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Topic 6: Rights in Security and cautionary obligationsMacNeil, Scots Commercial Law chapters 10 and 11.  Davidson et al, Commercial Law in Scotland chapter 5. Property book chapter 20. There will...

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Topic 6: Rights in Security and cautionary obligations MacNeil, Scots Commercial Law chapters 10 and 11. Davidson et al, Commercial Law in Scotland chapter 5. Property book chapter 20. There will be overlap. PART A: INTRODUCTION AND GENERAL PRINCIPLES Rights in Security? We have previously went over debt and it should be noted that often, people do not pay their debts. This is because sometimes when the obligation is actually analysed, there may be no obligation to make payment. If we assume that the debt is due however, then why don't debtors pay? 1. They do not want to pay and they want to drag things out. 2. They can’t pay because they do not have the money to pay. Where the debtor has decided not to pay, the creditor can go to court and raise an action. However, where the debtor cannot afford to pay: in this situation there is a risk that the creditor will make the debtor insolvent. When a debtor is liquidated - this arises because there are many more debts than there are assets and this results in many creditors losing out. How do you obtain payment of debt?      

The existence of the obligation in the first place Creditor will send a formal request Lawyer (at this point many pay due to seriousness) The court (some are happy to go to court to dispute) Decree - court saying debt is due or not. Then what? o Diligence: individual process. a process where one creditor can cease the assets from the debtor for payment of that debtors own debt. o Insolvency: collective process. Someone put in place on behalf of creditors - administers assets and pays off creditors. Risks with diligence and insolvency?

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Still not enough money/assets

Risks to the creditor from the onset…  

Non payment Not enough assets

What do you do about it? RIGHTS IN SECURITY !!! "any right which a creditor may hold for ensuring payment or satisfaction of his debt, distinct from and in addition to his right of action and execution against the debtor under the latter's personal obligation" 

So in event that debtor does not pay or does not have the assets, the creditor will have a right in security which means that the debt will be satisfied.

Key characteristics in rights of security: 

It is a second right in addition to the underlying personal right.

Two kinds we will be looking at: 

Asset securities o Over particular pieces of property. o Can take two forms: Right of retention (seller keeps ownership of asset until purchaser pays the debt. Seller has two rights; personal right for price and real right of ownership in the asset. Can sell it if debtor does not pay.) or Right of security in the strict sense (subordinate real right a right in a thing belonging to someone else. For example, if you own a house and give right in security over it - you still own the house but it means someone has a right in the property and if you do not pay the debt in question, they have the power to sell the asset on to someone else).

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If you sell house own, the debt still cannot be escaped. There will still be a right in security in the house.

What do you get with real securities? Prioirty: The acid test of a real right in security is priority in insolvency. This means if you have a real right you will get paid before the creditors who do not have a real right. YOU ARE PRIORITY (ranking - competition between creditors).

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Personal securities o Creditor gets a second personal right called caution. Characteristics shared by personal and real securities? o A right in security is an accessory right o Albatown case: there is a contract to sell a house, seller enters an agreement to sell to purchaser but purchaser can't may ATM but wants to move in. Purchaser is allowed to move in but seller says you still owe me the money, I will require you grant me a standard security for payment for the purchase price in the underlying contract.  Once underlying debt is extinguished (paid) the right in security is also extinguished (it is an accessory right which depends on the existence of an underlying obligation).

