What Is an Encumbered Security?
Encumbered securities (or encumbered assets) are securities that are owned by one entity, but which are at the same time subject to a legal claim by another. A lien is a common example of a en encumbrance placed on a property that still has outstanding debts owed to creditors, such a an unpaid mortgage. A margined investment account may also be encumbered by a broker who is due a margin call by an investor.
Encumbered can be contrasted with unencumbered (or free-and-clear) securities.
- An encumbered security or asset is owned by one entity, but there is also a legal claim to that asset by another entity.
- These claims may be due to the owner of the asset owing money to a creditor who uses that asset as collateral.
- Encumbered assets are subject to restrictions on their use or sale.
How Encumbered Securities Work
When an entity borrows from another, legal claim on the securities owned by the borrower can be taken as security by the lender should the borrower default on its obligation. The securities' owner still has title to the securities, but the claim or lien remains on record. In the event that the securities are sold, the party with the legal claim on them must be given the first opportunity to be paid back. In some cases, encumbered securities cannot be sold until any outstanding debts belonging to the owner of the securities are paid to the lender who holds a claim against the securities.
Encumbered assets can be sold, but the sale process requires approval by the buyer and seller, as well as any other entity that has a claim to the asset, such as the bank that issued the loan for the collateralized asset. This can lead to minimum sales price requirements, often in an amount equal to or above the collateralized debt amount against the subject property. This allows the debt to be effectively paid off as part of the sales transaction.
Just as a house may be used as collateral for a mortgage, securities may be used as collateral for borrowing. While the title does not change hands, what the owner can do with the asset or proceeds from the sale of the asset is limited by the extent of the lien on the assets.
Example of Encumbered Securities
Let's look at example of encumbered securities in a brokerage account. If Joe owns shares of ABC stock and wants to borrow money using those shares as collateral, those shares would then be considered encumbered. Depending upon the terms of the lender, Joe may not be able to sell the shares until the loan has been paid back. Or, if he does the proceeds may have to go to pay back the loan first before Joe uses them for anything else. If Joe defaults on the loan, the lending entity may take possession of the ABC shares to compensate for Joe's failure to pay back the loan.
Encumbered vs. Unencumbered Assets
Unencumbered assets are easier to transfer because only the property owner, acting as the seller, and the party interested in purchasing the property, acting as the buyer must approve the sale. Further, there will be no predetermined required sale price, allowing the seller to set the price at his or her discretion.
In most bankruptcy proceedings involving liquidations, encumbered assets are first considered the property of those holding rights to the property through the encumbrance, allowing the institution to recoup some of the losses through the acquisition, and a possible later sale, of the assets in question. In some cases, unencumbered assets do not have a predetermined owner if the assets are liquidated in bankruptcy. This allows the value of any liquidated unencumbered assets to be distributed to creditors who extended unsecured credit.