Third party mortgage was a transaction at undervalue

In the recent case of Rothstar Group Ltd v Leow Quek Shiong [2022] SGCA 25, the Court of Appeal had to consider the question of whether the grant of security can be a transaction at undervalue.

Why it matters if a transaction is a transaction at undervalue

A transaction is considered to be a transaction at undervalue if the person who entered into the transaction receives consideration the value of which, in money or money’s worth, is significantly less than the value, in money or money’s worth, of the consideration he provided in entering into the transaction. In general, the law does not look into the adequacy of the consideration provided by parties to a transaction. It is only if, at the time of entering into the transaction, the person was insolvent or became insolvent as a result, that the undervalue becomes a problem. This is because the transaction then has the effect of reducing the assets available for distribution to creditors when insolvency proceedings are taken out.

Once that person enters bankruptcy, liquidation or judicial management, if the Official Receiver (in bankruptcy proceedings), the liquidator (in winding up proceedings) or the judicial manager (in judicial management proceedings) considers the transaction to have been a transaction at undervalue, he may apply to court to have the transaction declared as such. The court may then make such orders as it considers necessary to restore the position of the bankrupt or a company in liquidation or judicial management to what it would have been if the transaction had not been entered into. This can include setting aside the transaction or, as was the case in this case, discharging the mortgage even though the loan it secured had not been repaid in full.

A mortgage granted to secure a loan made to the mortgagor’s company

The facts in Rothstar Group Ltd v Leow Quek Shiong are, very briefly. As follows:

• In April 2019 Rothstar Group Ltd (Rothstar) gave a loan (the Loan) to Agritrade International (Pte) Ltd (Agritrade).
• Ng Say Pek (Ng) was a director and shareholder of Agritrade (together with this son).
• Ng was also a director and the sole shareholder of Pictorial Development Pte Ltd (Pictorial). Pictorial owned a residential property (the Property) together with Ng.
• As a condition of the loan, Agritarade was to procure a third party equitable mortgage over the Property. Two months after the loan agreement was entered into, an equitable mortgage was granted by Pictorial and Ng. When Agritrade failed to make payment of the Loan when due (in July 2019), the maturity date of Loan was extended to February 2020. In November 2019, Agritrade, Pictorial and Ng agreed to provide a legal mortgage over the Property in exchange for the release of the equitable one.

All three parties (Agritrade, Ng and Pictorial) were subsequently placed in insolvency proceedings. The private trustees in bankruptcy of Ng and the liquidator of Pictorial claimed the right to the Property mortgaged to Rothstar. The private trustees applied to court for an order to have mortgage set aside as a transaction at undervalue.

Rothstar sought to rely on the English case of Re MC Bacon Ltd (1990) to argue that security granted in respect of an existing loan can never be a transaction at an undervalue.

Grant of security over grantor’s own existing debt not a transaction at undervalue

In Re MC Bacon Ltd, the English High Court had ruled that where a grantor has given security to secure his own existing debt, that cannot be a transaction at undervalue. Rothstar argued that the same rule applied where a grantor has given security to secure the debt of a third party. One difficulty that arose for Rothstar in making this argument is that the English Court of Appeal in a later case, Hill v Spread Trustee Company, had opined that it could not be a rule that the grant of security in such a situation can never be a transaction at undervalue.

The Singapore Court of Appeal therefore had to consider whether Singapore law should follow Re MC Bacon Ltd, and if so, whether that rule could be extended to security for existing third party debt. It held that it would adopt the principle in Re MC Bacon Ltd as part of Singapore law.

The Court explained that it found that judgement of the English High Court in Re MC Bacon Ltd persuasive. The English court had relied on the following reasons for its decision:

• The grant of security for the grantor’s existing debt, does not deplete the assets given as security or diminish their value.
• The grantor retains the right to redeem and the right to sell or remortgage the charged assets.
• All the grantor loses is the ability to apply the proceeds otherwise than in satisfaction of the secured debt. That is not something capable of valuation in monetary terms and is not customarily disposed of for value.

To these, the Singapore Court of Appeal added the following observations:

• In a case of a grantor of security giving security over its own existing debt, the balance sheet of the company remains the same. All that happens is that the grant of security attaches an existing liability to an existing asset.
• While the grantee is better off, the grantor’s position has not changed. Prior to granting the charge, the asset could have been seized by execution (pursuant to enforcement of a judgment debt) and after granting the charge, the assets could be still seized, although now by a receiver (pursuant to enforcement of the charge).