Securities who and what are they good for? Good for both parties: Security benefits both debtor (helps them to get credit if they can grant security) and creditor (allows them to give credit safely - they are protected). These have assumptions for centuries but it is uncertain how accurate these assumptions are. There was a recent study carried out on these matters and it was concluded that in relation to banks; they did not take security into consideration at all when giving loans. They looked at the business plan to see if it would work out or not. PART B: CAUTIONARY OBLIGATIONS

“Cautionary is an accessory obligation or engagement as surety for another, that the principal obligant shall pay the debt or perform the act for which he has engaged, otherwise the cautioner shall pay the debt or fulfil the obligation.” The Principal obligant owes money to a creditor. This obligation will likely have arisen under contract such as borrowing credit/a loan. The PO has an underlying obligation but the creditor wants protection. This is where the cautioner comes in - where the PO does not fulfil the debt, the cautioner will. Terminology Caution (noun); cautionry (noun); cautionary (adjective). A owes money to B (under what area of law?), and C guarantees to B that debt will be paid.  C is cautioner (guarantor). English term: “surety/ship.”  A is principal obligant (debtor).  B is the creditor. Things to note: The creditor B ends up with two personal rights. 

One against the principal obligant, A (the obligation owed by A to B is the obligation secured).

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B’s other personal right is against the cautioner, C (this obligation owed by C to A is accessory on the principal obligation).

Examples of cautionary obligations (1) (2)

(3)

(4)

By director/shareholders of small company. Family. o Bank might lend you money but they might want your parents to guarantee the debt will be paid, if you can't. Groups of companies. o Where you have individual companies set up for particular purposes. Bank is happy to lend money to them on the basis that another company/parent company in the group will meet the debts. Bank for customer: bank will charge premium.

(5) Insurance company for person appointed by court as e.g. executordative. o There are certain court processes in intestate succession if someone is appointed as Executor-dative. The appointment of the executor requires a bond of caution - a guarantee by the insurance company that they will meet payments in the event that the executor is unable to do so.

Quasi-caution? (this is when the law imposes a liability which looks like a cautionary obligation - but it is not actually a cautionary obligation). For example:  The indorsers of bills of exchange  Partner of firms This is deal with in law of bills of exchange and partnership.

Caution compared to other concepts? Examples which are often confused with cautionary obligations: 

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"guarantees" in contracts o If a contract mentions a guarantee this does not always mean it is a caution. It can just be an express term of the contract. Representation of credit-worthiness by bank o Document from the bank/statement that says this person has money in their account and should be able to pay the debts. This is not an undertaking by the bank that they will pay - they are just informing facts. Letter of comfort o Same thing as above basically.

Proper and improper caution Proper is where a cautionary obligation is on the face of it a cautionary obligation - it is explicit.

Improper cautionary obligation looks like a primary obligation - like it is the principal debt. Why must we know the difference?  Was v important before 1856  Still important because if you have a proper - you have a right to a discussion and a right to division  Removed as an implied term in 1856 but can be contracted into now Right of discussion?    

Degree of protection that was offered to the cautioner Creditor could not get any money from cautioner until they had taken every step possible to get money from the principal obligant. Harsh on creditor so removed in 1856 as an implied term but it can be contracted into. Now liability owed by principal obligant and cautioner is joint and several liability unless you have contracted for right of discussion. Joint and several liability? o Liability is shared and several means you can sue either or them. Creditor has choice and can raise action of enforcement against either. Who has the deepest pockets at a particular time? o If creditor chooses to sue cautioner - right of relief against principal obligant.

CREATION Is a cautionary obligation a contract or a promise? Can be created as either. Rules of formal validity (RoW(S)A 1995 ss1 and 2)  Doesn’t have to be probative.  If a contract doesn't have to be in writing but in practice all cautionary obligations generally are. Rules relating to validity  General principles from the law obligations are applicable.

