Atypical loan collateral: Collateral value in the banking business

Atypical loan collateral or Substitute collateral are also referred to as non-genuine collateral or flippantly referred to as a "letter to have a warm feeling". This is because they are usually - but not always - mere Declarations of commitment of the borrower. The borrower is already obliged to repay the loan amount plus interest. If he does not comply with this, the question is justified as to whether he is complying with the obligation arising from further declarations. The question also arises as to what the bank gains if it has a further claim, in case of doubt for damages, against the borrower in addition to the repayment claim under the loan agreement.

A small selection of these atypical loan collateral types, which occur in a wide variety of forms, is presented below. The article assesses their value as loan collateral.

From Prof. Dr. Patrick RöslerProfessor of Banking Law at the Allensbach University

Letter of comfort as loan collateral

Companies assume letters of comfort for their subsidiaries. It is important to differentiate between Soft and hard letter of comfort.

With the soft letter of comfort the patron lacks the legal will to make a binding declaration that could ultimately trigger payments. For example, he makes a non-binding declaration that he intends to manage the subsidiary in this or that way or that his business principles require him to do this or that. This has practically no value for the bank as loan collateral.

Only with the Hard letter of comfort the bank really has a collateral value. The patron gives a Equipment obligation agreement. In this agreement, he undertakes to the bank (External letter of comfort) to provide the subsidiary with sufficient financial resources to enable it to meet its obligations at all times. This is the only basis for the bank's right to demand payment from the sponsor to the subsidiary. However, there is no right to direct payment to the bank directly from the letter of comfort.

In practice, the letter of comfort is usually only exercised and, in case of doubt, legal action is only taken when the subsidiary is insolvent. Then the non-genuine contract in favor of third parties a claim for damages by the bank against the patron, which has breached its obligation to provide equipment.

With a internal letter of comfort the subsidiary only has a claim against the parent company; the bank cannot derive any claims directly from this. This can only be done by the insolvency administrator, who can assert the subsidiary's claims against the parent company in the event of the subsidiary's insolvency (controversial among courts and lawyers, some argue that the claims are lost in the insolvency). 

Declaration of unity as loan collateral

With the Obligation to form a tax group or the Organizational reversal a parent company that has concluded a domination and profit and loss transfer agreement with its subsidiary undertakes to cover the subsidiary's liabilities beyond the scope of this agreement and not to cancel or terminate the agreement as long as the bank has claims against the subsidiary. In this way, the bank secures its loan to the subsidiary beyond the control and profit and loss transfer agreement.

Negative/positive declaration as loan collateral

With the Negative declaration the borrower undertakes not to grant any other creditors security over a specific collateral or all of his assets. Any breach entitles the borrower to terminate the loan without notice.

With the Positive declaration In contrast, the borrower undertakes in a preliminary collateral agreement to provide specific collateral for a specific asset at the bank's request, such as a land charge on his business property. This concrete positive declaration gives a claim to a specific security. It is often drawn when the debtor's creditworthiness deteriorates.

From the general positive declaration The right to collateral reinforcement, which is also contained in No. 13 AGB-Banken and No. 22 AGB-Sparkassen, on the other hand, can only be derived from a claim to standard bank collateral at the debtor's discretion.

Very often, negative and positive declarations are also linked in an agreement. They can also be supplemented with a declaration of equalization obligation. The bank cannot attribute a direct collateral value to these declarations; only when the specific affirmative declaration has been successfully exercised does it have a further asset that it can use to guarantee the loan.

Equal treatment obligation, pari passu clause as loan collateral

With the in practice important Equality obligation or Pari passu clause the borrower undertakes to treat his lenders equally in terms of security. This means that if a company is financed by several banks, the borrower may only create a (pari passu) land charge on the business property for all financing banks and not just for one of the banks.

Third-party collateral, i.e. collateral that is not provided by the borrower, will regularly also be covered by the obligation, so that they must also be liable for all claims of the financing banks.

Financial covenants as atypical loan collateral

Financial covenants are a very popular form of "loan collateral" in large-volume and international corporate client business. In legal terms, this is not a collateral agreement, but a Subsidiary agreements to the loan agreement. The ancillary agreements relate to the observance or achievement (ascending covenants) of certain key business figures in the company. Examples include cash flow, equity, EBIT/EBITDA, gearing, etc.

In order to review the key figures, the Bank also has Information rights and obliges the borrower to adopt a consistent approach with regard to Accounting policies and valuation methods.

If the covenants are breached, the Bank can Post-collateralization rights (specific/general positive declaration) or Termination rights with the borrower. It is also possible to Risk margin increase when "tearing" certain key figures. However, this must be agreed as specifically as possible in order to withstand a GTC review.

When formulating such agreements, the bank must be aware that they are more specific (individual) agreements than the provisions on subsequent collateralization and termination in the AGB-Banks/Savings banks can be. These would then no longer be applicable to the cases of the specific covenant breach.

Atypical loan collateral: Summary

Atypical loan collateral are usually letters of commitment from the borrower, but also from third parties. Only in exceptional cases, such as a hard, external letter of comfort, can they be valued like conventional collateral. Financial covenants are borrower monitoring instruments rather than loan collateral, although they are usually called that.

If you are interested in such exciting instruments as atypical loan collateral in business, you should familiarize yourself with the Bachelor of Business Administration with a focus on "Banking" at Allensbach University employ.