Accordingly, the grant of security by a security giver to secure its own existing debt would not be a transaction at undervalue.

However, these reasons do not apply in where the existing debt secured was not the grantor’s own debt but that of a third party’s. Accordingly, the Court ruled that the scope of the principle in Re MC Bacon Ltd is limited to security granted for the grantor’s own existing debt. It does not extend to the grant of security for a third party’s existing debt and such a grant of security can, in principle, constitute a transaction at an undervalue.

Assessing a transaction to compare the value given and value received

In considering whether a transaction is a transaction at undervalue, the Court applied the following principles:

• What the law requires is that the value provided by the bankrupt/company in liquidation should be compared to the value received by the bankrupt/company in liquidation.
• In considering this, value is relevant only in so far as it accrues to the bankrupt/company in liquidation personally. The court therefore does not consider the value received by the beneficiary of the security nor that received by the third party debtor.
• The test of value is objective and not subjective. Accordingly, the bankrupt’s/company’s perception of value is not relevant. The focus is on whether there is diminution in the actual value of the bankrupt’s/company’s assets.
• The value of the consideration provided and the value of the consideration received by the bankrupt/company in liquidation must be assessed in money or money’s worth and must be quantifiable in monetary terms.

Applying these principles to the case before it, the Court found that the value provided by Ng was as follows (the same analysis applies to Pictorial’s situation):

• The grant of the mortgage over the residential property did deplete Ng’s assets because the existing debt secured by the mortgage was a debt owed by a third party, and was not a debt owed by Ng.
• Furthermore, under the terms of the mortgage, Ng had assumed a primary obligation to repay the loan to Agritrade.

The value received by Ng was only the loan that was given to Agritrade (the same analysis applies to Pictorial’s situation). While the court accepted that the value of commercial or practical benefits to Ng and Pictorial could be taken into account when determining whether the transaction was at an undervalue, in this instance the court described the benefit as an “unparticularised and unsubstantiated benefit which [was] said to accrue to Pictorial and Ng merely by dint of their association with Agritrade”. The court concluded that this “amorphous benefit” could not be valued in money or money’s worth.

Accordingly, the result of the comparison was clear: As Ng had received no value for the transaction while he had given significant value in the form of the grant of the mortgage, the transaction was one at an undervalue. All the other requirements for the Court to exercise its discretion being satisfied, the Court ordered the mortgage discharged. Rothstar were therefore left with no security.

Board resolutions of limited value for this purpose

One question that may arise is whether it will be sufficient for the board of a third party security provider (such as a parent company of a subsidiary borrower) to resolve that it is in the interests and benefit of that company to grant the security. Such resolutions are commonly issued to approve transactions and are relied on to evidence the existence of a corporate benefit. This may have limited value as a mitigant. The Court of Appeal said this, in relation to the grant of security by Pictorial:

“In this regard, no weight can be placed on the fact that Pictorial passed shareholders’ and board of directors’ resolutions in support of granting the Legal Mortgage, given that Pictorial’s sole shareholder was [Ng] and its only two directors were [Ng] and his wife. Contrary to what Rothstar contends, the close connections between [Ng], [Agrigrade] and Pictorial weigh against a finding that the Loan was of any real value to Pictorial or Ng. Moreover… Pictorial and NSP’s perception of the value they might receive from the transaction is irrelevant.” [emphasis added]

Therefore, while a statement in a resolution as to the benefit or value of the transaction to the company may be useful to address the legal requirement that a director acts in the company’s best interests (which is an easier test to satisfy as the courts are only concerned with whether the directors have acted honestly in what the directors think is in the company’s best interests), it should not be relied on in the context of establishing that the transaction is being entered into for full value in return.

Observations and key takeaways for creditors

The adoption of the rule in Re MC Bacon, that the grant of security by a security giver to secure his own existing debt will not be a transaction at undervalue, will be assuring to lenders. This rule is, however, confined to existing debt as it is only in that context that the company’s balance sheet remains unchanged. Where security is granted for new debt, the value of the security and the value of the new debt must still be compared.

However, what lenders will find concerning is the ruling that the grant of security to secure existing third party debt may be impugned as a transaction at undervalue. Indeed, there may be concerns that most third party security granted in similar circumstances could be at risk, as most will have been granted without any value, quantifiable in monetary terms, received in return.