Can cautioners escape liability? C = creditor D = debtor X = cautioner Consider some scenarios: 1. C induces X to enter cautionary obligation o Is this capable of being struck down? If you are induced and enter an agreement you would not normally agree to - you can escape liability. 2. C misrepresents position to X, but X knows real position. He lies about how much money the debtor actually has. o Can you escape liability? There is a misrepresentation but if you know the real position it is not an operative misrepresentation! 3. X gives cautionary obligation to C oblivious to financial position of D. o Could he escape liability? No. It is his look out. 4. As three, but X asks C about D's position. o Does creditor have to say anything if asked? Young v Clydesdale Bank - if asked they are under an obligation to give the information in this context. Royal Bank of Scotland v O’Donnell  while there is no obligation to represent a fact, if a representation of a fact is made it must be full and fair. A half truth may amount to a misrepresentation and concealing a material fact will amount to a half truth  in the field of cautionary obligations, the rules for full and fair representation must be applied vigorously as in many causes a cautioner is assuming responsibility for the obligation of another person where he may have limited knowledge about their affairs” 5. As 3, but C becomes aware that X completely misunderstands D’s position. Royal Bank v Greenshields 1914 SC 259 > The creditor must disclose the true position if they become aware that the cautioner is labouring under a material misapprehension

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Previously: dealing with situations where creditor can escape liability  however creditor has a ‘don’t ask don’t tell policy’  all of this focuses on relationship between creditor and cautioner However, generally it is not the creditor that is the person who causes the problem. Usually it is the debtor/principal obligant who causes the problem. It is in their interests to some extent to say everything is fine as if they can get cautioner to agree to grant of cautionary obligation, they can borrow more money.  what If principal obligant “dupes” the cautioner and says everything is fine when it is not and they have misrepresented the position Background position set out in Young v Clydsdale Bank  This case said if you he cautioner are gullible enough to be duped by the principal obligant without any further investigation to find out it the debtor is telling the truth about their financial position then it is tough  the principal obligant’s representations to the cautioner are non operative  basic rule is it is for the cautioner to check the financial position of the principal obligant However, there is an exception: Change began in English law in Barclay’s Bank v O’brien  when you were dealing with co-habitants/spouses there is the potential that one party can put pressure on another to enter agreements and the law acknowledges this. So what happens if husband wants to borrow money for business and he pressurizes the wife into signing in English law a mortgage deed over their property which means she is using her share of the house to underwrite her husband’s debts? – applying the basic principle in relation to her relationship with the creditor, the husband is a 3 rd party to her grant of the mortgage of the share of the house. Therefore if you apply traditional position, she is stuck in the event

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that the husband doesn’t pay even if she had been pressured into the transaction What this case does is to reverse this – this case provides a situation where it’s not undue influence but is effectively misrepresentation. Husband is saying to the wife everything will be ok – he will get the money to keep business going and it will be repaid because the business will do fine and she signs on this but he knows that the business is screwed at time of transaction. He has therefore misrepresented position to her and potential undue influence Case goes to HOL: held that for certain relationships. If the creditor has actual/constructive notice, the person who is guaranteeing the debt and the debtor are in a particularly close relationship where there would be the potential for undue influence/pressure – the banks put a notice and the bank needs to deal with this Security struck down Particular relationship that can be issues: same sex co-habitants, opposite se co-habitants, spouses The way in which the bank can deal with this now is by requiring the spouse/wife by taking independent advice – this was introduced by this case

2 Scottish cases: **Smith v BoS Appeal to HOL  the wife was induced to sign a standard security securing her husband’s business debt’s over their house  the property was co-owned  the bank did not require wife to get independent advice and she didn’t get this  it was established that the bank was unaware that the husband made misrepresentations to the wife. The debt wasn’t paid, bank seeks to enforce security and bank raises action  Court held that the general rule is in Young v Clydesdale bank that the cautioner (wife) is to look after their own position. However Lord Clyde used some judicial slide of hand to say that in Scots contract law, there is a general duty of good faith (he used cases about punishing bad faith in offside goals) if breached, the cautionary obligation can be challenged

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This case tells us: o If bank advised the cautioner to get advice, they have not breached duty of good faith o In this case however they have breached the duty (although it is unclear why) and the duty is struck down Operative quotes from Lord Clyde’s Judgment: o The creditor is in good faith unless the circumstances are “such as to lead a reasonable man to believe that owing to the personal relationship between the debtor and the proposed cautioner, the latter’s consent may not be fully informed or freely given.” o “All that is required of [the creditor] is that he should take reasonable steps to secure that in relation to the proposed contract he acts throughout in good faith. So far as the substance of those steps is concerned it seems to me that it would be sufficient for the creditor to warn the potential cautioner of the consequences of entering into the proposed cautionary obligation and to advise him or her to take independent advice.”

