ASSIGNMENT AND CHARGES OF CONTRACTUAL RIGHTS AND RECEIVABLES A version of this article, written by Head of Banking & Finance, Jonathan Porteous, first featured in Butterworths Journal of International Banking and Finance Law in October 2013. This article considers the very common situation where a borrower has assigned or charged contractual rights and receivables in favour of a lender. We provide analysis of the legal effect of such a transaction and discuss some key concerns for lenders in such transactions. KEY POINTS There is overlapping and confusing terminology in this area the article clarifies the distinctions Careful attention should be paid in drafting security documents when stipulating for charges or assignments to avoid unintended consequences Lender should beware the risks of taking charges or assignments where the counterparties do not have notice of them We examine the effects for an assignee/chargee of a prohibition on assignment in the relevant contract Rules on priority can create uncertainties for lenders and key risks are highlighted TERMINOLOGY Novation, assignment and charges A right under a contract (including a receivable constituted by a right to receive a payment under a contract) can be transferred to a third party (whether for the purposes of security or otherwise) either by assignment or novation. A novation requires an agreement between the counterparty, the transferor and the transferee, and 1
extinguishes the existing relationship between transferor and counterparty creating a new relationship between transferee and counterparty. It is unusual for a lender to take the benefit of a contractual right by novation, because it will usually imply the assumption of obligations towards the contractual party. Although mortgages of debts and contractual rights may occur by way of novation it is far more usual for them to be created by assignment between transferor and transferee. An assignment can be effected with or without notice to the counterparty and does not extinguish the contractual relationship between the assignor and the counterparty. Note that a sale of receivables is also an assignment. An assignee takes subject to equities that the counterparty could have raised against the assignor (e.g. rights of counterclaim, set-off and damages claims) and the assignee can never recover more than the assignor could have done had there been no assignment. A right under a contract can also be made subject to a charge. A charge, strictly speaking, does not transfer ownership to the creditor but is merely an incumbrance on the asset. So a charge may fall short of being an assignment although in most respects the practical effects will be very similar. Confusingly, however, charge can also be used as a generic term for all types of security, including mortgages. Additionally, an assignment can be by way of charge. The practical importance of these distinctions is discussed below. Mortgages and charges A mortgage is a transfer of ownership by way of security upon the express or implied condition that ownership will be re-transferred to the debtor on discharge of his obligation. A mortgage of a contract right may be effected by assignment or novation as noted above. A charge, as it does not transfer ownership to the creditor, does not as such give the chargee a right to enforcement without a court order, although this point is of little practical importance as section 101 of the Law of Property Act 1925 gives powers to appoint a receiver in respect of charges created by deed, and additionally most debentures will create a qualifying floating charge providing further extensive statutory powers. Finally, most debentures will also provide further assurance that the 2
debtor will execute an assignment if required, thus enabling a lender if necessary to take action direct against a counterparty. Absolute assignments and assignments by way of charge An interesting practical point arose out of the recent case of Bexhill UK Limited v Abdul Razzaq 2012 EWCA Civ 1376. In that case a chargee had assigned its rights in the charge to its own financing bank, Barclays. Aikens LJ drew a distinction between an absolute assignment and an assignment by way of charge only. If there had been an absolute assignment to Barclays there would be a need to join Barclays to the enforcement action (unless the charge could be said to be acting as agent for Barclays, which was not the case) whereas in the latter case the chargee would be able to sue in its own right without joining Barclays to the action. On the construction of the debenture, which stated that the chargor assigns and agrees to assign absolutely in favour of [Barclays] all its rights, title interest and benefit in the [Receivables] the judge concluded that the assignment was absolute and it was necessary to join Barclays to the action. Most debentures avoid this unwelcome result by providing for a fixed charge over contractual rights and receivables, leaving no room for doubt that the ability to enforce such rights (at least prior to enforcement) rests with the borrower. In receivables financing agreements debts are commonly assigned by way of security but (prior to enforcement) the borrower is authorised to collect the debts as agent for the lender. In invoice discounting agreements debts are assigned absolutely (by way of sale) but the borrower collects as agent. In factoring agreements the lender is assigned the debts and collects them. Another reason why a lender may prefer a charge to an assignment is where the relevant contract prohibits assignment (see further below). Legal and equitable mortgages It is possible to take a legal mortgage over certain classes of intangibles (e.g. shares, bills of exchange etc) but most mortgages over contractual rights and receivables will be equitable mortgages. The distinction is irrelevant for all practical purposes and of more importance is the distinction between legal assignments (or statutory assignments) and equitable assignments. 3
