Why banks should worry about changes to the law of contract

Every lender’s cardinal concern has always been the borrower’s ability to repay their debt and this is why the creditworthiness of a borrower tends to be thoroughly investigated in advance. To safeguard its interests, where a lender doubts the borrower’s ability to perform its obligations under a loan agreement, it will often seek additional security in the form of a guarantee from a reputable and creditworthy guarantor.

Currently, upon the default of a principal borrower, lenders are empowered to pursue guarantors for repayment of the loan without first exhausting all avenues of recovery against the assets of the borrower. The Law of Contract (Amendment) Bill 2019 proposes to reverse this position and compel a lender to go after the borrower’s assets prior to invoking a guarantee. Fortunately, the amendment would only apply prospectively to contracts entered into after the commencement date of that particular subsection.

Parliament’s intention may have been to protect long suffering guarantors of sacco and similar loans from losing their property immediately principal debtors default. However, the amendment may inflict unintended effects on the banking industry. A good case in point is the world of project finance where lenders commonly advance millions of dollars to newly formed special purpose vehicles (SPVs) whose core assets at the time of financial close (when the lenders inject the debt), consist of little more than a collection of contracts, licences and ambitious plans.

Under such circumstances, the lenders have understandably relied on guarantees to cover the risk of default by the borrower, since the project assets may not always be able to cover the value of the debt. Having guarantors stake their assets also ensures that they have some skin in the game and will take steps to ensure that a project succeeds, so as not to put their own assets at risk.

If, by virtue of the amendment, project lenders are required to first dispose the project assets before requesting the guarantor to cover the balance of the debt, this will act as a disincentive to a lender who may now insist on more expensive terms before granting the facility to the project company. In fact, one potential dire consequence of the amendment is that borrowers may be locked out of financing altogether where lenders do not have the assurance that they can swiftly enforce guarantees issued by the stronger and better funded parent companies of those borrowers.

It is with good reason therefore, that lenders have been on edge wondering about the impact of the amendment on the enforceability of guarantees, particularly as the requirement to pursue borrowers’ assets as a first step is not in line with international practice for projects. The proposed amendment was intended to apply solely to guarantees which create a secondary liability based on the default of the principal borrower who holds the primary liability to repay the debt.

However, in the absence of definitive clarification on this point, the jury is still out on whether it could potentially impact instruments such as performance guarantees or performance bonds which create primary liabilities that crystallise when certain conditions occur. If performance guarantees are impacted by the amendment, this would negatively impact projects which rely heavily on performance guarantees from various contractors.

Another contentious issue around the amendment relates to the Land Act. In project finance deals, lenders almost always take security over the project land by way of a legal charge. One of the provisions in the charge, which mirrors the provisions in the Land Act, 2012, is that a lender has several remedies available to it in the event of default.

These include; to sue the chargor for any money due and owing under the charge, to appoint a receiver of the income of the charged land, to lease or sublease the charged land, to enter into possession of the charged land or if it so wishes, to exercise its statutory power of sale to sell the charged land. The amendment under the Law of Contract Act does not seem to take into account the provisions of the Land Act which provide a whole array of remedies which the lender can utilise before realising the assets of the borrower. It is not clear how this conflict between the laws would be reconciled.

The advantage of guarantees is not just the security they give the creditor but also the time they save the creditor in recovering their debt, in the event of default. Well, creditors may as well forget this time-saving element as the amendment is likely to lengthen the debt recovery process due to the requirement to first liquidate the assets of the borrower before pursuing the guarantor.

This time lag poses a further risk to a creditor where an unscrupulous guarantor, who, knowing that a borrower’s assets have to be disposed first, quickly transfers its own assets in the interim, thus leaving themselves with no realisable assets by the time a suit is brought against them.

Furthermore, making it mandatory to dispose the principal’s assets also carries a cost implication as the assets need to be valued and advertised, and sale agreements also need to be concluded. The costs associated with these steps may end up reducing the loan amount that the creditor ultimately recovers. If these potential costs are built into the pricing for the loan, then borrowing will become a more expensive endeavour, which in turn would have a negative effect on the economy as it may stifle investment.

Overall, managing a longer, more costly and riskier debt recovery process, courtesy of the amendment, may lead a creditor to wonder if guarantees are still worth having.

The amendment has a laudable objective of protecting guarantors’ assets but if guarantors are overprotected, this could render guarantees effectively obsolete as no lender wants to rely on an instrument that they cannot readily enforce. Consequently, investors in capital-intensive projects may need to explore other innovative ways of securing their debt especially in the case of newly formed SPVs which have few or no assets at the time of financial close.

This may be an opportune moment for the banking industry to engage the government on this issue since guarantees are a crucial component of the financing for infrastructure and energy projects.

The writers are in Projects, Energy & Infrastructure Practice at IKM Advocates.