Types of security
The creation, perfection and enforcement of pledges of personal property (other than real estate) is regulated by the provisions of the Commercial Pledge Law (enacted by Royal Decree M/75 dated November 21 1424H) and the related regulations. A pledge can be created over any asset that: (i) exists; (ii) is owned by the pledgor at the time of creating the pledge; (iii) is clearly identifiable and is identified in the pledge agreement; and (iv) is capable of being sold.
As such, it is not possible for a borrower to grant a floating charge of the type often used in western jurisdictions and each pledged asset must be specified in reasonable detail in the pledge agreement.
The absence of floating charges (and therefore of common law-style debentures) is a significant challenge for many creditors, since it forces them to closely examine the borrower's collateral. In order to perfect a pledge over personal moveable property, the pledgee (usually an onshore bank acting as security agent for the lender or lenders) must obtain physical possession of the pledged asset. Alternatively, if the pledgee is not able to obtain physical possession (for example due to the nature of the asset being large and fixed to the ground, such as an item in a process plant), the pledgee must obtain recognised title documents for the pledged assets and/or (where possible) physical control over the pledged asset. The pledgor should not be permitted to retain any right to dispose of the pledged assets.
The Commercial Pledge Law covers both tangible assets and certain intangible assets, such as intellectual property. However, to the extent that intellectual property is unregistered, it will be difficult for the pledgee to obtain physical possession or control over the pledged intellectual property.
In addition to the tenet of possession and control, the asset must also be registered to the extent that an official form of registration exists for that asset. For example, in this case, a register of ships or the Saudi Arabian patent, copyright and trade mark registries.
In the context of a pledge over bank accounts, a pledge will attach only to credited funds of the pledged account on the date the pledge is created, which may well be a zero or minimal balance. As a result, a pledge over a Saudi Arabian bank account will usually contain an obligation requiring the pledgor to execute supplemental pledges on each date on which amounts in excess of a threshold specified in the account pledge are received into the secured account.
In addition, because currency is a fungible asset, there is a risk that the constant fluctuations in the secured asset (the account balance) may result in the pledge being held to have been released. Although lenders continue to take pledges over bank accounts as part of a security package, on enforcement lenders will more often seek to rely on their right of set-off as a remedy (although note that the right of set-off may not be effective where a borrower is declared insolvent).
Borrowers in Saudi Arabia, seeking to borrow funds for a particular project, will often assign proceeds of specific contracts to lenders. As in many GCC jurisdictions, a valid assignment cannot be effected unilaterally and must be notified to and acknowledged by the counterparty to the assigned contract. Even where the assignment is perfected by acknowledgement, it is not clear whether the Saudi Arabian courts would hold that the assignee has priority over other creditors on the assignor's insolvency.
Security power of attorney
Lenders often also require borrowers to issue an irrevocable power of attorney in favour of the lenders' security agent to enable lenders to exercise rights in relation to the secured assets in a default situation. However, shariah principles state that even where a power of attorney is unequivocally expressed to be irrevocable, it will nevertheless be revocable at will by either party. Some Islamic scholars have expressed the view that, as an exception to this rule, a power of attorney may be held to be irrevocable where it is clearly expressed to be irrevocable, granted in connection with a third party interest, with such third party relying on the irrevocable nature of the power of attorney. However, the existence of this exception remains subject to debate, and although lenders generally seek irrevocable powers of attorney, success in using the power to enforce security remains untested and uncertain.
In addition, as a practical point, powers of attorney granted in Saudi Arabia must be made before a notary, who may refuse to notarise a power of attorney granted in connection with a security document on the basis that it is being granted with a view to recovering interest. The recovery of interest, or payments in the nature of interest, is of course contrary to the principles of shariah law.
Guarantees and promissory notes
Guarantees from people or business entities related to the borrower are a common form of security in most jurisdictions. However, in contrast to common lending practice in many western jurisdictions, in Saudi Arabian transactions wealthy individuals related to the borrower (either as shareholders or ultimate beneficial owners) commonly provide personal guarantees in respect of all or part of the borrower's obligations under a loan facility.
In addition, loan documents in respect of Saudi Arabian projects will often provide for the delivery at regular intervals or on the occurrence of specified events (often on each drawdown date) by the borrower to the security agent of promissory notes, payable on demand, with a face value equal to the amount then outstanding under the facility.
Although not strictly speaking security for lending, lenders will view the promissory notes as an important part of the lending package since the use of a promissory note usually comprises free-standing evidence that the amount stated in the promissory note is due for payment, without the need to further prove the debt or ask the court to examine the loan instrument.
