A Review and Analysis of the CDR Mechanism

The out-of-court approach for corporate debt restructuring (CDR) was instituted by the Reserve Bank of India (RBI) over a decade ago. While it has been successful in several cases, there have also been significant shortcomings with the CDR mechanism.

In a recent speech, a Deputy Governor of the RBI undertakes a review of the CDR mechanism. A number of issues are examined in the speech, including –

- reasons for the large numbers of restructurings;

- excessive leveraging by borrowers, coupled with slowdown in the economy;

- lack of transparency in the restructuring process;

- the disproportionate burden assumed by the public sector banks; and

- operation of the moral hazard problem, leading to misuse of the CDR process by borrowers.

These and other issues, including the way forward are considered in the speech.

Although the CDR mechanism, despite its flaws, has helped in turning around companies, any review efforts can only be piecemeal in nature. The absence of a comprehensive and functional law on corporate insolvency in India will continue to be sorely felt.

Substance vs. Form Conflict in True Sale | Hong Kong Court Goes by the Language Used by the Parties

(The following post is contributed by Soma Bagaria, who is a Legal Advisor at Vinod Kothari & Company in Kolkata. She can be reached at soma@vinodkothari.com)

In every assignment transaction, there has been a constant conflict of whether the substance or form shall dominate while determining the nature of a transaction. There are two schools of thought on this: one which gives dominance to substance over form and the other which prefers the dominance of intention that is expressed rather than that not expressed, i.e. prefers the form over substance.

Generally speaking, when the nature of a transaction goes for determination, while respecting the intention of the parties set out in the documents, it shall be preferable to probe into the substance of the transaction rather than the plain label and language used so as to decipher what actually the transaction is all about. As has been said by many, language as an indicator is good but cannot be a determinant.

Recently, the Hong Kong High Court in the case of Hallmark Cards Incorporated v. Yun Choy Limited and the Standard Chartered Bank (Hong Kong) Limited[1](an insolvency law matter), where the document in question was the Receivables Purchase Agreement (“RPA”), has given supremacy to the form over substance and held a transaction as a sale even though, as discussed hereunder, the elements of a sale were absent.

1. Arguments of the Liquidator of the Company (Yun Choy Limited)

1.1. The liquidators of the Company argued that (a) the transaction amounted to a lending secured by a charge on the book debts of the Company; (b) since the charge is not registered, the same is invalid; (c) the transaction amounted to a general assignment of book debts and hence void by reason of non-registration under the applicable bankruptcy laws of Hong Kong.

1.2 The liquidators harped on the substance of the RPA arguing that even though the transaction was expressed as a sale and purchase of the debts due from the Company’s customers, in substance it was an assignment by way of security creating a fixed charge over the book debts.

1.3 The Company retained the risk of non-repayment of debt by a customer. Hence, in absence of transfer of risk, being an essential ingredient of sale, the transaction cannot be a sale.

1.4  In the transaction:

(a) In a termination event, the Bank could require the Company to purchase all the outstanding debts and sum of the funds in use;

(b) The Bank had to account to the Company who could recover full value of its book debts, i.e., if the payment by the Company’s customers to the Bank exceeds the sums debited in the factoring account, the credit balance would be payable to the Company;

(c) In case of a shortfall, the Bank could recover the balance from the Company;

(d) There was no fixed price for the purchase of a debt.

1.5. It was, therefore, argued that the elements set out in the case of In re George Inglefield Ltd.[2], were satisfied in the transaction, and hence, the same would not amount to a sale but a mortgage. George Inglefield case has set out clear differences between a true sale and a mortgage:

Basis	True Sale	Mortgage
No recourse	Seller is not entitled to get back the asset sold by returning the money to the purchaser.	Mortgagor is entitled, until foreclosed, to get back the asset by returning the money to the mortgagee.
Account of profit	Purchaser does not have to account the seller of any profit realized by sale of the asset purchased from the seller.	Any amount realized in excess of the amount sufficient to repay the mortgagee shall be accounted back to the mortgagor.
Right to receive the shortfall	Purchaser cannot recover from seller any amount which upon resale of the purchased property was insufficient to recoup the money paid to seller.	A mortgagee is entitled to recover from the mortgagee the difference between the amount from sale of asset and the amount due from mortgagor, if the amount from the sale of asset is insufficient to meet such amount due.

Looking at the clauses in the RPA, it could be validly argued that the principles of a true sale transaction (as discussed below) were missing, and looking at the substance it may not appear as a true sale.

