Security Enforcement – the strange case of the quiet Security Enforcement remedy which packs a punch
Appropriation – the powerful lenders’ remedy few have heard of
In leveraged finance structures (and often in other commercial lending situations) it is common for a lender to take share charges over the shares of a group. If the financial situation of the group deteriorates to the extent the lender decides to enforce the share charge after an event of default, a sales process is the most likely self-help remedy. This often involves the appointment of a receiver, which will market the shares and sell them on behalf of the lenders.
There is a little-known alternative to a sales process. In the UK a standard share charge will often include some mysterious language along the lines of:
‘this Charge and the obligations of the Chargor under it constitute a Security Financial Collateral Arrangement (as defined in the Regulations)’
This provision (which is easily overlooked) allows the lender to use a strong remedy called ‘appropriation’ facilitating a lender to take over the ownership of the asset. Put simply it enables the security taker to become the owner of the shares without the need to go through a court-based foreclosure process (highly cumbersome and little used) or to undertake a sales process. It’s a remedy which cuts across the normal common law rule that a lender cannot sell a secured asset back to itself.
The Regulations
English law incorporates the remedy of appropriation in the Financial Collateral Arrangements (No 2) Regulations 2003 (”the FCARs”) which was incorporated into UK law under Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements (“the FCD”). Notwithstanding the UK’s exit from the EU the FCAR remains in place. Note that not all member states incorporated the directive in the same way but the UK did so in such a way as to hold out the prospect that a share charge can constitute a ‘security financial collateral arrangement’ for the purpose of the FCAR and thus qualifies for the remedy of appropriation as long as it refers to the relevant legislation.
Regulation 17 of the FCARs provides "Where a legal or equitable mortgage is the security interest created or arising under a security financial collateral arrangement on terms that include a power for the collateral-taker to appropriate the collateral, the collateral-taker may exercise that power in accordance with the terms of the security financial collateral arrangement, without any order for foreclosure from the courts”.
Any question as to the efficacy of the FCAR and appropriation as a remedy was settled in a Privy Council case which upheld the remedy. The Privy Council in Cukurova Finance International Ltd & Anor v. Alfa Telecom Turkey Ltd (British Virgin Islands) [2009] UKPC 19 (05 May 2009)[1] shed some light on how a lender can appropriate, specifically, ‘Commercial practicalities require that there should be an overt act evincing the intention to exercise a power of appropriation, communicated to the collateral-provider’.
Valuation
Regulation 18 of the FCARs provides that when a lender appropriates it must value the financial collateral in accordance with the terms of the arrangement and in any event in a commercially reasonable manner. If the value of the collateral exceeds the secured debt, the collateral-taker must account to the collateral-provider for the excess value. Conversely, if the value of the collateral is less than the secured debt, the collateral-taker retains a claim against the collateral-provider for the balance of debt. Accordingly, the collateral-taker will naturally desire a low valuation of the collateral.
A new case, ABT Auto v Aapico[2] casts light on this remedy, particularly as regards valuation and the meaning of commercially reasonable manner. Neither the FCARs nor the FCD set out in detail what a commercially reasonable manner is. At paragraph 83 of the judgement the judge made the following point:
‘… I have come to the following conclusions relevant to the present case about what Regulation 18(1) requires:
First, the clear words of Regulation 18(1) place the duty of valuation on the collateral-taker. That means that it is the collateral taker that is responsible in law for the valuation, even if (as here) it has used a third-party valuer. If the third-party valuer has not carried out the valuation in a commercially reasonable manner, the valuation will not have been carried out in a commercially reasonable manner and the collateral taker cannot say that it has been, simply on the basis that the collateral taker itself has acted reasonably in retaining an apparently competent third party to do the work….
Second, it is the way in which the valuation is made which must be commercially reasonable. It does not necessarily follow that the result itself must be a commercially reasonable one. Nevertheless, if the value produced is less than could reasonably be expected, that may of itself be evidence that the manner of valuation has not been commercially reasonable. Conversely, a commercially reasonable result may indicate (in the absence of evidence to the contrary) that that result has been arrived at in a commercially reasonable manner. Furthermore, if the valuation result reached by an approach which is not commercially reasonable is the same as that which a commercially reasonable approach would have reached, there may be no point in setting aside the original valuation only to substitute an identical figure.
Third, the requirement for the valuation to be made in a commercially reasonable manner imports an objective standard. The subjective view of the collateral taker (or of its third party valuer) about what is commercially reasonable is irrelevant. As the recitals to the FCD make clear, its primary concern is with the financial markets. In that context, the word “commercially” indicates that the standard to be applied is that of reasonable participants in the relevant financial market. In other contexts, the manner of valuation must be one which conforms in that context to what Steyn LJ (as he then was) referred to as “the reasonable expectations of sensible businessmen” G Percy Trentham Ltd v Archital Luxfer Ltd [1993] 1 Lloyd's Rep 25 at 27; First Energy (UK) Ltd v Hungarian International Bank Ltd [1993] 2 Lloyd's Rep 194 at 196.