Mumford v BOS IH Decisions  property not co-owned, wife signed waiver of occupancy rights The bulk of the cases after in Scotland explain how Smith works: Braithwaite v BOS  this case is about the assignation of shares to secure an overdraft  Wife transferred shared to secure H’s overdraft. H faulted and wife lost her shares  W said on basis of Smith v BOS, you have beached duty of good faith – she wasn’t told about any risk/to get independent advice. There was no evidence that husband said anything to wife that misrepresented the background  Court held – no reduction of transaction here: it stands. Only can be struck down if there is a breach of duty of good faith and there is an actionable wrong which would taint a contract between the debtor and cautioner e.g. misrepresentation/undue influence

Now 2 stages after Braithwaite for Smith v BOS:  Breach of duty of good faith  Actionable wrong by debtor inducing the cautioner to grant the caution

The moves in England In England, the cases of ROB v Etridge took place.  the wife acting as guarantor for husband’s debts  lender asked her to get independent advice but that was it – didn’t examine quality of independent advice  wife argued that what if independent advice is rubbish  this case says that what the advice has to be like/quality of advice is:  Bank had to make sure that the nature of the independent advice was as follows; o Face to face meeting o W happy for solicitor to act o Explain document o Explain consequences and risks o Rely on financial information from lender to detail risks o Stress W not bound to proceed: give choice to continue or not. In the court of appeal, there were additional requirements (the ones above were toned down requirements). You also had to probe stability of relationship. If you cannot satisfy the court all the tests above has been met, then the security can be struck down  Cautioner has two options: o Sue lender o Sue solicitor o (HL position better than was in CA – probing stability of relationship &c) But what did this mean for Scotland? Etridge is presented in Royal Bank of Scotland v Wilson

2 brothers who borrowed money for their business and both the brother’s spouses were persuaded to enter securities over the family home  the bank sought to sell the property after the brother’s defaulted and the wives argued they needed to strike down the security Held o They firstly held that the bank had fulfilled its duty as it asked them to get independent advice. It didn’t enforce approach that you needed to check quality of advice. The bank only had duty to advise for independent advice o Also held there was no actionable wrong: endorsed the Braithwaite approach o The appeals failed on ground that the 2nd offenders didn’t occur the obligation gratuitously. By granting security in both names, the husband was also guaranteeing the debts – wasn’t just the wife alone guaranteeing o If you have benefit in success of the business, this hints that it is not a gratuitous obligation 

What did you need to show for Smith v BOS to apply You need 4 things for it to apply:  Look at the relationship: Can it be shown that the relationship between the debtor (principal obligant) and the cautioner was such that the cautioner’s consent to the grant of security “may not be fully informed or freely given.”? – Barclays Bank v O’Brien test for relationships of undue influence  Can the cautioner demonstrate that the debtor had “committed an actionable wrong” against the cautioner; AND has the cautioner relied on that actionable wrong when granting the third party security? – Required by Royal Bank of Scotland plc v WIlson: - what actionable wrongs are covered: Braithwaie test: misrep and undue influence + force and fear  Royal Bank v Wilson: Did the cautioner grant the third party security gratuitously (ie did the cautioner get nothing in return)?  Did the creditor warn the cautioner of the consequences of granting the third party security and advise the cautioner to take independent legal advice? – bank not obliged to check if you

did/check quality if you did. If you are advised to get independent advice that is enough New case Cooper v BOS 2014 is the only case which has applied Smith v BoS  there was no letter sent in this case saying get independent advice  because of this, the bank is hit by the other requirements  lawyer sued by bank because they didn’t say to get indepe...