Part XI

restating the law of security

Introduction

                11.1               In Part VII we provisionally proposed that traditional securities and their functional equivalents (quasi-securities) should be treated identically for the purposes of perfection by notice-filing, as with the overseas systems. However, the decision to introduce a similar system for England and Wales may have implications beyond simply requiring a financing statement to be filed in respect of a wider range of transactions than are currently registrable under the Companies Act 1985. In this Part we consider the implications for the general rules applying to security interests, and in particular the remedies available to either party if the security interest is enforced.[1]

                11.2               If charges and their functional equivalents are to be treated identically in that both types of security interest need to be perfected by notice-filing, it seems logical to treat them in the same way for other purposes also. For instance, in the UCC, the SPPSA and the NZPPSA it is provided that, with exceptions we will mention in a moment, if a security interest is realised and the amount produced by the sale of the asset exceeds the amount due to the creditor, the balance should be payable to the debtor. This applies whether the security interest was by way of charge or was a hire-purchase or other retention of title device.[2] Similarly, the Crowther report recommended that a secured party exercising its power to sell property subject to any type of security interest should be deemed to sell for the account of the debtor, and should be under an obligation to hand over any surplus remaining after discharge of expenses.[3] The Diamond report suggested that the provisions of the Crowther report dealing with the rights of the debtor and the rights of the secured party on default:

to be among the most important in the new scheme and a significant justification for adopting it.[4]

It recommended that the Crowther report proposals should be implemented.[5]

                11.3               The exception from the rules as to surpluses or deficiencies to which we referred in the previous paragraph relates to outright sales of receivables. We have proposed that outright sales of receivables should be registrable, and that this should affect the priority of competing claims over receivables. However we proposed that outright sales of receivables should be excluded from the application of the surplus and deficiency rules. Exceptions to this effect are found in the UCC and Commonwealth legislation, and were recommended also by the Crowther report.[6]

                11.4               The overseas legislation referred to goes further than dealing with the question of surplus. It sets out a scheme of remedies and other provisions applying to security interests in general, amounting to a partial restatement or codification of the law of security over moveable property. The Crowther report recommended a similar approach, and the Diamond report, without discussing the provisions in detail, agreed that there should be a scheme based on Part 5 of the UCC and Part V (“Default – Rights and Remedies”) of the Canadian Model PPSA.[7] One of the questions to be addressed in this Part is whether the new legislation we are provisionally proposing should do the same.

                11.5               The UCC, the SPPSA and the NZPPSA, like the systems envisaged by the Crowther and Diamond reports, apply to security interests in personal property created by any debtor, corporate or not. We have provisionally proposed that a similar scheme be adopted in England and Wales; but for reasons we have explained,[8] we think that it is likely that any notice-filing scheme will be applied in the first instance to security interests created by companies and only later be extended to security interests created by other debtors.

                11.6               There are therefore two separate issues. One is whether a restatement of the law of security along the lines indicated should form part of a complete scheme applying to security interests created by debtors generally. The other is whether it should form part of the more limited scheme, applying only to security interests created by companies. It is possible that consultees will think that if there were to be reform of the law applying to the granting of security over property other than land by all debtors, it would be appropriate to include such provisions in any legislation, but also consider that, in the context of reform affecting only security interests created by companies, it is unnecessary or even undesirable to set out a scheme of general provisions applying only to security interests created by companies.

                11.7               As will be seen below,[9] it is our provisional view that a complete scheme applying to security interests created by any debtor should include a restatement of the kind envisaged.

                11.8               As far as concerns security interests created by companies, what alternatives are there to restating the law of security? There seem to be two. One is for the new legislation to require that quasi-securities created by companies should be registered, and be subject to the same rules of priority as traditional security interests, yet not provide any further rules, for example on the entitlement to any surplus value the asset has over the outstanding debt or remedies for enforcement.

