New Corporate Laws
What & What

By Madan Lamsal & Keshav Gautam

After over four years of exercise in their drafting, four new corporate laws have been promulgated through ordinances. What are the significant changes?

The more one delves into the corporate governance laws promulgated recently, the more substantial changes in the existing system are noticed. But since the new Company Law has made very harsh penalties for failure to hold the Annual General Meeting (AGM) within six months of the completion of the fiscal year, at present the attention of all the companies is focused more on the provisions related to the AGM. Therefore, many important changes made by these new laws have not come to the open.

What everyone noticed immediately (apart from the stringent penalties for failure to hold AGM within six months) was the prohibition to the company to distribute any gift, either in cash or kind, to its shareholders charging the accounts of the company. Though some companies managed to observe the stricture, some others had to stoop to the pressure of the shareholders to give them the lunch expenses or transport expenses to reach the AGM venue, as was the practice till recently.

Haste

That should be enough to indicate that the time chosen to promulgate the new law was not appropriate. The parties concerned were not given sufficient time to digest the new provisions and prepare themselves to the changed legal environment. Had the laws been promulgated before the new fiscal year began, they could have used that time to study it.

Anil Sinha, one of the few most sought after corporate lawyers of the country, says, also lacking was sufficient public debate about the new provisions of these laws before promulgating them. “Had there been such debate, it would have educated the people concerned about the new provisions and it could have helped in their smooth implementation.”

However, it is denied by Bharat Raj Upreti, another hotly sought after corporate lawyer and the main person involved in drafting the Company Ordinance. “There were several rounds of consultations with the private sector and the professionals like lawyers and chartered accountants on the various drafts of the Company Ordinance,” he says and regrets, however, that Nepal Bar Association, where one such draft was floated, did not provide any feedback.

Still, it can be seen that the promulgation was made in a haste. Even the government was not prepared to take the immediate steps needed to implement these new laws.

Though the law was enforced over two months ago, a number of important regulatory structures required for the implementation of the provisions of the law are not in place as yet.

For example, the Company Registrar is now limited by the new Company Law to purely record keeping role plus a very few administrative duties. Many of the roles of the Company Registrar are now shifted to the Commercial Bench of the court. But this bench is still not formed. Though the Company Law has made a transitional provision by designating the existing Company Board as the authority to carry out the function that are to be shifted to the court, and this many of its provisions can be implemented, some will not. For example, if a personnel now working as a liquidator of a company dies or wants to resign, a new liquidator cannot be appointed because anyone to be eligible to be a liquidator now has to be licensed by the Insolvency Administration Office to be set up under the Insolvency Ordinance. But this office is still not set up, so no one can get a license to be a liquidator. Similarly, Insolvency Ordinance and Secured Transaction Ordinance are not going to be properly implemented as long as such Commercial Bench is not set up. Moreover, The Secured Transaction Act requires the Office of the Secured Transaction Registrar to be set up without which the provisions of the Ordinance cannot be implemented.

It shows that the government brought out these laws in a haste and the reason for the same is the pressure on the government from the donor agencies which were complaining that the government was going very slow with the economic reforms agenda in which the enactment of these laws were major points. The donors were peeved also because the process of preparing these drafts was started about five years ago with donor funding and the final drafts for them were prepared over a year ago. The frustrated donors had openly threatened the government to stop releasing further aid money if these laws were further delayed. But now, though the laws are promulgated, the donors are not going to be satisfied as the steps to implement these laws are not taken. And analysts predict further long delay in this.

Human Resource Problem

Shashi Raj Pandey CEO, Shree Investment & Finance

According to the corporate analysts, it will be very difficult to find the appropriately qualified judges to head the commercial benches of the courts as the nature of the cases to be referred to these benches will be substantially different from what the existing judges are experienced in. That may require some experienced corporate lawyers to be appointed as the judges in those benches. But as Shashi Raj Panday, a corporate analyst and CEO of Shree Investment and Finance Company Ltd., says, it will be difficult to find such a lawyer ready to take up the position. When the Debt Recovery Tribunal was being formed, it was delayed for quite long because the law required a senior Chartered Accountant to be included in the Tribunal and none of the Chartered Accountants was ready to take up the job which, though prestigious, was not remunerative enough, he recalls, and says “Similar problem may be encountered in the formation of Commercial Benches in the courts.”

