Volume 42 | Number 3 Summer 2007
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II. Poverty, Micro, Consumer, and Commercial Credit
From an economic development standpoint, poverty has been defined as a “lack of access to essential goods, services, assets and opportunities to which every human being is entitled.”7 Having lived among many who have experienced it firsthand, I would add despair and distrust for social institutions as predominant feelings among the poor. Unfortunately, those who experience such feelings have little impetus for self-improvement. What is even more unfortunate is that despair and distrust need not prevail. Even if poverty may never be completely eradicated, it can be significantly alleviated by legal institutions that make it possible for micro-, small-, and medium-sized businesses to obtain commercial and consumer credit at reasonable rates of interest.
A cursory review of recent literature of economic development reveals hopeful signs. For example, a December 2004 study by the Asian Development Bank (ADB) identified rapid, broad-based economic growth as the single most important factor in attaining poverty reduction.8 It showed that business growth, in particular, increases the demand for labour and the level of wages—further reducing poverty. Similarly, properly financed opportunities for self-employment have been proven to make an important contribution to poverty reduction.9
The above study is one among many serious economic and social science analyses conducted by various research institutions in the last two decades. They have confirmed that access to commercial and consumer credit is one of the essential elements of business and economic growth. Thus, it is becoming increasingly clear to economists and social scientists that the availability of commercial credit to small- and medium-sized merchants and their customers not only boosts overall economic growth (as reflected in significant gains in GDP), but it also reduces poverty.10 Accordingly, a 2004 World Bank study, using a broad cross-country sample, concluded that: “Financial intermediary development reduces income inequality by disproportionately boosting the income of the poor and therefore reduces poverty.”11
A. Micro-Credit and Its Non-Title Collateral
Some of this intermediation is attributable to “micro-credit,” a credit that enables individuals in the lowest income sectors of the economy to run very small businesses—micro-enterprises—that, in turn, increase household income and assets. Thus, micro-enterprise programs become effective fighters of poverty, and one of these programs has recently been rewarded with a Nobel Prize for its success in stemming despair and starvation in Bangladesh.12 In a nutshell, these programs make “‘cashew shellers in Senegal, avocado growers in Kenya, makers of hand-made paper in Bangladesh, and street vendors in Mexico less vulnerable to devastating crises.’”13
Micro-credit does not rely on the borrower’s title to his or (more frequently) her assets as collateral or as a source of repayment to the lender. It relies on the borrower’s appreciation of the importance of the loan and corresponding willingness to repay it. Appreciation and willingness are such that many borrowers are often willing to cover for each other’s liabilities.14 Yet, micro-entrepreneurs operating in the large informal economy—including many businesses owned by women—lack adequate financing to grow once their enterprise can start employing more than a handful employees. As a result, micro-enterprises “have less of an impact on economic growth than they might otherwise have.”15
Significantly, where commercial credit is available to small- and medium-sized enterprises, micro-enterprises can also become its beneficiaries and poverty is thereby further alleviated. As shown by the above-referenced World Bank Study, “the income of the poorest quintile grows faster than average GDP per capita in countries with better-developed financial intermediaries” (i.e., commercial or “mainstream” lenders).16 What is more, “income inequality . . . falls more rapidly in countries with higher levels of financial intermediary” lending.17 Not surprisingly, then, countries with developed financial intermediaries experience larger reductions in infant mortality and lesser reliance on child labor.18 Hence, as concluded by another World Bank economist, microfinance and finance of small- and medium-sized businesses are complementary, rather than competing, alternatives, especially when addressing the problem of poverty.19
B. Commercial Lending and the Self-Liquidating Loan
Unlike micro-credit, commercial lending enables the “mobilization” of the debtor’s assets as collateral and thereby facilitates repayment. This method of lending—institutionalized in eighteenth century England20 and fully developed in the twentieth century United States—stands in sharp contrast to the lending methods that prevail in most developing nations.21 In these nations, the debtors’ assets are pledged and immobilized either by the creditors’ possession or by their “safe” storage with third parties. Once immobilized, the release of these assets for resale, re-pledge, or transformation is only possible upon full repayment of the debt. In contrast, the Anglo-American commercial lending practice relies upon the mobilization of the assets by allowing the debtor to remain in possession of these assets and authorizing their use, transformation, exchange, or sale, thereby enabling the “self-liquidation” of the loan. As stated by the NLCIFT’s First Principle of Secured Transactions Law in the Americas, and as implicit in the OAS Model Law and the Latin American statutes and legislative drafts inspired by these principles:
Secured commercial and consumer credit is an effective tool for economic development because it allows the debtor’s use, transformation, sale or barter of collateral (mobilization). The mobilization of these assets leading to their sale or disposition makes possible the payment or self-liquidation of the loan . . . .22
1. Key Features of Commercial Collateral and the Immateriality of Its Title
