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Cautionary tale of the unintended consequences of a lender taking an assignment ‘by way of security’ of the benefit of development documents

  • United Kingdom
  • Construction and engineering - Articles
  • Litigation and dispute management

08-08-2017

Mailbox (Birmingham) Limited v Galliford Try Construction Limited [2017] EWHC 67 (TCC)

The Technology and Construction Court (TCC), earlier this year, considered the effect of an assignment of the benefit of development documents to a lender. The key question was whether, the borrower, Mailbox, had the benefit of the building contract at the time it commenced an adjudication against Galliford Try, the contractor. Galliford Try sought to resist enforcement of the adjudicator’s award on the basis that Mailbox did not have the benefit of the rights in the building contract because it had assigned these to the lender.

In considering this question the court examined the drafting of the debenture (a security document entered into between Mailbox and its lender) and the notice issued to Galliford Try in accordance with the debenture in order to determine whether an assignment of the building contract to the lender had taken effect. The court found that:

  • the assignment of the benefit of the contract to the lender was a legal assignment - it was in writing, absolute and notice had been given
  • issuing a notice was more consistent with an absolute legal assignment rather than by way of charge only
  • the drafting of the assignment provision in the debenture was sufficiently wide to capture future rights and therefore the building contract, which was entered into after the debenture
  • the lender had given express permission to Mailbox to exercise all rights assigned – this was not held to make the assignment conditional as the premise of the permission was that the rights had already been assigned
  • other clauses in the debenture drew a distinction between creating a floating charge, a fixed charge and assignment, which was construed as further evidence of the parties’ intention to create an absolute legal assignment and not a charge

Having concluded that the building contract had been assigned to the lender the court then considered whether it had been re-assigned to Mailbox, before Mailbox commenced the adjudication. The court determined that the lender had re-assigned the benefit of the contract, by a deed of assignment, to Mailbox, before commencing the adjudication, but had failed to issue the notice of assignment before doing so. This was deemed to create an equitable assignment. Where an assignment takes effect in equity, the general rule is that it is the party holding the benefit of the rights who has the right to sue in its own name, in this case Mailbox. It is open to the courts to require the assignor to be joined in any proceedings to enforce the assigned rights, but this is usually to protect the relevant debtor from a second claim. In the Mailbox, since there was no dispute between the lender and Mailbox as to the effect of the re-assignment and therefore no further claim in respect of the assigned rights, it was not necessary to join in the lender.

Issues arising

The standard market position, as reflected in the LMA debenture, is for lenders to take an absolute assignment, subject to re-assignment, of the development documents. The Mailbox case has highlighted a potential downfall of doing so and now any counterparty to an assigned development document when faced with a claim from the employer (borrower) will be alive to the potential defence that the employer does not in fact have the right to do so, having assigned such rights to a lender.

The case gives rise to many questions (most of which are not new) about the consequences of assigning the benefit of development (and indeed other) documents to a lender as part of the overall security package in a development finance transaction. These issues and potential solutions are discussed in this article.

Back to basics - assignments

An assignment assigns the benefit, the rights, in a development document to another party. An assignment cannot transfer the burden, the obligations, in a document.

Legal and Equitable Assignments

There are two types of assignment – legal and equitable. A legal assignment is an assignment of the benefit of any debt or other legal thing in action, including rights under development documents, which complies with the requirements of s136 of the Law of Property Act 1925 (“LPA”):

“s136 (1) Any absolute assignment by writing under the hand of the assignor (not purporting to be by way of charge only) of any debt or other legal thing in action, of which express notice in writing  has been given to the debtor, trustee or other person from whom the assignor would have been entitled to claim such debt or thing in action, is effectual in law…”

The requirements for a legal assignment are therefore:

  • the assignment must be absolute
  • the rights to be assigned must be wholly ascertainable and must not relate to part only of a debt
  • the assignment must be in writing and (at least) signed under hand by the assignor
  • notice of the assignment must be received by the other party or parties for the assignment to take effect

An equitable assignment is an assignment which does not fulfil the statutory criteria for a legal assignment in some way. There is no requirement for written notice to be given or received. In an equitable assignment the assignor maintains the legal ownership of the assigned rights, whist the assignee has the beneficial ownership of the rights.

The only significant difference between a legal assignment and an equitable assignment is that an equitable assignee may not be able to bring an action in its own name against the third party contractor, but may need to join the assignor as party to the action.

Assignment by way of security

“Assignment by way of security” is not a term of art – there is no defined creature in law which sets out what an assignment by way of security is.

