Grant of Security May Be Avoided as a Transaction at an Undervalue?

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The recent case of Encus International Pte Ltd v Tenacious Investment Pte Ltd & Ors [2016] SGHC 50 (Singapore, High Court, 31 March 2016) has implications for lenders which are especially pertinent in the face of the current difficult economic environment. In that case, the Singapore High Court observed that it may be possible for the grant of security to amount to a transaction at an undervalue under section 98 of the Bankruptcy Act. If accepted as the position in Singapore, it would increase the risk for lenders where they take security (whether fresh or additional) subsequent to the grant of a loan in order to strengthen their position when concerns arise about the future insolvency of the borrower.
 
Facts of the case
 
In this case, the parent company, Encus International Pte Ltd (Encus), of DKE Precision Pte Ltd (DKE) transferred shares it held in DKE to an investor, Tenacious Investment Pte Ltd (Tenacious). This transfer was the final iteration of a series of different transactions whereby Encus sought to obtain financing from a group of investors, which included Tenacious:

  • The first in the series was a Term Sheet whereby the investors agreed to lend SGD8.8 million to Encus, and Encus would provide security for the loan. The Court noted that the security “would be surrendered if [Encus] failed to meet certain profitability targets”.
  • This was later negotiated into a Convertible Loan Agreement pursuant to which the investors agreed that the loan of SGD8.8m was convertible into shares in Encus subject to a whitewash procedure being carried out (the whitewash procedure was duly completed). In addition, Encus would grant Tenacious a charge over its shares in DKE. The grant of the charge was superceded by events.
  • The final iteration that parties eventually completed was a Conditional Share Transfer Agreement. This provided for expanded grounds on which the right to have the DKE shares transferred would be triggered, including the insolvency of Encus.
  • On 26 January 2012, the Conditional Share Transfer Agreement was executed and, on the same day, the loan was converted into shares in Encus.
  • On 3 February 2013, following the insolvency of Encus, its DKE shares were transferred to Tenacious. 

Transactions at an undervalue
 
The liquidator of Encus sought, among other things, to have the share transfer declared void as a transaction at an undervalue pursuant to section 329 of the Companies Act read with section 98 of the Bankruptcy Act. Under section 98, a person enters into a transaction with another person at an undervalue if, among other things, he enters into a transaction with that person on terms that provide for him to receive no consideration; or he enters into a transaction with that person for a 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 provided by the individual.
 
Viewed as a single isolated transaction, the transfer of the DKE shares to Tenacious unarguably lacked consideration, leaving it open to the argument that section 98 was engaged. To deal with this, Tenacious argued that the transfer had been made pursuant to the grant of DKE shares as security for the SGD8.8m loan. As collateral, the transfer would not be a transaction at an undervalue provided that it was accepted that the law was that the provision of collateral could never amount to a transaction at an undervalue.
 
Whether the grant of security can never amount to a transaction at an undervalue
 
The Singapore High Court held that the facts did not bear out the argument that the DKE shares were collateral and accordingly it did not have to decide the legal question. However, the Court did comment on the issue and its views in that regard are of interest to banks and lenders.
 
The principle that the provision of collateral could never amount to a transaction at an undervalue was first established in the English High Court case of Re MC Bacon Ltd (1990). In that case, a company (Company) had an unsecured overdraft facility with its bank (Bank).  When the Company became insolvent, the Bank had to decide whether to continue lending to the Company. It agreed to do so believing that the Company could trade its way out of its financial difficulties, but required that the Company provide it with security for any further loans. It was therefore granted a first mortgage over the Company’s fixed and floating assets. Several months later, the Company went into liquidation. The liquidator applied to the English High Court to have the Bank’s security set aside as a transaction at an undervalue.
 
The English High Court held that the grant of security could never amount to a transaction at an undervalue. The Court noted that the test of whether a transaction was one at an undervalue was whether the value of the consideration received by the company in money or money's worth was significantly less than that given. However, the mere creation of a security over the company's assets did not deplete them or diminish their value and the company retained the right to redeem, sell or remortgage the charged assets.
 
The correctness of Re MC Bacon Ltd was doubted by Arden LJ in the English Court of Appeal’s decision in Hill v Spread Trustee Co Ltd (2006). In that case, charges over land and other assets were made by the chargor in return for loans. It was found on the facts that these charges had been granted specifically to put the land and other assets out of the hands of the Inland Revenue (to whom the chargor was assessed to owe GBP437,147 in taxes), and that no real pressure had ever been put by the lender on the chargor for repayment of the loans. In response to the argument that Re MC Bacon Ltd established the principle that the grant of a security could never be a transaction at an undervalue, Arden LJ stated that that there was no reason why the value of the right to have recourse to security and to take priority over other creditors, which the debtor creates upon granting the security, should be left out of account when assessing whether a chargor has given any consideration (when granting security) for the purposes of the provisions on transactions at an undervalue. She further said that the form of security in issue in that case were charges by way of legal mortgage and it was possible to maintain that such conveyances amounted to a depletion of the chargor’s assets.
 
In the Singapore High Court, Prakash J stated that, speaking for herself, she preferred the approach in Hill v Spread Trustee Co Ltd as, “while no doubt rare, it is possible that a situation will arise in which security is given without fresh consideration”. While the position remains unsettled in Singapore, therefore, this observation by Prakash J raises concerns that a bank that takes security for an earlier unsecured loan facility may find itself remaining unsecured should the grant of security be avoided as a transaction at an undervalue. Banks should therefore try to structure the transaction to minimise the risk of this occurring.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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