Understanding Flawed Assets in Banking

Introduction

A flawed asset is a contractual obligation that must be performed only when a contingency arises. There is a correlative right, which forms the asset in the hands of the obligee. It is an agreement between a bank and the customer where the money deposited by the customer with the bank, which is the asset, cannot be repaid until certain contingency or events have occurred.

Flawed asset is subject to two forms of attack. Firstly, flawed asset is a security interest and should be subject to limitation regarding its creating and enforcement. This criticism is mostly relevant to the use of flawed assets by the bank against the failure of the depositor or a party to the contracts to repay the loan. Because of this characteristic, it has been argued that flawed assets should be characterised as a security interest. The second criticism is that a flaw asset arrangement contradicts the anti-deprivation principles. This is particularly relevant to the ISDA Master agreement.

This essay will discuss the nature of the flawed assets arrangement. It will critically examine the efficacy of such arrangement from the perspective of anti-deprivation principles.

Nature and Efficacy

The contingency in a flawed assets arrangement is the occurrence of an event, which is usually the repayment of debt by the customer to the bank. A flawed asset arrangement will require the parties agree that the deposit is "flawed" where it would be repayable when the customer fulfills the condition. This asset is less valuable to the obligee than it would have

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1. Louise Gullifer, ‘Flawed Assets Clauses’ in Graham Virgo and Sarah Worthington (eds.), Commercial Remedies: Resolving Controversies (Cambridge University Press 2017) 414-415.
2. Chima Williams Iheme, Towards Reforming the Legal Framework for Secured Transaction in Nigeria: Perspective from the United Stated and Canada (Springer 2016) 115.
3. Louise Gullifer, ‘Flawed Assets Clauses’ in Graham Virgo and Sarah Worthington (eds.), Commercial Remedies: Resolving Controversies (Cambridge University Press 2017) 414-415.
4. Ibid.
5. Ibid.
6. Ibid.
7. Chima Williams Iheme, Towards Reforming the Legal Framework for Secured Transaction in Nigeria: Perspective from the United Stated and Canada (Springer 2016) 115.

Critically analyse (advantage disadvantage) the statement

Flawed asset arrangement: the Flawless Security…discuss the nature of the flawed assets and address the efficacy of flawed assets arrangements within the context of the anti-deprivation principles

been without the flaw. The flaw is thus beneficial to the obligor, where it intends to protect the obligor from the failure of the oblige from performing the obligation.

It is argued that flawed assets should be a part the discussion of commercial remedies. There are also other ways of enforcing the same protection as flawed assets within the scope of contractual remedies. For instance, contractual obligation, such as payment obligation, arises in case of a contingency that arises. However, flawed asset arrangements seem to confer better protection to the bank although they may perform the same commercial function such as charges over cash deposits. The case of Re Bank of Credit and Commerce International SA concerns the bank taking as security through a contract against the loans made to customers in the form of a charge over the money in the customers’ account with the bank. Lord Hoffmann held the charges valid. He stated that the charges are not ‘conceptually impossible’. He ruled that it is the proprietary right of the bank to claim payment of a deposit and hence, such a charge could be granted over deposit in favour of the bank.

The applicability of the anti-deprivation principle is based on the interest of public policy, especially concerning the liquidation of the depositor. This argument is based on pari passu principle, which provides for equitable distribution of a company’s estate among the creditors to ensure that one creditor does not receive more than its fair share. This principle is applicable if the arrangement is a bonafide arrangement where the parties have no intention of evading the insolvency law provision. The anti-deprivation rule is different from pari passu as it secures the size of the share so as not to reduce it by withdrawing of the asset from the company favouring a party that is not a creditor.

