Secured creditor has no absolute duty to preserve or maintain security for benefit of surety

The claimant creditor (the Creditor) had made loans (the Loans) to Qucomhaps (the Debtor) to finance the purchase of the assets of a Czech aircraft manufacturing company. Although the original advances were not documented in any binding loan agreement, agreements were later signed under English law to document the loan and provide a guarantee by Mr Harkin (the Guarantor).  As part of the security arrangements, a wholly-owned subsidiary of the Debtor, Morovan, provided third party security (the Security) by way of a charge over its assets. Moravan subsequently went into administration in the Czech Republic. The Creditor declined to file a secured creditor’s claim in the Czech administration and the Security was lost to other, allegedly fraudulent, purported creditors of Moravan.

 

The Creditor brought proceedings to recover the sums due under the Loans against the Debtor and the Guarantor (together, the defendants).  The defendants argued that, as the Creditor had failed to take steps necessary to protect the Security, neither party was liable. That defence was struck out and the Creditor obtained summary judgment. This was upheld on appeal to the High Court when it refused to imply terms in the loan and guarantee agreements to the effect that the Creditor was under a duty to take the required steps in the Czech proceedings to preserve its rights in respect of the Security. The defendants obtained permission for a second appeal to the Court of Appeal on the ground that the case raised an important point of principle concerning the extent of a secured creditor’s equitable duty to a guarantor – which had been dealt with only briefly by the High Court. The Court of Appeal considered only the question of whether the Creditor had breached its equitable duties to both the debtor and guarantor by failing to take reasonable steps to protect the Security.

 

 

The court rejected the defendants’ argument that a creditor has a broad equitable duty to the guarantor to take “reasonable steps to protect” its security. The court considered the scope of a secured creditor’s duty to a guarantor.

 

 

The court considered that it was clear law that where a secured creditor also has the benefit of a guarantee, it has an equitable obligation to perfect the security and thereafter not to release or surrender it. If the creditor neglects these duties it will lose the benefit of the guarantee (to the extent that it could have been satisfied by the security).

 

Counsel for the Creditor submitted that a lender has no other duty to take positive steps to preserve the security unless expressly agreed with the guarantor or debtor (although, of course, where a creditor chooses to enforce security (such as exercising a power of sale) it also has a duty to take reasonable steps to obtain a proper sale price).  However, the court was doubtful that this was as far as the duties on a creditor go – unless perhaps the notion of “perfecting” the security was treated flexibly. Newey LJ considered for example that, if to maintain the validity of the security the creditor was required not only to register it but also to pay a “modest” annual fee,  then there would be a “strong case” for saying that the creditor would have a duty to pay that fee.

 

 

On the other hand, the court was keen to stress that any duty to “preserve or maintain” security is not an onerous one. A creditor has no “absolute” duty to ensure a guarantor has recourse to the security.  A creditor is not obliged to “incur any sizeable expenditure or run any significant risk” to preserve or maintain a security.  There is no duty to preserve or maintain the security “at the peril of the creditor”.

 

One of the reasons given by the Creditor as to why it did not claim in the Czech insolvency proceedings was that it understood that the Security might be unenforceable in the Czech courts and that, had its claim failed, it could have been ordered to pay compensation equal to the amount of the claim. The court agreed that the Creditor was not under any obligation to expose itself to such a risk.

 

The court was receptive to the Creditor’s arguments that recognising a wider duty to protect security would be commercially impractical as it would:

− introduce undesirable uncertainty;
− be detrimental to the ability of a lender to carry on business; and
− be anomalous in circumstances where the law does not require a creditor to do anything to prevent the security losing its value (as opposed to preserving its availability to the creditor or guarantor).

 

Ultimately any hardship to a guarantor is resolved by the guarantor’s right to pay off the loan and take control of the security itself.

 

 

The court was rather more robust in relation to any duty to a debtor.  It was doubtful that a creditor could ever owe any equitable duty to a debtor to take steps to preserve or maintain a security granted by a third party. This would not make sense in circumstances where that security was never something to which the debtor would have recourse

 

 

This aspect of the High Court’s decision was not appealed.  By way of reminder, Sir David Eady (sitting as a Judge of the High Court) stated that the court will be reluctant to imply a duty that a creditor must take the necessary steps to preserve its security rights into a contract where no duty exists in law or in equity.  The defendants argued that it was appropriate to imply such a term in this instance as the Creditor would have known that the defendants could only repay the Loans using the Security. The court disagreed as the ability to repay a loan usually depends on a range of factors. In any case it did not necessarily follow that even if the Creditor had known this it would have given rise to the contended duty.

 

The High Court concluded that there was no chance of implying the terms proposed as they were not necessary to give business efficacy and, far from being the “obvious” intention of the parties, the situation was one which almost certainly would not have crossed the parties’ minds. There was no realistic prospect, therefore, that the Creditor was under a duty to take a particular step in foreign court proceedings merely because it would or may have preserved the Security.

 

 

The result of this litigation is unsurprising but will provide comfort to lenders that they do not owe duties to debtors and guarantors, absent express agreement, to take onerous steps to enforce or protect their security. This is consistent with the principle established by the Privy Council in China & South Sea Bank v Tan Soon Gin that a creditor is not obliged to exercise its powers in relation to its security in any particular way.

 

However, the suggestion that a creditor’s duties may go beyond merely “perfecting” and extend to “preserving or maintaining” the security, albeit on a qualified basis, does introduce some uncertainty. When would a step become too “significant” a risk or too “sizeable” an expenditure such that the creditor cannot be expected to take it?   In market standard documentation there are important clauses which guard against such uncertainty.   Parties typically agree that:

− any failure by a creditor to exercise a right or remedy under a loan document does not act as a waiver of that right;
− guarantors or providers of third party security explicitly waive any defence arising from the failure of a creditor to perfect or enforce security over any secured assets; and
− debtors waive any right, subject to certain exceptions, that they have to require that the security be enforced in any particular order or manner or at any particular time.

 

This is a sensible position that leaves it up to a creditor’s commercial judgement as to how to deal with its security.

 

 

This case summary is part of the Allen & Overy Litigation and Dispute Resolution Review, a monthly publication.  If you wish to receive this publication, please contact Amy Edwards, amy.edwards@allenovery.com.