United States: Loan Participation Interests And The Sale Of Depositary Receipts

Last Updated: September 10 2001
Article by Maximiliano Valera

Loan participation interests and the sale of depositary receipts over such interests as an alternative to some limitations imposed to local borrowers by the Mexican tax regulations regarding the quality of lenders from whom those borrowers could obtain funding, and the possible insolvency of the arranger of the transaction

Introduction

Mexican tax laws discourages local borrowers from raising funds internationally through financial intermediaries the same laws don’t consider 1st tier lenders. If a Mexican corporation is only able to get foreign funds from a bank local tax laws do not consider first tier, the borrower is forced to pay, depending on the category of the bank, either 15% or 30% over the nominal amount borrowed. This presents a problem for small or mid sized Mexican corporations, given the risk weighting rules that govern the entities considered 1st tier lenders in Mexico it is very difficult for those Mexican corporations to get financing. For reason of size, capital, past credit history, etc. small or mid sized Mexican corporations don’t meet the general credit qualifications first tier banks require to extend. As we all know, such banks have very strict rules as to the quality of the credit of their borrowers and deny financing to potential borrowers who fail to meet the banks’ strict credit conditions. Whenever a small Mexican corporation meets the requirements of one of the banks considered 1st tier in Mexico, the conditions said bank imposes on the small or mid sized borrower will be so strict that it will make the loan almost economically unfeasible. This leaves the borrower with the dilemma of getting financing at a very high prices with banks that local authorities consider 1st tier, if that is possible, or getting loans from banks considered 2nd tier at decent prices, but paying a tax that would make the loan sometimes even more expensive than paying the almost prohibitive prices 1st tier banks charge.

Some brokers the Mexican authorities do not consider 1st tier formulated a solution by which they could raise funds for those corporations from investors (definitively not considered 1st tier by Mexican tax laws) willing to take the risk small Mexican corporations for the return offered by the investment in the respective borrowers. This could be accomplished by engaging the services of financial institution considered 1st tier in Mexico as a fronting bank. The fronting bank would make a loan to the Mexican Corporation and sell a 100% participation in the loan to the broker who originated the transaction, which would convert the participation in clearing eligible depositary receipts. At the same time, the depositary receipts would be sold to the investors who had initially funded the loan. The first tier bank does not damage the quality of its loan portfolio since a sale of a 100% participation eliminates the risk from its books, the broker, although it does not have the capital to fund the loan, obtains it from investors willing to bear the associated risk. The fronting bank considered first tier in Mexico gets a fee for acting as lender of record before the Mexican taxing authorities. The fronting bank will have to maintain the credit on record and report it accordingly to the Mexican banking authorities even if it is not taking the risks associated with the respective second tier credit. This gives the Mexican Corporations we have mentioned many advantages since they do not have to pay a high tax and can get financing at a competitive rate without paying the required tax for dealing with a 2nd or 3rd tier financial intermediaries. Problems arise when the broker who originated the transaction and buyer of the participation becomes insolvent before the maturity of the loan and the depositary receipts mentioned in the example above. If that were to occur who would be entitled to the repayment of the loan: The holders of the depositary receipts or the estate of the bankrupt broker?

The intention of this note is to comment on a decision of the Supreme Court of The Bahamas that resembles notably the facts surrounding the structure described above. We are also briefing the relevant factual background to help you compare it to the facts surrounding the DR receipt structure explained above to be able to receive funding from 2nd tier or 3rd tier lenders without paying the associated tax the Mexican authorities impose. We are going to base our note on a transaction that took place between a small Mexican corporation, a US broker and a European bank, already absorbed by another bank, who was considered 1st

tier by the Mexican taxing authorities. The documentation they used for the deal will be discussed infra.

The Mexican Transaction

For illustration purposes, we will base the content of this note in a real transaction that took place three years ago. However, we feel that the current holders of the Depositary receipts and receiver of the estate of the broker who originated the transaction would not let us disclose the names of the parties involved in that operation. For purposes of this note we could say that based on available documentation, in 1998 a European bank considered 1st tier by the Mexican authorities (the "Fronting Bank") made a guaranteed loan (the "Loan") to a Mexican corporation (the "Corporation"). The basic documentation used for this transaction was a loan agreement, a participation agreement to sell the Loan, a deposit agreement to convert the participation in a clearing eligible instrument and an information memorandum describing the depositary receipts and the transaction. The Fronting Bank was then supposed to act as lender of record of the Loan before the eyes of the Mexican authorities. The fronting bank was supposed to carry the Loan in its books, but was allowed to transfer the risks associated with the Loan by way of participating out the Loan to investors willing to fund it. A US broker not considered 1st tier by Mexican tax laws (the "Originating Broker") arranged the entire transaction, including the Loan. At the same time, the Fronting Bank sold and transferred 100% participation interest in the Loan to the Originating Broker by executing a participation agreement (the "Corporation Participation Agreement"). Said 100% participation interest in the Loan was represented by a participation certificate (the "Participation Certificate"). The Participation Certificate was sold to the Originating Broker for a full consideration identical to the principal amount the Fronting Bank had advanced to the Mexican Corporation under the Loan.

The sale of the Participation Certificate was made without recourse against the Fronting Bank and without responsibility from the seller bank with respect to the Loan. The respective participation agreement makes clear that all actions or decisions in respect to the Loan can only be made after "consultation with, and receipt instructions from, each person or entity at the time holding a participation in the Seller [the Fronting Bank]’s interest in the Loan, including the Purchaser [the Originating Broker]" (we emphasized). The Mexican Corporation Participation Agreement goes on to say that in the event of a disagreement between holders of said participation, the Fronting Bank would act in accordance with the wishes of the parties holding a majority interest in the principal amount of the Loan. In the same document, the Fronting Bank waived all the rights that a normal lender would have in favor of the holders of the relevant participation, including the Originating Broker. Please note that despite being only one Participation Certificate, the Mexican Corporation Participation Agreement assumes that the Participation Certificate may be transferred to more than one holder because it provides the solution in case of a disagreement between various parties.

When the Fronting Bank gave up its rights and control over the Loan to the Originating Broker it also made clear that it would not be responsible, inter alia, for the effectiveness, enforceability, genuineness, validity or due execution of the Loan and the participation on the part of the Mexican Corporation. Once the Participation Agreement was perfected the owner of the Loan was Originating Broker. The Mexican Corporation Participation Agreement declared that it constituted a sale of 100% of the Loan and that in no way it could be construed as a loan by the Originating Broker to Fronting Bank, or as a pledge of any interest in the Loan by the Originating Broker to Fronting Bank. The Fronting Bank indeed did not have any obligation to repurchase the Loan from the Originating Broker upon default or otherwise. Then, the Fronting Bank’s functions were limited to receiving funds from the Originating Broker to grant a credit facility to the Mexican Corporation. The control and risk associated with that facility would immediately be transferred to the original provider of the funds and bearer of the risk associated with the financing, the Originating Broker. The Fronting Bank acted indeed, as it is established in the information memorandum of the Mexican Corporation DRs (the "Information Memorandum") and the deposit agreement between the Originating Broker, the receiptholders and a the relevant depositary ("The Mexican Corporation Deposit Agreement"), as a "Lender of Record". For its services in relation to the Loan the Fronting Bank charged a Facility Fee.

On the same date the Loan and the Participation Agreement were executed, the Originating Broker, the participant and owner of the Participation Certificate under the Mexican Corporation Participation Agreement, entered into the Mexican Corporation Deposit Agreement with the Fronting Bank offshore (a subsidiary of the Fronting Bank, hereafter defined as "the Fronting Bank Offshore") and the holders from time to time of any beneficial interest in the Global Receipt to be issued under the Mexican Corporation Deposit Agreement. In the Mexican Corporation Deposit Agreement, the Originating Broker assigned the Participation Certificate in the Loan to the Fronting Bank Offshore, who acted as depositary, and asked the same depositary to issue depositary receipts in respect of the 100% participation in the Loan ("DRs"). The 100%participation in the Loan was the same one represented by the Participation Certificate that the Fronting Bank had sold to the Mexican Corporation and that now, through the Mexican Corporation Deposit Agreement, was being assigned to the Fronting Bank Offshore to issue depositary receipts.

Then, on the maturity date of the Loan what was originally planned was that if the Fronting Bank received the payments due from the Mexican Corporation it would transfer those funds to the Fronting Bank Offshore, the depositary, who would transfer the funds received to the receiptholders through the clearing systems (Mexican Corporation Deposit Agreement and Terms and Conditions of the Receipts). Thus, the receiptholders were buying a participation in a loan to a corporation without necessarily being a bank or financial institution. The Fronting Bank Offshore, the depositary, could have sold the receipts to anyone who had securities accounts with the clearing systems, but because the owner of the participation was the Originating Broker, the Fronting Bank Offshore returned the original amount lent in the form of Depositary Receipts evidencing ownership in a loan to the Mexican Corporation (the "Mexican Corporation DRs’) to the Originating Broker on the same date the other agreements were executed. The latter transaction was documented by a Depositary Receipts Purchase Agreement where the Fronting Bank Offshore transferred free of payment in book-entry form the same original amount lent worth of DRs to the securities account of the Originating Broker with Clearstream (at the time called Cedel). The Fronting Bank and the Fronting Bank Offshore made the Originating Broker and the Mexican Corporation agree that the former were not going to make any representation and warranty as to the validity, legality or even enforceability of the Loan or of the ability of the Mexican Corporation to legally borrow the relevant funds.

