INVESTIGATION INTO COLLATERAL OPTIONS FOR LENDING TO MICRO AND SMALL ENTERPRISES

INVESTIGATION INTO COLLATERAL OPTIONS FOR LENDING TO MICRO AND SMALL ENTERPRISES September 2009 Vulindlela Development Finance Consultants, South Africa (Pty) Limited, and Kunene, Ramapala, Botha, KRB Law Firm

Table of Contents I EXECUTIVE SUMMARY AND RECOMMENDATIONS 2 II INTRODUCTION 12 III COLLATERAL FUNDAMENTALS 16 IV COLLATERAL SUBSTITUTES 20 V MARKET SIZE AND CHARACTERISTICS IN S.A. 23 VI SUPPLIERS OF MSE LOANS IN SA 26 VII SA ENVIRONMENTAL FACTORS 33 VIII BILLS OF EXCHANGE 40 IX SURETIES AND GUARANTEES 42 X MOVABLE ASSETS 44 XI LEASING AND INSTALMENT SALE 52 XII IMMOVABLE ASSETS 58 XIII CESSIONS 62 BIBLIOGRAPHY 67 INSTITUTIONS AND INDIVIDUALS INTERVIEWED FOR THE STUDY 2008/2009 69 ANNEX A NEW BUSINESS FINANCE CASE STUDY 70 ANNEX B SCHEDULE OF LENDER FRIENDLY LEGISLATION 74 ANNEX C PERUVIAN LEGISLATION 77 LIST OF ACRONYMS 83 Acknowledgements The authors would like to thank the large number of individuals and institutions who participated in this study, through sharing of experiences with the taking of collateral for micro and small business loans. We would like to extend a particular thanks to Mr. Graham Erasmus and his small business colleagues at Nedbank, Mr. Manu Muthusamy and Mr. Andre Tredoux, for sitting through multiple meetings, helping us to better understand the legislative constraints, and providing comments on the draft recommendations. A special thanks goes to Mr. George Watson and his team at New Business Finance, for allowing us to interrupt them over a three day period to prepare the case study provided as Annex A. We also appreciated the time taken by Mr. Roger Herbert of the Banking Association to explain the world of factoring and the new Invoice Clearing Bureau initiative in South Africa. Sharing experiences of microfinance beyond South Africa s borders, a special thanks goes to the team at ACCION International, and particularly to Ricardo Calvo who provided details of the Peruvian Legislation for a Global and Variable Security. We would also like to thank Finmark Trust for believing that collateral for micro and small business lending is a subject worthy of study and reform and for providing the financial support to take this forward. This investigation required a comparison of the law on paper with the law in practice. Seemingly inconsistent experiences had to be untangled and interpreted. The authors welcome feedback including corrections, criticism, or additions. Please send any comments to Barbara Calvin at bcalvin@vulindlelasa.com; or 082 826 7609.

List of Tables 1 Market Segments by Business Sophistication Measure (BSM) 3 2 Summary of Security Instruments 7 3 Qualifying MSEs per Province 24 4 Demographic Profile of the Micro and Small Business Segments 24 5 Business Profile of the Micro and Small Business Segments 25 6 Stability and Sophistication of the Micro and Small Business Segments 25 7 Illustrative Examples of Costs of Collections 37 8 Sector-by-Sector Potential for Asset Financing 55 9 Growth of Factoring 1998 to 2003 62 List of Boxes A Government References to the Collateral Policy Environment for MSE Lending 13 B Reasons Provided by Bankers for not Lending to MSEs 13 C NSIC Small Scale Business Rating System 22 D Theoretical Steps for Ordinary Summons 35 E Theoretical Steps for Special/Provisional Summons 36 F Data Collected and Provided by Credit Bureaus 39 G ACCION International Partners in India 40 H Challenges to Individual Microenterprise Lending in India 45 I Eligibility Criteria for Grameen Leasing Programme 54 J CASE STUDY SELFINA Tanzania 54 K BRI Unit Desa Philosophy 59 L Explanation of the einvoice Clearing System 65 1

I Executive Summary and Recommendations Introduction The primary purpose of this investigation, initiated by FinMark Trust, is to determine whether collateral constraints are one of the causes for the perceived financing gap for micro and small enterprises (MSEs) in South Africa. The study further intends to identify risk management strategies utilised in other countries, which could become attractive to lenders in South Africa, and identify policy options which could lift constraints in order to stimulate greater investment in the MSE sector. The study focuses on collateral options for loans ranging from R10 000 ($1 133) to R250 000 ($33 333), defined as the primary financing gap. Collateral is an asset pledged by a borrower to a lender until a loan is paid back. If the borrower defaults, then the lender has the right to seize the collateral and sell it to pay off the loan. 1 Assets can be physical, such as land, buildings, equipment, or vehicles; financial, such as a bank deposit or share certificate; or intangible, such as a personal guarantee. Most lenders agree that collateral plays three roles in lending: it demonstrates the commitment of the borrower prior to disbursement of the loan; it concentrates the mind of the borrower during the life of the loan; and it partially mitigates the loss in the event of default. 2 Borrowers prefer collateral that is easily available, minimises impact on the household, and minimises transaction costs. Lenders prefer collateral that can be appropriated in a timely manner, is marketable, minimises transaction costs, and provides protection in the event of liquidation. Each collateral option will be assessed in relation to these preferences. Collateral law does not exist as a distinct entity, but as a range of compartments of private law which combine to regulate the manner in which parties go about creating, perfecting, and enforcing security interests. These include contract, property, credit, commercial, bankruptcy and judicial process laws, as well as decrees governing asset registers. A collateral substitute involves a consequence of default which is a deterrent to the borrower but does not involve an asset. These include such items as group guarantees, letters from a local authority, supplier credit arrangements, or a credit bureau listing. Collateral substitutes are not included in this investigation. Client Market in South Africa Considering the five business segments defined in the National Small Business Act, the two segments covered by this investigation are the micro enterprise segment and the very small enterprise segment. Excluded segments include the survivalist enterprises, which would not qualify for a loan of R10 000, and the small and medium enterprises, which generally require more than R250 000 in financing. 2 1 Balkenhol B and Schutte H, Collateral, Collateral Law, and Collateral Substitutes, Social Finance Programme, Working Paper No. 26, 2001, Employment Sector, International Labour Office, Geneva, pg 7. 2 Related to this final point is the advantage of lower loan loss provisions for loans with collateral.

Applying the segmentation system utilised in the FinScope Small Business Survey, Gauteng 2006, and summarised in Table 1 below, we have further defined the two distinct markets to be covered by this survey: 1. Microenterprise market: Enterprises falling into Business Sophistication Measure (BSM) segments 4 to 6, which could qualify for a loan of R10 000 to R50 000, comprise the upper end of the microenterprise market. The estimated size of this market nationwide is 525 000 enterprises, of which approximately 27% reside in Gauteng. 2. Small enterprise market: Enterprises falling into segment BSM 7, which could qualify for a loan of R50 000 to R250 000, comprise the very small enterprise market. The estimated size of this market nationwide is 160 000, of which approximately 50% reside in Gauteng. Table 1 Market Segments by Business Sophistication Measure 3 BSM 1 to 3 Survivalist BSM 4 to 6 Microenterprise BSM 7 Small Enterprise Estimated number Nationwide* n/a 525 000 160 000 Registered 1% 16% 94% Business Sole Source of Household Income 81% 75% 74% Operate From Footpath Home Home/ Shop/ Office Education Level Some High School Some High School / Matric Post Matric Avg No. of Employees 0.1 to 0.2 0.47 to 1.78 8.88 Computers 0% 6% 77% Financial Records 18% 46% 93% * Only those estimated to qualify for loans of R10 000 and above The first three segments of the market (BSM 1 to 3) are operating at the low end of the microenterprise market and are not covered in this study. As illustrated, significant differences are found between the microenterprise market, represented by BSM levels 4 to 6, and the small enterprise market, represented by BSM Level 7. Business owners in the latter segment tend to be more educated and utilise computers and keep financial records. These businesses tend to be registered, often operate from premises separate from their homes, and provide employment. Despite these differences, however, the collateral options best suited to one segment are similar to those best suited to the other, and the same regulatory and judicial bottlenecks are hindering lending to both markets. Suppliers of MSE Loans in South Africa A profile of current lending to the MSE market in South Africa confirms that a financing gap exists for loans from R10 000 to R100 000, and particularly among previously disadvantaged enterprise owners. This fact was also identified by the Task Group of the Policy Board for Financial Services and Regulation early in the decade: For those SMEs with acceptable credit histories and sufficient collateral, access to bank credit appears to be satisfactory. For start-ups, micro-enterprises, entrepreneurs from previously disadvantaged communities or any other group with limited collateral or weak (or limited) credit histories, access is more limited. 4 3 FinScope Small Business Survey, Gauteng, 2006. 4 SME s Access to Finance in South Africa, a Supply-Side Regulatory Review, 2001. 3

Commercial Banks: The commercial banks all offer overdraft facilities to registered business entities which have maintained a current account for six months or more. These overdrafts are secured by personal sureties from the business owners. This form of financing, however, is not available to unregistered entities, the amounts are generally capped at 10% of annual turnover of the business, current account fees are high, and bank branches are not generally convenient to enterprises based in townships. As a result, less than 50% of these facilities are extended to previously disadvantaged individuals. ABSA Bank and Nedbank have launched strategic initiatives to better serve the small enterprise segment. These two institutions are the largest users of the Khula Indemnity Programme and have both introduced non-financial support programmes for small business. Both admitted, however, that the cost of serving this market is high and they prioritise term loans above R100 000. The cost of realising on collateral, including the Khula Indemnity Programme, leases, instalment sale agreements, or notarial bonds, is such that loans below approximately R80 000 are not attractive. Consumer Lending Organisations: Despite their familiarity with the lower income and previously disadvantaged markets, consumer lending institutions have not yet managed to succeed in MSE lending. While organisations claim that a significant proportion of their advances supports enterprise activities, the loans are approved in relation to a proven salary and not a self-employment income. Since over 75% of respondents in the FinScope Small Business Survey claimed that their business income was their sole source of household income, it is unlikely that the salary based consumer loans are reaching a large proportion of these households. African Bank attempted to serve this market in the early part of the decade with four separate initiatives: a contractor financing programme, a factoring programme, a taxi leasing programme, and a supplier credit franchise programme. For a variety of reasons unique to each programme, not one succeeded and African Bank lost a significant amount of money in this market segment. Where fraud was involved, it took many years for the cases to work through the court system and very little was realised at the end. Thuthukani Financial Services, the Real People Group, and Capitec Bank have all investigated this market but, due to perceived high costs, have not yet launched a product. Blue Financial Services is the only consumer lending organisation identified as currently active in this market, with the Small Business General Finance Programme having been launched in April 2008. While the policy provides for loans from R15 000 up to R3 000 000, the smallest loan advanced by the end of 2008 was R60 000 and the average loan size was R470 000; Blue is clearly also prioritising loans at levels above R100 000. Developmental Enterprise Lenders: While three group lending microfinance institutions extending loans below R10 000 have managed to reach scale and a high level of operational self-sufficiency (Small Enterprise Foundation, Marang Financial Services, and Women s Development Business), not a single individual lending organisation extending loans from R10 000 to R100 000 has managed to do the same. Many institutions and initiatives have been launched but have not survived. The two existing individual lending organisations which participated in this research, New Business Finance and Business Finance Promotion Agency, have managed to maintain loan loss rates at reasonable levels of between 5% and 9% of average portfolio outstanding over the past five years, but their operating costs are high due to the personalised service required for each client and they have not yet reached a self sufficient level of operation despite portfolios of over R20 million each. Factoring Companies: While factoring and invoice discounting is a common form of financing for the better established small and medium business sector, given the ban on cessions of accounts receivable for government contracts, factoring companies currently do very little business with the previously disadvantaged small enterprise sector. 4 Development Finance Institutions (DFIs): Staff at the two direct lending DFIs which participated in this study, Umsobomvu Youth Fund microenterprise division and Ithala Development Finance Corporation, admitted that their loss rates are high. Due to political mandates, they do not follow best practices for commercial microenterprise lending, such as rigorous pre-loan assessments and timely collection of arrears. They also serve high risk clients, such as start-up businesses, and high cost clients, such as those located several hundred kilometres from a branch office. While some previously disadvantaged small business owners are clearly benefiting from these services, the cost of sustaining these programmes is very high. A private sector solution would be preferable in the long run.

Environmental Factors in South Africa South Africa does provide an environment which is generally lender friendly, with an established credit bureau sector, well functioning private auction houses, and a fair legislative framework. Several policy initiatives over the past five years have been targeted at improving the environment for lending to MSEs, such as the introduction of the National Credit Act to replace a problematic set of credit laws. The primary shortcoming in South Africa is the judicial system, which is widely recognised as being inefficient and open to favouritism or corruption. Although on paper the period from client default until court judgment should take no more than three months, in practice this period requires six to 12 months or more. Problems encountered include lost files, a limit on the number of summonses which are issued per day, inefficient service from sheriffs of the court, inexperienced clerks of the court, corruption, difficulty in tracing clients or assets, varying interpretations of the National Credit Act, and delays in the granting of judgments. Furthermore, by the time judgment is received, the assets which may have mitigated the loss are often sold, missing, or damaged. Since a creditor cannot secure an emolument order from a self employed individual, the delays are particularly harmful for MSE lending. A final challenge is the value to be realised from appropriated assets. With unsecured loans or loans secured solely by a personal surety, a creditor is obliged to utilise a public sheriff to repossess and auction the assets at a sale in execution, where assets are often sold at prices significantly below market value. 5 For a small loan below R100 000, therefore, the costs of collection are very high in relation to the value to be realised. As shown in Table 7 in Section VII, the fixed costs of collection for a loan with a six month legal process, utilising a Magistrate s Court and irrespective of the loan size, are estimated to average R11 000. 6 Once auctioneer fees are added, the realised value is even lower. Inefficient judicial systems are a common characteristic of developing countries: In the context of societies in transition, and developing economies in general, there is also often a divergence between the formal and the actual operations of the legal framework. A complex set of socio-political factors is commonly at play to create this divergence. A contributing factor, often at work, is the sheer inefficiency of the judiciary. In effect, this raises the transaction costs considerably, adding to the risks associated with small financial transactions. 7 In South Africa, the concept of self help in legal matters is not permitted and microenterprise lenders may not function in an extra legal manner as seen in other countries, where clients have not challenged lenders who have recovered assets. Growth in the micro and small enterprise lending sector will continue to be slow until judicial solutions are developed to reduce the costs of security realisation. These solutions will need to incorporate two strategies: 1) A reduction of the role of sheriffs and other court actors in the realisation process; and 2) An improvement in turnaround times of the courts. Comparison of South African with Global Security Practices Globally, micro and small enterprise lenders depend on a wide range of security instruments, depending on the economic and cultural context and legal and judicial framework in each country. In principle, MSE lenders have adopted the collateral options which allow for swift action, timely realisation, and preference in the event of liquidation. 5 If a judgment is issued to repossess an asset which is leased, or subject to an instalment sale agreement or specific notarial bond, a lender may choose to utilise a private repossession agent and sell the goods at an auction run by a private auctioneer, where values realised tend to be higher. 6 High court costs for loans over R100 000 would be even higher. Table 7 provides illustrative examples, recognising that there are a wide variety of situations. 7 SME s Access to Finance in South Africa. A Supply-Side Regulatory Review, by the Task Group of the Policy Board for Financial Services and Regulation, 2002, pg 32. 5

Unsecured Loans: While microenterprise lenders worldwide offer unsecured loans for small loan amounts, once loans reach R10 000 they are typically supported with some form of security. In South Africa, unsecured loans have propelled the dramatic growth of the consumer loans industry over the past decade. This approach to lending will not support satisfactory portfolio quality for MSE lending, however, for the following reasons: 1) an emolument order is not possible so a writ of execution to seize assets is the only recourse, 2) a public sheriff must be utilised to appropriate the assets, 3) the sheriff is likely to submit a nulla bona return claiming there are no assets of value (due to assets being moved or the sheriff favouring or being bribed by the borrower), and 4) for the small proportion of cases which do end in a sale in execution, the value realised is likely to be low. Bills of Exchange: In many countries, a signed cheque is considered an unconditional promise to pay, or an unequivocal acknowledgement of debt, and is therefore supported by an expedited legal process. Undated or postdated cheques are utilised in both Egypt and India to secure microenterprise loans. In both countries it is a punishable offence to write a cheque without sufficient funds to honour it and realisation steps are faster than for normal credit agreements. In Egypt, cheques can be purchased in book stores by individuals who wish to contract with one another. In India, most urban based micro and small enterprises operate a cheque account. In South Africa, bills of exchange are also entitled to an expedited legal process, as described in Section VIII. It is not permissible or acceptable, however, to incarcerate an individual for dishonouring a debt in South Africa. In addition, cheques are becoming outdated as electronic payment mechanisms take their place. Finally, possession of a returned cheque still does not address the time delays and inefficiencies of the courts. Personal sureties: Personal sureties from owners of micro and small enterprises are utilised globally and in South Africa to secure loans to registered entities. These instruments, however, do not provide preference in the event of insolvency and are just as vulnerable to inefficient court procedures and low returns on public auctions as unsecured loans, as discussed above. Since a creditor must exhaust legal proceedings against the registered entity before taking legal action against the surety, this form of collateral also involves further delays. Third party guarantees: In certain countries where there is a high level of formal employment or a strong cultural imperative to repay debts, such as in Zimbabwe early in the decade, personal guarantees have been utilised by microenterprise lenders as a primary source of security. Taking a guarantor is costly, however, for a lending organisation as it must conduct pre-loan screening on the guarantor as well as the borrower. In South Africa, the majority of microenterprise owners cannot provide guarantors who have a steady source of income. Furthermore, for those who do locate a guarantor, the courts hesitate to enforce the guarantee if the individual claims they did not understand the commitment they were making. Movable assets: Attachment of movable assets is the most common form of security utilised globally in individual microenterprise lending. This is because movable assets meet each of the borrower preference criteria: availability, minimal disruption to household or business and low transaction costs. The legislative framework is not always conducive to this type of collateral, however, and some microfinance institutions find themselves skirting the law or finding alternative approaches. In South Africa, the law is not supportive. If an asset is pledged, possession of the asset must pass to the creditor unless a notarial bond is registered, but perfection and realisation of notarial bonds is expensive and time consuming. Creation of a constructive pledge, whereby the client consents to appropriation at the point of default, tends to result in clients refusing to sign the release form, particularly among the microenterprise market. Peru is one example of a country which has introduced a new type of floating pledge in order to overcome these obstacles for loans up to USD $30 000 secured by movable assets. In the Peruvian model, the borrower is deemed to be a custodian of pledged assets for the creditor. If the borrower defaults, the creditor may demand that the custodian return the assets within 24 hours, without obtaining a court order. It is a punishable offence if the custodian fails to comply. 6 Leases and instalment sale agreements: These instruments are utilised widely in financing for micro and small enterprises as they generally provide preference to the creditor in the event of default and, in many countries, a creditor does not require a court judgment prior to appropriating the asset. In some countries, such as Tanzania and Bangladesh, leases are offered for assets worth as little as USD $75. In South Africa, leasing and instalment sale agreements (referred to as asset finance) are preferred for assets worth R100 000 and above. With regards to registered businesses, a creditor can often succeed in getting the borrower to sign a release form upon default,

Table 2 Summary of Security Instrument Advantages and Disadvantages Characteristics Unsecured Loans An ordinary summons process is followed. Following judgment, a writ of execution is issued to seize assets. A negative listing is reported to the credit bureau. Bills of Exchange (signed cheques) A signed cheque is an unequivocal acknowledgement of debt. Utilised successfully in microfinance in countries where it is a criminal offence to dishonour a cheque (eg, Egypt and India). Personal Sureties (of owners of a registered business) The same as for unsecured loans, but consequences affect both the registered business and the owner(s). Third Party Guarantors Similar to unsecured loans but can rely on the guarantor to apply pressure on the borrower.). Pledging of Movable Assets (business and household equipment, furniture, and vehicles) For a pledge to be legally binding in South Africa, possession of the asset must transfer to the lender or a notarial bond must be registered with the deeds office, or the client must sign a consent form at the point of appropriation. This security is suitable for financing working capital requirements. Leases and Instalment Sale Agreements Appropriate instruments when a borrower is purchasing a new or used asset. Used widely in MSE financing globally, including assets with values as low as USD $75. Immovable Assets (land and buildings) Utilised widely in small enterprise financing globally. Perhaps the most reliable form of collateral. Cessions of Payments Cessions of accounts receivable in the form of invoice discounting and factoring are widely utilised in small enterprise financing worldwide. Advantages Administratively simple. Theoretical legal process 90 days. An expedited provisional summons process can be followed. Theoretical legal process 30 days. Legal action is taken against two entities: the registered business and the owner. More than one source of security is available. May proceed against the guarantor concurrent with the principal debtor. Provides more protection as the guarantor may have higher valued assets than the borrower, or an income against which an emolument order may be secured. Movable assets meet all borrower security preferences if they can remain with the borrower. Movable assets meet all lender security preferences if they can be appropriated in a timely manner. Specific notarial bonds provide preference in liquidation. General notarial bonds provide an opportunity for power of management. Allows for repossession and sale by a private auctioneer with a reserve value (only after issuance of a court order). Can be repossessed without a court order if client signs a release form. Can apply for an urgent application for judgment if the asset is at risk of being moved or damaged. Provides preference in liquidation. Procedures for registering and realising the asset are well understood and widely utilised. Provides preference in liquidation. The risk is based on the creditworthiness of the large buyer rather than the supplier. There is less risk than other securities as production and delivery have already taken place. Provides preference in liquidation. Disadvantages Actual legal process six to twelve months or more. Must use a public sheriff for repossession and sale. Majority of sheriff returns claim no assets of value. When assets are sold at a public auction, realised values tend to be low; the process is open to favouritism and corruption. No preference in bankruptcy. Provisional Summons still subject to inefficiencies of the courts. Subject to same disadvantages of public sheriffs and auctions as listed above. Cheques are becoming outdated. No preference in bankruptcy. Need to proceed against the registered entity first, before taking legal action against the individual. Subject to inefficiencies of the courts. Subject to same disadvantages of public sheriffs and auctions as listed above. Verifying a third party guarantor requires significant effort during the loan assessment phase, particularly if the individual is not employed. Few borrowers can identify a willing guarantor. The courts are hesitant to enforce this security if the guarantor is a family member who can claim they did not understand the commitment they were making. Subject to inefficiencies of the courts. Subject to same disadvantages of public sheriffs and auctions as listed above. If possession of the asset is transferred to the lender, the asset can no longer be utilised in a productive capacity. This approach no longer has commercial appeal except for the pawnbroking industry which makes short term loans primarily for consumption purposes. Notarial bonds are costly to register and realise; many attorneys are not experienced in this process; courts interpret requirements in different ways. Still subject to inefficiencies of the courts. Less flexible form of financing than pledging of movable assets; can only be accessed when purchasing a fixed asset. Tracing of assets can be a challenge. Involve more administration than other forms of financing, due to requirement to verify suppliers and quality of asset, track asset over time, and maintain more detailed accounting records. Still subject to inefficiencies of the courts. Still a small percentage of the previously disadvantaged market own property which can be appropriated and sold. Lenders may be reluctant to evict a borrower from a home for a small loan valued below R100 000. High cost of realisation in relation to a loan below R100 000 Full factoring is expensive. Non disclosure transactions are administratively onerous. Open to collusion between supplier and purchaser. Government ban on cessions to third parties eliminates a large proportion of this market. 7

convincing them that this will avoid costly legal proceedings and thereby eliminating the need for a court judgment. The disadvantages of leases and instalment sale agreements, however, are that they involve additional recordkeeping (due to the VAT, depreciation, and tax issues) and are only suitable for the financing of a new or used asset. Immovable assets: Lending against real/immovable property does not appear to be a solution for significantly expanding lending to the MSE market. There are only a few examples of the use of real property in microfinance globally, including Indonesia and Tanzania. In South Africa, a majority of the previously disadvantaged market still does not own real property. For those who do, many are subject to sale restrictions as the properties were acquired through a government support programme. A final disadvantage is the difficulty of evictions in terms of the Prevention of Illegal Evictions and Unlawful Occupation of Land Act 19 of 1998. Cessions: Cessions of accounts receivable, or factoring, have been growing as a source of finance for small and medium enterprises worldwide, particularly in Europe; however, factoring does not typically reach the microenterprise segment. In South Africa, government is the largest buyer of goods from the previously disadvantaged small enterprise segment, so that the restriction on cessions of government payments to third parties all but eliminates this financing option for the microenterprise market. 8 This same restriction also hinders the contractor financing programmes of MSE lenders. Findings and Policy Recommendations Based on this investigation, the four most promising collateral mechanisms for the MSE sector which are utilised internationally and appear to be well suited to the South African market if certain judicial bottlenecks could be removed are: (i) pledging of movable assets; (ii) asset finance (leasing and instalment sale); (iii) cession of contract payments, and; (iv) factoring or cession of accounts receivable. For the Micro Enterprise Market Loans of R 10 000 to R 50 000 Pledging of movable assets Asset Finance (Leasing and Installment Sale) Cession of contract payments For the Small Enterprise Market Loans of R 50 000 to R 250 000 Pledging of movable assets Asset Finance (Leasing and Instalment Sale) Cession of contract payments Factoring / Cession of Accounts Receivable The single biggest challenge facing lenders to MSEs in South Africa is the high cost of doing business in relation to loan sizes, particularly the cost of collateral perfection and realisation. In some cases, these costs are passed along to clients, resulting in a high cost of credit. In most cases, however, lenders have simply not pursued growth in these markets, resulting in a financing gap. With the collateral options available to them, few lenders are content to pursue loans below R100 000. This study concludes that the primary financing gap in South Africa is for loans from R10 000 to R100 000. The five recommendations below would reduce the cost of lending and collections, thereby beginning to fill this gap. 1. Facilitate pledging of movable assets Two separate elements are required to facilitate pledging of movable assets by micro and small enterprise owners. First, the assets must be allowed to remain in the possession of the owner. Second, the lender must be able to appropriate the collateral without going through expensive and lengthy court proceedings and without the consent of the borrower. We recommend that further investigation be done into options for achieving these elements for loans up to R250 000 within the South African legal framework. 8 8 The advisory to avoid cessions was introduced in the Public Finance Management Act (PFMA) of 1999 and the Municipal Finance Management Act (MFMA) of 2003.

One model to consider is the Global and Variable security instrument introduced by the Peruvian government in 1997 and described in Section X. This security is registered with a special register at the Movable Property Registrar of the National Public Register System. This instrument covers a range of assets in the business and household, including raw materials or inventory, which can be substituted for other property of equal nature and value. Through assignment of the role of custodian to the borrower, the creditor can demand that the assets be returned without obtaining a court judgment. This law has contributed to the dramatic growth of several large microfinance institutions in Peru, including MiBanco which has grown tenfold in the past ten years to 348 000 active clients, a loan portfolio of USD $700 million, and an average loan size of just over USD $2 000. One other approach would be to support the sale and leaseback of movable assets by MSEs, and to apply the advantages of leasing to these agreements, including preference in liquidation and the option to use private repossession agents and auctioneers. To control abuse of these instruments, government could consider restricting their issuance to lenders registered as developmental lenders with the NCR. 2. Reconsider jurisdiction for micro and small enterprise lending With court cases regularly extending beyond six months in the Magistrate s Courts, the cost of collections has become excessive and assets pledged are often missing or reduced in value by the time a judgment is issued. This is not the first time an investigation into MSE finance has suggested a review of the court system: Improving the accessibility and efficiency of the public infrastructure in this area (legal enforcement of claims against SMEs) would reduce the risk of and eventual loss resulting from an SME defaulting on debt or other obligations. It would therefore facilitate increased lending to SMEs. In addition, access to specialised courts to act against SMEs that default on loan obligations could also facilitate SME finance. 9 Two different international models could be considered to address this issue. The first model is an expansion of the scope of the small claims courts following the model of the United Kingdom, which includes small businesses and cases up to five thousand pounds (approximately R60 000). The UK small claims court also includes an arbitration stage which greatly accelerates resolution of cases. The Small Claims Court Act in South Africa presently provides a simple, speedy, and cost effective system for the resolution of disputes which, in our view, would suit the enforcement of debts owed by MSEs. Presently, the court s jurisdiction is limited to natural persons and amounts which do not exceed R7 000. The second model is an expansion of the scope of the commercial courts. Two examples have been cited as worthy of further study and consideration: the commercial courts in Tanzania and those in French West Africa. Recognising that either of these options would take some time to implement, several smaller amendments to current procedures could be introduced in the meantime to accelerate judgments: Magistrates could be encouraged to accept urgent applications for judgment for all collateral instruments which involve a movable asset, including special notarial bonds, instalment sale agreements, and leases. A creditor could be allowed to serve a summons for small enterprise loans below R100 000, rather than having it served by a sheriff who cannot as easily locate the client and may not treat the file as urgent. Enhance the performance of sheriffs of the court through introducing incentives, competition, and a better service mentality. Steps could include assigning more than one sheriff for each geographical area, strengthening qualification criteria, and improving the performance management system, including performance measurement and stronger performance remuneration. For assets seized from a small enterprise through a writ of execution, allow lenders the option to have these sold by a private auctioneer. 9 SME s Access to Finance in South Africa. A Supply-Side Regulatory Review, by the Task Group of the Policy Board for Financial Services and Regulation, 2002, pg 122. 9

3. Embrace and expand cessions of government payments to third parties Since government is the largest buyer of goods and services provided by MSEs, the current restriction on cessions of payments to third parties 10 has seriously curtailed both the factoring and contractor financing markets for previously disadvantaged MSE owners. With a cession, payments are made directly to the financier rather than to the MSE supplier. Valid reasons provided by government for the prohibition include concerns about fronting, the need to verify the financier to avoid fraudulent transactions, and administrative errors whereby invoices or contract payments are paid in error directly to suppliers, resulting in government being sued by financiers. We strongly recommend that other mechanisms are developed to manage these risks to replace the prohibition. The prohibition has resulted in factoring companies turning away a large percentage of the financing applications from the MSE segment. While some contractor financing programmes have continued to operate despite an inability to secure a cession, several have collapsed since the early part of the decade 11. Those institutions remaining in this sector, such as New Business Finance and the Business Finance Promotion Agency, are not operating on a self sufficient basis; they incur significant costs in their attempts to secure repayments. Once more fully established, the einvoice Clearing Bureau (ICB) will assist with preventing payment errors in invoice discounting, as described in Section XIII. In the meantime, however, we recommend that government develop other ways of managing the risks associated with cessions which would allow for a lifting of the prohibition. One option to consider is to limit cessions to the set of financiers registered as developmental lenders with the National Credit Regulator. At a minimum, this would eliminate the need for government departments to verify the existence and reputation of the financier. 4. Support the einvoice clearing bureau The einvoice or Validation Clearing Bureau hosted by BankServ, which provides electronic validation of accounts payable by purchasers, has the potential to significantly reduce both the cost and risk of invoice discounting, thereby encouraging more financiers to expand in this market. We recommend that government actively support this initiative. 5. Expansion of the registration system for collateral Registration of collateral is currently restricted to immovable property, vehicles, and movable assets registered under a notarial bond. Expanding the registration system to include all assets utilised in MSE lending would reduce the risk of duplicate assignment of assets and would provide stronger protection to lenders in the event of insolvency. We recommend that government further develop the registration system to include: i) assets subject to a lease or instalment sale agreement, ii) assets subject to a floating pledge, iii) accounts receivable, and iv) contract payments. Other Issues Affecting MSE Lending While not directly related to collateral, a number of other issues were raised by study participants as worthy of consideration. Most financiers mentioned the importance and value of post-loan monitoring to assist owners of small businesses, particularly those from previously disadvantaged segments of society. They believe, however, that support currently available from established service providers is not sufficient. Suggested reforms included the establishment of quality standards for business mentors and development of a new performance-based payment mechanism; perhaps based on the survival of the businesses assisted. 10 10 These prohibitions are suggested in the Public Finance Management Act No. 1 of 1999 and the Municipal Finance Management Act, No. 56 of 2003. 11 Including the African Bank and Beehive contractor financing programmes.