However, as the new corporate laws have not specified the qualifications for the judges to head such Benches, it may not be so difficult to find the solution to fill up the position. Still, there may be problems in speedy dispensation of the cases referred to such courts as such judges may need extra time to study and grasp the issues involved in the case.

One important repercussion of the new law that will be experienced soon is that no one will be eligible to stay in the Board of any company as long as his name is featured in the black list prepared by an authorized agency for defaulting on bank loan. This is likely to make a large number of present directors of the board of many companies ineligible for the post.

Some people predict massive shortage of qualified human resource also for the position of Company Secretary as the new law has required that a person cannot be a Company Secretary in more than one company. But though the educational qualifications and experience of the person required to be eligible for the post are quite stringent upon closer scrutiny, this may not be such a big problem. The Ordinance requires all companies with a paid-up capital of Rs. 10 million or more (private limited or public limited) to have a company secretary who should posses a professional certificate of qualification for such position (e.g. a chartered company secretary) issued by a competent institute and experienced in the job for at least three years. However, the Ordinance has provided for many exemptions as well in this requirement so that a person holding a Bachelor’s degree in Law, Management, Commerce or Economics and having an experience of working in the management of a company for three years can be appointed a company secretary.

CAs Complaining

The most adversely affected professionals by the new law are Chartered Accountants (CAs). They have started voicing grave concern about the difficulties posed to them in their profession due to the new law. In the zeal to control the auditors and make them responsible, the law has made it virtually impossible for many CAs to take the auditing job in public limited companies, say the CAs. According to this law, the restriction on a person to be appointed the auditor of a company for three consecutive years has been expanded to cover under it even the partners, former partners, employees and former employees of the existing auditor unless they have separated from the partnership or employment of the auditor three years earlier. Moreover, a person cannot be the auditor of a company in which he/she is a shareholder or in which his/her ‘near relative’ holds one percent or more of the paid up share capital of the company. Whether any near relatives have such share holding in a company is going to be very difficult for an auditor to ascertain.

Improvements

The new laws have introduced a number of new provisions claimed to be far improved than the earlier ones. “Till now we used to follow the Indian Company Law as our model, but now we have moved far ahead and with this new Company Law, our model is the English Company Law,” claims Upreti.

According to him, the new law is made such that any investor from a developed country would feel quite at home when he sees this new law. “It will thus encourage foreign investment,” he says. According to him, the new law tries to adapt the OECD principles on corporate good governance though a number of such principles could not be incorporated as the bureaucrats could not digest them.

One major improvement he cites in the introduction of the principle that it is up to the promoters of the company to decide how much capital they would need to raise and how they would raise it. “Thus, now, with this new law, the company does not need the permission of the Company Registrar or other agency to increase the capital. The annual general meeting can decide about it and it will be enough to notify about it to the Company Registrar paying the applicable fee,” he says.

However, he also says that he could not sell the idea to the government bureaucrats to do away with the practice of specifying the par value of the share, though there is some flexibility allowed about it in the new law. Now the company can issue the shares of Rs. 50 or above (if divisible by 10) par value. In the previous law, the companies were allowed to have the par of the share as Rs. 100 only. This allows the company to decide the par value of shares looking at the target groups from which it wants to collect share capital. If you want a few rich people as your shareholders, keep the par value at Rs. 10,000 and if you want many people even from relatively lower economic strata, you can keep the par value at Rs. 50.