The next logical step would be for the Originating Broker to transfer the Mexican Corporation DRs to the investors who had provided the funds to buy the 100% participation in the Loan (the "The Mexican Corporation Participation"), or for the Originating Broker to cause the Fronting Bank Offshore to transfer free of payment the portion of the Mexican Corporation DRs equivalent to the investments made by the relevant investors to those investors’ securities accounts with the clearing systems. However, most investors who bought the participation in the Loan were individuals who did not have securities accounts. Professionals on international finance would have expected the Originating Broker to have each of the investors who funded the Loan execute individual agreements similar to the DR Purchase Agreement the Originating Broker executed with the Fronting Bank Offshore. However, this was not done for reasons beyond the scope of this note. Some tentative answers to justify the Originating Broker’s actions: most investors in the Mexican Corporation DRs did not have Euro-securities accounts, that would have made necessary to open the accounts for them with common depositaries to the clearing systems or with institutional accountholders willing to maintain Euro-securities custody accounts for third parties. No doubt this would have been a costly and time consuming exercise, mostly if you think that these investors were not, we understand, frequent buyers of Euro-securities. Most of these investors relied on the Originating Broker to make investments for them, in Euro or other type of securities.

Why then would the Originating Broker, the Arranger of the transaction, engage and pay the Fronting Bank and the Fronting Bank Offshore a fee to complete the financing with the Mexican Corporation when it had the clients to fund the facility and the expertise to structure it? The Originating Broker may have been able to issue short-term securities for the Mexican Corporation, made them eligible for trading in the clearing systems and sell them to investors directly, in the same fashion it sold the Mexican Corporation DRs. In fact, a commercial paper or a secured short term note issued by the Mexican Corporation would have been an easier and less time consuming structure, not to say a more liquid financial instrument, that would have accomplished the purpose sought by the Originating Broker: advance funds to the Mexican Corporation by selling international clearing systems eligible securities to investors willing to take the Mexican Corporation’ risk. The Fronting Bank was apparently not willing to take the Mexican Corporation’ risk for it sold the entire participation in the Loan to the Originating Broker, who had indeed funded the Loan the same day the Loan was executed. Why the Fronting Bank needed to maintain prima facie ownership of the Loan when the Originating Broker, or more precisely the Originating Broker’s investors, were the ones taking all the risks associated with the investment and were supposed to be the right owners of the Loan?

Many answers to that question come to mind, but the answer we suggest is the reason for this note: Mexican regulations make difficult for local borrowers to raise funds from foreign banks that are not considered first tier banks by the local banking authorities and tax laws. The same regulations impose a tax on Mexican borrowers for getting financing abroad and the rate of that tax varies according to the qualification of the relevant lender by such authorities. As we have said, if a Mexican corporation were to borrow funds from Merrill Lynch it would only have to pay 4.9% of the amount borrowed to the Mexican tax authorities. On the other hand, if the same corporation were to borrow the same amount from a bank not considered first tier by the Mexican authorities it would have to pay either 15% or even 30% of the amount borrowed to the Mexican tax authorities. Given that institutions considered first tier banks by the Mexican authorities have very strict credit and risk limits it is very difficult, expensive and cumbersome for second tier Mexican corporations to borrow abroad. Those corporations face the not very pleasant dilemma of getting funds from first tier banks at very high rates or getting loans from second tier banks at lower rates than those, but paying a high tax to the local government in exchange. The third option for these corporations is to continue borrowing from local banks at not very competitive rates if compared with those offered internationally.

Even if the answer we proposed is not correct, it is a fact that the Fronting Bank of our example was a bank considered first tier by the Mexican authorities before a bigger institution acquired it, and the Originating Broker and its affiliates were not considered first tier.1 Then, if the Mexican Corporation had borrowed directly from the Originating Broker it would have had to pay either 15% or 30% over the nominal amount borrowed. On the other hand, by borrowing from the Fronting Bank, the Mexican Corporation only had to pay a 4.9% tax. Everything seems to indicate that the only reason the Fronting Bank accepted to grant the Loan was because the Originating Broker was willing to fund the facility. Otherwise, the Fronting Bank may have made the loan directly to the Mexican Corporation and would not have transferred the Mexican Corporation’ risk on the same day it granted the Loan. If the Originating Broker had made the Loan or provided the financing directly, the Mexican Corporation would have paid a higher tax than the 4.9% it paid by borrowing through the Fronting Bank. With this transaction, the Mexican Corporation got the best of both worlds: It got a loan at a competitive US dollar rate from a second tier bank, which was able to sell the Mexican Corporation’ risk to its clients, but it only paid the required tax corresponding to a first tier bank. If that first tier bank would have treated the Mexican Corporation’s credit as the credit of any other transaction, it may have never advanced funds to the Mexican Corporation under the circumstances they were advanced. The credit of the Mexican Corporation was obviously not good enough for1st tier banks since it was dealing with the Originating Broker and not with one of the first tier banks accepted by the Mexican tax and monetary authorities. No one can say that the foregoing assumptions are true, but, given the circumstances and the type of creditors and debtors involved, we believe they are a credible possibility.

As we said, the Originating Broker filed for voluntary liquidation before maturity of the depositary receipts and of the underlying Loan. Once the Originating Broker became insolvent, investors who bought the Mexican Corporation DRs faced the same problem that investors who bought the DRs from the broker who became insolvent and that are object of the decision discussed below. Then, one may think that if the owners of the respective participation interests were the arrangers of both transactions, and the only instrument they sold to their investors was in fact a sub-participation in a transaction structured by those arrangers, the owners of the underlying assets would be the arrangers. In that case, investors who funded the respective transactions would only be entitled to receive a portion of the bankruptcy estate distributed equally among the general body of creditors of the arrangers as it would be decided by the competent bankruptcy court. As the decision (as defined below) clearly estates this is not the case.

For different circumstances, the Mexican Corporation DRs and the transaction object of the decision below tried to accomplish the same goal, and although the DRs object of the Decision were certainly sold to a more sophisticated body of investors than those who bought the Mexican Corporation DRs, the respective structures were virtually identical. The Fronting Bank had to continue being the owner of the Loan and the Originating Broker had to sell clearing eligible instruments representing payments in the Loan to its clients. On the other hand, the originating broker of the Decision had to maintain ownership of the underlying Notes, but at the same time it had to sell payment rights thereunder to its clients. Both originating brokers went under prior the maturity dates of the respective underlying assets. Given the coincidence between both transactions, we hope that the findings of the Decision assist investors subject to transactions of the type described above to solve any conflicts that may face if they were to encounter similar problems to those presented by the Decision. The conclusion of this note also suggests a solution in case Mexican borrowers insist in using a structure similar to the one discussed above to raise financing in the international capital markets.

Now we will consider the background of the case decided in the Bahamas that we believe to a certain extent resembles credits structured in a similar way to the one discussed above for the Mexican transaction.

Socimer-Bombril

If we may, we suggest considering the background infra to facilitate the study of the decision we will discuss supra. We also need to inform you that as the day of writing, such decision was appealed to the competent Court in England and the author has not been made aware of the decision of that Court. The decision of that Court may be subject to another note.

Factual Background

The decision IN THE MATTER of Socimer International Bank Limited in liquidation and IN THE MATTER of the Companies Act, 1982 (the "Decision") resembles very much the factual background of the Mexican Corporation DR case we already discussed. The structuring of the financial transaction that originated the Decision, similarly to the Mexican Corporation DR, was a result of almost the same needs that originated the Mexican Corporation DR transaction. An investment bank needed to sell certain asset to investors, but also needed to maintain custody, or at least prima facie ownership, of that asset. That is to say, the asset object of the transaction had to continue being nominally owned by the arranger of the financing, but the rights generated by that assets such as payments to receive principal and interest thereon could and had to be transferred to investors. The investors who were offered the preceding structure had the funds to buy the assets, but they were not able to find investments of apparent equivalent quality offering the same return and risks the asset object of the Decision offered. So they accepted to acquire only certain rights or payments to be received from said assets. As in the Mexican Corporation transaction, in order to achieve the transfer of the respective payments and maintain custody of the asset a Depositary Receipt structure was designed.2

The Decision was issued in the context of the liquidation of Socimer International Bank Limited ("Socimer"), a Bahamian bank controlled by Spanish and Swiss interests with offices in the major capitals of Latin America that arranged several investment banking transactions in that region from the late 1980’s to the late 1990’s. Until very recently the Bahamas Investment Authority listed Socimer as one of its authorized members with banking and trust capacities.3 Similarly to the Originating Broker, Socimer arranged many capital market fixed income transactions despite not having enough capital to underwrite most of them. The business of Socimer was to sell securities and with the proceeds of the sales it provided short-term credit to small and mid-size Latin American corporations after deducting its arrangement fees.