Further enhancements to information collected by credit bureaus on micro and small enterprises represent another area for consideration, including the development of a rating agency specialising in small enterprises such as the one operated by NSIC in India (discussed in Section IV). Direct lending by government entities is a third issue to be addressed. There are very few global examples of state entities providing microenterprise loans directly and which have achieved an efficient or sustainable level of operation. Members of the two direct lending development finance institutions interviewed for this study, Umsobomvu Youth Fund and Ithala Development Finance, admitted that political pressure and an image of easy money had hindered loan quality. There is a danger that the presence of government lending programmes will make it more difficult for private sector lenders to reach a critical mass of clients in one market area, especially if subsidised interest rates or easier repayment terms are offered on government loans. Since most government institutions do not collect aggressively from delinquent clients, it may become harder for a private sector lender working in the same market area to discipline clients to take repayments seriously, thereby increasing operational costs. Now that several commercial lenders in South Africa (banks and consumer finance companies) are attempting to expand in the micro and small enterprise markets, these risks are more likely to materialise. One alternative strategy for government would be to loosen the conditions on the Khula Indemnity Programme to render these loans more lucrative for lenders and perhaps also reduce the guarantee fee paid by clients. Suggestions provided by study participants included raising the maximum rate allowed to be charged on loans to one percent above prime, reducing the penalties when reporting and paperwork are not fully compliant, and considering coverage for a portion of legal costs. Developing a stronger client service orientation and partnership with financiers, rather than penalising them for small infractions, was also suggested. Finally, several financiers interviewed felt that small businesses needed more equity rather than more debt, including active investors who would assist with capacity building of the entrepreneurs. We acknowledge the recent initiative by National Treasury to provide tax incentives to invest in venture capital companies specialising in small enterprises, and encourage further initiatives along the same lines for smaller enterprises. 12 12 Website of The National Treasury, www.treasury.gov.za. 11

II Introduction Objectives of the Study This investigation into collateral options for micro and small enterprises (MSEs) was initiated by FinMark Trust, an independent trust based in Johannesburg, and supported by DFID, the aid agency of the UK government, which promotes research and institutional development with the objective of increasing access to financial services by the under-serviced communities of Southern Africa. The primary purpose of the investigation is to determine if collateral constraints are one of the causes for the perceived financing gap for MSEs in South Africa, and identify possible policy options which could lift these constraints and stimulate greater investment in the MSE sector. A secondary purpose is to identify risk management strategies developed by MSE lenders in other countries which may be attractive to lenders in South Africa and feasible to implement despite environmental constraints. The researcher recognises that collateral is just one of several risk management strategies utilised by successful lenders to the micro and small enterprise sector. All participants in the study emphasised that the upfront assessment of the viability of a business and the character and entrepreneurial skills of the owner is more important than collateral, but all participants also confirmed that collateral plays a critical role. All participants in the study emphasised that the upfront assessment of the viability of a business and the character and entrepreneurial skills of the owner is more important than collateral, but all participants also confirmed that collateral plays a critical role. As documented in Box A, several policy documents relating to the MSE sector and issued by the South African government over the past ten years have referred to the need to review the environment for collateral. While many positive steps have been taken to create a fair, vibrant, and stable credit sector overall, with regards to the passing of the National Credit Act (NCA), the establishment of the National Credit Regulator, and the revisions to the Companies Act, this investigation will be the first focussed attempt to study the environmental factors with regards to collateral for MSE lending since the release of the White Paper on the National Strategy for the Development and Promotion of Small Business in South Africa, 1995. Specific objectives of the study include: To identify which collateral vehicles used locally or internationally have proven to be effective (with the exception of liquid collateral, such as term deposits or life insurance policies). To identify potential alternate collateral types, not commonly employed, which may prove to be useful. To identify the efficacy of collateral options in terms of an appropriate benchmark. To produce a matrix of appropriate collateral according to loan sizes. To identify legislative and regulatory bottlenecks which are making certain collateral options not feasible. The research for this report was carried out in three parts. The first constituted a desk review regarding the topic of collateral and collateral law and a survey of MSE financing mechanisms employed internationally. The second comprised a review of the current legislative and judicial environment for collateral in South Africa. The final part consisted of a summary of findings from interviews held widely with MSE finance providers in South Africa, including members of banks, NGOs, consumer lenders, and specialised finance entities, in order to identify their current lending methodologies, challenges faced, and recommendations for policy interventions. This study focuses on collateral options for loans ranging from R10 000 up to R250 000 (US $1 133 to $33 333), defined as the primary financing gap. As such, it will address both the microenterprise market and the small enterprise market. It will exclude loans below R10 000 which can be serviced through group lending methods or through a non collateralised step up approach to individual micro lending. The study will encompass markets served by banks, non-banks, and the not-for-profit sectors, including both informal businesses and businesses registered as sole proprietors, closed corporations, and private companies. 12

Box A Government References to the Collateral Policy Environment for MSE Lending White Paper On National Strategy For The Development And Promotion Of Small Business In South Africa, 1995: Given the critical role collateral plays in the attraction of conventional bank credit, attention will be given to the recognition of other types of securities and collateral substitutes, especially in the rural areas where land is communally held and with respect to women entrepreneurs Credit Law Review, August 2003, Summary of Findings of the Technical Committee, Department of Trade and Industry, pg 3: [T]here are weaknesses in debt collection and in access to court orders; collateral mechanisms are inefficient and difficult to enforce. Inaccurate and incomplete credit bureau information undermines credit providers ability to assess risk and have a detrimental impact upon consumers. Pg 5: Serious weaknesses in insolvency law and certain sections of the Magistrates Court Act (as relating to debt collection and enforcement against security) undermine housing and SME finance. Making Credit Markets Work A Policy Framework for Consumer Credit, February 2004, Pg 7: Banks, retailers and other credit providers have a need for a simple and transparent regulatory framework that is relatively easy to comply with. Effective debt recovery and enforcement are particularly important. Effective debt recovery procedures would assist credit providers by reducing bad debt write-offs, and assist consumers by ensuring that high bad debts of a minority of consumers do not feed through into higher interest rates for the rest. Effective enforcement would similarly be of value to both credit providers and consumers by ensuring that reckless credit providers do not increase the risk and cost to all parties..it is therefore imperative that the new credit policy balance consumer protection measures with the regulatory burden it imposes on credit providers. Pg 12/13:, The situation in the consumer credit market is largely mirrored in the enterprise finance market, where there is a clear distinction between the volume and cost of credit made available to small businesses and that extended to medium-sized and large businesses. There is thus an urgent need to review the current regulatory framework, not just for consumer credit, but also for contract enforcement and debt collection. Is Collateral an Unnecessary Evil? Some developmental lenders believe it is inappropriate to take collateral from a microenterprise owner who has few assets and a marginal income. The author of this study concludes, however, that availability of collateral mechanisms can open the market for finance as well as support growth of the sector. Most lenders to micro and small enterprises in South Africa and elsewhere incorporate a developmental objective in their vision or mission statements. Although the commercial players in the South African market, such as the banks or consumer lending organisations, do not expect to lose money on their small business portfolios, they also accept that this is an expensive market to serve and profits may be elusive. Reasons provided by formal financial institutions for being wary of this market are common worldwide, as cited in Box B. Additional reasons would include the lack of financial records and the high costs of serving this market relative to the size of the loans. Box B. Why We Do Not Lend To MSEs 13 Often do not repay Operate in high risk sectors Many are overly optimistic Lack managerial skills Make low profits Face many managerial constraints Many have no borrowing experience Divert loans Source: Conditions For Access to Financial Services for Micro- and Small-Scale Entrepreneurs, Deloitte & Touche, 1998. 13 Mutesasira, Osinde, Mule, Potential for Leasing Products: Asset Financing for Micro- and Small Businesses in Tanzania and Uganda, MicroSave, 2001, Pg 6. 13

With one or two exceptions, South African banks are involved in this market primarily as a way to meet the financial sector charter requirements and to foster a future clientele of medium sized companies. A few specialised lenders, such as New Business Finance, believe this market can be profitable in the long run but have not yet reached a break-even level of operation. In some countries, the value of a small business account is believed to derive primarily from the deposit services and not from the lending. 14 Due to the developmental orientation of suppliers to this market, all respondents confirmed that they go to lengths to help their clients succeed. Realising on collateral is a very last resort, initiated only when they conclude that the client is able but not willing to repay or the company is going into liquidation. Several of South Africa s banks have invested heavily in non financial support for their small business clients. ABSA has established ten of its own Enterprise Development Centres in order to provide non-financial support to emerging entrepreneurs, including access to markets and mentors and business advice. Over the past four years Nedbank has been offering business seminars two to three times per year in each of eighteen (18) locations in townships and city centres. These are highly popular, according to Nedbank staff, attracting an average of 300 attendees; these seminars include topics such as cash flow management, registrations and starting a business, human resources and labour relations, and sales and marketing. Nedbank also organises business mentorships through Business Partners and offers a low fee registration service called Swift Reg. New Business Finance (NBF) exemplifies strong relationship banking and customer care principles. Prior to approving a loan, the loan officer will assist a client to refine the business plan, cutting expenditures back to bare essentials to ensure the client does not become over-indebted. Disbursements are made primarily to suppliers, to avoid the temptation for a client to divert funds to consumption purposes. Loan officers maintain close contact with clients in their portfolio and provide extra counselling when it becomes apparent that a client is struggling. We ensure that the client is not worse off after receiving a loan from us. 15 A significant number of loans have been rescheduled by NBF during 2008 owing to the tougher economic climate facing clients. NBF exercises extreme patience in order to allow a client to get their business back on track. Over time, however, if the business is clearly failing or if the client is avoiding the loan officer, the client will be passed to the collections and legal departments to initiate legal steps. With regards to microenterprise lending with loan sizes from R500 to R50 000, leading microfinance institutions worldwide have consistently achieved average loss rates of below 5% of average portfolio per year, utilising both group lending and individual lending methodologies. In South Africa, the three largest microenterprise lenders: the Small Enterprise Foundation (over 50 000 active loans), Women s Development Business (over 30 000 active loans), and Marang Financial Services (over 25 000 active loans), have also met these global standards of portfolio quality utilising group lending methodologies. Not one of South Africa s microenterprise lenders utilising an individual lending methodology, however, has managed to sustain strong portfolio quality over an extended period as well as reach a significant size. Many initiatives have been launched and have closed within three to five years, as discussed further in Section VI. While there are a variety of reasons to explain these failures, and each had its own unique circumstances, there is an argument to be made that a regulatory environment for collateral which better reflects the unique requirements of lending to micro and small enterprises could help to prevent future failures. The taking of collateral is an important tool for managing risk which could improve the quality of a portfolio just enough to ensure sustainability of the lender. When applied judiciously and efficiently, collateral is far from an unnecessary evil; it could support the continuity of an important service to the micro and small enterprise markets. 14 14 Allan Kauder, Vise President for Business Banking, Bank of America, Banking on the Future Conference, October 2008, Johannesburg. 15 Mohammed Hoosain Hamdulay, Legal Advisor LLB, New Business Finance, 2008

How this Paper is Organised Section I provides an Executive Summary of the report and outlines the findings and recommendations of the research team. Section III on Collateral Fundamentals provides a framework for conceptualising collateral issues, including a definition of collateral, the role of collateral, borrower and lender preferences for collateral, as well as the legal framework for collateral. Section IV, with regards to Collateral Substitutes, addresses consequences of default which do not involve the pledging of an asset but still result in discouraging a debtor from defaulting. Sections V, VI, and VII furnish an overview of the South African market for micro and small enterprise lending, covering a profile of clients, suppliers, and other environmental factors. The final six Sections, VIII to XIII, provide an assessment of six types of collateral, including Bills of Exchange (cheques), Guarantees and Sureties, Movable Assets, Leasing and Instalment Sale Agreements, Immovable Asset Collateral, and Cessions. For each of these collateral types, we provide examples of how they have been utilised internationally, the relevant legal framework in South Africa, lender practices in South Africa, and recommendations for policy changes with regards to that particular instrument. This paper is merely the beginning of a dialogue regarding how to support security options for lending to micro and small enterprises in South Africa. While we were able to identify certain bottlenecks and make initial recommendations, each one would benefit from a more complete feasibility study. We hope policymakers and other stakeholders will take this process forward. 15

III Collateral Fundamentals Definition of Collateral Collateral is an asset pledged by a borrower to a lender until a loan is paid back. If the borrower defaults, then the lender has the right to seize the collateral and sell it to pay off the loan. 16 An asset can be physical, financial, or off balance sheet, such as a personal guarantee. In their agreements, borrowers and lenders must clearly define the asset pledged. Some movable properties escape a precise definition of quantity and quality, such as stored merchandise or perishable goods. In these cases, it is not the asset as such that becomes the object of the pledge, but the storage room with its contents 17. Some countries require each asset to be enumerated (Uruguay) and others allow for floating pledges where contents of a specific warehouse are pledged (Peru). The latter is clearly more lender friendly than the former. Once a pledgeable asset is identified, a lender needs to verify ownership of this asset and ensure that another lender does not have a prior claim to the same collateral. Lender friendly jurisdictions maintain an electronic register of movables and real property which are up to date, complete, transparent, accessible, and not costly to consult. A pledge is a contractual obligation in advance of an exchange of money. When the asset pledged remains in the hands of the lender/creditor, such as in pawn-broking, the rights of the lender are easy to identify and enforce. However, when the asset pledged remains in the hands of the borrower, appropriation by the lender is dependent on the law. Notarial bonds (or chattel mortgages) are designed to protect the lender in such cases. These instruments, however, require costly registration procedures and cannot be realised without going through court procedures. For the micro-market, lender friendly jurisdictions allow for the realisation of assets pledged without court participation. In most jurisdictions, when the asset remains in the hands of the borrower, he or she also retains the right to any returns accruing from use of the asset. Role of Collateral Collateral is just one of the three primary C s of credit utilised by lenders to manage their bad debt risk; the other two being Character and Capacity. While most lenders will agree that verifying the character of the borrower and the capacity of the entity to repay the loan are more important tools in risk management, most will also agree that collateral is a crucial final element in the lending mix to discourage default and provide for recovery. Collateral is used to concentrate the mind of the borrower. Since many SMEs do not have significant cash invested in their business, collateral ensures they have something to lose if the loan is not repaid. To a certain extent, collateral also provides some means of loan recovery. 18 From the lender s point of view, collateral serves both as a screening tool and a means to mitigate losses. If a borrower is willing to pledge their home or land or a household asset, it demonstrates confidence in and commitment towards their business. The possibility of losing these assets ensures that the borrower does not take repayments lightly. They are more likely to work seven days a week, and less likely to go on holiday or purchase a new car, for example, in order to avoid delinquent payments and possible loss of the assets pledged. Collateral is important but it is not the be all and end all. The other three components: viability, financial projections, and ability of the entrepreneur are more important. 19 When loans are small, as in loans to small and micro businesses, and the value of collateral pledged often does not equal the value of the disbursed loan, funds recovered after costs of realising on the asset may be a small portion 16 16 Balkenhol and Schutte, pg 7. 17 Balkenhol and Schutte, pg 11. 18 George Watson, New Business Finance, 2008. 19 Graham Erasmus, National Sales Director, Small Business Services, Nedbank, 2008

of the capital at risk. Nevertheless, lenders still believe it is worthwhile to pursue recovery to communicate that the lender is serious. In the microenterprise market, word spreads quickly. If there are minimal consequences to default, loss rates are likely to rise beyond sustainable levels. In the small enterprise market, although word does not spread as quickly, a lender has more to lose if one loan turns bad. Mitigation of risk becomes the primary motivation for realising on collateral. Collateral is indicative of the extent to which the entrepreneurs will commit themselves and it partly mitigates your risk.. we would not lend without collateral unless the entrepreneur had found the cure for AIDS! 20 Collateral can also place a lender in a priority position against other creditors in the event of insolvency. A lender friendly jurisdiction will allow a creditor to realise on pledged collateral despite the borrower entering into receivership. Borrower Preferences Regarding Collateral Characteristics of collateral preferred by borrowers include: availability, minimal impact on the household and enterprise, and minimal transaction costs. Availability: It is advantageous to MSEs when a lender will accept a wide range of collateral. If collateral options are flexible, the MSE has a better chance of meeting lender requirements. Since the majority of MSEs in South Africa and around the world do not have either tangible financial assets or real immovable assets to offer, lenders have developed alternatives based on assets which are more generally available, such as business equipment, household assets, inventory, and accounts receivable. Minimal Impact: For the low end of the MSE market, assets commonly owned with a resale value include fixed assets used in the business, such as a sewing machine or refrigerator, or assets used in the household, such as a television or lounge suite. If a lender takes possession of these assets to secure a pledge, it will have a serious impact on the business and household. For this reason, asset pledges have lost their commercial appeal in South Africa. Transaction costs: When a lender is required to go through a costly registration process in order to perfect its collateral, these fees are ultimately paid by the borrower. SMEs prefer, therefore, collateral options which minimise these transaction costs. Lender Preferences Regarding Collateral Characteristics of collateral preferred by lenders include: timely appropriability, marketability, minimal transaction costs, and preference in liquidation. Appropriability: This refers to the act of taking possession of an asset in order to realise on a pledge. Lender friendly environments support a rapid seizure of assets once a client is deemed to be unwilling or forever unable to repay. The longer an asset is held by a delinquent debtor, the lower the resale value is likely to be. The asset could go missing, or get damaged, or require extensive refurbishing if control of that asset is not gained within a month or two of a breakdown in relations with the lender. Contracts preferred by lenders are those which allow for appropriation even in the event of insolvency. In the world of microfinance, it is widely accepted that late payments and defaulters must be dealt with swiftly. If a community develops the view that a lender is not serious about collections and borrowers can miss payments without consequences, delinquency spreads like a virus and the lender is saddled with the task of collecting a deteriorating portfolio. This increases the cost of lending; costs which are either passed on to borrowers or result in failure of the lending institution. 20 Kenneth Fischer, General Manager, Small Business Development, Blue Financial Services, 2008 17

Astute borrowers learn the tricks to stave off legal action and these tricks are passed from one borrower to another. If the regulatory environment allows for multiple procedures to avoid or delay legal action, certain communities will take advantage of this and the sustainability of the institution will be placed at risk. Marketability: In the informal sector, it is generally not difficult to resell commonly held household and business articles. In the formal sector, however, where larger assets are involved, marketability is facilitated by more formal structures. Ideally there should be a mechanism to confirm ownership of the asset and ensure there are no prior assignments of the asset to another creditor. In addition, there needs to be an accepted procedure for valuing and selling the asset. MSE lending thrives in countries with active secondary markets and well managed auction houses which facilitate the realisation of a fair value for assets. Transaction Costs: Environmental factors which reduce transaction costs related to collateral include well functioning deeds offices and asset registries, efficient and low cost court procedures for realisation of assets, and the use of national ID numbers. Exemptions from registration and court proceedings for certain types of assets or certain types of transactions facilitate loans at the lower end. Each form of collateral and the collateral environment can be judged against how well they meet or support both the borrower and the lender preferences. Collateral Law It is widely recognised by development finance experts that inappropriate collateral laws and environments can unnecessarily restrict the flow of capital, particularly to micro and small enterprises which cannot meet traditional collateral requirements: If, because of a lack of collateral, a large number of loan contracts are not concluded, then Central Banks and other authorities responsible for the efficiency and security of transactions in the financial market and for a broad-based participation of the largest possible number of households and enterprises have a reason to be concerned. The social costs of collateral-related problems in terms of higher interest payments, a reduced volume of investment and lower output levels does therefore call for the attention of public authorities. 21 Collateral Law does not exist as a distinct entity. Rather, a range of compartments of private law combine to regulate how parties go about creating, perfecting, and enforcing security interests. These include: 22 Contract law (standard form contracts used by major banking groups); Property law (especially the dispositions of security rights over movables); Commercial law (especially concerning registers with information on ownership of company assets); Judicial process law; Bankruptcy code (especially priority claims to pledged assets); Special laws concerning foreclosure (judicial execution), sale by court order and sequestration; and Decrees governing land registers and other registers. An effective collateral law should encourage the conclusion of many financial contracts (density), broaden the financial sector by making it more accessible (access), and at the same time maintain or even raise the general level of financial contract security reflected in a low default rate and limited default losses across the financial sector (quality). 23 High transaction costs in connection with specifying, validating and realising collateral may ration out smaller and medium-sized borrowers. This is not at all unlikely, considering the way the law in many countries is administered. Often the institutions for the enforcement of claims do not exist (bailiff, courts) or, if they exist, they function too slowly. Rational lenders will require only collateral that can be liquidated without court orders, 18 21 Balkenhol and Schutte, pg 8. 22 Balkenhol and Schutte, pg 17. 23 Balkenhol and Schutte, pg 21.

i.e. financial assets in the possession of the lender. This could have a rationing effect on small businesses to the extent that they do not have financial assets to pledge (except savings deposits). In most countries, the legal execution of claims on movable property requires the intervention of a bailiff; the bank as creditor has to have already a writ of execution (for example a court judgment) or a title deed (i.e. a document with an immediate executory effect, signed and recognised by the debtors) in order to obtain satisfaction by the bailiff. Again, to the extent that smaller clients do not have such titles, one could say that the law reinforces an existing rationingout effect. 24 Later sections of this paper assess the South African legal environment in relation to lender friendly standards for a variety of collateral instruments. While the laws are generally supportive, it is the judicial mechanisms which are costly and create delays harmful to the position of creditors. 24 Balkenhol and Schutte, pg 20. 19

IV Collateral Substitutes In microfinance literature, the term collateral substitute refers to bad debt management strategies which do not involve the pledge of an asset but result in another consequence of default which is unappealing to the borrower and acts as a deterrent to late payments and defaults. Often these substitutes have limited marketability, cannot be enforced through the courts, or arise out of a subsidiary agreement. Examples include group guarantees, letters from local authorities, supplier credit arrangements, and listing with a credit bureau. In each of these examples, a consequence of default exists which is a deterrent to the borrower but does not involve an asset. Group Guarantees In the case of group guarantees, used successfully worldwide in group-based lending, the threat of being ostracised by other group members keeps an individual committed to pay his or her portion. In addition, all members of a group lose access to further loans if any member of the group has an outstanding payment, which encourages group members to cover for late payers and ultimately pay any outstanding defaults. As loan sizes grow, however, there is a corresponding decline in the ability and willingness of members to cover for one another. With a few exceptions, group lending does not work well for loans beyond approximately $2 000, or R15 000, and are not an alternative for the MSE market which is the subject of this paper. Local Authorities In a number of countries worldwide, such as Tanzania and Indonesia, where populations are stable rather than transient, and local authorities play a significant role in the lives of residents, microfinance providers can obtain reference letters from these authorities as a risk management strategy. If a borrower is late with a payment, and collection efforts by the field offices are not succeeding, the lender can solicit support from the local authorities. Often, simply the threat of embarrassment and disapproval by the local authority is a sufficient incentive for clients to make timely repayments. Before receiving an initial loan from BRI, village residents must receive a letter from the lurah (village head) indicating how long they have lived in the village and, if they do not have a business license, that the prospective client has had a business for at least a year. They also provide information about land ownership for the purpose of establishing collateral. Applicants may pay a small fee for these services, which may or may not be a transparent transaction depending on the village. 25 Involvement of local authorities, however, exposes the client or lender to potential abuse. Some may request a fee for their services and may withhold the letter until this is forthcoming. There is also a risk that this source of income will become more important for the local authority representatives than the quality control function they are expected to fulfil. Supplier Credit Supplier credit has been cited as the largest supply of credit to SMEs worldwide and in South Africa. The most prevalent form of credit used by small and medium-sized businesses in most if not all economies is trade credit. Trade credit payment information provides an important basis for assessing risk in small-business loans. It constitutes the bulk of small-business credit files in South Africa, accounting monthly for at least R24 billion in total outstanding credit. 26 20 25 Churchill C., Individual Lending Research Project, Case Study: Bank Rakyat Indonesia, 1995. 26 Turner, Varghese, Walker, Information Sharing and SME Finance in South Africa: A Survey of the Landscape, Centre for Competitive Credit, PERC Results and Solutions, August 2008.

A supplier has several advantages over financial institutions when extending credit. Firstly, the former have a history of past purchases, which gives them some knowledge of the weekly and monthly turnover of the business. Secondly, the mechanism of trade credit, which provides stock rather than cash, ensures that funds go into the business and are not diverted for consumption purposes. Thirdly, a trade supplier has the ability to cut off future stock supplies to the enterprise, which serves to concentrate the mind of the borrower in the same manner as a pledged asset. Finally, a trade supplier enjoys an advantage when it comes to reselling stock which may be recovered from an insolvent client. Supplier credit, however, also carries some disadvantages. The threat of cutting off supplies is only effective if the supplier has a near monopolistic position in the market area of the enterprise. If this threat does not result in payment, the supplier is left to collect through the court system. From the borrower s perspective, value created by supplier credit is limited in that it provides working capital only and it ties the borrower to one supplier. Supplier credit does not provide larger amounts of capital for fixed asset investments and does not allow the borrower to search for the best deals on business inputs from one period to the next. While steps to support further growth of supplier credit in South Africa are important initiatives, such as improved information sharing or enhanced court proceedings, supplier credit does not involve an asset purchased or pledged and is beyond the terms of reference for this study. Credit Bureaus While the primary role of a vibrant credit bureau sector is to facilitate character and capacity assessments by lenders, credit bureaus are also used by lenders as a collateral substitute. Avoiding a negative listing may be a sufficient incentive to concentrate the mind of a borrower, in some cases. The consumer lending sector in South Africa, which is largely based on unsecured credit to salaried individuals, has grown exponentially and has generated significant returns to investors without the benefit of specific collateral. Consequences of default in this case include 1) a negative credit listing which would make future credit more difficult to secure, and 2) the threat of an emolument or garnishee order or attachment of assets. As described in Section VII, South Africa has benefited from a well developed credit bureau sector, with healthy competition between four established players. The consequences of default mentioned above have been sufficient to maintain consumer loan loss ratios at between 5% and 15% of disbursements; rates which lenders have been able to cover with high interest and fees. In the microenterprise market, however, negative credit listings appear to exert less of an impact, perhaps because few institutions to date have been willing to extend credit to very small businesses and self employed individuals in the informal sector. Emolument orders are also not a relevant option for self employed individuals, except for those who subsequently become employed. In cases where an unsecured lender does obtain a judgment against a micro enterprise owner, the time and costs involved to carry out inventory, seize, and sell assets are a discouragement and are not conducive to the quick responses required to instil discipline in the microenterprise market. At the small business level, where entities tend to be registered, credit bureaus appear to have reliable data on both the entities and their owners. All respondents expressed satisfaction with the level of information provided by the credit bureaus (TransUnion, Experian/KreditInform, XDS and CompuScan). Some small business owners, however, appear to find ways to start new businesses under the names of family members, thus avoiding the consequence of a negative credit listing. In conclusion, lending to the MSE sector has not succeeded on the same platform that has supported lending to salaried individuals. A negative credit listing does not appear to be a sufficient deterrent for a majority of micro and small businesses, whether formal or informal. A new set of tools and approaches is required. 21

A Note on Credit Scoring Credit scoring for small and micro-enterprises has been growing in popularity worldwide over the past ten years. The first Small Business Credit Score (SBCS) was introduced by Fair Isaac Corporation in the United States in 1995, using five years of data from more than 5,000 small business loans from 17 banks in the U.S. The most recent Fair Isaac scores utilised information from 32 participating banks and more than one million loans. 27 In the world of microfinance, credit scoring has been developed by advanced institutions, particularly in Latin America. Credit scoring is a method of correlating loan behaviour or outcomes with personal and business data or variables, and is used to expedite client assessments and lending approvals. Clearly financial intermediaries that have hosted a bank account for a business entity for a period enjoy an information advantage with regards to that entity. Not only do they have access to publicly available data from a credit bureau, and borrowing/loan data if the entity has borrowed from them, but they also possess information regarding the deposit and withdrawal patterns of a current or savings account. In South Africa, the largest volume of lending to small enterprises is provided by the four major banks 28 in the form of overdrafts on current accounts. To determine the size of overdraft for which a business qualifies, the banks assess current account debit and credit patterns over a minimum of six to twelve months utilising behavioural risk scoring methods. An average performing business can qualify for an overdraft of approximately 10% of annual turnover, but this value is adjusted based on the risk score. These loans are offered to sole proprietorships, closed corporations, and private companies, but they are not unsecured; they are secured by personal sureties from the owners. Cooperative financial institutions also utilise methods of assessing risk based on behaviour patterns of a savings account. Savings based lending by credit unions typically involves extending a multiple of the average balance in a savings account over a period of time, adjusted by the amount of excess income or savings in an account on a monthly basis. For example, if an account appears to be growing by R300 per month, the lender assumes that the business entity could carry a loan instalment of R 300 per month. Cooperative lending is generally restricted, however, to loan levels below the threshold for this study and the quality of this lending is reinforced by community knowledge and peer pressure in the event of default. This type of lending methodology could not be scaled up on a nationwide basis without a corresponding decline in portfolio quality. Box C NSIC Small Scale Business Rating System 29 The National Small Industries Corporation Ltd (NSIC), a public sector enterprise in India established in 1955, works to promote, aid, and foster the growth of small scale industries and industry related small scale services/business enterprises in the country. NSIC promotes modernisation, upgrading of technology, quality consciousness, strengthening linkages with large and medium enterprises, and enhancing exports from small business. To enable small enterprises to ascertain the strengths and weaknesses of their existing operations and take corrective measures to enhance their organisational strength, NSIC is operating a Performance and Credit Rating Scheme through associated agencies like ICRA, ONICRA, Dun & Bradstreet (D&B), CRISIL, FITCH, CARE, and SMERA. A small enterprise has the liberty to choose among any of the rating agencies, which then charge a credit rating fee according to their policies. A portion of this fee is reimbursed by NSIC according to the turnover of the enterprise. Two primary benefits are cited on the website of NSIC: it 1) Provides an independent, trusted third party opinion on capabilities and creditworthiness, and 2) Facilitates more prompt credit decisions by banks. In conclusion, credit scoring is employed to manage risk but does not constitute a collateral substitute. Credit scores are predictive; they provide valuable information on a client s character and capacity to repay, but they do not present a consequence of default. Rarely is credit scoring utilised on its own in lending to small and micro enterprises; it is simply one of the risk management tools. 22 27 Turner, Varghese, Walker, pg 46. 28 ABSA Bank, First National Bank, Nedbank, and Standard Bank. 29 NSIC website.

