The conflict of 'flawed' Assets: Proprietary Security or Contractual Security?

Introduction

Sometimes the lines blur between what is proprietary security and what isn’t, when it comes to creditor protection. But, essentially, every step taken by a creditor to protect against the credit risk is security. The difference usually is that some steps amount to contractual security and others are deemed proprietary security. The most fundamental distinction between these two kinds of security is that one kind of security gives the creditor right against the borrower (or third parties, in case of a guarantee) while the other kind gives the creditor rights against the borrower’s assets. Another fundamental difference is in the lens from which the law views the security at the borrower’s insolvency. If the mechanism adopted by the parties is deemed to be proprietary security; at the insolvency of the borrower, the creditor who adopted this mechanism will be classified as a secured creditor. If the mechanism adopted is deemed to be merely a contractual security, at the insolvency of the borrower, the creditor will be classified as an unsecured creditor.

This classification have inescapable legal impact on creditors, the most important being priority of payment at the insolvency of the borrower. The unsecured creditor is usually subordinated to the secured creditor. In plain English, secured creditors get paid first before unsecured creditors. There is an exception however, but this article cannot afford to digress.?

Contractual and Proprietary security: A distinction

Explaining the difference between these two kinds of security may come in handy at this point. ?A lender is said to have proprietary protection when it has an interest over the property of the borrower. Most commonly, by mortgage or charge. This interest gives the lender the right to sell the property of the borrower and recover the loan advanced if the borrower fails to repay. Even more is that it can do this whether or not the borrower is in liquidation. Even when the borrower is in liquidation, the lender would be allowed to recover its money before the unsecured creditors gets a look in.

When a security is described as contractual, it simply seeks to explain that the creditor has a right, derived from the parties’ contract, against the borrower. This right is enforceable in court if it is breached or; if the condition that gives rise to the exercise of the right has taken place. Example will clarify this abstraction. One example is where the lender restricts the borrower from creating further security over its assets in favor of a subsequent lender. If the borrower breach this contractual restriction and creates security over its asset in favor of another lender, the lender has the right to demand that the loan is repaid immediately. If the borrower fails to pay, the lender, assuming he is unsecured, can go to court to enforce this right.

There are other similar forms of security that are merely contractual: Restriction on the borrower’s activities (Such as restriction on further borrowing or asset disposal), third party guarantee, credit insurance, set off, etc. The common thread between these contractual forms of security is that their rights are not secured on the company’s asset and at the insolvency of the borrower, the secured creditors get paid before them.

The Concept of ‘flawed’ Asset

It gets really interesting where there is genuine struggle to determine whether a creditor protection structure should ideally be classified as contractual security or proprietary due to its economic consequence. One of the structures that can cause this dilemma is the ‘flawed’ asset arrangement. In this arrangement, the creditor agrees to issue a loan to the borrower. One of the condition for the loan grant would be the borrower depositing a sum of money in an account with the lender. This money is deposited with the understanding that the borrower is disallowed from withdrawing it until the loan is repaid. Truly, it doesn’t make sense because if the borrower had the money to deposit, it would not be needing the loan in the first place. Hence, this structure is only practicable when a bank makes a line of credit available to the borrower.

Making available a line of credit is a loan arrangement, where the bank makes a specified amount of money, say Ten Million, available to a borrower. The borrower is then given the liberty to make a withdrawal from the available amount, say One Million, to pay back and borrow again as it desires. Applying a ‘flawed’ asset to this arrangement would be the lender demanding the borrower to deposit an amount with it to secure the individual withdrawals of the borrower per time. ?Another situation where a flawed asset arrangement may be used are in situations where the borrower undertakes a contingent obligation to indemnify a bank in respect of a letter of credit or bank guarantee provided on its behalf. The impact of this arrangement is that the money deposited by the borrower with the lender is never payable until the borrower has completely paid up its loan obligation. If the borrower never pays, the money will be permanently tied up with the lender.

Similarities of flawed Assets structures and Security interests

During borrower’s solvency

The effect of this arrangement has consequently, given room for arguments as to whether the flawed asset arrangement should ideally be classified as another security interest similar to a charge. And the similarities are there to see – especially if the flawed asset structure is combined with contractual set off. A charge is an interest created in favor of the lender over the borrower’s property to secure the performance of the borrower’s obligation. Failure on the path of the borrower to meets its obligation under the financing arrangement will lead enforcement of the security by the lender.

Flawed asset arrangement may not create an interest in the borrower’s assets. But it operates with the economic effect of preserving the borrower’s asset in favor of the lender to secure the performance of the borrower’s obligation. Also, with the inclusion of a contractual right to set off, if the borrower fails to repay the debt, it can extinguish the right of the borrower to the deposits by setting off the outstanding payments of the borrower under the loan with the borrower’s deposit. Structurally, this arrangement, though contractual, achieves the same outcome as a proprietary interest in the borrower’s asset.

During borrower’s insolvency

At the insolvency of the borrower, the two concepts also share identical treatments. During insolvency, the asset of the company are designated to the settlement of secured creditors in priority to unsecured creditors and shareholders. So, a creditor with security interest over the borrowers is fairly assured of getting paid. However, a creditor under a flawed asset arrangement, being an unsecured creditor, ought not to be as assured, as it is to be paid only after payment of secured creditors. However, because of the unique design of the flawed asset arrangement, the creditor can be fairly certain of retaining possession of the borrower’s deposit. This is because the right to retain the borrowers deposit will continue until the borrowers pays its debt. However, now the borrower is in liquidation, the debt will not be paid and so the creditor can continue to hold on to the deposit (the flawed asset). Even with the operation of statutory set off at insolvency, the deposit will remain largely preserved in favor of the creditor. This is because set off is only applicable with respect to mutual debt between two parties that is due and payable. However, because the borrowers deposit (the debt owed by the creditor to the borrower) is only conditional, it cannot be said to be payable unless the loan is fully paid. Consequently, set off cannot apply. Eventually, the borrower’s liquidator will be forced between paying the loan to the lender in full or writing down the value of the lenders debt to the borrowers as zero and the deposit is never recovered. Either ways, the creditor is ultra-protected. Unless, the flawed asset arrangement is deemed to run afoul of the anti-deprivation principle or the pari passu principle.

Conclusion

The benefits of taking proprietary security are considerable, especially relative to other less protected lenders. This is the inspiration for the policy drive behind the statutory requirement of registering security interest in a borrower’s property. This requirement consequently provides fair notice to subsequent lenders thus putting them in good stead to decide on lending to the borrower or otherwise. It can thus be argued that it is in the interest of the law to disallow contractual arrangement that carry the same economic effect of taking security even though not characterized as such by the parties. This argument have been upheld in jurisdictions like Australia with The Australian Personal Property Securities Act 2009 and in Canada in Caisse Populaire Desjardins de l'Est de Drummond v Canada (2009) SCC 29.?