The Financial Institutions (Secured Transactions) Act, 2016 received assent of the Senate last week. As Pakistan sets out to introduce the secured transaction law for financial institutions, the road ahead is not without challenges.

As a reference, a security agreement is where in case of default in repayment of loan the lender reserves the right of sale of an asset (collateral) of the borrower. This process of encumbering the property of the borrower is known as ‘attachment or creation’ of the security interest. The parties then seek to record the transaction in a collateral registry which is ‘perfection’ of a security interest.

Collateral registry is a systemised process, for creditors to record and prioritise their secured debts and, for borrowers to prove their creditworthiness (though this task is also partly performed by credit rating agencies). Every collateral is identified by a unique number in the registry which is accessible as public record.

A collateral, depending on its value, can be charged multiple times. Any subsequent creditor would be considered on notice of existing charges on a particular asset due to record of collateral register. In case of default of the borrower, the creditors have the right to sell the collateral and recover the loan amount.

While settling the claims of creditors for a collateral, ‘first in time, first in right’ is the general principle of priority followed. Among a group of creditors, a perfected creditor in all cases trumps an unperfected creditor and between two perfected creditors, the prior in time is considered superior in right. The process is mutually beneficial, as the lender bears a reduced risk of lending and the borrower benefits from financing at a cheap cost.

Where laws governing secured transactions are insufficient, uncertain, or absent, there is likely to be limited or no access to the affordable credit that is essential for business growth and investment in general. The secured transactions law has proved crucial to the success of SME sector in developed economies. In Pakistan, the scope of the new law is restricted to register only those transactions where the charged asset is moveable property (i.e. it is not land) and creditors are financial institutions.

Moveable assets account for most of the capital stock of a private firm, in particular of SMEs. A modern secured transactions law unlocks the potential value of moveable assets when it allows borrowing on its basis. The preferential treatment to financial institutions is justified due to their ready access to funds at any given time and ease of outreach to borrowers through an existing network.

For success of any secured transactions regime, it is imperative to have an efficient electronic collateral registry. In absence of a well-equipped system, even the best secured transactions law would be of no use. Though the new law envisions the creation of a centralised electronic registry with offices in multiple cities, it is yet to be seen if active steps would be taken for its establishment.

For a creditor, non-enforcement of security contract is a threat bigger than the default of a borrower. Creditors do contemplate default of borrowers in security agreements and seek repayment on its terms; however, if the agreement itself is not enforceable the creditor would have no way of redressal. Currently, Pakistan is ranked 151st for its contract enforcement (Doing Business report 2016). Where registration and preference received by the creditor in secured transactions regime seeks to reduce the information disparity, it also mitigates the risk of insolvency of the borrower.

A secured creditor has preferential rights over a charged asset, even if the borrowing entity undergoes bankruptcy or restructuring. Once bankruptcy proceedings initiate, a secured creditor can claim priority of security interest over all other creditors.

While the law is undoubtedly favourable for financial institutions, it discourages every other creditor to lend money to businesses. A secured creditor, by definition in the new law, can only be a financial institution. All other lenders, authorised or licensed by provincial governments, can neither register their interests nor can they receive preference under the new law.

All such unsecured lenders are regulated by the existing regime under the Contracts Act, 1872. The registration of a security agreement is optional which can be registered with sub-registrar on a district level. However, it is an unregulated regime with no clear rules as to preference, registration or perfection of interest. No separate collateral register exclusively dealing with moveable property is in place.

Another parallel regime is offered by the Securities and Exchange Commission where registration of security interests created only on the assets of a company are registered but there is nothing to help unincorporated businesses or entrepreneurial ventures.

In future, if a province decides to create its own centralised collateral registry with a different definition of secured creditor and distinct rules of priority of claims, an identical asset could be charged under more than one regime. In that eventuality, if there would be no coordination between two or more parallel regimes, the functioning of all laws would paralyse causing multiplicity of litigation.

The new legislation overrides the provisions of all existing laws and facilitates the financial institutions at the cost of reducing the lender base for a borrower. At the end of the day, the purpose of any secured transactions law is provision of affordable finance instead, the new law would allow financial institutions to monopolise the space.

A level playing field is not available to every other creditor whose security interest cannot be perfected and hence they cannot compete on equal footing with a financial institution. Inevitably, this would lead to heightened risk for such unsecured creditor and an overall increase in cost of financing for a borrower.

In developed economies, like US, a uniform public collateral registry is in place for both the moveable and immoveable properties on a state level and the secured parties include any type of creditor who provides value to the borrower.

There the secured transactions law does not discriminate between financial institutions and other creditors and all kinds of sources of funding are available to new start-ups, spurring the economic growth.

In the interest of creating an effective regime, it is best that a uniform collateral registry is created for all types of lenders by delegating the provincial and federal functions to one body or else this subject should be left to be dealt with by the provinces.

The writer is a lawyer.

fnazir@llm15.law.harvard.edu.

Published in Dawn, Business & Finance weekly, June 20th, 2016