V Market size and characteristics in S.A. Market Size One of the best sources of information on the small and micro enterprise market in South Africa is the FinScope Small Business Survey Report, Gauteng, conducted in 2006. 30 Primary objectives for the study included the following: to size, benchmark, and segment the small business market for the first time, and to inform new innovations for development of the small business sector. For this survey, 5039 households were contacted, in which 12 422 adults were found, or 2.5 per household. From this group, 2001 self employed or small business owners were identified, which represents 16% of adults or 40% of households. Given there are 6 635 000 individuals age 16 and over in Gauteng, this ratio suggested that there were approximately 1 054 000 small and micro enterprises in the province, defined as enterprises with 200 or less employees. The study developed a new methodology for segmenting this market called a Business Sophistication Measure (BSM). Seven separate segments were identified, from BSM 1 to BSM 7. Businesses were placed in a segment according to their formality, financial record keeping and compliance, use of business management tools, use of technology, and use of banking services. As one would expect, there is a significant correlation between the level of sophistication of a business and its demographic characteristics, such as the type of business, location, turnover levels, and education of the owner. Utilising turnover and other data provided by the FinScope Small Business Survey, we conclude that virtually no microenterprises in segments BSM 1 to 3 would qualify for a loan of R10 000 and higher. This means that our broad market can be described as those businesses in segments BSM 4 to 7 which would qualify for a loan of R10 000 and higher. Within this broad market, we have defined two very distinct market segments. For the purposes of this report, businesses in the BSM 4 to 6 categories shall be recognised as microenterprises. In 2006, there were a total of 458 000 microenterprises in this category in Gauteng, of which we estimate that not more than 30%, or 137 400, would have qualified for a loan of R10 000 or higher. Businesses in the BSM 7 category will be called small enterprises. In 2006, there were a total of 97 000 small enterprises in this category in Gauteng, of which we estimate up to 80%, or 77 600, would qualify for a loan of R10 000 or higher. Unfortunately we do not yet have comparable figures for the other provinces. FinMark Trust has only recently secured funding to conduct a national FinScope Small Business Survey in all the provinces. Survey results are expected in the first quarter 2010. In the absence of this data, therefore, we have extrapolated the size of the market for other provinces utilising the Statistics SA data on the density of formal and informal enterprises per province, as shown in Table 3. 31 In order to calculate the extrapolations, we took the ratio of qualifying microenterprises in Gauteng to total informal enterprises in Gauteng and applied this same ratio to the number of informal enterprises in other provinces. Similarly, we took the ratio of qualifying small enterprises in Gauteng to total formal enterprises in Gauteng and applied this same ratio to the number of formal enterprises in other provinces. Based on this table, we conclude that the market nationwide for individual microenterprise loans comprises approximately 525 000 and for small enterprise loans, approximately 160 000. 30 Syndicate members for this study included: FinMark Trust, Gauteng Enterprise Propeller, the Gauteng government, the Department of Trade and Industry, ABSA Bank, FNB, Standard Bank, and TransUnion. 31 FinScope Small Business Report, Gauteng, 2006. 23

Table 3 Micro and Small Enterprises Qualifying for Individual Loans Based on Density of Enterprises per Province, from Highest to Lowest, Statistics SA Population (mlns) Informal % of Population Qualifying 23% Formal % of Population Qualifying 40% Gauteng 9.45 6.5% 141 278 2.1% 79 380 KwaZulu Natal 9.77 5.9% 132 579 0.5% 19 540 Mpumalanga 3.25 5.9% 44 103 0.5% 6 500 Limpopo 5.41 4.9% 60 971 0.2% 4 328 Free State 2.74 4.7% 29 619 0.5% 5 480 North West 3.80 4.6% 40 204 0.3% 4 560 East Cape 6.50 3.2% 47 840 0.3% 7 800 West Cape 4.76 2.3% 25 180 1.6% 30 464 North Cape 0.82 2.1% 3 961 0.6% 1 968 Total 46.50 4.93% 525 734 0.87% 160 020 Market characteristics The tables below highlight the significant differences between the microenterprise and small enterprise segments. Table 4 provides further insights into the demographic characteristics of the two segments. Table 4 Demographic Profile of the Micro and Small Business Segments BSM 4 to 6 BSM 7 Informal Registered Previously Disadvantaged Male Female Primary School or Less Some High School Matric Post Matric or University No Prior Work Experience Business Sole Income Source Non SA Citizen 84% 16% 90% 54% 46% 17% 40% 32% 10% 35% 75% 13% 6% 94% 37% 61% 39% 2% 7% 29% 61% 12% 74% 3% Small enterprises in segment BSM 7 are still predominantly owned by whites, although the number of previously disadvantaged owners has reached 37% and this ratio is believed to be improving each year. Businesses in segment BSM 7 are mostly registered, whereas 84% in segments BSM 4 to 6 are still informal. A large majority (90%) of owners of businesses in segment BSM 7 have completed Matric or a higher qualification, whereas only 42% of owners in segments BSM 4 to 6 can claim the same level of education. 24 Table 5 below provides a profile of the types of businesses for each of the defined segments. Small enterprises in segment BSM 7 are primarily active in the service sectors (40%), followed by trading (20%) and professionals (15%). The service businesses would include catering, cleaning services, small security firms, panel beating, internet cafes, privately owned schools and pre-schools, dressmaking/textiles, taxi operators, and landscaping, to name a few. Microenterprises in segments BSM 4 to 6, however, are primarily active in trading (60%) followed by services (23%). Services in this segment would fall into a similar range to those in segment BSM 7 but would be smaller and may also include such activities as hair salons, taverns, and florists.

Table 5 Business Profile of the Micro and Small Business Segments BSM 4 to 6 BSM 7 Trading Service Construction Manufacturing Professionals Other City Centre Suburb Township Informal / Hostel Rural / Small Holding Footpath or Hawker Rented House Own House Backyard or Garage Factory, Office, Shop 60% 23% 6% 3% 1% 6% 8% 15% 56% 18% 3% 11% 11% 56% 17% 5% 20% 40% 11% 5% 15% 8% 19% 53% 14% 2% 13% 10% 11% 41% 5% 33% Microenterprises in segments BSM 4 to 6 are primarily found in townships and informal settlements, and operate from a home or backyard or garage. Small businesses in segment BSM 7, on the other hand, are primarily found in suburbs and city centres. While a majority work from home, a large number (33%) work from business premises such as a factory, office, or shop. Table 6 demonstrates that although the longevity of the two segments is somewhat similar, with a majority of businesses having been in existence for longer than two years, the sophistication levels are significantly different. Less than one half (46%) of the microenterprises keep financial records, compared with most (93%) of the small enterprises. The microenterprises do not have access to computers or the internet, whereas a majority of the small enterprises do enjoy these services. Table 6 Stability and Sophistication of the Micro and Small Business Segments BSM 4 to 6 BSM 7 Average Job Creation Keep Financial Records Longevity of Business Up to 2 years 3 to 10 years Over 10 years Electricity Cellphone Computers Fax Machine Internet Access Credit Card Machine 0.9 46% 37% 47% 16% 89% 75% 6% 3% 1% 0% 8.9 93% 31% 38% 31% 92% 87% 77% 55% 58% 23% 25

VI Suppliers of MSE Loans in SA Commercial Banks The commercial banks all offer overdraft facilities to small businesses, primarily secured by a personal surety from the owner. These overdrafts are typically limited to 10% of annual turnover and carry a rate of prime plus 5%. 32 If additional collateral is provided, the rate drops to as low as prime for an overdraft fully covered by liquid collateral, such as a bank deposit. The banks approve these overdrafts utilising a behavioural risk score based on the patterns of deposits and withdrawals on a business account over a twelve month period, together with a credit reference on the owner. These overdrafts are only available to registered businesses or sole proprietors who are assigned to the small business department of a bank. As such, they are not available to more than 50% of the microenterprises covered by this study. While still largely focused on segment BSM 7, and still dominated by white owners, the previously disadvantaged market is the fastest growing segment of overdraft clients. If a client requests an amount higher than the 10% guideline, or if they do not have a full 12 months history of operating their account with the bank, a guarantor or Khula guarantee/indemnity may be secured to cover the extra risk. Nedbank offers overdrafts, generally up to R100 000. These are particularly important for start up businesses, which tend to invest all their savings in capital items. 33 Two of the commercial banks, Nedbank and ABSA, have established departments and programmes to aggressively build business with MSEs owned by previously disadvantaged individuals. Nedbank Small Business Services targets businesses with turnovers of R150 000 to R7.5 million, but 70% have turnovers of below R1 million and are covered by the NCA, and 70% stem from the emerging black market. Nedbank secures its term loans either by taking tangible security, including residential or commercial real property, or by doing an asset finance deal, or by taking a Khula guarantee. During 2008, Nedbank was the fastest growing user of the Khula Indemnity Program and is now the second largest user after ABSA. Nedbank has developed a range of promotional programmes and incentives to attract the previously disadvantaged market. With a start up loan of R100 000 or more, Nedbank offers two full years of free banking. In addition, Nedbank offers three value added services: 1) Free seminars in 18 locations, including townships and city centres, 2 to 3 times per year in each. A range of topics are covered by subject matter experts, including cash flow management, business startups, business registration, IR - HR, sales and marketing. According to Nedbank, these seminars have been popular, with up to 300 attendees per session, 2) Business Mentorship: turnaround or start up mentorships organised through business partners, and 3) Swift Reg: a service to register a company for a fee of R450. One requirement is that the business must have an accountant to produce monthly management accounts. Although Nedbank s policy allows for small business term loan sizes starting at R25 000, and despite Nedbank s strong commitment to this market, loan sizes are rarely approved below R75 000. The cost of administering notarial bonds, instalment sale agreements, leases, or even Khula guarantees, is such that loans below R75 000 are not attractive. 34 ABSA, which is the largest participant in the Khula Indemnity Scheme, has set up ten of its own Enterprise Development Centres: two in Gauteng and one in each of the other provinces. These centres provide business support to emerging entrepreneurs through access to markets, business advice, and other non-financial support. Loan loss rates targeted by commercial banks for their small business portfolios range from 6% to 8% of average portfolio outstanding. Most respondents acknowledged that 2008 had been a difficult year and losses were expected to be higher than the target. 26 32 As such, this type of financing is much cheaper and more attractive than loans from NGOs or specialised MSE lenders which tend to price at rates allowed for developmental lenders under the NCA (RR*2.2+20%). Typically if a client draws more than the agreed amount, the extra is priced at NCA rates. 33 Mano Mathusamy, Head Credit Risk Small Business Services, Nedbank. 34 Mano Mathusamy, Head Credit Risk Small Business Services, Nedbank.

Bank representatives interviewed for this study generally felt that the MSE market has potential but that it is costly to serve. These individuals believe that it is too expensive and not feasible for a bank to adopt a relationship banking approach to the MSE market, following the model of New Business Finance. Ideas offered by the banks for stimulating this market included: Reduce the costs, limitations, and administrative requirements of the Khula guarantee scheme. Introduce an independent rating agency for MSEs similar to the one established by NSIC in India. Support more venture capital funds which also provide mentors, with whom banks could partner. Support the growth of specialised MSE finance banks which would have lower overheads and lower profit requirements/expectations. Enhance the services offered by SEDA and other business support agencies which provide low cost business advice, assistance in drawing up business plans, access to markets, and general mentorship support. Establish a small claims court for small businesses, which could expedite the realisation of security, giving the banks more confidence to lend. Consumer / Micro Lending Institutions Despite their familiarity with the lower income and previously disadvantaged markets, consumer lending organisations have not yet managed to succeed in MSE lending. Some have entered the market and exited again, for example, African Bank and Kagisano. Others have investigated the market but, for a variety of reasons, have not yet ventured forth. African Bank has launched several initiatives for this market, including contractor financing and factoring. After losing many millions of Rands and becoming embroiled in legal cases which lasted up to eight years, the Bank has now decided not to pursue SME lending in the foreseeable future. The Contractor Financing Programme was launched in a separate company in 1998 and was incorporated into African Bank in 2000. By 2002 the problems were evident, as described below; the programme was closed in 2003. The programme covered BEE contracts awarded by government, particularly housing projects. African Bank offered bridging finance and took a cession on payments from government departments. Certain loans were also covered by Khula Guarantees. Government required a Performance Guarantee from the contractor of 10% of the value of the contract these were also financed by African Bank. The contract would be entered into for a set term of generally from four to twelve months, with monthly payments to be made by government. Problems which developed and which have plagued other contractor financing schemes include: Contractors did not spend sufficiently on supplies; significant funds were diverted for consumption purposes. Projects lagged far behind schedules; fixed costs of labour and project management were much higher than the original budget and companies went into liquidation. Another consequence of the longer terms was that the value of the loan requirements would rise beyond the original guarantee provided by Khula. In one extreme case, a four month project turned into a four year contract. Contractors were not competent to complete jobs and government departments refused to pay. Government departments did not conduct any due diligence when appointing a contractor. Another scheme emerged in order to circumvent the cessions. For a few months, a contractor would function efficiently and the monthly payment was made. The contractor then approached government and convinced them to ignore the cession and change the bank accounts. African Bank had to sue government for breach of cession agreements. 35 It has taken eight years for these cases to go through the courts; the final case was concluded in 2008. Entrepreneurs would go into liquidation and then create another company in the name of a family member. In this way, the credit bureau would not reflect a negative listing for the new company. 35 This represents just one reason for Treasury to discourage cessions of payments to third parties as part of the Public Finance Management Act, 1999 and Municipal Finance Management Act, 2003. 27

African Bank believes there was and still is a substantial need and opportunity in this market. If government had worked together with this bank in vetting the contractors and honouring the cessions, this institution believes the programme may have worked. African Bank, which has assessed the market outside of government tenders, is not large enough to support a mass product rollout since the private sector is not as dedicated to awarding contracts to the BEE sector. With the factoring programme, African Bank attempted to work with middlemen between manufacturers and general dealers, such as a wholesale cash and carry. The biggest problem was that of fraudulent documents; both the sellers and buyers were involved in the scam. The buyers would confirm the orders and accounts receivable, but then backed out of paying. In this programme, African Bank took personal sureties from the company owners. The legal system took so long over the cases, however, that by the time a judgment was issued, the owner had transferred all of his/her assets to other relatives and liquidation yielded nothing. Certain themes and lessons, which were echoed by other organisations, arise from the experience of African Bank: The BEE market needs more than financing. Such businesses need mentoring and project management support. They need cashflow monitoring and control through payment of loans to suppliers. They need strong vetting. These functions can be provided by specialised MSE lenders, such as New Business Finance, but cannot easily be provided by the larger financial institutions. More effective relationships between banks and non-financial support institutions, such as SEDA, could perhaps address these requirements to some extent. The slow legal system is a strong disincentive for MSE lenders. Since loan sizes are not high, the cost of multiple year court cases is out of proportion to the Rand amount eventually realised. The reintroduction of government cessions of contract payments and effective control of these would open up the contractor financing market once again. Kagisano Financial Services operated a spaza shop financing scheme through wholesalers for a period, but eventually closed this. Thuthukani Financial Services, Capitec Bank, and the Real People Group have all investigated the MSE market but have not yet launched a product owing to perceived high costs of serving this market. Blue Financial Services is the only consumer lending organisation identified during the research which has aggressively entered the SME market. Blue launched its Small Business General Finance Loan Programme in April 2008. While loan sizes range from R15 000 to R3 million, the smallest loan made as at November 2008 was R60 000. At this date, 49 loans had been disbursed in South Africa, with a portfolio of R23 million, or an average loan of R470 000. As such, Blue is operating primarily at a level above the subject of this research. 36 Blue prioritises quick decision making (1 to 2 weeks for a straightforward deal and 3 to 4 weeks for a more complicated one) and quick disbursements. It will disburse once papers are signed, rather than wait for confirmation of collateral registration. The organisation has an in house legal department which attends to all the legal work except for the registrations, which are carried out by a small firm of attorneys. For Blue, as for most SME lenders, sufficient collateral is accorded only a low (10%) weighting in the decision matrix, following business viability, entrepreneurial competence, and own contribution. Loans are priced from prime plus 2% to prime plus 12%, depending on the risk profile. Blue claims it will look at loans turned away by banks, although it also participates in the less risky segments preferred by banks, such as the franchisee market. Security ranges from 10% to 50% of tangible collateral; the lowest ratio to November was 30%, with the average at 90%. For at least half the loans, a first or second mortgage bond has been registered. Other security includes specific and general notarial bonds on financed equipment; buy-back agreements / guarantees from franchisors (such as Multiserv and PK Vending) and personal and third party sureties. The sureties, however, are not accorded any value when calculating the collateral coverage ratio. The up-front registration cost of a notarial bond, estimated at approximately R2 000, is paid by the client, either with cash or capitalised as part of the loan. 28 36 Blue plans to lend in Swaziland, Lesotho, Nigeria, Namibia, and Botswana this year.

Enterprise and Developmental Lenders There are a few small and highly specialised MSE lenders operating in South Africa, including New Business Finance, based in Cape Town; Business Finance Promotion Agency, based in Port Elizabeth; and Retmil Financial Services, based in Bloemfontein. Many others which formerly provided loans to MSEs in the range of R10 000 to R250 000 have since closed down, including The Nations Trust and Nicro Enterprise Finance (absorbed by Umsobomvu Youth Fund), Khetani Financial Services, Nkwe Enterprise Finance, the Beehive contractor financing programme; several historical initiatives of the commercial banks; the supplier credit programme of Quattro Financial Services and more. It would be instructive to conduct a thorough review of why these organisations did not survive. 37. We believe a more enabling regulatory and judicial environment may have improved their chances of survival. NBF currently serves over 350 MSE clients from five offices nationwide. The total portfolio at the end of August 2008 was R28.3 million. Since NBF specifically targets the market which is the subject of this research, a full case study was conducted on their methodology and use of collateral included as Annex A. For all loans, NBF requires a personal surety from the owner; this comprises the sole form of security on approximately 50% of loans. Wherever possible, however, NBF will also take other collateral, such as a notarial bond, both specific and general (10% of loans), a vehicle pledge (10% of loans), or a cession of debtors (10% of loans). Only 3% of clients have offered real immovable property as security. The case study highlights the high cost of notarial bonds, the high cost of time consuming judicial proceedings, and the extra effort required as a result of the ban on cessions of government tender payments. Steps to address these three areas would certainly contribute to the sustainability and survival of New Business Finance. For all loans, NBF requires a personal surety from the owner; this comprises the sole form of security on approximately 50% of loans. Wherever possible, however, NBF will also take other collateral, such as a notarial bond, both specific and general (10% of loans), a vehicle pledge (10% of loans), or a cession of debtors (10% of loans). Only 3% of clients have offered real immovable property as security. The case study highlights the high cost of notarial bonds, the high cost of time consuming judicial proceedings, and the extra effort required as a result of the ban on cessions of government tender payments. Steps to address these three areas would certainly contribute to the sustainability and survival of New Business Finance. The Business Finance Promotion Agency (BFPA) has survived on grants for just over a decade, providing small enterprise loans from R6 000 to R600 000. BFPA recently began offering contractor loans up to R2 million, and has been appointed to manage the Khula Emerging Contractor Fund, a R50 million fund for public works contracts. The average loan size disbursed has grown significantly over the past three years, and stood at R170 000 for the year ending February 2008. BFPA covers the Eastern Cape Province from two offices, one in Port Elizabeth and one in East London. As at December 2008, BFPA was serving 374 active clients with a portfolio outstanding of R21.8 million. The range of security instruments utilised by BFPA is similar to that of NBF; BFPA requires a 70% coverage ratio for security. One interesting innovation developed by BFPA is a replacement to cessions of contract payments. BFPA signs a Memorandum of Understanding with government departments and registers on their supplier base. Each contractor deal defines a transferee, the small business, a transferor, BFPA, and the contracting authority. The authority must make payments into the account of the transferor which, in turn, pays the transferee. The average loan write-off rate for the past five years has been approximately 9% of average portfolio outstanding. At its current size and with this level of write-offs, BFPA is not yet self sufficient; operating losses run at approximately R3 million annually. While clearly playing an important developmental role, BFPA s survival will be uncertain until it strengthens its financial position. A more enabling collateral environment would facilitate such an outcome. 37 Recent visitors from Sa-Dhan, the Association of Community Development Finance Institutions of India, called South Africa the graveyard of microfinance. 29

Factoring Companies While all the banks conduct invoice discounting, it is the full factoring companies which deal with the smaller businesses. The three largest full factoring companies include Merchant Factors (M Factors), part of the Rand Merchant Group; Regent Factors, in which Khula has a 20% share; and Sasfin. Others include the Investec Group, Durban Factors, and other smaller players. Regent Factors, based in Durban, has demonstrated particular interest in the SME market. Regent works in all sectors except construction; 40% of its book is loans of less than R250 000, although the majority of these are R100 000 and above. Since fees tend to sit between 4% and 5% of invoice or exposure per month, clients must have margins of 20% and above to cover this cost. Clients who work with government tenders typically have a margin of 30% and up. They have not been able to support this market, however, because of government s attitude toward the cessions. The big challenge with SMEs is mentoring. They often do not price correctly; they don t have sufficient technical skill so the work can be shoddy; and they take too long to complete a job. To ensure the invoice will actually be paid, some form of mentoring is often required. The problem is that most mentors are incompetent; they are not experienced business people. The ideal would be to get the grey haired mentors who have retired, have plenty of experience, and are doing this as a way of putting something back into the community. They also tend to be cheaper. 38 In the SME market, the factoring house obtains the money from buyers and pays the suppliers of the SMEs. The SME is only given the money that it requires to pay wages. This is a labour intensive process. Development Finance Institutions (DFIs) Two direct lending DFIs were interviewed for the study: the Umsobomvu Youth Fund (Umsobomvu) and Ithala Development Finance Corporation (Ithala). These interviews confirmed the globally recognised lesson that it is not an easy task for a government entity to lend money directly as well as maintain a good quality portfolio. Borrowers tend to view government lending schemes as easy money. This needs to be counteracted by highly disciplined screening and collections procedures, for which government entities rarely possess the political will. Furthermore, direct government lending can lead clients to expect to get away with non repayment, thereby increasing the discipline and training burden for private sector lenders. The Umsobomvu microenterprise division offers loans through 12 branches from R1 000 to R100 000, with an average loan size of around R10 000. This portfolio started with Nicro Enterprise Finance in Cape Town and The Nations Trust in Gauteng; two organisations that were absorbed by Umsobomvu in 2004. Umsobomvu lends primarily to black youth under the age of 35. They also lend money to start-ups. These subsegments are clearly more risky than middle aged and experienced business people. The primary collateral taken is a third party guarantee from an employed person; family members or friends. Where possible they will also take a cession on a contract. The microenterprise division has a relatively new management team which laments the poor portfolio quality, which they attribute to three factors: business failure, lack of follow-up on security, and the image carried by the programme as easy government funding. Umsobomvu has not had good results with larger debt collectors; they are now switching to smaller, local debt collection firms. The Umsobomvu General Fund, which offers loans from R100 000 to R5 million, is purported to have a better quality portfolio. Since it is managed by seven loan officers at head office, most of the clients are based in Gauteng. Client screening is stronger; businesses must have been in existence for at least one year; real asset collateral is secured for at least half of these loans. This fund has generated a profit for the past two years. Umsobomvu also provides on-lending capital to the First National Bank Progress Fund, which takes fixed asset collateral and utilises guarantees from a French organisation. This fund is apparently performing well, but very few loans below R250 000 are granted; the average loan size is R1 million. 30 38 Michael Woollands, Managing Director, Regent Factors.

