Legal Business. Understanding And Overcoming Title And Security Issues In Asset Based Financing In Asia. Soon Choo Hock

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1 Memoranda on legal and business issues and concerns for multiple industry and business communities Understanding And Overcoming Title And Security Issues In Asset Based Financing In Asia Soon Choo Hock 1 Rajah & Tann 4 Battery Road #26-01 Bank of China Building Singapore Tel: Fax: eoasis@rajahtann.com Website:

2 Understanding And Overcoming Title & Security Issues In Asset Based Financing In Asia By Soon Choo Hock WHAT IS ASSET BASED FINANCING? Asset based financing has gained increasing popularity as a means of financing growth and providing working capital. The term in general refers to a means of financing whereby a lender accepts as collateral the assets of the borrower in exchange for a loan and other banking facilities. By way of contrast, in unsecured lending, loans are advanced based on the strength of the balance sheet, consistent earnings and credit history, with the borrower being required to adhere to strict financial covenants and ratios. In unsecured lending, lenders look for cash flow to repay the loans, while securities such as the account receivables and inventory are seen as a secondary means of repayment. Account receivables are the preferred security for asset based loans since receivables are among the most liquid of a company's assets followed by inventory. Further, receivables liquidate in a short period of time by themselves and are not susceptible to problems such as shrinkage or physical damage. However, some receivables are considered as having less collateral value, for example, progress billing, past due receivables, and receivables subject to set-off. Other assets that can also be used as collateral are equipment, real estate, commodities, raw materials, finished goods, letters of credit, patents, trademarks or any other asset where value can be determined. Typical Uses Of Asset Based Financing Asset based financing is common in the United States where it was created and perfected during the late 70's as a financing structure to acquire companies by leveraging their assets. Nowadays, it is more commonly used to meet companies general working capital requirements in circumstances where traditional bank loans may not be available, or where the companies are growing rapidly and do not have sufficient equity capital to fund receivables and inventory. The Financing Services Offered There are two main types of credit facilities offered in asset based financing, depending on the type of assets that are being used to secure the loan. Where the collateral comprises working capital such as account receivables and inventory, a revolving credit facility is usually extended. As a company generates sales and there is a corresponding growth in the account receivables and inventory, the operating loan that can be made available can be increased based on the value of these assets. Moreover, since financing is directly related to assets, balance sheet and income statement covenants do not play as important a role as compared to conventional bank financing. Hence, in asset based financing, the lender can provide larger overall operating lines of credit to borrowers compared to a conventional loan. Some of the borrowers may not even qualify for conventional bank financing. Page 1

3 The revolving facility would not have a scheduled repayment. Instead, when the assets, such as account receivables and inventory are converted to cash, the advances are repaid accordingly. Where the assets comprise of equipment, owner-occupied real-estate and other fixed assets, the loans typically take the form of term facilities with a scheduled repayment that corresponds to the fixed assets' useful life. Lenders providing such financing include equipment finance companies, leasing companies and mortgage bankers specialising in fixed asset financing. Such financing is usually provided on a transactional basis. STRUCTURED TRADE / COMMODITY FINANCING Traditional And Structured The traditional method of trade finance involves the payment of goods for money between two parties. The exporter would not release his goods until he is paid and the importer would not effect payment until goods are received. To satisfy both parties, the banking system is used as an intermediary and payment usually effected through a letter of credit. Thus the importer (applicant) would apply for a letter of credit to be opened in favour of the exporter (beneficiary) who would have to present a set of compliant documents. The documents that the exporter will have to present normally include signed invoices, transport documents, packing lists, and quality and quantity certificates. All these documents, which would be stipulated in the letter of credit, are to satisfy the importer that the goods are being shipped to him, and are of the quality and quantity as agreed under the sales contract. When the documents are presented to the bank, the latter will check that they comply with the terms of the letter of credit before releasing payment. In this way, the bank facilitates the transaction. A structured trade finance differs from the above in that it makes use of the underlying asset as security, divorced from the balance sheet. In this form of financing, the risk and sources of repayment is being moved away from the borrower to a third party or to the commodity or transaction that is being financed. Examples of third parties are a warehouse operator, forfeiting bank and insurance provider. Commodity finance enables borrowers to convert their wealth in the form of commodities, such as oil in the ground, cocoa, coffee and cotton, into ready capital. Methods Of Financing There are various methods of financing that can be employed in structured trade finance but the common feature of these methods is the provision for automatic reimbursement of advances from the underlying assets. Banks obtain security over the underlying assets in several ways such as through pledges, charges and assignment. The issues in relation to these securities are discussed in the paragraphs entitled Security Normally Taken In Asset Based Financing as similar issues arise when the securities are provided in the context of asset based financing. The methods employed include the following: Factoring and forfeiting; Warehouse receipt financing; Page 2