Legal and equitable assignments Legal (or statutory) assignment Under section 136 of the LPA 1925: 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 thing in action, of which express notice in writing has been given to the debtor, trustee or other person from whom the assignor would have been entitled to claim such debt or thing in action, is effectual in law (subject to equities having priority over the right of the assignee) to pass and transfer from the date of such notice (a)the legal right to such debt or thing in action; (b)all legal and other remedies for the same; and (c) the power to give a good discharge for the same without the concurrence of the assignor An absolute assignment can include an assignment by way of mortgage (but not an assignment by way of charge) even though there is a right of redemption and retransfer, as long as the counterparty is left in no doubt that the assignee has the sole right to the debt in question (at least for the time being). A notice providing that the debt has been assigned,but until further notice the counterparty should pay the assignor, may still qualify as a legal assignment. An assignment of a debt must be for the whole of the debt in order to qualify as a legal assignment. It must be of present, existing right not a future right. Equitable assignment Any assignment not qualifying as a legal assignment will be an equitable assignment (although note that financial collateral (i.e. security over cash, financial instruments and claims under loans made by credit institutions) is subject to its own regime under the Financial Collateral Arrangements (No 2) Regulations 2003 (SI 2003/3226). An equitable assignment can be created simply by manifesting an intention to make an irrevocable transfer of the contractual right. Giving notice to the counterparty is important for many reasons (see Box) but failure to give notice will not invalidate the assignment against the assignor. 4
Importance of the distinction As Chitty comments [Chitty on Contracts 31 st edition at [19-004], there is often little, if any, advantage in a statutory assignment over an equitable assignment. But the important procedural distinction is that a legal assignee can sue in his own name without joining the assignor, whereas an equitable assignee must join the assignor in any proceedings. However in other key respects, e.g. for validity and rules of priority, there are no distinctions. CONCERNS FOR THE LENDER Dangers of not giving notice to the counterparty See Box for an explanation of the advantages of giving notice to a counterparty. Any lender failing to give notice will lose the benefit of these important advantages. Effect of a prohibition on assignment Certain types of contract (e.g. personal contracts) are by their nature not capable of assignment and certain contracts are not assignable for reasons of public policy (e.g. benefits under social security legislation) but generally assignments of contracts will be effective unless the contract prohibits such assignment. English case law has established that a prohibition on assignment in a contract will be effective (Linden Gardens Trust Ltd v Lenesta Sludge Disposals Ltd [1994] 1 AC 85). The counterparty is entitled to ignore any purported assignment and such purported assignment will be a breach of contract (although because it has no effect damages will be nominal, but beware a right to terminate based on a purported assignment (though this would be unusual)). This is another reason (in addition to the concerns highlighted by the Bexhill UK Limited v Abdul Razzaq case noted above) why lenders generally do not stipulate in debentures for assignments of all borrowers contracts, but take charges over them instead. The assignee will therefore need consent from the counterparty to take an effective assignment and acquire rights against the counterparty. However, an invalid assignment is not ineffective as between the assignor and assignee. For example. an assignment by way of charge of the proceeds under a contract, or the factoring of a debt, will in principle create a right for the assignee over the proceeds of that debt, taking priority over other creditors of the assignor, irrespective of a prohibition of assignment in that contract. The courts have not had to 5
consider a contract purporting to prohibit a charge over the proceeds of a debt arising under the contract (and it is hard to see why a counterparty would be particularly concerned about such a thing but in the Linden Gardens Trust Ltd case Lord Browne-Wilkinson considered that such a provision may be invalid on the grounds of public policy. It is important that any security documentation or factoring documentation does not exclude from the ambit of the security rights under contracts which are expressed not to be capable of assignment, as a debtor sometimes attempts to put into the contract. This would of course result in a failure to obtain any right in proceeds from any contract where there is a no assignment clause, unless the express consent of the counterparty to the assignment were achieved. Risk of loss of priority There is not the space to attempt a comprehensive analysis of the complex English law priority rules, insofar as they govern assignments and charges over contractual rights and receivables, but we will highlight a few key points: Failure to register Charges over book debts are registrable under section 860 of the Companies Act 2006. It is universal practice to register any document that includes an assignment of, or charge over, a contractual right or receivable which is taken by way of security. Sales of receivables under invoice discounting and factoring arrangements do not have to be registered, although