Cession in security: Notice to the debtor

In this article, we discuss the role played by notice to the debtor in a cession in security. In practice, much emphasis is placed on the cedent issuing a notice to the debtor informing it of the cession in security, and the debtor acknowledging receipt thereof. In fact, the issuing and acknowledgement of the notice is typically a condition precedent to loan and cession in security transactions, often because the principal agreement (explained immediately below) contractually restricts either party from ceding its rights thereunder.

In a cession in security, the cedent pledges or encumbers its personal rights against its debtor and transfers such rights to the cessionary (ceded right(s)) to secure the fulfilment, by the cedent or a related party, of an obligation owed to the cessionary. The ceded rights arise from the contract between the cedent and its debtor which is the principal agreement while the indebtedness or the obligation arising there from is known as the principal debt. The obligation arising from the contract between the cedent and the cessionary is typically the repayment of a loan or the payment of a price for goods sold or services rendered, and is known as the secured debt as security is provided for the debt. As in previous articles, we mention that the issue as to whether the cedent cedes in security an aspect of a right, or the entire right, has been a controversial subject in South African law for more than a century, and is governed by competing theories that are beyond the scope of this article. We base this article on the pledge theory of cession in security.

As cession in security is a bilateral juristic act between the cedent and the cessionary, notice to the debtor, or for that matter the debtor’s consent to the cession, is not a requirement in South African law to constitute a binding cession. [National Sorghum Breweries Ltd v Corpcapital Bank Ltd 2006 (6) SA 208 (SCA) at paragraph 1; Van Staden and Another v Firstrand Ltd and Another 2008 (3) SA 530 (T) at paragraphs 28 and 29] A cession in security becomes operative when the cedent and the cessionary agree to the essential terms of the cession, whether or not the debtor was informed thereof or consented to the cession. A cession in security that complies with the common law requirements for cessions, and in the instance of listed securities ceded in security that complies with the Financial Markets Act 19 of 2012 (Financial Markets Act), is enforceable between the parties despite the debtor being unaware of the cession.

However, notice to the debtor is often included as a contractual condition in the form of a condition precedent to a loan and cession in security transaction. The reason for doing so has to do with mitigating risk, including overcoming any contractual restriction in the principal agreement on the parties ability to cede the ceded rights, rather than a legal requirement for a valid cession in security. A debtor, unaware of the cession in security and who, in good faith, renders performance to the cedent under its contract with the cedent, is immune from suit. In circumstances where the cedent defaults on the secured debt by, for example, failing to repay the loan, and the debtor unaware of the cession, renders performance to the cedent in the ordinary course, the cessionary will have no claim against the debtor for any loss it may suffer because performance was rendered to the cedent. The cessionary will therefore suffer the loss. It is therefore in the cessionary’s interests that the debtor be notified of the cession in security of the ceded rights, and that the debtor agrees to render performance due under its contract with the cedent, to the cessionary, if it notifies the debtor to do so.

In some instances, a debtor may, despite notice of the cession in security, decline to render performance to the cessionary out of concern for defaulting on its contract with the cedent. In Van Staden it was held obiter that the onus of proving knowledge of the cession rests with the cessionary, that the knowledge could be either actual or constructive and that, “A court will impute constructive knowledge to a debtor where it has reasonably shut its eyes to the truth by not heeding indicators of that truth.” [Van Staden, paragraph 29]

It is therefore conceivable that a court may impute knowledge of the cession in security to a debtor who received notice of the cession but declined to abide by it. Consequently, a debtor with knowledge of the cession, who makes payment to the cedent instead of the cessionary where the cessionary is entitled to payment under the cession, may, depending on the circumstances, be held liable for the cessionary’s loss. The cedent of course cannot compel its debtor to render performance to the cessionary on the cedent’s default of the secured debt, but its consent may persuade the debtor to abide by the instruction in the notice of the cession in security. Such instruction typically requires the debtor to make payment of the amount otherwise due to the cedent under the principal agreement, to the cessionary on notice from the cessionary. The parties would need to negotiate a mutually acceptable outcome should the debtor decline to render performance to the cessionary, bearing these principles in mind.

The role of notice to the debtor in a cession in security raises the issue of notice to third parties of the cession in security. Unfortunately, South African law, unlike the laws in other jurisdictions, has no legal requirement that obliges the parties to notify third parties such as debtors, of cessions in security of personal rights to book debts, moneys in bank accounts, insurance policies or unlisted shares, except in the case of the cession in security of listed securities. Typically, in certain jurisdictions, third parties are notified of a cession in security or the creation of a security right, by the mandatory registration of the cession or security right in a central registry administered by a regulator. The absence of such a legal requirement is, we submit, a systematic deficiency of South African law.

However, listed securities are treated differently in that section 39 of the Financial Markets Act requires that the cession in security or pledge of listed uncertificated securities or an interest therein, must be effected by entry in the central securities account or the securities account, as the case may be, of certain information stipulated in the section 39 of the Financial Markets Act related to the cession in security or pledge. Entry is defined in the Financial Markets Act as the electronic recording of inter alia any cession in security, pledge or other instruction in respect of securities or an interest therein. Section 39(1)(d) of the Financial Markets Act states that a cession in security or pledge that complies with the requirements aforesaid is effective against third parties. An interesting issue is whether section 39(1)(d) renders notice of the cession in security superfluous since the section deems the registered cession or pledge of listed securities as being effective against third parties such as the debtor. It is though probably safer to err on the side of caution by sending a notice of the cession to the debtor despite the effect of section 39(1)(d).

The South African common law position is that notice to the debtor of the cession in security is not a requirement in law to constitute a binding cession, but it pre-empts the debtor from rendering performance to the cedent if the cessionary is entitled to the performance due to the cedent defaulting on the secured debt. However, the legal requirements to cede in security or pledge listed uncertificated securities or an interest therein are regulated by section 39 of the Financial Markets Act and are different.