Sidestepping the adverse effects of formal insolvency processes by taking back what is yours

The importance of a security interest is highlighted when a company is unable to pay its debts. A security interest primarily secures the debtor’s payment obligation and insulates a secured creditor from insolvency. Hence, so long as a company is able to pay its debts as they fall due, a secured creditor has no significant advantage over its unsecured counterpart.

In formal insolvency proceedings, assets of a debtor must be available for its general body of creditors. Assets which the debtor has proprietary interest in prior to insolvency cannot be arbitrarily removed from the insolvent debtor’s estate. On the other hand, insolvency law respects security interests of third parties. Holders of security interests such as charges, mortgages, pledges and liens are often not impeded from enforcing their claims against the insolvent’s assets.

A creditor can enhance his protection by simply retaining his proprietary interest in an asset pending when the debtor performs his contractual obligation. Transactions involving retention of ownership do not create security interests but constitute a genre of quasi-security arrangements. The primary distinction between these quasi-security transactions and security interests is that security interests can only be granted in the assets of the security provider i.e. the debtor. In contrast,a creditor in these quasi-security transactions retains ownership of assets. No security interest can be created bya unilateral retention of ownership.

Hire-purchase agreements
In ahire purchase(HP) agreement, goods are hired in return for payment of installments by the person to whom they are hired (the hirer) with an option to purchase at the end of the bailment.The owner retains proprietary interestin the goods and only passes it to the hirer if the hirer exercises the option to purchase:Incar (Nig) Plc v Uralo Gen Ent Ltd (1998) 13 NWLR (Pt 582) 346 at 362B-D, F-G.In a HP agreement governed by common law, the owner may insulate itself from the hirer’s insolvency by inserting a clause for the termination of the agreement at the hirer’s insolvency. The termination and asset forfeiture do notviolate insolvency law given that the owner retained ownership of the asset pendingwhen (i) the hirer completes the installment payments, and (ii) exercises the option to purchase. Hence there is no removal of assets which ought to be available to the insolvent hirer’s general body of creditors.

Whereas the foregoing analysis is premised on the ground that the hirer’s interest in the hired asset is possessory, there isa school of thought which contends that the hirer’s installment payments andoption to purchase confer a (limited) proprietary interest in the goods on the hirer as opposed to a mere possessory right:Denning L.J. in Wickham Holdings Ltd v Brooke House Motors Ltd[1967] 1 W.L.R. 295 at 300 and Knox J inTransag Haulage Ltd v. Leyland DAFFinance Plc[1994] B.C.C. 356 at 365.The veracity or otherwise of this proposition is outside the scope of this piece. However, assuming this proposition is correct, a termination/forfeitureat insolvency will deprive the insolvent hirer of a valuable asset in breach of insolvency law. The foregoing analysis is restricted to HP agreements under common law. Different considerations will apply to transactions under the Hire Purchase Act 1965where sections 9 and 10 place restrictions on recovery of goods by owners.

Retention of title clauses
Where there is a credit sale with a part or the whole purchase price outstanding, a creditor may use a retention of title (ROT) clause in the contract to retain ownership of the asset pending when the debtor/buyer completes the performance of his contractual obligation. Where properly drafted and utilized, ROT clauses can insulate the creditor’s asset from insolvency notwithstanding that the insolvent buyer is in possession of the asset. At the buyer’s insolvency, the asset will not fall into the insolvent buyer’s estate. Section 19(1) of the Sale of Goods Act 1893 provides a doctrinal basis for ROT clauses.

ROT clauses do not create security interests, rather there is a mere unilateral retention of ownership. A simple ROT clause may not offerfoolproof protection. For instance, if a buyer sells the goods to a bonafide purchaser for value without notice,the clause will be worthless: s. 25(1) SOGA. To maximize the efficacy of ROT clauses,complex ROT clauses have evolved.Some of these clausesattempt to extend the sellers’ proprietary rights beyond the original goods to by-products, proceeds etc. These complex ROT clauses are often at risk of being re-characterised as security interests and consequently being void for non-registration. For instance a court may recharacterise an ROT clause which extends to by-products or proceeds as a charge on the ground that since the seller’s interest in the by-products/proceeds is defeasible by payment of the purchase price, the interest created is security as opposed to a retention of ownership.

Chattel Lease agreements
Chattel leases may be categorised into operating or finance leases. An operating lease is an agreement of hire of a machinery or plant, where the lessee rents the equipment for a time period that is less than the equipment’s useful life, and makes payments the total of which is less than the purchase price of the equipment. In contrast, in a finance leasethe period of rentalis designed to enable the lessor to recover the cost of purchasing the equipment as well as other financing costs, while also earning returns on the investment in the lease. The period of a finance lease is usually the equivalent of the estimated useful life of the equipment and all financial risks and rewards associated with ownership are transferred to the lessee.

Given that lessors in finance and operating leases retainownership of their assets, insolvency-termination/asset forfeiture clauses in these transactionsare valid and enforceable.

This may be harsh on a lessee in a finance leaseconsidering thatin practice (i) at the time the agreement is entered into, there is often a reasonable expectation that the chattel will not be returned to the lessor, (ii)the lessee amortises the full value of the chattel over the term of the lease by rental payments, (iii)the lessee bears the risks and enjoys the rewards associated with ownership, and (iv) the lease is expected to run throughout the life period of the chattel. To mitigate this harshness, a liquidator may consider seeking equitable relief from forfeiture.

Conditional sale agreements
A conditional sale agreement is a contract for the sale of an item where the buyer takes possession of the item but the seller retains title(and right to repossess)pending when the seller fulfills conditions specified in the agreement: Afrotec Tech Services (Nigeria) Ltd v MIA & Sons Ltd (2000) 15 NWLR (Pt 692) 730 at 785C-D, 785G. A termination/forfeiture clause in a conditional sale agreement entitling the seller to repossess the goods if the buyer becomes cash flow insolventis valid and enforceable. Given that the seller has retained ownership, the insolvent buyer’s general body of creditors will not be deprived of any asset which ought to be available to them.

In cases where there has been substantial payment, the above position may be harsh on the insolvent buyer whilst granting the seller a windfall. A liquidator may mitigate this hardship by an action for the recovery ofpaid installments on the ground of total failure of consideration: Dies v British and Int’l Mining [1939] 1 KB 724, 743. This will be based on the ground that the item which was the primary aim of the contract is no more available. A recovery action may be futile where the agreement stipulates forforfeiture without a right of recovery.

Conclusion
A creditor may enhance itsprotection against insolvency by retaining ownership of its assetspending whenadebtor performsits contractual obligations. Thesetypes of quasi-security arrangementshave the same functional effect as security interests. However, thesequasi-security transactions must be meticulously drafted/documented to avoid being recharacterised as security interests. If recharacterised, they may be void for non-registration under applicable laws.

Dr Udofia is an insolvency law expert and the head of corporate and commercial law practice Group at Fidelis Oditah & Co.Lagos.