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8. Louise Gullifer, ‘Flawed Assets Clauses’ in Graham Virgo and Sarah Worthington, Commercial Remedies: Resolving Controversies (Cambridge University Press) 414-415.
9. Ibid.
10. Louise Gullifer, ‘Flawed Assets Clauses’ in Graham Virgo and Sarah Worthington (eds.), Commercial Remedies: Resolving Controversies (Cambridge University Press 2017) 278.
11. Re Bank of Credit and Commerce International SA (No 8) [1998] AC 214.
12. Ibid, 225.
13. Geoffrey Yeowart, Robin Parsons, Edward Murray and Hamish Patrick, Yeowart and Parsons on the Law of Financial Collateral (Edward Elgar Publishing Limited 2016) 625.
14. Ibid, 237.
15. Royston Miles Goode, Principles of Corporate Insolvency Law (Sweet & Maxwell 2011) 99.
16. Ibid.

Critically analyse (advantage disadvantage) the statement

Flawed asset arrangement: the Flawless Security…discuss the nature of the flawed assets and address the efficacy of flawed assets arrangements within the context of the anti-deprivation principles

The anti-deprivation principle under the English law makes any agreement that takes away assets belonging to the company until its insolvency invalid as a matter of public policy. However, the agreement will not be invalid where the debtor has a limited interest in the asset in question and such interest comes to an end on the company’s insolvency. This latter situation does not make a flawed assets arrangement contradict the anti-deprivation. principle. Thus, if the depositor becomes insolvent, the asset will form part of the insolvent assets. However, the asset will remain a flawed asset subject to the contractual arrangement as before.

The Supreme Court in the case of Belmont Park Investments Pty Ltd. V BNY Corporate Trustee Services Ltd and Lehman Brothers Special Financing Inc validated the “insolvency-triggered secured priority flip clauses” and its ruling suggested reduction of the anti-deprivation principles. Until this decision, the UK followed the single integrated principle as in the case of Ex p Jay, re Harrison that held that “there cannot be a valid contract that a man’s property shall remain his until his bankruptcy, and on the happening of that event shall go over to someone else, and be taken away from his creditors”.

Brigg J recognised that in certain cases, the ‘ab-initio creation of a flawed asset is caught by the rule of anti-deprivation and in others it is not. Briggs J stated that the question was to determine why the flaw asset triggered the flawed asset rule in some cases and did not in others. In this context, Briggs J held that the differentiation could be made by determining whether the asset was chosen in an action of the company that represented a quid pro quo for something already done or still to be done by the lender. If it is the former, where the contract was executed in nature, the court may find it reluctant to permit the flawed-asset. In the latter care where the contract was executory in nature, the court would readily allow the

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17. Oshisanya, 'lai Oshitokunbo, An Almanac of Contemporary and Comparative Judicial Restatements (ACCJR Supp. i Private Law): ACCJR Supplement I (Almanac Foundation 2020) 261.
18. Ibid.
19. Geoffrey Yeowart, Robin Parsons, Edward Murray and Hamish Patrick, Yeowart and Parsons on the Law of Financial Collateral (Edward Elgar Publishing Limited 2016) 623.
20. Belmont Park Investments Pty Ltd. V BNY Corporate Trustee Services Ltd and Lehman Brothers Special Financing Inc [2011] UKSC 38.
21. Sarah Worthington, ‘Good Faith, Flawed Assets and the Emasculation of the UK Anti-Deprivation Rule’ (2012) 75(1) The Modern Law Review 112-121.
22. Ex p Jay (1880) 4 Ch D 19, 26.
23. Ibid.
24. Lomas v JFB Firth Rixxon Inc. [2010] EWHC (Ch.), 108.
25. Ibid.

Critically analyse (advantage disadvantage) the statement

Flawed asset arrangement: the Flawless Security…discuss the nature of the flawed assets and address the efficacy of flawed assets arrangements within the context of the anti-deprivation principles

flaw ab-initio. The anti-deprivation rule concerns only with attempts to evade the application of insolvency laws. Thus, if there is no such attempt to contradict the insolvency law in case of termination of or adjustment in an existing relationship on bankruptcy, the anti-deprivation cannot be applicable.