1. Due diligence: the first line of defence

The reason why the mortgage was susceptible to challenge was that the security providers were insolvent at the time security was given. Had the security providers not been insolvent (or had they not become insolvent as a result of granting the security), the security could not be impugned as an undervalue transaction.

For creditors therefore the first line of defence will one of due diligence on the security provider, specifically to assess its solvency and financial position. This would include an assessment of the security provider’s debts and its ability to pay them as they fall due. The same consideration applies to third party guarantees.

Where a third party security provider or guarantor is potentially insolvent at the time it provides the security or guarantee, creditors should be mindful that the security or guarantee will be particularly susceptible to challenge if there is no clearly identifiable benefit to the security provider or guarantor.

2. Particularising the Benefit

Where possible, when taking third party security or a guarantee (and especially where the security provider or guarantor is potentially insolvent), the benefit to the security provider or guarantor should be particularised, i.e. it should be made clear, ideally in financial terms (i.e. money or money’s worth), what the benefit the security provider or guarantor will receive from the giving of the security. Ideally, the benefit should be quantified by the security provider or guarantor itself (rather than being something proposed by the lender or the lender’s counsels), and the identified benefit should also pass muster, objectively.  Such benefits may include that the proceeds will be on-lent to that third party security provider or guarantor or that that company will derive some direct benefit from the loan, for example, that the proceeds will be used to develop an asset in which it has ownership interests, or financial projections indiciating the potential upside for the security provider or guarantor if the loans borrowed are deployed into the borrower’s business. If the security or guarantee is “upstream”, i.e. granted by a subsidiary of the borrower, it will be even more important to particularise the benefit to the subsidiary of the giving of the guarantee or security, since the benefit to the parent may not necessarily flow down to the subsidiary.

On a related note, the Court will not avoid a transaction, even if it is at an undervalue, if: (a) the company entered into the transaction in good faith and for the purpose of carrying on its business¹; and (b) at the time the company entered into the transaction, there were reasonable grounds for believing that the transaction would benefit the company. In this case, the defence was unavailable because Pictorial was merely a holding company, and was not entering into the transaction in connection with its own business.

_{1 See section 224(4) of the Insolvency, Restructuring and Dissolution Act 2018}

3. Be careful in attributing the interest of a Sponsor

Related to the benefit point is an assessment of shareholding interests. This case shows that the interests of a sponsor’s family member will not necessarily be attributed to the interests of the sponsor. The Court of Appeal highlighted that Ng only owned between 40% and 50% of the shares of Agritrade (with the rest being held by his son) and therefore the transaction may have been of limited benefit to him personally. Pictorial, though owned by Ng, did not itself own shares in Agritrade.

It is fairly common in transactions involving an individual sponsor for the sponsor to provide collateral over assets he or she controls, as security for a loan extended to a company which the sponsor controls. Sometimes, the collateral provided also may be jointly owned, for instance with a family member.

It is apparent from this decision that the Court will not necessarily assume that the benefits received by a family member of the sponsor will be attributed to the sponsor (and vice versa) when making a determination on whether a transaction constitutes an undervalue. Further, where security or a guarantee is provided by a company controlled by the Sponsor (a Sponsor SPV), to secure a debt of another (unrelated) company controlled by the Sponsor, it should not be assumed that Sponsor SPV would derive any benefit from the transaction (i.e. the value that the Sponsor derives should not be automatically attributed to Sponsor SPV), and where Sponsor SPV is insolvent or becomes insolvent as a result of the transaction, it is likely that its security or guarantee could be voided on a winding up or judicial management.

4. Be careful when structuring security arrangements

One unique feature of this case is that there was an equitable mortgage over the Property given shortly after the Loan was originally made. This equitable mortgage was consequently terminated in consideration for Ng and Pictorial agreeing to provide a legal mortgage of the Property. Two observations here:

(a) it is prudent to have security (e.g. the equitable mortgage) put in place as a condition precedent to the disbursement of the loan (and not subsequent to disbursement). While having the security executed as a condition precedent may not have changed the outcome here, it may have allowed Rothstar to argue that there was some additional upfront benefit to Ng and Pictorial in creating the mortgage was that it would allow Agritrade to borrow the Loan.

(b) if a legal mortgage is not available as a day-one security, an equitable mortgage (ideally with a caveat lodged on the mortgaged property) with a further assurance clause, requiring a legal mortgage to be created upon the occurrence of certain events (e.g. an event of default under the loan) would be a more prudent way of creating security.