usually a lender under such an arrangement will also take a debenture to cover non-vesting assets, give it the benefit of a qualifying floating charge and by registration of the charge enhance the chances of retaining priority over any subsequent assignee. Failure to register a registrable charge within the prescribed time limit will render the charge void against the liquidator, administrator and any creditor of the company (section 874 Companies Act 2006) though not against the company itself and not against the subsequent purchaser of an asset charged by an unregistered charge. Characterisation as a floating charge A charge over a contractual right (including a debt) is usually expressed to be a fixed charge, but if the lender allows the borrower to deal with the charged assets and withdraw from the security without the consent of the lender then it is likely that the charge will be considered a floating charge (National Westminster Bank plc v 6
Spectrum Plus Ltd and others [2005] UKHL 41 (Spectrum Plus)).. This will usually be the case where a lender takes a charge over book debts. On an insolvency, in contrast to a fixed chargeholder, a floating charge holder ranks behind expenses of the insolvency proceedings, preferential creditors and the prescribed part allocated to unsecured creditors. A sale of receivables (if clearly drafted as such) will not be recharacterised in this way. Subsequent assignment taking priority The so-called rule in Dearle v Hall (1828)3 Russ 1 governs the priority of successive assignments of a contractual right, debt or other chose in action. An assignee who takes without notice of an earlier assignment and is the first to give notice of the assignment to the counterparty gets priority. Where there is registration of a charge it will not necessarily always serve as notice to a subsequent assignee (it depends whether the subsequent assignee could reasonably be expected to search the register). In most cases in practice one would expect registration to constitute notice to a subsequent assignee. A further concern for a lender is the risk that where its charge is a floating charge (because there is insufficient control over the contractual rights/receivables) then it may lose priority to a subsequent assignee who does exert sufficient control over the contractual rights/receivables for it to amount to a fixed charge. This is provided the subsequent assignee does not have notice of a restriction on subsequent assignments. This is because a fixed charge takes priority over a floating charge even if created later in time (provided the later chargee has no notice of a negative pledge restriction under the floating charge). BOX GIVING NOTICE TO THE COUNTERPARTY Advantages of giving notice It is important for several reasons to give notice to the counterparty of an assignment of (or charge over) a contractual right (there is no distinction between an assignment and a charge for these purposes): Until the counterparty receives notice he may discharge the contract by paying the assignor rather than the assignee 7
Until the counterparty receives notice he can continue to accrue set off rights and counterclaims in respect of the assignor which he can set off against performance of the assigned obligation. For example: o on day one A assigns to B his right to receive 100 from C o on day 2 A incurs an obligation to immediately pay C 50 o on day 3 B gives notice of the assignment to C C is entitled to invoke his set-off right against A and only pay B 50. But note in this case that the notice stops further set-off rights occurring even if A and C have an ongoing contact predating the assignment which allows for mutual set-off. For example if on day zero A and C entered a contract with mutual set-off rights and on day 4 A incurs a further obligation to pay C a further amount, C cannot set this further amount off against B after having received notice of the assignment. Once an assignee gives notice he can prevent any amendment of the agreement between the assignor and the counterparty taking place after the assignment The assignee may lose priority if the assignor subsequently assigns the same right to another party who gives notice to the counterparty first. The only exception is where the later assignee had notice of the earlier assignment (or had constructive notice of it i.e. he should have had notice of it). This rule applies even where one of the assignments is a sale and purchase of debts Provided he complies with the requirements of s136 of the LPA (see above) an assignee giving notice can create a legal assignment, by which he acquires the right to sue the counterparty direct without having to join the assignor to the action. Usual practice of lenders Lenders will want to see notice of assignment given to key contract counterparties (which may for example include tenants in real estate financing) but often it will not be practicable to give notice to all counterparties. In receivables financing and invoice discounting facilities the borrower will be required to instruct debtors to pay 8
to designated accounts and the lender will have the right to inform debtors of the assignment to it, but will generally not do so unless there is a default. If a lender obtains an acknowledgement from a debtor to pay into a certain account then it minimises the risk that the borrower will require the debtor to pay into another account contrary to the terms of the charge and where those proceeds may be beyond the control of the lender. A counterparty making payment contrary to the terms of a notice from the lender and its acknowledgement of it may have to pay again in the manner prescribed by the lender if the lender has suffered loss as a result. Jonathan Porteous is Head of Banking & Finance at Stevens & Bolton LLP. Jonathan can be contacted on jonathan.porteous@stevens-bolton.com 9