Because of the self-liquidating nature of the commercial loan, its collateral has peculiar features. Firstly—and in contrast with the collateral in a home mortgage, which is immobile, long-lasting, and retains or increases its value during the life of the loan—the collateral of a commercial loan is mobile, perishable, and usually depreciates quickly in value. Consequently, and secondly, any moveable (tangible or intangible) object with sufficient market value to facilitate quick repayment of a commercial loan by its transformation, exchange, or resale can be collateral. Contrast this open number (numerus apertus) feature of commercial lending with the prevailing restrictive or closed number (numerus clausus) approach to collateral that prevails in developing countries.23 Thus, as pointed out by Safavian and Fleisig, Nigeria (among many other developing nations) recognizes only ten percent of the types of assets used in the United States as acceptable security for a loan.24
Thirdly, this open-numbered collateral can secure the loan of not one but many possible creditors simultaneously and successively. Consider, for example, the case of a retail merchant who seeks credit to purchase inventory goods such as shirts. These shirts, and the proceeds from their resale to the public, could be the collateral or part of the collateral that will secure the credit extended to him by a wholesaler or manufacturer, or by his bank. The proceeds of the sale of the shirts could also be collateral. These proceeds could be either moneys deposited in the retail merchant’s cash register after each sale, or they could be purchase orders, invoices, checks, promissory notes, or credit card receipts deposited in his creditors’ bank accounts, all as a result of daily, weekly, or monthly sales. Alternatively, they could be other inventory or other goods acquired as replacements for the originally-financed shirts. This revolving (including future-acquired) inventory and proceeds can serve as collateral for many creditors, with rights in them that can exist at the same time or be subsequently acquired. This “sharing” of present and future collateral by present and future creditors is possible because, from a legal standpoint, the ownership of the collection of goods that comprise the inventory and of their proceeds is fragmented into diverse possessory rights of specified scope or inclusiveness and duration. The enforcement of these rights requires that information be provided on the perfection of the possessory rights and their priorities to creditors or purchasers who may have an interest in relying on the same assets as collateral or in purchasing them. For this information to serve as effective and functional notice it must be a summary of the lien that is reliable, timely, and as public or widely accessible and as transparent as possible. Commercial and secured lending has no worse enemy than hidden or secret liens—i.e., rights that are either unrecorded or whose possession for security purposes is not apparent to a potential creditor or purchaser. Finally, enforcement of these possessory rights requires a quick, inexpensive, and extrajudicial procedure of repossession and resale.
Let us now observe the interaction between the fragmentation of ownership of the collateral and the possessory and malleable nature of the creditors’ rights in a typical U.S. financing scheme. Assume that the goods that will be manufactured will be the above-mentioned shirts. For ease of explanation (and contrary to what has become the U.S. commercial practice of outsourcing of most manual labor), let us assume that the shirts are manufactured in the United States. The manufacturer will need credit with which to purchase his raw materials and equipment. Accordingly, he will seek a loan from a bank and will grant this bank as a secured creditor a security interest. The security interest will typically include not only the raw materials and equipment but also the present and future inventory of shirts and their proceeds. Similarly, the wholesaler and retailers who will purchase the manufactured shirts from the manufacturer will need credit for their respective acquisitions.
In each acquisition, present and future inventories as well as their proceeds will serve as collateral. Yet, during the time the manufacturer’s shirts are being shipped by the manufacturer to the wholesalers or retailers, the bank that issued a letter of credit to pay for the shipped shirts on behalf of the wholesaler or retailer will also acquire a possessory right in these shirts. This security interest will be perfected by the manufacturer-shipper’s endorsement of a negotiable bill of lading, which attests to shipment of the goods, to the bank that issued or confirmed the letter of credit. This negotiable bill of lading will be issued to the shipper by the ocean carrier in charge of transporting the shirts to the wholesale or retailer. In endorsing the negotiable bill of lading, the manufacturer-shipper is not only creating the bank’s security interest, but is also providing notice of the existence of the security interest to the world at large. The reason for this notice is that by transmitting possession of a document that provides an exclusive right to claim the shirts from the carrier to the person holding the bill of lading, no one else can make such a claim. Hence, the bank’s possession of this bill of lading will entitle it to claim the delivery of the shirts from the carrier with a higher priority than that enjoyed by most other claimants of the shirts.
Among the claimants whose possessory rights or security interests are inferior to those of the bank that issued the letter of credit are: a) the sellers of the raw materials or equipment to the manufacturer of the shirts who are still owed part or all of their purchase prices, or the financiers for the manufacturer’s acquisition of the raw materials or equipment who are still owed all or a portion of their loans; b) the manufacturer who is still owed the purchase price of the shirts by the wholesale buyer of the shirts; c) the wholesaler who is owed the purchase price of the shirts sold to the retailer or the wholesaler’s bank, who has not been paid the amount lent to the wholesaler or retail merchant for their respective purchases of shirts; and d) the retail merchant who has paid part of the purchase price of the shirts to the manufacturer or wholesaler. These creditors or purchasers could not seek possession of the shirts or of the proceeds of their sale until the bank in possession of the bill of lading has been paid what it is owed for its issuance of the letter of credit.