Another important improvement is the introduction of the concept that the company’s directors, auditors, company secretaries, the chief executive officers are personally liable for anything that goes wrong in the company. “This will ensure good governance,” claims Upreti. Moreover, it has also been specifically provided for that any benefits gained by the persons in the higher management of the companies must be disclosed in the annual report of the company.

In an other improvement, the new law has reinstated the provision to allow foreign companies to operate as a branch in Nepal. This provision was there in the earlier law, but the Company Law of 1997 had omitted it which, as was experienced later, caused a number of malpractices to grow.

More important change in the introduction of the concept of a company that does not distribute profit among the shareholders. “This is to provide a stable institutional model to the voluntary organization,” says Upreti. In the existing model, such organizations need to be registered with the Chief District Officer and such registration needs to be renewed annually. Now such organizations can register as a company and carry out their voluntary activities enjoying the freedom from various restrictions imposed on other companies.

Another idea that Upreti says he could not sell across the bureaucracy was to do away with the requirement of minimum seven shareholders for public limited company and maximum 50 shareholders for private limited. “My idea was to distinguish private or public company on the basis of whether the company raises capital from the general public or not. But the bureaucrats could not digest it,” he says. However, the concept is included somehow in the new Securities Law which allows companies to sell shares by private placement (or without going to the general public) if the number of people to whom the shares are to be sold does not exceed 50.

One equally important new concept introduced in the New Company Law is the Investors Protection Fund. The idea is to transfer to this fund the amount from the companies that is set aside to distribute as dividend but for which the shareholder has not made any claim for more than five years. “There was a lot of protest from directors of companies that are enjoying this money. But we managed to get this provision included in the law,” recalls Upreti.

Now this money will be transferred to the new Fund and it will be used for educating the public shareholders, training the employees of company and stock-market related public agencies and like.

Lapses

Despite these and other improvements, the new Company Law has several technical blunders (see box).

Other Corporate Laws

The Insolvency Law and Secured Transaction Law are not much discussed till now, perhaps because the attention is focused entirely on Company Law or because these two laws are not going to be implemented as long as the administrative and judicial structure needed for their implementation are put in place.

However, the reforms they have tried to bring about by introducing new systems are important and far reaching.

For example, these laws will make it far easier for the banks and other lenders to realize their dues from the borrowers. While they have made it easier to lend against machines and vehicles without asking for real estate property as collateral, it will be easy to ascertain whether a machine or vehicle is already pledged as security to other lenders. Similarly, hire purchase loans, lease finance and credit sales can now be secured, that is if the laws are really implemented.

These laws also make it possible for the lenders to transfer the security right over a securitized asset. It is expected to help the banks to sell their bad loans to other banks or institutions.

The Insolvency Law has provisions claimed to be improvements over the provisions incorporated in the previous Company Law. For example, while only creditors with 50 percent of total outstanding dues could apply the process of liquidation in the earlier provision, now creditors with 5 percent of total loan or shareholders with 5 percent of total paid up capital can initiate the insolvency process. More importantly, the new law has provision also for restructuring a company that is facing financial difficulties.

Also the new Securities Law has brought about a number of improvements. For example, it has provisions to strengthen the Securities Board, the regulator of the securities market. The representatives from the government on the Board will now be joint secretaries as compared to under-secretaries earlier. The confusion about authorities of the Board, the Company Registrar and the Stock Exchange are cleared. For example, compared to earlier provision under which the Company Registrar was supposed to approve the prospectus, now this authority is clearly vested on the Board. Similarly, the Board is now empowered to even order suspension of a stock exchange. It is however to be seen whether the Board will actually be able to exercise its new authority effectively to promote the securities market.

The new Securities Law has also made it possible to introduce new trading instruments, including the right to sell the option to buy right issue of shares. New provisions about over-the-counter market, central depositing system, creation of Investor Protection Fund and environment created for the entry of new players (e.g. investment advisors, portfolio managers, clearing house etc.) are expected to broaden and deepen the securities market of the country.

