Much has been written about South Africa's inability to attract foreign direct investment at levels that one might expect from a resource-rich economy with relatively good physical and financial infrastructure. Although barriers to the practical implementation of funding transactions do not lie at the heart of this issue, they play their part and do at times tip the scales in favour of other jurisdictions. Examples of such barriers include the South African system of exchange control, persistent inefficiencies in the public administration of companies and the relative cost of, and complications involved in, taking security for syndicated loans and bonds. The vast majority of syndicated loans to South African corporates are secured and this article considers an alternative to the security structure commonly used in South Africa.
The problem with a security trustee / agent
The use of a security trustee is a common and critical feature of secured syndicated loans in most jurisdictions. Under English law governed syndicated loans this works very well and the rights, duties, obligations and liabilities of the security trustee are documented in a few generally non-contentious clauses. In jurisdictions where a trust cannot be effectively declared over the benefit of security rights or where trusts are not known at all, security agents with the exact same rights, duties, obligations and liabilities are used. In either case, the security interests created in favour of finance parties are created in favour of a single entity (the security agent / trustee), who holds the benefit of the security interests for the finance parties from time to time. This, in turn, facilitates secondary trading in syndicated loans without the need to amend, recreate and/or re-register security.
A trust cannot be created under South African law by simple declaration, but South African agency law is well developed and could facilitate the holding of security but for three issues:
- Under South African law, an agent does not have locus standi (the right to bring an action) in litigious proceedings before South African courts. On the enforcement of security granted to a security agent on behalf of a syndicate of lenders, the lenders would, therefore, have to be joined in the proceedings. This is inconvenient, but can be managed at enforcement.
- Although this does not seem to be supported by Roman-Dutch law (which forms the basis of the South African law of tangibles), there is a common view that security cannot be validly created under South African law in favour of a person to whom no primary obligation is owed. This necessitates the creation of a primary obligation, typically a guarantee or indemnity, in respect of which security may be validly created.
- There is a statutory prohibition on the creation of bonds (the form of security used to encumber fixed property, movable assets, mineral titles and related rights) in favour of an agent on behalf of another. These bonds can also not validly secure debts arising from different causes to more than one creditor.
The traditional solution
To address each of the concerns mentioned, security interests under South African syndicated lending transactions are generally held by a special purpose vehicle ("SPV") set up for this purpose and owned by a trust that is independent of the finance parties and the obligors. The trustee would normally be an independent professional trustee company and the beneficiary a non-profit organisation (most often, the Nelson Mandela Children's Fund). The SPV and the trust would be managed by the independent professional trustee company, at the cost of the borrower. The SPV grants a guarantee (which is a primary obligation under South African law) to the finance parties from time to time for the obligations owed to the finance parties. Each security provider indemnifies the SPV against claims made by the finance parties under the guarantee and provides security for its indemnity obligations over all its assets included in the agreed security package. To ensure that the SPV is bankruptcy remote, the SPV's obligations under the guarantee must be limited to the proceeds realised on the enforcement of the security (net of any costs incurred in such enforcement) and the costs of setting up and maintaining the SPV must be carried by someone other than the SPV.
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Although the security SPV structure has become a general feature of secured syndicated loans in South Africa, and it is an effective alternative to a security trustee / agent structure, it is not a perfect solution. It is costly to set up and maintain an SPV structure. Given that it involves the incorporation of a company and the establishment of a trust (a process which can easily take two months), it also often delays financial close on transactions that could otherwise have been implemented very swiftly. Where foreign banks are included in the syndicate, the structure is seldom well-received, partly because it is unusual and partly because it seems elaborate and complicated. Even more problematic are transactions where the South African security provider accedes as a guarantor and security provider at a later date. The extent of the amendments required to the finance documents and the cost and timing of setting up a security SPV structure is often difficult to justify. This necessitates an alternative solution.
Parallel debt structures
A parallel debt structure is also sometimes referred to as a "parallel covenant to pay" and involves the creation of a separate and independent obligation (in like amount to the secured obligations) that is owed by the borrower, guarantors and other security providers to a designated parallel debt holder. The parallel debt holder is usually a syndicate member and usually acts as security trustee / agent on the same transaction in relation to security interests created under other legal systems. The parallel debt is perhaps best described as an acknowledgement of debt or covenant to pay rather than a parallel loan agreement. The terms are quite simply that amounts actually received by the parallel debt holder are paid directly to the agent (for payment to the finance parties) in accordance with the agreed payment waterfall and that such payments reduce amounts owed by the borrower/guarantors to the finance parties in like amount. Similarly, whenever amounts are received by the agent in discharge of the obligations in the ordinary course (pre-enforcement), a pro rata amount is discharged on account of the parallel debt. The aggregate amount of the debt owed is, therefore, not increased; the aim is achieved; and the accessory security granted to the parallel debt holder is unaffected by changes in the composition of the lenders.
Parallel debt seems a very eloquent solution, because the principles are quite simple and the parallel debt language may be included in the main finance documents or the security documents. In countries where parallel debt is used (including The Netherlands, Germany, Italy, France and Spain), the structure is considered as totally transparent, and therefore as neutral from a tax and accounting perspective.
