ABSTRACT: The automatic security negative pledge is a commonly used mechanism in financing arrangements whereby the creditor is granted security over the assets of the debtor in the event that the debtor breaches the terms of the negative pledges found within the loan agreement. In this way, the automatic security negative pledge bridges the gap between the unsecured and secured creditor by offering greater flexibility than an outright security and greater protection than a purely contractual negative pledge. However, due to the flexibility required in equity and statutory law to accommodate such an ambitious security arrangement, sceptics have questioned the capacity of the automatic security negative pledge to produce a valid security interest, much less a security interest that provides the same level of protection as outright security. This article will argue that the legal mechanics required by an automatic security negative pledge are perfectly acceptable and accommodated in equity and that the legal and practical issues highlighted by sceptics can be managed through careful drafting and monitoring of the debtor. Overall, this article will elucidate why an automatic security negative pledge is a flexible and effective protection for creditors in financing arrangements.
The automatic security negative pledge can be effectively used to protect creditors in financing arrangements. By providing greater protection than a mere contractual negative pledge and greater flexibility than outright security, the automatic security negative pledge bridges the gap between the unsecured and secured creditor. In this way, the automatic security negative pledge offers creditors an alternative or ‘pseudo’ form of security that may better meet the demands of creditors and debtors alike. However, despite the widespread use of the automatic security negative pledge, sceptics argue that there are several key legal and practical issues that diminish or completely nullify the effectiveness of the automatic security negative pledge. This article will seek to examine and resolve, or at least mitigate, those legal and practical issues and established that the automatic security negative pledge is an effective form of protection for creditors.
To separate and resolve the issues concerning the effectiveness of the automatic security negative pledge, this article is divided into four Parts. Part 1: ‘What is the legal nature of an automatic security negative pledge?’ will examine the rights of a creditor both before and after a breach of the negative pledge. Part 2: ‘What factors will inhibit the creation of a valid security interest by an automatic security negative pledge?’ will examine the statutory and contractual law issues that may invalidate an otherwise permissible security interest. Part 3: ‘Will a security interest arising from an automatic security negative pledge be effective against third parties?’ will examine the capacity of an automatic security negative pledge to produce an equal or prior ranking security interest. Finally Part 4: ‘What non-proprietary rights will arise from a breach of an automatic security negative pledge?’ will examine the rights accruing to a creditor upon the breach of an automatic security negative pledge that do not include the enforcement of security over the assets of the debtor.
To facilitate the analysis of an automatic security negative pledge, the following scenario will be referred to throughout the article. A ‘Creditor’ extends a loan to a ‘Debtor’. Under the terms of the ‘loan agreement’, the Creditor is unsecured but has the benefit of a ‘negative pledge’, which operates to automatically create a security interest in favour of the Creditor upon its breach (the ‘automatic security negative pledge’). The Debtor, in breach of the negative pledge, creates an equitable security interest over its assets in favour of a third party. The Creditor, relying on the automatic security negative pledge, attempts to assert its security over the Debtor’s assets both against the Debtor and the third party.
Additionally, for the purposes of this article, the analysis of the automatic security negative pledge will be based on the following exemplar clause1 :
“The Debtor will not create or permit to subsist any encumbrance on the whole or any part of the respective present or future assets of the Debtor except for:
- encumbrances created with the prior written consent of the Creditor; and
- any encumbrance on any asset but only if simultaneously with the creation of such encumbrance the obligations of the Debtor hereunder are equally and rateably secured by a comparable encumbrance on other assets acceptable to the Creditor, all in form and substance satisfactory to the Creditor
Part 1: What is the legal nature of an automatic security negative pledge?
The automatic security negative pledge does not purport to immediately create security in favour of the Creditor. Rather, the automatic security negative pledge allows the Creditor to remain an unsecured lender until the breach of the negative pledge. By remaining an unsecured lender, the Creditor avoids the formalities of taking security, including registration and the execution of a written security agreement. However, if a breach of the negative pledge does occur, then the automatic security negative pledge, in theory, should have the additional benefit of securing the position of the Creditor. For this reason, an automatic security negative pledge is widely labelled as a contingent security agreement by academics.2
However, there are two aspects of this contingent security agreement that require further elaboration. First, a mere agreement to create security will not be recognised under the common law as a security interest and therefore must seek recognition in equity.3 Specifically, the Creditor must rely on the equitable maxim that ‘equity does that which ought to be done’4 in order to seek recognition of the agreement to create a security as an equitable security interest. Second, this equitable maxim must be considered in respect of contingent security agreements. This part of the article will bring together the divergent academic opinions regarding whether equity will recognise a security interest produced by an automatic security negative pledge.
Furthermore, there is an entirely different characterisation of the automatic security negative pledge held by a minority of commentators.5 This group contends that an automatic security negative pledge should be characterised as a floating charge, which crystallises upon the breach of the negative pledge. Given the significant consequences this characterisation could have on the validity and effectiveness of an automatic security negative pledge, this opinion will also be explored.
1.1 ‘Equity regards as done that which ought to be done’ in the context of non-contingent agreements
There are a number of cases that attempt to define the equitable maxim ‘equity regards as done that which ought to be done’.6 Broadly however, the equitable maxim will deem as completed7 an unexecuted agreement between two parties where valuable consideration has been provided.8 Originally, it was thought that the availability of specific performance was also necessary.9 However, later cases have expressed the view that the availability of specific performance is not necessary provided that there are no impediments or conditions preventing the execution of the agreement.10 As such, in circumstances where consideration has been provided and the contract can otherwise be performed, a party will be able to pray for the intervention of equity.11
With regards to security interests, the equitable maxim may operate to create an equitable security interest. In National Provincial Bank of England v Charnley, Scrutton LJ stated:
“I think that the substance of an equitable charge is this: if an agreement be made to grant some interest in existing or future property for the purpose of securing the payment of a debt, that agreement to give the security confers an equitable security or charge, though all the formalities necessary to create the actual security have not yet been complied with. Equity treats that as done which ought to be done.”12
Therefore, an unconditional agreement to create a security interest will constitute an equitable security interest with no further action required by the grantor.