                11.9               The other alternative is to include in the proposed legislation on company charges a short provision stating that for certain purposes, quasi-security devices such as hire-purchase should be treated ‘as if’ they were security devices in the traditional sense. Thus the parties would have the same rights and remedies as if the devices were securities, but without setting out those rights and remedies in the legislation.

             11.10               Thus our questions to consultees in this Part are:

             11.11               Before we ask consultees to decide these issues, however, we think it would be useful to describe in outline what might be contained in a restatement of the principal rules on creation and enforcement of securities and quasi-securities. At this stage we have not produced a draft restatement even as part of the scheme for extending the notice-filing scheme to all debtors. This is partly because of the short time in which this Consultation Paper has had to be prepared, and partly because it does not seem sensible to do the work unless consultees take the view that it would be desirable, either as part of the company charges aspect or as part of the wider exercise. Instead we merely describe in outline the main provisions that have been adopted in the NZPPSA (Part 9) and the SPPSA on creation of the security interest, the rights of the parties and remedies for default.[10] These Acts have been selected as the law in Canada and New Zealand is closer to the law in England and Wales than the codification contained in the UCC. We then return to the questions set out above.

             11.12               For those who are interested, the provisions of the SPPSA and NZPPSA are described in more detail in Appendix B, together with relevant recommendations of the Crowther and Diamond Reports. In the Appendix we give brief accounts of the existing law, comment on the need for particular provisions and ask for consultees’ views both on the provisions described and on whether there are others that should be included.

A restatement of the law of security

Scope of application

             11.13               The schemes for notice-filing that we have described in earlier parts of this Consultation Paper do not apply to possessory securities (principally the pledge). These are perfected by the creditor taking possession of the goods or document that forms the collateral. In addition we have provisionally proposed that security interests over some assets should be capable of perfection by ‘control’ rather than by filing.

             11.14                If the legislation were to contain a partial codification of the law of security, one point that would need to be considered is whether security interests that are not perfectable by filing, such as possessory security interests, should be brought within the system. Both the Crowther and Diamond reports suggested that although it should not be necessary to register such interests, they should come within the general schemes proposed in those reports.[11]

             11.15               The SPPSA and NZPPSA schemes apply to all security interests and indeed contain some provisions that apply only to possessory security.[12]

Effectiveness of the security agreement[13]

Creation[14]

             11.16               The SPPSA and NZPPSA each provide that a security agreement is effective according to its terms.[15] However the agreement is only enforceable against third parties where either the collateral is in the possession of the secured party or the debtor has signed a security agreement which contains the specifications of the collateral or the form the collateral takes.[16] The NZPPSA specifically states that a security agreement may be enforceable against a third party in respect of particular collateral even though the security agreement is not enforceable against a third party in respect of other collateral to which the security agreement relates.[17]

             11.17               The Diamond Report suggested that it would be useful to create model forms for security agreements, though it stressed that use of the form would be entirely optional.[18]

Attachment[19]

             11.18               The SPPSA, section 12 provides that a security interest attaches when:

unless the parties have agreed to postpone attachment. There are also rules for crops, the young of animals, minerals and trees.[20]

Rights and remedies on default

Secured party may require payment of money

             11.19               Where collateral is a debt or chattel paper, and there has been a default by the debtor under the security agreement, the secured party may require the party liable to pay the debt or the person liable under the chattel paper to pay the debt to him regardless of whether collections on the collateral were made prior to the notification.[21] The secured party is also entitled to ‘take control of’ the proceeds of any collateral to which the secured party is entitled.[22] In either of the above cases, the secured party must give notice to the debtor no later than 15 days after enforcing the security interest.[23] There are also provisions on the steps a secured party may take when the collateral is a licence.[24]

Taking possession

             11.20               The SPPSA provides that where the debtor has defaulted under the security agreement the secured party has the right to take possession of the collateral.[25] There are provisions dealing with property that cannot readily be moved from the debtor’s premises or of a kind for which adequate storage facilities are not readily available.[26] Under the NZPPSA a secured party with priority over all other secured parties may take possession of and sell the collateral where the debtor is in default under the terms of the security agreement or where the collateral is at risk.[27]

