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

---

[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.

Revised Draft Guidelines on Securitisation

The Reserve Bank of India has issued a revised draft of its guidelines on securitisation transactions. This takes into account reform efforts internationally to deal with distorted incentives of originators in downselling financial assets soon after their creation.

The preamble to the revised draft sets forth the rationale:

1.1 Securitisation involves the pooling of assets and the subsequent sale of the cash flows from these asset pools to investors. The securitization market is primarily intended to redistribute the credit risk away from the originators to a wide spectrum of investors who can bear the risk, thus aiding financial stability and to provide an additional source of funding. The recent crisis in the credit markets has called into question the desirability of certain aspects of securitization activity as well as of many elements of the ‘originate to distribute’ business model, because of their possible influence on originators’ incentives and the potential misalignment of interests of the originators and investors. While the securitization framework in India has been reasonably prudent, certain imprudent practices have reportedly developed like origination of loans with the sole intention of immediate securitization and securitization of tranches of project loans even before the total disbursement is complete, thereby passing on the project implementation risk to investors.

1.2 With a view to developing an orderly and healthy securitization market, to ensure greater alignment of the interests of the originators and the investors, as also to encourage the development of the securitization activity in a manner consistent with the aforesaid objectives, several proposals for post-crisis reform are being considered internationally. Central to this is the idea that originators should retain a portion of each securitization originated, as a mechanism to better align incentives and ensure more effective screening of loans. In addition, a minimum period of retention of loans prior to securitization is also considered desirable, to give comfort to the investors regarding the due diligence exercised by the originators. Keeping in view the above objectives and the international work on these accounts, guidelines have been formulated regarding the Minimum Holding Period (MHP) and Minimum Retention Requirement (MRR).

The draft contains all the detailed operational guidelines that are to be complied with to achieve the above policy objectives.

Legality of Sale of NPAs Between Banks

Last week, the Supreme Court issued its ruling on whether non-performing assets/loans (NPAs) can be transferred between banks without the concurrence of the borrowers.

The case involved a transfer of NPAs (relating to the borrower, APS Star Industries Ltd.) from ICICI Bank to Kotak Mahindra Bank. The borrower was in liquidation. When the assignee Kotak Mahindra Bank sought before the Company Court to substitute its name as lender, the borrower objected on several grounds (including improper payment of stamp duty). The Company Court refused to recognize the assignee on account of improper presentation of the document of transfer. On appeal, a Division Bench of the Gujarat High Court upheld the Company Court’s decision, but on a different ground, i.e. that the assignment of debts by banks is not an activity permissible under the Banking Regulation Act, 1949 (BR Act).

On further appeal, the Supreme Court considered two issues:

1. Whether inter se transfer of debts between banks is an activity permissible under the BR Act?

2. Whether the assignee bank (Kotak Mahindra) is entitled to substitution in place of the original lender / assignor (ICICI Bank) in proceedings relating to liquidation of the borrower company?

On the first issue, the Court examined in detail the scheme and provisions of the BR Act and concluded that assignment of NPAs is within the purview of a bank’s permitted business activity:

- The Reserve Bank of India (RBI) can lay down parameters enabling banking companies to expand its business;

- Apart from accepting deposits and lending, the BR Act leaves ample scope for banks to venture into new businesses being subject to the control of RBI;

- Section 6(1)(n) of the BR Act “enables a banking company to do all things that are incidental or conducive to promotion or advancement of the business of the company”;

- The Guidelines on Purchase / Sale of Non Performing Financial Assets dated 13 July 2005 issued by the RBI allow banks to deal inter se in NPAs, which makes the activity a bona fide business. After going into the rationale for declaring a loan as an NPA, the court goes on to hold that the Guidelines “have been issued as a “restructuring measure” in order to avoid setbacks in the banking system”.

On the second issue, the Court distinguished between the transfer of (i) mere rights, which can be effected without concurrence of the borrower, and (ii) obligations, which requires a novation of the contract (thereby necessitating concurrence of the borrower):

- In the present case, it was found that the assignor is only transferring the rights under contract (which represent its assets);

- There is no transfer of obligations of the assignor towards the assignee, as they continue to be borne by the assignor;

- Hence the deed of assignment transferring the NPAs from ICICI Bank to Kotak Mahindra Bank is not unsustainable in law.

In addition, the court also ruled that the provisions of the SARFAESI Act, 2002 are not applicable to the case because that relates to a transfer of financial assets from banks to specific types of financial vehicles (such as securitization companies and asset reconstruction companies).

With its ruling on the limited questions before it, the Supreme Court remitted the matter to the Gujarat High Court for consideration of the other issues.

Ajay Shah’s Blog has a nice summary and analysis of the judgment, while this discussion on CNBC-TV18 also examines the impact of the decision on the securitization markets. As these demonstrate, in view of the Supreme Court’s limited mandate, it can be said to have merely covered the tip of the iceberg when it comes to the plethora of issues that arise from securitization of financial assets. More issues can be expected to be addressed through the future course the matter is likely to take.

Although securitization has acquired popularity in the Indian markets for over a decade now, the legal regime has been founded on age-old principles of law laid down in legislation such as the Transfer of Property Act, 1882, and the law relating to stamp duty and registration. While these laws do provide solid fundamentals in terms of legal concepts within which modern financial practices such as securitization can be worked, the judiciary has been presented with limited circumstances to interpret these legislation in the modern context. The opportunity that the current batch of cases presents the judiciary may well help clear the air on some of the issues.

Finally, when the SARFAESI Act was enacted in 2002, there was great expectation that such a law would create a modern framework to carry out securitization transactions. However, with its limited application (recognized by the Supreme Court in this latest decision), one cannot afford to turn a blind eye towards pre-existing law on transfer of financial assets.