Real estate interests often constitute one of the most substantial assets held by a borrower, and as such in many jurisdictions real estate is a primary source of security for lenders. However, at present, in practice it is not possible as a practical matter for commercial lenders to obtain enforceable security over Saudi Arabian real estate.
In theory, it is possible for a borrower to grant security over real estate in Saudi Arabia by way of a pledge, perfected (in part) by the recording of the pledge on the title documents relating to the property by a notary public. In the context of commercial lending, this has proved problematic: since the early eighties, notaries in Saudi Arabia have refused to notarise mortgages or pledges of real estate in favour of commercial lenders, assuming that a mortgage or pledge in favour of a commercial lender would seek, contrary to shariah law, to secure obligations relating to payment of interest.
There has recently been a significant development in this area. At the end of June 2008, Saudi Arabia's Shura Council approved the long-awaited Draft Mortgage Law, which will provide a framework for the mortgage and lease-financing of real estate.
The new law is yet to be enacted and brought into force, and it will likely be some time before the relevant systems are in place to allow registration and perfection of a mortgage granted under the law, but the approval of the law, which has been in preparation and consultation for several years, is a significant development in the context of secured lending.
The new law contains a clearly expressed regime of creating security with priority of interest (against other ordinary creditors) over real estate, including provisions for tracing and preserving the secured property and provisions for enforcement.
The new mortgage law will be of key significance to banks and financial institutions lending to the increasing number of developers active in Saudi Arabia's surging real estate market.
A study published in March of this year predicted that just under $240 billion will be invested into Saudi Arabia's real estate market over the next 12 years, and as Saudi Arabia's real estate sector becomes increasingly sophisticated, developers will, as has been the trend in other GCC jurisdictions, seek to finance real estate development to a far greater extent than at present.
Market commentators have so far been divided as to what practical impact the new law will have, but without doubt the ability of lenders to take effective and enforceable security over real estate in commercial real estate development projects will be key to the development of the wider real estate sector in the Kingdom.
Security can be granted under the Commercial Pledge Law over certain types of shares and other securities by way of a share pledge.
The most commonly seen form of share pledge is a pledge over shares held in a joint stock company, perfected (as outlined above) by the delivery to the pledgee of physical possession or control of the pledged shares. In practice, the pledge is perfected by the recording of the pledge on the face of the share certificates relating to the pledged shares and in the company's shareholding register and the delivery of the original share certificates to the pledgee. In relation to tradable securities, the existence of the pledge should also be registered at the Securities Deposit Centre operated by the Tadawul, which will then block the pledged securities from trading or further pledging.
Granting a pledge over shares in a Saudi Arabian limited liability company (LLC) is more problematic. As outlined above, in order to perfect a pledge of shares the pledgee must obtain physical possession or control of the pledged shares. However, limited liability companies in Saudi Arabia do not issue share certificates to represent shares held by each shareholder; rather, ownership interests are recorded in the company's articles of association (the articles must be amended to reflect each transfer of shares) and evidenced by the entry of the shareholder's name in the company's register of shareholders. As such, it is very difficult for a pledgee to obtain the requisite physical possession and control. In addition, shares in limited liability companies are subject to statutory pre-emption rights in respect of which shareholders cannot give an advance waiver. Therefore, upon enforcement, the shares cannot be transferred to lenders without first being offered to other shareholders pursuant to the pre-emption right.
On some of the recent financings we have seen in the Kingdom as part of the wider security package, a pledge over shares held by shareholders in the limited liability company (LLC) borrower was used. To try to address the perfection and enforcement issues described above, a "synthetic" pledge was created, structured as if it were a pledge over joint stock company shares. The pledge was "perfected" as follows:
- each of the shareholders in the LLC purports to pledge all of its shares in the LLC to the security agent;
- the LLC's shareholders procure that the LLC issues share certificates in respect of the pledged shares;
- the existence of the pledge and a no-transfer instruction is recorded on the share certificates and on the LLC's share register;
- the share certificates, and all other documents evidencing title to the pledged shares other than the LLC's articles of association are delivered to the security agent as pledgee;
- the LLC's shareholders pass a resolution approving the pledge and resolving not to dispose of any pledged shares without the prior consent of the security agent;
- the LLC is formally notified of, and formally acknowledges, the existence of the pledge;
- the LLC notifies the Companies Registrar at the Ministry of Commerce and Industry of the existence of the pledge, the no-transfer instruction and the contractual restrictions against dealing, attaching to the pledged shares and requests a copy of the notice, and a copy of the shareholders' resolution, to be filed in LLC's file; and
- the shareholders and the security agent agree that the above actions constitute delivery for the purposes of the Commercial Pledge Law.