4 Countertrade; Export receivable financing; and Pre-payments. It is beyond the scope of this Paper to discuss all of the above. Instead, the Paper will discuss briefly warehouse receipt financing (see the discussion below under Pledge ). SECURITY NORMALLY TAKEN IN ASSET BASED FINANCING A security interest is a right given to one party in the asset of another party, to secure the payment or performance by that other party or by a third party. The basic reason for taking security in asset based or any financing transaction is to avoid the pari passu principle. This principle is a feature of insolvency law in common law jurisdictions such as Singapore and England, and provides for the equal treatment of all unsecured creditors of the debtor upon insolvency in the sense that the unsecured creditors will rank in proportion to their claims. Having security, however, allows the lender to avoid equal treatment by obtaining prior rights in the borrower s assets covered by the security interest. Alternatively, another purpose of taking security is to obtain rights against a third party who will be responsible if the debtor defaults. The various forms of security normally taken in asset based financing is discussed below. Pledge Nature of a pledge A pledge arises when a lender (the pledgee ) takes possession of the assets of the borrower (the pledgor ) as security until payment of the debt. Having possession of the asset is crucial to a pledge. However, the lender does not have to have actual possession of the asset; it is sufficient if he has what is known as constructive possession. Constructive possession, in modern practice, would normally involve either the possession of a valid document of title which represents the assets, eg bills of lading, or an acknowledgment (called an attornment) by a third party holding the goods, eg a warehouseman, that he holds the goods to the order, or at the disposition, of the lender. It is not clear whether there can be any other effective form of constructive possession. A pledge can be created simply and there is no requirement for documentation although it is good practice to take a written memorandum of the terms of the pledge. In practice, pledges are normally taken of goods and documentary intangibles, ie documents embodying title to goods (such as bills of lading), money (such as bills of exchange, cheques, promissory notes) or securities (eg bearer shares, share warrants, bearer bonds but not registered shares). Page 3

5 It should be borne in mind that where goods are represented by documents of title, a pledge of the documents in general is not deemed to be a pledge of the goods. There are two exceptions to this rule, and these are discussed below under Title and security issues under Pledges. In the context of banking facilities, a pledge is normally encountered in trade finance facility. Rights of pledgee and pledgor The pledgee s interest goes beyond a mere right to detain the asset. It encompasses the right to sell the pledged assets upon default by the pledgor and to apply the sale proceeds towards payment of the debt. The pledgor on the other hand continues to retain general ownership despite having transferred possession. At any time before the pledgee exercises its power of sale, the pledgor has the common law right to redeem by paying the debt and taking back the pledge. Title and security issues A pledge in general would not be caught by the Bills of Sale Act, Chapter 24 ( Bills of Sale Act ). This is because the pledge is based on possession of the goods or documents of title and hence the rights of the pledgee arise from possession and not from any security documents. However, the fact that it is based on possession also means that the value of a pledge as a security is limited by the extent of the pledgee s possession. Thus, the security would be lost if possession is lost. (There is, however, a legal device known as a trust receipt which allows a pledgee to transfer possession of the goods or bills of lading and at the same time ensure that the pledge continues. This device is discussed in further detail below under Trust receipts.) A common situation where a bank holds security documents as a pledgee is in the context of a letter of credit where the documents are the security upon which the bank may rely. As noted earlier, where goods are represented by documents, a pledge of the documents in general is not deemed to be a pledge of the goods. Thus the transfer of the documents does not change the possession of the goods, subject to the following two exceptions. The first is where a third party holding the goods, eg a carrier or warehouseman, is directed to deliver the goods or hold them on account of the pledgee, and the third party acknowledges or agrees to do so. In this respect, a mere order to the warehouseman from the pledgor to hold for the lender would not be sufficient. There must be the further act of acknowledgment or attornment by the warehouseman in order for the lender to have constructive possession of the goods. The form in which the direction or acknowledgment is given is immaterial. Basically, any act which informs the lender of the warehouseman s intention to hold the goods on behalf of the lender, would be sufficient to constitute an attornment. Where the third party is a warehouseman, the direction could take the form of a delivery order and the acknowledgment of a warrant for delivery of the goods or an entry in the warehouse books of the name of the pledgee as the person for whom the goods are to be held. The second exception is in the case of bills of lading which are the only documents recognised by the common law as representing the goods to which they relate. Hence, the transfer of the bills operate Page 4

