Issues for Bankers .au

[Pages:35]Allens Arthur Robinson Insolvency Forum 11 June 2003

Issues for Bankers

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How are a bank's contractual rights affected by a borrower's financial troubles?

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'material adverse change' clauses

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taking a charge in breach of a prohibition on assignment clause

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combining accounts and set-off

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enforcing security in a voluntary administration

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Traps for the unwary - how should a bank conduct itself when dealing with a

financially troubled borrower?

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misleading and deceptive conduct

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unconscionability

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shadow directors

Jim Dunstan Partner Allens Arthur Robinson

John Warde Partner Allens Arthur Robinson

This paper was prepared with the considerable assistance of Allens Arthur Robinson lawyers Amanda Neil, Nick Bilinsky and Annie Tan.

The Chifley Tower 2 Chifley Square Sydney NSW 2000 Tel 61 2 9230 4000 Fax 61 2 9230 5333 .au

? Copyright Allens Arthur Robinson 2003

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Introduction

This paper discusses some of the legal implications the financial troubles of the borrower can have for a lender bank. Part one of the paper deals with the impact the financial difficulties of a borrower can have on a bank's contractual rights. Part two of the paper considers the legal consequences that can flow from the way a bank deals with borrowers facing financial trouble.

Part One: Exercising Contractual Rights

When a bank agrees to provide financial accommodation to a customer, the finance and associated security documents which govern their relationship generally represent a negotiated position to which the parties have agreed following some degree of discussion and, at least in the case of more substantial corporate customers, some degree of bargaining. A bank is entitled in these circumstances to negotiate an agreement which best represents its interests. Many of the provisions contained in the documents are intended to serve this purpose so that, if it subsequently appears that the customer is no longer able to uphold its end of the bargain, the bank has some means of protecting its position.

How, then, do these provisions operate in practice? When a bank is dealing with a financially troubled borrower, to what extent can it rely on its contractual rights to avoid or minimise the detriment it will suffer? This part of the paper considers these questions in the following context:

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'material adverse change' events of default;

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charges and non-assignment provisions;

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combination of accounts and set-off; and

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enforcing security in a voluntary administration.

1.1 Material Adverse Change as an Event of Default

In finance documentation, material adverse change clauses generally appear in two forms:

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as representations which a borrower is required to make on entry into a finance

document and each time the lender advances it funds; and

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as events of default.

They are most relevant to banks dealing with financially troubled borrowers as events of default because they provide the bank with a potentially powerful tool with which to protect its interests. Due to their generality and vagueness, however, lenders should approach material adverse change events of default (MACEOD) with caution. Where a bank wrongly

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relies on a MACEOD clause, an action for breach of contract by the borrower may be the result.1

What is a 'Material Adverse Change Event of Default'?

A 'material adverse change event of default' is an event of default that occurs where there has been a material change in circumstances, such as a deterioration of the borrower's financial position or the value of a lender's security, which adversely impacts on the ability of a borrower to fulfil its obligations under a finance document.

An example of a MACEOD clause is as follows:

Each of the following is an Event of Default (whether or not it is in the control of the Borrower):...

(x)

(Material adverse change) Any other event or series of events, whether related or

not, occurs (including a material adverse change in the business, assets, prospects

or financial condition of the Borrower or the value of the Mortgaged Property),

which in the opinion of the Lender may have a Material Adverse Effect.

'Material Adverse Effect' is generally defined to mean a material adverse effect on:

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the ability of a borrower to perform its obligations under a finance document;

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the security of the lender; and/or

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the financial condition or business of the borrower.

Under a security document, the usual remedy is for the lender to appoint a receiver. Where a material adverse change event of default occurs under a finance document, the lender will generally refuse to advance the borrower any further funds and accelerate the loan. 2

When Can a Bank Rely on a Material Adverse Change Event of Default?

There is little Australian authority which deals with the way MACEOD clauses are interpreted. Their use has been upheld in some cases, and not in others.

One example of a case in which a bank successfully employed a MACEOD clause to call an event of default is Vision Telecommunications Pty Ltd v Australian and New Zealand Banking Group Ltd. 3 In that case, ANZ provided financial accommodation to Vision to enable it to set up a telecommunications franchise outlet. When the franchise failed, ANZ claimed that a material adverse change had occurred and refused to advance Vision any further funds. This was despite the fact that Vision had not defaulted in making its payments under the loan.

1 See for example Vision Telecommunications Pty Ltd v Australia and New Zealand Banking Group Ltd [2001] WASC 139. 2 Karlsson K "Material Adverse Change Clause" (2002) 17(9) Banking Law Bulletin 143

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Pidgeon AUJ upheld ANZ's right to call an event of default in these circumstances. The fact that the relevant clause was expressed in the subjective meant that the only opinions that were relevant were those of the officers of ANZ. His Honour declined to determine whether the opinions of a lender as to material adverse change must always be formed on reasonable grounds and, if so, whether the lender was obliged to make reasonable enquiries about the borrower's financial position before it formed its view. The reason for this was that ANZ's opinion in this case had been honestly and reasonably formed and the clause on which it relied did not require enquiries to be made.

