Cayman Islands Legal Issues in the Creation of Security

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CAYMAN ISLANDS LEGAL ISSUES IN THE CREATION OF SECURITY

SECURITY – LEGAL ISSUES

1. INTRODUCTION

1.1 The creation of security constitutes an arrangement whereby a creditor is able to look to a particular asset, or the asset’s proceeds of sale, if a debtor fails to discharge its liabilities to the creditor. Particularly with reference to our CDO practice, you should note that security cannot be granted to shareholders in respect of a company’s obligations in respect of ordinary or preference shares.

1.2 There is a distinction between real rights (rights in rem) and personal rights (rights in personam). A real right is a right which is exercisable against the world at large.1 A personal right is an interest which is protected solely against specific individuals.2 Taking a security interest over an asset confers a real right over that asset. Personal rights which confer additional rights, for example guarantees, are often described as personal security. However, strictly, security should only be those interests which confer a right in rem. All of the types of security discussed below confer rights in rem.

2. TYPES OF SECURITY

2.1 English and Cayman Islands law recognise four basic forms of security interest: mortgages (legal and equitable), charges, liens and pledges. In the context of structured finance, the most important of these are mortgages and charges. Liens and pledges are now rarely used. The type of security which will be appropriate will depend on various factors such as the status of the potential grantee of the security, the level of security and safety a creditor desires, the type of assets which are to be secured and whether the grantor wishes to continue dealing with those assets.

2.2 This table summarises the main differences, discussed in more detail below, between the various forms of security interest:

Type of Interest Creation and Impossible Properties Formalities

Legal mortgage Legal Depends on type of Cannot take legal property being mortgage over

1 Blacks Law Dictionary (1999) 7th Edn. 2 Blacks Law Dictionary (1999) 7th Edn. Cayman Islands Legal issues in the creation of security Page 2

secured. equitable interest

Equitable mortgage Equitable Depends on type No restrictions property being secured

Charge Equitable right to No formalities No restrictions resort to asset for payment

Pledge Legal Delivery of possession Property which is of property to incapable of being pledgee delivered

Lien Right of possession Delivery of possession Property which is of property to lienee incapable of being delivered

2.3 Mortgages

(a) Legal Mortgages

(i) Legal mortgages are the most comprehensive and secure form of security. A legal mortgage is the transfer, by conveyance or assignment, of the whole of the legal ownership of an asset by way of security. This transfer is, however, subject to an equity of redemption (which cannot be fettered) – an express or implied obligation to re-transfer ownership of the asset to the mortgagor if the mortgagor discharges his debt or obligations. Formally, the mortgagee has legal title of the asset. In reality, however, the substance of ownership, and generally possession of the asset, will remain with the mortgagor.3

(ii) The formalities necessary for creating a legal mortgage depend on the type of property being secured. This note does not cover the creation of security over Cayman Islands real estate which should never be encountered in our structured finance practice. A legal mortgage over debts or choses in action is created by an absolute assignment in writing which is not purported to be by way of charge only. Additionally, express notice in writing must have been given to the debtor, trustee or other person from whom the assignor would otherwise have been entitled to claim the debt or chose in action. The Property (Miscellaneous Provisions) Law (2001 Revision) provides in Section 5(2) that:

If the person liable in respect of such debt or thing in action has notice –

(a) that the assignment is disputed by the assignor or any person claiming under him; or

3 See Gough, Company Charges (1996) 2nd Edn Butterworths at 18.

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(b) of any other opposing or conflicting claims to such debt or thing in action, he may, if he thinks fit, either call upon the person making claim thereto to interplead concerning the same, or pay the debt or other thing in action into court under the Trusts Law (2001 Revision) or any statutory modification or successor thereto.

Legal mortgages over chattels do not generally require any formalities to make them effective, provided that there is a valid agreement and intention to create a mortgage.4

(iii) A legal mortgage over registered securities (shares or bonds) is created by transferring the securities into the name of the mortgagee or a nominee, for nominal consideration. The recipient should then be registered as the holder of the securities. An accompanying agreement should set out the equity of redemption, i.e. the rights of the mortgagor to have the securities re- transferred to him on discharge of all liabilities. For bearer securities, a legal mortgage is created when the certificates of title to the securities are deposited with the mortgagee and a memorandum of deposit is entered into between the mortgagor and mortgagee which transfers the legal interest in the securities. However, it is more natural for bearer securities to be delivered by way of pledge.

(b) Equitable Mortgages

(i) Here, the mortgagor transfers a beneficial interest in the relevant asset to the mortgagee while the legal interest remains with the mortgagor. An equitable mortgage is weaker than a legal mortgage and a pledge, because a bona fide purchaser of the legal estate without notice of an equitable mortgage (known as “equity’s darling”), will take free from the equitable mortgage.