Powers and duties of receivers

             11.21               Under the SPPSA a security agreement may provide for the appointment of a receiver and it may also set out the rights and duties of that receiver subject to any provisions in that Act or other Acts.[28] The SPPSA then sets out the role of a receiver, which includes taking custody and control of the collateral[29] and keeping records.[30]

             11.22               In contrast the NZPPSA does not outline the function of the receiver as this is dealt with in the Receiverships Act 1993, which details the duties[31] and powers[32] of receivers. Where a provision of the NZPPSA Part 9 is inconsistent with the Receiverships Act 1993 the latter Act prevails.[33]

Sale of collateral

             11.23               The secured creditor has a power of sale or disposal of the collateral that has been seized or repossessed.[34] It must give notice to the debtor or other relevant persons prior to sale of the collateral.[35] There are exceptions to the notice requirement for situations in which notice would be impracticable.[36] The sale must be made in a commercially reasonable manner;[37] under the NZPPSA there is a duty to sell for the best price reasonably obtainable.[38] It is provided that a good faith purchaser is not affected by any failure to follow the statutory requirements as to sale,[39] and that the sale will extinguish all security interests in the collateral and its proceeds that are subordinate to that of the secured party.[40] There are provisions as to the application of the proceeds.[41]

Surplus or deficiency

             11.24               Where a surplus has arisen following sale of collateral by the secured party the payment of that surplus has to be made in a specific order.[42] The SPPSA provides that the debtor is placed last to receive any surplus.[43] The legislation then deals with deficiency. The debtor is liable to pay any deficiency to the secured party except where a prior agreement contrary to this provision has been made or where another provision of the SPPSA or another Act applies.[44]

Retention of collateral (foreclosure) by the secured party

             11.25               Following a default by the debtor a secured party may make a proposal to take the collateral in satisfaction of the obligation secured by it.[45] Notice of the proposal must be given to those with a relevant interest[46] and objections by those persons must be received within the relevant period of notice.[47]

Right to redeem collateral

             11.26               Before the secured party or receiver has disposed of the collateral, or before the secured party has irrevocably elected to retain the collateral, it may be redeemed.[48] The redemption may be made by those entitled to notice of the disposition.[49] A person entitled to redeem may do so by “tendering fulfilment of the obligations secured by the collateral”[50] or paying a sum equal to the reasonable expenses of enforcing the security agreement.[51]

Reinstatement of security agreement

             11.27               The debtor may reinstate the security agreement prior to the secured party disposing of the collateral or being deemed to have taken the collateral in satisfaction of the obligation secured by it.[52] Reinstatement may occur where the debtor pays the sums in arrears “exclusive of the operation of an acceleration clause in the security agreement”;[53] remedies any default “by reason of which the secured party intends to sell the collateral”[54] and pays reasonable expenses incurred by the secured party in enforcing the security agreement.[55]

Applications to court

             11.28               The SPPSA provides that where an application is made by an ‘interested person’ the court may make an order which determines questions of priority or entitlement to collateral[56] or the court may direct that an action be brought or an issue is to be tried.[57]

Remedies of secured party when collateral is seized by a third party

             11.29               Under a notice-filing system, if a security interest has not been perfected, third parties such as judgment creditors or liquidators are entitled to seize the property that is subject to the security interest. Where the underlying security agreement is a loan, the debtor will still be liable for the outstanding balance and can recover the sums due from the debtor or prove in the insolvency. If the underlying agreement was a lease or a consignment, the SPPSA, section 21 provides that the measure of damages is the value of the leased or consigned goods at the date of seizure plus any further loss suffered as a result of the termination of the lease or consignment.