What an assignment by way of security creates will depend on the construction of the drafting of the document creating such assignment and what has actually happened. If the document creating the assignment operates to create a legal assignment by satisfying the requirements of s136 of the LPA, and a notice of assignment is issued, then the term “assignment by way of security” will not operate to stop the legal assignment taking effect.

This was reiterated in Mailbox where the court found that neither the provisions in the notice of assignment allowing the borrower to continue to operate the contract and envisaging re-assignment nor the inclusion of the wording “by way of security”, created anything other than a legal assignment to the lender, as the LPA requirements had been satisfied. When looking at the re-assignment of the building contract to Mailbox, it was the lack of notice that rendered the assignment an equitable assignment, rather than a legal assignment. The wording “by way of security” had no effect on the nature of the assignment.

An assignment by way of security is simply an assignment, be that legal or equitable, of a development document (or other debt or legal thing) to a lender as part of a security package.

Unintended consequences of assignment of developed documents

As highlighted in Mailbox, an assignment can cause borrowers and lenders unintended consequences and risks.

Permitted Assignments

Development documents often contain restrictions on the number of times the benefit in them can be assigned.  Depending on the drafting of the assignment provision, an assignment to the lender and subsequent re-assignment to the borrower may “use up” the permitted assignments. This could leave the assigned development documents sitting with the lender, rather than the borrower, even though the lender may (following redemption of the loan) no longer have an interest in the property. 

Close attention needs to be paid to the drafting of assignment provisions. To allow for maximum flexibility drafting should be included which states that assignment (whether by legal assignment, equitable assignment, charge or otherwise and including re-assignments) to and from any party providing finance to the borrower is permitted and does not count towards a limit on the number of permitted assignments.

It is also worth noting that if permission is needed to assign the benefit of a document and such permission is not obtained, this will not result in an equitable assignment, but rather no assignment at all.

The Borrower not having the rights it needs

Where the rights in the development documents have been assigned to the lender, the borrower no longer has the right to the benefit of the development documents and therefore does not have the right to have the works and services performed for it under the development documents or the right to receive payment from the counterparty to the development document (which would include liquidated damages for delay where these are paid by the contractor, rather than deducted from sums otherwise due to the contractor). The borrower is thereby automatically in breach of many of its obligations under the relevant facility agreement.

This paradox is often overcome by the inclusion of drafting in the debenture and the notice of assignment whereby the lender specifically grants the borrower the authority to continue exercising the rights under the assigned development documents, including the rights to have works and services performed and the right to receive payment from the counterparty to the assigned development document. However, this does not address the issue as to whether the borrower has the legal right to bring a claim under the relevant development documents.

Who has standing to bring a claim?

Should it be necessary to bring or defend a claim under a development document the party needing to defend or bring such claim may not have the standing to do so.  As explained above the nature of the assignment will determine who has standing to sue:

  • legal assignment  - the assignee can sue in its own name. The assignor has no rights (either legal or beneficial) to sue
  • equitable assignment – the assignee may need to join in the assignor to proceedings. The assignor cannot sue as it does not have the benefit of the rights

Where legal proceedings need to be brought against the counterparty to an assigned document:

  • if by the lender, they may need to join the borrower (depending on whether the assignment is legal or equitable)
  • if by the borrower, the rights will need to be re-assigned back to the borrower

In the event it is not possible to re-assign the relevant development document back to the borrower (for example as a result of a lack of remaining permitted assignments), lenders may find themselves being unintentionally drawn into costly and time consuming legal proceedings or in the event the lender is not willing to become so embroiled, borrowers may find themselves without the ability to make a claim at all.

No loss black-hole

There is also the risk of a no loss black-hole being created. It is easiest to illustrate this issue with a worked example - take the scenario where the borrower has assigned the benefit of the building contract to the lender. In this scenario the lender will have the benefit of the rights under the building contract. During the course of carrying out the works the borrower suffers a loss as a result of the contractor’s breach of contract (for example the contractor causes delay and the borrower has to pay delay and disruption costs to the consultants and/or other contractors). However, the borrower does not have the benefit of the rights under the contract and cannot therefore sue to recover such loss. The lender who does have such rights will not have suffered the loss. Although the benefit of the contract could potentially be re-assigned to the borrower, there is a general principle that the assignee of a claim cannot recover more than the assignor has lost[1]. In this scenario the lender will have become the assignor back to the borrower and as the assignor will not have suffered a loss and therefore the borrower, as the assignee cannot recover more than the lender has lost, which is nothing. This is the no loss black-hole – where no party is able to recover the loss.

