Purpose of Security
The purpose of security is to ensure that the creditor acquires the right to assets, to which recourse may be had in the event of non-payment. On bankruptcy, all of the debtor’s assets vest in the Official Assignee for the benefit of his creditors generally.
Security entitles the creditor to look to the secured assets to satisfy his debt in whole or in part. Security creates property rights for the creditor over the secured asset. The property rights can be asserted by the secured creditor against all comers, including other creditors and the debtor himself.
Instalment sales, deferred purchase price, leasing and hire purchase arrangements are not strictly credit and security agreements in themselves. The purchase and sale back of receivables (debts) and other assets may come close to affording credit. A sale and leaseback provides for credit arrangements similar to a loan, but do not of themselves, constitute loans.
A reservation of title is not a security transaction, although the difference is little in substance. A reservation of title is a deferral of the passing of title, until payment of the purchase price. In contrast, a mortgage involves a transfer of title already held by the debtor to the creditor. A reservation of title is, accordingly not registerable as a bill of sale or as a company charge.
The above type of arrangements may be useful in avoiding restrictions in existing loan agreements which limit the extent of further borrowing. They provide, credit in effect, without an actual loan of borrowings. Some have similar characteristics to loans and the provisions of the Consumer Credit Act apply to instalment sales, leasing and hire purchase arrangements, when a consumer is a party.
The charge does not involve the transfer of assets. Instead, it creates a proprietary right to have a designated asset appropriated to discharge specified indebtedness, from the proceeds of sales, whether sold through court, out of court or by a receiver. Charges may constitute legal or equitable interests. It creates a property right in the secures assets for the creditor. The contract for the ground of a charge is an equitable charge.
A fixed charge is one over a specific class of defined assets. The debtor may not dispose of the assets concerned, free from the charge. A floating charge is over a class of assets which may exist at present or in the future. The debtor is free to deal with the assets while it remains floating. The chargee’s interest is in a floating fund of assets and not in any specific asset. When the charge fixes or crystalises, it attaches and becomes fixed security.
Disguised Security Interest
Where an arrangement is in substance a loan and security, but is structured otherwise (e.g. a sale and leaseback) it may be deemed to be security interest. In this case, the court will look behind the labels used and determine whether the arrangement is in substance a security interest (rather than e.g. a sale and leaseback).
If the documentation is a sham and does not reflect the real transaction, which is in substance a security, the courts may re-categorise it as such. Even if the arranged documents does reflect the real transaction, then the real transaction may nonetheless be a security notwithstanding that it is labelled as a sales.
If in substance it amounts to a security, then it may be so categorised. The courts look at the substance and reality of the arrangement. If an arraignment is in fact a security arrangement but has been labelled otherwise, then there is a risk that its not non-registration under the Bill of Sales Act or under companies legislation will make the security invalid or vulnerable to set aside.
A genuine sale and leaseback is not a security transaction. Assets including buildings and equipment are commonly sold and leased back. A sale and leaseback of itself it not enough to cause the arrangement to be deemed a security in substance. There must be further factors present before the arrangement will be re-designated.
The courts will look as to whether the sale is in substance, a sale rather than a disguised mortgage. If the intention was that the goods are not to be sold, but are to be held as security, the arrangement may be treated as security.
A person may sell goods to a buyer with provision for instalment payment in the event of the default. The seller has either an option or an obligation to repurchase the goods.
In the former case, the arrangement is more likely to be treated as a genuine sale and repurchase. In the latter case, it is more likely to be treated as a security. Sale and re-purchase agreements are commonly referred to as “repos” and are commonly used in financing transactions.
The EU Financial Collateral Regulations remove the formalities applicable to some types of security and quasi-security arrangements. This is designed to remove the risk of the “repo” being characterised as a security interest and invalidated for non-compliance for non-registration , provided that the relevant conditions are complied with.
Reservation of Title
A simple reservation of title clause in a contract for the sale of goods is valid and effective. However, if the clause purports to cover the proceeds of further sales, it may be characterised as a charge over book debts and be thereby registerable.
Similarly, where a charge purports to take and retain title to a substituted new product, a new asset is created so that title can be no longer retained. The provision of future security over a new asset is likely to be characterised as an equitable charge on the asset, which risk being voidable if unregistered.
Factoring / Invoice Financing
Book debts may be sold to in order to finance working capital requirements. Typically, the debts are sold at a discount to face value, to reflect implicit interest and risk. The seller may remain responsible for collection and may guarantee payment with an obligation to re-purchase in the event of default in the underlying debt.
The arrangement will generally stand up as an outright assignment but in some cases, it may be characterised as a disguised security transaction. If the intention of the parties is that the there is a security assignment only (with a right of redemption), rather than an outright sale, it may be so characterised.
In some asset finance contracts, the borrower undertakes to repay an advance from a particular fund, usually constituting receivables. Notwithstanding that the creditors’ recourse is limited to the assets concerned, the arrangement made be characterised as a loan and security, where the borrower, in substance, retains an interest or equity in the asset.
Set-Off/ Charge over Debt
Set-off agreements extend the default position by which mutual sums immediately due by one party to another and vice versa, may be set off. They may, for example, provide that monies contingently owed by a guarantor may be set off against accounts owing to that guarantor. Set-off does not comprise the security interest in itself.
Where parties contract to provide set off wider than that allowable under default insolvency rules, it may be deemed invalid under insolvency laws. While a genuine set off is permitted, a set off that is artificially contrived may be deemed a disguised attack on the principle of creditor equality in insolvency.
A bank may, instead of purporting to a charge over its own balance by a letter of setoff, impose restrictions on the right to withdraw a deposit, held by its customer with it. It might be provided as a condition that a deposit may not be withdrawn for so long as money is owed by the company or an associated company. The restriction on withdrawal limits the bank’s repayment obligation to the customer without giving it a right over the credit balance (which is a debt by the bank to the customer)..
The bank does not “take” title to the balance in any sense and its liability to the customer remains intact. Instead, the discharge of the indebtedness is a pre-condition to the right to withdraw.
The arrangement may include an agreement with (say) two companies by which debtor takes over responsibility for repayment of the other company’s deposit so that the bank is correspondingly released. Technically, there is no charge (over the deposit) although the agreement has a similar economic effect.
A negative pledge is an undertaking, typically in a floating charge, by which the borrower undertakes not to grant any charge or mortgage ranking in priority to or equal to that of (typically) the floating charge. Where a later fixed chargeholder has actual notice of this restriction, the latter does not take priority in respect of asset within the floating charge.
A negative pledge clause may be provided, even where no security is created. In this case, the undertaking does not of itself create a security.
An agreement to put in place security in the future is an equitable charge if the asset identified is sufficiently certain. Otherwise, it is a contractual undertaking only, and has no value as a security.
A subordination agreement is an agreement to second rights to that of another equally ranking or subordinated creditors.