(ii) An equitable mortgage is created in any of the following situations:

(A) the legal owner of the asset enters into some instrument or does some act which though insufficient to confer a legal estate or title in the asset to the mortgagee nevertheless demonstrates a binding intention to create a security in favour of the mortgagee or evidences a contract to do so, which is supported by consideration5;

(B) the potential mortgagee is proposing to take security over an equitable interest in an asset;

(D) in the case of certain property (e.g. registered securities) the mere deposit of title certificates with a lender, with intent to create security, is sufficient to create an equitable mortgage.7

4 Gough, Company Charges (1996) 2nd Edn Butterworths at 24. 5 Swiss Bank Corpn v Lloyds Bank Ltd [1982] AC 584 at 594-5 per Buckely LJ. 6 Holroyd v Marshall (1862) 10 HL Cas 191, Tailby v Official Receiver (1888) 13 App Cas 523.

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(iii) An equitable mortgage over any legal interest in property other than land requires no formalities, except for an agreement with intention and consideration. The making of a related loan will be sufficient consideration for the creation of an equitable mortgage.

(iv) Unless registered securities are held on deposit with clearing systems such as Euroclear or CEDEL, registered securities are often delivered to the mortgagee by delivery of the share certificates together with a signed but undated transfer form which does not name the transferee.

(i) Charges do not transfer legal or equitable interests in the asset to the chargee, nor do they confer a right to possession. Instead, under an equitable charge, “specific property of the chargor is expressly or constructively appropriated to or made answerable for payment of a debt”8. The chargee has a right to resort to the asset in order to realise it towards payment of its debts. Charges are always equitable charges.

(ii) An equitable charge needs no formalities save for the agreement creating the charge.

(d) Pledges

(i) A pledge is a legal form of security which is created by delivery of possession of an asset to the pledgee. This delivery can be actual or constructive. Constructive delivery takes place when a bailee of the pledgor acknowledges to the pledgee that he holds the goods to the pledgee’s order. This process, known as attornment, means that the goods remain in the hands of a third party but in constructive possession of the pledgee.

(ii) Pledges of tangible property are unremarkable. There is a problem, however, in the concept of the pledges of certain intangible assets, often because of the difficulty in transferring possession. Subject to certain exceptions (e.g. bills of lading) a pledge of a document of title, for example, will generally only pledge the paper itself, not the underlying goods which the document of title represents.

(iii) Pledges of negotiable instruments are valid, except those instruments which cannot be transferred. Bearer securities can be pledged.

(iv) Personal property such as share certificates in respect of registered shares, which is incapable of being physically delivered, cannot be pledged.

(v) Extra care must be taken when acting in respect of the transactions involving bearer securities or other instruments as bearer instrument transactions are frequently a device used by money launderers. (See also bearer share restrictions at Sections 249-251 of the Companies Law (2003 Revision)).

7 Harrold v Plenty [1907] 2 Ch 314. 8 Re Charge Card Services Ltd [1987] Ch 150 at 176 per Millet J.

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(e) Liens

(i) A lien, although dependant on delivery of possession to the creditor, like pledges, is essentially different from a pledge.

“The difference between them is that in the case of pledge the owner delivers possession to the creditor as security, whereas in the case of a lien the creditor retains possession of goods previously delivered to him for some other purpose.”9

(ii) A lien confers a right of possession. A lien is a right to detain an asset until the obligation owed by the lienor is discharged. For this reason, liens are the weakest of the four methods of security.

(iii) Liens are created either by operation of common law or statute or are contractual. Examples of liens arising by operation of common law are the banker’s lien and the solicitor’s lien10.

3. ENFORCEMENT

3.1 Remedies of a Legal Mortgagee

(a) On default by the mortgagor of the terms in the mortgage, a mortgagee will want to enforce his security. He will have various options when it comes to enforcement.

(b) The main remedies for a legal mortgagee are:

(i) Appointment of a Receiver

(A) The mortgagee will usually have a power to appoint a receiver under the terms of the mortgage. This right will be exercisable after default. In addition, if the mortgage so provides, a mortgagee will be able to appoint a receiver before default. A usual clause would be that a mortgagee is entitled to appoint a receiver if he reasonably believes that the security is in jeopardy. Jeopardy will need to be defined in the mortgage.

(B) A receiver will be appointed over the secured assets and his powers in relation to those assets will depend on the terms of the mortgage security instrument.

(ii) Power of Sale

(A) The mortgagee will be able to sell the property in reduction or satisfaction of his debt. The power of sale will arise under the terms of the contract.

(B) The mortgagee will not be permitted to sell the property to itself or a connected party and will be under a duty to the mortgagor to obtain the best price possible for the assets11.

9 Re Cosslett (Contractors) Ltd v Mid-Glamorgan County Council [1998] Ch 495 at 508 per Millet LJ. 10 Brunto v Electrical Engineering Corpn [1892] 1 Ch 434.