The anti-deprivation principle is infringed mainly in two cases. Firstly, it is infringed in case of contracting out of pari passu distribution. This is supported by the case ruling British Eagle International Limited v Compagnie Nationale Air France (1975), the House of Lords ruled that where the distribution of assets results to certain creditors receiving more than their share of the assets, then such distribution contravenes the pari passu principle. Secondly, the anti-deprivation principle is infringed when the arrangement removes assets from the estate no or minimal consideration. This was seen in the case of Ex p Jay, re Harrison.

Irrespective of the established anti-deprivation principle, the English law also emphasis on party autonomy, as seen in Briggs J ruling above. This is particularly appropriate regarding complex financial instruments. Lord Collins supported this view when he stated that courts give effect to the contractual terms that parties have agreed. Thus, the anti-deprivation rule is given a commonsense application where it is not applied to bonafide commercial transaction. This is found in contracts where parties’ rights and obligations accrue over time and consideration is provided incrementally do not infringe the principle.

Problem arises when there is a difficulty in determining which contractual provision is bonafide reason such as protection the bank from the adverse effect of insolvency or malafide reason such as attempt to gain from the insolvency. Instead of differentiating between the two, the judicial test is that of valid commercially justifiable provisions. This test may face difficulty in application. This was seen in the case of Perpetual Trustee Co. Ltd and Another v BNY Trustee Services Ltd, where Lord Neuberger MR pointed out the difficulty in

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26. Ibid.
27. Peter Niven, ‘The Anti-deprivation Rule and the Pari Passu Rule in Insolvency’ (1877) 25 Insolvency Law Journal 5-28.
28. Brenda Hannigan, Company Law (Oxford University Press 2015) 701.
29. Ex p Jay (1880) 4 Ch D 19, 26.
30. elmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd, [2012] 1 All ER 505, 103-104; see also Brenda Hannigan, Company Law (Oxford University Press 2015) 701
31. Graham Virgo and Sarah Worthington, Commercial Remedies: Resolving Controversies (Cambridge University Press2017) 432.
32. Ibid.
33. Perpetual Trustee Co. Ltd and Another v BNY Trustee Services Ltd [2009] EWCA Civ 1160, [2010] Ch 347, 32.

Critically analyse (advantage disadvantage) the statement

Flawed asset arrangement: the Flawless Security…discuss the nature of the flawed assets and address the efficacy of flawed assets arrangements within the context of the anti-deprivation principles

identifying the precise nature or limits of anti-deprivation rule. Thus, in Money Markets International Stockbrokers Ltd v London Stock Exchange Ltd, he emphasised on a commercially sensible transaction entered into in good faith although he did not accept that the absence of good faith was a necessary element. Thus, Neuberger J suggested that if a deprivation provision is entered with the intent to depriving the r creditors of their rights in case of an insolvency, that provision is not valid.



The flawed asset arrangement may usually be coupled with other right of set-off and combination of accounts. A bank can create an advantage called the “triple-cocktail”. They will take a security in the form of a charger over their own indebtedness. They use their right to combine accounts to produce a single consolidated account where the sum they owe to the account holder is offset against those owed by the account holder to the bank. Then, they use a flawed-asset clause to convert their indebtedness to the other party into a conditional debt. In such case, the account holder must have firstly paid the money it owes to the bank under a loan agreement.

The efficacy of the flawed-asset arrangement is supported by the case ruling in Re Bank of Credit and Commerce International SA as mentioned earlier, which stated that the effect of such an arrangement is that the security will be just as good as that created by a proprietary interest in most of the cases. This charge is different from a charge back in that it does not need be registered under Section 860 of the Companies Act 2006. At the same time, it may also be difficult for bank to take a fixed charge over debts. This was seen in the case of National Westminster Bank plc v Spectrum Plus Ltd, which shows that the failure to achieve a fixed charge will make the charge a floating charge. The question is whether the bank can enforce the flawed-asset arrangement in the capacity as a debtor rather than a chargee in case of such a failure. This situation directs the bank to rely on flawed-asset arrangements. The efficacy of a flawed-asset arrangement is also put to test when drafting a flawed asset clause.