1.2 ‘Equity regards as done that which ought to be done’ in the context of contingent agreements
The position is different where an agreement or contract is merely contingent or conditional. Pursuant to the comments of Lord Atkinson in De Beers Consolidated Mines Ltd. v. British South Africa Co.,13 the equitable maxim cannot be used “to turn the conditional into the absolute, the optional into the obligatory, or to make for the parties contracts different from those they have made for themselves.”14 Equity will not intervene15 to execute a contingent or conditional contract because the contract cannot be performed until the contingency or condition has been satisfied.16 As such, “equity will not regard as done something which may never be done.”17 Where the contingency or condition is satisfied, it is arguable that any impediment to the application of the equitable maxim is removed.18 Some academics19 however, suggest that new or fresh consideration must be supplied following the satisfaction of the contingency or condition. This is the case even though the contract is otherwise performable.
1.3 The rights of the Creditor before the breach of the negative pledge
Between the execution of the loan agreement and the breach of the negative pledge, the Creditor has no immediate right to have security made available.20 Rather, the right of the Creditor to have security made available is contingent on the breach of the negative pledge by the Debtor. Before the breach therefore, the Creditor cannot be said to have an equitable security interest, as equity will not “turn the conditional into the absolute”21 . Instead, the rights of a Creditor before the breach of a negative pledge are of a contractual nature.22 The extent of equity’s intervention will be to enforce the contractual obligations of the Debtor, such as through the equitable order of an injunction or an order for specific performance to provide security.23 Non-proprietary rights are explored further in Part 4: ‘What non-proprietary rights will arise from a breach of an automatic security negative pledge?’
1.4 The rights of the Creditor upon the breach of the negative pledge
Upon the breach of the negative pledge, the automatic security negative pledge endeavours to grant the Creditor an immediate right to have security made available. Whether equity will recognise the creation of an equitable security interest in this way is a matter of contention amongst academics. As discussed, for equity to intervene and recognise an equitable security interest, there must be valuable consideration provided24 as well as the capacity for the agreement to be performed without further contingencies.25 While no more contingencies exist following the breach of the negative pledge, some academics argue that new or fresh consideration must be supplied.26 The basis of this ‘fresh consideration argument’ is that the consideration provided under the loan agreement, the loan itself, is only consideration for the contingent agreement to provide security.27 Therefore, new or fresh consideration must be provided upon the breach of the negative pledge in order to compel the intervention of equity to recognise the equitable security interest.28 However, there are three strong grounds for rejecting this argument.
The first ground is that the cases on which the ‘fresh consideration argument’ is based are largely inconclusive. The first case, In Re Jackson & Bassford Ltd,29 involved an agreement by a company to provide security in the future on demand. Upon the demand being made the company complied, although the security was later held to be a fraudulent preference. As the security amounted to a fraudulent preference, the matter of consideration was not determinative. However, in the decision Buckley J commented, “[i]t seems to me that in the present case the promise--which was certainly made and, I agree, for value--was a promise to which effect could not legally be given by calling for performance at a time when, in the absence of the promise, the security would have been a fraudulent preference.”30 Goode31 and Maxton32 cite this statement in support of their argument that an agreement to provide security on a contingency does not amount to an equitable charge. Conversely, Gabriel33 and Stone34 claim that Buckley J is merely explaining that the promise would have been permissible if it were not for the intervention of the fraudulent preference rules. It is submitted that the latter analysis is the better view. Regardless, the highly disputed nature of this statement makes it a weak foundation on which to base an argument.
The second case, In re Gregory Love & Co,35 involved an agreement by a company to provide security to one of its directors upon the occurrence of an uncertain future contingency. Similarly to In Re Jackson & Bassford Ltd, the resulting security was invalid so the question of consideration was not determinative. However, regarding the legal nature of the agreement, Sargent J commented that; “The agreement contains no present charge, but merely a right to the plaintiffs' testator to have a charge of a certain kind on the occurrence of either of two events. And an enforcement of the agreement would result in the plaintiffs getting a floating charge--not as at the date of the agreement, but as at the date when the first of the two events happened”.36 Although cited by Goode as supporting the ‘fresh consideration argument’,37 Gabriel asserts that the comments of Sargent J show that the enforceability of the agreement upon the occurrence of the contingency was “beyond doubt.”38 Again it is submitted that Gabriel’s analysis is the better view. Overall, it appears that the case law is unsupportive to the ‘fresh consideration argument’ and may even, as suggested by Gabriel, stand in “complete opposition”.39
The second ground for rejecting the ‘fresh consideration argument’ is the existence of Singaporean and Australian case law suggesting that no further value is necessary. In The Asiatic Enterprises (Pte) Ltd v United Overseas Bank Ltd,40 the Singapore Court of Appeal directly considered Goode’s argument regarding fresh consideration. In rejecting the argument, the Court stated; “It is, in our view, not a correct proposition, that where an agreement provides for a security to be given on the occurrence of a certain contingency, the security does not attach in equity upon such contingency occurring, unless the creditor provides fresh consideration.”41 The Court also commented that the ‘fresh consideration argument’ was not supported by any authority, including In re Gregory Love & Co.42 While the Singapore Court of Appeal is not binding on UK courts, the views expressed in this court serve to further isolate the ‘fresh consideration argument’.
