Encumbered securities are securities that are owned by one entity, but subject to a legal claim by another.
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.
Breaking Down Encumbered Securities
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
For example, 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. You should contrast with "unencumbered" securities.