---

Salient Features of New Company Law

The Company Ordinance 2062 replaces the Company Act 2053 effective 9 th October 2005.

The promulgation of the new Ordinance has been made with a view to further liberalize the economy and enhance investment in industry and commerce and make company’s promotion, operation and governance effective and transparent.

In addition to public and private limited, a non-profit company can also be established. All foreign companies operating in Nepal are brought under the ambit of the Ordinance.

A public company may issue shares at premium provided that it has paid dividend continuously in the previous three years and has a positive net worth. The share premium amount could be distributed as bonus share or used for redemption of preference shares. Net worth is defined as the value of the company’s assets arrived at after deducting the company’s total liabilities from the value of company’s assets minus paid up capital and those reserves out of which dividend can be distributed.

Preference share with varying rights could be issued. Such shares could be redeemable or unredeemable and convertible or non convertible and dividend could be cumulative or non-cumulative. A public company may issue secured or unsecured debentures. Such debenture shall have to be managed by a Trustee. The Ordinance has also provided for the second mortgage.

Henceforth, reduction in share capital would also require court’s approval.

The company has been permitted to buy back its own shares by satisfying the following conditions:

- The issued capital is fully paid.

- The shares are listed with the security board.

- The outstanding loan of the company is not more than double of the amount of share capital and free reserve, and

- The shares so purchased do not exceed twenty percent of the paid up capital and free reserve.

A company is prohibited from granting loan or any other financial assistance for buying or creating any kind of lien on its won shares or the shares of the parent company.

A company may issue shares at a discount under a capital restructuring plan, an arrangement made with the creditors or employee scheme.

The quorum for the annual general meeting of a public company has been reduced to the presence of minimum three shareholders holding 50% or more shares. The requirement of sending detailed financial statement to shareholders has been simplified. A summarized financial statement may be published in a daily newspaper instead of sending to each shareholder individually. Additional disclosure requirements have been prescribed for the Directors which include, among others, (a) salary and benefits paid to Directors, Managing Director, Managers, Auditors and CEO, (b) details of shareholders holding more than five percent shares (c) shares and debenture bought back/redeemed or issued during the year (d) amount due from the directors or shareholders holding more than five percent shares or their close relatives (e) amount borrowed from banks and financial institutions and outstanding principal and interest thereof (f) details of claims under litigation (g) number of workers and staff employed (h) details of dividend, commission, fee, royalty etc paid to a foreigner under management or technical agreement of more than one year tenure (i) details of management expenses and unpaid dividend.

Such statement needs to be certified by the auditor of the company and submitted to the Registrar of Company twenty one days prior to the date of annual general meeting. Failure to submit these statements would attract a fine of upto Rs. 20,000. Such fine is payable by the defaulting official personally.

Each public company is required to appoint independent director(s) on its Board. The number of such independent director has to be one at the minimum and two if the total number of directors exceeds seven. Qualification shares for directors have been made optional. Provision for appointment of alternate director has been made.

Stringent provisions for disqualification of a director are introduced. A person may not be a director of a company in the following circumstances:

1. an insolvent person within five years of insolvency

2. person convicted of corruption of moral turpitude

3. having personal interest in any business, transaction or contract of the company

4. a director, principal shareholders, auditors and advisor of another company having objectives similar to the company

5. a shareholder indebted to the company

6. a person who has been convicted or penalized under section 160 or 161 of the Ordinance (multiple circumstances prescribed under these sections)

7. a director of a company which has not submitted the statements to the Company Registrar required to be submitted under the Ordinance and

8. person holding office of profit in any other listed company

Further provision has been made for the removal of director. And the director shall vacate the office if convicted by a court of cheating the company or failing to perform his duty and fulfil his responsibility or acting beyond his authority. Further, a person blacklisted by a bank or financial institution cannot remain a director during the period of blacklisting.

Only a full time director can now be paid a reward of upto three percent of profit after tax. Hitherto, all the directors could be paid a reward of upto 5 percent of profit.