In addition to The Asiatic, there are Australian cases that do not follow the ‘fresh consideration argument’.43 The leading Australian case is Murphy v Wright.44 This case involved a guarantee arrangement under which a lender was granted the right to register a caveat against the property of the guarantor upon a default by the borrower. The court held that, upon a default by the borrower, the lender immediately accrued the right to register a caveat against property. Under the relevant land legislation, this entitled the lender to an equitable charge over the guarantor’s property.45 Whether such an equitable security would arise under UK law is not clear. Regardless however, the court in Murphy v Wright accepted that an equitable security interest could arise and did not deem it necessary to consider the issue of fresh consideration.
The final ground for rejecting the ‘fresh consideration argument’ is the counter-argument that sufficient consideration already exists. Sufficient consideration is evident in two ways. First, consideration is evident in respect of the money advanced under the loan agreement.46 Gabriel questions why the money advanced is consideration for the Creditor’s right to pass on the costs of obtaining finance at higher interest rates as well as the Creditor’s right to terminate the loan if an illegality occurs, but not the Creditor’s right to receive security upon a breach of the negative pledge.47 This would, therefore, appear to be a non sequitur in the ‘fresh consideration argument’. Second, consideration is evident in respect of the forbearance by the Creditor in not enforcing its contractual right to call an event of default.48 This ‘forbearance consideration’ however, may be difficult to establish in the circumstances that the Creditor is unaware of the Debtor’s breach and therefore unaware of its own forbearance.49 Nonetheless, the Creditor should have one, and perhaps even two, strong justifications that sufficient consideration has been provided in return for the right to receive security under the automatic security negative pledge.
Ultimately, the ‘fresh consideration argument’ seeks to split the automatic security negative pledge into two separate agreements, the agreement to provide contingent security and the agreement to make security available upon the breach of the negative pledge. According to the ‘fresh consideration argument,’ both agreements require the provision of consideration. It is submitted that there is no valid reason for making this separation. As discussed, the case law cited in support of the ‘fresh consideration argument’ is tenuous and far from authoritative. Cases from foreign jurisdictions either do not consider the matter of consideration to be relevant or directly reject the ‘fresh consideration argument’. Instead, the counter-argument appears to be the better construction. This argument asserts that the automatic security negative pledge constitutes only one agreement, for which consideration is the money advanced under the loan agreement. Pursuant to this counter-argument, valuable consideration has been provided50 and the agreement is otherwise performable.51 Therefore the equitable maxim ‘equity regards as done that which ought to be done’ will recognise the creation of an equitable security interest upon the breach of the negative pledge in favour of the Creditor.
1.6 The floating charge argument
An alternative theory contends that the legal nature of an automatic security negative pledge is that of a floating charge. This ‘floating charge argument,’ has received only minimal endorsement academically52 and judicially.53 The ‘floating charge argument’ contends that the Creditor receives a present security right, specifically a floating charge, from the time the loan agreement is executed, which crystallises upon the breach of the negative pledge.
The statement of Lord Scott in Smith v Bridgend54 provides some judicial endorsement for the ‘floating charge argument’. In Smith v Bridgend, Lord Scott comments that; “[i]n my opinion, a charge expressed to come into existence on the occurrence of an uncertain future event and then to apply to a class of assets that cannot be identified until the event has happened would, if otherwise valid, qualify for registration as a floating charge.”55 Lord Scott appears to be suggesting that a charge arising on a contingency would be registrable as a floating charge. In respect of automatic security negative pledges therefore, the loan agreement containing the automatic security negative pledge would need to be registered within the permitted period or be voided for lack of registration. However, there are two reasons for applying minimal weight to Lord Scott’s statement. First, in Lord Scott’s judgement, the security in question had already been characterised as a floating charge and therefore the comments of Lord Scott were dicta in nature. Second, Lord Scott’s comments contradict the decision in Evans v Rival Granite Quarries Ltd, which clearly held that a floating charge is a present security and not a mere agreement for security on a contingency.56 Additionally, the recently decided case, Rehman v Chamberlain (Liquidator of Meritmill (UK) Ltd),57 held that an agreement to create security in the future does not constitute an immediate equitable security interest. On the basis of this criticism, and the lack of corroborating judicial statements, it appears questionable as to whether future courts will build upon Lord Scott’s dicta.
The academic Hill endorses Lord Scott’s dicta however. Hill argues that an automatic security negative pledge over certain interests in land will constitute a registrable floating charge.58 Broadly, Hill’s article59 puts forward three main points. First, that there are certain contingent rights in land that should be characterised as proprietary interests.60 Second, an automatic security negative pledge over certain interests in land bestows similar legal rights to that of a floating charge with an automatic crystallisation negative pledge.61 Third, as a result of the first two points, there exists the risk that a court could re-characterise an automatic security negative pledge over certain land assets as a registrable floating charge.62
There are two issues with Hill’s proposition. First, Hill’s analysis is limited to interests in land only. The justifications put forward by Hill to recognise certain contingent interests in land as proprietary interests, rely on the intervention of specific provisions of the Law of Property Act 1925 as well as case law63 that relates solely to land. Therefore, to the extent that an automatic security negative pledge relates to non-land assets, the arguments put forward by Hill are unlikely to be applicable. Second, the cases64 cited by Hill in respect of the re-characterisation risk appear to be applied out of context. In Re Agnew,65 and followed in Re Spectrum Plus,66 Millett L outlined a two-stage characterisation process for the purposes of distinguishing between fixed and floating charges.67 There is nothing to suggest that Millett L contemplated that the two-stage process should be used to distinguish between a security interest and a mere non-proprietary contractual interest. Therefore it is submitted that case law does not support Hill’s re-characterisation risk argument.
In summary, the commentary of Lord Scott and Hill provides an interesting insight into the similarities between an automatic security negative pledge and a floating charge. It fails however, to satisfactorily justify why an automatic security negative pledge should be characterised as a floating charge. Lord Scott’s comments are dicta and are not supported by other case law while Hill’s argument is essentially limited to certain specific land interests. On this basis, it is submitted that the Creditor does not obtain a floating charge upon the execution of the automatic security negative pledge.
