SOUTH SQUARE DIGEST October 2018 www.southsquare.com Form v Function 25 Form v Function: part from being divided (supposedly) by a said1: “There are many ways of raising cash besides Acommon language, the laws of the UK borrowing … If in form [the transaction] is not a loan, and the US take a different approach to the it is not to the point to say that its object was to raise recharacterisation of contracts. money … or that the parties could have produced the same result more conveniently by borrowing and In particular, it is said that the UK takes the lending money.” Recharacterisation formal approach, while the US adopts the functional approach. Typically, the question arises when Substance over form means looking at the true character of a financing agreement the words used in the context of the falls to be determined: assuming it matters, is transaction as a whole the transaction one which creates an absolute Judges have often said, as Romer LJ did,2 that the of contracts in the interest (e.g. by way of sale) or one which is less English Court is concerned with substance rather than absolute (e.g. a security interest)? But what than form, but this must be understood in its does it mean to adopt a functional, as opposed to proper context. In ascertaining the substance a formal, approach in this context? In this article, of a transaction, the English Court is concerned we propose to explore that distinction. UK and US initially and – unless it is found to be a sham – The formal approach: recharacterisation almost exclusively with the provisions of the in English law written agreement entered into by the parties. In other words, it is concerned with the language In English law, characterisation in this context used by the parties considered in the context of is the process whereby the court determines the transaction as a whole.3 The only apparent the legal nature of a particular transaction. exception to this approach to date is that which Recharacterisation occurs where the parties to was adopted by Knox J in Re Curtain Dream plc,4 the transaction have purportedly characterised but it is suggested that this decision is now of it as creating one kind of interest but the court questionable authority and it seems unlikely characterises it, as a matter of law, as creating that it would be followed. a different kind of interest. In such instances, recharacterisation does not actually change The English law approach in summary the legal nature of the transaction, which The approach adopted under English law when remains the same throughout; rather it recharacterising a transaction may be summarised corrects mischaracterisation, and associated as follows: 1. Chow Yoong Hong mislabelling, by the parties. v Choong Fah Rubber • The English Court will first ascertain whether Manufactory [1962] AC Typically, the English Courts have had to 209 (PC). the written agreement between the parties is embark on the process of recharacterisation in a sham;5 that is, it neither accurately reflects 2. In re George Inglefield circumstances where, usually by virtue of the [1933] 1 Ch 1 (CA). the true agreement between them and nor is it 3. McEntire v Crossley provisions of a statute, the transaction will be 6 intended by the parties to do so. Brothers Limited [1895] AC void unless registered if, for example, it is to 457 (HL); Lloyds & Scottish be characterised as creating a security interest. • If the agreement is found to be a sham, Finance Ltd v Cyril Lord Carpets Sales Ltd [1992] Such questions have arisen in the context of the English Court will ignore the written BCLC 609 (HL); Welsh determining the application and effect of the agreement and seek to ascertain the real Development Agency v The Export Finance provisions of the Companies Act 2006 and its agreement between the parties by reference to Company Limited [1992] predecessors, the Bills of Sale Acts 1878 and other extraneous evidence instead.7 BCLC 148 (CA). 1882 (in relation to individuals) and the 4. [1990] BCLC 925. • If the agreement is found not to be a sham, the Moneylenders Act 1927 (since repealed). In English Court will construe its provisions for 5. Welsh Development addition, however, recharacterisation becomes Agency v The Export the purpose of ascertaining the legal rights Finance Company Limited relevant if, while not void, the rights conferred BY MARK ARNOLD QC and obligations they create and impose. As this [1992] BCLC 148 (CA). by the transaction may be less effective if, for & CO-AUTHORED WITH THE FOLLOWING involves questions of interpretation, the Court 6. AG Securities v Vaughan example, it is to be characterised as a floating [1990] 1 AC 417 (HL); Snook TEAM FROM WEIL, GOTSHAL & MANGES is concerned to determine the intentions of the v London and West Riding rather than a fixed charge. parties, ascertained objectively, by reference