In 1998 Socimer took control of approximately US$40 MM worth of some euro-notes issued by Bombril S.A., a Brazilian corporation. The latter entity through a series of corporate reorganizations eventually changed its name to Bombril-Cirio S.A., and more recently has been using the name Bombril S.A. again (for purposes of this letter, "Bombril").

The Notes that Socimer acquired were part of total of US$150 MM 8% Notes that were due to mature in August 1998 (the "Notes").4 Socimer acquired the Notes in the secondary market with funds received from investors through a Venezuelan company called Woodchuck. However, for reasons beyond the scope of this writing, contrary to its normal practice, Socimer did not sell the Notes it had bought with the funds investors advanced, but instead through a participation agreement (the "Participation Agreement") Socimer granted a participation in 100% of the interest and principal payments to be received under the Notes (the "Participation"), while retaining their custody and legal ownership. The beneficiary of the Participation was Chase Manhattan Bank Luxembourg, S.A. ("Chase Luxembourg"), who through a deposit agreement (the "Deposit Agreement") acceded, inter alia, to issue Depositary Receipts evidencing ownership in the Participation (the "Bombril DRs"). Chase Luxembourg, following instructions from Socimer, issued a global receipt so that depositary receipts could be transferred on the records of the Euro-securities clearing systems5 without the need for printing physical receipts. In this fashion, investors who had advanced funds to Socimer received a book- entry depositary receipt of equal value to the amount they had paid to Socimer, but the latter retained custody and ownership of the underlying asset (i.e., the Notes) of that depositary receipt. Socimer was thus the only holder of a specific portion of the Notes (i.e., US$40 MM) that was sold to investors as the Bombril DRs. Investors in the Bombril DRs were only entitled to receive the payments Socimer was going to receive as holder of the Notes.6 They were indeed participants in the Notes. Additionally, the agreements made very clear that the relationship between Chase Luxembourg and Socimer was a debtor-creditor relationship.

In early 1998 Socimer filed for voluntary liquidation. When Bombril made its required payments under the Notes later that year, the paying agent directed the payments to Socimer, the only Noteholder it had on record, who had agreed in the Terms and Conditions of the Bombril DRs to immediately pay Chase Luxembourg once it got the relevant payments on the Notes. Chase Luxembourg would then pay the respective DR holders. Socimer did transfer some interest payments it received from Bombril to Chase Luxembourg, who did not find appropriate to transfer the payments to the respective holders unless it got clarification on the status of the payments under the Notes from the liquidator of Socimer. The same happened to all subsequent payments under the Notes that Socimer received. Chase’s decision to hold the funds enraged the holders of the Bombril DRs for it made the Socimer liquidator consult several experts on English law in general and on international financial matters in particular before authorizing any transfer of funds to said holders. The liquidator’s prudence caused significant delays and expenses, which made the Bombril DR holders urge the Socimer liquidator to consult the judiciary to obtain a definitive answer. The result, at least temporary, of that consultation is the Decision. As we said, the Decision has been appealed and the Bombril DR holders are still awaiting the decision of the relevant Court of appeals.

The Mexican Corporation Participation Agreement

Before going to the specifics of the Decision, I would like to discuss the treatment of the Mexican Corporation Participation. According to the contracts that documented the Mexican Corporation DRs, and contrary to the agreements that documented the Bombril DR, the Mexican Corporation Participation was transferred to the Originating Broker and no debtor-creditor relationship existed between the Fronting Bank and the Originating Broker. If the Loan had involved recourse to the Fronting Bank in connection with the Mexican Corporation’s default, or in another fashion would have shifted the risks of the Mexican Corporation Participation back to the Fronting Bank, the Originating Broker would have been required to treat the Mexican Corporation Participation as an extension of credit to the Fronting Bank by the Originating Broker. The Fronting Bank sold 100% of the Loan Participation to the Originating Broker without recourse. As the Mexican Corporation Participation agreement clearly estates, the Fronting Bank was not obliged to repurchase the Certificate of Participation or guarantee payments under the Loan. The Fronting Bank had no liability to the Originating Broker and was not even obliged to enforce the obligations of the Mexican Corporation under the Loan.

As authorities in the field of international loans and participations confirm, the principal function of the participation agreement is to establish the nature of the transaction to which it relates as a non recourse transfer of an interest, and to identify the interests transferred because there is no statutory law that the parties can rely on to supply the intended non recourse transfer if they fail to state their intentions precisely. This measures are recommended because the sale of the participation does not give rise to a direct debtor creditor relationship between the borrower and the participant, even when, as in the Loan, all the seller’s interest in the Loan are transferred to the participant in what is called "100% participation".7 The Fronting Bank and the Originating Broker acted accordingly, above all because, apparently at least , the Fronting Bank just wanted to limit its role in the Mexican Corporation DR transaction to that of Lender of Record, as it is called in the Deposit Agreement and the preliminary Information Memorandum of the transaction.

The same authorities also agree that if the relevant participation contract establishes that the participation involves a nonrecourse sale and the economic reality of the participation supports the treatment of the transaction as a transfer, the participant can defend against the risk of being treated as a mere creditor of the insolvent seller with no greater claims to amounts received from obligors or collateral in respect of the underlying loan than any other creditor of the seller. They add that if the participant is treated by the respective agreement as the owner of the underlying loan to the extend of the participation, payments made to the insolvent seller by the borrower may to that extent be treated as property of the participant received by the seller for the benefit of the participant, and not as property of the insolvent seller subject to claims of its creditors.8

If the sale of the Mexican Corporation Participation were structured as true sale, the Mexican Corporation Participation Agreement should have made clear throughout that the Originating Broker may look only to the Mexican Corporation and the respective collateral on the Loan for repayment, and not to the Fronting Bank, except as conduit through which payments are to be made. This is the standard participation agreements must follow to avoid participations to be characterized as extensions of credit from the participant to the seller. Departure from this standard rule may include the right of the participant to compel repurchase of the participation by the seller and promises by the seller to make to the participant regardless of whether the seller has been paid.9 The Originating Broker and the Fronting Bank did not depart from the rule Mr Gooch and Ms Klein discuss in their work, on the contrary, they clearly stated that the Participation Agreement constituted a sale of the pro rata share [ratio of the amount of the participation or 100% of the Loan to the outstanding principal amount of the Loan. That is 100% of the Loan at the date of execution] and in no way shall be construed as a loan by the Originating Broker to the Fronting Bank or as a pledge of any interest in the Loan by the Fronting Bank to the Originating Broker. By executing the Participation agreement, the Fronting Bank waived its responsibility with respect to the Loan and confirmed that all decisions or actions with respect to the Loan had to exercised after consultation with, and receipt of instructions from, each person or entity at the time holding a participation in the Fronting Bank’s interest in the Loan, including the Originating Broker.

We have seen that if the Fronting Bank and not the Originating Broker had become insolvent, the Originating Broker would have been able to claim its participation under the Loan. All those rights derived from the ownership of the Participation Certificate were transferred to the Fronting Bank Offshore, as Depositary, and, accordingly, the Fronting Bank Offshore should have been the beneficiary of the rights granted by the Mexican Corporation Participation Agreement. The assignment of the Participation Certificate to the Fronting Bank Offshore was done under the terms of the Deposit Agreement in accordance with the Terms and Conditions of the respective Depositary Receipts (the "Conditions"). The initial paragraph of the Conditions read that the assignment of the Participation Certificate to the Fronting Bank Offshore was made without recourse or warranty of any nature from the Fronting Bank or the Originating Broker. The same statement is repeated by the assignment of the Participation Certificate from the Originating Broker to the Fronting Bank Offshore. The Originating Broker went even further and instructed the Fronting Bank to make payments under the Loan directly to the Fronting Bank Offshore, as depositary, so it could make the relevant payments to the receiptholders. The Originating Broker sold its rights under the Participation and tried to get itself out of the middle of the Mexican Corporation DR transaction when it assigned the Participation Certificate to the relevant depositary. Then, according to the Deposit Agreement, the Assignment and the Conditions, if the Originating Broker was no longer party to the contractual relationship with the Fronting Bank (seller-participant) under the Loan, the Fronting Bank Offshore should be entitled to receive the benefits of the Participation Certificate, not the Originating Broker.

Ownership of the Mexican Corporation Participation

The issue got complicated because the purpose of the Mexican Corporation Deposit Agreement was not only to make the Fronting Bank Offshore become the owner of the Participation Certificate, but also to issue depositary receipts representing ownership of the instrument. The holders of the DRs, party to the Deposit Agreement, would collectively be the owners of the Mexican Corporation Participation, not the Fronting Bank Offshore, as Depositary, nor the Originating Broker, as participant, or the Fronting Bank as Lender of record. The Deposit Agreement clearly said that the DRs represented entitlement to the Receiptholders to receive pro rata from the Depositary, subject to the Conditions, any amount received by the Fronting Bank in respect of the Mexican Corporation Participation as such amounts are received by or on behalf of the Fronting Bank Offshore. As you can see, according to the transaction documentation, the Originating Broker, as Participant under the Mexican Corporation Participation, had no rights under the DRs. For avoidance of doubt, the Conditions said that the DRs represented the entitlement from the DR holders to take delivery of any amounts received by the Depositary from the Fronting Bank, the Mexican Corporation or the Originating Broker. Please note that DR holders, the Participant and the Originating Broker, are treated by the Conditions as different entities. We believe then that the owners of the DRs, and therefore, of the pro-rata portion of the Mexican Corporation Participation were the DR holders. Who were the DR holders?