Fourth, the question of what, in any given case, is commercially reasonable is fact-sensitive. Depending upon the nature of the collateral and the circumstances of the case, there may perhaps be only one commercially reasonable manner of valuation. For example, where the financial collateral consists of traded securities listed on a single exchange, the only commercially reasonable approach to valuing those securities might perhaps be to do so by reference to the publicly quoted price of those securities on that exchange. In other cases, however, several approaches to valuation may all be commercially reasonable. It will depend, in each case, on the particular facts.
Fifth, in the context of the valuation required to be made on appropriation, there is no separate and independent requirement for the collateral taker to act in good faith, and no room for the implication of any of the equitable or other duties associated with the law of mortgage in English law. Recital 17 and Article 4 (6) of the FCD show that the limited “requirements under national law” there referred to are the only domestic law constraints permitted to the “rapid and non-formalistic enforcement procedures” provided for in Article 4. The statutory requirement in the case of a financial collateral arrangement is therefore simply that the valuation must be made “in accordance with the terms of the arrangement and in any event in a commercially reasonable manner” - no more, no less.’
Advantages for appropriation
The advantages for an appropriation remedy over a sales strategy are obvious for the lender. Selling the shares when the underlying financial distress is usually a value destructive proposition. The public distress of the company in question will often be of huge concern to employees, suppliers and counterparties. Often trading heads downhill during the process – keeping the show on the road during this difficult time is hard. Selling shares is complex, few will want to offer much without diligence and some assurance of future trading prospects. These dynamics often mean the lenders are the only bidders in leveraged finance structures anyway (perhaps working in tandem with the private equity house who might be prepared to put more money into the company but only if the lenders give concessions). The remedy of appropriation allows the lender to takeover, stabilise the situation and then sell when the times are more propitious. Selling the shares in a downturn often means selling them at the worst possible moment and the lender taking a big write off.
So why haven’t we seen more appropriations?
The remedy has been used sparingly since its inception in 2002. Lawyers are often reluctant to advise clients to attempt something which is new over the tried and tested. Lenders have been enforcing over property for hundreds of years and the common law (whether in England or in other Commonwealth countries) has provided excellent guidance on the dos and don’ts of an enforcement sales process. ABT-Auto-v-Aapico has now assisted lenders in understanding some of the key open questions – what is a ‘commercially reasonable manner’ and what happens if the lender gets it wrong. The judge on the latter question stated with admirable simplicity ‘the primary remedy for a valuation on appropriation that does not comply with Regulation 18(1) is for the Court, after the appropriation, to set aside that valuation, to substitute a compliant one, and to make any necessary consequential orders.’
Practical Issues with Appropriation
There are several practical issues which have warned off lenders using appropriation. Sending a notice of default with a notice that the lender is appropriating shares might be simple, but lenders (and particularly security agents) are often wary of taking ownership of a structure. Are there environmental or other reasons such as pensions liability which might cause liability to an agent? What are the tax and accounting issues – will a lender need to consolidate the newly owned entity into its group? Can the agent/lenders be sure that the company will continue to operate post the appropriation? Suddenly the stressed borrower’s issues become in a sense the lenders’ issue.
Conclusion
Whilst the practical issues will remain, I expect as we go further into an era of financial stress and where refinancing may not be possible, that appropriation will be used more frequently. ABT Auto v Aapico has clarifies certain aspects which were holding it back as a tool. Some debt funds are comfortable owning assets – such distressed debt funds often buy distressed loans in the secondary market for the purpose of ‘loan to own’. Expect to read more cases about appropriation in the coming years. The use of the remedy has been slow but like a stone rolling down the hill starting at a stately pace, the extensive use of appropriation will accelerate.
stephenphillips@freilibertas.com
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About the author:
Stephen Phillips founded FreiLibertas Law, a SRA regulated law firm in 2022. Stephen qualified as a solicitor in 1997 with Linklaters, in London, and spent five years in Singapore advising on project finance and corporate distressed mandates during the Asian Currency Crisis. Having moved back to London in the early 2000s he advised bondholders during the High Yield telecoms and energy market turbulence often using UK schemes of arrangement to implement a restructuring. During the Global Financial Crisis, he assisted funds, banks and corporates mainly in respect of their exposure to stressed leveraged finance / private equity structures. Stephen also advised on bank restructurings, and structured finance vehicles such as SIVs and CMBS. In the past few years, his focus has been energy-related matters, hospitality, construction and retail-related stress. He has also had a great deal of experience advising technology-related companies in prepacked administration sales. Stephen frequently advises investment funds, particularly in relation to special situations and creditor rights. More recently he has helped a number of founder directors who have faced personal claims arising from difficulties in the businesses they have founded.
Stephen was a partner at White & Case, for 8 years and more recently headed the European Restructuring team at Orrick, Herrington & Sutcliffe. He established Freilibertas Law in 2022. Stephen has been described by the Legal 500 as being “commercial” and as having “a deep understanding of cross-border matters”. He has won a number of industry awards for deals executed during his career and he writes for leading restructuring journals and newspapers.
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[1] Cukurova Finance International Ltd & Anor v. Alfa Telecom Turkey Ltd (British Virgin Islands) [2009] UKPC 19 (05 May 2009) (bailii.org)