A Guide to Third Party Security
Finance brief - February 2014
- A Guide to Third Party Security
- Letters of Credit
- The Cape Town Convention and Aircraft Protocol: ratification by the UK
A third party security is security given by an individual or entity which secures the liability of a third party. If the third party security does not contain any personal obligation to pay on the part of the mortgagor or chargor, it can be treated like a limited recourse guarantee so that the liability of the mortgagor or chargor is limited to the amount which can be realised upon disposal of the third party security.
In this guide, we look at how this type of security is different to direct security and the key considerations for lenders to be aware of and take into account when they are being granted third party security.
Why does third party security differ from direct security?
Third party security differs from direct security (where the individual or entity is securing his/its own liabilities), because the rights and duties applying in relation to guarantees and indemnities also apply to a third party charge . Generally speaking the duties are embodied in the overriding principle that a creditor must not prejudice the rights (of subrogation) of the surety against the principal debtor or the rights (of contribution) of the surety against his co-sureties. Broadly speaking, the right of subrogation is the right of the surety to "stand in the shoes of" the creditor once it has been repaid by the surety and the right of contribution is the right of the surety to recover from his co-sureties money to the extent that the surety has borne more than his fair proportion of the liability to the creditor.
How can you achieve the same effect as a third party security?
The same effect can be achieved by taking a guarantee and a direct security and indeed this is probably a better method. Many banks will not have a third party security template for this reason.
What features do you find in a third party charge which you do not find in a direct charge?
Apart from the obvious that the third party mortgage or charge secures a third party's obligations to the creditor and not the mortgagor/chargor's direct obligations, a third party mortgage or charge will need to contain guarantee type provisions to avoid the possibility that the surety may be inadvertently discharged by the acts or omissions of the creditor e.g. by the creditor granting time or indulgence to the principal debtor or varying the terms of the guaranteed liabilities.
What are the key issues you need to consider when taking third party security?
In a nutshell, these issues are exactly the same as if you were taking a guarantee, namely:
- Corporate benefit - can it be demonstrated that the directors are acting in the best interests of the company? This is not difficult where the liabilities to be secured are those of a subsidiary, but more challenging where the liabilities to be secured are those of a parent or co-subsidiary. If there is any doubt, a prudent creditor will require the shareholders to bless the giving of the third party security so as to avoid the directors being in breach of their fiduciary duties to the company and the possible set aside of such third party security on application to the court by the company or its liquidator or administrator.
- Undue influence - a guarantee/third party security from an individual can be set aside if , for example, the consent of a wife to stand as security for her husband's obligations is obtained as a result of undue influence , misrepresentation or other legal wrong of the husband and the creditor cannot demonstrate that it has taken certain reasonable steps to ensure that the wife received independent legal advice not only on the third party security, but also about the nature and effect of the underlying transaction.
- Transactions at an undervalue - if a company gives a guarantee or third party security and the benefit it received from giving the guarantee/third party security is significantly less than the benefit it conferred on the creditor, the guarantee/third party security can be set aside if:
- the company was balance sheet or cash flow insolvent when it gave the guarantee/third party security or became so as consequence of giving it; and
- the company enters into administration or liquidation within two years from the date of giving it (three years if the parties are connected),
unless it can be shown that the guarantee/third party security was entered into by the company in good faith and for the purpose of carrying on its business, and that at the time it did so there were reasonable grounds for believing that the transaction would benefit the company.
A similar regime applies to individuals, but the relevant period for an individual entering into bankruptcy is five years.
- Preference - A guarantee/third party security can be set aside within six months (or two years if the parties are connected) of it being given if it was given to benefit one creditor over the others and the company is insolvent when it was given or becomes insolvent as a consequence of giving the security.
A similar regime also applies to individuals, with the relevant period
- five years prior to the bankruptcy of the individual concerned if the preference is given or entered into is also a transaction at an undervalue;
- two years prior to the bankruptcy of the individual concerned in the case of a preference which is not a transaction at an undervalue and is given to a person who is an associate of that individual; or
- six months prior to the bankruptcy of the individual concerned in any other case of preference which is not a transaction at an undervalue.
If you are taking third party security, all the issues that apply to guarantees need to be considered and the document creating the third party security needs to have guarantee type provisions incorporated to protect the creditor.