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What are the best practices to reduce collateral disputes in loan agreements?

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Collateral disputes are one of the most common and costly sources of conflict in loan agreements. They occur when the parties disagree on the value, quality, or availability of the assets that secure the loan. Collateral disputes can lead to delays, defaults, litigation, or loss of trust. Therefore, it is crucial for lenders and borrowers to adopt some best practices to reduce the likelihood and impact of collateral disputes in loan agreements. Here are some of them.

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Kazim Ali

1 Define collateral clearly

The first step to avoid collateral disputes is to define the collateral clearly and precisely in the loan agreement. The collateral should be described in detail, including its type, location, ownership, condition, and valuation method. The loan agreement should also specify the rights and obligations of the parties regarding the collateral, such as maintenance, inspection, insurance, and reporting. By defining the collateral clearly, the parties can reduce the ambiguity and uncertainty that can lead to disputes.

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2 Use third-party valuation

Another best practice to reduce collateral disputes is to use third-party valuation services to determine the fair market value of the collateral. Third-party valuation can provide an objective and independent assessment of the collateral, based on reliable data and methodologies. The parties should agree on the selection, frequency, and scope of the third-party valuation, and include it in the loan agreement. By using third-party valuation, the parties can avoid biased or inaccurate valuation that can cause disputes.

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Irfan Hassan

Corporate Governance Specialist | Credit and Risk Management Expert | Islamic Banker | Trainer and Teacher
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The bank may not have the right expertise available inhouse to conduct the valuation of different collaterals. Therefore, third party valuation can be very helpful and also more acceptable to both the customer and the bank. If not already defined by the regulatory authority, the bank should define in its policy that if the amount of collateral exceeds a certain threshold than more than one collateral valuation from reputable valuators must be obtained and to be prudent, the bank should use the valuation with a lower value or the average of the two. This will minimize the risk for the bank.

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3 Monitor collateral performance

A third best practice to reduce collateral disputes is to monitor the performance of the collateral throughout the loan term. The parties should establish a regular and transparent reporting system that tracks the changes in the collateral value, quality, and availability. The parties should also communicate and cooperate in case of any events or issues that affect the collateral, such as damage, theft, or foreclosure. By monitoring the collateral performance, the parties can identify and resolve any potential problems before they escalate into disputes.

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Irfan Hassan

Corporate Governance Specialist | Credit and Risk Management Expert | Islamic Banker | Trainer and Teacher
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The bank should define the monitoring frequency of the collaterals in its policy document, in accordance with the prevailing banking regulations. Monitoring of those collaterals which fluctuate frequently with time should be done frequently. For example if the customer has given shares of companies which are traded on the stock exchange as security then they should be monitored on a daily basis and customer should be informed about the shortfall in the collateral in case the market value of the shares fall below a certain value. In case of property as collateral, it should be done on a minimum annual basis. In case the property values in the city have shown a significant downward trend, then as per loan agreement new valuation is required

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4 Negotiate collateral adjustments

A fourth best practice to reduce collateral disputes is to negotiate collateral adjustments in good faith and in accordance with the loan agreement. Collateral adjustments are changes in the amount or type of collateral that are required to maintain the loan-to-value ratio or other loan covenants. The parties should agree on the triggers, procedures, and timelines for collateral adjustments, and include them in the loan agreement. By negotiating collateral adjustments, the parties can maintain the balance and fairness of the loan agreement and avoid disputes.

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Irfan Hassan

Corporate Governance Specialist | Credit and Risk Management Expert | Islamic Banker | Trainer and Teacher
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The loan to value ratio should be used in the loan agreements for all types of collaterals. For those collaterals which can easily be converted into cash without recourse to a court of law, a letter of lien and setoff should also be obtained. If the value of the collateral falls below the level defined in the loan to value ratio the customer should be given a notice to top up the collateral e.g. stocks or reduce the financing amount. If the customer does not top up the collateral security or does not reduce the financing amount then the bank should set off the collateral security against the loan in accordance with the local banking laws and the policy of the bank.

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5 Use dispute resolution mechanisms

A fifth best practice to reduce collateral disputes is to use dispute resolution mechanisms that are efficient, effective, and enforceable. The parties should include dispute resolution clauses in the loan agreement that specify the methods, rules, and venues for resolving any collateral disputes that may arise. The parties should consider using alternative dispute resolution methods, such as mediation or arbitration, that can offer faster, cheaper, and more flexible solutions than litigation. By using dispute resolution mechanisms, the parties can minimize the costs and risks of collateral disputes.

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Irfan Hassan

Corporate Governance Specialist | Credit and Risk Management Expert | Islamic Banker | Trainer and Teacher
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Besides the dispute resolution mechanism, one of the best ways to reduce such disputes is to avoid them by ensuring that customers of good character and high net-worth and good cashflows are inducted by the bank.

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6 Seek professional advice

A sixth best practice to reduce collateral disputes is to seek professional advice from experts in risk management, law, finance, and valuation. Professional advice can help the parties to understand the legal, financial, and operational implications of the collateral, and to design and implement the best practices mentioned above. Professional advice can also help the parties to prevent, manage, or resolve any collateral disputes that may occur. By seeking professional advice, the parties can enhance their confidence and competence in dealing with collateral issues.

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Kazim Ali
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Very good points are covered in the suggestions, however, I would like to add another best practice is to register the collateral rights with the collateral regulatory authorities which can be different for each country i.e in Qatar we register our charge with ministry of justice to ensure there is no dispute on the lenders rights on the collateral. In some countries it is security of exchange commission which registers the charge.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Irfan Hassan

Corporate Governance Specialist | Credit and Risk Management Expert | Islamic Banker | Trainer and Teacher
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Collateral is a secondary source of repayment, primary being the cash flows of the company which has obtained financing and provided the collateral as a security. Depending upon the nature of collateral and the prevailing foreclosure laws in a country, the timeline for realization of collateral could be instantaneous to several years. It is often said that prevention is better than cure. Same analogy goes with the customers. If the customer has a good character than the chances of willful default would be low and the dispute on realization of collateral would not arise. Therefore, the due diligence to induct a customer should give significant weightage to the character and reputation of the customer as well as the cashflows of the firm

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What are the best practices to reduce collateral disputes in loan agreements?

1

2

3

4

5

6

7

1 Define collateral clearly

2 Use third-party valuation

3 Monitor collateral performance

4 Negotiate collateral adjustments

5 Use dispute resolution mechanisms

6 Seek professional advice

7 Here’s what else to consider

Risk Management

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What are the best practices to reduce collateral disputes in loan agreements?

1

2

3

4

5

6

7

1 Define collateral clearly

2 Use third-party valuation

3 Monitor collateral performance

4 Negotiate collateral adjustments

5 Use dispute resolution mechanisms

6 Seek professional advice

7 Here’s what else to consider

Risk Management

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