his loans.

This would consequence into a loss of his money, in addition. consequently, he may require a debtor while granting a loan to restrain from having new debts, or at the minimum, restrict to a certain level of further borrowing.

Barring or limiting the grant of dividend:

Keeping in view the weaker financial position of the debtor, a creditor may insist on inclusion of a clause in loan agreement which would make the debtor not to pay dividends to the shareholders or to limit such a payment up to certain level. This, again, would be a measure to ensure that without attaining a certain level of strength, the business would not be unprotected to further burdens.

Requiring a minimum net worth of the business:

A creditor may need in loan agreement that if the net worth of the business drops down a certain limit, he would be at liberty to need the speeding up in repayment of the loan. This is to avoid the expected threat to the money of the lender in case of a total failure of the business.

Limitation on use of the funds loaned:

The creditor may require the debtor not to use the money lent on anything except for the purpose it is progressive. This is because the lender advances money keeping in view the viability of the business or project. He may not be sure about the outcome of expenditure on other areas or projects. consequently, to ensure the appropriate use and regular repayment of the loan, he may not agree to allow the debtor to use it for some different purpose.

Calling for certain information:

The creditor may require the debtor, either as a condition precedent to the agreement or after the loan is progressive, to provide certain information to the creditor so as to keep him informed of the affairs of the business applicable to the financial position of the debtor. This is again a safeguard on the part of the creditor to keep him vigilant about the fate of his money.


In certain situations, a creditor may need a long-lasting role of monitoring the affairs of the debtor. This, usually, happens where the position of the debtor is quite weaker or the problems being faced by the company are credited to the poor management.(45) In case of any breach the creditor may stop further payments of loan installments, if any, and may need speeding up of repayment to obtain the debt. It will be necessary for the creditors to incur expenditure in gathering and analyzing information about the debtors actions and financial performance. This monitoring will ensure that defaults are detected as and when they occur (46) Monitoring, Contractual covenants, undertakings or restrictive covenants, being contractual in character, creates only contractual obligations and consequently do not provide, in themselves, an effective cover for the interests of the creditor. However, in addition to the security and other safeguard measures, they are capable of promising a reasonable protection to the creditor.

In addition to the above mentioned possible safeguards, following can be useful in disinctive circumstances.


Set off is the deduction of monies owed against sums due to be paid (47). Set off is a way to satisfy mutual claims by two parties, by deducting the smaller amount out of the bigger one. It may not be a usual case for a bank that in the event of insolvency a debtor would have a claim against the creditor in addition. But if it is the case, then a creditor can reduce a claim against itself, by the debtor company (or the liquidator), by deducting its own claim. However, for those who fund companies it is seldom the case. consequently, the option of set off can only be slightly useful in certain circumstances; otherwise in case of lending edges it does not provide any protection.


Factoring is an option for a creditor of selling out the receivables to other companies at a lower value. These companies, called factors, are specialized in debt recovery, and they make money from the differences of the amounts paid to the creditor and that recovered from the debtor. Factoring is useful, particularly, for recovery from the trade debtors, to save the creditor from cash flow problem. It helps in getting something, not the complete amount, from the dead debts. In case of big loans, however, this option can only be used as a last resort; which can bring only limited outcome for protection of the lenders.


A creditor, besides other safeguards, can opt for an insurance of the amount progressive by a loan agreement. This is not a free cover, neither it brings interest, instead it demands payment; nevertheless if an insurance provides cover for a risk of loss of a huge amount of loan, in case of default of payment by the debtor, or in the event of insolvency. However, in case of availability of appropriate security, it would not add much to the safety of the money progressive. Nonetheless, a creditor may weigh the cost of insurance in comparison with the risk covered and decide consequently. PROTECTION _ That Creditors Need: In the forgoing paragraphs we have had a look at different ways to safeguard the lenders.

It can be observed that none of them is perfect. Some of them, like covenants, are only capable of creating contractual obligations, which are not sufficient to safeguard the position of the creditors. The others, particularly, the quasi-securities are appropriate mostly for small and medium businesses. The lenders of big, sometimes syndicated, loans can not rely fully on these measures. However, in disinctive situations, creditors of the companies may like to blend their securities with these measures to enhance the level of protection. But, the most reliable safeguard for the creditors _ though not perfect _ remains a proper security. Only by putting themselves at the position of secured creditor, the lenders can have a maximum level of protection for their position. Nevertheless, the security, in spite of of being the best, is not necessarily a perfect safeguard. Sometimes it may not provide cent per cent protection to the creditors. And this is inter alia because of the without of information obtainable to them about debtor companies indebtedness.

There are suggestions to enhance the systems more and more _ like maintenance of a new register of security interests (48). All the same, a total protection seems to be something too ambitious, as a quest for perfection (49) always remains a fantasy. CONCLUSION: Debt financing is a shared characterize of todays commercial life. It works well for executing big projects with help of finances acquired as loans. But the problem of protection of the interests of the creditors could not be solved perfectly. Only by being a secured creditor, a lender can ensure the maximum level of protection, which in case of resourceful and well equipped lenders like edges goes up to 77 per cent: a reasonably high rate of recovery, but not completely successful. However, this level of protection attained by taking securities can be improved by adding certain other measures, where applicable, like quasi-securities: retention of title, hire buy and sale and lease back agreement; contractual covenants and others.

If the information about the details of indebtedness of all the debtors can be made obtainable openly, then there is more chances to provide protection for the lenders. There is a suggestion of maintaining a new register of security interest over the assets of the companies, which if put into practice can raise the level of protection to quite a high level. References:

38. Hobbs T, (1993) The Negative potential Clause: A fleeting Guide in Journal of International Banking Law J.I.B.L. 1993, 8(7), 269-274 39. ibid 40. Paul C & Montagu G op cit p 81 41. Finch V op cit p 659 42. Oxford Dictionary of Law, op cit 43. Paul C & Montagu G op cit p 188 44. Oxford Dictionary of Law, op cit 45. Institutions like World Bank and IMF often have to do so in certain situations of the developing countries where the loans are considered to be misappropriated by the corrupt political leadership, who in turn tries to criticize this role of these institutions and adventure it for their political gains. 46. Armour, John and Frisby, Sandra (2001) Rethinking Receivership Oxford Journal of Legal Studies: OJLS 2001.21(73) p 7 47. Oxford Dictionary of Law, op cit 48. Diamond A (1989) A Review of Security Interests in character, DTI, London: HMSO paras 11.6.2; 16.8 49. Kay, John and Silberston, Aubrey (1997) Corporate Governance, in Fiona Macmillan Patfield, Ed, Perspectives on Company Law:2, London: Kluwer Law International, p 66

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