The House Business Committee of the Kenya National Assembly is set to consider the contents of the Law of Contract (Amendment) Bill, 2019 (the Bill) which is scheduled to come up for the second reading in the National Assembly. The Bill proposes to amend section 3 of the Law of Contract Act (Cap 23 laws of Kenya) (the Principal Act) to introduce a new requirement on a creditor such as a bank to first realise the security of a principal debtor before bringing any action against a surety such as a guarantor.
We analyze below the likely impact of the Bill on enforcement of debt proceedings.
Current position of the Principal Act on guarantees and third-party security
Section 3 (1) of the Principal Act requires every agreement, memorandum or note relating to any special promise to answer for the debt, default or miscarriages of another person to be in writing and signed by the promisor. Based on this section, a creditor cannot institute a suit in court against a person who has given an oral promise to guarantee obligations of a principal debtor unless contemporaneous or subsequent to that, the surety signs an agreement, memorandum or note setting out the terms of the suretyship.
In addition to a signed written agreement by the surety, the Bill proposes to require a creditor to first realise the security of the principal debtor before instituting enforcement proceedings against the surety. The exact text of the proposed subsection is set out below:
“(1A) Notwithstanding subsection (1), before a suit is brought against a defendant under subsection (1), the plaintiff shall first realise the security of the principal.”
The Bill seeks to insulate sureties by ensuring that creditors exhaust all avenues of enforcing their security rights against a principal debtor before seeking to enforce their rights against a surety. The jury is still out on whether the proposed amendment will achieve this objective without negatively impacting trade.
In this analysis, we have considered two types of sureties:
- a surety who issues quasi-security such as a guarantee in favour of a creditor meaning that the surety has promised to assume personal liability for a debt of another but has not created security over its assets; and
- a surety who issues third party security (either on a full or limited recourse basis) over its assets, such as by way of a three-party charge, in favour of a creditor.
Creditors rely on quasi-security and third-party security to lend to debtors who would otherwise be risky because, for example, the debtors:
- are uncreditworthy as they have little or no assets;
- have no credit history to help the creditor undertake proper risk-analysis; or
- jointly own assets with other persons.
In such instances, a creditor would be willing to mitigate credit risk by obtaining quasi or third-party security from:
- the parent company of a subsidiary debtor;
- sister companies of the debtor in a group company structure;
- directors of a debtor company; and
- a spouse who co-owns an asset with a debtor.
Should the principal debtor default in meeting its obligations, the creditor turns to the quasi or third-party security provider to enforce its rights to payment.
Enforcement of quasi-security and third-party security has its own challenges which a creditor should weigh carefully before agreeing to lend. Enforcement is often challenged on grounds that the quasi or third-party security provider was unduly influenced or did not know the consequences of providing security for obligations of a third party. In the case of corporate third-party security providers, the security could be challenged on, among others, financial assistance or lack of corporate benefit grounds.
Interests of creditors and third-party security providers are often protected through protracted negotiations in the underlying contracts. Depending on the risk profile of the principal debtor, a creditor may demand that the surety assumes principal obligation – and not merely the secondary obligation- of the principal debtor. In that case, the creditor may want to reserve a right to enforce its rights directly against the surety without first seeking recourse from the principal debtor if the surety document has an immediate recourse clause. Example would be a case where a lender demands that group companies give cross-guarantee and indemnity as primary obligors where there is a predisposing risk that the principal debtor could divert its assets to related companies to frustrate enforcement efforts of a creditor.
In our view, the Bill takes away from the parties the flexibility to agree that the surety assumes the debtor’s principal obligations and not merely the secondary obligations. Additionally, it presents uncertainty on how some security structures such as composite debentures issued by group companies or indemnities will be enforced. Should the Bill pass, creditors are likely to reconsider how they structure credit arrangements. For instance, creditors may need to consider whether to adopt a co-debtor’s structure in which all related entities providing security will assume primary obligations.
The Bill is due to come up for the second reading and therefore there is still time to submit comments on the Bill.
If you have any queries regarding the financial services practice area generally, please do not hesitate to contact Peter Mwaura at email@example.com. Please note that this e-alert is meant for general information only and should not be relied upon without seeking specific subject matter legal advice.