6 as a transfer of the possession of the goods. Thus it is always possible to pledge the goods to which the credit relates by indorsing the bill of lading to the bank. Warehouse receipt financing and the particular problems in relation to taking a pledge over a bills of lading are discussed in further detail in the ensuing paragraphs. Warehouse receipt financing Warehouse receipt financing, as the term implies, relies on the storage of goods in an independently controlled warehouse. The warehouse operator will in turn issue receipts in one form or another, which then form the basis of financing, and are relied on by the bank or trader. In this way, the producer or exporter s promise that the goods exist, is replaced by that of the warehouse operator who becomes legally liable for the goods that are stored. If the goods are stolen, damaged or destroyed through any fault of his, the liability to make up the loss would fall on the warehouseman (and his insurance company where he is insured). The warehouse receipts would be transferred to the lender as security. As the commodities are no longer in the possession of the borrower, the lender would have easy recourse to the commodities should the borrower default. Critical to the success of warehouse receipt financing is the existence of reliable warehouses whose integrity are secured through government licensing and controls. In addition, the warehouse operator should have guarantees obtained from financial institutions, as well as have adequate insurance in place. Warehouse receipt financing is well developed in the United States, Canada and Australia where it is a common source of financing for farmers. A number of developed countries have enacted legislation regulating warehouse receipts and the transfer of such receipts. In such countries, warehouse receipts that are issued may be negotiable (transferable) or non-negotiable (non-transferable). A nonnegotiable receipt is made out in the name of a specific party who would then be the person who can authorise the release of the goods from the warehouse. In Singapore, there is no legislation regulating warehouse receipts. One has to rely on the general law in relation to pledges as discussed in the preceding paragraphs, since warehouse receipts would be given by way of a pledge to a lender. Hence, there would be a transfer of possession of the goods to the lender only when the warehouseman acknowledges a direction to deliver the goods or hold them on account of the lender. Specific issues in relation to transfer of bills of lading and transport documents The transfer of bills of lading and other transport documents to issuing banks and intermediary banks involved in letter of credit transaction may pose particular problems, depending on the nature of the transport documents and how they have been made out. The most straightforward situation is where a bill of lading is made out in the name of the shipper who indorses it over to the intermediary bank or issuing bank upon presentation of the documents. The shipper may indorse it specifically in the name of the bank or in blank. Upon indorsement, the intermediary bank or issuing bank becomes pledgee of the documents and the goods, and has security while the documents remain in its possession. Page 5

7 Where, however, the bill of lading is not made out to the intermediary bank s order or indorsed in its favour, but the documents, including the bill, are presented to the intermediary bank, the latter does not obtain security by way of a pledge. This is because on the face of the bill of lading, the intermediary bank does not receive title to the goods. If the issuing bank rejects the documents, the bill of lading would have to be indorsed to the intermediary bank to enable it to do any of the following: sell the documents, sell the goods or obtain delivery of the goods. A recent decision of the Singapore Court of Appeal in Bandung Shipping Pte Ltd v Keppel Tatlee Bank Ltd [2002] makes it clear that where a bank, as original holder, specifically indorses the bills of lading to another party, it must ensure that the bills are later re-indorsed to it if the bank subsequently wants to sue as holder of the bills of lading. It is not sufficient to simply stamp 'Cancelled' on the endorsements that the bank had made earlier, as had been done in that case. Only a re-indorsement will transfer the rights to suit to the bank under the Bills Of Lading Act, Chapter 384. In the case of transport documents which are not negotiable bills of lading, their delivery will not constitute a pledge of the goods. At most, it would constitute a pledge of the documents and an equitable pledge of the goods. Such transport documents would include straight sea waybill, mate s receipt and a ship s delivery order. Thus, a bank which finances shipment of goods by letter of credit and receives such documents does not obtain a complete a security. Trust receipts Where the bank loses possession of the documents or goods pledged, the security will be lost as the pledge will have come to an end. However, the customer (pledgor), may well want the goods in order to sell them so as to raise funds, or he may want the bills of lading in order to obtain the goods from the carrier when the cargo is discharged. How can the bank facilitate the sale without jeopardising its security? This can be achieved through the use of trust receipts (also known as a letter of trust ). Under a trust receipt, the party receiving the goods or the documents from the bank undertakes to sell the goods as the bank s agent, and to hold the proceeds (or the goods if they are not sold) on trust for the bank. This device allows the bank to transfer possession of the goods or bills of lading to its customer, and at the same time safeguard its position by ensuring that the pledge continues. This is because the law recognises that where redelivery is for a specific limited purpose, such as enabling the pledgor to sell the goods, the pledge is not destroyed. However, the practical effect of giving up possession is to diminish the bank s security since the bank no longer has control over the subject matter of the security. In this respect, a trust receipt does not protect the bank in the following circumstances: Where the customer sells the goods and misapplies the proceeds. If the sale is to a bona fide purchaser for value who does not have notice of the pledge, the purchaser will obtain a good title with the consequence that the bank will have no recourse against him. However, the bank will have the right to trace the sale proceeds received by the customer. Where the customer wrongfully pledges the documents of title to another bank as security for a loan in circumstances where the second bank does not have notice of the earlier pledge and takes the documents in good faith. The second bank would have priority with respect to the documents of title. Page 6

