The last word in security

At the end of October last year the House of Lords gave judgment in Morris vs Agrichemicals Ltd, laying to rest the doubt over a bank's ability to take a charge over cash deposited with it by a borrower. The decision was applauded but lawyers were still uncertain as to the implications for loan documentation (see Financial Lawyer, Euromoney December 1997).

Now, however, the Financial Law Panel has sounded the all-clear in its bulletin entitled "Security over cash deposits - a valediction" (April 1998). What makes the bulletin a must-read for all banking lawyers is the intellectual power behind it. The four lawyers singled out for mention by the FLP as members of the working group represent the best legal banking brains in English law (apart from Lord Hoffmann, who gave the House of Lords judgment): Michael Crystal QC; Professor Roy Goode QC; Francis Neate, formerly of Slaughter & May and now at Schroders; and Philip Wood, Allen & Overy's capital markets king.

"As a result of the decision of the House of Lords in Morris," they say, "a legal debate, which has been conducted for over a decade, has been drawn to a conclusion. The final position is satisfactory, so far as participants in financial markets are concerned. Care will still be required when transactions which involve security over cash are documented, but there need be no legal doubts as to the ability of advisers to draft documentation which achieves the desired effect."

To recap, Morris arose out of the liquidation of Bank of Credit & Commerce International. BCCI had lent money to a large number of corporate customers secured by cash deposits placed with it by individuals connected with those companies. In each case, the security consisted of a letter in which the individual charged the deposit to the bank and accepted that the deposit would only be repaid after the loan to the company had been paid off. When BCCI went bust, depositors argued that they could set off the deposit against the loan so that the company would be liable to repay the difference only; otherwise the individual would lose his deposit and the company would still be liable to the liquidator for the entire loan.

The nature of BCCI's interest in these deposits became crucial to individuals' arguments. They said that the letters did not create charges in favour of BCCI, following the reasoning of Charge Card (1986) in which the court said that it was conceptually impossible for a bank to take a charge over money placed with it to secure a loan. A deposit is in the bank's books as a debt owed by it to the depositor: you cannot have a proprietary interest in a debt which you owe someone else.

Instead, the individuals argued that the letters created a contractual obligation to pay off the debt they secured. If so, the debt must be the same debt as that owed by the company (since BCCI had in each case only lent one sum of money). So, if the individual could set off his personal liability to BCCI against the debt which the bank owed him (as required by Rule 4.90 of the Insolvency Rules 1986 - provided the individual did owe money to the bank), it must have the effect of reducing, pound for pound, the debt owed by the company. Thus the commercial effect would be to set off the deposit with the bank against the debt from the company.

The Court of Appeal did not accept this argument. It agreed with Charge Card - that the letter did not create a charge - but not with their way round it (which depended on interpreting the letter as creating a personal obligation to pay off the company's debt). But the court said the letter was still effective as a security document because the rights which the letter conferred on the bank put it, simply as a matter of contract law, in as secure a position as if it had had a charge.

The House of Lords agreed with the Court of Appeal that the contractual rights gave BCCI good security but took the opportunity to question whether the Court of Appeal had been right to uphold Charge Card. That case established that it was not possible for a debtor to acquire a charge over a debt which it owes. The House of Lords disagreed.

While lawyers applauded this outcome they were uncertain about its effects on documentation. In particular, where the depositor is a company (not an individual as in Morris) should the letter of deposit be registered as a charge and, if it isn't, isn't there a risk that a court might recharacterize the letter as a charge, making it void for non-registration? This is significant where the company does not want to create a charge because, for example, of covenants in other financing arrangements.

The FLP notes these concerns, says care should be taken with the documentation, but in effect encourages confidence to be placed in the courts - having clarified the law so positively - not to allow confusion to return in the future. Section 395 of the Companies Act 1985 requires floating charges and charges over a company's book debts to be registered. Since the courts have traditionally been reluctant to define "book debts", the FLP agrees that charges over debts should be registered to cover any possibility that the amount concerned may later be held to be a book debt or, in the case of a charge over a fluctuating account, a floating charge. But it says that there may be many situations where registration can be argued to be unnecessary.

It points out the House of Lords' view that, in relation to deposits with a bank, an obligation to register is unlikely to arise. As to the risk of recharacterization, the FLP says this risk is slight: "The courts have shown great reluctance to categorize transactions differently from the way they have been described by the parties, except (in the case of charges) where the description is, in reality, at odds with the substance of the transaction or where some degree of fraud or deception was involved. However, parties should be careful to ensure that documentation does not give the impression that a charge is being created, when they intend to create only contractual rights and obligations."