Directors and their close relatives have been barred from doing any ‘material transaction’ with the company or its subsidiary without the approval of the shareholders’ meeting.

The previous provision prohibiting a director of a public company from buying or selling of shares of the company where he is a director has been relaxed. Now directors can undertake such transaction by disclosing the fact to the company. If any director had gained personal benefit from any dealing made with the company, such amount will be treated as debit claim on him and the company is liable to receive reimbursement of the same. Directors are also made personally liable for compensating the loss caused to the company by their dishonest act or negligence.

The following limitations on the authority of Directors have been created

1 not to sale or otherwise dispose of more than 70 percent of the business or undertaking of the company

2 not to borrow an amount exceeding share capital and free reserves (working capital loan of less than six months excluded)

3 not to give in charity an amount exceeding Rs. 50,000 or one percent of average profit of past 3 years, whichever is less, in any financial year.

Each company needs to maintain account in accordance with the prevailing Nepal Accounting Standards. Auditor of a public limited company has to be rotated every three years. Stringent penalty has been prescribed for auditors for their negligence. New provision for the removal of auditor under certain circumstance has been incorporated. With the new provisions, an auditor may be subjected to multiple penalty for the same offence, e.g. the audit will be invalidated, shall pay a fine of upto Rs. 50,000 or be sentenced to two years jail term, shall be barred from audit practice for five years and losses caused by his negligence shall be recovered from him. Further, the auditor will be considered guilty under the Institute of Chartered Accountants Act.

The new provisions are inconsistent with the international best practices prevailing in the accounting profession. In other countries, auditors are punished only by the relevant accounting body of the country.

A listed company having more than Rs. 30 million paid up capital is required to constitute an audit committee comprising of three directors. An elaborate list of rights and duties has been prescribed for the committee. The responsibility includes review of internal control, monitoring of internal audit, recommending appointment of statutory auditor, prescribing accounting policies and complying with the requirement of regulators.

Concept of divisible profit has been introduced but it has failed to provide a comprehensive definition of the same.

Other provisions deal with the liquidation of the company, voluntary winding up, special considerations in respect of private limited company, one many company, foreign company, non-profit company etc. Some of these provisions are similar to those of the Company Act 2053. The concept of non-profit company is however new. Henceforth, a defunct company may be cancelled by order of the company registrar.

Elaborate and stringent penal provisions are introduced in section 160 and 161 of the Ordinance. In some instances, even a trivial error of omission or commission has been made criminal offence, which is not consistent with the liberal economic policy of the government. Most of the penalties could be imposed only by the order of the court. The Ordinance has envisaged setting up of commercial court or establishing a commercial desk at existing bench. Till such time commercial courts are set up, the authority vested in the court will be exercised by Company Law Board. The vesting of a judicial power on a quasi-judicial body set up by an executive order may be questioned as it will also be awarding jail sentence.

(Upadhyay is a prominent CA)

---

Introduction to Secured Transaction Law

By Gandhi Pandit

Gandhi Pandit

Recently government has promulgated secured transaction Ordinance. The purpose of this article is to explain underlying principal of secured transaction law.

In secured transaction, the debtor pledge its movable property to lender or creditor as collateral to obtain credit or to purchase goods on credit. So this law only applies in the transaction involving movable property, not to any such transaction that involves immovable property.

Secured transaction law address two major concerns of creditors should the debtor default on paying loan or debt:

i. Can the debt be recovered or realized from the collateral offered by debtor as security for such credit?

ii. Will such creditor or lender be given a priority to recover credit from that particular collateral over the claim of other creditors in the same collateral, should the debtor default?

Secured transaction laws ensures that the creditor whose credit is secured first shall have priority to recover the debt from that movable property which is pledged as collateral should other creditors also make claim in the same collateral.

