Donated by a Lex Mundi member firm. LEX MUNDI, LTD. The World's Leading Association of Independent Law Firms. http://www.lexmundi.com Karen Palmer Page 1 1/30/04 File Server:ACCALRD:LRDworkFiles:Lex Mundi forms:Lex Mundi Language.doc 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. Cayman Islands Legal issues in the creation of security Page 3 (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; (C) the parties have merely entered into an agreement to create a legal mortgage in the future over the asset6; or (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. Cayman Islands Legal issues in the creation of security Page 4 (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. (c) Charges (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)).