According to a DR Purchase Agreement, a party denominated the "Investor" bought the DRs from the Depositary free of payment and became the only DR holder. Said Investor was the Originating Broker, the same participant who had bought the Participation Certificate from the Fronting Bank and who had subsequently assigned it to the Depositary. Why the Originating Broker went through the adversity of issuing clearing systems eligible instruments, such as the DRs, and arranging a somewhat complicated structure to eventually return the Participation Certificate to itself, when it could have bought the Participation Certificate through the Participation Agreement directly? That would have accomplished the same thing the Originating Broker eventually achieved. The most logical answer is that it proceeded that way to get the investments of the investors who had originally funded the facility and had made possible to arrange and structure the Loan and the Mexican Corporation DRs. Then, if it were said that the owner of the DRs were the Originating Broker the transaction would have not made sense the way it was structured. Moreover, it would have been very difficult to obtain funds from investors without a product to offer (e.g., the DRs), but if investors would have known that the funds were going to become part of the Originating Broker’s assets the demand for the product would have lesser than it actually was. When the Fronting Bank Offshore issued the DRs, the intention of the relevant agreements was to entitle the DR holders to enjoy the benefits of the Participation Certificate, not to return the instrument to the Originating Broker.

The Conditions treat the DR holders and the Originating Broker as different entities. Generally to avoid any trouble with a transaction it did not originate, the Fronting Bank agreed with the Originating Broker that if an event of default under the Loan were to occur the Originating Broker would immediately assume the role of the Fronting Bank Offshore under the relevant agreements and the Fronting Bank would not be obliged to take any action or commence any proceeding against the Mexican Corporation unless an indemnity satisfactory to it were provided by in respect of costs an liabilities by one or more DR holders. The Conditions go on to say that in case an event of default were to occur the Originating Broker would cause the Global Receipt to be cancelled and issue definitive receipts (i.e., certificates in physical form). If definitive receipts were issued, upon request of any DR holder, the Originating Broker would assign all rights under the Mexican Corporation Participation and the Loan to the DR holders to proceed directly against The Mexican Corporation.

Then, if the Originating Broker were not the owner of the DRs, who would it be? Those who advanced the funds to the Originating Broker so it could engage the Fronting Bank to serve as a Lender of record to the Mexican Corporation, those which pro rata participation in the facility is very well documented and easily identifiable. After all, without the funding of those investors, the Originating Broker had not been able to advance the funds to the Fronting Bank to serve as Lender of record under the Loan.

Despite going against the economic reality of the transaction, the DR Purchase Agreement evidences that the Originating Broker bought the Mexican Corporation Participation from itself through the Fronting Bank Offshore. If the real role of the Originating Broker were not to be the owner of the DRs, what would its role be? Given that it became insolvent, would the payments under the Loan belong to its bankruptcy estate? We believe not because the DRs were held by the Originating Broker in trust (a constructive one) for the benefit of the real DR holders, or the investors who funded the facility to the Mexican Corporation, as the analysis of the Decision will show infra.

Authorities in bankruptcy law say that interests that the debtor holds in trust for another person or any property in which the debtor holds only legal title but not beneficial interest are excluded from the debtor’s estate according to the definition of property of the estate of the Bankruptcy Code.10 The National Bankruptcy Review Commission Report has supported this view when it has said that although the definition of "property of the estate" of the estate is extensive, it is limited to the extend of the debtor’s interest in property and is not intended to include property in which the debtor has no interest, such as property held by a debtor in trust for another.11 The same authorities when discussing preferential and fraudulent transfers say that a transfer held by the debtor in trust for another entity cannot be recovered as preference because the debtor holds only the legal, not the equitable, interest in that property.12 The same authorities cite a case where the 5th Circuit held that the primary consideration determining if funds are property of the debtor’s estate is whether the payments of those funds diminished the resources from which the debtor’s creditors could have sought payments.13

In the Mexican Corporation case the monies that were advanced to fund the Loan were clearly differentiated from other holdings in the respective investor’s account statement as holdings in the DRs, and not in other investments. Had not the Originating Broker became insolvent, it would have not paid, or was not supposed to pay, its creditors out of payments under the Loan. The Loan was a refinancing of a previous facility, and during the previous sale of the Mexican Corporation Participation, the Originating Broker continued paying its creditors with funds different from those generated by payments under the previous loan to the Mexican Corporation. The Originating Broker became insolvent before receiving any payments under the Loan from the Mexican Corporation. In fact, it never had control of those funds because the same day it received them from investors it passed them to the Fronting Bank to enable the European bank to fund the facility to the Mexican Corporation. The advances to fund the Loan passed from the respective investors to the Mexican Corporation. Since the Originating Broker was a mere conduit who had no control over those funds it could have never satisfied its own debts out of those funds. The funds were transferred to the Fronting Bank and subsequently to the Mexican Corporation on the same day. Then, payments under the Loan were never going to diminish the resources from which the Originating Broker’s creditors could have sought payments because the Originating Broker could have not disposed of those funds. Had the Originating Broker taken control of the funds and paid some of its own outstanding debts therefrom, it would have never been able to advance the amount lent to the Fronting Bank, the funds would have never reached the Mexican Corporation and the transaction would have never been concluded.

Although the cited 1995 case seems to support that payments under the Loan cannot be considered property of the Originating Broker’s estate, it had not been established the capacity in which the Originating Broker held those funds. As we have said, we believe that those funds were held in trust (a constructive trust) as the analysis of the Bombril case made by the Decision will demonstrate.

The Decision

We now turn to discuss the Decision which factual background we have tried to present up to this point in this note. It is easy to notice that the Bombril DR transaction was structured in a similar way the Mexican Corporation DR was: By executing a participation and a deposit agreement. The Decision says:

In order to decide the matter in issue between the parties, the court is required to interpret or construe, in particular, two Deposit Agreements and two Sub-Participation agreements made between SIBL and Chase on 19 November, 1996 and 6 February, 1997, respectively, in respect of the purchase of two tranches of Notes issued by Bombril at US$20,600,000.00 and US$15,500,000.00, respectively.

The agreement perfected by the Mexican Corporation Participation Agreement with respect to the Loan was accomplished by the Bombril Deposit and Sub-Participation Agreements, as these type of agreements are called in the UK. The Decision in its relevant part reads:

On 19 November, 1996 and 6 February, 1997, SIBL and Chase entered in to two Deposit Agreements whereby SIBL was to purchase US$20,600,000 and US$15,500,000 worth of the Notes respectively, from Woodchuck (the "Deposit Agreements") and at the same time SIBL was to grant Chase a participation in the Payment Rights - that is, 100% of the interest and principal when received by SIBL which would, however, retain custody and therefore legal ownership of the Notes but would not do certain things in relation to them without the specific instructions of Chase (the "Sub-participation Agreements").

As we saw, we could conclude by looking at various account statements from the Originating Broker and according to the declaration of its former clients, the Loan was funded by an advance made by investors willing to take the Mexican Corporation’ risk. According to the Decision the same occurred in the Bombril DR case:

The sums of money which were in fact used to purchase the Notes from Woodchuck were in fact advanced by the Receiptholders.

The Deposit Agreement for both transactions had the same goal in mind. As it is stated in the Mexican Corporation Deposit Agreement in relation to the Fronting Bank Offshore and Midland Bank (the common depositary for the clearing systems), the Decision continues:

Each of the Deposit Agreements provided for Chase to make a Global Receipt available to Chase Manhattan Bank, London Branch for the account of Morgan Guaranty Trust Company of New York, Brussels Office as operator of the Euroclear system and Cedel …so that the Deposit Receipts could be transferred on the records of the Clearing Systems without the need for individual Definitive receipts.

The preambles of both Deposit Agreements are almost identical. The difference is the underlying asset. In the case of the DRs the Loan, and the Notes in the case of the Bombril DRs.

The most relevant contention concerning the Decision was that the Bombril Participation Agreement represented that Socimer was not a trustee for the Participant. However, the lawyers representing some DR investors contested that a trust existed. We believe that most of the arguments of the Decision are applicable to the Mexican Corporation case. Not surprisingly, the Deposit Agreement also says that the Depositary (the Fronting Bank Offshore) has no trustee duties toward the DR holders.

The arguments defending the existence of a trust are reproduced from the Decision:

    1. the reference in the Preamble to the "100 per cent Participation" in the principal and interest with respect to the Notes";
    2. This is also found in the Mexican Corporation Participation, the Global Receipt and the Conditions of the Mexican Corporation DRs.