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34. Money Markets International Stockbrokers Ltd v London Stock Exchange Ltd [2002] 1 WLR 1150, 103.
35. Hugh Beale, Michael Bridge, Louise Gullifer and Eva Lomnicka, The Law of Security and Title-Based Financing (Oxford University Press 2012) 2153.
36. Ibid.
37. Re Bank of Credit and Commerce International SA (No 8) [1998] AC 214.
38. Hugh Beale, Michael Bridge, Louise Gullifer and Eva Lomnicka, The Law of Security and Title-Based Financing (Oxford University Press 2012).
39. Ibid, 2154.
40. Ibid.

Critically analyse (advantage disadvantage) the statement

Flawed asset arrangement: the Flawless Security…discuss the nature of the flawed assets and address the efficacy of flawed assets arrangements within the context of the anti-deprivation principles

The charge will not be applicable to any future assets. It rather applies to present and any new assets that come to the debtor’s estate. Thus, the charge automatically extends to the new assets. This is only possible if the charge has furnished the consideration.

The flawed asset arrangement seems to be a better protection for the debtor. Its efficacy lies in avoiding the triggers that attracts the provision of anti-deprivation rule. The main challenge is to differentiate between what is good or bad reason for the flawed asset arrangement.

Conclusion

To conclude, a flawed asset arrangement seems fill in for the weaknesses exposed in a charge over a fixed deposit. The arrangement allows a lendor (a bank) to bind the account holder to a negative pledge or promise favouring the lendor rights to protect its interest. The purpose of such a pledge is not to place the lender above the positions of interest of other creditors. Otherwise, the rule of deprivation will apply rendering any such arrangements invalid where arrangement that reduces the size of the share in a company’s/insolvent’s/account holder’s asset by withdrawing the asset to favour the lender will be invalid. Thus, a valid flawed assets provide better security when it does not attempt to do that as the debtor has a limited interest in the asset in question that completes upon end on the company’s insolvency.

1829

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41. Hugh Beale, Michael Bridge, Louise Gullifer and Eva Lomnicka, The Law of Security and Title-Based Financing (Oxford University Press 2012) 2154.

Critically analyse (advantage disadvantage) the statement

Flawed asset arrangement: the Flawless Security…discuss the nature of the flawed assets and address the efficacy of flawed assets arrangements within the context of the anti-deprivation principles

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Bibliography

Books

Beale H, Michael Bridge, Louise Gullifer and Eva Lomnicka, The Law of Security and Title-Based Financing (Oxford University Press 2012)

Goode RM, Principles of Corporate Insolvency Law (Sweet & Maxwell 2011)

Gullifer L, ‘Flawed Assets Clauses’ in Graham Virgo and Sarah Worthington, Commercial Remedies: Resolving Controversies (Cambridge University Press 2017)

Hannigan B, Company Law (Oxford University Press 2015)

Iheme CH, Towards Reforming the Legal Framework for Secured Transaction in Nigeria: Perspective from the United Stated and Canada (Springer 2016)

Oshitokunbo OL, An Almanac of Contemporary and Comparative Judicial Restatements (ACCJR Supp. i Private Law): ACCJR Supplement I (Almanac Foundation 2020)

Yeowart G, Robin Parsons, Edward Murray and Hamish Patrick, Yeowart and Parsons on the Law of Financial Collateral (Edward Elgar Publishing Limited 2016) 625.

Journals

Niven P, ‘The Anti-deprivation Rule and the Pari Passu Rule in Insolvency’ (1877) 25 Insolvency Law Journal 5-28.

Worthington S, ‘Good Faith, Flawed Assets and the Emasculation of the UK Anti-Deprivation Rule’ (2012) 75(1) The Modern Law Review 112-121.