2. Arguments of the Bank (i.e. the Standard Chartered Bank)

2.1  The Bank argued that:

(a) The Company’s entitlement to be paid the credit balance in the factoring account did not amount to an equity of redemption.

(b) There is nothing wrong in a sale of debt for the purchase price to be fixed by the amount to be collected by the purchaser later.

(c) A sale with recourse is still a sale.

2.2 In support, the Bank relied on two famous cases of Welsh Development Agency v. Export Finance Co Ltd[3] and Orion Finance Ltd v. Crown Financial Management Ltd[4].

(a) In Welsh Development case, the Court had held a transaction to be sale even though the same apparently looked like a financing transaction but was documented as a sale, setting out the following principles of determination:

(i) The agreement shall be looked at as a whole and its substantial effect shall be seen.

(ii) It is only by a study of the whole of the language that a substance can be ascertained.

(iii) The plain meaning of any term in the agreement cannot be discarded unless there can be found within the agreement other language and stipulations which necessarily deprive such term of its primary significance.

(iv) Factoring amounts to a sale of book debts, rather than a charge, even though under the purchaser of the debts is given recourse against the vendor in the event of default in payment of the debt by the debtor.

(v) There may be a sale of book debts, and not a charge, even though the purchaser can recover the shortfall if the debtor fails to pay the debt in full.

(b) Further in the Orion Finance case, the Court had said that unless the documents taken as a whole compel a different conclusion, the transaction which they embody should be categorized in conformity with the intention which the parties have expressed in them.

3. Verdict of the Hong Kong High Court

The transaction was held to be a sale.

4. Analysis of the decision

The Hong Kong Court did not give any basis for its decision and neither did it discuss the parameters of a sale transaction. This case is a clear case of a form over substance ruling.

However, looking at some of the factors of a sale, it cannot be said that the transaction was a sale

4.1 Going the US way – substance over form approach

In the United States, the Courts have normally refused to go by the label of the contract rather than looking into the nature of the agreement. One important aspect to be seen, which was elaborated in the case of Major’s Furniture Mart v. Castle Credit Corp[5], is whether the risks have been retained by the seller. In this case the Court had said that it shall be seen whether the nature of recourse is such that the legal rights and economic consequences of the agreement bear a greater similarity to a financing or a sale transaction.

Therefore, primarily, the US Courts have preferred a substance over form approach, which is different from the form over substance which the UK Courts have preferred.

4.2 Revocable Transaction

If the transaction is revocable, i.e. presence of a repurchase agreement has the effect of being treated as a secured borrowing.

4.3  Failure of the transaction to satisfy the determinants for a true sale transaction

(a) No recourse against the seller

The risks and rewards shall be transferred by the seller to the buyer, thereby eliminating a possibility of any recourse against the seller. This is primarily a negative attribute and may not in itself be a determinant factor as recourse is like a warranty given by the seller on the quality of the assets sold.

The transaction for determination before the Hong Kong Court gave the Bank a recourse against the Company, in spite of which the transaction was upheld as a sale. The Hong Kong High Court accepted the Bank’s contention that even though there may be recourse against the seller, a transaction could be sale.

(b) Retention of residual interest by the seller

In a sale transaction, the seller cannot have control on profits of the buyer that arise after the sale. This was also clearly highlighted in the George Inglefield case by the liquidator of the Company. As has been stated, the rewards shall also stand transferred along with the risk in a sale transaction.

(c) Uncertain sale consideration

Where the amount of sale consideration is not ascertained or fixed, it cannot be said to be a sale transaction. This factor makes the transaction move closer to a financing transaction.

5. Conclusion

The tendency of the UK Courts and those following the UK principles to accept the language of the contract as the primary indicator of substance continues. The ruling does not help resolving the substance v. form conflict, which still continues as an unresolved debate.

- Soma Bagaria

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[1]  [2012] 1 HKLRD 396

[2] [1933] Ch 1

[3] [1992] BCLC 148

[4] [1996] 2 BCLC 78

[5] 602 F.2d 538 (3d Cir. 1979). This is one of the most cited cases when determining a sale v. financing question.

The Romalpa Clause and Bankruptcy Protection

To a supplier or, more generally, to any commercial entity involved in the initial stages of a supply chain, protecting itself in the event of the bankruptcy or change in constitution of its principal buyers is a matter of great importance. It is therefore commonplace to find clauses in a contract creating, for example, a unilateral right to terminate in the event of change of control. Similarly, several devices are used to try to gain an advantage over other creditors in the event of bankruptcy, especially in a business that involves a substantial level of supply on credit. Of these, the most well-known mechanism is the “Romalpa clause” – a retention of title clause that provides that property in the goods does not pass until full payment is received. The recent decision of the UK Court of Appeal in Bulbinder Singh v Jet Star Retail demonstrates some of the limitations of such clause, particularly because of the buyer's implied authority to dispose of the goods.