1.7 Conclusion on the legal nature of an automatic security negative pledge
There are two primary characterisations of the legal nature of an automatic security negative pledge. Of the two characterisations, the ‘floating charge argument’ is the least endorsed both academically and judicially. The other characterisation contends that the Creditor receives a contractual right to have security made available upon the breach of the negative pledge. Within this characterisation, there is a divergence of opinion as to whether equity will recognise the creation of an equitable security interest upon the breach of the negative pledge due to the issue of consideration. It has been argued that there is insufficient justification for the ‘fresh consideration argument’. Therefore, it is submitted that the appropriate characterisation of the rights bestowed by an automatic security negative pledge is that of an agreement to create security upon a contingency, which equity will recognise as an equitable security interest only upon the breach of the negative pledge.
Part 2: What factors will inhibit the creation of a valid security interest by an automatic security negative pledge?
Even where equity recognises a security interest, there are contractual and statutory issues that may invalidate the security. These issues include; identifying the assets over which security is to be created, identifying the security to be created and registering the security before it is voided for lack of registration. Each of these issues will be considered in turn.
2.1 Identification of assets
The first issue regards the identification of the assets to be secured. A security will fail for lack of certainty if the security agreement does not sufficiently identify which assets are to be the subject of the security. In Tailby v Official Receiver,68 Lord Watson stated that “[w]hen there is no uncertainty as to its identification, the beneficial interest will immediately vest in the assignee.”69 Mere difficulty in identification will not be enough to make the security ‘uncertain.’70 An example of an insufficient identification of assets arose in Berrington v Evans,71 where the debtor covenanted “to sell so much of his estates as shall be found necessary”72 in order to satisfy an outstanding debt. In dismissing the claims of the creditor, the court held that the words used were too general to create a specific security interest.73
There are two methods by which the automatic security negative pledge can avoid the problem of identification. First, the terms of the automatic security negative pledge can stipulate that the security is to cover the same assets that were secured to the third party. This can be achieved through the requirement to provide ‘equal and rateable’ security.74 Second, the automatic security negative pledge can create a separate list of assets over which the security is to apply. To the extent that this list can be identified, the security will not be uncertain. Therefore, the problem of identifiability can be overcome through effective drafting.
2.2 Identifying the security to be created
Similar to the identification of assets, the terms of the security to be created must be identified with sufficient certainty. Regarding this issue, McKnight suggests that “the facility agreement should stipulate that the two securities would be of the same nature and have the same terms and conditions”.75 By duplicating the third party security, the terms of the security can be identified without difficulty.
Part 25 of the Companies Act 2006 governs the registration of charges created by companies.76 Under section 859A, a company creating a charge must register that charge with the registrar within the ‘permitted period’ of 21 days.77 Section 859H deals with the consequences of a failure to register a charge within the permitted period and states that the charge will be void against; a liquidator of the company, an administrator of the company and a creditor of the company.78
In respect of the automatic security negative pledge, the issue arises where the Debtor breaches the negative pledge and the Creditor is unaware of this breach. In this event, the automatic security negative pledge will automatically create a security, which the unaware Creditor will most likely fail to register within the permitted period. Consequently, the Creditor will not be able to enforce that security against any secured third party.79
The most effective solution to the issue of registration is to ensure that any automatic security is identified as soon as it arises. The Creditor could monitor the register to determine if any new charges have been created or could monitor the operations of the Debtor to ascertain when prohibited security is being created.80 While such actions may be inconvenient for the Creditor, it is submitted that if the Creditor were aware of the Debtor’s financial difficulty, it would justify the added expense and burden of surveillance. Furthermore, the information undertaking covenants in the loan agreement could be drafted to ensure that the Creditor has sufficient information with which to monitor the Debtor’s security creating potential. As such, the Creditor could manage the registration risk to a large extent if it considered the additional expense and burden worthwhile.
This discussion regarding registration follows the assumption that the permitted period commences from the breach of the negative pledge. An alternative view is that an automatic security negative pledge should be characterised as a floating charge and therefore registered upon the execution of the loan agreement, which brings the charge into existence. However, as discussed in Part 1.6, this ‘floating charge argument’ has received minimal academic or judicial endorsement and does not appear to reflect the accepted definition of a floating charge. Therefore, on the basis that the automatic security negative pledge is not a floating charge, it would not be accepted as a registrable charge.
2.4 Conclusion on the factors inhibiting the creation of a valid security interest by an automatic security negative pledge
This Part has explored the issues that could potentially affect the validity of a security arising from an automatic security negative pledge. It appears that contractual issues of certainty can be largely overcome through effective drafting. The statutory issue of registration is more substantial. Where a Creditor closely monitors the Debtor that it knows to be in financial difficulty, the problem of registration might be manageable, although a risk remains.
Part 3: Will a security interest arising from an automatic security negative pledge be effective against third parties?
Even where an automatic security negative pledge produces a valid security interest, its value to a Creditor will be largely diminished if a third party takes a prior ranking security. Taking subject to third party security has several negative impacts on the Creditor’s position.81 First, the pool of assets available to service the loan is diminished. Second, the Creditor’s credit analysis of the value of the loan, which assumes pari passu payment, is rendered obsolete. Third, the negotiation leverage of a subordinated lender is severely diminished as secured lenders can negotiate with the safety of having the first claim over the assets of the borrower.
In response to this, the terms of the automatic security negative pledge require an ‘equal and rateable’ security to be created. As further protection, drafters should incorporate an ‘in scintilla temporis’ clause into the terms of the automatic security negative pledge in order to obtain priority. This Part will assess the effectiveness of both these contractual terms and will also examine the viability of challenging an earlier security interest in the context of the priority rules.
