SECURITY DEPOSIT ARRANGEMENTS IN INSOLVENCY

• Citation: (1996) 8 SAcLJ 458
• Date: 01 December 1996
• Published date: 01 December 1996

I. INTRODUCTION

The notion of a security deposit is simple enough. As commonly understood, it is a sum of money paid by one party (‘the depositor’) to another (‘the depository’) for the purpose of securing the performance of the obligations of the depositor himself, if it is a two-party arrangement, or, in the case of a tripartite arrangement, the obligations of a third party (‘the principal debtor’) under a principal contract. Typically, the principal contract is one which involves the future repayment of money or payment of instalments or rentals, and the security deposit is given as an assurance of such payments being made. In many cases, the depository is a bank and the principal contract is a loan; however, a security deposit may also feature in other contexts, for example, property leases and leasing contracts.

Security deposits are security devices which no doubt have been in use for some time, but their nature and effect have attracted judicial attention only recently. Two distinct sets of problems have arisen in the case of the insolvency of the depositor and the depository respectively. Where it is the depositor who is placed in insolvent liquidation or bankruptcy, the immediate question is whether the security deposit constitutes an effective security, in particular, whether there are any impediments of insolvency law which affect the depositor in the enforcement of his security. Where it is the depository which has been put into insolvent liquidation or bankruptcy, it will be the depositor who will be concerned as to whether he has a proprietary claim over his security deposit in the hands of the depository and, if not, whether he can nevertheless invoke set-off in respect of the amount of his security deposit so that, to that extent, the obligation secured by the deposit is discharged.

II. SECURITY DEPOSITS: FORMS AND FORMALITIES

The term ‘security deposit’ is not a term of art. It is merely a convenient expression used to denote an arrangement the commercial effect of which is that a lender or obligee receives a sum of money from the borrower or obligor or a third party as security that the borrower or obligor will repay his debt or perform his obligations, as the case may be. It is intended that, upon default by the borrower or obligor, the lender or obligee should be able to resort to the deposit to the extent of his loss.

In law, such a commercial arrangement may take effect by any one of three legal devices — a trust, a charge or a flawed asset arrangement. The first and second confer a proprietary interest on the depository while the third creates only a contractual arrangement between the parties. The mechanics, features and formal requirements of each are different.

1. Trust

Conceptually, a trust can be created over the actual monies representing the security deposit. No debt is created by the payment of the deposit money by the depositor to the depository; instead the depository becomes a trustee of the deposit moneys. Further, no particular formalities are required as long as the intention of the parties is clearly expressed in the documentation. However, a trust arrangement suffers from a number of drawbacks.

The trust may be one of two types. The first is where the depository holds the security moneys on trust for the depositor absolutely but subject to a right to have recourse to the moneys for payment of any amount which he is entitled upon breach of the principal contract. This mechanism is sometimes used in respect of retention funds in construction contracts.1 It has been said that such a trust subject to a right of deduction protects both the depositor and the depository against the risk of insolvency of the other,2 but this may be open to question. It is clear that the depositor will be protected in the case of the insolvency of the depository; however, it may be that, in the event of the depositor’s insolvency, the depository may not be able to exercise his right of deduction. The right of deduction may be regarded as a ‘contracting out’ of the pari passu rule of distribution in insolvency law3 and, if so, it would be void as being contrary to public policy.4 In relation to construction contracts, the contractual right of an employer, in the event of the insolvency of the contractor, to pay the subcontractors directly and to deduct the amounts paid from the sums due to the contractor has been struck down.5 There is therefore a possibility, at least, that the right of a depository to deduct sums from moneys held on

trust for the depositor may be similarly invalid in the case of the depositor’s insolvency.6

