Improving SME lending through secured transactions reform

SMEs make up a large part of Sri Lanka’s economy, with over one million SMEs accounting for approximately 75% of all businesses across all sectors of the economy. SMEs are estimated to contribute about 45% of total employment in Sri Lanka. While the issues for SME competitiveness – including access to finance – have been widely discussed, these issues have only further aggravated due to the COVID-19 pandemic – Pic by Shehan Gunasekara 

• A review of recent efforts

By Zul Luthufi and Anushka Wijesinha

Small and Medium Enterprises (SMEs) in Sri Lanka have long suffered challenges in accessing finance, both for operating capital as well as for growth. While the problems are well known, the solutions for it have been in short supply. 

A recent initiative to address one aspect of the access to finance problem – collateral – has gained much interest and warrants closer exploration. This article serves to discuss Sri Lanka’s recent attempts at secured transactions reform, including a review of draft legislation crafted in this regard and highlights key features and why these are important for improving access to finance.

SMEs in Sri Lanka and access to finance challenges 

SMEs make up a large part of Sri Lanka’s economy, with over one million SMEs accounting for approximately 75% of all businesses across all sectors of the economy (IFC, 2020)i. SMEs are estimated to contribute about 45% of total employment in Sri Lanka and have important inclusive growth implications as SMEs are spread throughout the country. 

While the issues for SME competitiveness – including access to finance – have been widely discussed (for instance, Wijesinha et al. 2015), these issues have only further aggravated due to the COVID-19 pandemicii. As noted by ADB (2020), compared to large firms, SMEs are more vulnerable in times of economic downturn and supply-side shock because they (i) are too small to downsize, (ii) are less diversified in their economic activities, (iii) have lower capitalisation, and (iv) lack various financing optionsiii. 

Despite various Government schemes to provide relief – debt moratoriums and concessionary credit line (refinanced by the Central Bank), most SMEs are afraid to accumulate high interest debt burden and roll-over risk of working capital without sufficient revenue (ADB, 2020).

Even prior to the pandemic, SMEs faced difficulty accessing credit through banking and non-banking financial institutions, due to a variety of factors (as discussed in Wijesinha et al, 2015) most acute of which is their inability to provide acceptable or sufficient collateral, usually in the form of immovable propertyiv. This limited access to credit is also manifest in the proliferation of microfinance institutions and informal money lenders who lend funds at a higher interest rate than the prevailing market interest rate to the SMEs who seek additional capital to manage their enterprisesv.

Given the highly collateralised nature of SME lending in Sri Lanka, and little meaningful steps towards cash flow-based lending (usually reserved for prime customers), new solutions within the current system need to be found.

Secured transactions and SME financing

A robust secured transactions system has proved to be an efficient enabler for SMEs to gain access to creditvi. Since equipment, inventory and receivables can be secured as collaterals through secured transactions, a low cost flexible financing based on a business’s cash conversion cycle such as revolving loan facilities can be achieved. Secured transactions system lowers the cost of borrowing by enabling the secured creditor to assess their risk with a high degree of predictability, and by enabling the secured creditor to recover the encumbered asset in the event of non-payment or non-performance by the debtor. 

Research in the Pacific region has shown that SMEs are the major beneficiaries of secured transactions reform, and resulted in an increase of new loans to these firms within a short span of timevii. This system also includes a mechanism to achieve third-party effectiveness by allowing for the secured creditor to register a notice of the collateral used in a secured transaction quickly and inexpensively. By registering a notice of collateral, secured transactions allow for concurrent security rights to exist and have different priority status in the same assetviii. The notice enables credit information to be maintained and disseminated, and for the security interest in an asset to be ranked through a centralised system.

Transactions that create a right in any type of asset meant to secure the performance of the debt should be considered secured transactions. These transactions include, but are not limited to, chattel mortgage, conditional sale, debenture, fixed charge, floating charge, pledge, and trust indenture or trust receiptix. Having a centralised collateral registry and modern secured transaction laws also contributes to the ease of doing business and the strength of credit reporting systems. In fact, the effectiveness of collaterals in facilitating lending are considered in the World Bank’s Doing Business Index (DBI) under the ‘Getting Credit’ pillar. So, any moves to reform this space will help the country improve its DBI scores. 