3.1 Equally and rateably
The purpose of seeking equal and rateable treatment is to prevent the Creditor from being placed in a worse position as a result of the third party taking security.82 Where ‘equally and rateably’ refers to the ranking of the ranking of the security, academics are sceptical as to whether equivalence can be achieved.83 This scepticism arises from the fact that the creation of the automatic security is contingent on the creation of third party security. Consequently, the third party security must take priority on the basis that it is created first.84 Furthermore, for two security interests to be created pari passu there must be evidence of this intention in both security agreements.85 Clearly there will be no intention on the part of the third party. As such, it would appear that the automatic security negative pledge cannot operate to create an ‘equal and rateable’ security in respect of ranking. However, it is submitted that this serious issue can be overcome through the inclusion of an ‘in scintilla temporis’ clause.
3.2 The ‘in scintilla temporis’ clause
Given the difficulty of obtaining ‘equal and rateable’ security in respect of ranking, some academics have endorsed the use of in scintilla temporis clauses.86 The purpose of an in scintilla temporis clause is to deem that the automatic security comes into existence in scintilla temporis87 before the breach of the negative pledge. By including an in scintilla temporis clause, the automatic security negative pledge should operate to create a prior ranking security in favour of the Creditor on the basis of the first in time rule.88 A similar legal process can be observed in floating charges that contain automatic crystallisation clauses. Automatic crystallisation clauses operate to automatically crystallise a floating charge into a fixed charge at some point prior to a prohibited security being created by the chargor in favour of a third party. This is similar to an automatic security negative pledge, which operates to automatically create a security at some point prior to a prohibited security being created by the chargor in favour of a third party.
Common law courts have provided cautious but positive endorsement of automatic crystallisation clauses. In Re Brightlife,89 Hoffman J expressed the opinion that parties to a security agreement should be free to determine the terms under which a floating charge will crystallise, provided those terms are sufficiently clear to avoid uncertainty.90 Hoffman J later reaffirmed this position in Re Permanent Houses (Holdings) Ltd.91 Australian92 and New Zealand93 courts have also expressed support for automatic crystallisation clauses. However, automatic crystallisation clauses cannot be used to retrospectively create security interests. In the case Fire Nymph Products Ltd v Heating Centre Pty Ltd (in liquidation),94 a provision in a floating charge security agreement provided that the floating charge would crystallise “at the moment immediately prior” to a prohibited dealing. The granting of security to third parties without the consent of the chargee constituted a prohibited dealing. The court accepted that the parties to the security agreement were able to dictate the terms under which the charge crystallised, but they were unable to create a retrospective interest.95 The court distinguished the case from the earlier New Zealand decision in Re Manurewa Transport Ltd. In that case a floating charge was deemed to crystallise at the time the debtor ‘attempted’ to create security in favour of a third party and was held to be valid.96 In the context of an automatic security negative pledge therefore, it is arguable that the in scintilla temporis clause will be valid where the clause operates to create security at a discernible point in time, not merely at an artificial point in time that can only be determined after the third party security has been created. It is submitted that such a discernible point in time may include the time that a board resolution is passed to grant security to a third party or when negotiations with the third party commence. Where a security is created in favour of the chargee at these points in time under an in scintilla temporis clause, then this security will take priority to a security granted to a third party, as it was created first in time.
3.3 Priority issues arising where the Creditor obtains an earlier security interest under an ‘in scintilla temporis’ clause but a third party takes a later security interest without notice of the negative pledge
A limitation to the in scintilla temporis clause however, is that it will not be effective against a third party taking security without notice of the Creditor’s interest. Regarding automatic crystallisation clauses, Gough contends that a third party chargee without notice will not take subject to a crystallised charge.97 Notice requires that the “subsequent chargee knew of the provision in the floating charge that crystallisation would occur on the creation of a subsequent charge”.98 The onus of proof is borne by the holder of the crystallised charge.99 This position has received judicial support in Fire Nymph Products, with Gleeson CJ commenting that “the way in which third parties are affected will depend upon the rules as to priorities, often involving questions of notice”.100 In that case, the third party chargee was held to have notice of the earlier crystallised charge and therefore took subject to that charge. This limitation of automatic crystallisation clauses was noted in Deputy Commissioner of Taxation v Horsburgh by Murphy J who commented that “[t]he priorities which attach to subsequent chargees who take without notice of the existence of a prior floating charge or of its terms operate against the efficiency of automatic crystallisation clauses – but not against their legality.”101 In the context of an automatic security negative pledge therefore, the matter of notice is critical to the effectiveness of the automatic security negative pledge. It is submitted however, that the Creditor can mitigate this risk by expanding the information undertaking covenants in the loan agreement to ensure that the Creditor has sufficient information with which to monitor the Debtor’s security creating potential.
3.4 Priority issues arising where a third party obtains an earlier security interest with notice of the Creditor’s negative pledge
Where a third party takes an earlier security interest, the third party will prima facie take subject to that interest on account of the first in time rule.102 However, where the third party takes an earlier security with notice of the terms of an automatic security negative pledge, the Creditor may be able to claim equitable relief on the basis that the equities are not equal.103 This situation may arise where an automatic security negative pledge does not include an in scintilla temporis clause and the ‘equal and rateable’ clause is only effective in producing a subsequent security interest. Although this position is relatively unexplored, there are two possible arguments that might be put forward.
