Secured creditor vs Unsecured creditor, what’s the difference?

Q: WHAT RIGHTS DOES A SECURED CREDITOR HAVE?

A secured creditor has three main rights: - the first is if they are unpaid and you are in default of your agreement, they have the right to take control of the asset and sell it. - the second right is that when the asset is sold, they are paid before anyone else. - the third is that they can stop an asset that they have security over being sold unless they will be repaid in full. One of the key requirements of having valid security is that the secured creditor must control the assets, which manifests itself in the powers they have.

The following article outlines the differences between a Secured Creditor and an Unsecured Creditor, and how this impacts you if you are categorised as a creditor under one of these classifications.

However, in all instances and throughout the article, we underpin our guidance with the strong recommendation that any company director experiencing financial difficulties should consult an insolvency professional as soon as possible. We offer a free one-hour consultation where clients may discuss and seek our initial views on their situation. Indeed, it’s entirely possible to recover a business experiencing financial difficulties, and formal insolvency may not be the best option for the client.

WHAT IS A SECURED CREDITOR?

This is a creditor that has some form of control over your or your company’s assets – this is their “security”. The most common example of secured lending is a mortgage. Secured lending is often broken into two parts referred to as a fixed charge and a floating charge (explained below).

Fixed charge security ranks ahead of all other interests in the assets. For example, if you became bankrupt as an individual or fall into liquidation as a company, the trustee/liquidator would look to sell your or your company’s property to enable the equity to be released for the benefit of your creditors.

If there is a fixed charge loan in respect of the property, for example, a mortgage, the mortgagee must be paid in full before any amounts are paid over to the insolvency estates. It is possible to have multiple secured creditors over the same asset and they rank based on who has the earliest charge chronologically. The costs of the sale of the assets are usually paid before the secured lender, however, they will be subject to the secured lender’s agreement.

Other examples of security are motor vehicle finance, invoice finance facilities, loans (usually large loans), and stock loans. For the security to be valid, the documents need to be properly executed. For example in a corporate situation, charges need to be registered at Companies House within one month of creation to be valid against a liquidator.

WHAT IS AN UNSECURED CREDITOR?

An unsecured creditor is a creditor that does not have any form of security (excluding personal guarantees) over a liability owed to it/them. Hence the term unsecured.

Unsecured creditors rank last for dividend purposes, with only shareholders ranking after them. Most commonly unsecured creditors will be trade accounts e.g. wholesalers, subcontractors, utilities, rent, employees for redundancy and notice pay and other suppliers.

The easiest way to establish if a creditor is unsecured is to eliminate it as another category of creditor. To be a fixed or floating charge creditor, the creditor must have the benefit of a security document registered with the appropriate body. To be a preferential creditor the liability must be in respect of arrears of employee wages, holiday pay, pension contribution arrears or HMRC taxation (VAT/PAYE). If a creditor does not meet one of these criteria they will be unsecured.

THE DIFFERENCE BETWEEN SECURED & UNSECURED CREDITORS

SECURED

As described above, the secured creditor has rights over the company or individual’s assets as set out in the charge document. For example, where they have a secured charge over a property, they must be paid first.

UNSECURED CREDITOR

Unlike a secured creditor, unsecured creditors have no specific rights over any of the insolvent party’s assets. As a result, they rank towards the bottom of the pecking order and commonly will only receive a pence in the pound return, if any, in insolvency proceedings.

EXAMPLES OF SECURED CREDITORS

The most common example of a secured creditor is a property mortgage. All other security operates in the same fundamental manner as a property mortgage. Other common forms of security are a landlord’s security over your rent deposit, an invoice finance facility, motor vehicle hire purchase and similar arrangements.

Bank loans and overdrafts are also commonly subject to security once they exceed certain levels. There is no restriction on who can be a secured creditor as long as both parties enter into a proper arrangement and documents are properly executed and registered as appropriate and consideration is given in exchange for the security. For example, if done properly, security can be granted to a family member or friend who has lent you money – i.e. security is not just available for financial institutions such as banks.

DIFFERENCE BETWEEN A SECURED AND UNSECURED CLAIM?

A secured claim is a claim for money owed where the lender has been given security e.g. a mortgage in exchange for the loan. An unsecured claim is where no security has been given.

