Member Article

A recent Hong Kong case has shed same light on banks' ability to take security over documents delivered under documentary credits. A typical trade finance transaction Typically, in trade finance transactions, a bank will issue letters of credit in favour of its customers’ suppliers and take security by way of pledge over the goods being purchased from the suppliers and the documents, including documents of title, relating to those goods which are to be presented under the letters of credit. To create a valid pledge the bank must take possession of the items the subject of the pledge - either actually or constructively e.g. by holding the key to the warehouse where the goods are stored or an attornment from the warehouse keeper saying that the goods are held to the bank’s order. From this it will also be noted that it is only possible to pledge physical objects or documents which represent or embody title to goods, money or securities, such as bearer shares or bonds and bills of lading. In order to enable customers to sell the goods (and use the sale proceeds to repay the bank), the bank has to release possession of them. So, to ensure the bank retains its security interest in the goods and the proceeds of their sale, the bank will normally require customers to sign a trust receipt to supplement its pledge security. Under a trust receipt, customers agree to hold the goods, documents of title and the proceeds of their sale on trust for the bank. It is also settled law that neither a valid pledge nor the related trust receipt are registrable against Hong Kong companies under Section 80, Companies Ordinance (see Re David Allester Ltd. [1922] 2 Ch 211). Far East Structural Steelwork Engineering Limited (In Liquidation) [2005] 2 HKC 18 The judgment of the Hong Kong Court of First Instance in the case of Re Far East Structural Steelwork Engineering Limited (In liquidation) (the “Company”) contains some helpful guidance for banks engaged in trade finance and a useful reiteration of the law in relation to banks’ security in trade finance transactions. Facts of the case The case related to an application under section 182 of the Companies Ordinance, taken out by the liquidators of the Company to set aside some debits made from the Company’s account by its bankers after the Company had gone into liquidation. The debits were made in pursuance of rights claimed by the bank under its security for certain trade finance transactions. (Section 182 provides that in a winding up by the court, any disposition of the property of the company made after the commencement of the winding up shall, unless the court otherwise orders, be void). The case concerned what seemed to be a fairly typical trade finance facility. The Company would apply to the bank for the issuance of a letter of credit to its suppliers to finance its purchase of goods. The documents to be presented under the letter of credit to obtain payment were an invoice issued by the seller of the goods and a cargo receipt certifying the goods had been received and were in order signed by the Company. The bank’s security for these transactions was a pledge of the goods supplemented by a trust receipt in relation to goods and documents of title (see above for a description of how this security arrangement is intended to work). The bank debited the Company’s accounts after the Company had paid the proceeds of sale of the goods into the accounts and also shortly after the Company had gone into liquidation. Issues for consideration The principal issues considered by the court were the nature of the security created in favour of the bank and its validity against the liquidators. Related to these issues was whether a cargo receipt could constitute a document of title. The bank gave evidence that a practice had developed in the Hong Kong market of treating cargo receipts as documents of title and that a successful challenge to this practice would have profound (adverse) commercial implications. Court's decision The Court held that the bank's security was void against the liquidator for the following reasons: (1) No valid pledge of either the goods or a document of title relating to them had been created. • A cargo receipt did not constitute a valid document of title to goods because, inter alia, it did not confer on the bank any right to delivery of the goods. The Court generally approved of the dicta in Official Assignee of Madras v. Mercantile Bank of India [1935] AC 53 that, generally speaking, only bills of lading are recognised by the common law as being able to transfer ownership to the goods they represent by delivery. • There had been no constructive delivery of the goods themselves to the bank as there was no evidence that the person who had been in physical possession of the goods had "attorned" to the bank i.e. acknowledged that he held the goods for the bank and not the Company. (2) Although there was no pledge, the Company clearly intended to create a charge over the goods by delivery of the cargo receipt and the trust receipt but this was void against the liquidator for lack of registration under Section 80, Companies Ordinance. • Both the trust receipt and the cargo receipt (and the Court might have added, the document creating the pledge) were bills of sale (amongst other things, they constituted "agreement[s]…. by which a right in equity to any personal chattels or to any charge or security thereon, is conferred" for the purposes of the definition of bill of sale in the Bills of Sale Ordinance (Cap. 20), and bills of sale executed by companies must be registered under Section 80, Companies Ordinance. Lessons from the case If the bank was right in its evidence that cargo receipts are treated in Hong Kong as documents of title then this practice should stop. Banks should ensure that bills of lading in relation to goods they are financing are presented under their letters of credit. Banks should also ensure that their customers require warehouse keepers or other persons storing pledged goods to executed formal attornments in their favour acknowledging that the goods are held to the order of the banks, and not the customers. Finally, if in any doubt about the validity of their pledge security, banks should register their trade finance security documents at the Companies Registry against their Hong Kong customers or foreign companies with a place of business in Hong Kong.