The difference between a pledge and out-and-out cession agreement makes a big difference to debt. For creditors and debtors, it’s important to know the difference, writes Rynette Pieters, Director of Business Restructuring.
Managing debt is an essential part of maintaining financial health. An important reminder of this can be found in a recent Supreme Court of Appeal (SCA) judgement in the case of Engen Petroleum Limited v Flotank Transport (Pty) Ltd. The case concerned the interpretation of a cession agreement concluded between Engen and a company called Windsharp Trading (Pty) Ltd.
What does this have to do with debt? To begin with, we need to understand what is meant by a cession agreement.
A cession is a legal act of transfer. This means that when you, the cedant, sell or transfer ownership of an asset, you also transfer ownership of a right to another person, the transferee or cessionary. As a cessionary, you can cede this claim to your own creditor in order to secure any owed debt.
Cession often comes into play when a company is in the process of being liquidated. In this case, certain cession agreements ensures a creditor will receive their money first. With such an agreement in place, you become a secured creditor which means you get preference ahead of others such as the receiver of revenue or other trade creditors.
In the case of Engen v Flotank, the issue began back in 2014 when Windsharp began its liquidation process. At that time, Engen notified Flotank, a debtor of Windsharp, of the existence of the cession and requested Flotank to pay them directly. Instead, Flotank paid back Windsharp, leading to Engen going to the High Court to request Flotank honour their original request.
At the time, the High Court ruled in favour of Flotank. Their reason had to do with a type of cession known as in securiatem debiti which meant the original agreement was constructed as a pledge, granting payment privilege to the liquidator of Windsharp, who would then be responsible for paying these proceeds to creditors such as Engen. In its appeal, Engen argued for the first time in court, that the security cession should have viewed as an out- and-out cession, and not a pledge.
So, what’s the difference between a pledge and out-and-out cession?
Let’s say I owe you money and someone else owes me money. I can use their debt as security for what I owe you, which allows me to cede the money owed to me by someone else as security for my own debt. So what happens if I default on my own debt?
This was the question faced by the SCA in their judgement, which required the court to recognise two opposing theories in our law regarding security cessions: the “pledge theory” and the “outright cession theory”.
In the case of “pledge theory”, debt is “pledged to the cessionary while the cedent retains the “bare dominium” or “reversionary interest” in the claim against the debtor.
In other words, if I default on my payments to you and there's a pledge construction, then you may go and notify the person who owes me money that I have ceded that debt to you as security, and they must pay you until that debt is satisfied. In that case, once I’ve paid you back, the debt returns to me. That is what’s known as a reversionary right. It means I still actually own the asset and I've simply provided you with the right to take hold of it in the case that I default.
In the case of an out-and-out cession, I would transfer ownership of a debt directly to you, meaning you can use that debt to satisfy any money I owe you. And then once my debt to you is satisfied, then you have a duty to transfer back whatever is remaining of that right that's been transferred to you.
When it comes to liquidation, in the case of an out-and-out cession the company who has ceded their debt to a creditor no longer owns that debt at all, and it doesn't form part of the liquidated company’s estate. If instead it’s a pledge agreement, then the company still owns the debt, but only the reversionary rights, which means it owns the right to get the debt back once the debt has been discharged.
So, in an out-and-out cession, the liquidator has no right to collect debt. Instead, a creditor collects the debt directly themselves. In a pledge scenario, the liquidator will collect the debt, while earning a fee on that as they’re responsible then for paying the creditors.
What was the CSA judgement?
The SCA had to consider an age-old debate in South African law, whether a cession securitatem debiti had to be construed as a pledge or out-and-out cession? In the case of the former, Windsharp would still hold a reversionary interest to the claims. If the claims were ceded “out-and-out” to Engen, Engen would be in a position to use the proceeds of the claims as security, only ceding them back to Windsharp once the debt was settled.
In the end, it all came down to wording, and the extra mention of revisionary rights. While on the surface, and what the initial High Court found, the agreement was a pledge. But the SCA came to a different conclusion, when considering the extra wording in the pledge.
The SCA held that the cession agreement was intended to be an “out-and-out” agreement. This was due to the stated inclusion that “any and all reversionary rights the Cedent [Windsharp] might otherwise have had in and to the claim hereby ceded”. This meant that Engen had taken cession of “all reversionary rights”, leaving the company with ownership of the claims, and an obligation to re-cede any claims to Windsharp only once their owed debt had been discharged. And so, the court found that Flotank had been obliged to make payments to Engen and not Windsharp, once they’d received the cession notice.
What does this mean for cession agreements?
By default, a cession constructed as in securitatem debiti is interpreted through “pledge theory”. But as this case has shown, if the wording of the cession indicates another intention, such as “reversionary interest”, a court must abide by the intention of the parties, and treat it as an “out-and-out” cession.
So, for a creditor looking to enter into a security cession, it is worth including revisionary interest in the same manner as Engen. This is a better situation for a creditor because you’re then able to collect your own debt. The opposite is true for a debtor, who would prefer a pledge from a cash flow perspective.
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