8 A trust receipt is not a bill of sale nor does it embody a charge. It merely records the terms of the trust. The rights of the bank under a trust receipt do not arise under the document at all but under the original pledge. Where, however, there is no valid pledge initially, the trust receipt will constitute a bill of sale within the Bills of Sale Act. Further, it will constitute a charge if given by a company, and would have to be registered under the Companies Act, Chapter 50 ( Companies Act ). Hence, if trust receipts are used in circumstances where there are no documents evidencing title to the goods and the bank never had actual or constructive possession of the goods, the trust receipts will not be effective to give the bank rights over the goods. It is therefore very important to ensure that where a trust receipt is used, there must be a valid existing pledge of the goods or documents of title to the bank. Mortgage Mortgages can be created over tangible and intangible assets and there is no requirement for the lender to have actual or constructive possession of the assets. It is a security interest created by the transfer of title (or ownership) to an asset or of an interest in an asset by way of security, with an express or implied obligation to re-transfer title on the discharge of the mortgagor's obligations. Distinction between legal and equitable mortgage Mortgages can be either legal or equitable. In broad terms the distinction between a legal and equitable mortgage lies in the nature of interest transferred. In a legal mortgage, both the legal and equitable interest and title are transferred to the lender (known as the mortgagee ) which makes the legal mortgage the most secured and comprehensive security interest a lender can have. An equitable mortgage only transfers the beneficial interest in the asset to the mortgagee with the legal title remaining with the owner (known as the mortgagor ). In general, an equitable mortgage will arise where: the formalities necessary to create a legal mortgage have not been completed; the mortgagor's interest in the asset being mortgaged is itself an equitable interest; or the parties have merely entered into an agreement to create a legal mortgage in the future over the asset in question. Title and security issues While the legal mortgage is the most secured and comprehensive security interest a lender could possess, there are a number of formalities and registration requirements that would have to be complied with in order to create an effective legal mortgage. For instance, most mortgages and assignments by way of security created by companies must be registered with the Registry of Companies. Further, where the mortgage is over land, it would need to be registered under the relevant land registry. Page 7

9 Charge Charges, like mortgages, can be created over tangible and intangible assets. There is also no requirement for the lender to have actual or constructive possession of the assets, thus distinguishing it from a pledge. Given the similarity, the terms mortgage and charge are sometimes used interchangeably, although there is a clear technical distinction between them. The essential difference between a mortgage and a charge is that a charge does not involve a transfer of title of the security to the lender (referred to as the chargee ). What the chargee obtains is the right to sell certain specified property of the debtor (referred to as the chargor ) in satisfaction of the secured debt that the latter is unable to repay. The charge thus creates an encumbrance in favour of the chargee. Distinction between fixed and floating charge A very important distinction in the case of charges is that between a fixed and floating charge. A fixed charge is one which attaches as soon as the charge has been created or the debtor has acquired rights in the asset to be charged. The effect of this is that the debtor cannot dispose of the asset free from the charge without the chargee's consent except by satisfying the indebtedness secured by the charge. A floating charge, however, does not attach to specific assets and the debtor is at liberty to deal with or dispose any of the assets free from the charge during the ordinary course of business so long as the charge remains floating. Fixed charges would thus be appropriate for those assets which the chargor does not have to dispose of in the ordinary course of its business, namely land, plant and machinery and intangible property such as rights under contracts and intellectual property rights. Floating charges on the other hand are generally taken over assets that are consumed or disposed of in the course of business. These would include raw materials and manufactured products. A floating charge ceases to float and becomes a fixed charge (or crystallises) on the occurrence of certain events which entitle the lender to intervene and assert his security rights over all the assets then comprised in the fund, and to any assets of the specified description subsequently acquired by the debtor. The events which crystallise the charge include the insolvency of the borrower company, the enforcement of the security or when the company ceases to carry on business. Benefits of a fixed charge A lender will try to take a fixed charge over a floating charge whenever practicable mainly because: The lender acquires immediate real rights over the asset which can only be defeated by a disposition to a bona fide purchaser for value without notice. By contrast, the disposition of an asset which is the subject of a floating charge will as a general rule, take effect free from the charge, whether the disposition be outright by way of sale, or by way of charge or mortgage. This freedom to dispose of the asset may not provide sufficient comfort to the lender that the value of the security is being maintained. Page 8