             11.30               The SPPSA contains provisions on security interests over fixtures and growing crops, in particular dealing with the question of priority as against interests in the land.[58] It also deals with accessions to goods[59] and processed and commingled goods.[60]

General provisions

             11.31               The SPPSA and NZPPSA contain some general provisions. Thus the SPPSA provides that (unless otherwise provided in that Act), a provision in a security agreement or any other agreement purporting to exclude any duty or onus imposed by that Act, or purporting to limit either the liability of, or amount of damages recoverable from, a person who has failed to discharge any duty or obligation imposed by that Act, is void.[61] The SPPSA deals also with the debtor’s right to transfer goods;[62] and contains rules on such matters as the service of documents.[63]

Tracing

             11.32               In the event of an unauthorised disposition of the collateral, should a security interest continue to exist over the asset? This involves the question of tracing. The Diamond report said:

it would be desirable for the new legislation to spell out the details with some precision, and in my view it should be made clear that … the right to trace does not depend on the presence of a fiduciary relationship.[64]

Is a restatement needed?

             11.33               We now turn back to the questions posed earlier. To repeat: should a notice-filing scheme for securities and quasi-securities created by debtors of all types contain a restatement of at least the principal rules on creation and enforcement of securities and quasi-securities? If in the first instance the scheme applies only to companies, is a restatement necessary? Alternatively, should the scheme for companies have no provisions on these issues? Or should it contain a short provision to the effect that for the purposes of enforcement, quasi-security devices within the scheme should be treated ‘as if’ they were securities?

             11.34               We think that to subject quasi-securities generally to notice-filing and the associated priority rules, without providing that they are to be treated like traditional securities, is possible. However it would produce less than satisfactory results.

             11.35               First, the result would be to perpetuate the distinctions for which the earlier reports so roundly criticised the current law. It will be recalled that the Crowther report saw two points as fundamental:

Replacement of what are at present distinct sets of rules for different security devices by a legal structure applicable uniformly to all forms of security interest.[65] 

             11.36               Secondly, simply to make quasi-securities registrable but to do no more might produce unattractive results. Take the question of surplus value. If there were no rule that surplus value obtained on the sale of a ‘title-retention’ transaction like a hire-purchase agreement, it would mean that no creditor could have a security interest in the same asset subordinate to the quasi-security, even if the asset were worth much more than the sum outstanding. The holder of the quasi-security would simply be able to take back the asset concerned without being accountable to anyone else for the surplus value. This of course is the position under the present law; however, in a notice-filing system applying to quasi-securities it might cause difficulties. It would mean that the register, in order to give adequate information to third parties, might have to indicate whether the security interest claimed was a quasi-security or a ‘true’ security; or at least it would mean that third parties would have to enquire into the nature of the security interest. This would make the law more - rather than less - complicated and it seems unnecessary.

             11.37               We have suggested that for security interests granted by companies it might be possible to achieve the desired result, in the first instance, by a short ‘as if’ provision. The difficulty we see with this, and why we do not propose it as a long-term solution, is that it may be difficult to decide which parts of the law of security should be treated as applicable to quasi-security devices - or to which quasi-security devices. As we pointed out earlier, we would wish to follow other schemes in exempting from the ‘surplus and deficiency rules’ either all outright sales of receivables (as in New Zealand) or at least those that do not have ‘a security purpose’ (as in the SPPSA).[66]

             11.38               Moreover, the law governing the creation of and remedies relating to traditional security devices is far from perfect. As our brief survey above suggests - and as is demonstrated further in Appendix B - it is complex, sometimes drawing distinctions that seem outmoded and unnecessary; it is, as we have discovered to our cost, not easy to find; and it does not deal with many practical issues that concern creditors and debtors in the modern world. The case for revision would be even stronger were it to apply to security interests created by non-corporate debtors, since then the provisions of the Consumer Credit Act 1974 apply, usually improving the law but adding to its complexity. The law on security is ripe for restatement in the form of a simple statutory code, and preferably one that does its best to make the law accessible to the businesspeople and consumer advisers who have to apply it. Restatement should aim, in the words of the Tax Law Rewrite Project:

To make any replacement legislation clearer and more accessible to the reader, so far as is possible without making the law significantly less certain, by using language which is non-technical with simple sentences, by setting out the law in a simple structure following a clear logic and by using a presentation which is easy to follow.[67]

             11.39               The New Zealand Law Commission did not make any recommendations on restating the law of security, but merely proposed that remedies could be dealt with separately.[68] Likewise, the Australian Law Reform Commission suggested that it was unnecessary to extend the scope of its report to consider the law governing remedies on default.[69] However this latter Commission reported that one of the architects of the New Zealand Law Commission report now considered that remedies should have been covered,[70] and the NZPPSA does incorporate a scheme of remedies.[71] Thus Commonwealth experience suggests that in the long run a restatement of the rules is desirable.