The basis of secured transaction is that seller or lender obtains security interest in the movable property of debtor to secure its credit extended to debtor. Security interest gives creditor a right of foreclosure of property placed as collateral should debtor default in repayment of loan. This law is needed because the collateral usually remains in the possession and ownership of debtor. If debtor is dishonest he may have ample opportunity to obtain additional credit from different creditors creating security interest in the same collateral. In this situation, the law need to look into a mechanism which will help innocent creditors from being defrauded by dishonest debtor. In order to protect creditor from such mischievous activities of debtor, the laws introduce the concept of perfection of security interest and rule of priority which ensure that the first to perfect security interest shall have the priority of claim in that collateral. Therefore, the key element of secured transaction is the creation and enforcement of security interest which secure the payment of debt from the debtor and provide priority to those who first obtain such interest in the collateral.

What is Security interest and how is it created in moveable property owned by Debtor. A security interest is every interest in movable property which secures payment or performance of an obligation.

For Example:

Buyer wants to buy a TV from Sony Company’s dealer. The buyer does not have cash to pay full amount of the TV which cost RS 50,000. The buyer request the seller to let him pay the total price on monthly instalment. The seller will agrees to sell TV to buyer on credit by creating security interest in TV. Should the buyer fail to pay the installment on time, the seller shall have the right to capture the TV from buyer and recover its credit by selling that TV.

In this scenario, the seller is called secured creditor because he is a person in whose favor a security interest over that TV is created. Buyer is a debtor who owes price of TV to the seller. Here the seller is secured party.

In order to become secured party, the creditor must have security interest created in the personal property of the debtor. A enforceable security interest is created if following requirements are met:

a. Unless the collateral is in the possession of secured party, there must be a written agreement concluded between creditor and debtor describing the collateral and signed by the debtor.

b. Value given to the debtor:

The secured party must give value to the debtor. Value means any consideration that is sufficient to support a simple contract.

c. Debtor has rights in the collateral:

The debtor must have present or future legal right or right to possession of the collateral. A debtor who does not have ownership or possessory rights to the property cannot give a security interest in that property.

If these three elements are met, a security interest is created in the movable property of debtor in favor of creditor who extends credit.

Attachment:

If these requirements are met, the right of the secured party is attached to the collateral. Attachment means that the creditors has enforceable security interest against the debtor should the debtor default to repay the debt.

Attachment ensures that the security interest between the debtor and the secured party is effective.

A security interest may be created in various type of personal property which includes.

# Goods including

i. consumer goods bought or used for personal family use purpose

ii. equipment bought or used primarily for business

iii. farm product including crops, livestock

iv. inventory held for sale or lease

v. fixture that are affixed to real estate so as to become part thereof.

# Instruments as such as checks, notes, bonds and other investment

# Chattel Paper (a writing that evidences monetary obligation, e.g. conditional sales contract

# Document of Titles including bill of lading, warehouse receipt

# Accounts (such as account receivable)

# General intangibles (such as patents, copy rights, franchise, royalties and the like)

Purchase Money Security Interest:

Purchase Money Security Interest is an interest which is created when the seller, while selling good on credit obtain security interest in the goods sold. At the time of sale, the debtor gets goods on credit and seller obtains security interest in those goods.

Purchase Money Security Interest is an interest a creditor automatically obtains when it extends credit to purchaser to purchase goods.

Perfecting a Security Interest:

A creditor has two main concerns if the debtor defaults:

i. satisfaction of the debt out of certain pre-designated property and

ii. Priority over other creditors should there be more than one claim in one property.

Even though a security interest is created, the secured party must still need to take steps to protect its claim to the collateral over claims that third parties (e.g. other secured creditor, general creditors) may have. The concept of perfection of a security interest establishes the right of secured creditors against other creditors who claim an interest in the same collateral. Perfection is the legal process by which secured parties protects themselves against the claim of third parties who may wish to have their debts satisfied out of the same collateral.