At Ithala Development Finance Corporation, the micro loans unit finances loans from R10 000 to R500 000. It offers a range of products including agricultural loans, bridging finance, co-operative finance, empowerment equity loans, land and building finance, invoice discounting finance, order discounting finance, plant and equipment finance, VAT loans and working capital loans. The co-operative loans performed badly, largely due to the perception of easy money. Government advertised these loans to their constituency. No collateral was taken and the loans carried subsidised rates, reinforcing the grant mentality: 40% of the first R50 000 loan constituted a grant; the balance, under R10 000, was charged at prime less 5%; while an amount above R100 000 was charged at prime. This product has been put on hold. The overall micro portfolio has been deteriorating. Reasons provided for this include: a superficial level of financial assessment; collateral has not been emphasised; and a risk fund was established by the provincial government which was fully utilised within the first year and not renewed. The policy states that 60% of the loan must be covered by collateral; often the assets being funded are provided as collateral (land or building or machinery). With the bridging loans, the invoice discounting, and the order discounting finance, Ithala was using cessions rather than collateral. When government banned the cessions, the portfolio deteriorated significantly and Ithala suspended disbursal on these products. Due to government pressure, however, Ithala was forced to start disbursing again. Ithala believes that MSEs form a large potential market, but that more mentoring and lending support is required: More and more provincial governments are stipulating that a certain percentage of their purchasing has to go through SMEs. The reality is, however, that SMEs lack capacity. While money is allocated to capacity building, few lenders have the personnel to manage the chosen service providers and money tends to be wasted. 39 Khula Enterprise Finance The 2008 Annual Report for Khula Enterprise Finance states that the Indemnity Programme for funding through banks grew by only 5% from R230 million in 2007 to R242 million in 2008. By contrast, approvals to RFIs and joint ventures grew 41% from R365 million in 2007 to R516 million in 2008. In 2007, Khula introduced a three tiered indemnity agreement, with coverage levels depending on the loan size: R 10 000 to R 250 000 R 250 000 to R 1 mln R 1 mln to R 3 mln 90% indemnity 80% indemnity 70% indemnity A guarantee fee of 4% annually is paid to Khula by the business for loans below R250 000, and 3% for loans above R250 000, which provides an incentive for the business to graduate from the scheme as soon as possible. Prior to realising on a Khula guarantee, the financial institution must first realise on the collateral, including personal sureties, which can take many months. While all banks believe the Khula guarantee can play an important role, the financial and non-financial costs of the Khula scheme are high, thus reducing its appeal. Concerns raised by the banks included: 1. Reporting to Khula is somewhat onerous and penalties are applied if reports are late or if Khula is not informed of a change of events. 2. Khula will not help to cover legal costs; consequently, the bank could still be significantly out of pocket. 3. Khula caps the interest on loans subject to a guarantee to 1% above prime, significantly reducing the profit on these loans. 39 Neli Shezi, Divisional Manager, Microfinance and Cooperative Development, Ithala Development Finance Corporation. 31

It appears that the stream of uptake of the Khula indemnity programme has been slowing down over the past two years, largely owing to these limitations. At a minimum, Khula could consider lifting the cap on interest that a participant may charge on loans. Currently a large gap exists between prime plus 1%, allowed by Khula, and the NCA maximum allowable rate of over 35% for small business lending (RR% X 2.2 + 20%). The market is not sufficiently attractive to banks at prime plus 1%. Khula provides on-lending capital to nine RFIs. Two are group lenders serving the survivalist segments of the market: the Small Enterprise Foundation and Marang Financial Services. The Median Fund provides venture capital to small and medium businesses. Vengrow Capital operates a supplier credit service through Metro Cash n Carry. Regent Factors is developing a reverse factoring product (discussed under Section XIII) and True Group Investments, a unit of Real People, has not yet launched its MSE product. This leaves just three RFIs that provide the type of financing under investigation in this research paper: New Business Finance, Business Finance Promotion Agency, and Retmil Financial Services. This is another indication of the dearth of successful MSE lenders in the country. Other Guarantee Programmes USAID, the European Community, and others are also offering guarantee schemes for MSE lending. While each of these can support small business lending to some extent, it is administratively costly for a financier to participate in multiple guarantee schemes. It is preferable to find sustainable legislative and judicial solutions to support this sector without relying on external assistance. 32

VII SA Environmental Factors In many ways South Africa has a mature credit environment, including an established credit bureau sector, efficient private auction houses and active secondary markets, acceptance of national ID numbers, availability of debtor insurance, and mature lending institutions. With merely a few exceptions, the legislative framework for credit is also strong. The biggest constraint hindering access to credit by micro and small enterprises is the inefficient Magistrate s Court system which raises the costs of lending and collections. Legislative Overview There are two main types of security vehicles in South African law: personal security and real security. Personal security refers to instances where third parties undertake a primary or secondary obligation in relation to a credit contract concluded by a debtor. Examples of personal security include Contracts of Guarantee or Surety Contracts. Real Security refers to instances where an asset belonging to the debtor is set aside and protected for the purpose of securing a creditor s claim. The law of real security governs both movable assets (such as vehicles or equipment) and immovable assets (such as land or buildings), as well as incorporeals, such as financial assets, including debts. Promissory notes and cheques are not considered to be a form of security but are governed under the law of Bills of Exchange. The other legislation relevant to creditor collateral includes laws on leasing and instalment finance (or hire purchase) instruments. One of the greatest challenges for any creditor is to ensure that security provided by a debtor is protected during insolvency of the debtor. South African law provides this protection to some extent. If a creditor has a mortgage bond over immovable property or a special notarial bond or a pledge over movable property, he is regarded as a secured creditor over the property and is given preference over other creditors. A general notarial bond does not give the same preference to the creditor during liquidation, but it provides preference over other concurrent creditors with regard to the residue of the estate. South African law related to collateral and security is generally clear and fair and conducive to lending. One exception to this is the law regarding the pledging of movable assets, in which either a notarial bond must be registered with the deeds office, which is expensive, or possession of the asset must be transferred to the lender. A third option is to utilise a constructive pledge in which possession is transferred only at the point of default, but this requires a signed consent form from the borrower. Given that movable assets are the primary assets owned by microenterprises, the disadvantages of these three options effectively eliminate this collateral option for microenterprise lenders. Suggestions for addressing this barrier are included under Section X regarding Movable Assets. A majority of consumer lending institutions simply offer unsecured loans, utilising loan agreements in the format dictated by the NCA according to the size of the loan. 40 Following default, notices are sent to the client according to Section 129 of the NCA. The debtor is informed about his/her default and is advised to request assistance from a debt counsellor or alternative dispute expert or consumer court or an ombudsman with jurisdiction. If the consumer fails to respond to the letter or rejects the proposal made in the letter, the credit provider may issue and serve a summons. If the client does not defend the matter (the most common occurrence), the creditor may apply for a default judgment at the relevant court. If judgment is granted, a writ of execution to seize household assets or an emolument attachment order against an income stream is provided. Rarely will a microlender request a writ of execution. For small loan amounts to a low income individual, creditors will prefer to wait until the client is employed and make an application for an emolument order at that time. They can confirm employment status through a credit bureau reference on a three or six monthly basis. A creditor is allowed to litigate against the debtor within three years after the original default. 40 Small loans range from R1 to R15 000 and medium loans range from R15 001 to R250 000 according to the Act. 33

With lending to micro and small enterprises, an emolument order is not an option. The only option for an unsecured MSE lender is to request a writ of execution to appropriate assets, which rarely yields any value. One study participant estimated that only 10% of writs of execution ever result in a sale in execution; the sheriff will most likely return with a nulla bona return, claiming there are no assets available, even though the creditor may be aware of business or household assets. This could be due to the sheriff favouring or being bribed by the borrower or the borrower having relocated the assets. For the small number of cases which do result in a sale in execution, the lender may not appoint a private auctioneer and goods could be sold for a fraction of their value; sometimes even sold back to the borrower. An unsecured lender to the micro and small enterprise market is therefore faced with a very low probability of realising any value upon default and borrowers learn over time that there are no serious consequences to default. With other collateral options, such as specific notarial bonds, instalment sale agreements, or leases, the creditor may take control of the repossession and sale function through the appointment of a private auctioneer. In these cases, a judgment must still be obtained, but realising a market value for the asset is more likely. South African Court System There are two primary courts utilised in South Africa for commercial transactions: the Magistrate s Court, which handles matters up to R100 000, and the High Court, which handles matters over R100 000. The most common procedure is the one specified as an ordinary summons, as explained in Box D below. In theory, the process described below for ordinary summons in the Magistrate s Court need not take more than three months, unless the case proceeds to trial. In practice, however, the period averages six to twelve months or more. The delays are partially related to increased volumes over the past five years and partially related to inadequate management procedures: There are serious process failures which are not fully recognised, Andre Tredoux, Head Vehicle and Asset Finance Collections and Recoveries, Nedbank. Process issues raised by study participants include: Courts limit the number of summonses issued per day (e.g. the Johannesburg Magistrate s Court limit is 50 per day). Sheriffs might not read their instructions carefully and make mistakes, such as serving a summons on a family member rather than in person. This could result in wastage if the summons has to be served twice. Sheriffs take too long to serve a summons or to send back their return of service. Some areas do not have an assigned sheriff. Court files get lost, resulting in delays and costs (the advocate needs to create a new file and draft an affidavit). Clerks of the court are sometimes inexperienced and open to corruption. Inadequate performance management system to ensure productivity of court staff. Delays are experienced in the granting of judgments (for instance, in the Johannesburg court, a judgment can take up to ten months to be granted). General misunderstandings occur with regards to NCA provisions (for example: not exempting registered businesses from certain provisions). Courts have different opinions on the Section 129 letter. The issuing of a writ of execution is often delayed by missing court files. Debt administrators and/or debt counsellors can take control of the process, resulting in delayed payment of debts. Tracing of debtors is both challenging and expensive. Unfortunately, all of the problems experienced with the Magistrate s Court for unsecured consumer loans are the same as those experienced by small business lenders for a range of collateral instruments: personal sureties, guarantors, notarial bonds, leases, instalment sale agreements, and others. Availability of collateral will not necessarily accelerate the court processes. 34 The primary advantage of a collateral instrument which identifies a particular asset, such as a notarial bond, lease, or instalment sale agreement, is that the creditor may choose to utilise private repossession agents and private auctioneers and set a reserve value for the assets. These instruments also provide extra protection in the event of liquidation.

Box D Theoretical Steps for Ordinary Summons (Unsecured, Other) 1. Once client has been in arrears for twenty (20) days or more, a first notice in terms of Section 129 of the NCA may be delivered to the debtor. 41 The courts will require proof of delivery of this letter. (This step not required for registered entities.) 2. The client has ten (10) days to seek assistance from a debt counsellor or alternative dispute agent or consumer court or Ombudsman with jurisdiction with intent to resolve any dispute under the agreement or develop a plan to bring payments under the agreement up to date. 3. If no response is received, the creditor may issue a summons. The Creditor prepares the summons which is stamped by the court and is served on the client by the sheriff. This must be delivered before the prescription of the matter (usually three years). Cost: Approximately R20 revenue stamp; R100 sheriff fee, but depends on each sheriff and the kilometres travelled. 4. The client has five (5) days to enter an appearance to defend in the Magistrate s Court, or ten (10) days in the High Court. 5. If no appearance to defend is filed, the creditor may apply for default judgment. This will be granted assuming the paperwork is in order: a) proof that notice was sent, b) copy of original loan agreements, and c) certificate of loan balance. 6. The default judgment is issued within 40 to 90 days, depending on the Magistrates Court; some are faster and some are slower or busier. The magistrate may issue a writ of execution, which is sent to the sheriff. (For employed individuals or those on a pension or those receiving an annuity, the creditor may ask for an emolument order or a garnishee order rather than a writ of execution.) 7. The sheriff will attend to the writ of execution by visiting the individual and demanding payment of debt or demanding that movable assets should be pointed out to satisfy the judgment. The sheriff is required to take an inventory of assets. The sheriff is also required to take the property into his custody and report what he has done to the registrar (if applicable) and the judgment creditor. The sheriff may leave the assets at the premises of the judgment debtor provided the debtor signs an undertaking that he/she will produce the assets on the date of sale. Cost: R150 sheriff fee (depending on each sheriff and the kilometres travelled). 8. An advertisement is placed in two suitable newspapers concerning the sale of the assets by public auction (for assets above R3 000). Each notice is advertised separately indicating a case number. Sheriffs generally have a set day for auctions, for example, either Thursdays or Fridays. Cost: 20% commission fee for public auction; as low as 5% for a private auction. Alternatively, the creditor may request that the assets be sold at a private auction. 9. If there are no assets to attach, the creditor can choose to serve an Enquiry, S65, on the debtor personally, requesting the debtor to present themselves in court for a magistrate to decide what can be extracted. Some creditors prefer, however, to wait six or twelve months to see if the debtor becomes employed and an emolument order can be requested. If there are insufficient movable assets the creditor can execute against immovable property. Elapsed Days 20 10 5 5 40 to 90 10 10 Alternative Steps if Client is Accepted by a Debt Counsellor (steps 1 and 2 as above) 3. If the individual is accepted by a debt counsellor for debt review in terms of s86 of the NCA, the debt counsellor has sixty (60) days to present a proposal to creditors. Failing which, the creditor may proceed with legal action back to Step 3 above. 60 Alternative Steps if Client Enters an Appearance to Defend (steps 1, 2, 3 and 4 as above) 5. If after point 4 above, an appearance to defend is delivered by the client, the process goes to court and resolution is likely to be several years away. 6. Within 10 days (15 in the High Court) after the receipt of an appearance to defend the creditor may apply for summary judgment if he/she is of the view that the appearance to defend has been entered mainly to delay the proceedings and that the defendant has no reasonable defence. 7. The summary judgment is set down in court within 10 days and the creditor may proceed to execute against the property of the defendant, following point (7) above. The defendant may oppose the application. 8. If judgment is refused, leave to defend the matter is granted and the matter proceeds to trial. 10 10 The problems which arise with the Magistrates Court also arise in the High Court, but not to the same extent or frequency. The High Court is somewhat more efficient, but it is also more expensive due to the need to work through an advocate or attorney with rights of access to the High Court. 41 Assuming client is not exempt from the NCA. 35

Box E provides the steps for a provisional summons which can be utilised with Bills of Exchange. Advantages include expedited steps and the right to deliver the summons directly (and not through the sheriff). In theory, this process should require no more than 30 days to issue a judgment. The same delays and inefficiencies are experienced with regards to a provisional summons as an ordinary summons; however, this process rarely occurs within the theoretical timeframe. Commercial banks wield more negotiating power than smaller MSE lenders to manage the fees of attorneys and demand performance from them. It is the smaller developmental lenders which suffer the most from protracted court proceedings. Box E Theoretical Steps for Special/Provisional Summons (Bills of Exchange) Elapsed Days 1. and 2. Steps 1 and 2 for ordinary summons may be skipped for a provisional summons. 3. The creditor prepares a provisional summons which is stamped by the court and served on the client by the creditor (not by a sheriff). This summons calls on the debtor to pay the debt immediately or, failing such payment, to appear before the court on a certain day to admit or deny his liability. The plaintiff chooses a date from those available on the court roll. 4. If the debtor denies liability, he must serve and file an affidavit at least a day before the hearing, setting out grounds upon which his defence lies. The debtor must further state whether he admits or denies his signature on the document or whether he admits or denies the authority of his agent. 5. If the plaintiff admits liability the court may give a final judgment against him and the process reverts to point 7(as indicated in Box D on previous page) for the ordinary judgment. 6. A court may refuse provisional sentence and may order the defendant to file a plea, within 5 days. 7. If the court grants provisional sentence and the debtor subsequently gives notice that he wishes to enter into the principal case, the matter then becomes a trial action. The plaintiff has to provide security which must be paid into the court. The parties may agree, however, to waive the security requirement. 30 5 Cost of Collections Expenses incurred by a creditor during the collection process include: the cost of staff in an internal collections department, fees for external attorneys, fees for private repossession agents, sheriff fees and stamp duties, commissions to auction the assets, and the opportunity cost of capital, or lost interest on the capital. Table 7 below provides an illustration of the range of costs for an ordinary summons procedure which does not go to trial or a debt collector. The first part of the table calculates the fixed costs of collecting a loan, which varies according to the time frame: that is, the number of months it takes to close a file. It is assumed that for each hour spent by an internal collections staff member, a similar number of hours would be spent by an external attorney assisting with the file. For a three month collection process, it is assumed that both the internal staff and external attorney would spend nine hours on the file. This rises to 18 hours for a 12 month collection process. The table also makes the conservative assumption that for each outstanding loan, sales at the auction would realise the full value, which is generally not the case with a small enterprise loan. For example, the table assumes that for a loan of R75 000, auction revenues would be R75 000. If a private auctioneer is utilised, commissions can be negotiated down to as low as 6% all in. If a public auctioneer is utilised, commissions rise closer to 20%. The table illustrates that for a defaulted loan of R75 000, a creditor could recover as much as 82% of the value, assuming utilisation of a private auctioneer and a smooth legal process which takes only three months. On the other extreme, however, for a defaulted loan of R30 000, utilising a public auctioneer and assuming a slow legal process of twelve months, the creditor would recover just 28% of the value. 36

Table 7 Illustrative Examples of Cost of Collections Low Average High Assumed Months to Collect 3 months 6 months 12 months Internal Collections Staff and External Attorney Hours 9 hrs (3 hrs/month) 12 hrs (2 hrs/month) 18 hrs (1.5 hrs/month) Cost of Internal Staff @ Salary and Benefits R30K (R220/hr) R1 980 R2 640 R3 960 Attorney Fees @ R500 per hour R4 500 R6 000 R9 000 Repossession Agents R2 000 R2 000 R2 000 Sheriff Fees R 500 R 500 R 500 Total Fixed Costs R8 980 R11 140 R15 460 Loan of R75 000 Net Revenue 6% Commission R70 500 R70 500 R70 500 Net Amount Recovered after Fixed Costs R61 520 R59 360 R55 040 Proportion Recovered 82% 79% 73% Net Revenue 20% Commission R60 000 R60 000 R60 000 Net Amount Recovered after Fixed Costs R51 020 R48 860 R44 540 Proportion Recovered 68% 65% 59% Loan of R30 000 Net Revenue 6% Commission R28 200 R28 200 R28 200 Net Amount Recovered after Fixed Costs R19 220 R17 060 R12 740 Proportion Recovered 64% 57% 42% Net Revenue 20% Commission R24 000 R24 000 R24 000 Net Amount Recovered after Fixed Costs R15 020 R12 860 R8 540 Proportion Recovered 50% 43% 28% Opportunity Cost R75 000 @ 20% pa R3 750 R7 500 R15 000 Opportunity Cost R30 000 @ 25% pa R1 875 R3 750 R7 500 The opportunity cost of funds refers to the lost interest on the capital tied up in the defaulted loan. The assumed interest rates in the table are 20% for the loan of R75 000 and 25% for the loan of R30 000. The table demonstrates the high cost of each additional month s delay in the conclusion of a legal case. Small Claims Court The South African small claims court, which handles matters up to R7 000, is restricted to solving disputes for natural persons. The process in the small claims court entails the simple steps shown below. These would also be suitable for cases involving small businesses: A letter of demand is sent to the debtor; he/she is given 14 days to pay the amount owed. The letter has to be delivered by the plaintiff or be sent by registered post. If the debtor fails to pay the money, a summons (standard format) can be issued by the court at the request of the plaintiff. The summons stipulates a date of hearing. The summons is served by the plaintiff (and not by the sheriff). If the defendant refuses to accept it, the sheriff can be requested to serve it. 37

A commissioner conducts the hearing in an inquisitorial manner and grants judgment or rejects the claim. If judgment is granted, the court may issue a writ of execution (approval to seize assets), which is executed in the same manner as writs of execution in the Magistrates Court. South African Ranking on Collateral Environment From 2003 to 2005, USAID supported an initiative for Eastern Europe and the newly independent states called FILE, Fostering an Investment and Lender Friendly Environment. This project included the introduction and revision of elements of collateral law, enhancements to judicial procedures, establishment of asset registries, and facilitation of secondary markets through the establishment of auction houses. 42 Annex B documents the lender friendly principles which were incorporated into the collateral law during the FILE initiative and compares these with South African regulations and practices. Overall South Africa ranks well against these standards. The few areas where South Africa falls short include: The register of assets is limited, covering only immovable property, vehicles, and assets registered under a notarial bond. The process to lodge a notarial bond at the deeds office is expensive. No access to small claims court for registered entities. Delivery of notices complicated by two aspects; some magistrates require first notices to be delivered by registered post rather than in person and the sheriff must deliver a summons. In conclusion, it is the mechanisms of enforcement, and particularly the court procedures and delays, which most hinder the MSE lending sector and threaten its viability. A majority of recommendations in this report are directed at eliminating or reducing the role of the courts in MSE transactions or reducing time delays and costs in other ways. Credit Bureaus There are four primary credit bureaus in SA which provide both consumer and corporate credit references: TransUnion (formerly ITC), Experian (which recently acquired the corporate reference provider KreditInform), XDS, and CompuScan. The latter previously specialised in the microloans industry, but has since emerged as a full file bureau. While similar information is provided by each company this depends on the number and nature of their membership base. They are also differentiated by their value added services, such as credit scoring, tracing services, or ID validations. An initiative to integrate the CPA and NLR databases, and establish a new entity and governance structure to host this data, was launched by the NCR, CPA, and MFSA, in late 2007. Objectives and benefits include one repository for reporting and storing data and equal access by all primary credit bureaus which meet certain technical and security standards. Over time, the distinction between regular lending and microlending will fade and these two databases will become one. Within 12 months, the National Credit Regulator hopes to launch a National Credit Register of all outstanding credit commitments per consumer and legal entity. At the moment, certain loans are missing from the CPA and NLR data, such as loans fully secured by pensions or private banking loans; the new register will capture these. The register will play a different role from the CPA and NLR data in that it will not have dynamic reporting on payments but will simply reflect the total credit commitments per entity. Both of the above initiatives will improve the quality of credit bureau data on consumers. Since up to half the enterprises in the micro and small enterprise segments relevant to this study are likely to be unregistered, these improvements will enhance the environment for lending to these individuals. 38 42 Technical assistance for this initiative was provided by Chemonics International Inc., Deloitte Touche Tohmatsu Emerging Markets Ltd, and Booz Allen & Hamilton.

Box F Data Collected and Provided by Credit Bureaus 1. Credit and Payment Profiles from Members of the Credit Providers Association (CPA) All of the banks and large retailers are members of the CPA. This association requires that all members report on the borrowing and repayment data of clients to all four primary credit bureaus, and that data is equally available to all members of the CPA. Each member reports monthly, but on different dates depending on their accounting cut-off date. As a result, the information is between one day old and one month old for each member at any point in time. Despite the common data reporting, each credit bureau has unique validation procedures which result in some differences between the data. 2. Credit and Payment Profile from Members of the National Loans Register (NLR) Up until May 31st, 2007, the Micro Finance Regulatory Council (MFRC) required that all credit providers extending loans under R10 000, covered by the Usury Act Exemption, report their borrowing and repayment data to one of two primary Credit Bureaus: TransUnion or Experian. These two institutions were then obliged to synchronise the data and make it available to all the clients and agents of these two credit bureaus who were registered with either the MFRC or CPA. CompuScan was a significant collector of the data through their microlending members and had access to this data as an agent of Experian. (CompuScan is now a primary credit bureau.) Unlike the CPA data, the NLR data was required on a realtime basis. Once the NCA came into effect on June 1st, 2007, there was no longer an ongoing requirement to report to the NLR. Many members see the value of this data and have continued to report; this data is critical for accurate affordability assessments, which are a requirement of the NCA. However, it is problematic that not all members continue to report and some of the larger entities, such as retailers, now report their smaller loans through the CPA channel described above. The integration of CPA and NLR databases would further improve the credit environment. 3. Data from the Courts Data on civil judgements and administration orders are publicly available and are gathered from the courts by each credit bureau or their agents. 4. General/Demographic Information This data includes names and ID numbers, employment history, current and previous addresses, contact number information, and other occupants living at the same address. This data is proprietary and will be more extensive for those credit bureaus with a larger number of clients who are submitting data. 5. Enquiries This data includes the number and nature of enquiries to a credit bureau for a particular entity over the past two years; it gives an indication of the degree to which an entity is searching for credit. This data is also proprietary and will be more extensive for those credit bureaus with a larger number of clients who are doing enquiries. 6. Value-Added Services These services differentiate one credit bureau from another. They include generic and customised credit scoring models, tracing services, ID verification, and other services. Private Auction Houses South Africa hosts a mature sector of private auction houses. The largest three include: Aucor, Park Village Auctions, and Burchmores. These private auction houses maintain relationships with second hand dealers of different types of equipment and vehicles. They also have contacts nationwide as well as good transport procedures; consequently, stock can be rotated. Aucor, for example, operates five branch offices in South Africa and one in Namibia. It deals in equipment from the following industries: Aviation and Marine, Catering and Hospitality, Mining, Construction, Home and Office Furniture, and Manufacturing. It also deals in cars and light delivery vehicles, heavy commercial vehicles, and real estate. Aucor operates both on-line and in-person auctions and offers a range of services such as valuations, private auctions, and consulting. In addition to assets for sale following judgments or liquidations, it assists businesses with excess stock and voluntary office closures. 39

VIII Bills of Exchange International Experience Promissory notes and unpaid or bounced cheques are two common forms of bill of exchange utilised in lending to micro and small enterprises. They both indicate a promise to pay or unequivocal acknowledgement of debt which, when not honoured, allow the creditor to follow expedited court procedures. Unpaid cheques are backed by strong legislation in many countries. In both Egypt and India, if an individual signs a cheque without having sufficient funds to cover it, he or she can be sent to prison for between three months and three years. At the Alexandria Business Association (ABA) Small Enterprise Project in Egypt, when a payment is not forthcoming following multiple visits from branch staff, the company lawyer will guide the police to the borrower, who is then taken into custody and presented before the courts. The matter then becomes a negotiation between the borrower and the judge. Less than 1% of clients ever go to court and less than 0.3% ever go to prison. 43 Obtaining a cheque book, however, is not always an easy task for a microenterprise. In Egypt, cheques can be purchased in book stores by individuals who wish to contract with one another. The ABA produces post-dated cheques for each instalment of a loan, to be signed by clients. One cheque is also signed for the whole amount of the loan. If a client defaults, ABA can then take the client to court and claim the full amount outstanding prior to the maturity date of the loan. In India, due to unfavourable laws on pledging of movable assets, microenterprise lenders have also turned to cheques as an enforcement mechanism. Box G ACCION International partners in India 44 Three of ACCION s partners in India use cheques to secure individual loans: Grameen Koota, YES Sampann and Swadhaar. As per the Reserve Bank of India (RBI) regulation, loans below Rs.25 000 ($500 or R3 850 45 ) should be unsecured; asking for collateral for these loans is illegal. Yet, regulation is not entirely clear and all MFIs and other FIs in India providing individual loans ask for some form of collateral. Most lenders in India providing individual loans ask for Undated Cheques (UDCs) on which the dates and amounts are left blank. Post-dated Cheques, with one cheque for each instalment, can be used as a repayment form, but this incurs a large administrative cost. ACCION uses crossed cheques (or account payee cheques) which are made out in the name of the MFI. UDCs are a powerful tool; they are the only form of collateral which gives the MFI an opportunity to take legal action within an acceptable period of time. The MFI presents a cheque when the borrower becomes delinquent, usually after 30 or 45 days, depending on the specific delinquency situation. If the cheque bounces, the MFI needs to give two weeks notice to the borrower. If the client fails to honour the cheque, the MFI can present the case to court. It usually takes approximately 6 months before a sentence is passed. This process can be faster but can also take much longer. Clients are aware, however, that the outcome could be incarceration, and they attempt to clear the debt during this period. A borrower needs to have a bank account, and the account needs to show some activity, otherwise there is a risk that the account is deemed to be dormant and frozen by the bank. Clients without bank accounts cannot produce PDCs or UDCs and alternative collateral is required, such as a guarantor. Grameen Koota requires clients to either present a UDC or a guarantor for loans higher than Rs20 000 ($400 or R4 000). 80% of clients with a bank account opt for UDCs, indicating their inability or unwillingness to find a guarantor. In India, a high proportion of urban microentrepreneurs belonging to the individual loan target market have bank accounts. SA Lender Practices In theory, South African law allows for a faster court procedure in the form of a provisional summons when the creditor is in possession of a returned cheque, as outlined in Section VII. In addition, a Section 129 notice is not required since a bounced cheque is not considered a credit agreement. In practice, however, the same problems and delays that affect other court proceedings affect these provisional sentence proceedings 40 43 Calvin B, Alexandria Business Association, Individual Lending Research Case Study 1995. 44 Information provided by Hannes Manndorf, ACCION International. 45 Exchange rates at September 2009, $1 USD = 48.33 Rupee; R1 = 6.52 Rupee.

In South Africa, not one respondent claimed to rely on post dated cheques to secure their loans. These are utilised more in supplier credit arrangements than in loan agreements. Conclusions We do not regard post-dated or undated cheques as a solution to the MSE financing gap in South Africa for the following reasons: 1. In South Africa, it is illegal to incarcerate an individual for not paying a debt, so the Egyptian or Indian model could not fully apply here. (It is only a criminal offence if an individual is charged with obstructing the course of justice during the normal collection process.) 2. Cheques are becoming obsolete as electronic payment mechanisms are adopted. 3. Most individuals and enterprises in the low income brackets tend to operate a savings account rather than a current account. 4. Even if a creditor is in possession of a bounced cheque, all the problems of the Magistrate s Court will still hinder the securing of a speedy judgment. Until these problems are addressed, we do not foresee any improvement for the MSE sector through the use of post-dated cheques. SA Legal Framework Bills of Exchange Legally, a cheque is an unconditional order in writing addressed by one person to a bank, signed by this person, requiring the bank to pay on demand a sum certain in money to a specified person or his order or bearer. 46 The South African Bills Of Exchange Act 34 of 1964 defines a cheque as a bill drawn on a bank and payable on demand. Bearer means the person in possession of an instrument or a note which is payable to the bearer. The holder in due course means a holder who takes the bill, complete and regular on the face of it, in good faith and for value, before it is overdue, and without notice of previous dishonour or of any defect in the title of the person who negotiated it to him. The payee of a bill payable to order (or cash cheque) is not a holder in due course because the instrument is not negotiated to the payee; it is issued to him or her. The definition of a cheque implies that three necessary parties must appear on it: (a) the party who gives the order and who signs the bill is the drawer. (b) the party to whom the order is addressed to is the drawee (acceptor). (c) the party to whom the cheque is payable is the payee. On acceptance of the cheque, the acceptor becomes the principal debtor because by acceptance, he undertakes to pay the holder. 47 The post-dated cheque can be negotiated before the date, and, if acquired in good faith and for value, its purchaser will be a holder in due course. However, the drawee bank paying a post-dated cheque before its due date does so at its own risk and will generally be unable to debit the account of the customer with the amount paid. It will be entitled to do so only on the date of the cheque, unless payment has been countermanded before then. The drawee bank paying a post-dated cheque before its due date may have a claim based on unjustified enrichment against its customer. The bank has a duty to honour the customer's cheque, provided that there are sufficient funds in the customer's account to meet the full amount of the cheque, or special arrangements have been made. Exercise of reasonable care and skill in carrying out its obligations to the customer and maintenance of confidentiality is also important on the part of the bank. In carrying out its duties to honour the customer's cheque, the drawee bank must make payment in due course. The advantage of holding a bounced cheque is that the creditor can obtain a Provisional Sentence, a speedy judgment in respect of the amount due and payable. In principle, provisional sentence is granted only when the plaintiff s action is founded upon a document in which the defendant has unconditionally acknowledged his or her indebtedness to the plaintiff in a fixed and definite amount of money. The courts require that an acknowledgement be clear and certain on the face of the document so that no extrinsic evidence is required to establish the indebtedness. In addition, there is no need to send a notice in terms of section 129 of the NCA because a bounced cheque is not considered a credit agreement in terms of section 4(5) of the NCA. 46 Lawsa 2nd ed vol.19. 47 Section 52, Bills of Exchange Act, 34 of 1964. 41

IX Sureties and Guarantees International Experience Third party guarantors are commonly utilised in micro and small enterprise lending worldwide, particularly in cases where the borrowing clients have few assets of their own. A guarantor can apply pressure to the borrower to make repayments timeously, they can act as a business mentor, and they provide a second source of loan recovery. Assessing a guarantor, and realising on their promise to repay can be costly, however. Third party guarantees are particularly effective instruments in countries where there is a strong cultural imperative to repay debts. The Kingdom Bank group in Zimbabwe has utilised third party guarantees as a primary risk management strategy since launching its microenterprise unit, MicroKing, in early 2002. MicroKing grew to 8 000 clients within 18 months, with a portfolio outstanding of US $500 000, an average loan size outstanding of just US$65, and portfolio at risk over 30 days consistently less than 5%. 48 For the ACCION International partners in Latin America, guarantors are typically expected to earn a gross income of twice the monthly instalment of the loan. 49 If they are self employed, the microfinance institution bears the cost of conducting a full business and financial evaluation for the guarantor as well as for the client. SA Lender Practices Agreements to repay in the form of a personal surety from an owner comprise the most common form of collateral for small and micro enterprise lending in South Africa. As mentioned earlier, all the big four banks offer bank overdrafts to small businesses, secured by a personal surety from their owner(s). Specialised small business lenders, such as New Business Finance or the Umsobomvu Youth Fund, also utilise sureties as a primary collateral mechanism. The law governing personal security in South Africa is well established. A personal surety allows the lender to obtain a judgment against the business owner as well as the business entity in the event of default. Furthermore, this judgment can be listed on a credit bureau record under both the business name and owner s name. As mentioned in Annex A, New Business Finance does not accept third party guarantees unless the party has a financial stake in the business. If guarantees are accepted from family members, other than a spouse, who have an emotional rather than a financial interest in the guarantee, the courts are reluctant to enforce these contracts if the guarantors claim they did not understand the commitment they were making. At Nedbank, guarantors could be employed or self employed, but must be high net worth individuals (with net assets of R750 000 plus), and must come with a strong credit bureau report. This type of guarantor is the ideal business coach. Sometimes the guarantor will set a time limit, such as 24 months, after which they will be released from their commitment. The majority of clients, however, cannot find such a guarantor. Market research conducted among microenterprises in the North West province of South Africa in 2001 found that a majority (over 80%) claimed they would not be able to provide an employed guarantor. While supporting access to finance for a privileged few micro and small enterprises, the policy of taking third party guarantees will not significantly enhance the provision of loans to enterprises in the target range of R10 000 to R250 000. Conclusions As for bills of exchange, the only way to expand MSE lending through guarantees or personal suretyships is to improve the efficiency of the court system. Even so, however, these instruments will not greatly expand the market due to limited access to suitable guarantors by micro and small enterprise owners. 42 48 Unfortunately the economic crisis in Zimbabwe began hitting MicroKing hard in 2004 and the organisation had to consolidate its offices; it is still lending, however, on a reduced scale. 49 Ricardo Calvo, Project Manager, Global Operations, ACCION International.