There are several cases where the courts have shown a desire to ensure that wrongdoers do not escape liabilities as a result of black-holes and because the cause of action (the benefit in the contract) happens to lie in the hands of someone else[2]. However, why invite the risk of the black-hole argument being raised as a defence in the first place.

It is possible to include express drafting to protect against such a black-hole, though the efficacy of such drafting is not guaranteed. The drafting would provide that a counterparty to an assigned document cannot contend that an assignee is precluded from recovering any loss resulting from a breach of the relevant document, regardless of the date of such breach, by reason that the assignee is not the original beneficiary or by reason that the assignor has not suffered any or as much loss.

Is assignment by way of security needed and what are the alternatives?

 The unintended consequences identified above raise the question as to whether assignment by way of security should continue to be taken by lenders?

Collateral Warranties

Traditionally a security package will consist of collateral warranties in favour of the lender from the building contractor, the professional team (including employer’s agent/ project manager, quantity surveyor, principal designer, architect, structural engineer and mechanical and electrical engineer) and subcontractors with design responsibility[3]. Assignment of the benefit of the development documents in favour of the borrower, which would include the building contract, appointments of borrower retained consultants and collateral warranties in favour of the borrower, to the lender is then taken as an additional layer of security.

The collateral warranties in favour of the lender, assuming they satisfy the usual standard requirements of lenders, will allow the lender to step-in to the associated development documents, including the building contract, in the event of borrower default under the relevant development document (i.e. failing to pay the contractor) and in the event of borrower default under the facility agreement.

If there is a full collateral warranty suite then question whether the belt and braces approach of taking assignment by way of security is in fact needed, given the issues this can cause.

Charge

The main alternative to taking an assignment by way of security would be to take a charge over the development documents. A charge will usually not raise the potential difficulties for borrowers and lenders raised by an assignment.

One risk with a charge, however, is that it could be interpreted as a floating charge, for example because the lender exercises insufficient control over the operation of the relevant contract. On insolvency, a proportion of the proceeds of the borrower’s floating charge assets (known as the “preferred part”) is reserved for the benefit of its unsecured creditors. However, in reality, in the event of enforcement the lender will generally either seek to sell the property or the shares in the borrower. There will not be any separate realisation of the charged contracts and as such there will not be any “proceeds” arising out of those contracts which could fall to be subject to the preferred part. We do not, therefore think lenders should be unduly concerned about this risk.

A charge also does not provide any direct rights as between the lender and the contractual counterparty. As such, a lender with only a charge will not have any direct rights to compel performance. This would need to be done by the borrower, or there would need to be a mechanism  by which the lender can step-in to the development documents. A solution to this issue, if assignment is permissible, would be, in addition to the charge, to include a provision in the facility agreement requiring the borrower to assign the development documents in the event of default under the facility agreement (however, such an arrangement may not survive borrower insolvency).

Recommended approach

To ensure maximum flexibility to meet the requirements of a lender’s security package it is recommended that borrowers ensure that their development documents provide for:

  • a full collateral warranty suite
  • unrestricted assignment to and re-assignment from lenders
  • no restrictions on charges

It is suggested that where a full collateral warranty suite is available the lender should take a charge over the development documents in favour of the borrower (rather than an assignment by way of security). The lender will be a “qualifying floating charge” holder for the purposes of appointing an administrator of the borrower and if it needs to direct the operation of the relevant contracts it can do so via step-in provisions in the collateral warranties.

Where collateral warranties (or a full suite) are not available, and where the development documents allow for a sufficient number of permitted assignments to allow for assignment to and re-assignment from the lender, the relevant development documents in favour of the borrower should be assigned to the lender to plug any gaps in the warranty package. The development documents would then need to be re-assigned to the borrower if the borrower subsequently needs to make a claim for breach under such documents or once the lender no longer has an interest in the development[4].

Where collateral warranties (or a full suite) are not available and assignment is restricted, the lender should take a charge over the relevant development documents. The lender will be a “qualifying floating charge” holder for the purposes of appointing an administrator of the borrower. If assignment is permissible, though not sufficient to allow for assignment and re-assignment, in addition to the charge, an express provision should be included in the facility agreement requiring the borrower to assign the development documents in the event of default under the facility agreement.



[1]                 Dawson v Great northern and City Railway Company [1905]

[2]                 See for example Technotrade v Larkstore [2006]

[3]                 In a design and build procurement structure. Construction management will require collateral warranties from all major trade contractors, the construction manager and the main consultants (the exact list of parties to be confirmed with the lender’s project monitor)

[4]                 The latter scenario will most likely already be provided for in the drafting of the security documents, however, the former scenario will most likely require express drafting to be inserted.

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