10 In the winding up of a company, a fixed charge has priority over preferred creditors whereas a floating charge ranks after the preferential creditors. Examples of preferred creditors are (a) costs of the liquidation; (b) employees' wages and salaries; and (c) retrenchment benefits. Title and security issues While lenders may prefer a fixed charge, describing it as fixed charge in the documentation does not, of itself, ensure that a fixed charge has been created. The courts do not determine which category a charge falls into simply by reference to the label used, or by reference to the nature of the property over which it is created. The critical consideration is the degree of freedom which the chargor company has to deal with the charged property in the normal course of its business. Essentially, for there to be a fixed charge, the lender should have sufficient control over the assets to prevent the chargor from dealing with them in the ordinary course of its business. This requirement has given rise to difficulties in the case of receivables (or book debts). This is discussed further below under the paragraph entitled Security Over Book Debts. A charge should confer on the lender express rights to take possession of the assets comprised in the security, either by itself or through an agent or by appointing a receiver. The assets can then be used in the operation of the business, be sold or otherwise disposed of on such terms as the lender thinks fit. In foreign jurisdictions, where the legal system is not based on the common law system, the concept of a floating charge may not be recognised. In which event, there may be difficulty taking security over inventory stock in trade or work in progress. Assignment Intangible assets, such as debts, rights under contracts and rights under insurance policies can be assigned as security. By assignment it is meant the the immediate transfer of an existing proprietary right, vested or contingent, from the assignor to the assignee. If the assignment is in writing and notice is given to the other party (eg the debtor), the assignment will be legal; otherwise it will be equitable. An important limitation of assignments is that only the benefits under a contract can be assigned. Obligations or burdens of a contract cannot be assigned and can only be passed to another party by means of a novation under which the new party agrees to take on the obligations of the original party and the original party is discharged from liability. Title and security issues In order for an assignee to sue in his own name and not depend on the assignor for enforcement, the assignment must satisfy the conditions in section 4(8) of the Civil Law Act, Chapter 43 ( Civil Law Act ). Section 4(8) of the Civil Law Act provides as follows: Any absolute assignment by writing under the hand of the assignor, not purporting to be by way of charge only, of any debt or other legal chose in action of which express notice in writing has been given to the debtor, trustee or other person from whom the Page 9