DO SECURED CREDITORS GET PAID?

Ultimately this depends on the specific circumstances. If the lender has advanced more money than the value of the asset over which they have security, there is a risk they will not be repaid. Where secured creditors are advantaged is that any disposal of assets subject to their security requires their agreements for the sale to conclude.

For example, if you as an individual went bankrupt and had a mortgage of £150K, and at the time your property had a value of £140K, your trustee would not be able to sell your property without the bank’s agreement as the bank would lose money. As such they are unlikely to agree to the sale.

It is important to note in this example, it is assumed mortgage payments are being maintained. As the secured creditor controls when the asset can be sold, they are therefore unlikely to be agreeable to a sale where they will lose money.

As such any transaction entered into will be closely scrutinised as if the secured creditor is to agree to a loss they will need to be satisfied that this is the best outcome for them. This means that secured creditors are important stakeholders in insolvency scenarios and they are not against exercising their rights to protect their position.

WHAT RIGHTS DOES A SECURED CREDITOR HAVE?

A secured creditor has three main rights:

the first is if they are unpaid and you are in default of your agreement, they have the right to take control of the asset and sell it.
the second right is that when the asset is sold, they are paid before anyone else.
the third is that they can stop an asset that they have security over being sold unless they will be repaid in full.

One of the key requirements of having valid security is that the secured creditor must control the assets, which manifests itself in the powers they have.

HOW DO YOU BECOME A SECURED CREDITOR?

Any creditor can become a secured creditor by entering into an appropriate agreement with the borrower. However, it is important to note that the validity of security is a well-explored area of law and there are several criteria to ensure that the security is valid.

It is important therefore to ensure the document is accurate and to ensure it is binding on all parties. If you are considering securing an existing liability, it is essential to take advice, as in an insolvency scenario the Insolvency Practitioner has a duty to remove invalid security. Finally, unless obtained by way of a court order, the borrower must agree to give you security.

CAN UNSECURED DEBT BECOME SECURED?

In short, yes. There are two main methods. Firstly, by the agreement between all parties and in the form of a binding security document properly completed and registered with third-party authorities as appropriate.

The second way is where you are pursuing a debt if you have received a County Court Judgement (CCJ) you can apply to the Court for security, most commonly in the way of a charge over the borrower’s property. If the court agrees to make the order, then you obtain security without the borrower’s agreement. In an individual as opposed to a corporate scenario, it’s important to take advice as the trustee in bankruptcy does not have to honour charges over residential property secured by the Court if they were created in a specific time frame.

If you find yourself in a situation of financial uncertainty or distress, we strongly suggest that you consult an insolvency professional to look at your case to advise as necessary.

WHAT HAPPENS IF YOU DON’T PAY UNSECURED DEBTS?

The most common consequence of not paying unsecured debts is that the creditor will obtain a court order and will instruct high court enforcement officers, often referred to as bailiffs, to seek to recover the sums due to them. The other main action they will take is to try to force the insolvency of you / your company.

If you are struggling to pay your unsecured liabilities, there is a risk that if you become insolvent, any transactions you enter into may be open to challenge.

WHICH CREDITORS ARE PAID FIRST IN A LIQUIDATION?

In insolvency proceedings, it is set out in legislation the order in which creditors are paid. This order is as follows:

As such, the fundamental difference between creditors is where they rank for dividend payments.

If you are experiencing financial difficulty, you can be supported through this difficult process by experts who understand the pressures you are facing and have experience in working swiftly to deliver a strategy to resolve the issues you face. This is undertaken by seeking prompt advice from an Insolvency Practitioner.

Chamberlain & co offers a free initial one-hour consultation which is discrete and can be held via telephone, face-to-face meeting, or through a digital medium such as Microsoft Teams. All matters are discussed confidentially, and the team is used to making discrete enquiries on a no-name basis when working with you to produce a strategy to resolve your issues.

As with all insolvency practitioners, Chamberlain & Co are committed to delivering best advice in all scenarios, and the team’s work has been recognised regularly at the Yorkshire Accountancy Awards and Turnaround, Rescue and Insolvency Awards.

You can contact us by calling 0113 242 0808; or by emailing us at advice@chamberlain-co.co.uk or by completing our online contact form here.