3 November 2022 by Finance & Banking Alert

Cession in security: Identifying the most suitable basis

A borrower’s obligation to repay a loan can be secured using different forms of security rights and quasi-security rights, with some rights being asset backed and others not.

The theoretical basis of the pledge and cession in securitatem debiti (cession in security) of rights in South African law is one of two theories. The advantages, disadvantages and practical consequences of applying these theories to a cession in security, are considered. Although a basic, limited discussion of the nature of the cession theories is provided, its true theoretical nature, given its complexity, is best left to an academic treatise. Aspects of cession in security have been thoroughly analysed in previous articles.

In a cession in security, the cedent pledges its personal right in the debt owed to the cedent by its debtor (principal debt) and cedes (transfers) such right to the cessionary (ceded right(s)) to secure the fulfilment of an obligation owed by the cedent or a related party to the cessionary (secured debt). It is based on the common law principle, established by the Appellate Division (as it then was) in National Bank of South Africa Ltd v Cohen’s
Trustee
1, that one debt, the principal debt, can be used to secure the repayment of another debt, the secured debt.

Cession in security structuring

A cession in security can be structured by applying either the pledge theory (so named because of its resemblance to the pledge of corporeal assets) or the pactum fiduciae/outright cession theory (referred to as the pactum fiduciae theory). In Grobler v Oosthuizen²  the Supreme Court of Appeal held that the parties’ intention determines the character of the cession in security. If, however, the parties did not elect to apply either theory or their intention is unclear, as is often the case, the default legal position according to Grobler is that the pledge theory applies to the cession in security.

Grobler settled the courts’ vacillation between these theories and its application, which had continued for decades prior to 2009. Recently, in 2022, the Supreme Court of Appeal in Engen Petroleum Ltd v Flotank Transport (Pty) Ltd3 confirmed the position in Grobler.

The theories of cession in security differ in respect of the basis on which personal rights are used as security, and the aspects of personal rights that are in law ceded in security. In a cession in security based on the pledge theory, the cedent retains its dominium or reversionary interest in the principal debt. The cedent pledges its right of action (the right to collect or enforce the principal debt) in that principal debt to the cessionary as security to repay the secured debt. The pledge is given effect to by a cession. It is thus only the procedural aspect of the principal debt that acts as security whilst legal title to the substantive right remains vested in the cedent. Once the cession in security is effective, the cedent has no legal standing to enforce the principal debt against its own debtor until the cedent has repaid the secured debt. The cession is complete and perfected when the parties consensually agree to the cession. Delivery of documents evidencing the ceded right is not required to perfect the cession but if the right is constituted (as opposed to evidenced) by a document, then the case law is to the effect that delivery is required. In a cession in security based on the pactum fiduciae theory, the cedent divests itself of its right to the entire principal debt (both the dominium or reversionary interest and the right of action) by ceding out-and-out (transferring) the entire right to the cessionary who acquires legal title to it, subject to the condition that once the secured debt is repaid, the cessionary must re-cede the ceded right to the cedent. The cedent thereby acquires a personal claim against the cessionary for the recession of the ceded right (recession claim).

Pledge theory advantages

The pledge theory has numerous advantages. The cedent remains the holder of the reversionary interest in the principal debt, which is an asset in its estate. The cedent can use its reversionary interest as further security for existing or new loans, which facilitates lending cycles. In our article titled Cession in security: The real meaning of reversionary interest dated 8 July 2020, the meaning of reversionary interest is discussed. The cession in security constitutes the cessionary as a secured creditor on the cedent’s insolvency in respect of the ceded rights. A lender as cessionary is thus, on the cedent’s insolvency, put in the best position the law permits it to be, to recoup some or all of its losses incurred (due to the cedent as borrower failing to repay the loan) from the realised ceded rights. Academic proponents of the pactum fiduciae theory criticise the pledge theory as being a legal impossibility as one cannot, they contend, have a real right of pledge over personal rights arising from the principal debt. This aspect, and the counter arguments, are beyond the scope of this article.       

Pactum fiduciae theory disadvantages

The pactum fiduciae theory has numerous disadvantages. The cedent forfeits its principal debt to the cessionary and hence cannot use it for commercial purposes. If the cessionary goes insolvent the principal debt falls into the cessionary’s insolvent estate and the cedent ranks as a concurrent creditor of the cessionary in respect of its recession claim if it took no security for its recession claim. These consequences would be especially unfair to the cedent if it was repaying the secured debt at the time of the cessionary’s insolvency. Academic proponents of both theories acknowledge this as the central weakness of the pactum fiduciae theory. At least one renowned academic, Professor GF Lubbe, has in fact concluded that this theory is flawed as a security measure because of the cessionary’s insolvency risk.4  Furthermore, if the principal debt’s value exceeds the secured debt’s value, the difference is excess value that the cedent could have, but for the application of the pactum fiduciae theory, used commercially to raise further loans. Additionally, whether such excess value can legally act as security is doubted as the secured debt would at that point already be secured. In other words, the excess value secures no debt and is therefore not accessory in law to the secured debt as it should be. In our article titled The nature of cession in security dated 20 September 2017, the legal requirement that security rights must be accessory to the secured debt is discussed. While the pactum fiduciae theory removes the risk of the cedent’s liquidation for a lender as cessionary because the principal debt becomes an asset in the cessionary’s estate, the aforementioned disadvantages outweigh such benefit.

The parties to a loan transaction should give careful consideration to the issues in this article when deciding on which theory to apply to their cession in security.

 

  1. National Bank of South Africa Ltd v Cohen’s Trustee 1911 AD 235
  2. Grobler v Oosthuizen 2009 (5) SA 500 (SCA)
  3. Engen Petroleum Ltd v Flotank Transport (Pty) Ltd (876/20) [2022] ZASCA 98 (21 June 2022)
  4. GF Lubbe (original text by PM Nienaber) ‘Cession’ in The Law of South Africa vol 3 3 ed (LexisNexis, 2013) at paragraph 180
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