Method of Perfecting a Security Interest:

There are basically three methods of perfecting a security interest, which are as follows:

a. Perfection by possession of collateral:

If the creditors have physical possession of the collateral, no financing statement has to be filed. Thus possession of collateral by creditor is the best way of perfecting security interest in that collateral. The rational behind this rule is that if someone other than the debtor is in possession of the property, then a potential creditor is on notice that another person may have interest in the debtor’s property. A secured creditor who holds the debtor’s property as collateral must use reasonable care in its custody and preservation.

Example:

Suppose Romila borrows Rs. 50,000.00 from Shyam and gives her scooter in the possession of Shyam as security for the loan. Another creditor Hari also obtains a judgement against Romila. Hari, cannot recover scooter from Shyam. Even though Shyam has not filed a financing statement, his security interest in the scooter is perfected because he has possession of the scooter.

Generally, a security interest in money and most negotiable instruments can be perfected only by taking possession of the collateral. This type of transfer is called a pledge.

b. Perfection by filing a Financing Statement:

Most of the time, creditors find it difficult or impossible to take physical possession of the collateral because it would deprive the debtor the chance to use that collateral ( farm equipment, industrial machinery and consumer goods) and others are simply impossible (e.g. account receivable) Filing a statement in the appropriate government office is the most common method of perfecting a creditor’s security interest in such collateral.

Financing statement is a document filed by a secured creditor with appropriate government office that constructively notifies the world of his or her security interest in that personal property.

c. Perfection by a Purchase Money Security in Consumer Goods:

Seller and lenders often extend credit to consumers to purchase consumer goods. While selling consumer goods on credit, the creditor obtain security interest in the consumer goods that are sold on credit.

A creditor who extends credit to a consumer to purchase a consumer good under a written security agreement obtains a purchase money security interest in the goods. This automatically perfects the creditor’s security interest at the time of the sale. The creditors do not have to file a financing statement or take possession of the goods to perfect his or her security interest.

Two types of consumer goods are excepted from this rule: e.g. motor vehicle and fixture in which security interest is perfected only by filing financing statement.

For Example, assume that Meena buys a Rs 50,000.00 large screen TV for her home on credit extended by the seller, Blue star Departmental Store. The Store requires Meena to sign a security agreement. The Store has a purchase money security interest in the TV that is automatically perfected at the time of credit sale.

The Scope of Security Interest: The Concept of Floating-Lien

In addition to creation of security in the collateral that is in existence, a security agreement can create security interest in other type of property such as the proceeds of the sale of collateral, after acquired property (property acquired in future date) and future advances. This is called concept of floating lien.

A floating lien is a kind of security interest in property that was not in the possession of the debtor when the security agreement was executed; this includes after- acquired property, sale proceeds and future advances.

Priority of Claims

Often, two or more creditors may claim an interest in the same collateral or property. The priority of the claims is determined according to (1) whether the claim is unsecured or secured and (2) the time at which secured claims were attached or were perfected.

Rules for Determining Priority

The established set of rules for determining priority among conflicting claims of creditors is as follows:

1. Secured versus Unsecured Claims . A creditor who has the secured interest in the debtor’s collateral has priority over unsecured interests.

2. Competing Unperfected Secured Claims . If two or more secured parties claim an interest in the same collateral, but neither has a perfected claim, the first to attach has priority.

3. Perfected versus Unperfected Claims. If two or more secured parties claim an interest in the same collateral, but only one has perfected his or her security interest, the perfected security interest has priority.

4. Competing Perfected Secured Claims. If two or more secured parties have perfected security interests in the same collateral, the first to perfect (e.g., by filing a financing statement or taking possession of the collateral) has priority.

Exceptions to the Perfection-Priority Rule Perfection does not always protect a secured party from third-party claims. As discussed in the paragraphs that follow, the law recognizes several exceptions to the perfection-priority rule.

