The risks in a security cession of rental income
May 2013 | EXPERT BRIEFING | CORPORATE GOVERNANCE
As security for the repayment of a loan, lenders often require borrowers who are landlords, to cede in security to lenders, their right, title and interest (rights) in and to rental income due to borrowers.
This article analyses the legal risks for lenders and borrowers in security cessions of rental income under South African law.
Security cessions of rental income are often contained in security cession agreements and/or in mortgage bond (bond) documents.
If a security cession of rental income is constructed so that the borrower’s rights to such rental income are on execution of the document, immediately and unconditionally ceded to the lender, the lender is immediately vested with such rights. In such circumstances, the borrower’s legal action against defaulting tenants can be met with the formidable defence that the borrower lacks locus standi to sue for unpaid rentals because it ceded such rights to the lender under a loan transaction.
This is an approximation of the facts in Picardi Hotels Ltd v Thekwini Properties (Pty) Ltd 2009 (1) SA 493 (SCA) (Picardi case). A clause in a bond document contained a standard security cession of rental income. The appellant raised the plaintiff’s lack of locus standi to sue for unpaid rentals as a special plea. The Supreme Court of Appeal (SCA) held inter alia as follows. It is settled law (in South Africa) that a security cession deprives the cedent of the right to recover the ceded debt and that the cedent retains only a bare dominium or reversionary right therein. On a plain, ordinary and grammatical interpretation of the clause in the bond, all the constituent elements of a cession were in place such that an effective and unconditional transfer of rights (from the mortgagor to the mortgagee) occurred when the bond was executed. The use of the present tense in the bond document was a strong indication that an immediate rights transfer was intended. The respondent was therefore divested of the power to sue the appellant for the unpaid rentals. The respondent should have taken a recession (of the ceded rights) from the bank to again vest it with the right to sue for the unpaid rentals (rental rights recession).
The bond contained a proviso that the mortgagee bank could only act upon the ceded rights with the mortgagor’s consent, unless the mortgagor was in default of the bond or the loan secured thereby. The SCA held that this did not mean that the security cession was conditional and only became effective upon the happening of the events in the proviso, namely, with the mortgagor’s consent or on default. The mortgagee’s rights were not suspended until then. What was suspended was the mortgagee’s ability to personally exercise those rights until default and notice was given. If the contrary interpretation were correct, namely, that the cession was conditional and only became effective with the mortgagor’s consent or on default, that would be destructive of the very purpose for which the security cession was conferred, to provide security for the loan that the bank was to advance. This would mean that the mortgagee bank would enjoy no protection in the event of the mortgagor’s insolvency.
The legal risk to the borrower of a security cession of rental income that vests effective, immediate and unconditional rights in the lender is that if it then sues defaulting tenants, such tenants can defend the action on the basis that the borrower lacks locus standi to sue because it ceded such rights to the lender under a loan transaction. The borrower ought to obtain a rental rights recession from the lender to enable the borrower to recover its core revenue if that is the ceded rental income, and it has multiple tenants. If the borrower does not do so, it would have to obtain the lender’s consent each time (through a rental rights recession) it wishes to sue for unpaid rentals. This could hamper the borrower’s operations.
The legal risk to the lender (whether prior to or on default or insolvency of the borrower) of a rental rights recession is that it is thereby divested of its security rights. The lender should not prematurely re-cede the ceded rights (implement the rental rights recession). In the context of a rental rights recession, the lender is at serious risk if the security cession of rental income is its only form of security or if in monetary terms it forms the core of the lender’s security rights. Typically though, lenders hold multiple forms of security, with security cessions of rental income being on such form.
If the rental rights recession is effective upon the earlier of the issue of a letter of demand or commencing formal legal proceedings, the borrower is vested with the requisite locus standi. It is, however, trite law that the borrower requires locus standi from the time it institutes action, not before, and must retain such locus standi until final judgement is delivered. Thus, having locus standi at demand stage is a bonus. If the borrower issues a letter of demand or commences formal legal proceedings without such a rental rights recession in place, it may plead that it acted in some sort of agency or representative capacity by doing so. To control when the rental rights recession is effected and thus to control when the lender loses its security, the lender could specify a rental threshold below which there is an automatic rental rights recession and above which the lender’s prior consent would have to be obtained.
The rental rights recession should be conditional upon the borrower ceding in security in favour of the lender, its rights to the proceeds that may result from any such litigation against the tenants. It is able to do so if the security cession is of an extant right, typically contained in a lease agreement, yet to be enforced. South African courts have recognised for more than a century that future rights can be ceded and transferred in anticipando.
In such a scenario, the lender has the assurance that it is only re-ceding its security rights when the borrower absolutely requires it to recover unpaid rentals and the borrower has the assurance of locus standi when it institutes legal action.
In loan transactions, it is risky to regulate security cessions of rental income or for that matter, any security cessions, twice or more times in different documents as this may give rise to ambiguity or conflicting interpretations. It is recommended that it be regulated once only in the relevant security cession agreement, and if necessary, such cession be referred to or incorporated by reference in the other finance documents.
Adnaan Kariem is a director at DLA Cliffe Dekker Hofmeyr Inc. He can be contacted on +27 (0)21 405 6102 or by email: firstname.lastname@example.org.
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