SECURITY STRUCTURES – THE CROSS-JURISDICTIONAL COMPROMISE
Syndicated loan transactions that require a sharing of transaction security among the lenders are common in the English, South African and global debt capital markets.
This article assumes that the underlying finance documents are governed by English law to illustrate how a cross-jurisdictional compromise can be found. However, the same compromise can be reached for a funding transaction governed by another law, such as New York law, German law or Australian law.
Where some of the transaction security is located in a jurisdiction other than the UK, it becomes necessary to find a way to accommodate the different legal systems and practices when taking security in a syndication. This is so that the lenders share the transaction security, as commercially intended, in each jurisdiction that the transaction touches.
The intention in syndications is to establish a security structure that permits the borrower and other security providers to extend the security to an entity separate from the lenders; this separate entity in turn provides a guarantee or other undertaking to the lenders. Given that a separate entity holds the transaction security, there is no need to repeat the perfection and/ or registration of the transaction security when there is a change in the members of syndication. This security structure also ensures that the lenders can equally, and if intended parri passu, share in the security.
English law achieves the sharing of security in syndications by means of the security trust structure. A trustee holds the transaction security for the benefit of the lenders. The security trustee is usually a specialist trust company that carries out this function in the normal course of its business. Where the security trustee holds security originating from different jurisdictions, and the trust concept is not recognised in any of those jurisdictions, a local security agent (usually the security trustee in the syndication) is appointed to hold the jurisdiction-specific security for the syndication.
South African structure
There are a number of reasons why the English law security trust structure does not work under South African law. First, it is a well-established principle under South African law that for one party to validly provide security to another, there must be a primary obligation owed by the party providing the security to the party benefiting from the security. In other words, a fundamental principle of South African law is that real security is an accessory obligation that depends on the creation and existence of a principal or primary obligation. If there is no valid principal obligation, the security will have no effect. Applied in the context of the English law security trust structure, the security trustee is not the party to which the security provider owes a primary obligation (i.e. the debt).
Second, the South African Deeds Registration Act, 1973 provides that:
- debts to more than one creditor arising from different causes (such as debt to various lenders in a syndication, each of whom has a separate loan outstanding to the borrower) may not be secured by the same mortgage bond or notarial bond; and
- mortgages or notarial bonds must be passed in favour of a principal, not an agent (e.g. the jurisdiction-specific security agent mentioned earlier).
These challenges have led to the development under South African law of the so-called security special purpose vehicle (SPV) structure. Briefly, this structure entails:
- a separate, ring-fenced private company being incorporated (SPV) and 100% of its issued share capital being held by an independent South African trust;
- the SPV issuing a guarantee to the security trustee (or in the South African context, the facility agent and remaining finance parties) for the debt and obligations owing by the borrower to the syndication; and
- the borrower (and, often, its holding company, subsidiaries and group entities) providing a back-to-back indemnity to the SPV, and the borrower and other security providers extending security under that indemnity to the SPV (usually in the form of pledges, security cessions and bonds).
While the security SPV structure allows a syndication to achieve the same commercial result as is achieved under the English security trustee structure, the security SPV structure is costly due to the incorporation and annual maintenance of the SPV and the shareholder trust. There are also timing implications in incorporating these two entities. Lastly, the structure is generally unknown to foreign lenders in this syndication and it may take time for all of the transaction parties to become comfortable with it.
The parallel debt structure creates an additional primary obligation owed by the borrower in the context of the security trustee structure. In addition to the primary debt obligation (Debt Obligation) to repay the loan or loans to the lenders, the borrower assumes an additional obligation (Parallel Obligation) to the security trustee.
This Parallel Obligation is parallel to and essentially mirrors the Debt Obligation, but does not mean that the borrower agrees to a doubling of its debt obligations. The parallel debt wording will usually be included in the facility agreement or the intercreditor agreement. Further, the parallel debt construct provides that any payment by the borrower to the security trustee in respect of the Parallel Obligation discharges the borrower’s debt to the lenders pro rata and vice versa.
Given that the Parallel Obligation is not an obligation pursuant to which cash actually flows, it is merely an acknowledgement by the borrower to be obliged to pay amounts to the security trustee equal to the amount owing under the Debt Obligation.
In the parallel debt construct, the Parallel Obligation is considered a primary obligation to the security trustee, giving it an independent and separate right to demand payment of any amounts owing due and owing under the Parallel Obligation in its own name. In this context, the security trustee acts as a creditor and principal, not as an agent of the syndication. To the extent that the security trustee receives any amount in payment of the Parallel Obligation from the borrower, the security trustee must then distribute that amount to the syndication who are creditors in respect of the Debt Obligation. Any amounts received by the security trustee under the Parallel Obligation results in a commensurate reduction of the amounts due and payable to the syndication under the Debt Obligation.
The parallel debt structure remains untested in the South African courts. Our view is however that as long as the Parallel Obligation is a valid and primary obligation under English law and if, according to English law, the security trustee is a genuine principal and not an agent, the South African security providers may provide security against the Parallel Obligation.
Notably, another untested aspect under South African law is whether the South African courts would consider the parallel debt structure and specifically, the Parallel Obligation, a simulation. This question could arise given that the security trustee does not render any performance to the borrower that is commensurate with its purported claim as creditor against the borrower in respect of the Parallel Obligation. If it were to be successfully argued that the Parallel Obligation exists only by virtue of the Debt Obligation, and is thus ancillary to the Debt Obligation, the Parallel Obligation cannot be said to be a primary obligation.
This could result in the South African courts holding that the parallel debt contract is a simulation, especially if they take the view that the transaction parties’ real intention is not to create an independent debt but for the security trustee to act as the agent of the lenders while holding the transaction security. These legal uncertainties are usually dealt with by means of appropriate assumptions and qualifications in the relevant legal opinion issued in respect of the syndicated loan transactions.
Therefore, it is possible to accommodate different legal systems and practices when taking security in a syndication, enabling the lenders to share the transaction security in each jurisdiction affected, including South Africa.
For more information, please contact our Banking and Finance Department.