             11.40               Our provisional conclusion is that a system of notice-filing that takes a functional approach, so as to apply to both securities and quasi-securities created by a debtor of any type, should contain a restatement of at least the principal rules on creation and enforcement of securities and quasi-securities. In general the same rules should apply to both kinds of interest. Thus it should operate so as to ensure that there was no difference in the treatment of surplus arising from resale as between security devices in the traditional sense and functionally-equivalent devices that involve the creditor retaining title.[72] The creditor who ‘enforces’ the security device by taking possession of the asset should be placed under similar obligations to obtain a good price for the asset and to account for the surplus to the debtor or junior creditors.[73]

The initial scheme for companies only

             11.41               We have explained that any notice-filing scheme is likely to be applied in the first instance only to security interests created by companies.[74] Even here there would be advantages in having a restatement. We do not think that the fact that the scheme would be confined to company security interests really affects the substance. The point of stating the relevant rules in the legislation is to clarify them and in particular to make it clear when the particular rules are applicable. The fact that the debtor is a company does not make the rules significantly easier to understand or to apply. Those issues are much the same whoever the debtor is. 

             11.42               If there are advantages in having a restatement ‘sooner or later’, the issues become ones of timing and the means of implementation. That poses two problems. The first is time. To draft a restatement of the law on creation of security interests and the rights of the parties and enforcement would take some time. Even if there were no questions of policy, it would require at least that an ‘exposure draft’ be circulated for consultation. In practice there are likely to be issues of policy (even beyond those flagged up in Appendix B) on which we would need to consult. The second is the means of implementation. It would no doubt be possible to include a restatement of the law of security in Regulations which would be made under any forthcoming Companies Bill and which would apply only to security interests created by companies, but it would produce unjustified distinctions between securities created by companies and those created by non-corporate debtors.

             11.43               Thus though in an ideal world we would prefer to enact a statutory statement of the rules on the creation of security interests, the rights of the parties and enforcement at the same time as a notice-filing system covering quasi-securities created by companies, it seems likely that lack of legislative time, if nothing else, will mean that this cannot be done.

             11.44               Earlier we suggested as one solution a short ‘as if’ provision, to the effect that quasi-securities might be treated ‘as if’ they were securities in the true sense. The difficulty might be to know which rules of ‘security’ should apply to quasi-securities. It would be possible to give an indication - for instance, the provision might include a statement that this would apply when the property is repossessed because of the debtor’s default and would include:

             11.45               However, we think such an approach is likely to be unsatisfactory. Either the legislation would have to limit very severely the ‘security’ rules that should apply to quasi-securities, in which case the limits will seem arbitrary; or, if it is in broader terms, it is likely to cause considerable uncertainty. In our view it would be better to apply none of the security rules other than the requirement of notice-filing and, where relevant, those of priority, until a full restatement can be prepared setting out which rules apply in what circumstances.

             11.46               We therefore propose that, as a temporary measure only, the scheme for replacing registration of company charges by notice-filing of both charges and the quasi-security devices we have indicated should not contain provisions dealing with the creation and enforcement of security interests. It could then be brought into force by Regulations made under any proposed Companies Act. However, a restatement of relevant rules, setting out clearly what these are and the extent to which they apply to each kind of security interest should be prepared for subsequent enactment, preferably with the extension of the notice-filing scheme to non-corporate debtors that we proposed in Part X.[75]

             11.47               We ask consultees whether they agree with our provisional conclusions that: