The creation of security constitutes an arrangement whereby a creditor is able to look to a particular asset, or the asset's proceeds of sale, if a debtor fails to discharge its liabilities to the creditor. Particularly with reference to our CDO practice, you should note that security cannot be granted to shareholders in respect of a company's obligations in respect of ordinary or preference shares.
There is a distinction between real rights (rights in rem) and personal rights (rights in personam). A real right is a right which is exercisable against the world at large.1 A personal right is an interest which is protected solely against specific individuals.2 Taking a security interest over an asset confers a real right over that asset. Personal rights which confer additional rights, for example guarantees, are often described as personal security. However, strictly, security should only be those interests which confer a right in rem. All of the types of security discussed below confer rights in rem.
TYPES OF SECURITY
English and Cayman Islands law recognise four basic forms of security interest: mortgages (legal and equitable), charges, liens and pledges. In the context of structured finance, the most important of these are mortgages and charges. Liens and pledges are now rarely used. The type of security which will be appropriate will depend on various factors such as the status of the potential grantee of the security, the level of security and safety a creditor desires, the type of assets which are to be secured and whether the grantor wishes to continue dealing with those assets.
This table summarises the main differences, discussed in more detail below, between the various forms of security interest:
Type of Interest
Creation and Formalities
Depends on type of property being secured.
Cannot take legal mortgage over equitable interest
Depends on type property being secured
Equitable right to resort to asset for payment
Delivery of possession of property to pledgee
Property which is incapable of being delivered
Right of possession
Delivery of possession of property to lienee
Property which is incapable of being delivered
Legal mortgages are the most comprehensive and secure form of security. A legal mortgage is the transfer, by conveyance or assignment, of the whole of the legal ownership of an asset by way of security. This transfer is, however, subject to an equity of redemption (which cannot be fettered) – an express or implied obligation to re-transfer ownership of the asset to the mortgagor if the mortgagor discharges his debt or obligations. Formally, the mortgagee has legal title of the asset. In reality, however, the substance of ownership, and generally possession of the asset, will remain with the mortgagor.3
The formalities necessary for creating a legal mortgage depend on the type of property being secured. This note does not cover the creation of security over Cayman Islands real estate which should never be encountered in our structured finance practice. A legal mortgage over debts or choses in action is created by an absolute assignment in writing which is not purported to be by way of charge only. Additionally, express notice in writing must have been given to the debtor, trustee or other person from whom the assignor would otherwise have been entitled to claim the debt or chose in action. The Property (Miscellaneous Provisions) Law (as amended) provides in section 5(2) that:
"If the person liable in respect of such debt or thing in action has notice:
- that the assignment is disputed by the assignor or
any person claiming under him; or
- of any other opposing or conflicting claims to such
debt or thing in action, he may, if he thinks fit, either
call upon the person making claim thereto to interplead
concerning the same, or pay the debt or other thing in
action into court under the Trusts Law (2001 Revision) or
any statutory modification or successor
Legal mortgages over chattels do not generally require any formalities to make them effective, provided that there is a valid agreement and intention to create a mortgage.4
A legal mortgage over registered securities (shares or bonds) is created by transferring the securities into the name of the mortgagee or a nominee, for nominal consideration. The recipient should then be registered as the holder of the securities. An accompanying agreement should set out the equity of redemption, ie the rights of the mortgagor to have the securities re-transferred to him on discharge of all liabilities. For bearer securities, a legal mortgage is created when the certificates of title to the securities are deposited with the mortgagee and a memorandum of deposit is entered into between the mortgagor and mortgagee which transfers the legal interest in the securities. However, it is more natural for bearer securities to be delivered by way of pledge.
Here, the mortgagor transfers a beneficial interest in the relevant asset to the mortgagee while the legal interest remains with the mortgagor. An equitable mortgage is weaker than a legal mortgage and a pledge, because a bona fide purchaser of the legal estate without notice of an equitable mortgage (known as "equity's darling"), will take free from the equitable mortgage.
An equitable mortgage is created in any of the following situations:
- the legal owner of the asset enters into some instrument
or does some act which though insufficient to confer a legal
estate or title in the asset to the mortgagee nevertheless
demonstrates a binding intention to create a security in
favour of the mortgagee or; evidences a contract to do so,
which is supported by consideration5
- the potential mortgagee is proposing to take security
over an equitable interest in an asset;
- the parties have merely entered into an agreement to
create a legal mortgage in the future over the
- in the case of certain property (e.g. registered
securities) the mere deposit of title certificates with a
lender, with intent to create security, is sufficient to
create an equitable mortgage.7
An equitable mortgage over any legal interest in property other than land requires no formalities, except for an agreement with intention and consideration. The making of a related loan will be sufficient consideration for the creation of an equitable mortgage.
Unless registered securities are held on deposit with clearing systems such as Euroclear or CEDEL, registered securities are often delivered to the mortgagee by delivery of the share certificates together with a signed but undated transfer form which does not name the transferee.
Charges do not transfer legal or equitable interests in the asset to the chargee, nor do they confer a right to possession. Instead, under an equitable charge, "specific property of the chargor is expressly or constructively appropriated to or made answerable for payment of a debt"8. The chargee has a right to resort to the asset in order to realise it towards payment of its debts. Charges are always equitable charges.
An equitable charge needs no formalities save for the agreement creating the charge.
A pledge is a legal form of security which is created by delivery of possession of an asset to the pledgee. This delivery can be actual or constructive. Constructive delivery takes place when a bailee of the pledgor acknowledges to the pledgee that he holds the goods to the pledgee's order. This process, known as attornment, means that the goods remain in the hands of a third party but in constructive possession of the pledgee.
Pledges of tangible property are unremarkable. There is a problem, however, in the concept of the pledges of certain intangible assets, often because of the difficulty in transferring possession. Subject to certain exceptions (eg bills of lading) a pledge of a document of title, for example, will generally only pledge the paper itself, not the underlying goods which the document of title represents.
Pledges of negotiable instruments are valid, except those instruments which cannot be transferred. Bearer securities can be pledged.
Personal property such as share certificates in respect of registered shares, which is incapable of being physically delivered, cannot be pledged.
Extra care must be taken when acting in respect of the transactions involving bearer securities or other instruments as bearer instrument transactions are frequently a device used by money launderers. (See also bearer share restrictions at sections 249-251 of the Companies Law (as amended)).
A lien, although dependant on delivery of possession to the creditor, like pledges, is essentially different from a pledge.
"The difference between them is that in the case of pledge the owner delivers possession to the creditor as security, whereas in the case of a lien the creditor retains possession of goods previously delivered to him for some other purpose."9
A lien confers a right of possession. A lien is a right to detain an asset until the obligation owed by the lienor is discharged. For this reason, liens are the weakest of the four methods of security.
Liens are created either by operation of common law or statute or are contractual. Examples of liens arising by operation of common law are the banker's lien and the solicitor's lien10.
Remedies of a legal mortgagee
On default by the mortgagor of the terms in the mortgage, a mortgagee will want to enforce his security. He will have various options when it comes to enforcement.
The main remedies for a legal mortgagee are:
1. Appointment of a receiver
The mortgagee will usually have a power to appoint a receiver under the terms of the mortgage. This right will be exercisable after default. In addition, if the mortgage so provides, a mortgagee will be able to appoint a receiver before default. A usual clause would be that a mortgagee is entitled to appoint a receiver if he reasonably believes that the security is in jeopardy. Jeopardy will need to be defined in the mortgage.
A receiver will be appointed over the secured assets and his powers in relation to those assets will depend on the terms of the mortgage security instrument.
2. Power of sale
The mortgagee will be able to sell the property in reduction or satisfaction of his debt. The power of sale will arise under the terms of the contract.
The mortgagee will not be permitted to sell the property to itself or a connected party and will be under a duty to the mortgagor to obtain the best price possible for the assets11.
This is a cumbersome enforcement measure and is very rarely used nowadays12 because the power of sale is thought to be as effective. Foreclosure is only available on application to the court. An order for foreclosure abrogates the mortgagor's equity of redemption and leaves the entire value of the mortgaged property in the hands of the mortgagee. The court is entitled to sell in lieu of foreclosure.
Even after foreclosure has taken place, a mortgagee may still sue the mortgagor on his covenant to repay, until he has sold the property to a third party.
4. Alternative remedies
A legal mortgagee has an immediate right to possession. This right is regardless of default unless there is an express or implied exclusion under the terms of the mortgage that the mortgagee will only take possession on default. A mortgagee can also take possession before the legal redemption date for the mortgage has passed.
Remedies of an equitable mortgagee
An equitable mortgagee has no right to possession.13 Nevertheless, an equitable mortgagee may apply to the court for specific performance. This enables the mortgagee to require that his equitable mortgage be converted to a legal mortgage or to request the court that he be put in possession, before or after default. Obviously, a court will be more likely to put a mortgagee into possession if default has occurred.
An equitable mortgagee will be entitled to foreclosure, and in accordance with the terms of the charging document, to sell the property or to appoint a receiver.
In the case of an equitable mortgagee of a debt, the mortgagee will have an action for payment against the debtor in equity.
Remedies of equitable chargee
A mere equitable chargee cannot foreclose on the property.14 He is, however, entitled to the appointment of a receiver or to sell the property, either pursuant to express terms in the charge document or by application to court.
Remedies of pledgee
A pledge confers a power of sale on the pledgee. Also, since a pledgee is entitled to immediate possession, common law actions in tort such as conversion will lie.
Remedies of lienee
A lienee merely has a right to detain the property until his debt has been satisfied. Generally, he has no power of sale. However, a banker's lien does confer a power of sale.15
FIXED AND FLOATING CHARGES
In Re Cosslett (Contractors) Ltd16 at the Court of Appeal stage, Lord Millett, then Millett LJ, described the essence of a fixed charge as:
"a charge&on a particular asset or class of assets which the chargor cannot deal with free from the charge without the consent of the chargee".
A fixed charge is therefore created when particular real or personal property, capable of being ascertained and defined, is specifically set aside or appropriated to the discharge of the chargor's debt.
The chargee of a fixed charge is given an immediate interest in the property subject to the charge. This interest binds all those into whose hands the property may come with notice of the charge.17
This characteristic of fixed charges does however mean that a company, with assets subject to a charge, is unable to deal with those assets, without the consent of the chargee, without committing a breach of the terms of the charge. A company which has a fixed charge over a substantial part or the whole of its assets, especially its circulating capital, would find it difficult to continue its business. Considerations of the fixed charge's paralysing effect on business led to the development of the floating charge.
Under Cayman Islands' law, both fixed and floating charges can be granted notwithstanding that the chargee is the obligor.18
A floating charge is a charge which floats over the property charged so that a company is able to deal with that property. The chargor's ability to deal with the property will continue until some event occurs which causes the charge to crystallise over the property, thereby becoming a fixed charge. At this point, the chargor will be restricted in its dealings with the property charged.
Floating charges first appeared in England in the 1870's but it was not until 1903 that the courts began to define floating charge. In Re Yorkshire Woolcombers Association Ltd, Romer LJ described the floating charge as having the following three characteristics:
- a charge over a class of present and future assets;
- the assets within the class changing in the ordinary
course of business; and
- the company retaining the power to deal with those assets
in the ordinary course of business.19
The defining feature of a floating charge is therefore that the chargor will have the right to remove property from the scope of the charge without the consent of the chargee. This was confirmed by the Privy Council in Agnew v Commissioner for Inland Revenue.20
The main advantage of a floating charge is its flexibility. Charges can be taken over many assets which cannot realistically be made the subject of a fixed charge (eg book debts, stock-in-trade), without inhibiting a company's ability to continue trading. The flip side to this is that since a company can remove property from the scope of the charge, there is a possibility that the subject matter of the floating charge will be lost leaving the chargee with an effectively unsecured debt.
An English law governed floating charge granted by a UK company will, usually grant to the chargee the right to appoint an administrative receiver. It should be noted that Cayman Islands law does not recognise the concept of an administrative receiver and a Cayman Islands law floating charge should create and empower the role of a contractual receiver which can be a receiver over all of the company's property.
A disadvantage of floating charges is their vulnerability in the event of insolvency of a company. Creditors who are owed debts which are classified as preferential, will take in priority to floating chargeholders. Preferential debts include liquidator's fees and expenses, unpaid government fees and expenses and the unpaid salaries of employees.
In addition, the assets subject to a floating charge may be diminished by the following:
- post-execution dispositions;
- set-off rights; and
- leasing and factoring type transactions.
To avoid such problems of vulnerability, in the context of a structured financing, a chargor which is an SPV will often be required to give representations and warranties that it has no preferential creditors and no liabilities other than those envisaged by the transaction documents and to give undertakings that it will do nothing to create such creditors/liabilities.
As mentioned above, crystallisation is the process of conversion of the floating charge into a fixed charge on the occurrence of certain events. Crystallisation is either implicit or express.
Implicit crystallisation occurs on the following events:
- if an order for liquidation of the company is
- if the company ceases trading or carrying on
business22 insofar as there is a difference
between a company ceasing to carry on business and a company
ceasing to be a going concern, the material event for
crystallisation is the cessation of
- if the company disposes of in substance the whole of its
undertaking or trading assets with a view to the cessation of
trading or cessation as a going concern24;
- if the chargee takes possession of the charged assets
through seizure under power or licence25;
- if a receiver is appointed over the charged assets by or
on behalf of the chargee26; and
- if the chargee obtains or exercises some other remedy
with a view to enforcement of the security or protection of
the charged assets27.
Express crystallisation occurs when, pursuant to the terms of the charge, either the chargee notifies the company that the charge shall crystallise or an event occurs where under the express terms of the charge, the charge specifies that that event shall cause the charge to crystallise.28 The latter is known as automatic crystallisation. Automatic crystallisation does not immediately destroy the chargor's apparent authority to deal with the assets. If the chargee takes no steps pursuant to an automatic crystallisation, the parties will probably be deemed to have agreed that the crystallisation should be inoperative.
Priority of charges
Rules of priority are very important because if a company is defaulting on its debts, there will often be a number of secured creditors who are trying to enforce their security at the same time. The following rules apply between fixed and floating charges. However secured creditors often avoid the issue by executing a deed of priority before advancing money (e.g. waterfall provisions in securitisation documentation).
Fixed charge v fixed charge
Where two fixed charges are perfected, the first in time to be created prevails.
A bona fide purchaser for value of a legal estate without notice overrides equitable interests including the interests of a chargee. Also, since a company can only charge what it owns, if it acquires an asset with limited rights, the chargee takes subject to the rights of the third party. 29
Fixed charge v floating charge
A floating charge is generally postponed to a subsequent fixed charge.30 The exception to this is where the fixed chargee has actual or constructive notice of a restriction in the floating charge preventing the creation of subsequent charges ranking in priority or pari passu with the floating charge.31
Floating charge v floating charge
Traditionally, where there are two floating charges over the same assets, priority was governed by the date of creation of the charge.32 However, in Griffiths v Yorkshire Bank Plc33, it was held that priority between floating charges is governed by the date of crystallisation. This decision was not followed in the later case of Re H & K (Medway) Ltd34 on another matter and academics such as Palmer and Paul L Davies have strongly criticised Griffiths, because it will allow the rights of the first chargee to depend on an accident of timing. It is unlikely that Griffiths will be followed but this area is not entirely settled.
It is clear, however that if a second floating charge is granted over only part of the assets which are secured by the first floating charge and the second charge cannot be said to be the same character as the first charge, it is permissible that the second charge take priority over the first.35 Charges are of the same character if they are granted over exactly the same assets and on the same footing as each other or if the second charge is in priority to the first charge.36
1 Blacks Law Dictionary (1999) 7th Edn.
2 Blacks Law Dictionary (1999) 7th Edn.
3 See Gough, Company Charges (1996) 2nd Edn Butterworths at 18
4 Gough, Company Charges (1996) 2nd Edn Butterworths at 24
5 Swiss Bank Corpn v Lloyds Bank Ltd  AC 584 at 594-5 per Buckely LJ
6 Holroyd v Marshall (1862) 10 HL Cas 191, Tailby v Official Receiver (1888) 13 App Cas 523
7 Harrold v Plenty  2 Ch 314
8 Re Charge Card Services Ltd  Ch 150 at 176 per Millet J
9 Re Cosslett (Contractors) Ltd v Mid-Glamorgan County Council  Ch 495 at 508 per Millet LJ
10 Brunto v Electrical Engineering Corpn  1 Ch 434
11 Cuckmere Brick v Mutual Finance  Ch 949
12 Palk v Mortgage Services Funding Plc  2 WLR 415 at 419
13 Ashley Guarantee plc v Zacaria  1 WLR 2 at 69 per Nourse LJ
14 Tennant v Trenchard (1869) 4 Ch App 537
15 The banker's lien does not extend to interests in securities held by banks as custodian for clients. Custody liens do no
therefore confer a power of sale.
16 Re Cosslett (Contractors) Ltd v Mid-Glamorgan County Council  Ch 495 at 510 per Millet LJ. This case was
referred to the House of Lords.
17 Agnew and another v Commissioner of Inland Revenue (Re Brumark Investments)  2 AC 710
18 For example, a Bank's obligations to return deposited money to the chargor (see Section 2 of the Property
(Miscellaneous Provisions) Law (as amended).
19 In Re Yorkshire Woolcombers Association Ltd  2 Ch 284
20  2AC 710 PC
21 Re Brightlife Ltd  Ch 200 at 211 per Hoffman J
22 Edward Nelson & Co Ltd v Faber  2 KB 367 at 376 per Joyce J
23 Re Woodroffes (Musical Instruments) Ltd  Ch 366 at 367 per Nourse J. However, Nourse J did note that the two
phrases often seem to be used interchangeably.
24 Hubbuck v Helms (1887) 56 LJ Ch 536
25 Mercantile Bank of India Ltd v Chartered Bank of India, Australia and China and Strauss & Co Ltd  1 All ER 231
26 Re Florence Land and Public Works Co (1878) 10 Ch D 530 at 541 per Jessel MR
27 A submission by Gough, Company Charges (1996) 2nd Edn Butterworths at 137
28 Re Brightlife Ltd  Ch 200
29 This is an application of the principle of nemo dat quod non habet.
30 Cox Moore v Peruvian Corporation Limited  1 Ch 604
31 English & Scottish Mercantile Investment Co Ltd v Brunton  2 QB 700 at 707 per Lord Esher MR
32 Benjamin Cope & Sons Ltd  1 Ch 800
33 Griffiths v Yorkshire Bank Plc  1 WLR 1427 at 1435 per Morritt J
34 Re H & K (Medway) Ltd  1 WLR 1422
35 Re Automatic Bottlemakers Ltd  Ch 412
36 Benjamin Cope & Sons Ltd  1 Ch 800 per Sargant J
Wayne Panton, Partner
David Whittome, Partner
James Gaudin, Partner
British Virgin Islands
Jack Boldarin, Partner
Hugh O'Loughlin, Partner
Rod Palmer, Partner
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.