11 assignor would have been entitled to receive or claim such debt or chose in action, shall be and be deemed to have been effectual in law, subject to all equities which would have been entitled to priority over the right of the assignee under the law as it existed before 23 July 1909, to pass and transfer the legal right to such debt or chose in action, from the date of such notice, and all legal and other remedies for the same, and the power to give a good discharge for the same, without the concurrence of the assignor. Essentially, the conditions that must be satisfied in order for there to be an effective legal assignment under the above provision are as follows: The assignment must be absolute, ie it must transfer the entire interest of the assignor unconditionally to the assignee and place it completely under his control. What this means is that the legal assignment cannot be by way of a charge. But it can be by way of security as in the case of a mortgage where there is a proviso for redemption and reassignment upon repayment of the loan. Thus, when taking security over a debt (or a revenue generating contract), the lender should take an outright assignment with a provision stating that after the secured liabilities have been paid, the assigned property will be reassigned to the assignor (at its request and cost). Note that an assignment by way of charge would nonetheless be effective as an equitable assignment. The assignment must be in writing and duly signed by the assignor. No particular form, however, is required. The assignment must be of the whole of the debt or rights. Written notice must be given to the debtor / obligor. Notice becomes effective on the date at which it is received by the debtor. Generally, notice may be given in any form so long as it is clear and unambiguous, accurate and identifies the rights being assigned and to whom they are being assigned. One of the limitations of assignment is that the assignee always takes 'subject to equities' which exist at the time notice of the assignment is received by the debtor / obligor. This encompasses the following two concepts. The first is the principle of transfer which dictates that the assignee cannot be assigned any greater right than that held by the assignor: also expressed as 'assignee takes subject to assignor's defects in title'. The second is that the debtor can raise by way of defence against a claim made by the assignee certain claims it has against the assignor or its predecessors in title. These are claims which exist at the time notice is received, and are sufficiently closely connected to the contract which is the subject of the assignment (eg defence of set-off, cross-claims). The giving of notice freezes the position. In view of the above limitation, an assignee should obtain details of all existing claims that the debtor has against the assignor or its predecessors in title, and which are sufficiently closely connected to the contract which is the subject of the assignment. Where possible, the assignee should also obtain a warranty from the assignor that there are no existing equities. Under Singapore law, following English common law, rights under contracts cannot be assigned if an assignment is prohibited by the terms of the contract itself. (Where the contract is silent on this question, the rights can be assigned.) These prohibitions can take the form of an absolute prohibition on assignment or partial prohibition, ie a third party's consent must be obtained before an assignment Page 10

12 can be effected. Thus an assignor should obtain a copy of the agreement between the assignor and the third party and check whether there are any restrictions on assignment. If an assignment is taken in breach of a prohibition against assignment, the assignment will still be valid but the assignor cannot enforce it against the debtor unless the debtor waives the prohibition or consents to the assignment. As such, the security represented by the assignment would be weakened. Security Over Book Debts Until recently, it was considered possible to take a fixed charge over book debts and a separate floating charge over their proceeds. However, the Privy Council in the recent case of Agnew v IRC (Re Brumark Investments Ltd) [2001] rejected the split charge phenomena. The Privy Council made it clear that a debt or receivable could not be separated from its proceeds. A debt cannot be enjoyed in specie; its value could only be exploited by exercising the right (ie, collection in the case of the book debt) or by assigning it for value to a third party (and an assignment of a receivable which does not carry with it the right to the receipt has not practical value). In respect of the question of whether a floating or fixed charge was created, the Privy Council laid great stress on the secured lender s control of the charged assets as the crucial factor in determining the nature of the charge. In other words, are the charged assets intended to be under the control of the company as granter of the charge, or the charge holder? Title and security issues It has always been possible to take a fixed charge over the uncollected book debts of a borrower. The decision in Agnew v IRC (Re Brumark Investments Ltd) clarifies that the question of whether a charge over book debts and its proceeds is a fixed or floating charge depends on whether the charge holder is entitled to, and in practice does, exert sufficient control over the charged assets. In order to determine this, a court will consider what the borrower might do with the proceeds. The parameters of the Privy Council decision are not entirely clear. What is clear is that there will be a fixed charge over book debts if the charge prohibits the borrower from disposing of or collecting its book debts. Even if there is no express prohibition, it would be sufficient if the borrower is not free to collect the debts and use the proceeds on its own account. Generally, if the lender allows the borrower to collect the book debts as its agent, the lender should ensure that the proceeds are paid into a blocked account in the lender s name. Further, the borrower should not be able to access the account without the express consent of the lender. This, however, may not always be commercially acceptable or practically viable. However, it may be sufficient to have in place an arrangement whereby money from the blocked account is 'swept' over to the borrower s business account on a monthly, or more frequent, basis (with the lender's permission). Page 11

13 Security Over Credit Balances With Banks Under Singapore law, security can be taken over credit balances (eg a deposit account with the bank), both in the case where the bank does not hold the account as well as where it does. Legislation was passed specifically confirming that a bank could take a charge over deposits placed with it. In this respect, section 13 of the Civil Law Act provides as follows: For the avoidance of doubt, it is hereby declared that a person (the first person) is able to create, and always has been able to create, in favour of another person (the second person) a legal or equitable charge or mortgage over all or any of the first person's interest in a chose in action enforceable by the first person against the second person, and any charge or mortgage so created shall operate neither to merger the interest thereby created with, not extinguish or release, that chose in action. Section 13 was adopted from Hong Kong. In UK, the position was uncertain until the decision of the House of Lords in two cases arising out of the liquidation of BCCI, Morris v Rayners Enterprises Incorporated and Morris v Agrichemicals Ltd [1997] where the Court ruled that a bank can take a charge over a deposit held by it and that such a charge would provide effective security. Usually, security will be taken over a fixed deposit account as opposed to a current account. Security can be taken over (a) specified accounts or (b) all accounts of the depositor. Some banks think that they should take option (b) as it gives them access to more accounts of the depositor. However, this can backfire if the depositor decides to park his money elsewhere to avoid the charge. Title and security issues One of the matters that have to be determined at the outset is the type of security that should be taken. In view of the disadvantages of a floating charge, the preferred security is a fixed charge. However, as discussed earlier, the nature of the charge is not determined by the name given to it. More often than not, it is determined by the way the account is in fact operated. The issue is one of control. The ability of the depositor to make withdrawals from the charged account has severe consequences on whether the security over the deposit is held, at the end of the day, to be a fixed or a floating charge. It is prudent to insert restrictions on withdrawal to prevent the balance in the account from being depleted. The lender taking security over the deposit account should ascertain that the chargor does indeed beneficially own the moneys in the account. In this respect, the charge documents should contain a warranty by the depositor that: the moneys are not subject to a trust; the moneys are not held by the depositor in his capacity as agent; the deposit account is not subject to negative pledge; and the deposit has not been assigned, charged or otherwise encumbered. Page 12

14 It should also be stated in the charge documents that the benefit of the deposit is incapable of assignment, charged or being otherwise disposed of. This will protect the bank from the possibility of a subsequent assignment. The charge documents should also contain an Exchange Control Clause to allow banks to mature and convert fixed deposits that were deposited in another currency. The usefulness of such clauses was evident after Malaysia introduced its Exchange Control Measures. There is some uncertainty as to whether a charge over deposits created by companies have to be registered with the Registry of Companies and Businesses ( RCB ). By way of background, a company is required to register certain forms with the RCB (Forms 33 / 34) if it creates a charge over which section 131 of the Companies Act applies. For the purpose of a bank deposit, the closest paragraph is the one that requires registration if there is a charge on book debts of the company (section 131(3)(f)). There is case law suggesting that a company's account at a bank does not ordinarily constitute book debts, and hence does not have to be registered. However, the prudent course would be to register a charge over a bank account where that charge has been given by a company. Deposits placed with another bank Where a bank takes a charge over deposits placed with another bank, the lender would have to bear in mind the following factors which would weaken the value of its security: lack of control / ability to monitor the account; other bank's set-off rights and its impact on the lender s security (such rights are usually provided for in standard account opening forms); and no right of set-off against the deposit. Generally, the manner of taking security is taken by way of assignment with notice given to the other bank. To enhance its security, the lender should ask the depositor to obtain from the third party bank, an undertaking not to set-off the moneys in the account against the other debts of the depositor. Security Over Shares Under Singapore law as well as in most common law jurisdictions, there are several ways in which security can be taken over shares and other investments securities. In this respect, security may be given by way of: a legal mortgage where the shares are registered in the lender s name or its nominee as shareholder of record, and the share certificates issued in the lender s name or that of its nominee. It is the most secured and comprehensive form of security interest as it transfers legal title to the mortgagee and prevents the mortgagor from dealing with the shares while they are subject to the mortgage; Page 13

15 an equitable charge where the share certificates are deposited with the lender together with share transfer forms executed in blank and any other incidental documents necessary to perfect the transfer. The terms of the security will be evidenced in a memorandum of deposit which should give the lender a power to sell the shares on default by the chargor; or a pledge constituted by delivery of the bearer documents. This method applies only to bearer securities which can be pledged simply by delivery of the bearer documents. Title and security issues When taking security over shares, the following are some of the issues to be considered: Memorandum & Articles Of Association The rights of members are contained in the Memorandum and Articles of Association ( M & A ) of the company. Before taking security over shares, the M & A of the company should be reviewed to determine what these rights are. Among the provisions which have to be reviewed would be (a) transfer restrictions; (b) preemption rights; and (c) liens over shares. Exercise of membership rights For the duration of the security, the lender would have to consider who gets to exercise the rights of members, eg to receive notices and to vote at general meetings. Usually if a bank takes a mortgage of the shares and registers itself or its nominee as a member of the company, it or the nominee (as the case may be) will be treated by the company as a member. Where a charge is taken and the chargor remains the member, the chargor will be treated by the company as the member. Where a bank takes a mortgage, it may be possible to appoint the chargor as the bank s proxy and allow the chargor to vote as it pleases. Accruals dividends / distribution / rights / bonus Accruals would generally refer to (a) dividends; (b) rights issue; or (c) bonus issues. When taking security over shares, the following has to be determined: Who has the right to the dividend; the chargor or the bank? Would the chargor be compelled to exercise its rights under any rights issue? Would the bonus / rights share be subject to the same security? Page 14

16 KEY MATTERS IN TAKING AND PERFECTING SECURITY The following are general issues that should be addressed when taking any form of security. Governing Law In determining the governing law of the security document, there are several considerations to bear in mind. In the case of security interest over tangible property, the security interests should be taken in conformity with, and be governed by, the laws of the country in which the asset is physically situated. In the case of contract rights and other intangible assets, the governing law should be the law of the place where they are enforceable. Where a mortgage is being taken over land and buildings, local laws relating to the mortgage must always be satisfied. A security interest over large items of machinery fixed to land or buildings may be treated as a security interest in the land itself. This is sometimes the case under Singapore law, as well as English law, depending on the manner in which the property concerned is fixed. Formal Documentary Requirements There may be formal requirements of the governing law or the law of the place where the document is executed as to the form of documentation. These need to be adhered to strictly. For example, under the Civil Law Act, guarantees must be in writing but there is no prescribed form of wording. Legal Capacity And Authority It is crucial to ascertain that the party providing the security has the necessary legal power under its constitutional documents or under the laws of the country in which it is incorporated to grant the security. If security is given by a state entity or public corporation, the security would have to fall within the prescribed purpose for which it was established. Even if there is a power to grant the security, an issue may arise as to whether that particular security interest is enforceable against it as being a proper exercise of its powers (eg in common law jurisdictions, it generally must be shown that any transaction entered into by a company confers a genuine commercial benefit on that company, either direct or indirect). Authorisation And Execution Whenever a security is being provided by an organisation such as a company, a society or a government body, the lender would also have to consider whether the appropriate governing body or officials of the organisation have authorised the execution of the security document, and further, whether the security is within the terms of the constitution of the organisation. The security document must also be duly executed as required by: the constitution of the organisation; the laws of the country in which the document is executed; and Page 15

17 in accordance with any board resolution or similar authorisation. Consents A number of consents may be needed in order for the security to be effective. In this respect, the lender must ascertain whether: there are any governmental or other consents or approvals that have to be obtained; and there are any taxes or duties that have to be paid. Ownership Of Assets In order to determine whether the party providing the security owns the assets that are to be used as collateral, appropriate searches should be made at registers of ownership interests (in the case of land, aircraft, ships and intellectual property rights). Appropriate enquiries should also be made to ensure that the assets are not owned by third parties (eg under hire purchase agreements or retention of title provisions in supply contracts). Checks should also be made to ensure that there are no prior security interests over the assets by making searches at appropriate registries or making enquiries of third parties (eg other parties to a contract where rights under that contract are being assigned, or debtors). Registration There may well be registration requirements that have to be satisfied in order to perfect the security. For instance, charges granted by companies must be registered with the Registry of Companies and Businesses. Pledges and guarantees do not, however, require to be registered. Where the security has to be registered, the lender must also consider whether the security should be registered in the country or jurisdiction: where the security provider is incorporated; in which the relevant asset is situated; and / or where the security is to be enforced. Page 16

18 Notices Notices may need to be given to third parties to perfect the security. For instance, for a legal assignment of a debt or rights under a contract, notice has to be given to the debtor or other party to the contract. Rajah & Tann is one of the largest law firms in Singapore. It is a full service firm and given its alliances, including US premier firm Weil, Gotshal & Manges, is able to tap into a number of countries. Rajah & Tann is firmly committed to the provision of high quality legal services. It places strong emphasis on promptness, accessibility and reliability in dealings with clients. At the same time, the firm strives towards a practical yet creative approach in dealing with business and commercial problems. The information contained in this Paper is correct to the best of our knowledge and belief at the time of writing. The contents of the above are intended to provide a general guide to the subject matter and should not be treated as a substitute for specific professional advice for any particular course of action as the information above may not necessarily suit your specific business and operational requirements. It is to your advantage to seek specific legal advice for your specific situation. In this regard, you may Rajah & Tann's Knowledge & Risk Management Group at eoasis@sg.rajahandtann.com. No part of this Paper can be reproduced at anytime for whatever purpose at all without the clearance of the Knowledge & Risk Management Group of Rajah & Tann. Page 17