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(iii) Foreclosure

(A) This is a cumbersome enforcement measure and is very rarely used nowadays12 because the power of sale is thought to be as effective. Foreclosure is only available on application to the court. An order for foreclosure abrogates the mortgagor’s equity of redemption and leaves the entire value of the mortgaged property in the hands of the mortgagee. The court is entitled to sell in lieu of foreclosure.

(B) Even after foreclosure has taken place, a mortgagee may still sue the mortgagor on his covenant to repay, until he has sold the property to a third party.

(iv) Alternative Remedies

A legal mortgagee has an immediate right to possession. This right is regardless of default unless there is an express or implied exclusion under the terms of the mortgage that the mortgagee will only take possession on default. A mortgagee can also take possession before the legal redemption date for the mortgage has passed.

3.2 Remedies of an Equitable Mortgagee

(a) An equitable mortgagee has no right to possession.13 Nevertheless, an equitable mortgagee may apply to the court for specific performance. This enables the mortgagee to require that his equitable mortgage be converted to a legal mortgage or to request the court that he be put in possession, before or after default. Obviously, a court will be more likely to put a mortgagee into possession if default has occurred.

(b) An equitable mortgagee will be entitled to foreclosure, and in accordance with the terms of the charging document, to sell the property or to appoint a receiver.

In the case of an equitable mortgagee of a debt, the mortgagee will have an action for payment against the debtor in equity.

3.3 Remedies of Equitable Chargee

A mere equitable chargee cannot foreclose on the property.14 He is, however, entitled to the appointment of a receiver or to sell the property, either pursuant to express terms in the charge document or by application to court.

3.4 Remedies of Pledgee

A pledge confers a power of sale on the pledgee. Also, since a pledgee is entitled to immediate possession, common law actions in tort such as conversion will lie.

3.5 Remedies of Lienee

11 Cuckmere Brick v Mutual Finance [1971] Ch 949. 12 Palk v Mortgage Services Funding Plc [1993] 2 WLR 415 at 419. 13 Ashley Guarantee plc v Zacaria [1993] 1 WLR 2 at 69 per Nourse LJ. 14 Tennant v Trenchard (1869) 4 Ch App 537.

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A lienee merely has a right to detain the property until his debt has been satisfied. Generally, he has no power of sale. However, a banker’s lien does confer a power of sale.15

4. FIXED AND FLOATING CHARGES

4.1 Fixed Charges

(a) In Re Cosslett (Contractors) Ltd16 at the Court of Appeal stage, Lord Millett, then Millett LJ, described the essence of a fixed charge as:

“a charge…on a particular asset or class of assets which the chargor cannot deal with free from the charge without the consent of the chargee”.

(b) A fixed charge is therefore created when particular real or personal property, capable of being ascertained and defined, is specifically set aside or appropriated to the discharge of the chargor’s debt.

(c) The chargee of a fixed charge is given an immediate interest in the property subject to the charge. This interest binds all those into whose hands the property may come with notice of the charge.17

(d) This characteristic of fixed charges does however mean that a company, with assets subject to a charge, is unable to deal with those assets, without the consent of the chargee, without committing a breach of the terms of the charge. A company which has a fixed charge over a substantial part or the whole of its assets, especially its circulating capital, would find it difficult to continue its business. Considerations of the fixed charge’s paralysing effect on business led to the development of the floating charge.

(e) Under Cayman Islands law, both fixed and floating charges can be granted notwithstanding that the chargee is the obligor.18

4.2 Floating Charges

(a) Nature of Floating Charges

(i) A floating charge is a charge which floats over the property charged so that a company is able to deal with that property. The chargor’s ability to deal with the property will continue until some event occurs which causes the charge to crystallise over the property, thereby becoming a fixed charge. At this point, the chargor will be restricted in its dealings with the property charged.

15 The banker’s lien does not extend to interests in securities held by banks as custodian for clients. Custody liens do no therefore confer a power of sale. 16 Re Cosslett (Contractors) Ltd v Mid-Glamorgan County Council [1998] Ch 495 at 510 per Millet LJ. This case was referred to the House of Lords. 17 Agnew and another v Commissioner of Inland Revenue (Re Brumark Investments) [2001] 2 AC 710. 18 For example, a Bank’s obligations to return deposited money to the chargor (see Section 2 of the Property (Miscellaneous Provisions) Law (2001) Revision)

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(ii) Floating charges first appeared in England in the 1870’s but it was not until 1903 that the courts began to define floating charge. In Re Yorkshire Woolcombers Association Ltd, Romer LJ described the floating charge as having the following three characteristics:

(A) a charge over a class of present and future assets;

(B) the assets within the class changing in the ordinary course of business; and

(iii) The defining feature of a floating charge is therefore that the chargor will have the right to remove property from the scope of the charge without the consent of the chargee.

(iv) The main advantage of a floating charge is its flexibility. Charges can be taken over many assets which cannot realistically be made the subject of a fixed charge (e.g. book debts, stock-in-trade), without inhibiting a company’s ability to continue trading. The flip side to this is that since a company can remove property from the scope of the charge, there is a possibility that the subject matter of the floating charge will be lost leaving the chargee with an effectively unsecured debt.

(v) An English law governed floating charge granted by a UK company will, usually grant to the chargee the right to appoint an administrative receiver. It should be noted that Cayman Islands law does not recognise the concept of an administrative receiver and a Cayman Islands law floating charge should create and empower the role of a contractual receiver which can be a receiver over all of the company’s property.

(vi) A disadvantage of floating charges is their vulnerability in the event of insolvency of a company. Creditors who are owed debts which are classified as preferential, will take in priority to floating chargeholders. Preferential debts include liquidator’s fees and expenses, unpaid government fees and expenses and the unpaid salaries of employees.

(vii) In addition, the assets subject to a floating charge may be diminished by the following:

(A) post-execution dispositions;

(B) set-off rights; and

(viii) To avoid such problems of vulnerability, in the context of a structured financing, a chargor which is an SPV will often be required to give representations and warranties that it has no preferential creditors and no

19 In Re Yorkshire Woolcombers Association Ltd [1903] 2 Ch 284.

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liabilities other than those envisaged by the transaction documents and to give undertakings that it will do nothing to create such creditors/liabilities.

(b) Crystallisation

(i) As mentioned above, crystallisation is the process of conversion of the floating charge into a fixed charge on the occurrence of certain events. Crystallisation is either implicit or express.

(ii) Implicit crystallisation occurs on the following events:

(A) if an order for liquidation of the company is made20;

(B) if the company ceases trading or carrying on business21 insofar as there is a difference between a company ceasing to carry on business and a company ceasing to be a going concern, the material event for crystallisation is the cessation of business22;

(C) if the company disposes of in substance the whole of its undertaking or trading assets with a view to the cessation of trading or cessation as a going concern23;

(D) if the chargee takes possession of the charged assets through seizure under power or licence24;

(E) if a receiver is appointed over the charged assets by or on behalf of the chargee25; and

(F) if the chargee obtains or exercises some other remedy with a view to enforcement of the security or protection of the charged assets26.

(iii) Express crystallisation occurs when, pursuant to the terms of the charge, either the chargee notifies the company that the charge shall crystallise or an event occurs where under the express terms of the charge, the charge specifies that that event shall cause the charge to crystallise.27 The latter is known as automatic crystallisation. Automatic crystallisation does not immediately destroy the chargor’s apparent authority to deal with the assets. If the chargee takes no steps pursuant to an automatic crystallisation, the parties

20 Re Brightlife Ltd [1987] Ch 200 at 211 per Hoffman J. 21 Edward Nelson & Co Ltd v Faber [1903] 2 KB 367 at 376 per Joyce J. 22 Re Woodroffes (Musical Instruments) Ltd [1986] Ch 366 at 367 per Nourse J. However, Nourse J did note that the two phrases often seem to be used interchangeably 23 Hubbuck v Helms (1887) 56 LJ Ch 536. 24 Mercantile Bank of India Ltd v Chartered Bank of India, Australia and China and Strauss & Co Ltd [1937] 1 All ER 231. 25 Re Florence Land and Public Works Co (1878) 10 Ch D 530 at 541 per Jessel MR. 26 A submission by Gough, Company Charges (1996) 2nd Edn Butterworths at 137. 27 Re Brightlife Ltd [1987] Ch 200.

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will probably be deemed to have agreed that the crystallisation should be inoperative.

(i) Rules of priority are very important because if a company is defaulting on its debts, there will often be a number of secured creditors who are trying to enforce their security at the same time. The following rules apply between fixed and floating charges. However secured creditors often avoid the issue by executing a deed of priority before advancing money (e.g. waterfall provisions in securitisation documentation).

(d) Fixed Charge v Fixed Charge

(i) Where two fixed charges are perfected, the first in time to be created prevails.

(ii) A bona fide purchaser for value of a legal estate without notice overrides equitable interests including the interests of a chargee. Also, since a company can only charge what it owns, if it acquires an asset with limited rights, the chargee takes subject to the rights of the third party. 28

(e) Fixed Charge v Floating Charge

A floating charge is generally postponed to a subsequent fixed charge.29 The exception to this is where the fixed chargee has actual or constructive notice of a restriction in the floating charge preventing the creation of subsequent charges ranking in priority or pari passu with the floating charge.30

(f) Floating Charge v Floating Charge

Traditionally, where there are two floating charges over the same assets, priority was governed by the date of creation of the charge.31 However, in Griffiths v Yorkshire Bank Plc32, it was held that priority between floating charges is governed by the date of crystallisation. This decision was not followed in the later case of Re H & K (Medway) Ltd33 on another matter and academics such as Palmer have strongly criticised Griffiths, because it will allow the rights of the first chargee to depend on an accident of timing. It is unlikely that Griffiths will be followed but this area is not entirely settled.

It is clear, however that if a second floating charge is granted over only part of the assets which are secured by the first floating charge and the second charge cannot be said to be the same character as the first charge, it is permissible that the second charge take priority over the first.34 Charges are of the same character if they are

28 This is an application of the principle of nemo dat quod non habet. 29 Cox Moore v Peruvian Corporation Limited [1908] 1 Ch 604. 30 English & Scottish Mercantile Investment Co Ltd v Brunton [1892] 2 QB 700 at 707 per Lord Esher M.R. 31 Benjamin Cope & Sons Ltd [1914] 1 Ch 800. 32 Griffiths v Yorkshire Bank Plc [1994] 1 WLR 1427 at 1435 per Morritt J. 33 Re H & K (Medway) Ltd [1997] 1 WLR 1422. 34 Re Automatic Bottlemakers Ltd [1926] Ch 412.

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granted over exactly the same assets and on the same footing as each other or if the second charge is in priority to the first charge.35

5. SECURITY OVER FUTURE ASSETS

5.1 The common law has always denied the legality of taking security over future assets (i.e. assets which do not yet exist). At common law, therefore, security over future property by way of a mortgage or a charge is invalid. However, in Holroyd v Marshall36, the House of Lords held that security over future assets is valid in equity by virtue of the contract of assignment. Hence, while it is not possible to have a legal mortgage over future assets, it is possible to take an equitable mortgage or charge over future assets. Security by way of pledge or lien, however, can never be taken over future assets, because there can be no physical delivery of future assets.

5.2 Attachment of security to existing assets takes place, when possession passes (pledges and liens), when legal title is conveyed (legal mortgages) or when the security agreement is made or when money is advanced (equitable mortgages and charges). Before Holroyd, however, it was difficult to conceive of when attachment would take place in the case of a security over future assets. In Holroyd, it was decided that security over future assets attaches automatically once the assets are acquired, with no fresh consideration needed.

5.3 Once attachment has taken place, the security still takes effect from the date of creation of the security agreement. This means that even though attachment does not happen until the assets are acquired, once they are acquired priority will be governed by the date of the original security agreement.

6. SECURITY OVER BOOK DEBTS

Security may be taken over a book debt either by a mortgage or a charge. Strictly speaking, the security will be over either the right to payment of the debt or the proceeds of the debt.

6.1 Types of Security

(a) Legal Mortgage

A legal mortgage over a debt is created by a legal assignment. An assignment must be by writing, must not purport to be by way of charge only and must be of the whole debt. The assignee will take subject to equities such as a prior perfected equitable assignment and accrued rights of set off. The assignee does not therefore have the full rights of a bona fide purchaser for value. He will however, after having given express notice in writing to the debtor, be able to sue for the debt in his own name.

(b) Equitable Mortgage

(i) An equitable mortgage over a debt is created by equitable assignment. Any other equitable assignment can be created informally subject to an act by the assignor manifesting an intention to make a present assignment. Additionally, if the assignment is over future debts, the assignment will only take effect in equity as an agreement to assign and must be supported by consideration.

35 Benjamin Cope & Sons Ltd [1914] 1 Ch 800 per Sargant J. 36 Holroyd v Marshall (1862) 10 HL Cas 191.

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(ii) There is no requirement that notice need be given to the debtor. However, if an equitable mortgagee wishes to convert its security to a legal mortgage, it can do so by giving notice to the debtor. Often, however, an assignee will not wish to give notice for commercial reasons – such as the assignor not wishing the debtor to know about the assignment or the assignee preferring that the assignor continues to collect payment of the debt.

(iii) An equitable mortgagee differs from a legal mortgagee in that he cannot sue the debtor without joining the assignor as a party to the proceedings either as plaintiff or defendant.

A mere chargee in respect of a charge over a debt has no right to sue the underlying debtor. He may require the chargor to sue and he will then be entitled to the proceeds of the debt. A charge over receivables should confer on the chargee power to convert it into a mortgage and should therefore contain a power of attorney to the chargee to execute an assignment in the name of the chargor.

6.2 Priority

(a) It is possible for a number of people to have taken security over the same debt. The rules as to who takes priority will depend on whether or not the claimants have notice of the security taken before theirs.

(i) Claimant has No Notice

(A) Between all permutations of legal assignees and equitable assignees, priority is governed by the date notice is given to the debtor, regardless of the time that the assignment was actually made.37 Here, it is only necessary that the second chargee has no notice of the first charge at the time of creation of the second charge. It is irrelevant if he has notice of the first charge at the date he notifies the debtor.38 Where neither party has given notice, the charge created first in time has priority.

(B) The rules as to priority between a legal or equitable assignee and a mere chargee are still unclear. It is possible that it will be governed by the date of notice to the debtor. However, the better view is that priority is governed by the date of creation of the competing interests.

(C) The rules as to priority between two mere chargees are also unclear. It is thought here also that the better view is that the priority will be governed by the date of creation of the charges.

37The rule from Dearle v Hall (1828) 3 Russ 1. 38 Mutual Life Assurance Society v Langley (1886) 32 Ch 460.

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(ii) Claimant has Notice

If a chargee or mortgagee has actual and constructive notice of a prior interest, he will take subject to that prior interest.

(iii) Freedom of Dealing

(A) Where there is a floating charge, priority may be affected by the terms of the charge itself.

(B) If the floating charge permits the debtor to remove debts from the scope of the floating charge, then prior to crystallisation, any assignees of debts will take priority to the chargee.

(C) Often, however, there is a prohibition in the charge on the creation of further charges having priority to a floating charge. Whether a party with a subsequent interest will take subject to this floating charge will then depend on whether they have actual notice.

7. RECHARACTERISATION OF FIXED AND FLOATING CHARGES

7.1 Recharacterisation of Charges

(a) Re Brumark39 and Book Debts

(i) Before Brumark, it was assumed that a charge over uncollected book debts would be a fixed charge and a charge over the proceeds would be a floating charge40, unless the proceeds were directed to a specific account41.

(ii) In Brumark, there was a purported fixed charge over uncollected book debts and a floating charge over the proceeds since no direction to a specific account was given. The issue in the case was therefore whether the charge over the uncollected book debts was a valid fixed charge. The Privy Council decided that, although a fixed charge on fluctuating assets such as book debts is possible, in the case in question, the charge was a floating charge. The test of whether a charge was floating or fixed was said to be dependant on who controlled the assets in theory and in fact. If a chargor is free to deal with charged assets and withdraw them from the ambit of the charge, the charge will be floating. The test is a two stage process:

(A) Firstly, the intention of the parties is ascertained as it is expressed in the document;

(B) Secondly, the interest is categorised. This is not a matter for the parties to decide but is a question of law.

39 Agnew and another v Commissioner of Inland Revenue (Re Brumark Investments) [2001] 2 AC 710. 40 Re New Bullas Trading [1987] Ch 200. 41 In Siebe Gorman v Barclays Bank [1979] 2 Lloyd’s Rep, a direction to the specific account of a chargor was sufficient to make the charge a fixed charge.

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(iii) The court did not decide whether debts are divisible from their proceeds. It was stated that choses in action are not enjoyable in specie and the only way to enjoy book debts is through realisation by collection or assignment. What mattered, therefore, was who controlled this process of realisation of the debts.

(iv) The main implication from Brumark is that it appears that the characterisation of fixed and floating charges depend on who controls the assets covered by the charge in terms of the security documentation and in terms of who controls the assets in fact after the charge has been granted.

(v) Brumark has several implications for the drafting of charge documents. Firstly, contractual prohibitions preventing a borrower from disposing of debts and allowing a bank to give directions in relation to debts and their proceeds is no longer sufficient to ensure a charge remains fixed.

(vi) Instead it appears that a provision should be included in security documentation allowing assets to be released from the charge only with the consent of the chargee. This consent should not be a blanket consent but should be individually required for each asset released.

8. QUASI-SECURITY

8.1 Introduction

(a) Quasi-security is a generic term for forms of comfort which do not strictly create security interests. The following types are commonly seen:

(i) guarantees;

(ii) set-off;

(iii) subordination; and

(iv) ring-fencing arrangements.

8.2 Guarantee

(a) Under a guarantee, the guarantor guarantees the obligations of one party to a contract to another. Should the contracting party fail to meet his obligations, the guarantor will be required to furnish payment in his stead. This example will use the example of a guarantee of the obligations of a borrower to a lender under a loan agreement.

(b) In principle a guarantee is an accessory contract: that is, it depends on the existence of a primary obligation (for example, that of a borrower). In practice, though, many contracts which are given the title of guarantees are in fact free-standing obligations and include wording specifying that the guarantor's obligations are free-standing principal debtor obligations and will not fall away if the underlying contract fails for any reason.

(c) Under a guarantee, the guarantor may guarantee just the borrower’s obligation to make his payments under the loan agreement, or he may undertake responsibility not just for the repayment of the debt but also for performance of all other obligations of

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the debtor. This will cover any additional liability in damages which the debtor may incur.42

(d) It should be stressed that the lender does not obtain any security as a result of the guarantee. All he has is a personal right against the guarantor should the conditions for payments being required to be made under the guarantee be met.

(e) On the bankruptcy of the principal obligor, however, the lender does not have to deduct anything received from the guarantor from the amount of his proof. This gives some comfort and increases his chances of recovery. The guarantor cannot lodge a proof until the creditor has been paid in full (unless the creditor has unwisely accepted a guarantee for less than the full amount and the guarantor has paid his share).

(f) Upon paying the guaranteed debt in full, the guarantor becomes subrogated to the rights of the lender. Should the lender hold any security over the borrower’s assets, the guarantor will succeed to this. He will also usually have an indemnity from the borrower for sums paid under the guarantee.

8.3 Set-off

(a) General

(i) Set-off may broadly be described as the discharge of mutual obligations to the extent of the smaller obligation. The right of set-off falls into a number of classes:

(A) legal set-off;

(B) equitable set-off;

(D) contractual set-off (applicable pre and post insolvency).

(ii) Classes (a) to (d) all apply pre-insolvency, and operate in a different fashion from set-off post-insolvency (class (e) above). The most relevant of these to a structured finance lawyer are (c), (d) and (e).

(b) Legal set-off

Legal set-off is the set-off of liquidated claims in court proceedings.

Equity extends this right of set-off, most importantly by permitting a claim for unliquidated damages to found a set-off.

(d) Banker’s right of set-off

(i) This allows bankers to combine accounts of a single customer so that they can set-off the debt balance on one against the credit balance on another and

42 See Moschi v. Lep Air Services Ltd [1973] AC 331

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pay only the difference (unless there is an agreement to keep them separate).

(ii) In order for set-off to operate (and this applies to set-off generally), there must be mutuality between the parties, unless they have made an agreement to the contrary. Essentially, this means that the parties must have contracted with one another (or the bank account must be held) in the same capacities. If, for example, one account is held in a personal capacity, and another is held as trustee for a third party, the bank is not permitted to set one off against the other.

(iii) It was made clear in National Westminster Bank v. Halesowen Presswork and Assemblies Ltd43 that there is no requirement on the bank to give notice to or obtain the consent of the other party – where set-off is otherwise permitted – to the set-off.

(iv) In the absence of agreement, a bank is also restricted in that it may not combine a debt presently due to the customer with a debt payable by the customer at a future date. Nor may the bank retain money presently payable to the customer so as to combine accounts at a future date.44

(e) Contractual Set-Off

(i) Generally

Set-off. Amendments were made to the Companies Law in 1993 so that contractual rights of set-off and netting are given statutory recognition so that lenders are protected in particular in the event of the insolvency or liquidation of a company. Section 112(2) provides that in the course of the winding up of a company:

"the collection in and application of the assets of the company … is without prejudice to and after taking into account and giving effect to the rights of preferred and secured creditors, to any agreement between the company and any creditors that the claims of such creditors shall be subordinated or otherwise deferred to the claims of any other creditors and to any rights of set- off or netting of claims between the company and any persons, whether conferred by agreement or law, and subject to any agreement between the company and any persons to waive or limit the same".

Ring fencing arrangement. By using limited recourse wording in contracts, creditors can agree that their recourse is limited to specific pools of assets and will not extend to other pools which may be available to satisfy other creditors or, often in the case of CDOs, to pay amounts owing in respect of preference shares. Segregated portfolio companies can also be used to ringfence separate portfolios of assets to specific creditors.

Subordination. Under a subordination agreement, two creditors of the same debtor agree between themselves that the claims of one of them (the “junior creditor”) shall rank behind those of the other (the “senior creditor”).

43 [1972] AC 785 44 See Jeffryes v. Agra and Masterman’s Bank (1866) LR 2 Eq 674

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9. FORMALITIES AND REGISTRATIONS

9.1 Searching at Local Registries. There is no central public registry in relation to Cayman Islands companies or charges created by such companies. Each company must, however, maintain a Register of Mortgages and Charges at its registered office in the Cayman Islands. Each Cayman Islands company must maintain a registered office in the Cayman Islands.

9.2 Court Search. A search of the Cause List and the Register of Writs and Originating Process maintained by the Clerk of Courts Office in Grand Cayman will reveal if there are any court actions pending against the company.

9.3 Company Incorporated Under Local Law and Asset Within Jurisdiction

Where security is created by a company incorporated in the Cayman Islands and the asset is situated within the Cayman Islands, it is necessary under section 54 of the Companies Law to register any charge created by the company in the Register of Mortgages and Charges of the company. This is a register maintained at the registered office of the company in the Cayman Islands and may be inspected by any member or creditor of the company.

Section 54 provides as follows:

"(1) Every limited company shall keep at its registered office in writing on one or more sheets, whether bound or unbound, a register of all mortgages and charges specifically affecting property of the company, and shall enter in such register in respect of each mortgage or charge a short description of the property mortgaged or charged, the amount of the charge created and the names of the mortgages or persons entitled to such charge.

(2) If any such property of the company is mortgaged or charged without such entry as aforesaid being made, every director, manager or other officer of the company who knowingly and wilfully authorises or permits the omission of such entry, shall incur a penalty of one hundred dollars.

(3) The register or mortgages required by subsection (1) shall be open to inspection by any creditor or member of the company at all reasonable times; an if such inspection is refused, any officer of the company refusing the same, and every director and manager of the company authorising or knowingly and wilfully permitting such refusal shall incur a penalty of four dollars every day during which such refusal continues; and in addition to the above penalty, the Judge sitting in chambers may, by order, compel an immediate inspection of the register."

9.4 Company Incorporated Under Local Law and Asset Outside Jurisdiction

Where security is created by a company incorporated in the Cayman Islands and the asset over which security is taken is situated in the Cayman Islands, it is still necessary to register any security as a charge as described above.

9.5 Ships

Taking security over ships registered in the Cayman Islands is achieved through the grant of a deed of covenant which is supported by a registered statutory mortgage as required by the Merchant Shipping Laws.

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9.6 Aircraft

There is no prescribed form to the taking of security over aircraft registered in the Cayman Islands, however, the general law relating to mortgages of chattels applies and it is necessary to register the mortgage in the Register of Aircraft Mortgages.

10. NOTES ON STANDARD FORM EQUITABLE MORTGAGE

10.1 The equitable mortgage is drafted as a form of freestanding third party security deed to be granted by the company in respect of its subsidiary’s obligations under a loan agreement. The drafting contemplates either the chargor being a corporate service provider holding shares on a charitable trust or an operating company owning full legal and beneficial title to the subsidiary’s shares. In the case of any execution of the document by a corporate services provider holding shares pursuant to a declaration of trust, care should be taken to ensure that the declaration of trust includes rights for the trustee to charge the beneficial title to those shares pursuant to the terms of the share charge.

10.2 Clause 3 chargor covenants. It is important to create this freestanding principal payment obligation in this document and not to merely reference that the chargor is creating security in respect of the secured obligations.45 This wording is of course not required to the extent that the equitable mortgage is in respect of the chargor’s own obligation under a loan agreement as opposed to the obligations of its subsidiary.

10.3 Clause 4.1. It is not necessary to specify the consideration where the mortgagor is the borrower and the mortgage is a condition precedent to withdrawing. The purpose of describing the security in Clause 4.1 as continuing is to exclude the rule in Clayton’s case (1816) and provide that the security is not discharged by a payment which temporarily reduces the secured obligations to zero.

10.4 Clause 4.2(d). This is only required to the extent that the charge is in respect of all of the shares in the company and that on enforcement of the charge, the chargor should be able to appoint new directors and officers.

10.5 Clause 4.2(e). As well as Clause 4.2(e) which provides an undertaking for the company to register transfers of the charged shares to the chargee or its nominee, it is sometimes requested that the memorandum and articles of association of a company be amended to specifically permit any transfers of shares made pursuant to the charge. This is unnecessary and not particularly helpful in my view and, in particular, the chargor would not have any rights in respect of the memorandum and articles of association of the company prior to it becoming a shareholder in the company.

Clause 4.2 often includes a form of irrevocable proxy to be given by the chargor to the chargee. Again, my view is that this is unnecessary. Any powers that the chargee should reasonably require to act in the name of the chargor are already provided under the irrevocable power of attorney contained at clause 10.1 of the charge.

10.6 Clause 4.6. Where the company is a single purpose SPV, the chargor often covenants to procure that the subsidiary’s business will be run fully in accordance with the transaction documents and, in particular, that the subsidiary will not incur any material liabilities.

45 See Lingard on Security pages 119-120.

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10.7 Clause 5.4. This clause is required. For any charge to also constitute an equitable mortgage it must include a provision allowing the mortgagee to convert the same into a legal mortgage at any time.

10.8 Clause 10. The equitable mortgage contains a power of attorney and it must be executed by deed on behalf of the chargor in accordance with the Powers of Attorney Law in order that it constitutes an irrevocable power of attorney which will outlast the chargor’s insolvency.

10.9 Limited Recourse – Clause 12. Please note that in giving opinions that limited recourse clauses generally constitute obligations of non-Cayman entities and not obligations of Cayman obligors or chargors. It is therefore not meaningful to say that the Cayman company’s obligations are in respect of all such clauses are enforceable.

10.10 Schedule 1 – Share Transfer Certificate. Please note that the form of this share transfer certificate is different from the form Walkers has traditionally used and is more appropriate for use in connection with the creation of security over shares.