    3. in sub-clause 2. 1, the words "SIBL grants Chase a participation in the Payment Rights..." coupled with the restriction on SIBL being able to dispose of the Notes without Chase's consent;
    4. This argument may be found in the Mexican Corporation Participation Agreement where a 100% participation interest is granted, the same contract says that decisions or actions in respects to the underlying Loan can be exercised in consultation with, and receipt of instructions from, interested parties, the same document that forbids the Mexican Corporation from selling any part of the Loan, except as provided in the Mexican Corporation Participation Agreement, and finally on the latter mentioned agreement where it is granted that the contract perfected a sale of 100% of the participation interest in the Loan.

    5. the reference in sub-clause 2.5 to breach of trust or fiduciary duty "...(on the footing that, as seems possible, 'Participant' in [that] clause is a misnomer for SIBL";
    6. The same reference is made by the Global Receipt where it exempts the relevant assignment of any recourse or warranty and the Mexican Corporation Deposit Agreement where the Fronting Bank Offshore is exempted from any liability towards the Mexican Corporation Receiptholders.

    7. the requirement in clause 4 that SIBL should "...have regard to ... the interests of" Chase; and
    8. This is equivalent to the limited exercise of control left to the Fronting Bank when it transferred the 100% Participation to the Originating Broker. The Mexican Corporation Participation Agreement is even more broad than the Bombril Participation given that the agreement commands the Fronting Bank to act ‘in accordance with the wishes of the of the Interested Parties holding a majority interest in the Loan’.

    9. the provision in sub-clause 5.4 that the terms and conditions of the relevant Deposit Agreement should be deemed to form an integral part of the Participation Agreement, so clearly requiring them to be considered in construing the Participation Agreement.

The Mexican Corporation Deposit Agreement, although not mentioned as part of the Mexican Corporation Participation Agreement, does form integral of the Conditions of the Mexican Corporation DRs as reference is made to its definitions on the bottom line of the Preamble of the Conditions.

The Decision also indicated other ten provisions in the Bombril Deposit Agreement which, in the absence of the "no trust" (also present in the same document for the Mexican Corporation DR) provision would have indicated the existence of a trust. These are –

    1. the references 3 to a "100 per cent. participation" in the Payment Rights'
    2. The same reference of the Mexican Corporation Deposit Agreement indicates 100% participation.

    3. the definition of "Participation Agreement" in sub-clause 1. 1 as Chase's "100 per cent. Undivided participating interest in the Payment Rights";
    4. The Definition of Participation Agreement, which referred to the definition of Participation in the section mentioned above could be compared to this provision.

    5. the provision in clause 3 that SIBL "shall retain all rights as Noteholder (other than the Payment Rights) thereunder" thereby indicating that SIBL was not to retain the Payment Rights;
    6. In the Mexican Corporation case this is found in the Conditions where it is indicated that all payments received from the relevant obligors were to be made to the Receiptholders, not to the Fronting Bank Offshore or the Originating Broker.

    7. the reference in the third sub-paragraph of clause 3, whereby SIBL granted Chase a 100 per cent participation in the Payment Rights;
    8. This argument is similar to one present in the Mexican Corporation Deposit Agreement where the Participation Certificate is issued to the Participant and to the Preambles of both the Mexican Corporation Global Receipt and the Conditions.

    9. "Upon receipt of payments of principal and/or interest by [SIBL under the Notes [SIBL] shall instruct the transfer of such funds to the account of [Chase], for further credit to the Receiptholders: in respect of the Receipts";
    10. You could make an analogy with the Mexican Corporation Deposit Agreement and the Mexican Corporation Global Receipt.

    11. the reference in sub-clause 4.1 to a "transfer" of the Payment Rights to Chase;
    12. A provision similar to this one in the Mexican Corporation case was found in the Deposit Agreement, although no transfer of payment rights is mentioned because the agreement says that the DRs "represent the entitlement from the of the Receiptholders to receive pro rata from the Depositary…..any amount actually received by or on behalf of the Depositary from" the Fronting Bank. The difference lies in the distinct underlying assets. It is common practice to buy and sell participations in loans and it is widely understood that the buyer acquires, inter alia, payment and collection rights thereunder. On the other hand, when a buyer acquires a Euro-note through the clearing systems, it secures ownership of the asset to the extent of its purchase, and not of part of it only. It is not common to see the sale of different rights out of a liquid and perfectly divisible financial instrument, as the Bombril Euro-notes were.

    13. in paragraph I of the form of Global Depositary Receipt, the reference to "the granting" to Chase by SIBL" of a 100 per cent. participation in the Payment Rights";
    14. As mentioned, the same affirmation is made in the first paragraph of the Mexican Corporation Global Receipt.

    15. the provision in the said paragraph of the Global Depositary Receipt that "The Payment Rights and any amounts of principal and interest received by [Chase] hereunder constitute fiduciary assets of [Chase]" the importance of this being, not that the Payment Rights are fiduciary assets, but that they are referred to as assets of Chase and not of SIBL;
    16. Part of the Global Receipt may be compared to the preceding argument. Again, no payment rights are used in the Mexican Corporation transaction because the Lender of Record continues to be the Lender under the Loan, but not the owner of the beneficial interest, including payment rights, therein. The DRs in the Mexican Corporation transaction are not described as fiduciary asset of the Fronting Bank Offshore because the transfer of the ownership through a sale of the Participation was clearly documented. This was not the case of the Bombril DR. The ownership of the underlying note belonged to Socimer, but its payments belonged to the Bombril DR holders. The Notes were then held as fiduciary assets by Chase Luxembourg because neither the Notes (including its voting rights) nor the payments thereunder were part of Chase Luxembourg’s patrimony.

    17. in term I (a) of the Terms and Conditions to the Global Depositary Receipt, the provision that Chase 'will hold the Payment Rights on a fiduciary basis for the Receiptholders' (indicating again that Chase was to hold the rights under the Notes, not mere contractual rights, against SIBL); and
    18. The rights under the Loan represented by the Mexican Corporation Receipts are mentioned in Conditions of the Mexican Corporation DRs. The rights are against the Mexican Corporation under the Loan and not against the Originating Broker.

    19. clause 3 of the Deposit Agreements which contemplate that the amounts received by SIBL from Bombril will be passed straight on to Chase.

The same is found in the Mexican Corporation Deposit Agreement and the Conditions of the DRs under Payment of Principal and Interest Payments.

The Decision continues and reproduces the conclusions of the affidavits presented to the Court that affirmed that because of the no trust provision (as the Mexican Corporation Deposit Agreement stated) Socimer could not be considered a trustee for the holders. One affidavit is quoted to say that although the no trust provision exists that does not mean that Socimer could not be considered a trustee since it may appear to contradict Chase’s participation as 100% undivided interest and principal. This applies to the Mexican Corporation DRs because in the Mexican Corporation Participation Agreement it is expressed that the original amount lent plus interest accrued thereon as "a credit to be transferred". The entire principal amount of the Loan, therefore an undivided interest in the same. The Decision goes on to explain why if a debtor-creditor relationship were established in the agreements to document the transaction that would exclude a trusteeship. Please note that the debtor-creditor relationship is expressly excluded from the Mexican Corporation DR transaction in the Participation Agreement.

The Decision on page 22 makes reference to a work on International Banking where the following is reproduced:

...Should the original lender go into liquidation, the liquidator would be entitled to the repayments, and the purchaser would be a mere creditor of the original lender. Some participation agreements are so structured as to constitute a sale of a right to receive payment in essence an assignment, but one where the selling bank acts as a collecting agent or trustee for the purchasing bank. There are few decided cases on this arrangement. At first sight it appears to offer a way for a subparticipant to be protected, but if the selling bank adopts the procedure common to most banks and mixes funds received by it in respect of loans, then the benefit of a trust or agency will be lost and, again, the purchasing bank will simply have the status of a creditor in the liquidation."(Italics mine)

Here, there is no evidence of SIBL receiving funds in respect of any of the Notes and mixing it with other funds in its business; indeed, it is required to pass on the sums to Chase the same day, where possible.

In the Mexican Corporation case there is no evidence either in respect of the Originating Broker receiving funds in respect of the Loan and mixing them with other funds in its business. It is also required to pass the sums to the Fronting Bank Offshore the same day it received the funds from the Fronting Bank or in some instances the Fronting Bank is asked to send the funds received from the Mexican Corporation directly to the Fronting Bank Offshore.

Then the Decision explores what are participations, sub-participations and participation agreements are considered under English law. We don’t consider relevant to reproduce all the authorities quoted by the Court, except for the definition of funded sub-participation by Jeffrey Barratt as quoted by the Decision that says:

"In broad terms a funded sub-participation…is an agreement whereby the buyer (or subparticipant) will put the seller in funds (by placing a deposit with the seller) for an agreed participation in a loan or for an agreed proportion of each advance. In return the seller pays to the buyer amounts by way of repayment of principal and payments of interest on such deposit equal to a pro rata share of the payments of principal and interest received from the borrower."