Mr. Singh was engaged in the business of manufacturing clothing under the trade name of Isher Fashions UK [“Isher”] and was also in time the sole shareholder of Jet Star, a retailer of fashion garments. Isher supplied a large quantity of clothing to Jet Star until 2008, when Jet Star found itself unable to pay many of its suppliers. A winding-up petition was filed by some of its other creditors, and it was placed in administration on November 19, 2008. Nevertheless, it continued to trade between 20 and 24 November, and sold in that period a significant quantity of stock supplied by Isher Fashions. The contract between Isher Fashions and Jet Star contained a retention of title clause, which it is useful to set out in full:

6.2 Isher Fashions shall retain property, title and ownership of the Products until it has received payment in full in cash or cleared funds of all sums due and/or owing for all Products supplied to the Customer by Isher Fashions under this Contract and any other agreement between Isher Fashions and the Customer.

7. DEFAULT

If the Customer

. . .

7.1.4 . . . has a bankruptcy petition presented against it, has appointed in respect of it or any of its assets a liquidator, . . . receiver, administrative receiver, administrator or similar officer . . . then Isher Fashions shall have the right, without prejudice to any other remedies, to exercise any or all of the following rights:

. . .

7.1.9 Isher Fashions may require the customer not to re‑sell or part with the possession of any Products owned by Isher Fashions until the Customer has paid in full all sums due to Isher Fashions under this Contract or any other agreement with the Customer

Isher Fashions had not exercised its right under Clause 7.1.4. at the relevant time. Nevertheless, it brought a claim against Jet Star for conversion. It had to be conceded that a buyer, in these circumstances, has implied authority to dispose of the goods although title has not passed – the nature of the relationship between a supplier and a buyer makes that conclusion inevitable. Isher Fashions suggested, however, that a retention of title clause is analogous to an agreement for a floating charge. If this premise is established, it would follow that that implied authority to dispose of goods automatically terminates when the buyer is placed in administration, for it is well established that an instrument that creates a floating charge prevents a company from disposing of its assets “outside the ordinary course of its business.” A detailed analysis of the scope of this expression is available in Etherton J.’s judgment in Ashborder BV v Green Gas, in which it was accepted that a transaction by a company that is intended to or has the effect of bringing its business to an end is outside the ordinary course of its business. Thus, this suggestion, if well-founded, would have considerably strengthened the effectiveness of a retention of title clause.

In Bulbinder Singh, Moore-Bick LJ agreed that the ordinary course of business test has been correctly formulated but held that there is no effective analogy between a retention of title clause and a floating charge. For one, the scope of a retention of title clause depends, in the ultimate analysis, on the intention of the parties as manifest in the particular contractual context, and it is misleading to suggest that every such clause has the same effect. For example, the provision in clause 7.1.4 (extracted above) that the seller is entitled to withdraw the buyer’s authority to sell is itself a conclusive indication that the buyer, in the absence of the seller taking such action, does have that authority. In other words, if it is the case that insolvency automatically terminates implied authority, clause 7.1.4 would have been unnecessary. Moore-Bick LJ held that this is the reason the analogy between a floating charge and a retention of title clause breaks down:

The parties clearly had in mind, therefore, that the buyer might be permitted to continue to deal with the goods even after it had become insolvent or (as here) had gone into administration. In my view that is an important distinction between this contract and a debenture creating a simple floating charge and one which has significant implications for the scope of the buyer’s authority to dispose of the goods. It is an important feature of a floating charge that it crystallises on the insolvency of the debtor and thereby provides the creditor with the protection he seeks. Under this contract, by contrast, the protection provided by the retention of title clause is contingent on the decision of Isher Fashions to withdraw the buyer’s authority to deal with the goods. I do not think, therefore, that one can draw a direct analogy between the two [emphasis mine].

It followed in Bulbinder Singh that the buyer’s authority to dispose of goods was not limited by the ordinary course of business test.

This decision is an important reminder that the step from a Romalpa clause to automatic limitations on implied authority to dispose is often one too many. The result may be different if the retention of title clause, unlike in Bulbinder Singh, provides not only that title is retained, but that authority to re-sell or dispose is terminated in advance of a seller's notice to that effect, on the event of administration.