Secured transactions reform in Sri Lanka will help to democratise formal lending since businesses and individuals can access credit in situations where unsecured credit would not be available at a reasonable cost or would not be available at all. Movable assets being used in income generation in the SMEs such as trade stock, equipment, etc., are readily available to SMEs and banks can start taking these as collateral, like how they often do with large and prime customersx.

Secured transactions reform and the Sri Lankan context

Sri Lanka ranks at 132 out of the 190 countries when scored under the Getting Credit pillar of the DBI, scoring well below the regional average and well below that of India, which is ranked 25th globally.

A positive take away from the DBI is the appreciation of available credit information maintained by the Credit Information Bureau of Sri Lanka (CRIB)xi. The CRIB, established under the Credit Information Bureau of Sri Lanka Actxii, claims to be one of the first credit bureaus in the South Asian region and is established under a Public-Private Partnershipxiii.

The legacy system in Sri Lanka allows for the debtor’s movable property to be secured as collateral for availing financing facilities through the Registration of Documents Ordinancexiv. The Registration of Documents Ordinance provides that a pledge, mortgage, or bill of sale of movables will give the creditor rights on the property that is being secured where the property is actually delivered into the possession and custody of the creditor or where the pledge, mortgage or bill of sale of movables is created by a written and signed instrument and is duly registered within 21 days, with the Registrar of Landsxv. Intangible property too being a movable asset can be secured through the Registration of Documents Ordinancexvi.

The Companies Actxvii allows for a floating charge to be created over movable and immovable property, uncalled capital, circulating assets, including cash, stock in trade, raw materials, book debts and other receivables of the companyxviii. The Companies Act by allowing floating charges, subject to Registration of Documents Ordinance and the Mortgage Act, allows a creditor to secure a lien over non-constant assets. 

Furthermore, the Mortgage Actxix provides for the registration of a mortgage of a motor vehicle to a person and the effect of registration of a mortgage of a motor vehicle is that the registered mortgage shall subsist despite any subsequent sale, mortgage or other transaction to any third partyxx.

However, though the legacy system allows the use of movables assets as collateral, a modernised system that enhances efficiency, transparency, and accountability is necessary to facilitate greater access to finance for SMEsxxi. 

Efforts at secured transactions reform in Sri Lanka

In 2009 Sri Lanka enacted the Secured Transactions Actxxii to provide an improved legal framework for securing obligations through movable assets and to establish the Secured Transactions Register to be maintained by the CRIB. However, the Secured Transactions Act, according to the International Finance Corporation (IFC), falls short in increasing the flow of secured credit and requires further amendments to promote its efficient usexxiii. The IFC concludes that the current registration system of notices under the Secured Transactions Act (STA) makes it difficult to determine whether an asset offered as security has already been used as collateral at another bank and that the registration of assets does not provide legal protection against third partiesxxiv.

The Secured Transaction Law Reform Project, a project set up by Professor Roy Goode with a group of academics and professionals interested in the issue of secured transaction reform, claim that the Secured Transactions Act was not a “wholesale reform of the law” and that the STA is missing of a “number of important features” in a modern secured transaction regimexxv.

Although its shortcomings, the STA succeeded in setting up the Secured Transaction Registry maintained by the CRIBxxvi. The Secured Transactions Registry is an electronic database where secured creditors are able to notify their security interests in movable goods and so that the secured creditor will have priority in that security interest. 

The Director of Bank Supervision of the Central Bank of Sri Lanka on 8 August 2011, directed all licensed banks to register any pledge, mortgage or obligation on movable assets as collaterals for loans and other banking facilities, as provided for in the Secured Transactions Act, in the Secured Transactions Registry and to utilise information which can be obtained from the CRIB for their credit risk management decisionsxxvii. Services provided through Secured Transactions Registry include the initial registration of notices; continuation, amendments and termination of such notices; supplying searching services for current and historical records.

Realising the shortcomings of the STA and to remedy such shortcomings, on 1 February 2013 the CRIB entered into an agreement with the IFC to obtain relevant technical assistance and to pave way for a “well-developed Secured Transactions Act”xxviii.

The proposed new Bill

On 16 August 2019 a bill titled Secured Transactions, was published in the Gazette and presented to Parliament by the Minister of Finance on 23 October 2019. The Secured Transactions Bill, seeks to address the shortcomings in the current secured transactions legal framework. The Bill drafted with the technical assistance of the IFCxxix has notable features when compared with the existing STA. A summary of these additional features is set out below. 