SA Legal Framework Guarantors and Sureties A guarantee contract is a contract in terms of which a person binds himself to pay the debt of another. Under the NCA a credit guarantee is defined as an agreement in terms of which another person undertakes or promises to satisfy upon demand any obligation of another consumer. In terms of the law, the borrower or principal debtor still carries the primary liability for the debt incurred. The guarantor incurs secondary liability. That is, the guarantor becomes liable only if the principal debtor fails to pay. In the event of default, however, the creditor may pursue both the principal debtor and the guarantor concurrently. A suretyship agreement is a contract in terms of which one person (the surety) binds himself as debtor to the creditor of another person (the principal debtor) to render the whole or part of the performance due to the creditor by the principal debtor if and to the extent that the principal debtor fails, without lawful excuse, to render the performance himself. The surety consequently becomes bound together with the principal debtor for the liabilities or obligations of the principal debtor to its creditor. At common law, before a surety can be called upon to pay or perform, however, the creditor must first exhaust its remedies against the debtor. If the surety contracts as surety and co-principal debtor, the creditor can elect to claim payment or performance from both the debtor and surety or either. The formalities of a suretyship contract are regulated by section 6 of the General Law Amendment Act 50 of 1956. This Act requires that the contract must be reduced to writing and signed by or on behalf of the surety. The identity of the principal debtor, the creditor and the surety must appear on the document and the principal debt and obligations must be clearly stipulated. The contract of suretyship must be stamped. However, failure to stamp the document within a prescribed time does not invalidate it, as the Stamp Duties Act provides for the stamping of instruments and payment of validating penalties. In a contract of suretyship, the surety binds himself to the whole or part of the performance due to the creditor. There may be instances where different performances are due by the principal debtor arising from separate obligations existing between him and the creditor. Whether the surety is liable in respect of all the debts owed by the principal debtor or whether his liability is confined to only one or some of those debts depends upon the intention of the parties. Two or more persons can bind themselves, knowingly or unknowingly to each other, to the same principal debtor in respect of the same principal debt. Such persons are called co-sureties and are accordingly liable singuli in solidum, i.e. each for the whole debt, subject to the right of each to demand from the creditor that the debt be divided between them. A surety who binds himself as surety and co-principal debtor is liable jointly and severally as the principal debtor. Contracts of guarantee create primary obligations which are not dependent on the existence of any other debt or agreement (List v Jungers 1979 (3) SA 106) (A). This factor distinguishes a contract of guarantee from the contract of suretyship, which creates an accessory obligation. An accessory obligation is an obligation that is dependent on the existence or coming into existence of a valid and effective principal obligation. There can be no accessory obligation when the principal obligation to which it relates is a nullity or if the principal obligation has been extinguished, for example, by performance or payment. With a contract of guarantee, the creditor may choose to pursue legal action against the guarantor concurrently with action against the principal debtor. With a contract of surety, the creditor must first take action against the principal debtor. The guarantor must have the legal capacity to enter into the transaction. A guarantee must be evidenced by a written note or memorandum signed by the guarantors. Without such written evidence, a guarantee is unenforceable. There is no registration involved and no complications concerning proof of title. A guarantee can easily be enforced by court action. As with any other securities given by third parties (collateral security), it can be ignored when claiming against the principal debtor; it is up to the creditor to decide. A major problem with the guarantee is that it has been classified by the NCA as a credit agreement (section 8(1)(c)). This means that the credit provider has to make sure that the contract complies with the NCA. For instance: (a) compliance with pre-contractual disclosures; (b) contract must be written; (c) limitations on contractual clauses; (d) registration with the National Credit Regulator; (e) reckless lending requirements; (f) limitations regarding interest and financial charges; (g) rendering of statement of accounts (starts after a guarantor is required to pay); (h) pre-enforcement compliance (section 129); and (i) a consumer who is a guarantor, can also apply for debt review, thereby delaying the realisation process. In South Africa, the procedure to realise on a personal surety takes a minimum of three months, as described in the box below. In practice, however, interviews revealed that the average length of time to conclude legal action is 12 to 24 months. If the loans are in the range of R15 000 to R50 000, few legal firms or debt collectors will prioritise these. A strong in-house legal department is required to manage the process successfully. 43

X Movable Assets International Experience The use of movable assets for collateral can be achieved either through the pledging of existing assets or through leasing or instalment sale agreements for new assets. The latter provide the best lender protection in South Africa and other countries in the case of newly purchased vehicles or equipment. Pledging of existing assets, on the other hand, facilitates lending for working capital (inventory, labour, accounts receivable, and small assets) or the purchase of an existing business. A pledge of assets is achieved either through a general pledge agreement or through a notarial bond (or chattel mortgage) which is registered with an authority. Asset-based lending is an important source of financing in the United States, where asset-based loans account for about one third of total bank commercial and industrial loans. But it is only significant in two other countries, Canada and the United Kingdom. To be feasible, asset-based lending requires well-defined commercial law that clearly specifies security interests, an efficient lien registration system that clearly defines when liens are filed, and an efficient bankruptcy system that preserves lender priority (particularly security priority) and minimises time in bankruptcy. 50 Despite this assertion that asset based lending is limited in the formal sector to a few developed countries, movable asset collateral is a common strategy adopted by successful individual-based microenterprise lenders globally, for loan sizes from US $500 to $30 000. Movable asset collateral meets each of the borrower preferences listed earlier. Availability: While most microenterprise owners do not have real property to pledge, most do have some household or business assets which can be pledged, such as refrigerators, furniture, and appliances. Minimal Impact on the Household and Business: As long as the assets do not need to be transferred into the possession of the lender, such as in pawn-broking, assignment of these assets has no impact on the household and business unless the borrower defaults and the assets are seized. Minimal Transaction Costs: In jurisdictions where the creditor does not need to register the asset (as in Malawi) or has access to a special small asset registry (as in Peru), and may appropriate the asset without going through court procedures (both Malawi and Peru), movable asset collateral also meets this criterion of low cost. The other primary advantage of movable asset collateral is its flexibility. Just as with the BRI Kupedes loan in Indonesia which is secured by land (described in Section XII regarding immovables), a term loan secured with movable assets can be used for either working capital or fixed assets, or can support consumption smoothing in the household, in contrast to supplier credit or leasing or factoring, which provide less flexible forms of finance. One pioneer in the field of individual-based microenterprise lending is Interdisciplinaire Projekt Consult (IPC), a Frankfurt based consulting firm which has successfully implemented individual lending technologies with microfinance institutions worldwide. One of the early success stories for IPC was Financiera Calpia of El Salvador, a non-bank financial institution established in 1995 through the transformation of an NGO which had been lending to the small and micro enterprise sector since the late 1980s. In December 1995, Calpia had 12 060 loans outstanding with a portfolio of US $6.37 million, giving an average loan size of just over USD $500. Portfolio at risk over 30 days 51 stood at just 1.8%, indicating a strong capacity to manage risk. By 2003, Calpia had grown to more than 43 000 loans outstanding with a portfolio of USD $43.3 million and an average loan size of USD$1 000. Guarantees used to secure Calpia credit depend on the size of the loan and the socio-economic status of the client. The system is designed for maximum flexibility with the objective of serving all clients who evidence a real demand for credit. 52 Collateral that is pledged by clients is not physically removed (as with pawn loans), although certificates 44 50 Bakker, Klapper, Udell, Financing Small and Medium Sized Enterprises with Factoring: Global Growth in Factoring and its Potential in Eastern Europe, pg 10. 51 Portfolio at Risk is the primary measure of portfolio quality used in microfinance. It is calculated as the principal balance outstanding of loans in arrears divided by the total principal outstanding of all active loans. 52 Burnett, J, pg 17.

of property are taken when feasible. Collateral provided for Calpia loans is usually a combination of the following: furniture; fixed assets; anticipated harvests; co-signer with property or assets; deeds or property certificates; mortgages; bank papers and deposit certificates. All loans must be guaranteed for 100% of the value of the loan. For many microenterprise clients who cannot personally provide 100%, this requires that a co-signer be used to secure loans. At twenty days overdue, credit agents collect goods pledged as collateral. (The police are not involved in this procedure except in extreme cases. Calpia refrains from use of the courts since delays of up to 2-3 years in processing time make this an ineffective option. The inadequacy of the legal system in supporting Calpia s enforcement of loans is problematic and alternatives have been developed.) In rare cases where judicial action is taken, the borrower is responsible for covering costs incurred. 53 Where the legal environment does not facilitate pledging and realisation of movable assets in a cost effective manner, microfinance institutions are forced to find alternatives or apply a loose interpretation of the law. NGOs lending to the low end market tend to operate without strong government supervision and can, in some cases, follow procedures in contravention of the law without serious consequences. 54 Their client base also tends to be less willing and able to challenge the policies. Box H Challenges to Individual Microenterprise Lending in India MicroSave India Focus Note No. 14 Asset-backed lending requires clear legal documents establishing ownership of an asset to the borrower. In India, common household assets like land or a house are generally owned jointly with other members of the family. Elsewhere across the globe, these issues are addressed by collateralising small scale productive (lathes, sewing machines etc.) and household (furniture, appliances etc.) assets. These assets are risky since they can easily be disposed of by the borrower. However, more importantly, the realisation of movable asset collateral in India is simply not feasible indeed any attempt to seize assets is likely to be met with a formal complaint to the police against the MFI for trespassing and theft thus initiating a criminal case! To address these issues, Indian MFIs use a mix of different types of collateral, depending on the loan size several Indian MFIs are already attempting this segmented approach. Two of the large MFIs from South India, use a mix (one or more) of the following:1) Undated Cheques from the borrower, 2) Guarantee from a government employee (guarantor also should provide PDCs), 3) Title deed of any fixed asset (mortgage), and 4) Hypothecation of larger movable assets (say a tractor) Clearly, skirting the law is not a desirable situation. An ideal regulatory environment for movable asset collateral at the low end of the market would be one in which asset pledges are allowed without requiring possession to transfer to the lender and without a requirement for court procedures prior to realising the collateral. A special regulatory framework for movable assets collateral to support microenterprise lending was passed in Peru in 1997 (See Annex C for a detailed description of the legislation.) When introduced, the law covered any credit agreements up to $30 000. Staff and directors of Mibanco, an ACCION affiliate and one of the largest microenterprise lenders in the country, advocated for this legislation. Prior to the passing of the latter, clients of Mibanco were required to find guarantors, which resulted in the exclusion of a good number of potential borrowers. Mibanco did take asset pledges for a few years, until they were challenged by clients and realised they needed a supportive legal environment. 55 53 Burnett, J, pg 20. 54 It would be interesting to conduct a survey of how often this is the case in microenterprise lending. 55 Ricardo Calvo, Project Manager, Global Operations, ACCION International. 45

An introductory paragraph to the legislation states: This new type of security is different from the commonly known security as the debtor keeps possession of his property offered as collateral; in order to enable him to continue with his business, industrial, or commercial, or economic activities in full. In this contract, the rights of the creditor are protected not by possession of the property, as in the case of normal securities, but through a legal mechanism that consists of the registration of the pledge contract in the special register kept by the Movable Property Registrar of the National Public Register System. 56 Primary provisions of the Peruvian legislation, Act No 26702, include: 1. The Act provides for a floating pledge called a Global and Variable Security, which covers a range of assets in the business and household, including raw materials or inventory: which can be substituted for other property of equal nature, as long as it does not affect the value of the security or the rights of the creditor. 57 2. The Act allocates a custodian type responsibility to the borrower: By virtue of entering the Global and Variable Security Contract, the constituent (natural person or representative of a legal person) becomes the custodian of the property offered as security, undertaking all obligations relating to a custodian. Therefore, he is obliged to deliver the collateral property, property of equal nature or, otherwise pay its value in money, which is a simple requirement of the creditor in case of noncompliance of the guaranteed obligations. Therefore, beside the civil responsibility undertaken by the noncompliant party, it shall be liable for criminal charges against him due to unlawful misappropriation as prescribed in article 190 of the Criminal Code. 58 3. Once a floating pledge is registered on the Special Register kept in the Movable Property Register, it will protect the creditor in the same way as does a special notarial bond: It will have all the effects prescribed by law for third parties, by virtue of the publication and order of registration which will determine the preference rights granted by the Registrar. 4. In the event of liquidation, the creditor has absolute preference regarding the value of the global and variable collateral, excluding all other creditors. 5. The borrower, or custodian, is obliged to inform the lender of any of the following events: The existence of other global and variable securities on fungible property of equal nature; Substitution of the collateral property; Deterioration of the collateral property; Entering into a new global security agreement on property of similar nature; and Change of the place wherein the collateral property will be kept. Once a client is in default, the lender may call for the return of the collateral within 24 hours without a court ruling. If the collateral is not returned, it becomes an offence; the custodian is deemed to be stealing the collateral. At this point, the lender may choose to either collect the collateral or sue the client. The primary beneficial outcomes from this legislation include: It has expanded the market which financial institutions are willing to serve; It has reduced the cost of realising on collateral, thereby improving efficiency and lowering borrowing costs; It has helped to reduce over-indebtedness by establishing a register of floating pledges; and It has improved discipline and professionalism within Peruvian non-bank financial institutions, which are aware that their collateralisation will be reviewed by the office of the superintendent of banks. 46 56 Act No. 26702, Global and Variable Security. 57 Act No. 26702, Global and Variable Security. 58 Act No. 26702, Global and Variable Security.

It is unclear whether or not the Peruvian law has actually resulted in lower loss rates for the portfolio. Mibanco has grown tenfold in the past ten years to 348 000 active clients. With a loan portfolio of $700 million, the average loan size outstanding is just over $2 000. If the larger SME loans were excluded from these figures, the average micro loan size would be even smaller. Portfolio at risk over 30 days at Mibanco currently stands at an impressive 2.7% and loss rates have averaged below 3% since inception. In some countries, such as Tanzania, a Sale and Leaseback arrangement has been developed in an attempt to strengthen the rights of lenders while leaving the asset in the hands of the borrower. By transferring ownership to the lender, the right of the lender to seize the asset in the event of default or insolvency is strengthened. In South Africa, however, the existing judicial system does not look favourably on these arrangements, deeming them to be a way to get around the law. The growth of the pawn industry in many countries is a result of the law generally placing more rights in the hands of lenders if they are holding the pledged asset. Pawnbroking is costly, however, due to the requirement to store the asset safely and since the MSE loses use of this asset. In microfinance, pawnbroking is generally utilised for emergencies or consumption lending rather than for business lending. Enforceability of loan contracts and marketability of seized assets signal the borderline of the formal financial sector; if a major objective in financial sector development is to push out further the sector's frontiers so as to broaden access of the poor to the market, then it is interesting to explore ways to enforce creditor claims that do not involve the formal judicial process. In most developing countries, the law and its administration do not reach the poor and, even if they did, then the poor would not be able to afford legal recourse. Any effective extralegal mechanism is therefore relevant for financial sector broadening. The same applies to marketability; while the majority of the population has no or very limited real and financial assets that can be pledged as collateral, they do have some personal or family belongings to which they are attached; if such "assets" perform comparable risk protection and screening functions and are accepted by a bank, then this could have far-reaching implications for financial sector broadening. 59 SA Lender Practices Regarding Pledges Very few lenders to micro and small enterprises in South Africa are using asset pledges due to the requirement for possession of the asset to pass to the creditor. A constructive pledge can be established in a loan agreement, without transfer of possession, which establishes the right of the lender to take possession of the asset upon default. This approach, however, requires the client to sign a release form at the point when the asset is appropriated. Nkwe Enterprise Finance, operating in the North West Province, attempted to utilise this instrument when it was launched in 2001. With regards to an average loan size of R3 000, 60 the types of assets pledged included televisions, refrigerators, lounge suites, trailers, and small tools. Within twelve months of operating in one community, however, clients learned that they could delay legal proceedings simply by refusing to sign the release form. 61 At NBF, 10% of loans are secured with a vehicle pledge. The vehicle is registered in the name of the client but NBF holds the registration documents and an extra set of keys. This approach can work for vehicles due to the added security of holding the registration documents. Pawnshop loans in South Africa and elsewhere are structured as a pledge. These loans, however, tend to be used more for household emergency purposes, rather than for business investment. They tend to be short term in nature, from one week to three months, and act as a substitute for loans from moneylenders. Pawnshop loan products are best suited to countries which have enjoyed a culture of saving in gold and other valuables. In Peru, for example, households began saving in gold during the hyper-inflationary years; this paved the way for a vibrant pawnshop industry which also provides some small business loans. 59 Balkenhol B and Schutte H, Collateral, Collateral Law, and Collateral Substitutes, Social Finance Programme, Working Paper No. 26, 2001, Employment Sector, International Labour Office, Geneva, pg 16. 60 In equivalent current Rands. 61 While utilising the pledge instrument, Nkwe achieved impressive write off rates of just 4% of disbursements. 47

SA Lender Practices Regarding Notarial Bonds Some lenders in South Africa do utilise notarial bonds for loans between R50 000 and R250 000, but most expressed a reluctance to do so due to the cost and time involved in realisation. The Security by Means of Movable Property Act No. 57 of 1993 regulates the notarial bonds registered over corporeal (tangible) items. The Act states that corporeal items registered with the Deeds office are deemed to be pledged and delivered to the mortgagee. 62 While registering a notarial bond may only cost R2 000, primarily comprising legal fees, realising on a notarial bond generally requires R10 000 or more. NBF has registered both a specific and general notarial bond for approximately 10% of its term loans. A notarial bond is considered to be worth registering if it would cover assets valuing at least R50 000 and a minimum of 30% of the loan size. With every general notarial bond, NBF also attaches the accounts receivable of the company and includes a power of management. This means the NBF can place a person to watch the cash flows and ensure debtor payments do not get swept out of client accounts. The owner continues to manage the business but, once a person is placed at the premises to oversee the finances, it becomes uncomfortable and the individual tries to clear the delinquent amounts. This strategy, however, is only applicable for specialised small business lenders. The banking community would not be able to accommodate such a labour intensive process. NBF will first collect on their notarial bonds. If they do not cover the losses this way, they will proceed to attach the clients household assets through the promissory note and personal sureties. At Nedbank, specific notarial bonds are avoided in certain provinces where attorneys are either expensive or not experienced in registering the bonds correctly. 63 Some deeds offices are more demanding than others regarding the details registered for each asset, such as the serial numbers. This is expensive; the loan officer needs to inspect and verify each asset. 64 Nedbank does not believe general notarial bonds provide any real security protection: General Notarial bonds are not worth the paper they are written on. It is hard to prove which assets were covered by the bond and assets go missing by the time judgment is received. 65 Franchisee Buy Back Guarantees A third type of security on movable assets in South Africa is a buy-back guarantee on equipment offered by franchisors. Franchisee loans, however, rarely start below R500 000 and are above the level relevant for this investigation. Conclusions Improvements can be made in the legislative framework for movable asset collateral which would enhance access to credit by MSEs. Policy makers could consider the following: 1. Introduce special legislation for small movable asset security, such as the Peruvian model, which allows for rapid appropriation without going through the courts. 2. Enhance the effectiveness of notarial bonds by standardising procedures between Magisterial Districts, conducting further training of magistrates and attorneys, and explore further ways to reduce the costs of registration and realisation. 3. Consider allowing urgent applications or special summons to apply to all loans secured by a notarial bond. 48 62 The Act alters the decision of Cooper v Die Meester 1992 3 SA 60 (A), which stated that a special bond conferred no preference in favour of the mortgagee. 63 For example, an attorney may forget to include a clause that the landlord s lien should be removed from the notarial bond assets. 64 There are ten Deeds offices in the country, as follows: Pretoria, Johannesburg, Cape Town, Pietermaritzburg, Bloemfontein, Nelspruit, Umtata, King Williamstown, Kimberley and Vryburg. 65 Mano Muthusamy, Head of Credit, Nedbank Small Business Division.

SA Legal Framework Movable Assets The most common form of real security in South Africa is the Mortgage. Mortgage is a common word in South African law. It has numerous meanings. Generally, it is used in a comprehensive sense to refer to any right over the property of another, which secures an obligation (this includes security over both immovable and movable properties, including pledges). 66 It also refers to the securing of a debt by registering a bond over immovable property (restrictive use of the term). It is also sometimes incorrectly used to refer to the contract by which a right is created i.e. mortgage bond. Mortgages in South African law arise from three sources: (a) agreements to create a mortgage in the narrow sense, a pledge or a notarial bond if perfected by compliance with prescribed legal formalities, (b) operation of law (e.g. liens and hypothecs), and (c) judicial mortgage, which results from the attachment of property in the execution of a judgment. There are three legal requirements for a valid mortgage: (a) there must be valid legal obligation, (b) there must be property, (c) the creation of a real right. The principal obligation may arise from various causes including: money lending transactions, dowry, a purchase, mandate etc. The obligation may relate to a present or future performance. It may also be claimable or contingent on the occurrence of a future event. A global bond mortgage of all immovable properties that are owned by a debtor is not permissible but various properties of the debtor can be mortgaged at the same time through a composite bond. South African law permits several individuals to become joint mortgagors, who may be joint owners of an encumbered property. There can also be joint mortgagees, provided the principal obligation is the same for all the co-mortgagees. Co-mortgagees cannot, generally, stipulate that the share of one mortgagee will rank before the share of others in order of preference. Unless there are indications to the contrary, all co-mortgagees should be considered to hold equal shares. The mortgage is an accessory agreement. It cannot exist on its own. There has to be an underlying principal agreement. The validity of a mortgage depends on the underlying agreement. A mortgage cannot exist if the primary agreement is invalid in law or if the parties never intended to conclude the principal agreement. The mortgage is, therefore, susceptible to any objections and weaknesses that exist in the primary agreement. This characteristic of mortgages distinguishes it from other forms of real rights. A mortgage can cover the whole or part of the obligation of a debtor. The value of the asset mortgaged need not be the same amount as the debt that is owed. A mortgage can cover any movable and immovable property. This extends to part ownership of assets or sectional title units. 67 also cover incorporeals, for instance: 68 It can (a) (b) (c) (d) (e) a debt that is owed to a debtor, a right of action, document evidencing a life policy, share certificate, personal servitude. A mortgage can be registered on limited real rights (e.g. registered long term leases or subleases of land). South African law does not confer a right on the mortgagee to sell the mortgaged asset without using the formal court process (parate executie). It is in fact illegal for a credit provider to sell encumbered property without following the court process. This is intended to protect the debtor from unscrupulous credit providers or even genuine mistakes that may be committed by credit providers e.g. where the credit provider genuinely but mistakenly believes he is owed money by the debtor. The prohibition of parate executie also extends to agreements which state that the mortgagee is entitled to acquire the mortgaged property in the event the mortgagor defaults in his payments (pactum commissorium). The law, however, permits the parties to agree, at the time of a defaulted payment, that the mortgagee will obtain the property at a fair market value or that the creditor should realise the security. The client signs a consent form and this amounts to a conditional sale, which is a separate agreement from the original one. 66 Scott and Scott Will, Mortgage and Pledge 3rd ed 1. 67 Section 11(1)(c) of the Sectional Titles Act No. 66 of 197.1 68 Scott op cit 40. 49

SA Legal Framework Movable Assets continued Generally, the mortgagee is required first to obtain judgment following the provisional sentence proceedings. He may through a writ of execution obtain a judicial sale of the property or may request to sell the property himself. The proceeds of the sale are paid to the mortgagee and any excess is given to the mortgagor. A mortgage gives the mortgagee a preferred right over the mortgaged property in the event of the insolvency of the mortgagor. 69 If the mortgagor s is the only secured claim, he is entitled to insist that the proceeds of the sale of the property pay his debt, interest on such debt and other permissible charges. If there is any amount that remains, it can be shared with other creditors. If the secured asset is unable to cover the total debt owed, the mortgagee is entitled to obtain the balance of the amount owed from the residue of the insolvent estate. When making this claim he will rank as a concurrent creditor. A mortgage of a movable thing in South Africa can be achieved either through a pledge or a special notarial bond. A valid pledge of movable property between the pledgor and the creditor arises by means of delivery of the movable article to be held as security to the creditor and an agreement to pledge the said article to the creditor. Mere agreement between the parties, without delivery of the article, will only validate the pledge to the extent that it is binding on the debtor; therefore, the creditor will only have a right of action against the debtor, but will not enjoy preference over the movable article against concurrent creditors of the debtor. 70 In other words, a pledge is a real right which is established by means of taking possession and not by means of an agreement to pledge. The requisite delivery, which permits the protection of the pledgee against third parties, is one which places the pledgee in possession of the thing. It may take two forms, actual delivery, i.e. the physical placing of the pledged item with the creditor, or constructive delivery. Constructive delivery may take different forms: (a) (b) (c) (d) (e) Brevi manu occurs when a person who already has possession of a property ceases to hold it in one capacity and holds it in another capacity; Attornment occurs when an agent who is in possession of the property agrees to hold it as a pledge for the benefit of his principal s creditor; Symbolical delivery occurs when the article itself is not delivered but the means of accessing the article is, e.g. delivery of a motor vehicle key; Longa Manu refers to delivery of very heavy items. The pledgor will merely indicate the thing pledged without physically delivering it; Constitutum Possessorium occurs where the owner of the property agrees to hold the item in terms of a new ground or cause e.g. as an agent. The requirement of possession of the mortgaged asset in the case of a pledge means the economic value of the pledged asset cannot be exploited by the pledgor. The security of a pledge is lost: (i) where the assets are given back to the pledgor for his use, (ii) where the pledgor holds the goods for himself or his own benefit, (iii) where the pledgor holds the goods for the purpose of carrying on business. This means the pledgee is not permitted, generally, to redeliver the goods to the pledgor. The pledgee on the other hand is permitted very limited use of the asset pledged and has the burden of preserving the value of the asset pledged. As a result of the above, the pledge no longer has a commercial appeal in South Africa. A notarial bond is a bond that is attested by a notary public and registered with the deeds office. A notarial bond can be general (which may include property presently owned by the pledgor or which he will own in the future) or specific (items that are specifically mentioned in the bond). It is also possible to register in one and the same bond, a special bond over specified movables and a general notarial bond over the entire mortgager s remaining movables. There is no requirement for the delivery of an asset that is the subject of a notarial bond. A notarial bond can be registered for both incorporeal things (such as book debts, the goodwill of a business, shares in a company e.t.c) and corporeal things (refers to tangible or readily recognisable things). The Security by Means of Movable Property Act No. 57 of 1993 regulates the consequences of notarial deeds registered over corporeal things. The Act states that corporeal items registered with the Deeds office are deemed to be pledged and delivered to the mortgagee. 71 50 69 Section 89 (1) of the Insolvency Act No. 24 of 1936. 70 Section 95 of the Insolvency Act. 71 The Act alters the decision of Cooper v Die Meester 1992 3 SA 60 (A), which stated that a special bond conferred no preference in favour of the mortgagee.