In Pan Foods Company Importers & Distributors Pty Ltd v Australian and New Zealand Banking Group Ltd, 4 the bank's right to call an event of default based on a material adverse change was also upheld. In that case, the High Court found that the facts that Pan Foods was experiencing substantial trading losses, declining cash sales, inadequate cash flow and stale stock, a continued loss of $200,000 per annum and a predicted shortfall on enforcement of security were significant enough to constitute a material adverse change. The Court also found that it was also open to ANZ to conclude that Pan Foods would not be able to restructure its business, so as to negate the effect of the change. In Canberra Advance Bank Ltd v John Bernard Benny, 5 however, the bank's use of a MACEOD clause was not sanctioned by the Federal Court. Canberra Advance Bank had relied on factors including a revised cash flow projection for the borrower's project, its desire to change to interest only payments and a threat to wind up the borrower as evidence that there had been a material adverse change in the borrower's financial position. The Federal Court held that none of these events constituted such a change. Rather, they were 'mere projections' and, whilst they were evidence that a material adverse change may have occurred or may occur in the future, Canberra Advance Bank had failed on the evidence to prove that they reflected a change of the requisite kind. Similarly, in Roger James Poignand v NZI Securities Australia Ltd6 the Federal Court held that, although there had been an adverse change in the company's position, it was not sufficient to conclude that this change was material based entirely on a comparison between the financial statements of the borrower over the years. More information and analysis was required.

The cases outlined above indicate that the circumstances in which a lender can rely on a material adverse change to call an event of default are not settled. Much will depend on the way the clause in question is drafted and the facts of the particular case. Unless a

3 [2001] WASC 139 4 [2000] HCA 20 5 (1992) 115 ALR 207 6 (1994) 12 ACSR 523

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bank has conducted careful analysis as to the borrower's financial position and the evidence gathered strongly indicates that the borrower will not be able to repay its loans, relying on a MACEOD clause will involve some risk.

What Should You Do?

Before a lender exercises its rights pursuant to a MACEOD clause, it should consider all the circumstances and form an opinion as to their impact on the borrower's ability to meet its contractual obligations. Note, however, that the circumstances that are relevant probably do not include those that are wholly outside the control of the borrower and in respect of which it has assumed no risk, such as an currency crisis or an industry downturn. 7

Although there is no strict requirement of reasonableness, a lender's actions are probably more likely to be sanctioned by a Court where its opinion is honestly and reasonably formed and based on proper investigation and analysis. To this end, a lender would be well advised to make full enquiries regarding the borrower's financial position and to document its actions carefully.

1.2 Charges and Non-Assignment Provisions Without an unequivocal statement by an Australian appellate court, the question of whether an equitable charge constitutes an assignment is still a highly problematic point of law. From the point of view of practice, where a provision of a commercial contract prohibits an assignment of the contract, it is important to know whether the charge will contravene the non-assignment prohibition. More particularly and for our purposes, in a project finance context (to take an example), where a financier provides construction finance to a developer in the expectation that a fixed and floating charge over the builder's assets will secure receipts from contracts, knowledge of the status and enforceability of that charge in the context of a non-assignment clause is crucial from the point of view of the financier for establishing water-tight security.

To determine whether an equitable charge constitutes an assignment, it is necessary to examine the relevant authorities, both judicial and academic, and to compare the rights of a chargee with the rights of an assignee under an assignment.

7 See for example the United States cases Esplanade Oil & Gas v Templeton Energy Income 889 F2d 621 (5th Cir 1989) and Wells Fargo Bank v US 26 Cl Ct 805 (Cl Ct 1992).

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Are Charges Assignments?

The Case for the Negative

There is considerable authority to suggest that an equitable charge is not an assignment. In Trancred v Delagoa Bay and East Africa Railway Co8 Denman J stated that:

A document given 'by way of charge' is not one which absolutely transfers the property with a condition for conveyance, but is a document which only gives a right to payment out of a particular fund or particular property, without transferring that fund or property.

Note that His Honour was only interpreting section 25(6) of the Judicature Act 1873 which applied to assignees under absolute assignments, but not assignments purporting to be by way of charge only.

Sykes and Walker also doubt that a charge is an assignment. They state that "an hypothecation is not an assignment of a res; it is an encumbrance on a res".9 This view is reinforced by the decision of Chitty J in In re Earl of Lucan, Hardinge v Cobden: 10

What is given is not the thing but a charge upon the thing. That is the true effect of the deed.

A charge then may be considered a potential right or power exercisable upon default by the chargor. It differs altogether from a mortgage (a form of assignment), where there is a transfer of an existing proprietary interest.11

Professor Goode also comments on the distinction between mortgages and charges. Whereas a mortgage constitutes a conveyance (that is, it confers a proprietary interest), a charge conveys nothing. That said, in terms of floating charges, the term 'assignment' is used loosely by Goode. To him, a floating charge may be described as an 'incomplete assignment' because "the vesting of an equitable proprietary interest in the chargee is deferred until crystallisation and completed only at that point".

There are cases supporting the view that a floating charge is not an assignment until crystallisation occurs.12 Again, 'assignment' is used loosely in this context. Sykes and Walker, on the other hand, although commenting that the term 'assignment' is used loosely in certain contexts, opine that floating charges are of the hypothecation type and do not involve assignment, even on crystallisation. While acknowledging Blackburn J's decision in National Mutual Life Nominees Ltd v National Capital Development Commission that the

8 (1889) 23 QBD 239 at 242 9 at 772 10 (1890) 45 Ch D 470 at 475 11 See for example Burlinson v Hall (1884) 12 QBD 347 per Day J. 12 See for example Ferrier v Bottomer (1972) 126 CLR 597 at 607 and National Mutual Life Nominees Ltd v National Capital Development Commission (1975) 37 FLR 404 at 409-10.

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crystallisation operated as an assignment in equity of the charged property, Sykes and Walker consider this finding "very debatable". Despite the views of Sykes and Walker, in Sheahan v Carrier Air Conditioning Pty Ltd, 13 Brennan CJ comments that the statement that assets are "assigned" is too imprecise, and that "the extent of the equitable interest of a creditor in a fund to be applied in payment of his debts depends upon the terms governing the disbursement of the fund that are enforceable by specific performance". More recently, Mullins J in Starelec (Qld) Pty Ltd & Vangale Pty Ltd (in liq) v Kumagai Gumi Co Ltd14 also remarked:

In any case, the true effect of the charge given by Starelec...must be determined by reference to the provisions of the charge which may assist in determining whether on crystallisation the charge takes effect as a charge only or as an equitable assignment of the charged property.

From these authorities we can infer that in certain commercial situations the equitable interest in a charge may amount to an assignment (even in the loose sense provided by Goode), although when those situations arise has not been authoritatively determined. This question was sidestepped by Mullins J in Starelec.

Charges over debts are especially problematic. The creation of a charge over a debt essentially places the chargee in the same position as if he were an assignee in equity. The remedies of the chargee effectively make him such, as the most efficient recourse available is to sue the debtor in equity for the amount in question. In such circumstances, it may be possible for a party to create a charge, which is prima facie not an assignment, but which is intended to operate as an assignment at the time of, or just before, the debt comes to be enforced.

The Case for the Affirmative In Macintosh v Turner Corporation Ltd (in liq) and Others,15 Sackville J held that a charge constitutes an assignment and that a clause of a contract which prohibits assignment without consent precludes a charge from charging a party's right to performance of the contract, and also its right to receive benefits accrued under the contract. His Honour relied upon the decision of the House of Lords in Linden Gardens Trust Ltd v Lenesta Sludge Disposals Ltd16 and the principle that an assignment of contractual rights in breach of a contractual prohibition is ineffective.

13 (1997) 189 CLR 407 at 422-423 14 [2002] QSC 137 15 (1995) 13 ACLC 1314 16 [1994] 1 AC 85

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In that case, Turner Corporation Ltd entered into a building contract with Austotel Pty Ltd. The contract contained a provision in which the parties agreed not to assign the contract without the other party's consent.

Turner gave a charge to the State Bank of New South Wales in return for funding. The charge secured Turner's undertaking and assets "whatsoever and wheresoever both present and future". No consent was obtained.

Turner defaulted under the charge and the bank appointed a receiver. Turner went into provisional liquidation. A dispute between Turner and Austotel arose under the contract. The liquidator settled the dispute, which resulted in Austotel paying Turner $1,525,000. When the Court ordered the winding up of Turner, the liquidator applied for directions as to whether it was justified to pay the money to the bank. A creditor of Turner opposed the directions on the ground that the clause in the contract prohibiting assignment precluded the bank's charge from attaching to the money.

Sackville J found in favour of the bank. His Honour considered that, once Austotel paid Turner an amount under the contract, the money lost its character as an accrued benefit under the contract and simply constituted one of its assets. As a matter of construction, the provision that Turner should not "assign this agreement" could not prevent Turner effectively charging an asset constituted by moneys received as the result of performance of the contract.17

In other words, although the charge in question was ineffectual to charge Turner's right to performance of the contract and its right to receive benefits accrued under the contract, once moneys were actually paid to Turner, they formed part of its general assets independent of the contract and were therefore capable of being charged. It was fortunate for the bank that the money had been paid and asset was not just a benefit which had accrued under the contract.

The Queensland case of Starelec is the latest Australian pronouncement on the subject of whether an equitable charge can amount to an assignment. While it ultimately did not decide the question, it did discuss the rights conferred on a chargee under a charge. In describing a chargee's interest under a floating charge, Mullins J quoted WJ Gough: 18

Under a floating charge, the chargee acquires an equitable proprietary interest in the charged assets only at the time of crystallisation. Prior to crystallisation, the floating chargee obtains a personal equity, or 'mere equity', against the chargor arising under the floating charge contract.

and:

17 ibid at 1316 18 Company Charges 2nd Ed, (1996) at pp 332-333 qxns S0111142726v1 150120 11.6.2003

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