Apart from the assistance provided by the IFC, various other institutions such as the United Nations Commission on International Trade Law (UNCITRAL) have provided a case for reform and have set out model laws for reforming secured transaction laws by incorporating principles of a modern secured transaction legal frameworkxxx. In addition to the UNCITRAL Model Law on Secured Transactions, Article 9 of the Uniform Commercial Code and the European Bank for Reconstruction and Development Model Law on Secured Transactions are widely used model laws on secured transactions which a state may choose to adopt into their national legislation in order to harmonise and modernise secured transactions laws in that state. 

The principles in these model laws are for an effective secured transactions legal framework, where a debtor is able to provide as collateral their movable asset to the creditor, and the creditor is able to enforce their rights on the collateral, not only against the debtor but also against a third party. For this, each party’s rights and obligations must be defined by law. The Secured Transactions Bill sets out the formalities and the prerequisite in order to create these rights and obligationsxxxi.

A security right under a secured transaction is a right in rem, or a property right, that is created through a security agreement under commercial circumstances. 

Although the Secured Transactions Act does not specifically provide for a security agreement, in terms of the Secured Transactions Bill a security right attaches to the collateral only once a debtor enters into a security agreement with the secured creditor. A security agreement must include the value and a description of the collateral sufficient to enable it to be identified, whilst the debtor should have rights in the collateral or the power to transfer the rights in the collateral in order to create a security right in the collateralxxxii. How a secured agreement is created is not limited to writingxxxiii. Additionally, a security right is formed even without a security agreement when the creditor is in possession of the collateralxxxiv. There is also precedent in other jurisdictions, where in the event there is no express security agreement, the court has interpreted whether a security agreement is implied by the partiesxxxv.

In terms of the new Bill, in addition to the security agreement, a financing statement is required for the creditor to enforce his or her security interest against a third partyxxxvi. A financing statement is a notice that is prepared in the prescribed form and is registered in the Secured Transaction Registry in order to gain priority over the collateral. A security interest is perfected when a security interest has been validly createdxxxvii.

The new Bill also contemplates situations where a financing statement that is registered should, as a matter of course, be amended, after the creditor is informed in writing by the debtor. For example, when the obligation under the security agreements to which the financing statement relates has been performed the secured creditor will be notified and is required to discharge the financing statementxxxviii. 

The Bill also allows a security interest to stretch beyond the collateral described on a financing statement filed by the secured creditor to include proceeds obtained upon the sale of the original collateralxxxix.

Having given practical thought by the drafters of the Bill, in order to minimise the disruption caused in day to day business activity, the Secured Transaction Bill states that a buyer of goods from a seller who sells the goods in the ordinary course of business takes them free of any security right, even though it is perfected and the buyer knows of it, unless the buyer was also aware that the sale constituted a breach of the security agreementxl.

The road ahead

Since tabling of the Bill in late 2019, there has been little interest in putting it before Parliament for debate and subsequent approval, although the obstacles for SMEs to access credit remain and the present Government has a stated goal of supporting SME development. It is now time to accelerate the passage of the Bill, after stakeholder dialogue in order to ensure the reforms are feasible, comprehensive and actionable. 

Insolvency laws also play a part in secured transactions reform. The realisation of collateral when a security agreement is breached results in the security right having little or no value to a secured creditor when insolvency proceedings have commenced. Thus, an effective secured transactions regime must go hand in hand with effective insolvency lawsxli. Insolvency laws should contain clear rules as to the effect of insolvency proceedings on the rights of a secured creditor, so as to enable secured creditors to quantify the risks associated with insolvency and incorporate those risks into their assessment of whether to extend credit and on what termsxlii. It is noteworthy that Sri Lanka Insolvency Ordinancexliii was enacted in the year 1854!

Additionally, in a globalised environment where credit flows across national borders, the recognition of security rights across jurisdictions will better enforce the rights of a secured creditor. Security rights are often lost once an encumbered asset is transported across national borders. Further, the harmonisation of secured transaction laws by adopting model laws on secured transaction will encourage creditors to extend credit in cross-border transactions and result in enhanced international tradexliv.