SA Legal Framework Movable Assets continued The holder of a general notarial bond or a special bond registered since promulgation of the Security by Means of Movable Property Act enjoys a real right of security in the assets subject to the bond. The Act prevents the owner from dealing with and disposing of assets subject to the bond, or of bonding them to another creditor. The creditor can take possession of the property from the hands of an acquirer and can prevent a judicial attachment of the property in favour of a third party. The rights of the bondholder are of importance mainly upon insolvency. The bondholder is not a secured creditor and is only entitled to a preference over the concurrent creditors of the insolvent with respect to the proceeds of assets subject to the bond. The mortgagee can protect himself, to some extent, by inserting a perfection clause. A perfection clause entitles the holder of the bond to take possession of the movables over which the bond has been registered with the registrar of deeds. 72 Such a clause amounts to an agreement to constitute a pledge and will be enforced at the instance of the bondholder, whereupon the creditor obtains a real right of security. The holder of a special notarial bond enjoys the protection of the doctrine of notice. For instance, a later bondholder who has knowledge of the existence of a prior bond will not be entitled to perfect the bond in disregard of the prior bond With a special notarial bond, the creditor has preference in liquidation, but not with a general notarial bond. With a general bond, the creditor must act before a landlord, otherwise the landlord has preference and the creditor would rank along with other unsecured creditors. General notarial bonds are difficult and costly to manage as the creditor must keep up to date records of the assets of the enterprise. The costs of registering and realising on a notarial bond are particularly high due to the preference for utilising the High Court for these instruments. Accessing the said court requires either an advocate or an attorney with a right of access to the High Court. The cost of registering an asset is a minimum of R1 200 including legal costs for assets up to R10 000 and increases from that point. The cost of realising on the asset is a minimum of R12 500. This means that lenders will not even consider utilising this approach for loans of less than R50 000 to R80 000, depending on the institution. 72 Security by means of Movables Act 57 of 1993. 51

XI Leasing and Instalment Sale International Experience Leasing is a form of debt finance but, in contrast to loan contracts, leasing does not require collateral. Leasing is a contract through which someone uses equipment owned by somebody else. The user (the lessee) pays specific regular amounts to the owner (the lessor). The important feature of leasing is that use of the equipment is separated from its ownership. 73 The leasing arrangement benefits both parties the lessee generates extra income from the use of the equipment and the owner receives income while retaining the security of ownership. Enterprises throughout the world use leasing to finance vehicles, machinery and equipment. In developed (OECD) countries up to one third of private investment is financed this way. 74 Leasing in developing countries saw strong growth during the 1990s, largely as a result of improvements in the legal and regulatory environment. Leasing incorporates multiple advantages over the pledging of assets. With a lease there are no costs involved in verifying property rights and, if the lessee becomes delinquent, enforcement and repossession are automatic and generally do not require court action (although this is not the case in South Africa). Replacing a loan contract with a lease agreement also has the advantage of preventing diversion of funds away from the business. In many countries, there is an active secondary market for leased equipment, including lessor institutions. Purely in terms of facilities to get around a collateral constraint and disregarding other aspects (impact on the cash flow of the lease-taker, fiscal drawbacks) a leasing contract would seem to be an attractive alternative to a loan contract. 75 Favourable environmental factors for leasing include: A big enough market of entrepreneurs in need of medium-term investment finance; Active secondary markets and stable market values for the most commonly leased equipment; Availablility of technical advisors to assist in choice of equipment; Availability of spare parts and competent maintenance workshops; Availability of fire and theft insurance for equipment for SMEs; and Availability of medium term financing for the leasing companies. Due to these factors, leasing is better suited to urban rather than rural areas, where monitoring and equipment maintenance could be difficult. NLC of Pakistan ($10,000 average lease) imposes insurance on the life of the client, so that NLC does not have to repossess the asset when the client dies. Mark Havers (2000) argues that this is both prudent for NLC and very humane for the client s family. Equally, NLC takes out insurance to cover all risks (fire, theft, etc.) on each leased asset as well as residual value insurance in case a repossessed asset is worth less than the outstanding amount of the lease. All the costs of this insurance are included in the lease payments made by the client. This reduces the resistance by clients to have insurance while securing the needs of the leasing institution. 76 Other than for vehicles, leased equipment is generally not registered with an authority; the purchase receipt and lease contract together provide proof of ownership. A lease contract carries significant legal hazards due to the fact that ownership and usage are separated. For example, who carries the risk if the equipment does not function effectively? If the supplier is providing warranties to the lessor, who purchases the equipment, are these warranties still valid when the equipment is used by a third party? Can the lessor apply any restrictions on usage of the equipment? 73 Deelen, Dupleich, Othieno, & Wakelin, Leasing for Small and Micro Enterprises, A Guide for Designing and Managing, Leasing Schemes in Developing Countries, pg 3. 52 74 Deelen, Dupleich, Othieno, & Wakelin, pg 3. 75 Van Rijn, Steel, SDC. Balkenhol B and Schutte H, pg 16. 76 Mutesasira, Osinde, Mule, Potential for Leasing Products: Asset Financing for Micro- and Small Businesses in Tanzania and Uganda, MicroSave, 2001.

Due to these legal complications, there is more certainty and leasing is facilitated when a country promulgates specific laws about leasing. In a number of countries, the legal framework takes the form of a Leasing Act or a statute with an equivalent name. The Leasing Act usually covers issues such as: the definition of leasing; the rights and obligations of the parties; the right of the lessor to repossess the asset; claims on residual value; tax treatment for lessor and lessee; licensing and prudential requirements. A legal framework should recognise the three party structure of leasing, and make one or other party unambiguously liable for performance and saleability. This is important not only for minimising disputes, but also for increasing the attraction and competitiveness of the leasing sector as a whole. 77 Countries which have wanted to stimulate investment in equipment by SMEs (the United States and Ghana for example) have introduced favourable tax treatment for leasing, allowing accelerated depreciation for the lessor and full tax deductions of lease payments for the lessee. Since small and micro enterprises are often not profitable enough to take advantage of accelerated depreciation rules, it is advantageous to allow the lessor to benefit from these. Most countries, however, lay down certain requirements which must be met in order to qualify for these tax advantages. In some countries the leasing law restricts how the final payment is defined. In these countries, the lessor must carry the risk related to the residual value of the equipment. Kenya and Argentina have similar rulings that in effect forbid full pay-out or bargain options for tax leases. In these countries, if the transfer price of the asset is not at market value, then the lease is not classified as a tax lease. In India, Bolivia, and Mexico, on the other hand, bargain options are allowed in tax leases. Tax benefits still apply even if the asset is transferred to the lessee at a nominal price at the end of the lease term. 78 Lessors tend to require an up-front deposit of approximately 10% of the equipment value (but this can be as high as 30%). Some jurisdictions, however, will not allow beneficial tax treatment for a lessor if they take a security deposit. In Korea in the late 1970s, lessors were given accelerated tax deductions as well as preferential customs rates for imported equipment. This led to the development of a vibrant leasing sector. Formal leasing companies worldwide express a preference to serve medium sized businesses which meet the following criteria: 79 they are cash rich and generate a regular income flow; need non-specialised assets with a ready secondary market allowing easy sale of repossessed assets; possess assets which are multi-purpose and can be used across sectors; and own assets which have clear titles of ownership for ease of repossession and liquidation. (This explains the dominance of the transport sector in many countries.) There are a few examples, however, of organisations which have successfully applied leasing to the small and micro enterprise markets, including: SELFINA and Akiba Bank in Tanzania, Network Leasing Company (NLC) in Pakistan, ANED in Bolivia, and Grameen Leasing in Bangladesh. SELFINA and Grameen reach the lowest levels of the microenterprise sector, including leases as small as US $75. FINCA Uganda and OLP (Pakistan) have developed relationships with cellular telephone providers Celtel (Uganda) and Voice Tel Tech (Pakistan), to provide a lease package which enables the buyer to set up as a Public Communication Office (PCO) providing telephone, e-mail, and fax services. 77 Deelen, Dupleich, Othieno, & Wakelin, pg 78. 78 Deelen, Dupleich, Othieno, & Wakelin, pg 93 79 Mutesasira, Osinde, Mule, Potential for Leasing Products: Asset Financing for Micro- and Small Businesses in Tanzania and Uganda, MicroSave, 2001. 53

Box I Eligibility Criteria for Grameen Leasing Programme 80 (Asif Ud Dowla, 1998) A member must be at least a three-time loanee. A member must have an additional source of income so that instalments can be paid. Lessee or a member of the family must have prior experience in managing the leased item, and the member of the family must oversee the item. In the case of transport items, lessee or a member of the family must be an experienced and licensed driver. Leased item must be used properly and the repayment rate must be satisfactory. A member must have a space or will create an appropriate space to store the leased item. Box J Case Study Selfina, Tanzania 81 The SERO Group of companies established the SERO Businesswomen's Association (SEBA) in 1994 with the aim of enhancing women's economic development through the provision of training in entrepreneurship. SELFINA (SERO Lease and Finance Company) was established by the Group in 1995 as a limited company with the aim of providing lease finance and loan capital to assist poor female entrepreneurs to enable them to start or expand their businesses. In order to qualify for a loan, clients must first attend a sensitisation meeting. This is followed by an interview in the office and then a visit by a (lease originator) to the client s place of business. A client must obtain a pro-forma invoice and must deposit 15% of the value of the equipment. This helps to share the risk and demonstrates the commitment of the client towards the project. A client must also provide two guarantors, which may be family members. SELFINA pays directly to the supplier. In the first four years of operation, by July 2001, more than 2300 women had benefited from the services of SELFINA. Leases worth TSh 1.3 Billion 82 ($1.5 million) had been issued during this period, for an average loan size of US $ 600. The smallest lease during this period was US $72 and the largest was US $ 2 875. The effective lease term is 6, 12, or 18 months, depending on the value of the lease. The most frequent businesses and equipment purchases included: catering/retail (freezers, refrigerators, cookers, microwave ovens); tailoring (manual and electrical sewing machines, embroidery sewing machines, overlockers, chain stitch machines); secretarial (photocopiers, computers and printers, typewriters); beauty salons (dryers, steamers) and others: nursery schools, carpentry, handicrafts, water pumping, and handlooms. According to Wamara, 83 SELFINA's clients are predominantly mature, married, middle-class women, with above average education, hailing from a limited number of Tanzania mainland's twenty regions. A quarter of sample clients work for the government or parastatal companies, as do nearly half their husbands. Most of the remaining clients run small-scale businesses on a full-time basis. The majority of SELFINA's clients are involved in small-scale retailing and catering, followed by tailoring and farming. The majority of clients (75.5%) thought that SELFINA's assistance had increased their earnings and only 18% thought it had not. But two-thirds of clients said monthly earnings had increased only slightly, and only 16% said the increase was substantial. The majority (70%) said they had not encountered problems in keeping up with repayments, whereas the remaining 30% had encountered such problems. But only 5% of respondents said they were behind in their payments. An investigation into leasing in Uganda and Tanzania on behalf of MicroSave concluded that small and micro enterprises were favourably disposed to leasing as a financing vehicle. Most small enterprise operators were very positive about the typical leasing product. They tend to prefer a product with a low initial deposit of 2-5%, a grace period of 1-4 months, and flexible repayment schedules that are responsive to variations in cash flow. 84 In most instances, lessors and lessees prefer to deal in new assets. Due to economic considerations in Tanzania and Uganda, however, second hand equipment is occasionally permitted for MSEs. In some cases, imported second hand equipment is more reliable than new locally made equipment. In these cases, lessors will engage reputable, independent, machinery assessors whose valuations can be relied upon to determine resale values accurately. 54 80 Mutesasira, Osinde, Mule, pg 18. 81 Pinder, Caroline, EDIAIS Project Manager, SELFINA (SERO Lease and Finance Company) Tanzania, Case Study, 2001. 82 In August 2001, $1 = 870 Tsh. 83 A Brief Evaluation of SELFINA Ltd's Leasing and Loan Activities, TADREG, Tanzania, Sept 1998. 84 Mutesasira, Osinde, Mule, Potential for Leasing Products: Asset Financing for Micro- and Small Businesses in Tanzania and Uganda, MicroSave, 2001, pg iv.

The study found that strict enforcement and repossession of assets from delinquent clients was essential to the success of a leasing institution. In Tanzania, the law does not require a court judgment prior to appropriating the asset, but the contracts must be properly drawn up to avoid legal problems: Laxity with enforcing this policy could severely compromise the company s portfolio. Leasing companies have a policy concerning when repossession should take place. The standard practice among the leasing companies is that the asset is to be repossessed after three missed instalment payments. Some institutions repossess the assets within a much shorter timeframe. However, it is important that the lessor seek legal advice on how to go about the process of repossessing and selling off leased assets. While the asset remains the property of the lessor for as long as the lease has not been paid off in full and the title of ownership has not been transferred to the lessee, these assets are installed on the lessee s property. In Tanzania, there have been instances where delinquent lessees have sought injunctions citing trespassing to prevent lessors from coming onto their property to repossess. 85 A wide range of assets were identified by this study as potentially forming the basis for a broad leasing service: Table 8 Business Assets and Sector-by-Sector Potential for Asset Financing Sector Micro-Business (less than$2,500) Small Business ($2,500 $50,000) Retail Trade and Service Refrigerators, freezers,shelves, weighing scales, sewing machines, sofa sets for events Food Processing Juice bars juicing; machines, fridges/coolers, Honey farms-hives, honey harvesting gear. Dairy - milk coolers, cream containers, pasteurizers, filling machines, milk separators, mobile milk units, etc. Information Technology Computers and printers for secretarial services fax machines, photocopiers Education Computers, printers, UPS, stabilizers, generators, etc. for computer training schools. Transport Motorbikes, bicycles Small Scale Manufacturing Hand tools, sewing machines Construction Hand tools, painting equipment, brick making equipment Entertainment and Hospitality Chairs, cooking pans, utensils, warmers, tents, cooking stoves, music systems, generators for events Health Clinics Examination couch, weighing scale, blood pressure machine, stethoscope, sterilizers, simple microscopes, refrigerators for vaccination, filing cabinets Agriculture Small scale spraying equipment, hand-tools, wheel barrows, bicycles Small Mining Pick, shovels, wheel barrows Retail Trade and Service Freezers, refrigerators, weighing scales. Food Processing Milk vans, milk processing plants, canning equipment, bottling equipment, generators, coolers, water bottling equipment Food Processing Computers, generators, UPS Units, satellite dishes, printers especially for internet cafes Food Processing Hardware for accessing internet, computers to streamline administration, buses and trucks Food Processing Taxis, buses, trucks, tourist vans Food Processing Electrical equipment and tools, carpentry equipment, welding machines, grinders, generators, cutters Food Processing Trucks, compactors, brick laying equipment Food Processing Chairs, cooking pans, utensils, warmers, tents, cooking stoves, music systems, generators for events Food Processing Admission beds, larger, diagnostic equipment, larger refrigerators, filing cabinets Food Processing Tractors, trucks, power generators, land Food Processing Portable compressors, crushers, generators, security alarms, swim suits, pick up trucks, excavators, jigs, processing equipment, gem cutting machine, test kit Sale and leaseback is a technique utilised by some microfinance institutions globally to take advantage of the additional security provided by a lease in cases when a client requires working capital and is not purchasing a new asset. 85 Mutesasira, Osinde, Mule, pg 24. 55

SA Lender Practices The legal and tax environment in South Africa is favourable for leasing and instalment sale agreements, which are both governed by the National Credit Act. With regards to a financial lease the asset is deemed to be owned by the lessor until all payments are made. In terms of an instalment sale agreement, the deal is generally structured such that the asset is owned by the debtor, but the creditor retains a right to reclaim the asset until all payments are made. The lessee pays VAT upfront in the case of a financial lease but can reclaim it. Only the interest portion of the financing agreement is tax deductible. When the term of the agreement comes to an end, the VAT consequences will depend on what happens to the asset. If the lessor disposes of the asset to a third party or the lessee, VAT is payable on the price. If the asset is abandoned to the lessee, however, there are no VAT implications. In the case of an instalment sale agreement, VAT can be claimed upfront by the debtor, who can also claim wear and tear (depreciation) of the asset. With regards to a vehicle lease, the registered user is the client but the title holder is the creditor; South Africa has a well established regulatory framework and industry for vehicle leases. All the South African banks utilise leasing and instalment sale agreements for the small business market. At Nedbank, these deals are considered for loans of R50 000 or above 86 and are utilised for vehicles or boats, yellow metals (tractors, bobcats, excavators, and suchlike), or office and manufacturing equipment. There is a smaller resale market for office equipment; therefore recovery values are not good and banks generally require a 10 to 20% deposit (depending on other risk characteristics). With regards to an instalment sale agreement, ownership remains with the client/debtor but the law recognises a priority claim to the asset by the creditor in the event of default. The lender must deposit funds directly to the asset supplier and must retain a purchase receipt. The loan agreement must include the serial number of the asset. The bank finances the asset and the VAT. Once the client claims the VAT back, after three or four months, this is immediately repaid to the bank. The balance of the asset purchase price is amortised over the life of the loan, generally 60 months. The client claims the depreciation and accounts separately for the loan interest. Instalment sale agreements rank at the same level as leases in the event of default or bankruptcy while both rank ahead of landlords. The primary benefits of these two instruments are their priority claims in the event of insolvency, the duty of the debtor to inform the creditor of the whereabouts of the asset, and the right of the creditor to sell the asset through a private auctioneer with a reserve value. An instalment sale is generally preferred by lenders in preference to leases since ownership of the asset is not contested (it generally rests with the borrower) and the bank is not saddled with an asset of which it needs to dispose at the end, or during the life, of the financing period. Also, less recordkeeping and administration is required for such an agreement. Both instruments are affected by inefficient court procedures as a court order must be obtained before the appropriation of the asset, unless the client signs a voluntary release form. One bank claimed that it is able to obtain a release form from 70% of clients by convincing them that it is in their interest to avoid the legal costs. If the client refuses to sign the release form, the creditor may file an urgent application for a judgment, arguing that the asset may be damaged or relocated if left in the hands of the debtor. Magistrates do not view these requests kindly, however, and might not comply. Conclusions To support this type of lending, policy makers should consider the following: 1. Accept and support urgent applications for judgment for all lease and instalment sale agreements; this would reduce the risk of assets being relocated or damaged. 56 86 With a preference for deals of R100 000 and above.

2. Investigate the possibility of judgment creditors appropriating the assets without a prior judgment and without a signed release form. This could be restricted to institutions registered as developmental lenders with the National Credit Regulator and to loans below a certain value, say R100 000. 3. Expand the asset registry to include instalment sale and lease agreements other than vehicles; this would prevent / reduce the sale of assets subject to these agreements and would render it easier to trace these assets in the event of repossession. SA Legal Framework Leases and Instalment Sale Most lease agreements and hire purchase agreements that are concluded with MSEs are regulated by the NCA. Like its predecessor, the Credit Agreements Act, the NCA applies to a broad scope of agreements including lease, hire purchase and instalment agreements. Hire purchase agreements are included in the broad definition of an instalment agreement, as follows: a sale of movable property in terms of which (a) all or part of the price is deferred and is paid by periodic payments; (b) possession and use of the property is transferred to the consumer; (c) ownership of the property either (i) passes to the consumer only when the agreement is fully complied with; or (ii) passes to the consumer immediately subject to a right of the credit provider to repossess the property if the consumer fails to satisfy all of the consumer s financial obligations under the agreement; and (d) Interest, fees, or other charges are payable to the credit provider in respect of the agreement. The NCA regulates most financial leases. A lease agreement is defined as a contract in terms of which (a)temporary possession of any movable property is delivered to or at the direction of the consumer, or the right to use any such property is granted to or at the direction of the consumer; (b) payment for the possession or use of that property is (i) made on an agreed or determined periodic basis during the life of the agreement; or (ii) deferred in whole or in part for any period during the life of the agreement; (c) interest, fees, and other charges are payable to the credit provider in respect of the agreement, or the amount that is deferred; and (d) at the end of the term of the agreement, ownership of that property either (a) passes to the consumer absolutely; or (b) passes to the consumer upon the satisfaction of specific conditions set out in the agreement; Agreements that do not meet the abovementioned requirements are regulated by the common law. It should be noted that South African common law does not make a distinction concerning the various lease agreements. A lease agreement is simply defined as an agreement where a lessor agrees to lease a property to a lessee in return for the payment of rental. The various types of leases came about as result of business innovation and need. Parties to a credit agreement may secure loans by using a sale and leaseback agreement. These transactions are normally constituted by two contracts, i.e. the contract of sale and the lease agreement. The seller, who will be the owner of the property, sells to the creditor and the creditor leases it back to the seller. The lease agreement will, in all probability, result in the asset being re-owned by the initial seller. The lessee will pay interest and financial charges during the life of the lease. Although a sale and leaseback may appeal to credit providers it presents the following challenges: (a) A court may determine that it is a simulated transaction. For instance, it may determine that there is no real intention to conclude a sale agreement (The Commissioner of Inland Revenue v Conhage (Pty) Ltd 1994 (4) SA 1149 (SCA) and Vasco Dry Cleaners v Twycross 1979 (1 )SA 603 (A). (b) The agreement is a lease agreement for the purposes of the NCA and the process, requirements and timeframe stipulated in the Act apply. (c) The agreement no longer has the tax advantages that it once had. (d) The transaction may have Value Added Tax consequences. (e) The credit provider has to comply with the court process and NCA procedures before he can repossess the item that is the subject of the sale and lease agreement. One of the major challenges will be debt counselling. The use of the leaseback as an alternative to a pledge is not ideal because of the possibility that a court 57

XII Immovable Assets International Experience While borrowing against property may be the most widely-used financing method for medium sized and small businesses with turnovers above approximately R1.5 million, this form of financing is generally not suitable for a majority of MSEs: A majority of owners do not own property which would qualify for a mortgage bond; The legal costs involved in registering a mortgage bond are high in relation to loan sizes; and Creditors are hesitant to evict a family from a home when the loan size is less than R100 000. For similar reasons, and with a few notable exceptions, immovable assets are also not commonly seen in microfinance globally. Perhaps the best known exception to this is the Bank Rakyat Indonesia (BRI) Unit Desa Division, which serves the lower income market at the village level throughout Indonesia and became one of the leading pioneers in microenterprise lending using an individual rather than a group lending methodology. BRI is a state bank and is one of Indonesia s largest banks as measured in terms of total assets. The Unit Desa division of BRI is one of the Asian giants of microfinance with more than 3.5 million borrowers and 21.2 million savings accounts. 87 The Unit Desa division has also been a solid generator of profits for its parent bank. In 1960, Indonesia launched the Basic Agrarian Law, a comprehensive legal effort to modernise land ownership. The law recognised previous ownership rights and provided a new certification process under which land was to be registered. Under this law, absentee ownership was forbidden and all unclaimed land reverted to government ownership. This programme resulted in a large number of villagers holding land titles that could be pledged for financing purposes. The 1983 agricultural census showed that approximately 44% of all farm households were either landless or operated holdings too small to meet more than subsistence requirements. The average landholding on Java was 0.66 hectares, and ranged from about 1.5 to 3 hectares in other parts of the country. 88 To be eligible for a loan from BRI, the enterprise must meet the following criteria: Demonstrate sufficient cash flow to repay the loan; Demonstrate an honest and reliable character as verified by neighbours and suppliers; Provide the unit with a letter from the head of their village; Provide the bank with collateral. The primary form of collateral taken (80%) is in the form of land, although the units can accept virtually any form of fixed or movable asset to which a reasonable indication of ownership can be produced, including jewellery and appliances; and For loans of more than approximately US$1 000, borrowers must also possess a business licence. When the KUPEDES loans for small and micro enterprises were first introduced in 1984, BRI was required by banking regulations to demand collateral. This regulation was removed in 1992, but BRI does not intend to adjust its collateral requirement. The importance of collateral as a means of reducing risk and promoting repayments at BRI presents an interesting contradiction. When asked to identify the most important factors influencing client repayment, staff and management throughout the unit division usually identify the client s sense of obligation to repay their debts as the primary motivating factor, followed by the prompt payment incentive. These same persons, however, almost unanimously believe that the quality of the portfolio would suffer significantly if they did not require collateral. To reconcile this apparent contradiction, a few explanations were offered. The most compelling explanation is that, while collateral is not a primary motivation to repay on a monthly basis, it serves as a psychological burden, an important reminder in the back of the borrower s mind. Finally, collateral is considered important, even though BRI almost never acts on it, because it demonstrates the good faith of the applicant. 89 58 87 Other Asian giants include Grameen Bank, ASA, and BRAC of Bangladesh and VBSP of Vietnam. 88 Churchill C, pg 6. 89 Churchill C, pg 37.

The only time the bank would consider acting on collateral would be if the outstanding balance were greater than US $ 1 000 and the unit staff were to believe that the client is able but unwilling to repay and is trying to deceive the bank. Otherwise, Unit Desa would prefer to reschedule the loan to reduce payments to a level manageable for the client. Box K BRI Unit Desa Business Philosophy 90 The unit banking system comprises one basic loan product, KUPEDES (general rural credit), which serves a vast array of productive purposes. It can be used for working capital loans as well as for fixed investments; for agricultural purposes, such as rice farming or cow fattening, and by market traders to purchase stock; for three years or three months; it can be as little as Rp 25,000 (US$11) and as much as Rp 25 million (US$10,600). With a few adjustments for larger loans (a slightly more complex business assessment and lower interest rates) and a different term structure for agricultural loans (seasonal rather than monthly instalments), this broad-based product serves the needs of a wide swath of the low-income market. The simplicity of the product, and the fact that it is uniformly implemented in more than 4,000 retail outlets around the country, is an important factor in the success of the unit system. BRI s unit banking approach represents a psychological reorientation regarding risk and return at the bottom end of the financial services market. Unit staff believe that small-scale borrowers are less risky than their wealthier compatriots because they have better character and are more likely to stay within their means. From the perspective of unit staff, the ideal client is someone who repays their loan on time. Loan officers look for clients who are disciplined, honest, and responsible. In assessing a loan application, these characteristics are more important than business variables. The unit division s motto is The right person, the right time, the right amount. The success of the BRI Unit Desa system can be attributed to many environmental factors. Registration of land parcels to rural families certainly helped to render these families bankable, but it appears that the letters from village authorities and other factors were the primary risk management strategies utilised. SA Lender Practices Most banks and other formal sector lenders to small businesses in South Africa will take a primary or secondary mortgage on property if it is available. For the previously disadvantaged clients, however, this is usually not an option. NBF conducts a deeds search for each new client; only 3% have been found to own any real property. The study of Township Residential Property Markets in 2003/04 91 concluded that out of four sub-markets within the townships, including the informal, incremental, old township, and privately developed sub-markets, only the last mentioned was trading actively on the secondary markets. The average household incomes of the owners of homes in this sub-market at the time were over R7 000 per month and primarily belonged to the BSM 7 business segment. Credit providers generally do not accept immovable property that is below R400 000 in value. Most individuals who fall in this market group are likely to own houses as a result of government housing schemes or public and private partnerships, including the following (detailed in the Housing Code): RDP houses; Housing Subsidy Scheme; Housing Subsidy Scheme Institutional funding; Project-linked Subsidy Scheme; Discount Benefit Scheme; Public Sector Hostels Redevelopment Programme; National Housing Finance Corporation (NHFC); and National Urban Reconstruction and Housing Agency. 90 Churchill C., Bank Rakyat Indonesia Case Study. 91 Nell, Gordon, and Bertoldi, Township Residential Property Markets, Phase III, 2004. 59

The government also grants ownership and property rights to poor people through the following legislation: Upgrading of Land Tenure Act No. 112 of 1991; 92 The Conversion of Certain Rights into Leasehold and Freehold No. 81 of 1988 (Conversion Act); 93 Land Titles Adjustment Act 111 of 1993; 94 Kwa-Zulu Ingonyama Trust Act No.3KZ of 1994; 95 and The Communal Land Rights No. 11 of 2004. 96 There are various legal limitations and impediments that undermine the use of low cost housing as security. These include the following: Section 10A (1) of the National Housing Act No. 107 of 1997 prohibits a beneficiary of a housing loan from selling a property for a period of 8 years after the date of acquisition. This condition, however, only binds the original beneficiary. It does not apply to subsequent sales. The legal process for the registration of first or second mortgages is expensive and complex. In addition to the above costs stamp duty has to be paid for the registration of mortgages, in terms of the Stamp Duties Act No. 77 of 1968. Fortunately, properties below the value of R500 000 have been exempted from the Transfer Duty Act No. 40 of 1949. In some situations, there is no legal title or ownership of the property. This has been corrected to a large extent by the Conversion Act and the Upgrading of Tenure Rights Act No. 112 of 1991. The process of conversion, however, has not been finalised in some townships. The legal process that has to be followed before a secured property can be sold is laborious and expensive. Most rural people do not have ownership rights over their property. These properties are usually owned communally. They are regulated in terms of communal rules. As indicated above, the Communal Land Rights Act permits individuals to apply for freehold tenure if the Communal rules permit. Various South African laws make it difficult or impossible for a mortgagee to sell or alienate land that has been mortgaged. In addition to the various servitudes the purchasing of the land may be unattractive because of the difficulty of evictions in terms of the Prevention of Illegal Evictions and Unlawful Occupation of Land Act 19 of 1998. Although there are various challenges that arise with regard to land tenure in South Africa, the government has attempted to provide citizens with more security over property. This is a major development considering that a majority of people in the country were deprived of land ownership for many years. Another hindrance which affects the use of immovable property to secure a business debt (which applies to all mortgages), is the difficulty of registering a second mortgage over a property. Financial institutions often refuse to be second in the queue; preferring to pay off the existing loan and cancel the registered mortgage. This causes inconvenience for the consumer and results in unnecessary legal costs and time wastage. In order to avoid this, most consumers are forced to apply for further loans with the institution that already holds the mortgage bond. This creates uncompetitive behaviour which is detrimental to the consumer. It limits or nullifies options that are available to the consumer, especially if the first institution refuses to grant the further loan or if the new loan is granted with unfavourable terms. Conclusions Continued efforts by government to strengthen property rights will eventually facilitate access to credit by those small enterprises which have a strong enough cash flow to support property ownership. In the meantime, we conclude that changes to the regime governing real immovable property are not a priority for expanding access to business loans in the range of R10 000 to R250 000. 92 This refers to the conversion into ownership of property rights such as leaseholds, deeds of grant, and tribal land. 93 This applies to property permits that were given to people in terms of the Black Urban Areas Consolidation Act No R 1036 of 1968. 94 Allows the Minister of Land Affairs in certain situations, e.g. where an heir or predecessor fails to take ownership of land, to permit the transfer and registration of the 60 property. 95 Creates a corporate body called the Ingonyama Trust, which administers tribal land in terms of the Kwa-Zulu and Iziphakonyiso Act No. 9 of 1997. The Act requires the trust to deal with the land in terms of Zulu indigenous law and prohibits the alienation or encumbering of the land. 96 Permits the registration of property in South Africa to various communities in terms of communal rules. Section 9 of the Act permits an individual to have freehold tenure over his/her property, if the rules of the communal entity permit it.