The Decision then concludes:

While at first glance, the arrangement between SIBL and Chase may appear to fall within the description given by Mr. Barratt, in substance it does not, for there was in fact no loan by SIBL to Woodchuck or Bombril which SIBL was able to offer a participation in nor were any of the Notes the property of SIBL prior to their receipt upon the payment of the funds from Chase. Again, it must be remembered that the parties to the subparticipation agreements in this case, deliberately chose to describe SIBL as "the Arranger" rather than the "Seller" which latter appellation was applied to Woodchuck.

In the Mexican Corporation case there was no loan from the Originating Broker to the Fronting Bank or the Mexican Corporation, as specifically expressed in the Mexican Corporation Participation Agreement, nor was the Loan property of the Originating Broker prior to receipt upon the funds from its clients to buy the Participation in the Loan. The Originating Broker was also described as Arranger in the Mexican Corporation Deposit Agreement, where in fact the 100% participation in the Loan was transferred to the relevant Depositary, and the Terms and Conditions of the Mexican Corporation DRs.

The Decision lists advantages and disadvantages of sub-participation agreements as perceived by Mr. Barratt, and concludes:

While the substance of the transaction between SIBL, Chase, Woodchuck and the Receiptholders may partake of some of the elements of a funded sub-participation as defined by Mr. Barratt, in my judgment, there are sufficient distinguishing features to take it outside that definition; for example, there is no evidence that any funds were "deposited" with SIBL in the sense in which that term is generally understood when reasonable persons deal with banks. Further, Chase was given the right to tell SIBL how to deal with the Notes in the circumstances set out in the Sub-Participation Agreement. In addition, SIBL was bound, by the Sub-Participation agreement to pay over to Chase all sums received from Bombril within one day of such receipt.

In the Mexican Corporation’ case, no "deposit" with the Originating Broker took place either, since investors were sold a participation in a loan to the Mexican Corporation and were sold the Mexican Corporation’s risk. Also the exercise of control was vested in the Interested Parties and not in the Fronting Bank by the Mexican Corporation Participation Agreement. The Agreement considers the Originating Broker an Interested Party, but not the only one. In the Mexican Corporation transaction, the Originating Broker assigned the Participation Certificate to the Depositary so it could receive, on behalf of the Receiptholders, the relevant payments under the Loan without the need to go through the Originating Broker, the original buyer of the Mexican Corporation Participation. According to the Conditions and the Global Receipt, the Fronting Bank was supposed to pay the Fronting Bank Offshore, the Depositary, any payments received from the Mexican Corporation on the Maturity Date. No mention of the Originating Broker, at least in its capacity as purchaser, is made by the Conditions or the Global Receipt.

The Decision continues:

There was also no such assignment by Woodchuck, who was described as the "Seller" to Chase or the Receiptholders. If, however, Woodchuck received the payments from the Receiptholders through Chase and SIBL (and there is no suggestion that it did not) and if, subsequently, sums representing the principal and interest on the Notes were paid to Woodchuck by Bombril, I have little doubt that any reasonable businessperson would think that Woodchuck was bound to pay over such sums to the Receiptholders or their designate. Further, apart from the words in the documents relied on by counsel for the Liquidator as showing that SIBL is not a trustee (even a constructive one?) for the Receiptholders, it must be borne in mind that if, as appears from the documents, SIBL did not pay any of its funds to Woodchuck for the Notes, then it could not be in any better position in equity than Woodchuck would have been, had the latter received the payments from Bombril after the "sale" to SIBL.

In the Mexican Corporation case an assignment between the Originating Broker and the Fronting Bank Offshore, the Depositary, indeed took place. There was also an identifiable stream of income for good consideration. There is no evidence that the Originating Broker did not receive payments from the investors to fund the Loan. In fact, the account statements of those investors reflect the opposite. Then, those advances were paid to the Fronting Bank to be passed to the Mexican Corporation. Since the funds were received from the Originating Broker, it became the owner of the Mexican Corporation Participation and subsequently assigned it to the Fronting Bank Offshore, as depositary. If the Mexican Corporation paid the Fronting Bank and the latter paid the Fronting Bank Offshore and, following the DR Purchase Agreement, it paid the Originating Broker, no reasonable business person will doubt that the Originating Broker is bound to return the advances previously made, together with interests, to the investors. As in the Bombril case in relation to Socimer, Woodchuck and Chase, since the Originating Broker did not pay any of its funds to the Fronting Bank for the Loan, then it could not be in any better position in equity than Woodchuck would have been in the Bombril transaction. Please note that in the Mexican Corporation case a "sale" between the Fronting Bank and the Originating Broker took place as indicated by the Participation Agreement, however, the transaction was funded by the investors and not by the Originating Broker.

The Decision then continues pointing out some writings and decided cases from the US and Canada. Since the Loan and the Mexican Corporation DRs were governed by NY law, this section of the opinion is even more relevant than the previous ones. Many authorities and cases are cited, among them, Chief Justice Sawyer made references to the cases In Re Yale Express System, Inc. 245 F. Supp. 790 (S.D.N.Y. 1965) and Federal Deposit Insurance Corporation, Receiver v Mademoiselle of California, 379 F. 2d (9th Cir. 1967) together with articles published by authorities on the subject.

For example, the Decision quotes an article entitled "Underlying relationships in bank participations" and says:

Moreover, the selling bank continues to retain all or most of the control over the loan and the borrower, thus casting doubt on the assignment by failing to demonstrate the presence of one of the most important elements of an assignment, that the assignee must control that which was assigned to it. In such a case, the relationship that the courts may allow is to declare it an equitable assignment".

In this case, while SIBL remained the "owner" of the bearer Notes, Chase had the right to prevent SIBL from agreeing to a change, for example, in the manner or extent of the payments of principal and interest due under the Notes. And, of course, as noted earlier, there is no evidence that SIBL advanced any of its funds for the purchase of the Notes from Woodchuck.

The same applies to the Mexican Corporation case where there is no evidence that the Originating Broker advanced its own funds to "buy" the Loan and the Fronting Bank had to consult Interest Parties, the Originating Broker and others, to make decisions with respect to the Loan and was forbidden from consenting to any modification with respect to the Loan and the Loan Documents as indicated by the Mexican Corporation Participation Agreement.

The Decision goes on to say that SIBL was not in fact the Seller of the Notes but a mere custodian thereof and because the funds to buy the payment rights were obtained from investors it understands why the debtor-creditor relationship is related to the Notes and not the payments thereunder. This comment is made to defeat the treatment of Debtor-Creditor relationship between Socimer and Chase that the Bombril participation tried to establish, which does not apply to the Mexican Corporation case since such relationship was categorically excluded by the Mexican Corporation Participation.

The Decision also makes reference to the law in Canada by quoting and article by Mr. Peter Lawarne where the Bahamian Court emphasized that:

…the law therefore appears to be that where there is a sale by way of an assignment of an undivided percentage interest in a stream of income, when identifiable assets come into the hands of the assignor, they are bound in the hands of the assignor for the benefit of the assignee. If the fund out of which the moneys are payable is identifiable then the assignor/lead lender will be required to pay over the appropriate part of that fund to the assignee participant, whether or not he is characterised as an express or constructive trustee. The courts in Canada readily construe constructive trusts where the legal title to property is in one person and the equitable right to the beneficial enjoyment of that property is in another.

The Decision when analyzing the interpretation to be relied by the Court, it analyzed more cases and concluded:

…this court, in construing the agreements between SIBL and Chase, and in trying to discover the intention of the parties to those agreements, should bear in mind that if the strict interpretation of the words used in the agreements lead to an unreasonable result, that is one indication that it could not have been what the parties intended.

And:

….."This practical rule of thumb (if I may so describe it without disrespect) must however have its limits. There comes a point at which the court should remind itself that the task is to discover what the-parties meant from what they have said, and that to force upon the words a meaning which they cannot fairly bear is to substitute for the bargain actually made one which the court believes could better have been made. That is an illegitimate role for a court. Particularly in the field of commerce, where the parties need to know what they must do and what they can insist on not doing, it is essential for them to be confident that they rely on the court to enforce their contract according to its terms.

The Decision also mentions other cases where it was expressed that even if the relevant contract were badly drafted that afforded no reason to the depart from the fundamental rule of construction that the intention of the parties must be ascertained from the language they have used interpreted in the light of the relevant factual situation in which the contract was made. The poorer the drafting the less willing any court should be to attribute an improbable and unbusinesslike intention.

The Decision additionally went on to say that:

Here, the court must not lose sight of the actual words used to express the arrangement between Chase and SIBL as well as the Receiptholders and Woodchuck. It seems quite unreasonable that anyone would pay money for personal property (the Notes) and then do not expect some benefit from those Notes.

The same unreasonableness would appear if it is concluded that investors would have paid money for a participation in the Mexican Corporation’ Loan without expecting to receive anything in return or that they would have advanced funds to the Mexican Corporation knowingly taking the Originating Broker’s risk.

