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The Jersey Law Review - February 2004
SHORTER ARTICLES AND NOTES
SECURITY AGREEMENTS – THE NEED TO SPECIFY
Fraser Robertson
Introduction
1 As practitioners are aware various security mechanisms have been available for some considerable time in relation to certain types of property (e.g. the creation of hypothèques over immovable property, and the delivery in pledge of tangible movable property to a creditor). Until the commencement of the Security Interests (Jersey) Law 1983 (“the Law”), however, there were at the very least serious doubts and difficulties surrounding the use of intangible movable property as security. The Law remedied this and enabled a security interest to be taken over intangible movables (such as but not limited to shares). It is of note that the Law made provision for the use of intangible movable property as security by a method “distinct from hypothecation and pledge” and introduced a discrete closely defined new regime covering formation, form, enforcement and other matters.
2 The new rights created by the Law have greatly facilitated commercial business in Jersey and, as such, it is an important piece of legislation. Against that background it is perhaps surprising that there had not until recently been any significant judicial pronouncement as to the interpretation of certain of the formal requirements introduced and imposed by the Law.
3 In EM.TV & Merchandising AG v Bayerische Landesbank & others the point at issue between the parties was a narrow but commercially important one, namely whether the security agreement between the parties complied with article 3(1)(f) of the Law which provides that “For the purposes of this Law a security agreement shall - … specify the events which are to constitute events of the default”. Upon the issue as to the construction of the word “specify” turned the validity of the security agreement between the plaintiff and the defendant banks.
The facts
4 The facts of the case can be briefly summarised for present purposes. The plaintiff owned 100% of a Jersey company known as Speed Investments Limited (“Speed”) which ultimately owned the very valuable television rights in Formula One motor racing. A German company known as FEB purchased a majority of the shares in Speed with loans from the three defendant banks. By means of a security agreement between the plaintiff and one of the banks (as security trustee for the three banks) the plaintiff purported to create a security interest over its remaining shareholding in Speed to guarantee (on a limited recourse basis) all monies owed by FEB to the banks. The “events of default” (which would give rise to the statutory power of sale under article 8 of the Law) were defined in the security agreement by reference to : -
(a) events of default in the Financing Agreements (as defined) (in essence finance agreements between FEB’s parent group and the various banks); and
(b) breaches of obligations under the “Financing Documents” (as defined) which included an intercreditor agreement governing the relationship between the defendant banks themselves, and to which the plaintiff was not a party.
5 It was held by the Royal Court that “even at its simplest, it was necessary to refer to at least one external agreement in order to ascertain what an event of default was”.
Legal issues
6 One of the main submissions made by the plaintiff was that the word “specify” in article 3(1)(f) of the Law meant that the events of default had to be contained within the security agreement itself, and that it was not sufficient for the security agreement to refer to other documents in order that the events of default might be identified. Reliance was placed inter alia upon the Canadian case of Re Paddle River Construction Co Ltd. in which it was stated: “the words ‘specified contracts’ do not mean that the contracts are identifiable from some document recording the transaction. It seems to be that they must be unambiguously identified in the document itself”.
7 Further reliance was placed upon the legislative history of the Law and in particular the amendments introduced by the Security Interests (Amendment) Jersey Law 1985 (“the 1985 Law”).
8 Article 3 of the Law originally provided -
“(1) For the purposes of this Law a security agreement shall-
(a) be in writing;
(b) be signed by the debtor; and
(c) specify –
(i) the name of the debtor;
(ii) the name of the secured party;
(iii) particulars of the collateral sufficient to enable it to be identified;
(iv) particulars of any encumbrances affecting the collateral;
(v) the events which are to constitute events of default;
(vi) the nature, duration and amount of the obligation payment or performance of which is secured under the security agreement.
9 The effect of the 1985 Law was that article 3 now reads as follows -
“(1) For the purposes of this Law a security agreement shall -
(a) be in writing;
(b) be dated;
(c) identify and be signed by the debtor;
(d) identify the secured party;
(e) contain provisions regarding the collateral sufficient to enable it to be identified;
(f) specify the events which are to constitute the events of default; and
(g) contain provisions regarding the obligation payment or performance of which is to be secured sufficient to enable it to be identified.”
10 In essence the 1985 Law removed the need to “specify” a number of matters and substituted different concepts in relation to those matters. Thus security agreements no longer had to “specify” the collateral (i.e. the charged property) but merely had to “contain provisions regarding the collateral sufficient to enable it to be identified”. The only matter remaining required to be “specified” was events which were to constitute events of default. The plaintiff thus contended that to allow events of default to be ascertained by reference to other documents would be to give the same meaning to “specify” as to the phrase “contain provisions sufficient to enable it to be identified” which clearly could not be the case given the nature of the 1985 amendment.