(Zul Luthufi is a corporate lawyer at a leading law firm in Sri Lanka with a background in economics. [email protected])

(Anushka Wijesinha is an economist and co-founder of the Centre for a Smart Future. He serves on the Boards of Seylan Bank PLC, HNB Finance PLC and Fairfirst Insurance and was formerly a member of the Monetary Policy Consultative Committee of the Central Bank of Sri Lanka. [email protected])

Footnotes

i IFC, 2020, Gendered Impacts of COVID-19 on Small and Medium-Sized Enterprises in Sri Lanka, https://www.ifc.org/wps/wcm/connect/region__ext_content/ifc_external_corporate_site/south+asia/resources/gendered+impacts+of+covid19+on+small+and+medium+sized+enterprises+in+sri+lanka

ii Wijesinha, A. and Perera, N. (2015), Banking on SME Growth: Concepts, Challenges and Policy Options to Improve Access to Finance in Sri Lanka, Working Paper Series, March 2015, Institute of Policy Studies of Sri Lanka: Colombo. 

iii ADB, 2020, ‘Impact Assessment of Covid-19 on Small and Medium Enterprises Financing in Sri Lanka’, https://www.adb.org/sites/default/files/linked-documents/49273-004-sd-03.pdf

iv Naleen Edirisinghe, 10 September 2013, Why banks insist on immovable property as collateral for advances, http://www.ft.lk/article/187586/Why-banks-insist--on-immovable-property-as-collateral-for-advances

v Amalini De Sayrah. (04/10/2019). Repayment and Relief: Addressing microfinance debt in Sri Lanka. https://groundviews.org/2019/04/10/repayment-and-relief-addressing-microfinance-debt-in-sri-lanka/ 

vi Paul Holden, Secured Transactions Reform and SME Access to Finance: Issues and Examples from the Pacific Region, ADB–OECD Study on Enhancing Financial Accessibility for SMEs 

vii Ibid 4

viii Ibid 5

ix Secured Transactions Bill, Clause 2 (a) (ii)

x Department of International Law Secretariat for Legal Affairs, Secured Transactions Reform In The Americas

xi World Bank Group, Doing Business 2020 Sri Lanka

xii No. 18 of 1990

xiii Credit Information Bureau of Sri Lanka (n.d). http://www.crib.lk/en/index.php/about-us-2

xiv No. 23 of 1927

xv Section 17 of the Registration of Documents Ordinance No. 23 of 1927

xvi F.J.& G. De Saram, Security over Collateral, Lex Mundi Publication

xvii No. 07 of 2007

xviii Section 427 of the Companies Act 

xix No. 6 of 1949

xx Section 102 and 103 of the Mortgage Act No. 6 of 1949

xxi IFC. (2018 March 29). Empowering small businesses through secured transactions reform that improve access to finance. http://www.ft.lk/financial-services/Empowering-small-businesses-through-secured-transactions-reform-that-improve-access-to-finance/42-652221

xxii No. 49 of 2009

xxiii Ibid 19

xxiv IFC. (2018 March 29). Empowering small businesses through secured transactions reform that improve access to finance. http://www.ft.lk/financial-services/Empowering-small-businesses-through-secured-transactions-reform-that-improve-access-to-finance/42-652221

xxv Secured Transaction Law Reform Project. (n.d). https://securedtransactionslawreformproject.org/reform-in-other-jurisdictions/asia/sri-lanka/

xxvi Section 07 of the Secured Transaction Act

xxvii Central Bank of Sri Lanka, Major Administrative Measures Adopted by the Monetary Board in 2011, Part III

xxviii IFC helps Sri Lankan Small Businesses Grow through Easier Access to Loans. (2013 February 1). https://pressroom.ifc.org/all/pages/PressDetail.aspx?ID=21474

xxix Ibid 27

xxx Ibid 3

xxxi Part III of the Secured Transaction Bill 

xxxii Clause 20 of the Secured Transaction Bill 

xxxiii Clause 19 (3) of the Secured Transaction Bill 

xxxiv Clause 20 (ii) of the Secured Transaction Bill 

xxxv In Tough Co. v. Wurlitzer in Court of Appeal of the State of California (unpublished), the Court in interpreting California Uniform Commercial Code § 9203 (UCC § 9-203) held that an enforceable security interest could be implied from the terms of the bill of sale and the creditor’s testimony.

xxxvi Clause 49 of the Secured Transaction Bill 

xxxvii Part V of the Secured Transaction Bill 

xxxviii Clause 60 of the Secured Transaction Bill 

xxxix Clause 19 and clause 31 of the Secured Transaction Bill 

xl Clause 34 of the Secured Transaction Bill 

xli Ibid 3

xlii Ibid 3

xliii No.24 of 1884

xliv Ibid 3