The Decision when making its conclusions analyzes the affidavits of defenders of both positions says:

…. the contract between Chase and SIBL did not preclude a constructive trustee relationship between SIBL and the Receiptholders. The fact that no funds of SIBL were advanced to enable the purchase of the Notes, ownership of which automatically vested in SIBL upon receipt since they were bearer notes, is part of the factual matrix against which the Sub-Participation Agreements are to be interpreted.

The same applies to the Mexican Corporation, since the Originating Broker did not advance any of its own funds ownership of the Participation vested in the Originating Broker because the Mexican Corporation perfected a sale when it executed the Mexican Corporation Participation Agreement, all is part of the factual matrix against which participation agreements are to be interpreted.

Then the Decision continues, italics are mine:

I find persuasive support for that view in the decisions in the Mademoiselle case cited above as well as In re Canadian Commercial Bank: Canadian Deposit Insurance Corpn v. Canadian Commercial Bank [198615 WWR 531].

In the Mademoiselle case, the Court considered the rights of a loan participant, which asserted a preferred claim as a matter of property law, and a borrower, which wished to set off its deposit against its note due the bank. In that case, San Francisco National Bank ("SFNB") lent $60,000 to Mademoiselle, a partnership, and then sold eighty percent of the note to Union Bank. Mademoiselle, as borrower, "did not receive any notice of any assignment of any interest in the note" and Union Bank did not file a financing statement perfecting its interest or giving public notice. After SFNB was declared insolvent, Mademoiselle and Union Bank made conflicting claims.

The court recognised that before it could find that there was a trust of the funds in Mademoiselle's account with SFNB, the circumstances must suggest that a trust of those funds was intended and that Union Bank ... "must be able to identify a specific fund or payment in the possession of the receiver cognizable in equity as [Union Bank's] own property". The court, in effect, found that as there was in fact no increase in the assets of SFNB but only a setting-off against SFNB's indebtedness to Mademoiselle, Union Bank's claim failed.

So too in Hibernia National Bank v. Federal Deposit Insurance Corporation 733 F. 2d 1403 (C.A. 9" Cir. 1967), where a certificate of participation sold by Penn Square Bank to Hibernia read:

"We hereby confirm that in consideration of your payment to us, we are holding for your account a pro rata interest on the unpaid principal of the subject note with the same proportionate interest in any and all interest to accrue on the note..."

the court held that the certificate of participation could not be characterized as a trust agreement since Hibernia was not able to identify a specific fund in the possession of the receiver "cognizable in equity as Hibernia property". The court also noted that Hibernia was not a creditor of the borrower and could look solely to Penn Square Bank or the Federal Deposit Insurance Corporation as its receiver for the satisfaction of its claim.

In this case, there is an identifiable fund which, from the evidence before me, was received by SIBL from Bombril in respect of the Notes and which, in equity, SIBL was bound to pay to Chase for payment to the Receiptholders.

Following the same reasoning, in the Mexican Corporation’ case there is an identifiable fund which the Mexican Corporation had to pay, and partially paid, to the Originating Broker in respect of the Loan, which, in equity, is bound to pay the Fronting Bank Offshore so it could pay the relevant investors. The Certificate of Participation, different from the one cited in Hibernia, was distinguished from the rest of the Originating Broker’s property.

The Decision then enters to consider theory of constructive trusts and when cites Underhill and Hayton when it says inter alia:

The constructive trust arises as a result of the maxim 'Equity regards as done that which ought to be done', the assignor being bound to hold the materialised former future property on trust for the assignee by virtue of his earlier receipt of consideration from the assignee. As Dixon J stated in Palette Shoes Pty Ltd v. Krohn:

…'Because value has been given on the one side, the conscience of the other party is bound when the subject matter comes into existence, that is, when, as is generally the case, the legal property vests in him. Because his conscience is bound in respect of a subject or property, equity fastens upon the property itself and makes him a trustee of the legal right or ownership for the assignee. But although the matter rests primarily in contract, the prospective right in property which the assignee obtains is a higher right than to have specific performance of a contract and it may survive the assignor's bankruptcy because it attaches without more eo instanti when the property arises and gives the assignee an equitable interest therein.~

Applying the principles there outlined to the facts of this case, the moment that the payments of interest and principal were received by SIBL, then Chase's right became a higher right than to have specific performance of a contract because the Receiptholders' right to be repaid the sums they had previously invested attached without more the instant the moneys which for these purposes I accept is a fungible asset - vested in SIBL.

The same can be said about the Mexican Corporation’ case: the moment that the payment of interest and principal were received by the Originating Broker from the Fronting Bank Offshore, in its capacity as investor under the DR Purchase Agreement, then the investors’ rights became higher right than a specific performance of a contract because the investors’ right to be repaid the sums they have invested attached without more the instant the moneys, which for these purposes the Decision considered fungible assets, vested in the Originating Broker.

Expanding upon constructive trusts, the Decision affirmed, italics are mine:

…"So long as the vendor enters into a specifically enforceable contract for the sale of property he becomes constructive trustee thereof for the purchaser until the contract is completed by transfer of the property to the purchaser or to the order of the purchaser. Once the purchaser has wholly fulfilled his side of the contract (eg by paying over the purchase price) but the vendor still has title to the property then the vendor holds the property on a bare trust for the absolutely entitled purchaser. Until then the vendor's trusteeship is' a highly self-interested modified form of trusteeship."

I do not think counsel for any of the parties in this case disputes that the foregoing extracts represent the law of England in relation to the kinds of transactions mentioned: for as indicated earlier, on the undisputed facts of this case, the purchase price of the notes was advanced through Chase from the Receiptholders and was paid to Woodchuck by SIBL which, in turn, received the Notes, title to which passed on receipt. As soon as any payment of interest or principal was received by SIBL from Bombril in respect of those Notes, SIBL became bound in equity, dehors the contract, to pay that sum over to Chase who had undertaken to act on a fiduciary basis for the Receiptholders.

It cannot be disputed then, under English law, that the property of the Mexican Corporation’ DRs held by the Originating Broker constitutes a constructive trust. The price of the Loan was advanced through the Originating Broker from the investors and was paid to the Fronting Bank, the Lender ‘of record’, by the Originating Broker which, in turn, received the ownership of the Loan, title to which passed on receipt. If the Mexican Corporation makes payments under the Loan to the Fronting Bank and the latter pays the Originating Broker, as investor under the DR Purchase Agreement, the Originating Broker should become bound in equity to pay that sum over to investors who allowed the Broker to acquire the Mexican Corporation Participation. If the reasoning of the Decision were to convince you, payments under the Loan would belong in equity to the original investors who funded the Fronting Bank to grant the Loan to the Mexican Corporation and its subsequent sale to the Originating Broker.

Please note that the Decision was based on two US cases, Mademoiselle and Hibernia National Bank and the law of England concerning constructive trusts. In the case of constructive trusts in the United States, the term is defined as "trust created by operation of law against one who by actual or constructive fraud,…by abuse of confidence, ….or by any form of unconscionable conduct or other questionable means, has obtained or holds legal rights or property which he should not, in equity and good conscience, hold and enjoy."14 One authority on the subject also says that constructive trust are created by courts of equity whenever title to the property is found in one who in fairness ought not to be allowed to retained. They can be created where no express trust is involved but property is obtained or retained by other unconscionable conduct.15

We don’t find constructive trusts in English law, as discussed by the Decision, very different from constructive trusts in the United States as said authorities understand them.

In the Mexican Corporation’ case, even if no wrongdoing from the Originating Broker could be proved, if the investors who originally advanced the funds to purchase the Loan did not get repaid under the Mexican Corporation DR, the Originating Broker, who did not risk its capital for the investment, will be unjustly enriched if it got such payments. The previously quoted authority also says that whenever equity finds that one has title to property, real or personal, although innocently obtained, now held under such circumstances that the retention of title will result in unjust enrichment, equity may declare such title –holder to be the trustee of a trust constructed by it for purposes of working out justice, which is merely a convenient means of remedying a wrong. These trusts are also called fraud rectifying trust, the sense of fraud does not only refer to an intentional misrepresentation but any kind of wrongdoing.16

Now, would the Originating Broker unjustly be enriched if it were held that payments under the Mexican Corporation DR belonged to the defunct corporation’s bankruptcy estate? What was the wrongdoing that would originate the unjust enrichment? The property in discussion (i.e., cash to advance to the Mexican Corporation) was obtained by intentional misrepresentation, investors were induced to purchase a participation in the Loan through the DRs, as the preliminary information memorandum of the Mexican Corporation DR evidences, and the only investor who signed the DR purchase agreement and, acquired title to the DRs, was the Originating Broker. The Originating Broker should have advised those investors that the Originating Broker was the entity buying the Mexican Corporation DRs and not them, although the Originating Broker was using the investor’s funds to complete the purchase. I cannot be certain, but, by reading the preliminary information memorandum, the traditional form of selling literature used to inform investors their rights as well as the characteristics of the investments they may purchase, it is not evident that purchasers of the Mexican Corporation DRs were going to bear the Arranger’s risk of becoming insolvent. If investors had known that by investing in the Mexican Corporation DRs, they were going to bear the Originating Broker’s risk, the demand for the investment would not have been similar. Investors were apparently not properly informed and perhaps did not realize the situation due to their lack of experience in investment instruments similar to DRs.