11 In summary, one of the main legal contentions raised by the defendant was that it was permissible to incorporate documents by reference, and that the principle of incorporation by reference was sensible in the context of security agreements as part of complex financing arrangements in order to avoid unnecessary repetition and cumbersome documentation. Reliance was placed on Skips A/S Nordheim v Syrian Petroleum Co. Ltd. The Varenna- where Oliver LJ stated -
“The purpose of the referential incorporation is not – or at least is not generally - to incorporate the intentions of the parties to the contract whose clauses are incorporated but to incorporate the clauses themselves in order to avoid the necessity of writing them out verbatim. The meaning and effect of the incorporated clauses has to be determined as a matter of construction of the contract into which it is incorporated having regard to all the terms of that contract”.
12 The defendant also placed reliance on a couple of company convening notice cases which contained references to “specify” but these are not material for the purposes of this article, given the nature of the Royal Court’s judgment.
13 The Royal Court held that events of default were “specified” as required by the Law if they were definitely or explicitly identified in the security agreement taken together with any documents incorporated by reference, provided that there was no ambiguity. It added that to construe otherwise would unnecessarily increase the length and complexity of security agreements.
14 The decision may have been greeted with a collective sigh of relief by practitioners in the Island as it had been a growing practice in commercial security transactions for the events of default to be identified by means of reference to clauses in related documents and agreements. There is no reason to suppose that this practice has ceased following the decision in EM.TV.
15 There are, however, with respect to the Royal Court, grounds for concern as to whether the reasoning behind the decision in EM.TV will withstand detailed scrutiny if a similar matter were to arise in future. The Royal Court in essence confined its reasoning to the dictionary definition of the word “specify” and to what it perceived to be the practicalities of the situation, but it is arguable that its reasoning was flawed in various respects.
(a) “Specify” and the absence of ambiguity
16 The Court took the word “specify” to mean that events of default should be “definitely or explicitly set out”. The Court, however, then took that definition to mean or connote merely an absence of ambiguity; “the essence of the requirement is that there should be an absence of ambiguity”. The full Oxford English Dictionary definition of the word “specify” is to “name (something) definitely or explicitly; to set down or state categorically or particularly; to relate in detail”. On either the full definition of “specify” or the Court’s formulation it would appear to be strongly arguable that “specify” cannot simply mean an absence of ambiguity. Further it is clear from the judgment that in the Court’s view ambiguity would be fatal to the validity of a security agreement; “clearly the longer the paper trail, and the more convoluted the cross-referencing may be, the greater the scope for argument that ambiguities exist.” That line of reasoning raises various questions. For example, does it mean that any ambiguity means that a security agreement fails to “specify” events of default even if all that is required is a resolution of the ambiguity by the normal process of judicial contractual interpretation? It is observed that that would be a curious result which could strike down many security agreements quite unwarrantably. Further at what point does “the scope for argument that ambiguities exist” get so great that an agreement fails the test? The line of reasoning adopted by the Court unfortunately raises more questions than answers.
(b) Straitjackets
17 The Court expressly rejected the submission that “specify” required all the particulars of Events of Default to be contained within the security agreement itself and went on to state that - “such a construction would impose a straitjacket that is not required by the words of the statute”.
18 In using the word “straitjacket” the Court implicitly suggested an unjustified restriction of an otherwise useful activity. To put it another way, it is arguable that it mis-characterised a requirement to identify all the relevant events in the security agreement itself as being something which was unworkable, difficult or impossible to achieve or somehow fundamentally undesirable. This conclusion was supported by no more than the Court’s finding that inconvenience would be produced, although such a finding was unsupported by any evidence.
19 It is arguable that the Law requires a high degree of formality, and that any such formal requirements are invariably likely to be “inconvenient”. However, such inconvenience is a general feature of formal requirements, and the fact that a degree of inconvenience may be produced arguably does not justify a dilution of the requirements themselves. The question the Court had to resolve was whether the Law did require the plaintiff’s construction. That question could not be answered by analysing or indeed mis-characterising the effects of the requirement and then holding that that was not “required”.
(c) Flexibility in the Law
20 A further ground for the Court’s decision was that no express provision was made in the Law to the effect that particulars of events of default should be contained within the security agreement itself. The Court further identified that various other parts of the law permitted flexibility of expression in stating: - “…indeed in other parts of the 1983 Law (in article 3(2) for example) there is evidence that the legislature intended a measure of flexibility as to the manner in which parties could express their agreement”.
21 Article 3(2) of the Law provides as follows -
“Subject to paragraph (1), a security agreement may be in such form and contain or refer to such matters as shall be agreed between the parties to such agreement”.