On the other hand, there are two claimants whose possessory right to the shirts is superior to that of the bank. One of these claimants is the ocean carrier who has not been paid his freight charges and who is still in possession of the transported shirts. The other claimant is the consumer-buyer of the shirts who bought them from the retail or wholesale merchant in the ordinary course of their respective businesses. Where such a buyer exists, none of the pre-existing unpaid secured lenders or commercial purchasers can repossess or recover the shirts from him. The creditors’ secured claims could only be made effective against the proceeds obtained by the retailers, wholesalers, or manufacturers from the sales of the shirts to the consumers.
The above rights to the possession of the collateral are more malleable (if not ephemeral) than those of a typical home-mortgagee. Moreover, the only party whose right to the possession of the shirt approximates the right of ownership of a home-mortgagor is that of the consumer-buyer in the ordinary course of business. Yet, unlike the home owner, the possessory right of the consumer is not the product of a “historical” or linear chain of transactions or being the holder of a Hernando de Soto’s talismanic ownership document.25 The consumer-purchaser’s possessory right is a product of the lawmakers’ decision to protect a third party who is a stranger to the preceding chain of transactions. Without such a protection (which means providing the stranger with immunity against pre-existing possessory rights), the viability of a marketplace whose participants are predominantly strangers would be undermined as they would fear buying, borrowing, exchanging, or otherwise participating in the marketplace.26
What matters in the law of commercial lending, then, is not who is the “historical” owner of the shirts or who is the creditor with the best chain of title to the shirts, but who has the best right to their possession or to their market value at a given point during the transactional and useful life of the shirts or of their proceeds. Accordingly, the “being” of rights in a collateral such as the original inventory shirts, which can become cash or commercial paper and reappear as tangible goods (such as new shirts or other inventory) or be transformed into intangible goods (such as accounts or wire transfers), resembles that of the river described by the Greek philosopher Heraclites as: “You cannot step twice into the same river, for other waters and yet others go ever flowing on.”27 Accordingly, when a merchant pledges his inventory, title to this collateral is, in the words of the Uniform Commercial Code, “immaterial.”28 In the final analysis, then, the meaning of collateral in commercial lending is not a “thing” or group of things but the right to the possession of what becomes a stream of income generated by the use, transformation, sale, or exchange of commercial assets. And by assets we mean any object, tangible or intangible, deemed valuable in the marketplace by those who participate in it.
The economic and legal policies that determine who has the best right to the possession of that stream of income are, in the final analysis, those that make the river of commerce flow best by encouraging contributions to its stream. These contributions could be by sellers of raw materials, financiers of equipment, providers of services, or providers of financing with which to acquire any or all of the above items of value. The value of their contribution can be determined or ascribed by the lawmaker or by the parties to the loan on a quantitative or a qualitative basis, or as a combination thereof. It is now time to discuss the legal components of an effective system of secured lending.
C. Commercial Lending and Debtor and Creditor Protection
Fairness in the treatment of debtors and creditors is one of the most important components of an effective law of secured transactions. Poor debtors lack the bargaining power of most of their creditors and, hence, become vulnerable to exploitive and abusive lending practices. A lack of protection against these practices often leads to the debtors’ insolvency and to their inability to function as productive members of society. Where ordinary or bona fide debtors are treated as criminals, the result is not only inhumane but also counterproductive—the availability of credit does not improve, and the cost of credit continues to climb.29 For these reasons, debtor protection—particularly of those who are most vulnerable—contributes to the availability of credit for micro-, small-, and medium-sized businesses.
On the other hand, since credit is only extended when lenders are willing to lend, adequate creditor protection is key to the availability of finance for small- and medium-sized businesses as well as for micro finance. In the words of Chilean Central Bank economic researchers who studied the effect of inadequate monitoring of bank loans on poorer debtors: “[I]nefficient [creditor] legal protections, disproportionately increase financial restrictions for creditors that have less wealth.”30 The main reason for this restriction is the fixed cost of monitoring debtor performance by the lending banks. Because these costs are fixed and larger loans are more profitable, lending banks do not monitor the performance of smaller borrowers as carefully as they do that of their larger borrowers. Inadequate monitoring of small borrowers makes it easier for these borrowers to adopt riskier business and repayment practices. These practices, in turn, lead to a higher probability of insolvency.
Likewise, inefficiencies in bankruptcy procedures have a greater effect on small businesses than on large ones. Using a survey of practices in sixty-two countries, the same Chilean researchers explored the impact of creditor protection on the availability of bank credit to small- and medium-sized enterprises. They found that better protection of all creditors reduced the financing gap between small and large firms.31 In light of the above findings, we need to examine the role of legal and cultural factors in making commercial and consumer credit available at reasonable rates of interest in developing nations.