As an alternative to the traditional security SPV structures used in South Africa, parallel debt structures are not costly and are easy to implement. Nevertheless, parallel debt structures remain uncommon in South Africa, except in two instances.
Firstly, section 11(3)(a) of the South African Mining and Petroleum Resources Development Act, 2002 (Act No. 28 of 2002) does not permit the encumbrance of any prospecting or mining rights without the consent of the relevant Minister, unless the encumbrance is created in favour of a bank or another approved financial institution. Given that a security SPV could never be a bank or other financial institution, parallel debt is the only effective way to give South African law governed security over mining rights where there is more than one lender.
Secondly, parallel debt is often used where a South African security provider accedes to an existing syndicated lending transaction in respect of which no security SPV structure has been set up and where the South African security provider is not required to give any registered security (in respect of which the statutory prohibitions on security held by an agent for others apply).
Concerns with parallel debt
There is no doubt that parallel debt is more efficient and more commercial than SPV structures and that, on the face of it, a parallel debt structure deals effectively with each of the South African law issues that arise when a security trustee / agent is used (namely, (i) the lack of locus standi that an agent would have before South African courts if security were to be enforced; (ii) the need to create security in favour of a person to whom a primary obligation is owed; and (iii) the statutory prohibition on the creation of mortgage bonds, special and general notarial bonds and mining mortgages in favour of an agent on behalf of another). However, before one might conclude that parallel debt should be the preferred South African security structure in all circumstances, it is worth considering the following additional concerns that are raised in relation to parallel debt structures:
Credit risk on the security agent: If security interests are held by a single member of a syndicate (as parallel debt holder), the other finance parties take credit risk on the parallel debt holder, because the parallel debt is owed to it as (secured) creditor, to the exclusion of the other finance parties. This is a real risk and arises in all jurisdictions where parallel debt is used. In practice, it may be of little concern if the parallel debt holder is a bank with a strong credit rating.Further this concern may be mitigated by, for example, having the parallel debt holder create security over its parallel debt claim in favour of the other finance parties.
Disposition without value: It is important that the parallel debt should be seen as a real stand-alone debt and if it is, one might ask whether the parallel debt and the concomitant security would constitute a disposition without value under section 26 of the South African Insolvency Act, 1936 (Act No. 24 of 1936) in the event of the insolvency of the borrower. In our view, such an argument would fail, provided the parallel debt provisions correctly provide for the automatic pro rate reduction of the parallel debt whenever the principal debt is discharged and vice versa.
Change of parallel debt holder: Because of the accessory nature of the security, a security interest granted in favour of a parallel debt holder may need to be recreated if the parallel debt holder changes resulting in applicable hardening periods running afresh. Although this may be avoided by transferring the parallel debt claims to a new parallel debt holder, the costs of such a transfer and the creation of new security may be prohibitive, especially in the case of registered security. This is a major disadvantage because in practice the parallel debt holder is usually the same financial institution which carries out the facility agent role which means that the security structure would be compromised should that institution want to resign both as agent and as parallel debt holder (which might happen should the relevant institution trade all of its participation as lender in that same facility, for instance should the borrower become financially distressed). This risk could be reduced in practice if an independent professional trustee company were to be appointed to both of those roles from the outset.
Simulated transactions: Under the South African doctrine of simulated transactions (sometimes referred to as the substance over form doctrine), South African courts will champion the legal substance of a transaction over the form in which it is presented if the nature of the transaction is in dispute. Although this doctrine is applied most frequently in relation to tax avoidance, our Supreme Court of Appeal, in the matter of Commissioner for the South African Revenue Service v NWK Ltd 2011 (2) SA 67 (SCA), confirmed that the doctrine applies equally to other disputes and suggested that anti-avoidance rules developed under the South African Income Tax Act, 1962 (Act No. 58 of 1962) might be used to determine whether any commercial transaction is simulated (as was done more recently in Roshcon (Pty) Ltd v Anchor Auto Body Builders CC). The NWK judgment is controversial and has been criticised by lower courts, but if its dictum were to be applied to parallel debt structures, a court might disregard the parallel debt and concomitant security granted for such debt if the sole or main purpose of the structure was to avoid a peremptory provision of a South African statute, in this case the provisions of the Deeds Registries Act, 1937 (Act No. 47 of 1937) and the Mining Titles Registration Act, 1967 (Act No. 16 of 1967) that prohibit the passing of certain types of security in favour of any person as the agent of another. That said, it is an established principle that parties may arrange their affairs to avoid statutory prohibitions (as those mentioned above) provided the arrangement does not result in a simulated transaction. Whether the substance over form doctrine can be successfully applied to parallel debt structures will depend on the exact nature of (and circumstances surrounding) each transaction.
Although security SPV structures are tried and tested, the law must facilitate commerce. The legal certainty that the SPV structure provides cannot justify its continued use at the expense of the alternative parallel debt structure except under circumstances where one or more of the specific concerns relating to parallel debt structures highlighted above find application.