In the general run of lending business, a bank will take security over the assets of a corporate borrower (direct security) to enhance its chances of getting repaid.
Besides direct security, the bank may seek a third party security, treated as a guarantee, in practical terms, by which a third party guarantor assumes loan liability of the borrower (principal debtor) in the event of default.
In this ninth part of our series, we discuss about the third party/direct security distinction and the critical issues for banks to consider when taking third party security.
The distinction between third party security and direct security rests on the applicability of guarantee and indemnity rights, duties and protections to a third party security provider (Bolton v. Salmon  2 ch. 48, Ch D).
Those rights, duties and protections are an incarnation of the doctrine of suretyship that a creditor must not prejudice the surety’s right of subrogation, i.e. the right to sue the principle debtor in the creditor’s name after the loan is paid off to the creditor in full.
In practice, though, banks rarely have a third party security template, as they are accustomed to taking a guarantee (individual personal guarantee, or corporate guarantee) and a direct security, thereby attaining the same effect as a third party security.
It should be appreciated fully that a guarantee/third party security secures a surety’s obligation to the bank and not the direct obligation. On this point, if the bank varies materially the facility letter, this may inadvertently release the guarantor/third party security provider, consistent with Chitty, J.’s observation in Bolton v. Salmon, which is substantially in accord with Section 85 (Discharge of surety by variance in terms of contract) of Tanzania’s Law of Contract Act, Cap 345 (R.E.2002).
The critical issues that banks need to consider in third party security are identical to a guarantee. Do two of these issues, transactions at an undervalue and preferences, ring a bell for you? We considered them in last week’s part 8 of this series. But first, let us take a look at the issues of undue influence and corporate benefit.
A guarantee/third party security that was taken as a result of undue influence, fraud or misrepresentation can be set aside. Tanzanian courts have struggled with this problem, particularly as it relates to wives who have been persuaded or deceived in giving guarantees to banks for the business debts of their husbands.
Tanzanian law is well-settled; a (third party) mortgage of a matrimonial home without spousal consent is invalid in the eyes of law. Some banks have lost fortunes because of this.
As regards corporate benefit, can it be shown that the directors acted in the company’s best interests in giving guarantee/third party security? Surely, this is uncomplicated if the loan is for the subsidiary, as, in the end, a successful subsidiary brings benefits to its parent company. Yet, it is very difficult—though not impossible—if the loan is for a parent or other subsidiary.
If the benefit is not clear in the board of directors resolution, a bank should require the shareholders to sanctify the undertaking of the guarantee/third party security. This would bypass a breach of director fiduciary duties and prevent those shareholders from moving the court to set aside such security.
In any case, a bank can take comfort in the legal principles of equity if it acted in good faith, although the directors’ actions are ultra-vires.
Nevertheless, as we shall shortly see, the corporate benefit issue is also critical in the midst of corporate insolvency.
A transaction at an undervalue involving a guarantee/third party security can be set aside if the company within goes into administration or liquidation and the benefit it received from giving the guarantee/third party security is significantly less than the benefit it conferred on the lending bank unless it can be proved that the company gave the security in good faith and for value.
Similarly, a guarantee/third party security can be set aside if it was given to benefit one creditor over the others (preference) and the company is insolvent when the security is given or becomes insolvent in consequence of giving the security.
In undervalue transactions and preferences, timing is of crucial importance, because the Companies Act 2002 has prescribed specific vulnerability periods.
To provide protection against loss, banks should consider the issues discussed above, including incorporating carefully crafted guarantee-like clauses in the third party security agreement; exercising care when varying the underlying loan contract; and obtaining title insurance.