Purchase Money Security Interest - Inventory as collateral

Under certain circumstance, a perfected purchase money security interest prevails over perfected non-purchase money security interests in after-acquired property. The order of perfection is irrelevant. If the collateral is inventory, the perfected purchase money security interest prevails if the purchase money secured party gives written notice of the perfection to the perfected non-purchase money secured party before the debtors receives possession of the inventory.

Consider this example: Toy Shops, a retailer, borrows money from First Bank for working capital. In return, First Bank gets a security interest in all of Toy Shops’ current and after-acquired inventory. First Bank perfects its security interest by filing a financing statement. Later, Toy Shops purchases new inventory on credit from Mattel, a toy manufacturer. Mattel perfects its purchase money security interest by filing a financing statement and notifies First bank of this fact prior to delivery of the new inventory. Toy Shops defaults on its loans. Mattel’s lien has priority.

Purchase money Security Interest – Nov-Inventory as Collateral

If the collateral is something other than inventory, the perfected purchase money security interest would prevail over a perfected non-purchase money security interest in after-acquired property if it was perfected before or within ten days after the debtor receives possession of the collateral.

Consider this example: On September 1, Matco, a manufacturer, borrows money for working capital from First Bank and gives First Bank a security interest in his current and after-acquired equipment. First Bank perfects its security interest by filing a financing statement. On September 20, Matco purchases a new piece of equipment on credit from Allegheny Industries, an equipment manufacturer. On, September 30, Allegheny perfects its purchase money security interest by filing a financing statement. Matco defaults on its loans. Here, Allegheny’s perfected purchase money security interest prevails because the lien was perfected within ten days after the debtors received the collateral. If Allegheny had waited until October 1 to perfect its purchase money security interest, First Bank would have prevailed.

Buyers in the Ordinary Course of Business

A buyer in the ordinary course of business who purchases goods from a merchant takes the goods free of any perfected or unperfected security interest in the merchant’s inventory even if the buyer knows of the existence of the security interest. This rule is necessary because buyers would be reluctant to purchase goods if the merchant’s creditors could recover the goods when the merchant defaults on loans owed to secured creditors.

Consider this example: Central Car Sales, Inc., a new car dealership, finances all of its inventory of new automobiles borrowing from the First Bank. First Bank takes a security interest in Central’s inventory of cars and perfects this security interest. Kim, a buyer in the ordinary course of business, purchases a car from Central for cash. The car cannot be recovered from Kim even if Central defaults on its payments to the bank.

Second-hand Consumer Goods

Buyers of second-hand consumer goods take the goods free of security interest if they do not have actual or ‘constructive knowledge’ about the security interest, and buy the goods for personal, family, or household purposes. The filing of a financing statement by a creditor provides ‘constructive’ notice of the security interest.

Consider this example: Anne purchases a microwave oven on credit from Stearns, a retailer, to be used for household purposes. Pursuant to security agreement, Stearns acquires an automatically perfected purchase money security interest in the oven. Suppose Stearns does not file a financing statement. Anne sells the microwave oven to her neighbor, Jeff, for cash. Anne defaults on her loan payments to Stearns. Then Stearns could recover the oven from Jeff if it had filed a financing statement prior to the sale to Jeff.

Default

Secured Transaction law shall have provision for the rights, duties, and remedies of the secured party and the debtor in the event of default. The term default is usually not defined. Instead, the parties are free to define it in their security agreement. Failure to make scheduled payments, bankruptcy of the debtor, breach of the warranty of ownership as to the collateral, and other such events are commonly defined in the security agreement as default.

The Secured Transaction Ordinance 2062 has incorporated most of the concept explained above. The law is enacted but will remain ineffective unless secured transaction registry is established. Government is working toward formulating rules and regulation in order to establish secured transaction registry allowing secured party to file notice for perfection of his or her security interest in movable property placed by debtor as collateral.

Cover Story | Editorial | Biznews | Political | Management No Laughing Matter | Sectoral | Economy | Interview | Visiting People Stock Taking | Personality | Marketing | SMe Focus | Biz toon | Main | Past Issue