First, is the decision in Williams v Burlington Investments.104 In that case, one party had the benefit of a registered agreement to create a legal mortgage, which was later executed into a legal mortgage. The other party possessed an equitable mortgage, which had been created after the registration of the agreement to create a legal mortgage but before the execution of the actual legal mortgage. The court awarded priority to the holder of the later legal mortgage on the basis that the holder of the earlier equitable mortgage had taken its security interest with notice of the agreement to create a legal mortgage, despite that agreement not constituting a security interest in itself. In this case, the notice argument was strengthened by the intervention of the Land Charges Act 1925, which allowed an agreement to create a legal mortgage to be registered. Nonetheless, this case has been cited by academics as an example of where notice of an agreement to create security was effective in determining priority.105
Second, an analogy can be made with the operation of an automatic crystallisation negative pledge in similar circumstances. Where a party takes security with actual notice of an earlier floating charge negative pledge, which prohibits the creation of further security, that party will take subject to the earlier floating charge.106 The counter-argument is that such an analogy should not be made on the basis that a floating charge is a present security interest while an automatic security negative pledge is mere contract before the breach.107 Nonetheless, if the Creditor was to obtain a security interest following the creation of the third party security, then the Creditor may be able to seek relief from the equitable jurisdiction of the court. According to McKnight, “where the lender has itself a proprietary interest competing with that of the defendant, [an equitable remedy might include] a declaration upholding the lender’s claim to priority in the relevant asset and that the defendant should hold its rights on trust for the lender.”108 Accordingly, an automatic security negative pledge will provide the Creditor with a more effective equitable remedy than a mere contractual negative pledge.
3.5 Conclusion on the effectiveness of a security interest arising from an automatic security negative pledge against third parties?
For an automatic security negative pledge to create an ‘equal and rateable’ security the Creditor must incorporate an ‘in scintilla temporis’ clause within the terms of the automatic security negative pledge. Based on the judicial treatment of ‘crystallisation negative pledges,’ it appears an ‘in scintilla temporis’ clause will be valid if drafted appropriately. Finally, there may exist an opportunity for a Creditor to claim equitable relief in the event that a third party takes security with knowledge of the terms of the automatic security negative pledge. However, such a claim has little precedent and has not, as yet, received substantial academic examination.
Part 4: What non-proprietary rights will arise from a breach of an automatic security negative pledge?
It has been argued that an automatic security negative pledge can be drafted to create a valid security interest upon a breach of the negative pledge. However, where an automatic security negative pledge is drafted inappropriately or otherwise fails to create a security interest, there may be other remedies available to the Creditor. These remedies will be considered but, as will be discussed, they insufficiently mitigate the loss arising to the Creditor from failing to take security under the automatic security negative pledge.
The Creditor should be able to proactively seek a prohibitory injunction against the Debtor to prevent the breach of the negative pledge.109 Obtaining a prohibitory injunction should be a relatively straightforward process where the negative pledge clause is clear as to its intentions on the basis of Lord Cairns comments in Doherty v Allman; “[i]t is not then a question of the balance of convenience or inconvenience, or of the amount of damage or of injury - it is the specific performance, by the Court, of that negative bargain which the parties have made, with their eyes open, between themselves.”110 In Marco Productions, Ltd v Pagola,111 the court demonstrated a willingness to grant a prohibitory injunction to restrain the breach of a negative undertaking even though the applicant could not prove that damage would result from the breach of the negative pledge clause. In the scenario of a negative pledge clause precluding the creation of further security, the potential damage is manifest and the case for a prohibitory injunction should be strong.
The foremost issue with seeking a prohibitory injunction is that it requires the Creditor to have knowledge of the fact that the Debtor is planning to breach the negative pledge. Such knowledge may not be readily available to the Creditor as the Debtor is unlikely to advertise the fact that it is seeking to breach the terms of the negative pledge and, by extension, the loan agreement. Accordingly, unless the Creditor has clear prior notice of the intended breach of the negative pledge, the prohibitory injunction is of little value.
The other form of potential injunction is the mandatory injunction. The mandatory injunction goes further than the prohibitory injunction by taking positive steps to undo an action.112 In respect of the negative pledge, it would require the courts to unwind the security granted to the third party. Han comments that the granting of a mandatory injunction in such a scenario would be “inappropriate”113 as “this would cause the third party damage out of all proportion to any advantage which the unsecured negative pledgee ought to obtain”.114 Goode considers that a court is “unlikely” to grant a mandatory injunction in the context of an automatic security negative pledge.115 Therefore the value of a mandatory injunction in the context of a breach of an automatic security negative pledge is likely to be minimal.
4.2 Tort of interference with contractual relations
The tort of interference with contractual relations is a claim that can be made directly against the third party. A classic definition of the tort is provided by Jenkins LJ in DC Thomson & Co Ltd v Deakin who states: “[t]he tort is committed if a person without justification knowingly and intentionally interferes with a contract between two other persons".116 Of the elements of this tort, knowledge appears to be the most difficult to establish.
The third party must have sufficient knowledge of the terms of the contract to know that its actions were inducing a breach of contract.117 According to the comments of Browne-Wilkinson J in Swiss Bank Corporation v Lloyds Bank Ltd,118 the requisite level of knowledge must be actual, as opposed to constructive.119 However, it has been suggested that the constructive knowledge should also be accepted120 and this appears to be the approach adopted by the court in Merkur Island Shipping Corporation v Laughton.121 Nonetheless, according to McKnight, the preferred and current state of the law regarding knowledge is that enunciated by Browne-Wilkinson J, which is that actual as opposed to constructive knowledge is required.122
Where the tort is established and it can be shown that the Creditor has suffered a loss, damages should be available. The amount of damages will equal the difference between the value of the Creditor’s claim as an unsecured creditor, had the third party never taken security, and the value of the Creditor’s claim as diminished by the third party’s secured claim to the assets.123 As a result, in calculating damages, the court would take into account the fact that the value of the third party’s security interest would have been shared amongst all the unsecured creditors of the Debtor.124 This means that any actual loss suffered by the Creditor may well be a small fraction of the value of the security. Furthermore, as pointed out by Han, the third party would still gain much more by taking security and paying out the tortious damages, than by not taking security at all.125 Therefore, there may be little incentive for a Creditor to pursue a tort of interference with contractual relations claim if the Debtor is so indebted that the potential damages arising the claim are negligible.