While the above structure is untested in terms of enforceability, the synthetic perfection of the pledge by the creation of share certificates represents, for the time being, the closest lenders can come to obtaining a perfected pledge over shares in an LLC in the Kingdom.
One must consider what happens to those security interests when the security agent seeks to enforce its rights. There is in fact very limited precedent of actual enforcement of security, and as such the topic remains uncertain.
Where a dispute arises between a bank and its customer in relation to a banking matter (other than the exceptions set out below), the dispute must be in the first instance referred to the Banking Disputes Settlement Committee of the Saudi Arabian Monetary Agency (the SAMA Committee) for settlement. The SAMA Committee aims to propose settlements in accordance with the terms of the agreements under dispute, and has tended to apply shariah principles less strictly than the mainstream Saudi Arabian courts so as to give effect to practices that are recognised in international banking practice.
As noted above, there are a number of exceptions to the SAMA Committee's general jurisdiction in respect of banking disputes.
Disputes relating to negotiable instruments, including promissory notes, are heard before the Office for Settling Negotiable Instruments Disputes (NIO).
Provided a promissory note meets certain criteria as to form, the NIO generally does not look behind the note to ascertain whether the underlying transaction complies with shariah hence the popularity of the promissory note in Saudi Arabian lending transactions.
Enforcement by way of sale of assets pledge under the Commercial Pledge Law may only be undertaken by an order of the Board of Grievances.
A secured lender can seek to enforce security where there is a payment default in respect of a payment of principal. Security cannot, under shariah law, be enforced because of a default in respect of payment of interest, or any payment in the nature of interest. It is uncertain whether a secured lender could successfully enforce security in respect of any other default (other than failure to pay).
In respect of pledged or mortgaged assets, the security documents will typically provide that, on enforcement, the security agent will have the right to sell the pledged assets and apply the proceeds towards extinguishment of the debt. However, the implementing regulations of the Commercial Pledge Law provide for a statutory procedure for enforcement of any security created under the law. Where the borrower defaults on a payment of principal, the pledgee can, after a short notice period, apply to the Board of Grievances to sell all or part of the pledged assets. Assuming the application is successful, assets up to the value of the outstanding secured obligations must then be sold by public auction, again following a short notice period to the borrower and any guarantors.
Where the lender or security agent holds a valid power of attorney to deal with the secured assets, the security agent as attorney can sell the assets and apply the proceeds of the sale to repay the debt.
In the context of insolvency, including determining priority of creditors, the Board of Grievances has general jurisdiction.
There are a number of legal challenges that need to be considered by lenders seeking to obtain enforceable security in respect of loans advanced to Saudi Arabian borrowers or in respect of Saudi Arabian projects, as well as by the lawyers and financiers structuring those transactions. These are not new challenges and there are numerous international banks regularly lending substantial sums into Saudi Arabia (the past few months have seen the close of several major financings, such as the Hajj and Umrah terminals financing, the $4.5 billion Maaden/SABIC Ras Al Zour fertiliser plant financing and the $6 billion Kayan financing), which demonstrates the ability to structure transactions within the boundaries of the Saudi system. However, with the ever-increasing size and complexity of transactions and the sophistication of borrowers and project sponsors, awareness and understanding of the legal principles involved in taking security in Saudi Arabia is crucial for those advising on the structuring of financing transactions in the Kingdom.
Trowers & Hamlins Dubai
Henry Cort is a partner in Trowers & Hamlins' Dubai-based banking and projects team. Henry specialises in Saudi Arabian transactions, private equity, secured finance and refinance work, acquisitions, disposals, corporate finance, project finance and development matters. He is experienced in structuring, negotiating and documenting the full range of English and overseas law-governed commercial and finance documentation underpinning significant international development projects and their acquisition, sale, financing and refinancing.
Henry has acted on a number of high profile transactions, recently acting on an underwritten acquisition bid for $500 million of telecommunications assets in Indonesia, a $1 billion asset acquisition in Saudi Arabia, and is currently acting on the acquisition finance for a bid for a major stake in a power station in Abu Dhabi.
Trowers & Hamlins Dubai
Rachel Rayfield is a senior lawyer in Trowers & Hamlins' Dubai-based banking and projects team. Rachel undertakes a wide variety of work, including project development, project finance and corporate borrowing transactions. Rachel's experience includes, in 2007, advising the successful bidding consortium on the full range of commercial and finance documentation for the $1.9 billion Shuqaiq II IWPP in Saudi Arabia. Rachel is currently advising a major Saudi Arabian banking group in relation to the financing of the development of a water transmission system in the Eastern province of Saudi Arabia.