Last things first: “Perfection” and the removal of obstacles to enforcement

Lawyers often find themselves trawling through corporate constitutions to verify the powers and capacity of a borrower to take on external funding and provide security for their repayment obligations. Although restrictions on external borrowings and related security over company assets do still find their way into some memoranda of incorporation or similar constitution documents, this is the exception rather than the rule – the modern corporate constitution is generally permissive, except in some cases. For example, where shareholder minority protections require replication in the memorandum of incorporation in order to be enforceable under South African law.

That may all be good and well, but what lawyers sometimes miss in the process are the embedded hurdles in a corporate constitution that could obstruct enforcement of security if that ever becomes necessary. Although the notion of “perfected” security is not a legal term in South Africa, it does have a somewhat loose practical meaning associated with it. Generally, lawyers understand it to imply that mortgages and notarial bonds are required to be registered in order to be enforceable. It is also sometimes taken to mean that the steps required to ensure that obstacles to enforcement have been removed, have in fact been taken (before the exposure which is being secured against actually arises, e.g. prior to disbursement of a loan to a borrower). One example of this is often found in standard private company memoranda of incorporation or similar constitution documents, namely the embedded right of directors to refuse to recognise a transfer of shares and have the register of members updated for such a transfer (with the historic reason for the restriction being the need to protect ‘private company’ status through a limitation of transferability). The implications for security over shares are self-evident – at a time when financiers need it most, the borrower or its board, is able to frustrate a transfer of its shares, or at least to dilute the threat of imminent enforcement and therefore the leverage of lenders (not so much leverage against the borrower itself as leverage against fellow creditors).

Assessing constitutional documents for possible limitations

Recently, we concluded a cross-border lending transaction where the security included pledged shares in a company. Upon closer inspection, the very last article on the final page of the articles of association of the company in question contained a typical private company restriction where the board of directors could refuse registration of a transfer of shares. This meant that the lender would have risked delay, potential litigation expense or even loss as a result of valuation movements before being able to ultimately enforce the security. To resolve that, the company had to amend its articles to remove the restrictive wording.

It is imperative that lawyers always properly assess constitutional documents for possible limitations of this nature. Founding documents may contain restrictions in relation to (i) borrowing powers, (ii) guarantees, (iii) prohibitions on financial assistance, (iv) limitations on encumbrances on assets, (v) shareholder consents or notifications for specific transactions, (vi) voting thresholds for special and ordinary votes, and (iv) ring fencing provisions where the company is to serve a very narrow and specific purpose. These all actually go to the powers and capacity of the company to engage in transactions of this nature. A restriction in the form of a right in favour of directors to refuse to recognise a transfer of shares in the company would not, but this does in fact pose a potential problem upon enforcement.

The general practice in the South African debt markets is to require that the applicable board adopts a resolution where it recognises the existence of security and undertakes to give effect to a transfer of shares that might occur if the security is ever enforced. The potential problem with this is that board resolutions are capable of revocation without much complication – while this may constitute and event of default at that time, it would merely add to an existing list of defaults and create scope for obstructionism. There might be a robust basis for challenging such a revocation, but that would cost time and money and the first prize would always be to avoid such a situation in the first place. South African lawyers should consider whether the practice in certain overseas jurisdictions of removing the restriction in the articles, is worth following here.

Security must not be restrictive over the business of the borrower

Keeping things simple, security must be limited to its purpose, with actual restrictions on the business of the security provider set at a level which is appropriate and necessary – operational interference can be counterproductive for a lender that ultimately wants its money back and doesn’t want to spend its days monitoring loans and related borrower operational matters. Here is an example from a standard loan agreement of the typical “negative pledge” provided by a borrower and/or guarantor in relation to its assets:

“A borrower or security provider may not:

• sell, transfer or otherwise dispose of any of its assets;
• sell, pledge, transfer or otherwise dispose of any of its receivables on recourse terms;
• enter into or permit to subsist any title retention arrangement;
• enter into or permit to subsist any arrangement under which money or the benefit of a bank or other account may be applied, set-off or made subject to a combination of accounts; or
• enter into or permit to subsist any other preferential arrangement having a similar effect.”

It is sometimes said that the negative pledge is the ‘Holy Grail’ of senior loan financing. They are found in every properly drafted senior loan agreement, whether investment grade or leveraged finance – and everywhere in between. At the same time, they are by their nature restrictive. Foreseeably, depending on the nature of the business, these provisions could impede its ongoing operations and decisions. Normally, assets that are provided as security include shares, movable and immovable property, bank accounts, insurance proceeds, certain contractual rights, and intellectual property; each with its own specific formalities and requirements for creating security and perfection requirements. Therefore, in as much as security needs to be tight, when negotiating the negative pledge and related security provisions, careful consideration must be given to the terms of those provisions. The best examples of assets potentially affected by these provisions are trading stock, debtors and cash – all working capital or “floating capital” which presupposes a continuous movement in the balances of these assets (if there were not, one would be concerned). Borrowers need to dispose of stock, transfer cash and sue or otherwise collect debtors, which in the last case is not possible where a security cession of the debt remains in place without a re-cession to the borrower in order to establish locus standi. Accordingly, it is important that the typical negative pledge and security documents allow flexibility in this regard.

Risk must be allocated to the party best capable to take it on

A simple basis for contractual risk allocation generally is said to be that risks must always be allocated to and, where appropriate, secured by, parties best capable of doing so. This principle becomes abundantly clear in more complex transactions such as structured project finance deals, where risk arises across a wide spectrum of counterparts and areas, government as a counterparty or permitting agent, land, construction and operations – to name a few. Normally in these complex arrangements, one has to take a step back and put together a risk matrix to ensure that the risks are secured by the appropriate party. The proper approach therefore is to say:

• What is the risk?
• Who is the risk taker, the risk allocation?
• Identify the risk mitigant, the appropriate party best capable to mitigate the risk.

The examples below practically demonstrate this principle – the risk category, the risk allocation and pass-through to the party most capable to secure the risk.

Financial risks: These include insolvency risk, asset risk and taxation risk. Insolvency is a lender risk and is best managed by early events of default triggers, financial covenants and guarantees, and security documents may include a letter of credit, guarantee and security assets. Asset risk is secured by maintenance covenants and residual value guarantees, or even repossession.

Construction risks: These could occur in the form of delay, insolvency of a contractor, or failure to build to specification. The borrower normally bears the construction risk. In mitigation, the best party capable to take that risk is the contractor, via pass-through mechanisms from the borrower to the contractor and an added layer of security such as performance guarantees or bonds provided by the contractor, borrower indemnities and other measures such as draw stops.

Operational risks: These encompass asset loss or damage, environmental risk or third-party liability, etc. At a minimum these risks are best managed though an insurance policy provider, at the back of borrower indemnities or covenants, or via maintenance reserve facilities to ensure that the operational assets of the project remain covered. Pass-through of the risk to the operator could entail the provision of guarantees or letters of credit by the operator or its parent.

Political risks: Political risks include adverse government policies or actions, civil strife, war or political events that depreciate the value of an asset or business. These are events that fall outside the hands of the parties to a financing and are best mitigated by political risks insurance (PRI) provided by either a national export credit agencies or private PRI insurance providers.

This is not an exhaustive list of risks that can be identified in commercial transactions, the main point is to demonstrate the principle that whenever we look at risk, we need to think about the best party capable to secure that risk.