SA Legal Framework Immovable Assets (Property) Immovable assets play a pivotal role in money lending transactions, including lending for business purposes. Collateral of immovable property is one of the safest forms of security that is readily and widely accepted by most credit providers in South Africa. Any owner of immovable property can constitute a valid mortgage over his/her property. Generally, the law only allows owners of properties to register mortgages over property (unless the owner is insolvent or lacks the requisite capacity to conclude legal agreements). The South African system of registration of mortgages ensures this by requiring the signature and consent of the owner of the property. Registration without the consent of the owner of immovable property invariably occurs because of oversight or a mistake by the deeds office or as a result of fraud. There are two jural acts that have to occur in order to constitute a valid mortgage over immovable property. There must be an agreement between the mortgagor and the mortgagee to mortgage the property. This agreement needs to be followed by a formal process of registration in terms of the Deeds Registries Act. If there is compliance with the two acts a real right of mortgage becomes established (the real right is constituted by the registration process). There are generally no formal requirements concerning mortgage agreements. An agreement will constitute a valid mortgage only if there is intention by the mortgagor to create a right of security over the property in favour of the mortgagee. The legal requirements of contracts apply and have to be complied with (e.g. legal capacity and so forth). A mortgage gives the mortgagee security for an outstanding debt or obligation. The mortgagor, however, continues to be the owner of the property. He is permitted to use the property for his benefit or lease it out to third parties provided he does not infringe on the rights of the mortgagee. His dominion over the property, however, is curtailed or limited. He may not, for instance, alienate the property or subject it to a servitude without seeking the consent of the mortgagee. Mortgage bonds normally include a clause that permits a mortgagee to foreclose on the encumbered property if the debtor fails to comply with his obligations in terms of the underlying agreement. The right to foreclose is exercised at the discretion of the mortgagee. A mortgagee can therefore elect not to foreclose on a property and instead insist that the mortgagor should comply with his obligations. The mortgagee has the right to foreclose even when there is a belated payment that has been made by the debtor. 97 97 Boland Bank v Pienaar 1988 3 SA 618 (A). 61

XIII Cessions International Experience Two types of cessions are found in MSE financing: cessions of accounts receivable, also called invoice discounting, and cessions of contract payments. Factoring is a variant of invoice discounting; it is the purchase of accounts receivable from a company by a factor. In factoring, ownership and management of the accounts receivable are transferred to the factor. As such, factoring does not legally involve collateral. Factors generally offer a bundled service, including credit, creditor management, and debt collection. Debtors are informed of the role of the factor and invoice payments are made directly to the factor. Factors, in turn, may outsource the collection of bad debts to a collection firm. Table 9 Global Growth of Factoring 1998 to 2003 Factoring has seen rapid growth worldwide over the past five years, particularly in Europe. In the United States and Canada, asset-based financing is preferred to factoring, reflecting the strong credit and collateral rights in those countries. Annual Volume of Volumes 1998 Factoring Deals 98 (million euro) Volumes 2003 (million euro) % Growth Five Year Average % Europe 295 779 546 935 84.9% 17% Americas Africa and ME Asia Australasia Total 91 240 4 320 61 590 3 481 456 410 105 542 6 162 88 774 13 979 760 392 14.6% 42.6% 44.1% 301.6% 66.6% 3% 8% 9% 60% 13% Factoring has grown in popularity as a means to finance SMEs since the credit risk lies with the debtors rather than with the SME itself. Factoring is particularly well suited when debtors comprise large well established businesses. Since SMEs often do not have the expertise to manage their debtor books, the collections service of the factor is particularly valuable and reduces risk to the SME market. The basic principle of factoring is to find businesses that are growing and highly geared (making it difficult to raise additional capital) and obviously which have money sitting in their debtors book. 99 A final advantage of factoring is that the accounts receivable are not tied up in the estate in the event of insolvency, since they are owned by the Factor. A key issue for factoring is whether a financial system s commercial law views factoring as a sale and purchase transaction rather than as a loan. If it does, creditor rights and loan contract enforcement are less important for factoring because factors are not creditors. That is, if a firm went bankrupt, its factored receivables would not be part of its bankruptcy estate because they would be the property of the factor. 100 Factors generally pay 70% of the value of the account receivable up front, with the final 30% being transferred once payment has been received from the debtor. 101 There are two primary risks in factoring: financial risk (can the debtor pay?) and operational risk (has the business produced to an acceptable quality?). If the goods have already been delivered and an invoice has been produced, then some of the operational risk has been mitigated (that of the business producing at all, or producing on time). However, there is still the problem of credit notes. Generally the buyer would receive the goods and sign them in before checking their quality. If the goods are deteriorating on the shelves (or being returned by customers) then the buyer will simply send them back to the supplier and ask for a credit. This may easily happen before the supplier is paid, if the buyer pays on a 60 or 90 day basis. 62 98 Bakker, Klapper, Udell, Financing Small and Medium Sized Enterprises with Factoring: Global Growth in Factoring and its Potential in Eastern Europe, 2004. 99 Michael Woollands, Managing Director, Regent Factors. November 2008 100 Bakker, Klapper, Udell, pg 17. 101 Once an invoice is in the creditor s ledger, it could still come out again for a variety of reasons; this is why a margin of about 30% is included in the financing arrangement.

Factors generally charge a commission on each transaction as well as interest on the outstanding balance. They may also charge an application/origination fee and a due diligence fee. In developed countries, factoring is generally done on a non-recourse basis, whereby the factor carries the risk of non-payment. For less creditworthy debtors, however, factoring may be done on a recourse basis. Factors can achieve economies of scale by pooling accounts receivable from different enterprises for the same debtor. In this way, factors develop an in-depth knowledge of the payment behaviour of these debtors: Factors generate proprietary databases on account payment performance. The largest and more experienced factors essentially become the equivalent of large credit information exchanges, offering an alternative to private commercial credit bureaus and public credit registries. 102 Favourable environmental factors for factoring include: Availability of credit insurance; Good information infrastructure (i.e. credit bureaus) on payment performance of debtors; Quality of accounting information; and Support for creditor rights and contract enforcement. One reason certain suppliers prefer to borrow against an invoice, as in invoice discounting, rather than selling it, is that a sale would distort the supplier s balance sheet. With invoice discounting, the current asset is visible and the corresponding liability (a trading loan or overdraft) is also visible. 103 A cession of contract payments is not as secure as a cession of accounts receivable since the credit precedes the revenue stream. With invoice discounting or factoring, the work has already been completed by a supplier and the debtor has accepted the invoice. In cessions of contract payments, the work has not yet been completed; the lender carries the risk of non-performance. SA Lender Practices Factoring Financing productivity rather than speculation can significantly reduce a lenders risk. 104 Several variations of cessions financing are actively applied in South Africa: Invoice discounting for larger suppliers is offered by all the big four banks on a non-disclosure basis, in which the supplier maintains the debtor administration function. Invoice discounting for smaller suppliers is offered by selected banks on a single invoice and disclosure basis. Full factoring, performed on a disclosure basis in which the factor assumes the debtor administration function, is offered by several specialised financing entities. The three largest full factoring companies include Merchant Factors (M Factors), part of the Rand Merchant Group; Regent Factors, in which Khula has a 20% share; and Sasfin. Others include the Investec Group, Durban Factors, and other smaller players. In 2008, invoice discounting and factoring accounted for R10.3 billion in financing, despite the fact that only 1900 suppliers utilised these services. 105 Of these deals, 40% were carried out on a full disclosure basis. A financing agreement is negotiated upfront. Some financiers prefer agreements which require the client to present every invoice rather than selected invoices; this is less risky as the risk of one invoice can be offset against the risk of others. 106 In South Africa, however, most players have moved to single invoice agreements; suppliers choose which invoices to sell and these are presented to the factor. Large sized businesses tend to prefer the invoice discounting service. Medium sized businesses choose either of the two services. 102 Bakker, Klapper, Udell, pg 9/10. 103 With full factoring, when the invoice is sold, there should be a note in the balance sheet to highlight the concurrent liability in respect of invoices sold with recourse. 104 Roger Herbert, Banking Association of South Africa. 105 Invoice discounting accounted for a vast majority of this volume. 106 One disadvantage of this approach is the need to ensure that no prior cessions have been concluded on one or more of the invoices. 63

Government is the biggest purchaser in the country, followed by the chain stores. Any regular supplier to these entities could, therefore, take advantage of financing through factoring. Government is notoriously slow on payment of invoices, which makes factoring even more attractive to SMEs with government tenders, and more risky for the factoring house. In theory, government is bound to pay all MSEs within 14 days of presentation of invoice but there is a large gap between policy and implementation. 107 This financing option, however, is not open to MSEs in South Africa because government has implemented a ban on the cession of accounts receivable. In the UK, current legislation has established that no entity has a right to stop anyone ceding their invoice to a bank or a third party for payment. At Regent Factors, 90% of their declines in the SME market are due to an inability to obtain a cession. For invoice discounting, banks have inspectors who visit suppliers to prevent fraud; they check the general ledger and debtors books. However, they do not confirm each invoice with the buyer. Full factoring is a more labour intensive process. Staff need to contact buyers to confirm each invoice presented. They ask three questions: Is this a genuine invoice and will it be paid? Which account will be credited? On which date will the payment be made? Factoring is only practical where there is a reasonable margin. In South Africa, fees tend to be set between 4% and 5% of the invoice per month for the smaller invoices below R100 000, which means that suppliers need to have margins of 20% and above. 108 Some factors charge a fee based on the total invoice amount; others charge based on the exposure amount. The cost to the MSE can, however, be offset by the supplier discounts that they can access by paying suppliers early. Factors tend to steer away from construction factoring as it is too difficult to separate the phases of work. Debtor insurance can help. All factoring in SA is done with recourse if the buyer does not pay then the factor will simply reclaim from the MSE. If the MSE has debtor insurance, this risk is mitigated. This usually costs 0.3% of the invoice price; it is cheaper if the whole book is insured. 109 Regent Factors will discount invoices as low as R5 000 in value, but only if the client is expected to present a stream of invoices; the bulk of invoices are for R100 000 and above, but 40% of its book value is for loans of less than R250 000. For small enterprise clients, Regent receives the money from buyers and pays the client s suppliers; this ensures that the client will remain viable. The client is only given the money required to pay wages. There are three new developments currently in progress in South Africa aimed at expanding the factoring market: the promotion of reverse factoring; the automation of factoring to reduce costs through an electronic Invoice Clearing Bureau; and an automated register of cessions. In reverse factoring, the factoring company enters into an agreement with a large buyer to take over the sourcing of, and payments to, small suppliers. The factor then offers the suppliers the option of discounting their invoices. Khula has invested in Regent Factors with the objective of introducing reverse factoring to support the small enterprise market. Regent has recently made a reverse factoring proposal to the Durban city council, but the concept has not yet been tested in practice. An initiative to automate the factoring process is currently under way with the development of switch type software patented by Durban Factors. 110 This software is currently hosted by BankServ, the repository, in the form of an Invoice Clearing Bureau (ICB), alternatively called the Validation Clearing Bureau (VCB). Compatible software is then loaded on the accounting systems of the supplier and the debtor. The Box on the following page explains how the system works. 64 107 Michael Woolands, Managing Director, Regent Factors, November 2008. 108 Clients who work with government tenders typically have a margin of 30% plus. 109 There are a number of debtor insurance suppliers in South Africa, including Credit Guarantee Insurance Company which is largely owned by the banks. 110 Bankserv will charge a user fee while Kerdachi will receive a royalty from each transaction.

The software cost will be minimal for suppliers; merely a few hundred rand. At R30 000, however, the cost to buyers constitutes a larger stumbling block. To address this issue, the ICB has approached the banks with the suggestion to register their clients (the big buyers) on the system at their cost. One benefit to the buyers is extra BEE points on their scorecards. For a small business, the ICB system could speed up the financing cycle and reduce the cost significantly when compared with traditional factoring. Box L Step by Step Explanation of the einvoice Banking System 111 1. The SELLER submits its invoice data (excluding line items) electronically to the Invoice Clearing Bureau (ICB) hosted by BANKSERV. 2. The SELLER s invoice is sent to the BUYER with delivery of the goods. 3. The BUYER checks the goods and passes the invoice to the Accounts Payable Department which is then processed for payment on the due date. This data confirms that the invoice is a genuine valid invoice and is sent electronically to the ICB as a VALIDATED INVOICE. 4. The Validated Invoice data sent by the Buyer is then checked against the relevant invoice data submitted by the seller to the ICB. If the invoice data matches, the information is made available to the bank, which can finance the invoice(s) in terms of its standard lending agreement with the supplier. 5. Certain financiers can submit the SUPPLIER s invoices to the ICB on behalf of the SUPPLIER. A seller wishing to raise money on outstanding debtors (invoices) would approach his/her commercial bank and apply for an overdraft based on the value of the outstanding invoices. Simply by going into the ICB, the bank can confirm the value of the supplier s outstanding invoices. After just a few reference checks, financing of 60% to 100% of the invoice amounts could be made available through an overdraft; the above process is expected to take approximately 10 days from submission of invoices to the bank. Where factoring typically charges 4 5% of invoice value or exposure, einvoice financing would cost a much lower percentage: approximately 1% fee by the clearing bureau plus the cost of the overdraft offered by the commercial bank; a total cost of approximately prime plus 3% to 6% for einvoicing compared to a cost of 48% to 60% for factoring. Another advantage of the Invoice Clearing Bureau is that it will automatically prevent an invoice from being assigned twice. This initiative is wholly South African, is unique in the world, and arose out of the principles of the Financial Sector Charter which seeks to bring sophisticated financial products to all sectors. The system solves the problem for a whole United Nations department that seeks to remove bans on cessions around the world. 112 The Office of the Accountant General within the National Treasury issued accounting legislation early this decade which introduced prohibitions on the acknowledgment of cessions of payments to third parties. 113 These prohibitions are included in the Public Finance Management Act, No. 1 of 1999 and the Municipal Finance Management Act, No. 56 of 2003. Some of the reasons provided for this decision include concerns about: (a) fronting, (b) fraud and the need to verify the financier, and (c) administrative errors whereby invoices were paid to suppliers in error, resulting in government being sued by financiers. Since government is the primary customer of previously disadvantaged small businesses, this legislation has created a serious stumbling block to extending factoring to the small business sector. National Treasury views the ICB as a means to prevent administrative errors and is now reconsidering its decision on the prohibition. 111 Extracted from the BankServ Brochure on the ICB. 112 Roger Herbert, Banking Association of South Africa, 2008. 113 Riaz Ahmed, Financial Sector Development, National Treasury, 2008. 65

SA Lender Practices Cessions of Contract Payments Lenders to the small business sector do take cessions of contract payments in cases where the contractor/supplier enjoys a good reputation for delivery and the buyer is a large private buyer. It is not clear, however, to what degree this instrument is supporting expansion of the market to previously disadvantaged individuals. Just as with factoring, the ban on government cessions of payments has significantly reduced the contractor financing available to the MSE market. Conclusions Factoring and cessions of contractor payments are important financing vehicles for the MSE market. Policy makers could support growth of this market through the following initiatives: 1. Reverse the prohibition on payments to third parties. This step could be limited to financiers registered as developmental lenders with the National Credit Regulator. 2. Introduce a general register of cessions which would facilitate financing for a wide range of intangibles, including: receivables; contracts; insurance policies; bonds and shares; and director or shareholder loan accounts. (The Banking Association has been actively promoting this development.) 3. Support expansion of the einvoice Clearing Bureau. SA Legal Framework Cessions In South African law factoring requires a cession agreement for the transfer of existing and future debts. The following principles will apply: (a) the consent of the debtor is required if the cession alters the legal obligations or performance of the debtor; (b) the cession should not cause a greater burden for the debtor; (c) the cessionary (factor) does not obtain any better right than the cedent (supplier); (d) a debt cannot be ceded to multiple cessionaries (this is the reason why a National Register of Cessions is required in South Africa) (e) a consumer s debts with several creditors can be ceded to a single creditor; (f) the cedent (supplier) is required to assist the cessionary in the collection of the debt; (g) the cessionary (factor) becomes the owner of the debt and he is the only one who can enforce it; (h) any right or defence that the debtor had against the cedent (supplier) will also apply to the cessionary; and (i) the cessionary has to accept all the rights and defects of the contracts. A cession in securituatem debiti, the law applying to invoice discounting, functions in the same manner as that of a pledge, but it refers to instances where a creditor cedes the debt owed to him to another person. Unlike an ordinary cession, the cessionary undertakes to restore the ceded debt to the cedent when the secured debt has been redeemed. Like a pledge, the cessionary does not own the debt and he therefore cannot alienate it (National Bank of SA Ltd v Cohen s Trustee 1911 AD 235). The principles and disadvantages that apply to this cession are as follows: (a) The debtor of the pledged debt must as a rule pay the cessionary (financier) any outstanding amounts. This discharges his obligations vis-à-vis the cedent (supplier). The cedent loses any right to sue the debtor. If the cessionary fails to pay the money back to the cedent, the cedent will only have a personal right against the cessionary; (b) If a debtor, who has not been informed of a cancellation of a cession, pays the cessionary (financier), he is immune from any further actions by the cedent; (c) if a debtor, who is ignorant of the cession, pays the cedent (supplier) he discharges any claims that either parties might have against him. This compromises the security value of the cession; and (d) if the cedent (supplier) fails to pay the secured debt the cessionary is permitted, without prior judgment or excussion of the cedent, to take any paid money to pay the secured debt. The cession in securituatem debiti carries the risk of being compromised if the debtors pay directly to the cedent. The cedent may also be compromised if the cessionary uses the money collected and is unable to return it to the cedent. 66

Bibliography Background on the Small Business and Credit Environment in South Africa Financial Access for SMEs, Towards a Comprehensive Strategy, Draft Discussion Document, April 1998, DTI Centre for Small Business Promotion. FinScope Small Business Survey, Gauteng, 2006. Credit Law Review, Summary of Findings of the Technical Committee, Department of Trade and Industry South Africa, 2003. Making Credit Markets Work, A Policy Framework for Consumer Credit, Department of Trade and Industry, 2004. SME s Access to Finance in South Africa. A Supply-Side Regulatory Review, by the Task Group of the Policy Board for Financial Services and Regulation, 2002. General Information on Collateral and Collateral Law Cheung Sam and Sundaresan Suresh, Lending Without Access to Collateral, A Theory of Micro-Loan Borrowing Rates and Defaults, 2007. Balkenhol B and Schutte H, Collateral, Collateral Law, and Collateral Substitutes, Social Finance Programme, Working Paper No. 26, 2001, Employment Sector, International Labour Office, Geneva. McGuire and Conroy, Fostering Financial Innovation for the Poor, The Policy and Regulatory Environment, The Foundation for Development Cooperation, Brisbane Australia, Office of Development Studies, Bureau for Development Policy, United Nations Development Programme, 1999. Papers on a Range of Instruments Anup Singh and K Somanadha Babu, Challenges of Introducing Individual Lending in India, MicroSave India Focus Note No. 14. Date not available. Bakker, Klapper, Udell, Financing Small and Medium Sized Enterprises with Factoring: Global Growth in Factoring and its Potential in Eastern Europe. The World Bank Poland, Warsaw Office, A joint publication of the World Bank s Private and Financial Sector Development Department and the Development Economics Research Group, 2004. Burnett, J, Financiera Calpia S A, El Salvador, A Case Study on Individual Lending Techniques, for Calmeadow, 1996. Calvin, B, Alexandria Business Association Small and Micro Enterprise Project, A Case Study, 1995. Churchill, C, Bank Rakyat Indonesia Unit Desa Division, A Case Study, Calmeadow, 1995. Deelen, Dupleich, Othieno, & Wakelin, Leasing for Small and Micro Enterprises, A guide for designing and managing leasing schemes in developing countries, Edited by: Robert Berold, International Labour Organisation, 2003. Leasing, A New Option for Microfinance Institutions, USAID Technical Note No. 6, 2000. Maddams B, Deputy CEO, Khan Bank of Mongolia, Microfinance by a Commercial Bank, Japan Microfinance Symposium, 2007. Mutesasira, Osinde, Mule, Potential for Leasing Products: Asset Financing for Micro- and Small Businesses in Tanzania and Uganda, MicroSave, 2001. Nell, Gordon, and Bertoldi, Township Residential Property Markets, Phase III, Finmark, 2004. Peruvian Legislation on Global and Variable Security, 1998. Pinder, C, EDIAIS Project Manager, SELFINA (SERO Lease and Finance Company) Tanzania, Case Study, 2001. Turner, Varghese, Walker, Information Sharing and SME Finance in South Africa: A Survey of the Landscape, Centre for Competitive Credit, PERC Results and Solutions, August 2008. Yagan and Franzese, The Importance of Trade Credit and its Mysterious Absence from Microfinance: Recommendations for the Microfinance Community, independent paper, May 15, 2006. 67

Bibliography continued USAID Fostering an Investment and Lender Friendly Environment (FILE) in Eastern Europe and the Newly Independent States BiH Bankruptcy and Liquidation Laws, Towards a Bankruptcy Trainer s Handbook, Chemonics International Inc., Deloitte Touche Tohmatsu Emerging Markets Ltd., National Center for State Courts, June 2004. BiH Collateral Law, Creditors Handbook, Chemonics International Inc., Deloitte Touche Tohmatsu Emerging Markets Ltd., National Center for State Courts, 2004. BiH Collateral Law, Establishment of the Auction Centre, Chemonics International Inc., June 2006. BiH Collateral Law, Stimulating Secondary Market for Assets Acquired through Foreclosure, Chemonics International Inc,, Deloitte Touche Tohmatsu Emerging Markets Ltd., National Center for State Courts, 2005. BiH Collateral Law, Communication and Education Campaign, Chemonics International Inc, 2004. BiH Core Training Modules for Collateral Law, Chemonics International Inc, 2004. Collateral Law and Central Registry Program, Latvia, Final Report, August 25, 1999, Booz Allen & Hamilton. Core Training Programme of BiH, New Bankruptcy and Liquidation Laws, Chemonics International Inc, 2003. 68

Institutions and Individuals Interviewed for the Study, 2008/2009 Commercial Banks ABSA Bank Small Business: Sisa Ntshona, Manager Customer Value Proposition. The Banking Association South Africa: Roger Herbert, Invoice Financing. First National Bank: Stephen Gooch, SME Lending; Eben van Vuuren, Commercial Banking Credit; Heather Lowe, Head of Enterprise Development. Nedbank: Graham Erasmus, National Sales Director Small Business Lending; Mano Muthusamy, Head Credit Risk Small Business Services; Andre Tredoux, Head, Vehicle and Asset Finance Collections and Recoveries. Standard Bank: Chetty Desigan, Manager BEE Lending; Tinyiko Seane, Head Capacity Building, Community Banking. Consumer/Micro Lending Organisations African Bank: Jimmy Catsavis, General Manager: Distribution & Contract Management. Blue Financial Services: Kenneth Fisher, General Manager, Small Business Development. Capitec Bank: Pieter Marais, Marketing Director. Real People: Bruce Schenk, Managing Director. Thuthukani: Mark Seymour, CEO. Enterprise and Poverty Lenders Business Finance Promotion Agency: John Alufayi, Financial Manager. New Business Finance: George Watson, Managing Director; Muhammed Hoosain Hamdulay, Legal Advisor. Regent Factors: Michael Woollands, Managing Director. The Kuyasa Fund: Olivia van Rooyen, Director. Validation Clearing Bureau (VCB): Neville Kerdachi, CEO. DFIs and Other Ithala Development Finance Corporation Limited: Neli Shezi, Divisional Manager, Microfinance and Cooperative Development; Raymond Phungula, Manager Risk Control. Khula Enterprise Finance: Obakeng Khutsoane; Nosipho Ncobo, Client Care Coordinator, Indemnity Program. National Treasury: Riaz Ahmed, Financial Sector Development. Umsobomvu Youth Fund: Stieneke Samuel, Director, Microfinance, Enterprise Finance. International Representatives Consulted ACCION International: Ricardo Calvo, Project Manager, Global Operations. ACCION International: Hannes Manndorf; Victoria White. CGAP: Jennifer Isern. ILO: Craig Churchill. International Finance Corporation: Zahia Lolila Ramin. MicroSave: David Cracknell. Opportunity International Bank Malawi: Steve Mgwadira, Head of Credit. Opportunity International: Ken Vander Weele. Sero Lease and Finance Ltd (SELFINA), Tanzania: Victoria Kisyombe; Fausta Lema, Operations Manager. World Council of Credit Unions (WOCCU): Barry Lennon 69

Annex A New Business Finance Case Study New Business Finance was launched in Cape Town in 1998 by Mr George Watson, a U.K. businessman who brought to South Africa 27 years of commercial finance experience. In 2001, the company received a sizable equity injection from another U.K. investor and, in 2005, an agreement was signed with Khula Enterprise Finance for a series of drawdowns with respect to on-lending capital: R 4 million in March 2005; R 9 million in March 2006; and R 20 million in March 2007. A fourth commitment of R 50 million was supposed to have been disbursed before the end of 2008. NBF offers loans from R10 000 to R250 000, typically to small businesses which do not have a sufficiently strong history of earnings generation to qualify for an overdraft from a commercial bank. Since NBF charges the maximum rates allowable under the National Credit Act, businesses with a strong cashflow would rather obtain an unsecured line of credit from a commercial bank at prime + 5%, if they had access to these funds. Over 90% of NBF clients are historically disadvantaged while more than 30% are start-up businesses. Females comprise approximately 40% of clients. Approximately 90% of clients are juristic, primarily registered as closed corporations. NBF currently employs six loan officers operating from four offices: two in Cape Town; two in Pretoria; one in Johannesburg and one in Nelspruit. A summary of performance over the past three fiscal years is provided in the Table below: 1 February 2006 February 2007 February 2008 August 2008 Portfolio (R mlns) R9.05 R14.9 R34.2 R28.3 Active Loans 110 159 413 367 Rand Disbursed (R millions) R8.61 R21.41 R45.69 R14.32 No. Disbursed 144 295 643 206 Average Loan R59 800 R72 600 R71 060 R69 560 Loan Officers 4 6 6 6 Total Staff 12 12 22 22 Active Loans per LO 28 27 69 59 Portfolio per LO (R mlns) R2.26 R2.49 R5.71 R4.72 Portfolio per Staff (R mlns) R0.75 R1.24 R1.56 R1.31 As demonstrated above, the NBF portfolio grew with each Khula disbursement. A delay in the disbursement for 2008 caused a decline in the portfolio over the past six months; a trend which is expected to be reversed shortly. The average loan size has grown moderately over the past three years, but by no more than an inflationary adjustment. The portfolio per loan officer grew strongly in the year ending February 2008, at 129% to R5.7 million. The portfolio per staff member grew more moderately, however, at 26%, as NBF expanded its head office in order to provide stronger support. NBF has managed to maintain good portfolio quality ratios despite the difficult market segment it is serving. As shown in the table below, write-offs have not exceeded 4% of average portfolio outstanding over the past three years, even though more than 30% of loans are consistently over 30 days in arrears. These figures underscore the necessity for patience when serving this market; the cash flow may not always be steady but, when carefully screened and chosen, the majority of clients eventually pay. 70 1 Figures extracted from the Loan Data Sheets submitted to Khula.

