Security for an obligation

What it means

Security for an obligation means instruments that strengthen a creditor's position in case the debtor does not pay or otherwise fails to perform. They include a lien, a surety, a bank guarantee, a contractual penalty, a right of retention, a security transfer of title and an acknowledgment of debt.

The instruments differ in what they give the creditor. A lien and a security transfer of title give a priority right to be satisfied from a specific asset. A surety and a bank guarantee add another debtor. A contractual penalty encourages performance through the threat of a sanction.

Security does not change the obligation itself but supplements it. If the debtor pays, the security lapses. If not, the creditor can enforce the security, often faster and with more certainty than through ordinary court collection.

How it works in practice

The choice of security depends on the value of the deal, trust in the partner and cost. For routine transactions a contractual penalty or retention of title may suffice, while large contracts or loans call for a mortgage over property, a bank guarantee or a shareholder's surety.

When a debtor is late, it is useful to obtain an acknowledgment of debt, which extends the limitation period and makes proof easier. In construction contracts, retention money is common, with the client holding back part of the price until defects are fixed.

In the accounts, security received and given is usually recorded off balance sheet and disclosed in the notes. When guaranteeing another company's obligation, it must be considered whether a provision is needed if payment is probable.

What to watch out for

Some forms of security require a statutory form or registration, for example entry of a lien in the register of liens or in the land register. Without the correct form or registration, the security may not be effective against other creditors, especially in bankruptcy.

Security given to a shareholder or related party without adequate consideration may be problematic under the prohibition on returning contributions and tax rules. In bankruptcy, the trustee may also challenge such acts as voidable.