4.3 The ‘De Mattos v Gibson principle’
The De Mattos v Gibson principle derives from the case of the same name.126 In that decision, Knight Bruce LJ stated that where the purchaser of an interest in property takes that interest with knowledge of a contract relating to the property, that purchaser will be prevented from dealing with the property in a manner inconsistent with the contract. The courts in Swiss Bank127 and Mac-Jordan Construction Ltd v Brookmount Erostin Ltd128 have both accepted the principle as a binding authority.
The De Mattos v Gibson principle has been described as the “equitable counterpart” of the tort of interference with contractual relations.129 However, the De Mattos v Gibson principle differs in respect of the remedy. Whereas the common law tort will lead to an award of damages, the equitable De Mattos v Gibson principle will instead lead to an injunction order to prevent the defendant from exercising certain rights that interfere with the original contract. Thus, a Creditor might be able to prevent the third party from realising its security over the assets of the Debtor.130
However, the equitable nature of the De Mattos v Gibson principle would mean that any remedy would be discretionary and might be refused. Potential grounds on which an equitable remedy could be refused include delay in seeking relief, acquiescence by the Creditor or the Creditor’s own unclean hands.131 This discretion of the court was exercised in both De Mattos v Gibson132 and Swiss Bank133 to deny the respective plaintiffs equitable relief on account of extenuating circumstances, even though the validity of the principle was confirmed in both cases. As a consequence of these issues, it would appear that the De Mattos v Gibson principle is severely limited in respect of both the narrow scope of its remedy and the discretionary nature of its application. Additionally, the paucity of cases in which this principle has been explored, much less applied, suggests that it would be difficult to rely on this principle with any significant level of certainty.
4.4 Conclusion on non-proprietary remedies
It is evident that where a Creditor fails to obtain security in the Debtor’s assets, the available non-proprietary courses of actions are largely inadequate. Of the available non-proprietary courses of actions, a prohibitory injunction provides the most ideal solution, but requires prior knowledge of the breach. Pursuing a claim under either the tort of interference with contractual relations or the De Mattos v Gibson principle is both difficult to establish and may provide an insufficient remedy.
This article has argued that an appropriately drafted automatic security negative pledge can be effectively implemented to protect the interests of creditors. This conclusion has been reached by separately examining the pertinent legal and practical issues regarding the automatic security negative pledge and procuring solutions. Overall, this article has reached two conclusions. First, equity will recognise the creation of a security interest upon the breach of the negative pledge with no need for further consideration. This however, is provided that the automatic security negative pledge is drafted with sufficient certainty and that the issue of registration is managed through effective observation of the debtor. Second, it has been argued that the security created by an automatic security negative pledge will be effective against third parties that take security with notice of the negative pledge. The ‘in scintilla temporis clause’ provides an effective method of obtaining priority over third party security interests. The legal operation of an ‘in scintilla temporis clause’ is analogous to that of an automatic crystallisation floating charge, which has received clear judicial support. Critically though, this priority will not extend to third parties that take security without notice and this risk must be managed through effective observation of the debtor. Finally, the non-proprietary remedies were shown to be largely ineffective. Broadly, this ineffectiveness reflects the strength of the proprietary rights obtained by the third party compared to the mere tortious and equitable claims of the creditor. Overall, the automatic security negative pledge provides a creditor with a uniquely flexible and effective form of security in financing arrangements.
*Peter Madden studied a Bachelor of Commerce and a Bachelor of Laws at the University of Sydney before working in tax law for 2 years. Peter then left Sydney to pursue a Master of Laws in International Banking and Finance Law at University College London. Following the LLM, Peter has commenced a training contract at Norton Rose Fulbright at their London office. Peter has also previously worked as a research assistant to Professor Ben McFarlane in the area of proprietary estoppel.
1 Based on the example of an automatic security negative pledge provided in: Gregory Hill, ‘Negative pledge with provision for ‘automatic security’ on breach: a form of floating charge?’ (2008) 23 BJIB & FL 528, 528.
2 Roy Goode, Goode on Legal Problems of Credit and Security (Louise Gullifer ed, 4th edn, Sweet & Maxwell 2008) 54; Tan Cheng Han, ‘The Negative Pledge as a “Security” Device’  Sing JLS 415, 436; Jonathan Stone, ‘The Affirmative Pledge’ (1991) 6 JIBL 364, 365; Julie Maxton, ‘Negative pledge and equitable principles’  JBL 458, 464.
3 National Provincial and Union Bank of England v Charnley  1 KB 431, 445.
4 Banks v Sutton (1732) 2 P.Wms. 700, 715; Crabtree v Bramble (1747) 3 Atk. 680, 687; Walsh v Lonsdale (1882) 21 Ch.D. 9, 14-15; Frederick v Frederick (1721) 1 P.Wms. 710, 713; Charnley (n 3) 445.
5 Hill (n 1) 529; Smith v Bridgend County Borough Council  UKHL 58;  1 AC 336, 61-63 (Lord Scott) (Smith v Bridgend).
6 Banks (n 4) 715; Crabtree (n 4) 687; Walsh (n 4) 14-15; Frederick (n 4) 713; Charnley (n 3) 445.
7 Crabtree (n 4) 687.
8 Frederick (n 4) 713.
9 Holroyd v Marshall (1862) 10 HLC 191.
10 Tailby v Official Receiver (1888) LR 13 App Cas 523, 547-547; Richard Calnan, Taking Security: Law and Practice (2nd edn, Jordan Publishing Limited 2012) 62-63.;
11 Burgess v. Wheate, Attorney General v. Wheate (1759) 1 Eden 177, 186.
12 Charnley (n 3) 445.
13  AC 52.
14 ibid 65-66.