February 2006 February 2007 February 2008 Reserve Ratio Reserves / Gross Loan Book 3% 11% 10% Provision Ratio Provisions / Average Loan Book 0% 10% 4% Write-off Ratio Write-offs / Average Loan Book 0% 4% 1% Value in Arrears > 30 days Arrears Value > 30 / Total Portfolio R3.67 (41%) R2.11 (14%) R5.27 (15%) No. Loans in Arrears > 30 days No. Arrears >30 / Total Active Loans 93 (85%) 59 ( 37%) 147 (36%) Maintenance of acceptable loss rates at NBF has required highly labour intensive procedures, as discussed below, while the company has not yet reached a financially self sufficient level of operation. Two key questions remain to be answered: 1. Will NBF be able to maintain historically good portfolio quality levels as it grows beyond the initial team of founding staff members; and 2. Will NBF be able to reach efficiency levels required to achieve profitability while still maintaining portfolio quality? New Business Finance offers three types of loans: term loans up to 24 months, bridging finance up to 3 months and a revolving credit facility up to 6 months. At September 2008, term loans accounted for the largest proportion of total portfolio, at R 10.1 million, or 37%. Bridging loans, however, accounted for the highest number of loans, at 190, or 54%. No. Portfolio % Avg Loan Size Term Loans 106 R10.1 37 R95 378 Bridging Loans 190 R8.4 31 R44 317 Revolving Loans 57 R8.8 32 R154 386 Total 353 R27.3 R77 197 One of the risk management strategies employed is that of flexible instalment amounts on the term loans. Repayments of principal are adjusted according to the seasonal cycle of the business. This is a strategy utilised in agricultural finance which has been successfully adapted by NBF for the small business market. Repayments can also be set on a weekly or fortnightly rather than monthly schedule for businesses with high turnovers, such as small traders. Term Loans Bridging Finance Revolving Credit Loan Amounts 10K to 250 K 10K to 250 K 10K to 250 K Loan Terms 6 to 24 months Up to 3 months Up to 6 months Collateral Notarial Bonds, Cessions, Vehicles, and Personal Sureties Personal Sureties Personal Sureties Repayment Monthly or Fortnightly (a few weekly); variable instalment amounts Balloon payment at end of term. Irregular payments with final payment at end of term. As often as possible, NBF will prevent diversion of funds by depositing loan funds directly to suppliers; NBF views this policy as a primary risk management mechanism. To reduce the possibility of collusion, NBF encourages the client to utilise reputable suppliers. If a large amount of funds are deposited directly into a client s bank account, it is tempting for them to spend some of it on the household. 2 2 George Watson, 2008 71

NBF has grown the bridging finance product recently to improve cashflow and fee income and reduce risk. Bridging loans are extended primarily to repeat clients who have shown good repayment behaviours. NBF has put extensive effort into refining procedures for this product to ensure that it is paid by a client as soon as funds are deposited into a client s account. Its staff prefer to deal with government contracts since they now understand how the government payment cycles operate and know the individuals in government accounts departments including, for example, municipalities, Eskom and Transnet. The city of Cape Town makes payments on the 15th or the 25th. NBF is aware of which banks the clients utilise and when funds should reach a client s account. They monitor a schedule of deliverables for each contract and stay in touch with project managers, so they know when a payment for a contract is due. NBF can also exert pressure on contractors to pay invoices timeously; in this way they become an advocate for the client. If a contract is longer than three months, NBF will still require full repayment of a disbursement within three months; its staff break the project down into discrete stages. Longer periods increase the risk of the project manager changing or other developments occurring which could affect repayments. If the project clearly requires terms longer than three months, NBF will consider a revolving credit facility. Managing the above process, however, requires dedicated, experienced, and mature staff. If government were to allow cessions of tender payments, the process would be significantly streamlined. It is still unclear whether this approach can be scaled up to a nationwide programme and be successfully supervised in a decentralised structure, without a corresponding decline in portfolio quality. While NBF considers collateral to be a less important component of risk management than the assessment of the client and the viability of the project, it does believe that the client must have something to lose: Collateral is used to concentrate the mind of the borrower. Since many do not have significant cash invested in the business, collateral ensures they have something to lose if the loan is not repaid. To a certain extent, collateral also provides some means of loan recovery NBF always tries to realise the collateral. If we simply write-off the loan, word will spread that we are soft and portfolio quality will disintegrate. 3. For all loans, NBF requires a personal surety from the owner; this comprises the sole form of security on approximately 50% of loans. Wherever possible, however, NBF will also take other collateral, such as a notarial bond, both specific and general (10% of loans), a vehicle pledge (10% of loans), or a cession of debtors (10% of loans). Only 3% of clients have offered real immoveable property as security. Other types of security utilised on a small number of loans include life policies, control of bank accounts through joint bank signing authority, and sale and leaseback. Hire purchase and sale and leaseback have not been attempted recently due to the administrative requirements for calculating the value added tax and the notice requirements prior to seizing an asset. By the time the notice period has passed, there is a good chance that these assets are no longer traceable. If a notarial bond will cover at least 30% of the loan size, and if it covers assets worth at least R50 000, it is considered to be worth registering. With a general notarial bond, NBF also attaches the debtors and includes a power of management. This means that NBF can place a person to watch the cash flows and ensure debtor payments do not get swept out of client accounts. The owner continues to manage the business but, once a person is placed on the premises to oversee the finances, it becomes highly uncomfortable and the individual tries to clear the delinquent amounts. NBF will first collect on the notarial bonds. 4 the clients household assets. If it does not cover its losses in this manner, it will proceed to attach With a vehicle pledge, the vehicle is registered in the name of NBF, which holds the registration documents and an extra set of vehicle keys. A deeds search is conducted on all clients to see if they possess any real property, but property is held by less than 5% of clients. NBF has taken a second mortgage bond on one or two occasions, but does not regard this alternative 72 3 George Watson, 2008 4 NBF does not require life insurance to be taken out for term loans; the quoted rates have been too expensive. It is now considering a block policy arrangement.

as desirable. Commercial banks which hold the first bonds tend to resist second bonds being registered for collateral purposes. In the event of foreclosure, it is also difficult to remove individuals from their homes. NBF does not accept third party guarantees unless the third party has a financial stake in the business. If guarantees are accepted from family members, other than a spouse, who have an emotional rather than a financial interest in the guarantee, they can easily claim that they did not understand the commitment that they were making and the courts are reluctant to enforce these contracts. If the guarantee is provided by another investor in the business, however, they can provide assistance and exert pressure on the entrepreneur. NBF has an in-house legal department headed by a qualified attorney, who drafts all legal documents, coordinates conveyancers to visit deeds offices around the country, and manages all bad debt collections. While personal sureties and notarial bonds require in theory about three months to the point of realisation, the average length of cases being pursued by the NBF attorney was 12 to 18 months. Realising on collateral is seen as a last resort. NBF recognises that clients are low income and do not possess assets. 5 It does not want a client to be worse off after receiving a loan. It also attempts all possible means to set the business back on track and allow clients a long period before proceeding with collateral realisation. 5 With regards to personal sureties, assets are available to attach in only 60% of cases. 73

Annex B Lender Friendly Regulatory Framework for Collateral Pledging of Assets The Pledge Document Identification of Assets Perfection of Assets Court Jurisdiction Court Jurisdiction Advantages Authentic documents not restrictive Allow for a basket of assets rather than just specified assets, such as a storage room and its contents. Allow for assets to remain with the borrower. List of exempted items is reasonable. A registry exists to confirm prior claims on assets: registry to be up to date, complete, accurate, secure, and accessible. Process to consult the registry is economical. Process to lodge with the registry is timely and economical. Jurisdiction is allocated to the court which can most easily enforce or execute the pledge: i.e.: where the land is located; where the judgment debtor resides; or where the asset resides and not any jurisdiction identified in the pledge agreements. If the assets are located in more than one jurisdiction, the primary jurisdictional court will liaise with the other courts, to save the lender from having to file in multiple jurisdictions. Access to small claims courts for lower amounts. Jurisdiction is allocated to the court which can most easily enforce or execute the pledge: i.e.: where the land is located; where the judgment debtor resides; or where the asset resides and not any jurisdiction identified in the pledge agreements. If the assets are located in more than one jurisdiction, the primary jurisdictional court will liaise with the other courts, to save the lender from having to file in multiple jurisdictions. Access to small claims courts for lower amounts. Disadvantages Has some restrictions. Document varies depending on the structuring of the contract. Rerum universitas - provides for a pool of assets to be attached, such as stock in trade of a business. A general notarial bond can be registered against assets of a debtor. A notarial bond for all present and future assets of the debtor is not permitted. The pledge does not allow for assets to remain with the borrower. A registry is available for notarial bonds only. Process to consult the registry is economical. Attorneys fees to register a notarial bond are high (R2500 or more). Court in whose area the property is situated or where the debtor resides will have primary jurisdiction. Pledge agreements can alter this. No primary jurisdictional court and multiple jurisdictions unavoidable. Access to Small Claims Courts for smaller amounts (below R7 000). But corporate entities excluded. Court in whose area the property is situated or where the debtor resides will have primary jurisdiction. Pledge agreements can alter this. No primary jurisdictional court and multiple jurisdictions unavoidable. Access to Small Claims Courts for smaller amounts (below R7 000). But corporate entities excluded. Realisation of Assets Notices Required Prior to Contract Enforcement Application to Court to Seize Asset (Application of a Motion for Execution by Judgment Creditor) Lender Friendly Provisions Simple, with minimal time periods. Efficient delivery requirements (not onerous). Paralegal execution acceptable. Submission procedures simple. Minimal required response times. Court files organised, secure, and available. Provision for Urgent Applications. Ability to seize assets without a court order in some circumstances. Ability to request court to confirm / investigate debtors assets. South African Ranking Difficult to prove receipt of S129 notice by the debtor. Many magistrates require that delivery be done by registered post. Sheriff must deliver summons. The use of court processes is time consuming and expensive, especially if the debtor has moved from the agreed address. Security and organisation of court files depend on the court. Urgent applications are permissible in limited circumstances only. South African law prohibits any form of self help. Court does not generally investigate a debtor s assets, unless it is in terms of an s 65 procedure (a hearing). 74

Realisation of Assets Court Decision and Approval to Seize Asset (Filing of a Motion for Execution) Delivery of Court Order to Debtor Seizure Steps - Movables Storage and Sale of Assets Lender Friendly Provisions Updates made to registries immediately. Notices to debtor simple with minimal time periods (or notice boards in place of personal delivery of notices). The decision on enforcement need not contain an explanation unless it completely or partially rejects or refuses the motion for enforcement. The decision may be issued by affixing the motion for execution by seal, a provision that expedites the work of courts. The decision on enforcement must provide instructions on a legal remedy available to the parties. Provisions for voluntary execution: The court shall demand that the judgment debtor settle the claims and pay prescribed expenses within a stipulated period. Claims involving bills of exchange and cheques could have a shorter period than other claims. For moveable asset security, delivery of the court order could coincide with the inventory and seizure; this prevents the assets from being moved or damaged. The debtor may propose that garnishment be carried out against a salary or other regular form of income as a substitute object of enforcement. This should be acceptable to the court as long as the creditor will receive full value of the debt within a reasonable period of time. For real property, the debtor may propose that judgment be carried out on a different piece of property. If the creditor had a lien on the property, the creditor must agree on other property proposed. Either provide a bailiff/sheriff quickly and at low cost or allow the judgment creditor to seize the assets directly. Presence of licensed auctioneers to seize assets. Inventory of assets combined with execution in the same visit no need to compile inventory separately. Inventory to include most easily liquidated assets first. Only enough assets listed to cover the debt amount. Inventory to be done if assets are held by a third party. If this person refuses, assets are immediately transferred to the creditor. Auction houses operating to create active secondary markets. Regularly scheduled court sales and bank sales held by Auction house. Provisions for fair appraisal of assets and to prevent assets being sold at far lower than appraised values. Provisions to allow priority access by co-owners. Clear and fair rules for who covers the auction costs. For moveable assets, auction house to provide storage facilities. A minimum period is stipulated during which the auction house may not sell the assets without agreement from the debtor, unless the items are perishable. The auction house may not sell any assets until the decision on execution becomes enforceable. If objections are filed, therefore, assets are kept until the process is concluded. For real assets, courts must facilitate inspection of the property by persons interested in buying it. If the debtor or other persons are obstructing this process, the court can order their removal during the inspection period, with the help of police if necessary. If deemed necessary, the courts must also be able to order the removal of the debtor permanently and assign the creditor or other person to protect the property. South African Ranking All services and notices have to be carried out in terms of the normal court rules. This process can be complicated, time consuming, and expensive. Execution process is expensive and inefficient because it is done by sheriffs. The debtor will often be informed by the judgment creditor that a judgment has been obtained against him. He is required to comply with the judgment immediately. If the debtor fails to comply with the court order, a writ of execution can be issued against movable property followed by immovable property. The court may prescribe the payment of a debt within a stipulated time, following a s65 financial inquiry. A garnishee or emolument order can be issued against the debtor. Whilst parties can agree that the creditor should take possession of alternative unbonded immovable property, the creditor is not compelled to accept such a proposal. Only sheriff can seize property but a creditor may request or instruct that the property be sold by private auction. Inventory and seizure happens separately. Movable assets have to be attached first. Creditor enjoys the right to follow up property in the hands of third parties. The sheriff will remove goods placed under attachment to a place of safe custody, usually his / her storage facility and supply the plaintiff with a date for sale of the goods so removed. Where the goods attached are valued by the deputy sheriff in excess of R 3 000, the execution creditor must advertise the sale in one newspaper circulating in the district, at least 10 days prior to the date appointed for the sale. Sale execution carried out by sheriff to the highest bidder, unless the credit provider requests a sale by an auction house. No provisions for inspection of property held by the sheriff or immovable property before sale. No regulation of situations where a debtor refuses an inspection. 75

Realisation of Assets Collection and Distribution of Income Lender Friendly Provisions Time limits for when purchase funds must be deposited. Otherwise the sale is awarded to the next highest bidder. Fair and efficient distributions between creditors. Provisions for liability in the event of asset delivery prior to payment. South African Ranking On the date appointed for the sale, the sheriff sells the goods by public auction to the highest bidder. The creditor may set a reserve value. On payment of the purchase price by the purchaser and delivery by the sheriff of the goods to the purchaser, title to the goods is conferred on the purchaser. After the sale, the sheriff prepares a distribution account detailing the proceeds, costs, and the payment to the execution creditor. A trust cheque is then issued to the execution creditor together with a final return of service. General Court Issues Objections by Debtor or Third Party Hearings Notices Lender Friendly Provisions Short time frame to raise objections. Short time frame for court to respond to objections. Objections not stopping execution procedure: objections are treated as complaints and responses are treated as responses to a complaint. This treatment leads to shortening of the procedure in the courts. Can call hearings if deemed necessary and can make judgments if a party to the hearing does not show up. Notices on boards in lieu of personal deliveries for certain items. South African Ranking Where a third party makes a claim in respect of property attached by the sheriff in execution of any process of the court, and the execution creditor has not admitted the claim within 10 days after receipt of the notice, the sheriff is required to prepare and issue a summons requiring such claimant and the execution creditor to appear on a specified date to have the claim adjudicated upon. A judgment debtor who has failed to satisfy the judgment debt within 10 days of the date of the judgment can be required to attend a hearing concerning his financial affairs. A court may issue a writ of arrest if the debtor fails to attend the hearing. If a debtor fails to attend, the court may order the payment of the judgment debt in specified periodical payments. Court process documents have to be served personally on the debtor by the sheriff. Other notices can be served personally or by registered post. Decision Making Taking actions and rendering decisions in executive proceedings may be conferred on an associate under the judge s authority. Magistrates are assisted by Clerks of the Court. Default Interest Adjusted in relation to market rates. Default interest after a judgment limited by legislation (presently 15.5%). NCA limits default interest. The rates depend on the nature and amount of loan. Interest also limited by the in duplum rule. Execution Postponement Dismissal of Execution Judgment creditors may file for a postponement but not judgment debtors. An execution will be dismissed if it becomes impossible to accomplish. The judgment creditor should be given an opportunity to file another Application for Motion for Execution on another asset. A court may stay execution if the circumstances justify it. The court may stay the execution of a writ, made by way of motion application, where a writ does not conform with the judgment or where the judgment is not definite and certain, or where the cause of the action is no longer applicable. The court is also entitled to stay a sale in execution where it is justified under the circumstances. Death of a Party Fair rules for appointment of a representative for the debtor or creditor in the event of death. Process fairly regulated. Fines Fines for failing to meet obligations during any of the steps above. Wilful refusal or failure to comply with an order of court may result in imprisonment for contempt or a fine. 76

Annex C Peruvian legislation Chapter IV Global And Variable Security This refers to a security comprising fungible movable property, which contract must be registered in a special register. This security is also known as non-transferable collateral. This new type of security is different from the commonly known security as the debtor keeps possession of his property offered as collateral in order to enable him to continue with his business, industrial, commercial or economic activities in full. In such a contract the rights of the creditor are protected, not by possession of the property, as in the case of normal securities, but by means of a legal mechanism that consists of the registration of the pledge contract in the special register kept by the Movable Property Registrar of the National Public Register System. 1. DEFINITIONS Act Nº26702 defines the Global and Variable Security Contract as being understood to be an agreement in which consensus is reached on the value of the movable property pledged, and that allows the party (debtor or third party) to dispose of it in order to substitute it for another and others of an equal value, as support for the operations related to the credit insurance, trade acceptances or other credit operations. In turn, the Regulation approved by the SBS by Resolution Nº430-97 of 16th June 1997, is based on the definition of the right originated as a result of the global and variable security contract; thereby, as a nontransferable collateral value on fungible movable property that can be substituted for other property of equal nature, as long as it does not affect the value of the security or the rights of the creditor. 2. LEGAL a. It is a contract between the owner of the property given as collateral (debtor or third party) and the creditor. This contract creates a real right in favour of the creditor having preference and criminal attributes recognised by the Civil Code. b. It is a binding contract, as it becomes valid once the debtor offers the collateral and may be demanded by the creditor. c. It is a formal contract, in other words; in order to be valid it is required that a document exists, with a valid date and legalised signatures when the value of the collateral exceeds UIT 40 (USD $30 000). d. It forms part of an agreement as it is a contract creating collateral for a main credit, which means that the security contract s validity is subject to the contingencies of the main contract which is the base of the guaranteed undertaking or operation. e. There is no transfer of the movable property from the debtor or undertaking party to the creditor. The reason for the non-transfer of the property to the creditor is due to the fact that such collateral property will enable the debtor to continue with its business activities, thus obtaining the necessary income to meet its obligations to the creditor that provided it with the necessary finance. f. The objective of the contract is to create a valuable security of fungible property, which is understood as that which can be substituted for others of the same quality, nature, class and value, for example goods in a business, raw materials of the industry concerned and the products manufactured therein. 3. OPERATIONS TO BE GUARANTEED The Regulation states that a global and variable security can guarantee obligations arising from credit operations carried out with companies forming part of the financial system (for example: overdrafts, credit lines, current account advances, direct credits, etc.) including those arising from credit insurance and trade acceptances; in the latter case, the security is over the property detailed, in the invoice and that represents unpaid delivery of goods, and the debtor of the transferred property becomes custodian of the same. 4. CONTRACT CONTENTS According to Resolution SBS Nº160-98 of 5th February 1998, the contract has to contain various special elements, which absence will affect its validity. Such requirements are the following: a. To include a Global and Variable Security Contract ; b. Identification details (name of the company, tax number, legal representative registered in the Company Register and address of the creditor; c. Identification details (name of the person or company, tax number, legal representative registered in the Company Register) and address of the debtor; 77

d. Credit amount, interest rate agreed upon, place, payment terms and deadline. These have to coincide exactly with the main contract details; e. Description of the property in lien, detailing particulars that identify it as the collateral property such as class, nature, quality and sale value on the date of becoming a collateral; f. Identification and address of the custodian; g. Place where the collateral property will be located; h. Details of extra-judicial procedures agreed upon, to be executed upon non-compliance of the guaranteed obligation. It has to be noted that, should there not be an agreement in this regard, the property sale shall be executed as prescribed under the Civil Procedural Code. 5. SECURITY CUSTODIAN By virtue of entering the Global and Variable Security Contract, the constituent (natural person or representative of a legal person) becomes the custodian of the property offered as security, undertaking all obligations relating to a custodian. Therefore, he is obliged to deliver the collateral property, property of equal nature or otherwise pay its value in money, which is a simple requirement of the creditor in case of noncompliance with the guaranteed obligations. Therefore, besides the civil responsibility undertaken by the noncompliant party, it shall be liable for criminal charges against itself due to unlawful misappropriation as prescribed in article 190 of the Criminal Code. 6. REGISTRATION OF THE LIEN Article 3, paragraph 3 of the Regulation, as a requirement for the validity of the global and variable security, prescribes that this has to be registered in the Special Register in the Movable Property Registrar of the National Public Register System (Res. SBS Nº160-98). The said registration will have all the effects prescribed by law for third parties, by virtue of the publication and order of registration which will determine the preference as regards rights granted by the Registrar. The registration of the lien shall be made valid through the registration of the contract from which it arises, and the latter, at the same time, shall be formal as required by the Act, as follows: if the amount of the collateral is less than 40 UIT, a private document with legalised signatures shall be sufficient; should the amount be in excess thereof, an official record shall be necessary. 7. ALLOCATION OF PAYMENT The general rule for this type of contract is that the proceeds of the collateral be allocated first to debt repayment, according to the order established by the parties agreement when creating the security. Should there not be an agreement in this regard, it shall be subject to general rules, as follows: first to repay interest, then costs and then capital repayment. 8. MAIN OBLIGATIONS OF THE CONSTITUENT PARTY A. Information and Communication Duties The constituent party is obliged to inform and/or communicate with the creditor regarding any of the following events: The existence of other global and variable securities on fungible property of equal nature; Substitution of the collateral property; Deterioration of the collateral property; Entering into a new global security agreement on property of similar nature; and Change of the place wherein the collateral property will be kept. B. Property Register And Inventory The duty of taking inventory of the property involves the following aspects: 78 A detailed, quantitative and qualitative inventory of the collateral property at the moment of granting the global and variable security; and

Inventory of the property that will be used to substitute for that which is given as collateral. The register is a special accounting book in which the collateral property affected by the global and variable security will be detailed for each different creditor. C. Maintaining a Minimum Stock This requirement is intended to ensure that the security remains in force as collateral for the guaranteed credit, due to causes inherent in the nature and use of the property or due to force majeure. In the event of any of the above mentioned occurrences, the constituent shall be able to replace it with other property of the same kind and quality. Its immediate substitution shall be sufficient. D. Control Authority of the Creditor The constituent party shall allow the creditor to exercise control of the activities related to the collateral property, as long as it does not alter the normal economic cycle of the debtor company and only in order to ensure the validity of the collateral. 9. CONSTITUENT PARTY S INSOLVENCY According to what is prescribed in Article 231 of Act Nº26702 and under paragraph 8 of the Regulations, the creditor enjoys absolute preference with respect to the value of the global and variable collateral, excluding all other creditors in the event where the constituent party goes into liquidation. In other words, the said equity contingency of the debtor does not affect the creditor s right to auction the collateral property and use the proceeds as repayment of its credit. In such event, the secured creditor shall have the right to request the competent entity in charge of the restructuring or liquidation process, that its entitlement to payment of the amount owed be recognised and that payment in its favour be made from the proceeds of the collateral property. This relates to any balance payable which was not covered by the proceeds of the auctioned collateral property. To the contrary, should there be a balance in favour of the constituent party (if the proceeds of the auction were higher than the guaranteed debt), the creditor is obliged to advise such event, or deliver such balance, to the competent authority. 10. SPECIAL REGISTER Pursuant to Res. SBS Nº160-98, the creation of a Special Register of Global and Variable Security has been prescribed, which shall be under a Movable Property Special Register in the National Public Registrar System, wherein it is compulsory to register such contracts. 79

Appendix Regulations pertaining to the Global And Variable Security Contract RES. SBS Nº430-97(18.06.97) Lima, 16th June 1997 THE BANKING AND INSURANCE COMMISSIONER IN VIEW OF THE FACT: That Act Nº26702 of 6th December 1996 has approved the General Financial System and Insurance System Act of the Bank and Insurance Commission, General Act henceforth, with effect from 10th December last; That Article 231 of the General Act regulates the global and variable security contract as a guarantee method that companies may use within the financial system in order to guarantee compliance with various operations; That it is advisable to regulate the global and variable security contract, including the particular characteristics relating to the inherent objective of the same; Taking into consideration the opinion of the Joint Banking Commission and Legal Advisory Committee, as well as the Rules and Regulations Office; According to what is prescribed by Act Nº26702 and the authority conferred under Article 349 of the General Act referred to; IT IS DECIDED: ARTICLE 1. DEFINITION OF GLOBAL AND VARIABLE SECURITY Global and variable security is understood to be the non-transferable collateral on fungible property that may be substituted by other property of equal nature, as long as it does not affect the value of the collateral or the rights of the lender. Substitution of the original collateral may only be made by prior agreement between the parties, as long as substitutes are included in the total of the original property offered as collateral and they have a higher capital value than said collateral. For the purpose of this resolution, fungible property is that which can be substituted by another property of the same quality, nature, class and value. ARTICLE 2. OBLIGATIONS GUARANTEED BY THE GLOBAL AND VARIABLE SECURITY The global and variable security may guarantee obligations arising from credit operations entered into with companies within the financial system, including those arising from credit insurance and trade acceptance. ARTICLE 3. VALIDITY REQUIREMENTS OF A GLOBAL AND VARIABLE SECURITY In order for a global and variable security to be valid, it must comply with the following requirements: 1. That the constituent party of the security be the owner of the collateral property or that it be legally authorised to offer it as collateral; 2. That the amount arising from the global and variable security be for a determined or determinable amount; and 3. That said amount is registered in the Special Global and Variable Security Register that will form part of a Special Section of the Movable Property Register in the National Public Register System.* 80 * Text according to Art. of Res. SBS Nº160-98 (05-01-98).

ARTICLE 4. CONTENTS OF THE GLOBAL AND VARIABLE SECURITY CONTRACT The minimum requirements regarding the contents of a global and variable security contract are: 1. The title Global and Variable Security Contract must be included; 2. Identity and address of the lender; 3. Identity and address of the borrower; 4. Amount of the guaranteed credit, interest rate, place, method and terms of payment as well as other relevant conditions; 5. Description of the collateral property, detailing its particular characteristics, class, nature, quality, quantity and sale value as of date of becoming collateral; 6. Identity and address of the custodian; 7. Place where the property subject to this security will be kept; and 8. Indication of the extrajudicial procedure agreed upon to be executed in the event of non-compliance with the guaranteed security. Should there not be an agreement in this regard, its execution shall be dealt with according to the Civil Code regulations.* ARTICLE 5.- GLOBAL AND VARIABLE SECURITY CONSTITUENT S RESPONSIBILITY As prescribed in Article 2310 of the General Act, the natural person creating the global and variable security or the representative of the constituent legal entity, whichever applies, will be considered as custodian of the collateral property and is obliged to deliver to the creditor the same property or property of an equal nature or, failing this, to pay its value in money upon receiving a simple request in the event of non-compliance with the guaranteed pledge. Without prejudice to the civil responsibility incurred by the non-compliant constituent, as custodian he will be committing the act of unlawful appropriation, as described in the Criminal Code. ARTICLE 6. ALLOCATION OF EXECUTION PROCEEDS FROM THE GLOBAL AND VARIABLE SECURITY The proceeds of the lien shall be allocated to its repayment until paid in full, according to the order established by the parties agreement when creating the security. Should there not be an agreement in this regard, it shall be subject to the general rules prescribed under ARTICLE 1257 of the Civil Code. ARTICLE 7. OBLIGATIONS OF THE GLOBAL AND VARIABLE SECURITY CONSTITUENT By virtue of the global and variable security contract, the constituent party undertakes the following responsibilities: 1. In the event of non-compliance by the debtor, to facilitate the creditor by providing the necessary means to execute the global and variable security. 2. As custodian, assume responsibility to deliver to the creditor fungible property of the same kind and quality as that encumbered by the global and variable security or its value in money: either the highest proceeds from the execution value on the date of said payment or that corresponding to the time of creating the security. 3. To reimburse expenses incurred by the creditor in respect of the execution of the global and variable security, if applicable. 4. To notify the creditor of the existence of other global and variable security agreements entered into which affect fungible property of the same nature. 5. To make a detailed, quantitative and qualitative inventory of the collateral property at the moment when the global and variable security is granted. 6. To notify the creditor of the substitution of the property subject to the global and variable security, making an inventory of the same, with the same details as mentioned in the previous paragraph. 7. To notify the creditor when the fungible property in lien has deteriorated, indicating the causes thereof, and immediately substituting it according to the agreement between the parties. 8. Not to take up new global and variable security on property of similar nature, without giving prior notice to the creditor. 9. Not to change the place where the collateral property is kept, without previously obtaining the creditor s agreement in writing. 10. To keep a minimum stock of property of a similar nature and not subject to other pledges, that will allow the immediate substitution of the property subject to the security in the event of disposal, loss, theft, deterioration or a similar event. 11. To keep a special and independent accounting register of the property subject to the global and variable security for each creditor. 81

12. To grant the creditor the authority to control the activities relating to the collateral property. 13. To take up insurance against risks that may affect the collateral property in agreement with the creditor to whom he must endorse the pertinent policy. 14. To grant facilities so as to enable the creditor to verify that the pledged property is in fact physically in the place specified. ARTICLE 8. INSOLVENCY OF THE GLOBAL AND VARIABLE SECURITY S CONSTITUENT In the event where the constituent becomes insolvent, it shall notify the competent entity to this effect so that the collateral property is excluded from the rest of the property. The lending creditor may request that its debt be recognised, only to the extent that its proportion would be higher with the proceeds from the sale of the pledged property. Should the allocation of the proceeds of said sale result in a balance in favour of a constituent party, the creditor shall notify this fact or deliver such balance to the competent authority in charge of the liquidation process. ARTICLE 9. RULES AND REGULATIONS APPLICABLE Whatever is not prescribed in this Regulation shall be subject to the Civil Code. ARTICLE 10. SPECIAL REGISTER OF GLOBAL AND VARIABLE SECURITY The Special Register of Global and Variable Security mentioned under paragraph 3 of Article 30 of this Resolution shall be a Special Section of the Movable Property Register in the National Public Registrar System.* Register it, notify it and publish it. MANUEL VÁSQUEZ PERALES Banking and Insurance Commissioner 82

List of Acronyms ABA BEE BFPA BRI BSM CPA DFIs DFID FIs FILE ICB MFI MFRC MFSA MSE NBF NCA NCR NGO NLR NSIC OECD PDC SME UDC UK USAID VAT VCB Alexandria Business Association, Egypt Black Economic Empowerment Business Finance Promotion Agency Bank Rakyat Indonesia Business Sophistication Measure Credit Providers Association Development Finance Institutions Department for International Development, U.K. Financial Institutions Fostering an Investment and Lender Friendly Environment einvoice Clearing Bureau Microfinance Institution Micro Finance Regulatory Council Micro Finance South Africa Micro and Small Enterprises New Business Finance National Credit Act National Credit Regulator Non Governmental Organisation National Loans Register National Small Industries Corporation Organisation for Economic Cooperation and Development Post Dated Cheque Small and Medium Enterprises Undated Cheque United Kingdom United States Agency for International Development Value Added Tax Validation Clearing Bureau 83

PO Box 61674 Marshalltown 2107 Republic of South Africa Howick Gardens Waterfall Park 84 Bekker Road Vorna Valley Tel +27 11 315 9197 Fax 086 518 3579 www.finmarktrust.org.za