The second type of trust which may be used is where the depository holds the security moneys on trust for both the depositor and depository. The depositor has a beneficial interest which is determinable to the extent of his failure or, in a tripartite arrangement, the failure of the principal debtor to discharge the obligations under the principal contract. Conversely, the depository has a beneficial interest which is contingent upon the same event. In essence, the mechanics used, to a certain extent, resemble those in a protective trust.7 Upon default, therefore, the depository’s contingent beneficial interest in the deposit moneys becomes a present beneficial interest and he becomes the absolute owner of such moneys as are sufficient to indemnify him for his losses arising from the default under the principal contract; on the other hand, the depositor’s corresponding beneficial interest in such moneys terminates absolutely. Care must again be taken that the agreement does not contravene the pari passu principle of distribution.8 The very difficult distinction is between a trust which gives an interest to the beneficiary which is determinable upon bankruptcy or insolvency, and one which gives an absolute interest subject to a condition defeating that interest in the event of bankruptcy or insolvency; the former is valid9 while the latter is void.10

Apart from the above uncertainties, a trust arrangement is disadvantageous in that the deposit moneys, being trust assets, must be physically set aside by the depository and cannot be expended during the duration of the trust.11 This may be commercially unacceptable to a depository. Further, realistically speaking it is usually the depository who is in the stronger bargaining position and it is unlikely that he would accede to such a restriction prohibiting the use of the deposit moneys. The main advantage of having a trust arrangement is that the depositor has a proprietary claim

over the deposit moneys in the insolvency of the depository; no real advantage accrues to the depository which he cannot obtain by structuring the security deposit arrangement in another mode, that is, by way of a charge or a flawed asset.

2. Charge

A security deposit arrangement may also be effected by means of a charge. The charge will be over the debt owed by the depository to the depositor in respect of the deposit. At common law it appears to be conceptually impossible for a charge to be created over a debt owed by the chargee to the chargor, as one cannot have a proprietary interest in a debt owed to oneself.12 In Singapore,13 however, section 9A of the Civil Law Act14 states:

For the avoidance of doubt, it is hereby declared that a person (‘the first person’) is able to create, and always has been able to create, in favour of another person (‘the second person’) a legal or equitable charge or mortgage over all or any of the first person’s interest in a chose in action enforceable by the first person against the second person, and any charge or mortgage so created shall operate neither to merge the interest thereby created with, nor to extinguish or release, that chose in action.

That a provision in these terms effectively abrogates the apparent common law position and allows a charge to be created over a chargee’s own indebtedness was recently confirmed by the Privy Council in Tam Wing Chuen v Bank of Credit & Commerce Hong Kong Ltd.15 It is thus clear that in Singapore a depository may obtain a charge over the security deposit provided by a depositor.

One disadvantage of using a charge is the uncertain requirement of registration in the case of a corporate depositor. The charge has to be registered if the security deposit is a ‘book debt’ of the depositor, as a charge on the book debts of a company is registrable.16 The oft-cited but less than precise definition of ‘book debts’ is that they are debts accruing in the ordinary course of a company’s trade as are commonly entered in its business books, whether they are actually so entered or not.17 It has also been thought that a normal bank balance of the company, in the absence of special circumstances, is probably not a ‘book debt’.18 Nevertheless, it may conceivably be argued that a security deposit with a bank is not a normal bank balance and, furthermore, security deposits are not exclusively given to banks. It thus remains unclear whether a security deposit is to be classified as a book debt, and probably the correct answer is one which varies according to the circumstances of each individual case. Consequently, prudence may dictate that, in a doubtful case, a charge over a security deposit should be registered.

In Asia Commercial Finance (M) Bhd v JB Precision Moulding Industries Sdn Bhd,19 the Malaysian Federal Court held that a security deposit paid by a company to a leasing company pursuant to a leasing contract conferred a lien on the leasing company.20 This is a somewhat puzzling conclusion. Generally speaking, a lien is a right given to a lienee by the general law to retain possession of property owned by the lienor until the lienor fulfils his obligations to the lienee. In its true sense, and this is probably the sense intended to be conveyed by the statute, a lien cannot be created consensually.21 As such, it is difficult to see how the agreement...