to Investments Ltd [1967] 2 QB 786 (CA). There are many ways of raising cash the words they have used taking into account 7. Orion Finance besides borrowing the relevant factual matrix where appropriate. Limited v Crown Financial Management Limited [1996] In the financing context, English law recognises • Having determined the rights and obligations BCLC 78 (CA). that there are many ways of raising cash besides created and imposed by the written agreement, 8. Agnew v Commissioner borrowing. Merely to recognise a transaction as a the English Court will then classify, or of Inland Revenue [2001] 2 AC 710 (PC); Smith financing transaction, therefore, does not assist in characterise, the agreement. That is a matter (Administrator of Cosslett the task of characterising that transaction because, of law, rather than being dependent on the (Contractors) Ltd) v Bridgend County 8 MARK LAWFORD PETER ISAKOFF ALINTA KEMENY ELISABETH SPERLE PATRICK STEEL under English law, financing can perfectly well intentions of the parties. If, in other words, Borough Council [2002] Partner – London Partner – Washington Associate – London Associate – New York Associate – New York be effected in different ways. As Lord Devlin once the parties have characterised and labelled 1 AC 336 (HL). SOUTH SQUARE DIGEST October 2018 www.southsquare.com Form v Function 27 FEATURE ARTICLE: FORM AND FUNCTION: RECHARACTERISATION OF CONTRACTS IN THE UK AND US their written agreement inconsistently with its true legal or ascertainable, the seller may repurchase from the buyer character having regard to the rights and obligations for the property originally sold.15 The same apparently holds which it provides, the parties’ own label will be ignored. true even if the seller is obliged to repurchase the property (e.g. as part of a repo transaction).16 • That is not to say that the labels adopted by the parties US courts generally frown on attempts by parties to avoid will be ignored in all circumstances. If it is found that So much, then, for the approach to recharacterisation under the intended consequences of the Bankruptcy Code by the true character of the transaction, as a matter of English law. Time now to contrast it with the approach law, is consistent with the label used by the parties, the adopted under US law. entering a lease to cover what in economic substance is a English Court will accept the parties’ label.9 Indeed, it The functional approach: recharacterisation under secured financing will generally be slow to reject the label when considering US law a bona fide mercantile document issued in the ordinary course of business.10 Recharacterisation under US law specifically applies to lease agreements and often arises in the context of US bankruptcy Legal substance over economic effect proceedings. In particular, a debtor in bankruptcy may seek When the English Court speaks of substance in this context, to recharacterise a lease agreement as a security interest by it refers to the legal substance of the transaction. It is establishing that the economic substance of the transaction emphatically not concerned with its economic substance is consistent with a security agreement as opposed to a or commercial effect, but rather with its legal nature. true lease.17 In doing so, the US court takes a “functional” The economic or commercial effect of the transaction is rather than a “formal” approach to the interpretation of the irrelevant to the process of determining its legal character, agreement. In contrast to the position under English law, as a matter of English law.11 recharacterisation by the US court changes the legal nature of the transaction. Thus, under English law, the sale and leaseback arrangement, for example, is a well-recognised financing transaction, the The context of applications to recharacterise Benefits of recharacterisation 9. Welsh Development 17. United Airlines, Inc. purpose of which is to raise funds. In the absence of any Agency v The Export v. HSBC Bank USA, N.A., The issue of recharacterisation often arises in the context There are myriad circumstances that may result in a party Finance Company Limited 416 F.3d 609, 612-15 evidence that such an arrangement is a sham, or unless it of real estate transactions, equipment leasing and financing. seeking to recharacterise a lease as a secured financing, [1992] BCLC 148 (CA). (7th Cir. 2005) can be demonstrated that no absolute transfer of title by way (“United Airlines I”). In a bankruptcy context, the characterisation of the particularly to gain a strategic advantage by using or 10. MacWilliam Inc v of sale has taken place, the English Court will generally not Mediterranean Shipping 18. Id. at 613. agreement is relevant as: avoiding an aspect of the Bankruptcy Code. While this recharacterise it as a loan arrangement, whether secured or SA [2005] AC 423.