22 The Court thus seems to have placed reliance on article 3(2) as demonstrating a level of flexibility against which “specify” was to be construed. That approach, however, would seem to have been misconceived, as the very wording of article 3(2) makes it clear that its provisions are “subject to paragraph (1)”. In other words to the extent that flexibility is permitted by the Law that flexibility is only permitted outside the realms strictly governed by article 3(1). It is to be observed that in placing reliance on article 3(2) in the final paragraph of its judgment the Court appeared to ignore the contrary view it expressed earlier in dealing with a similar submission made by the defendant in stating -
“Counsel for the defendant placed some reliance on article 3(2) of the 1983 Law…. Whilst this may be indicative of an intention on the part of the legislature to create some flexibility in the manner in which the parties can express their agreement, it does not assist to counter the argument of the plaintiff. Paragraph (2) is subject to paragraph (1). If therefore, paragraph (1) requires that all particulars of events of default should be contained within the security agreement, paragraph (2) does not avail”.
(d) Presumed intention of the legislature
23 The Court further appears to have factored into its reasoning the “presumed” intention of the legislature in stating - “To construe the statute in that way would not only run counter to the presumed intention of the legislature, but would also produce inconvenience…”
24 In appearing to place reliance upon the presumed intention of the legislature, the Court however did not identify what that presumed intention was. Indeed there was no evidence as to what the intention of the legislature was. The only inference as to what the intention of the legislature may have been is to be gleaned from the 1985 Law. It would appear strongly arguable that the retention of “specify” in relation solely to events of default was in order to impose a different and stricter requirement from those events in relation to which the word “specify” was substituted or indeed diluted. In other words the only inference that can be gleaned is that the legislature intended to create a difference between the requirements in relation to events of default and the requirements in relation to other matters. If the Royal Court’s decision is correct it would seem that the changes brought in by the 1985 amendment were pointless as “specify” would have the same effect as requirements “to contain provisions regarding (a matter) sufficient to enable it to be identified”.
25 The matter is arguably reinforced upon consideration of the report of the Finance and Economics Committee (upon which the 1985 Law was based), the opening paragraph of which reads as follows: - “The Security Interest (Amendment) (Jersey) Law has been drafted following a request by the Jersey Lawyers, Accountants and Bankers Joint Committee that consideration be given to amendment of a number of detailed points in the Security Interests (Jersey) Law 1983 in order to make absolutely certain that security agreements, which relate to a variety of complex and high value lending commitments, could not be set aside for obscure technical reasons”.
26 It may, of course, be possible (although perhaps unlikely) that the legislature simply overlooked the need to change the requirement to specify events of default. In the absence of any such evidence, however, the strong inference must be that the legislature deliberately intended to leave a stronger word in place in relation to events of default.
(e) Incorporation by reference
27 Finally the Royal Court concluded that provided that Events of Default could be definitely or explicitly identified in the security agreement and in any documents incorporated by reference the requirements of the law would be satisfied. The issue of incorporation by reference arguably, however, deals with a different contractual aspect to the issue in EM.TV. The authorities on this principle (e.g. Skips A/S Nordheim) in general involve a consideration as to what the parties have agreed and made part of their contract and consequently how the contract in question is to be construed. The issue in EM.TV was the nature of the requirements of article 3(1)(f) of the Law, in other words the formal requirements of the contractual document itself. The construction of the terms of a bargain is one matter, (and indeed where one is permitted to have incorporation by reference it does indeed save setting out verbatim what appears in other documents), but whether an agreement complies with formalities is an entirely separate matter. One of the essential points of issue in EM.TV was whether the equivalent of incorporation by reference was as a matter of law excluded by the use of the word “specify” in the Law. The Court appears to have factored in the option of identifying matters (events of default) in any documents incorporated by reference on the basis that the legislature did not expressly proscribe incorporation by reference of particulars of the events of default, and that to refuse such incorporation by reference would produce inconvenience in that security agreements would become longer and more complex. The Court, however, does not appear fully to have analysed whether on a true construction the use of the word “specify” excluded the principle of incorporation by reference.
Conclusion
28 The issue in EM.TV concerned highly technical arguments on a very narrow point of statutory construction, and the Royal Court’s judgment produced what to many will be accepted as a sensible, practical resolution of the potential problem. Upon the basis of the judgment the majority of practitioners will, in all likelihood, continue to prepare security documentation by reference to other related documents and agreements which is undoubtedly a convenient manner in which to deal with matters, particularly in complex transactions. For the reasons set out in this short article there may, however, yet be a degree of uncertainty as to the exact nature of the formal requirements of the Law, and it would perhaps be prudent for practitioners to bear this potential uncertainty in mind in preparing security documentation in the future.
Fraser Robertson is an advocate of the Royal Court of Jersey and a partner in Bailhache Labesse, 14-16 Hill Street, St Helier, Jersey JE1 1BD. He appeared to the plaintiff in the case under review.