Particularly in the state of New York, the law that governs the contracts which documented the Mexican Corporation DRs, four elements are necessary to create a constructive trust: confidential relationship, reliance upon a promise to reconvey, a transfer of property in reliance thereon and unjust enrichment of the transferee.17 I believe the four elements necessary for the creation of the constructive trust are present in the Mexican Corporation’ case. A confidential relationship existed between the Originating Broker and the investors for the latter kept their monies and securities holdings deposited with the former. Investors relied on the promise that they would get their investment back from the Mexican Corporation’ payment under the Loan, they certainly did not believe that the funds the Mexican Corporation was going to pay were going to become part of the Originating Broker’s patrimony. A transfer, in the form of an advance, of funds took place from the investors to the Originating Broker to fund the Loan, investors relied on the announced rate of return over the investment in the DRs, not on securities issued by the Originating Broker. Should the Originating Broker maintain rights to receive payments under the Mexican Corporation DRs an unjust enrichment will take place given that the insolvent company will be getting capital and interest thereon over an investment in which it merely acted as an intermediary. It is our understanding that the Originating Broker never used its own sources to buy the Mexican Corporation Participation and subsequently the DRs.

It cannot be argued that the Originating Broker did not fund the participation, but it did buy the DRs when it executed the DR purchase agreement free of payment, nevertheless. Even if theory of constructive trust were not accepted, no consideration was given in return for the acquisition of the DRs under the DR Purchase Agreement. Such contract should not be perfect without consideration, the Mexican Corporation Participation Agreement should be. As a result, the valid holder of the DRs should be the Fronting Bank-Bahamas. Said DRs were nevertheless held for the benefit of the owners of the instrument. The owners of the DRs should be those who advanced the funds to the Originating Broker, so it could transfer them to the Fronting Bank to enable the European bank to lend such funds to the Mexican Corporation. Abuse of confidence and misleading information to those investors later made the Originating Broker get the DRs without paying for them.

It cannot be said that the Originating Broker intended to fraudulently take possession of the DRs when it signed the DR Purchase Agreement, it may have done so to facilitate the transfer of the DRs to the only Euro-securities account available to the investors; its own. However, investors should have been originally informed that their investments were going to be treated as the Originating Broker outstanding obligation and eventually become part of the broker’s estate. There relies the abuse of confidence. For this case, it would be advisable to check the means the Originating Broker and the Mexican Corporation used to persuade the investor to invest in what they bought as the DRs.

The Originating Broker abused the confidence of the investors because it offered them, and got their funds to buy, the Participation, but it kept the investment for itself and never transferred it back to those who had trusted the Originating Broker to manage their purchase of the DRs. Those entitled to the ownership of the Participation never got actual title to or possession of the DRs, which was the only evidence of their investment.

Conclusion

I hope that you agree that the facts of the Decision are so similar to the Mexican Corporation’s case that analysis of structures like the Mexican Corporation DRs without considering the Decision would make that analysis incomplete. Given that the factual background of both the Mexican Corporation and Bombril are so similar, we believe that it would be difficult that in cases like the Mexican Corporation DR a Court would opine differently from the Supreme Court of the Bahamas. However, I also understand that these issues are decided on a case by case basis and that the competent Court in charge of examining and deciding on the relevant case may find different circumstances and use different premises which may draw a different conclusion from Chief Justice Sawyer’s.

Today there are less and less second tier borrowers around and even less institutions considered first tier by Mexican authorities that are willing to act in the capacity of the Fronting Bank of our example. Also, for the same reasons exposed, it is very difficult for small Mexican corporations not to fall into the temptation of agreeing to participate in a transaction similar to the one which structure we have tried to brief herein. If this is the case, what can we learn from the Decision? That when considering transactions structured similarly to the one exposed, small Mexican corporate borrowers should try to eliminate the risk of the second tier financial intermediary who would certainly add an unnecessary risk to the already many risks associated with this type of operations. In the structure we described, the risk of the Originating Broker, which is one if the many risks necessarily involved in the structure described supra (i.e., the borrower’s, the lender of record’s, the depositary’s and paying agent’s, etc.), could be eliminated by not transferring the participation interest in the relevant credit to the property of the Originating Broker of our example. Since the Originating Broker is one of the parties, or the party of the transaction, more susceptible to become insolvent, it is important to avoid that the repayment of the underlying credit is considered part of the estate of the Originating Broker should it become insolvent before maturity of said credit. The borrower can accomplish this by transferring the participation interest in the credit that originated such interests to a reputable third institution who could act as a trustee for benefit of the holders of the relevant depositary receipts. The trust should be formed in a way that its only property is the participation interests in the relevant credit. The trust then can issue DRs or trust certificates evidencing ownership on the underlying credit. The Originating Broker of our example could still participate in the transaction as a placement agent for the trust. In this fashion, the reciptholders will be buying participation interests in a credit to a Mexican corporation by buying clearing eligible DRs or trust certificates issued and held by a trust formed for the benefit of the receiptholders and administered by a real trustee (in opposition to a constructive one). This will certainly eliminate the discussion of the capacity in which the Originating Broker may hold the participation interests in the underlying credit because it will simply not hold them. They will be held by a trustee to watch the interests of the reciptholders and the eventual insolvency of the Originating Broker will thus become irrelevant for them. The borrower should enter into an agreement with the Fronting Bank who will sell the participation to a trust, who will issue DRs and engage the Originating Broker to place the DRs without actually getting possession of them.

Footnotes

  1. Please refer to the list on the Mexican Miscelanea Fiscal where Non Mexican banks are categorized and taxes are imposed on local borrowers who borrow from them depending on the category of the lender. For example, if a Mexican borrower got a loan from Socimer, for example, it had to pay a higher tax than if it had gotten the same financing from a 1st tier institution
  2. For a description of a typical structure of a bearer depositary receipts, please see Wood, P., International Loans, Bonds and Securities Regulations, Sweet & Maxwell, London 1995, 157-158.
  3. Please see www.interknowledge.com/bahamas/investment/bankng01.htm.
  4. Should you require more information on the Notes, we suggests consulting the relevant selling literature and additional publicly available information on the securities.
  5. At the time of issue of the Bombril DRs, the Euro-securities (or international securities) clearing systems were Morgan Guaranty Trust Company of New York as Operator of the Euroclear System (better known as Euroclear) and Cedel Bank Societe Anonime (or Cedel). In January of last year, the latter system changed its name to Clearstream. A global depositary receipt was issued so it could be retained within the clearing systems and transfers could only be affected on a book entry basis between accounts within both systems, and between the systems themselves. In the international securities market, trading is almost always made inside the clearing systems. On the other hand, settlement outside the systems typically requires a telegraphic transfer of funds and physical delivery of the securities in a particular financial center. For more on the clearing systems, please see Scott, H. and Wellons, P., International Finance (2 nd Edition), Foundation Press, Inc. New York 1995, 855-865.
  6. In 1998, some emerging market analysts discussed then current corporate reorganization that Bombril was experiencing and the voting required by its Noteholders to approve such reorganization. Socimer’s sale of the payment rights while keeping ownership of the bonds caught the attention of some of those analysts who suggested various alternatives to explain the reasons behind Socimer’s actions. After all, why would you want to issue DRs, which is an instrument traditionally used to give liquidity to non-liquid underlying assets, when your underlying asset is one of the most liquid instruments in the securities markets (i.e., a Euronote)?
  7. Gooch, A. and Klein, L. Documentation for Loans, Assignments and Participations, Euromoney Books, London 1996, 247-249 making reference to In re Pearsons Bros., 787 F.2d 1157 (7 th Cir. 1986) and In re Yale Express System, Inc. 245 F. Supp. 790, 792 (S.D.N.Y. 1965).
  8. Gooch, supra note 8 at 250.
  9. Id. at 251
  10. Weil, Gotshal & Manges LLP, Restructurings, Euromoney Books, London 2000, 50-51 citing 11 U.S.C. § (c) (1); § 541 (b) (1), (2) and § 541(d).
  11. Id. at 102.
  12. Id. at 222 endnote 6 making reference to Bergier v. IRS, 469 US 53 (1990).
  13. Id. endnote 10 citing Southmark Corp. v. Grosz (In re Southmark Corp.), 49 F. 3d 1111, 1117 (5 th Cir.1995).
  14. Black’s Law Dictionary 314 (6 th ed. 1990) citing Davis v. Howard, 19 Or. App. 310, 527, P.2d. 422, 424.
  15. Bogert, G., Trusts (6th edition), Hornbook Series, 1987, 286.
  16. Bogert, supra note 18 at 287.
  17. Simonds v. Simonds, 45 NY. 2d 233 (1978)

The views expressed in this note are exclusively those of the author and do not necessarily represent those of Standard Miami or any affiliate of the Standard Bank Group of South Africa.

The contents of this note are intended as a general commentary about the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
Maximiliano Valera
 
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