Lending Against Collateral – Africa?

Lending against collateral – why should collateral value matter for banks/financial institutions?

The last couple of years have seen significant progress in the appreciation of the basic principles that lay the foundation for sound lending practices and the integrity of the financial services sector. The banking industry is one of the main drivers of the country’s economy, and this places a high standard of responsibility and accountability on all stakeholders to protect the basic principles that have been established over the years to protect banks and financial institutions from unscrupulous borrowers.

Any bank or financial institution taking collateral for a loan is concerned with ensuring that the security taken is sufficient to cover the credit facilities it has advanced. The primary purpose of taking security is to minimize credit risk and, to the extent possible, obtain priority over other creditors in the event of the borrower’s bankruptcy or liquidation. In addition to the above, taking security is relevant to the risk-weighting of capital for purposes of complying with capital adequacy requirements. It is also noteworthy that the amount of credit that a bank or financial institution may advance to a borrower (including the borrower’s related parties) is subject to regulatory limits provided under the Banking and Financial Institutions (Credit Concentration and Other Exposure Limits) Regulations, 2014 (Credit Concentration Regulations).? Where a loan is secured with collateral with a value of at least 125% of the facility, the bank or financial institution can lend an amount of up to 25% of its core capital. Where the collateral value is less than 125% of the credit facility, the lending limit is limited to 25% of the bank’s/financial institution’s core capital. This decreases further to 5% of the core capital where a facility is unsecured. The Credit Concentration Regulations give room to banks/financial institutions to exceed these single borrower’s limits where a facility is guaranteed by cash, fixed deposit, notes, bonds, treasury bills, or by a guarantee issued by a first-class or international bank or financial institution, or by the government. Clearly, the value of the collateral is critical in determining a bank’s or financial institution’s capacity to lend and, more importantly, the amount that can be made available to a particular borrower given the security value that has been offered to the bank or financial institution.

It is equally important for a bank or financial institution to mitigate credit risk that could result in the erosion of its capital. To this end, it is important for a bank/financial institution to ensure that the value of collateral that it takes to secure a facility is sufficient. We have seen instances where the court limits a bank’s ability to pursue a borrower for any outstanding liabilities following the realization of collateral. This position was held by the High Court in True Colour Limited v. CRDB Bank Plc & Another (Land Case No. 53 of 2017) and in the case of Rose Miyago Assea v. Bank of Africa (Tanzania) Limited(Commercial Case No. 138 of 2017). The decisions in these two cases are similar and quite extreme. The High Court held that once a bank or financial institution sells the collateral it holds, the borrower is discharged from further liability based on the reasoning that the bank has accepted a lower amount. By doing so, the bank should assume its own risk. In the latter case, the High Court (Commercial Division) went as far as warning banks that once collateral is realized through the sale and the sale does not realize the full amount owing to the bank, the bank cannot initiate any further action to recover the outstanding liability, and the bank’s right of enforcement is limited to the property held as collateral.

As expected, this position caused uncertainty within the banking industry, particularly coming at a time when the property market has been adversely impacted by the global economic situation caused by a multitude of complex and somewhat interconnected crises, including the COVID-19 pandemic, climatic changes, war and supply chain disruptions. Notably, though, the High Court has progressively departed from this rather conservative and awkward position and held that it is possible for banks to pursue further action as is necessary to recover liabilities extending beyond the amount gained from the realization of collateral. In the case of Bank of Africa (Tanzania) Limited v. Naif Salum Balhabou (Commercial Case No. 140 of 2016), the High Court held that a lender cannot be precluded from pursuing the borrower for the balance of the loan where the amount gained from realization of collateral does not fully liquidate the outstanding liability. Unless there is evidence of negligence or breach of duty by the lender, the sale of the property would result in the lender fetching a price lower than the property's market value.

Thankfully, the apex court of the land has stepped in to clear any uncertainty on this position by overruling the decision of the High Court in True Colour Limited and Rose Miyagocited above. In the appeal between CRDB Bank Plc v. True Colour Limited & Another (Civil Appeal No. 29 of 2019), the Court of Appeal authoritatively relied upon Sheldon and Fidler’s Practice and Law of Banking, 11th Edition stated that “if, after the sale, the net proceeds are insufficient to discharge the mortgage debt in full, the mortgagee has a right of action against the mortgagor on the personal covenant to pay if, as is usual, one is contained in the mortgage and, if not, he still has a right of action on the debt against the debtor, whether he be the mortgagor or a third party”. The Court of Appeal also touched on the decision of the Court of Appeal of England in Cuckmere Brick Co Ltd v. Mutual Finance Limited [1971] 2 All E.R 633, where the Court of Appeal of England stated that “…it is to be observed that if the sale yields a surplus over the amount owed under the mortgage, the mortgagee holds the surplus in trust for the mortgagor. If the sale shows a deficiency, the mortgagor has to make it good out of his own pocket”.

The Court of Appeal adopted a similar position in Bank of Africa (Tanzania) Limited v. Rose Miago Assea(Civil Appeal No. 214 of 2019) and, relying on the same position set out in Cuckmere Brick Co. cited above, held that “…where mortgaged property is auctioned and the purchase price does not satisfy the debt, in the absence of bad faith or fraud in the conduct of the auction, the lender has the right to claim for the balance of the outstanding amount from the borrower”.

These decisions are a huge stride in reinstating the core principles of borrowing and building a sound financial system by placing emphasis on borrowers understanding the importance of fulfilling their obligations to meet their part of the bargain, which requires them to repay their loans as a covenant. This is critical for the sustainability of the banking industry. Interesting to note, however, is that the lender’s right to further pursue outstanding liabilities does not extend to the mortgagor where the mortgagor is not the borrower. In Bank of Africa (Tanzania) Limited v. Rose Miago Assea, the Court of Appeal clearly stated that “in this case, the mortgagor was not the beneficiary of the credit facility and thus, after the sale of his property, he was discharged from the lability arising from the credit facility”. The court went further to state that the responsibility to fully liquidate the loan rests with the borrower and, as such, any deficiency after the sale of the mortgaged property should be recovered from the borrower. This position provides much-needed guidance on a mortgagor’s liability in a third-party mortgage, where the mortgagor and the borrower are different parties. Notably, decisions of the Court of Appeal are binding on the High Court and other lower courts and, as such, the legal principle emanating from the decision of the Court of Appeal in CRDB Bank Plc v. True Colour Limited & Another and Bank of Africa (Tanzania) Limited v. Rose Miago Assea is binding on the High Court and lower courts, provided that the Court of Appeal has not departed from the said decisions.

The importance of the value of collateral held by a bank or financial institution cannot be downplayed, and it is important for both lenders and mortgagors to understand the implications that this may have in the event of default and realization. As can be seen from the decisions of the Court of Appeal discussed above, banks have the right to pursue further action against a borrower for liquidation of outstanding liabilities where the value gained from the sale of collateral is not sufficient to liquidate the outstanding liabilities in full, provided of course that the bank has exercised care and diligence in the realization process. This means that a bank can sue a borrower for recovery of any outstanding balances that remain owing after the disposal of security. As a point of caution and concluding point, where the security is a third-party mortgage, any further action for recovery of the outstanding balances by the lender can only be directed to the borrower and not the mortgagor.