15 Interestingly it appears that equity will allow an exception where the agreement relates to security over future property (Holroyd (n 9)). Goode asserts that “[a]n agreement for a mortgage or charge is treated in equity as a security interest only if it is not subject to any contingency other than the debtor’s acquisition of an interest in the asset”. (Goode (n 2) 76)
16 Re Anstis (1886) 31 Ch.D. 596, 605-606.
17 Maxton (n 2) 466.
18 Peter Gabriel, Legal Aspects of Syndicated Loans (Butterworths 1986) 87.
19 Goode (n 2) 57; Maxton (n 2) 472; Andrew McKnight, ‘Restrictions on dealing with assets in financing documents: their role, meaning and effect’ (2002) 17 JIBL 193, 204.
20 Gabriel (n 18) 84.
21 De Beers Consolidated (n 13) 65-66.
22 Goode (n 2) 54.
23 Gabriel (n 18) 85.
24 Frederick (n 4) 713.
25 Walsh (n 4) 14-15.
26 Goode (n 2) 57, Maxton (n 2) 472, McKnight (n 19) 204.
27 Maxton (n 2) 467.
28 Goode (n 2) 55.
29  2 Ch 467
30 ibid 479.
31 Goode (n 2) 55.
32 Maxton (n 2) 469-470.
33 Gabriel (n 18) 88.
34 Stone (n 2) 365.
35  1 Ch 203.
36 ibid 211.
37 Goode (n 2) 55.
38 Gabriel (n 18) 87-88.
39 ibid 88.
40  1 SLR 300 (The Asiatic).
41 ibid 307.
43 Murphy v Wright (1992) 5 BPR 11,734; Troncone v Aliperti (1994) 6 BPR 13,291; Chiodo v Murphy (1995) V Conv R 54-531.
44 Murphy (n 43).
45 ibid 11,739.
46 Gabriel (n 18) 87; Han (n 2) 437; Stone (n 2) 365.
47 Gabriel (n 18) 87.
48 McKnight (n 19) 203; Goode (n 2) 56.
49 McKnight (n 19) 203.
50 Frederick (n 4) 713.
51 Walsh (n 4) 14-15.
52 Hill (n 1).
53 Smith v Bridgend (n 5) 61-63 (Lord Scott).
56  2 K.B. 979, 1000, (Buckley LJ).
57  EWHC 2318 (Ch)  B.C.C. 770, 781.
58 Hill (n 1).
60 ibid 529.
61 ibid 531.
63 For example, Dunn v Blackdown Properties Ltd  Ch 433, refers to easements.
64 Re Brumark Investments Ltd  2 AC 710 (Re Agnew), 31-32; Re Spectrum Plus Ltd (In Liquidation)  UKHL 41;  2 AC 680 (Re Spectrum Plus).
65 Re Agnew (n 64).
66 Re Spectrum Plus (n 64).
67 Re Agnew (n 64) 31-32.
68 Tailby (n 10).
69 ibid 533.
71 (1839) 3 Y & C Ex 384.
72 ibid 391.
74 McKnight (n 19) 203-204.
75 McKnight (n 19) 204.
76 Companies Act 2006, pt 25 (CA 2006).
77 ibid s 859A(4).
78 ibid s 859H(3).
79 ibid s 859H(4).
80 Goode (n 2) 56.
81 Philip Wood, International Loans, Bonds, Guarantees, Legal Opinions (The Law and Practice of International Finance vol 3, 2nd edn, Sweet & Maxwell 2007) 112.
83 Gabriel (n 18) 86 footnote 15; Stone (n 2) 369.
84 Phillips v Phillips (1861) 4 De GF & J 208, 215.
85 Gartside v Silkstone and Dodworth Coal and Iron Co (1882) 21 Ch D 762, 767-768.
86 Stone (n 2) 364; Goode (n 2) 56-57; Han (n 2) 438-440.
87 Literally meaning ‘a sliver of time.’
88 Phillips (n 84) 215.
89 Re Brightlife  Ch 200.
90 ibid 215.
91 Re Permanent Houses (Holdings) Ltd  BCLC 563, 567.
92 Fire Nymph Products Ltd v Heating Centre Pty Ltd (in liquidation) (1992) 7 ACSR 365.
93 Re Manurewa Transport Ltd  NZLR 909.
94 Fire Nymph (n 92).
95 ibid 373.
96 Re Manurewa (n 93).
97 William James Gough, Company Charges (2nd edn, Butterworths 1996) 255.
100 Fire Nymph (n 92) 373.
101  2 VR 591, 601.
102 Phillips (n 84) 215.
103 Bailey v Barnes  Ch 25 at 36; Harpham v Shacklock (1881) 19 Ch D 207, 214.
104 (1977) 121 Sol Jo 424.
105 John Stumbles, ‘The Legal Problems of Secured Financing’ (IBC conference, Sydney, 1987) 9; Stone (n 2) 365.
106 English & Scottish Mercantile Investment Co Ltd v Brunton  2 QB 700, 707; Wilson v Kelland 2 Ch 306.
107 Goode (n 2) 58, 196-197.
108 McKnight (n 19) 202.
109 Han (n 2) 421-422.
110 (1878) 3 App Cas 709, 719-720.
111  1 KB 111.
112 Goode (n 2) 58.
113 Han (n 2) 422.
115 Goode (n 2) 58.
116  Ch 646, 702.
117 JT Stratford & Son Ltd v Lindley  AC 269, 332.
118  Ch 548 (Swiss Bank).
119 ibid 575.
120 John Crosthwait and Nigel Boardman, ‘Wither the negative pledge’ (1986) 1(3) JIBL 162, 162; Han (n 2) 425.
121  2 AC 570, 591.
122 McKnight (n 19) 201.
125 Han (n 2) 431.
126 De Mattos v Gibson (1858) 4 De G J 276.
127 Swiss Bank (n 118) 573.
128 Mac-Jordan Construction Ltd v Brookmount Erostin Ltd  CLC 581, 587.
129 Swiss Bank (n 118) 573.
130 Han (n 2) 435.
132 De Mattos (n 126) 300-301.
133 Swiss Bank (n 118) 575-576.