BANK FINANCE AND REGULATION Multi-Jurisdictional Survey SECURITY OVER COLLATERAL. SRI LANKA F.J.& G. De Saram

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1 BANK FINANCE AND REGULATION Multi-Jurisdictional Survey SECURITY OVER COLLATERAL SRI LANKA F.J.& G. De Saram CONTACT INFORMATION Mr.Tudor Jayasuriya F.J.& G. De Saram Attorneys-at-Law & Notaries Public 216, de Saram Place, Colombo 10, Sri Lanka Can assets be charged, liened and/or encumbered in your jurisdiction? Please insert any exemptions, if any. Assets can be charged, liened or encumbered. Under our law, all these three words mean the same thing ie. That the property is mortgaged and hypothecated. 2. In your jurisdiction, under what circumstances may security arrangements be subjected to choice of law and/or choice of forum clauses (does it matter, whether the security itself is located abroad and/or governed by foreign law [e.g. a pledged claim])? What is the market practice in your jurisdiction? Is there a treaty on this in your jurisdiction, whether bilateral or multi-lateral? Are there any requirements for enforcement in your jurisdiction? Security arrangements are subject to choice of law and/or choice of forum clauses where private international law applies to the parties/transaction eg. Where one of the parties to the transaction is a national of a foreign country or where the contract is performed in a foreign country. There must be a foreign element in or a foreign aspect to the contract for it to attract the operation of the principles of private international law.

2 If the security is located abroad, the mortgage or charge must be created in accordance with the law of the foreign country. Enforcement too is in the foreign country, in its forum, and according to the law and procedure of that country. Likewise, any mortgage over property located in Sri Lanka should be created in accordance with the law of this country and is governed by the law of this country and the forum too are the courts of this country. The principles above stated cannot be regulated by private contract. They are a matter of law. There are no treaties relating to enforcement of security either bilateral or multilateral. 3. In your jurisdiction, are floating charges or security over the overall assets of an entity accepted, and if so in what terms? The Companies Act No. 7 of 2007 contains provision which provide that a Company may grant a charge (referred to in the Act as a floating charge ) over the whole or any part of the property and undertaking of the company, for the purpose of securing a debt or any other obligation incurred or to be incurred by the company or any other person. A floating charge may apply to any property of the company whether held by the Company at the time of creation of the floating charge or acquired thereafter including: (a) movable and immovable property (incorporeal property is movable property eg. book debts and receivables) (b) uncalled capital (c) circulating assets, including cash stock-in-trade, raw materials, book debts and other receivables A floating charge created under the provisions of this Act shall notwithstanding the provisions contained in any other law, have effect as a security over the property of the company to which it is expressed to apply, in the manner and to the extent specified in the Act - (a) subject to the provisions of the Registration of Documents Ordinance where applicable, and (b) subject to section 103 of the Mortgage Act (Section 103 of the Mortgage Act relates to the effect of registration of a mortgage of a motor vehicle in the Register of Motor Vehicles the effect of this seems to be that the registererd mortgage shall subsist despite any subsequent sale, mortgage or other transaction) 4. In relation to the following types of assets, please explain in your jurisdiction the types of security that can be created or granted, if the security requires any type of registration or perfection requirements, an estimate of cost (including applicable taxes and any other duties/ costs) and timing for granting such security, and any special considerations regarding the asset type:

3 (a) Aircraft; A mortgage can be created over an aircraft. An aircraft is movable property. Therefore, the mortgage must be registered (within 21 days) in the Land Registry (of the district where the aircraft is at the point of creation of the mortgage). If the owner of the aircraft is a company, the mortgage must be registered (within 21 days) in the Register of Mortgages and Charges at the Office of the Registrar of Companies. Unlike in the case of a motor vehicle or a ship, there is no system of registration of the mortgage in a Register of Aircraft. (b) Bank Accounts; Moneys in Bank Accounts can be mortgaged. A mortgage over moneys in bank accounts will not, deprive the Banker of his Banker s lien and Banker s right of setoff (which the law gives him) unless he expressly waives them in favour of the mortgagee. Thus, where the Banker has not waived his lien or right of setoff, he can exercise his right of setoff and appropriate the moneys in the bank account in settlement of the debt due to him, regardless of the mortgage. The money in the charged account however is secure as against seizure by third parties. (c) Animals, Crops (in ground and severed) and Timber; Animals can be mortgaged. It is a mortgage over movable property. The mortgage has to be registered within 21 days. A mortgage over animals include their progeny. Crops once severed from the ground are movable property. A mortgage over such crops is a mortgage of movable property, which has to be registered within 21 days. Standing crops are immovable property. A mortgage thereover is therefore a mortgage of immovable property, which can be created only by a notarially attested mortgage bond. The mortgage bond should be registered at the Land Registry. There is no time limit for registration. If a standing crop, it is immovable property. If severed from the ground, it is movable property. Comments in the preceding paragraph will apply. (d) Equipment; If the equipment if fixed to the ground or otherwise permanently fastened, it is immovable property. If not, it is movable property. Our above comments relating to mortgages of movable and immovable property will apply.

4 (e) Intellectual Property; Intellectual property rights are mortgageable. Intellectual property rights, being incorporeal property (chose in action), they are movable property. Our comments above relating to mortgages of movable property will apply. We make one observation. If one were to go by strict law, it is not necessary to register a mortgage of intellectual property rights in the Land Registry. Intellectual property rights, being a chose in action, are exempted from the applicable provisions of our Registration of Documents Ordinance. (f) Inventory; What we understand by the term inventory are book debts. Book debts are mortgageable. Book debts being incorporeal property, a mortgage of book debts is a mortgage of movable property. Book debts being choses in action, a mortgage of book debts needs no registration at the Land Registry. However, a mortgage of book debts as defined in Section 89 of the Mortgage Act needs to be registered. The provision in the Registration of Documents providing for the exemption of choses in action does not apply to book debts as defined in Section 89 of the Mortgage Act. (g) Leases; Leasehold rights of the lessee can be mortgaged. Leases can be of movable property or of immovable property. A mortgage over leasehold rights over movable property is a mortgage of movable property. Accordingly, the mortgage needs to be registered within 21 days. A mortgage of leasehold rights over immovable property is a mortgage of immovable property. Our comments above relating to mortgages of movable and immovable property will apply. It is but rarely that in Sri Lanka a lessee of movable property will mortgage his leasehold rights. It is generally the lessor who mortgages his right to receive the lease rentals and the underlying asset, of which he holds the freehold title. (h) Mineral Interests, including Hydrocarbons; They can be mortgaged only after they are severed (or extracted) from the ground. Until then, it is part of the land. State leases ordinarily reserves to itself the right to the minerals. Our comments above relating to mortgages of movable property will apply.

5 (i) Promissory Notes and Chattel Paper; The right to receive payment on these promissory notes and chattel paper can be mortgaged. It is a mortgage of movable property. The right to receive payment being a chose in action, the mortgage needs no registration at the Land Registry. (j) Real Estate; Real estate is land (immovable property). Land always includes fixtures and anything standing thereon or permanently fastened thereto. Our comments above relating to mortgages of immovable property will apply. (k) Receivables (credit rights under contracts or invoices); Receivables above described can be mortgaged. It is a mortgage of movable property. The mortgage need not be registered at the Land Registry because the contractual right to receive is a chose in action. (l) Rights under Contracts (excluding Receivables); The position is the same as in (k) above. (m) Shares (in book-entry and certificate form and other securities); A mortgage of shares can be created under the common law. The Mortgage Act also contains special provisions for the creation of mortgages of shares in favour of approved credit agencies as defined in the Act, in the manner mentioned in that Act ie. executing the instrument of mortgage in the prescribed form; depositing the share certificates with the agency, and executing instrument of transfer in blank in favour of the agency thereby providing such approved credit agencies with an expeditious method of recovering the dues from the borrower under the mortgage, without recourse to Courts. (n) Vessels; Ships can be mortgaged. The Merchant Shipping Act No. 52 of 1971 of Sri Lanka (Shipping Act) as amended contains provisions applicable to mortgages of ships registered under this Act. Registration of a mortgage of ship with the Registrar of ships under the Shipping Act is essential, for the purpose of gaining priority, in terms of that Act. The charge created by the mortgage of ship should also be registered at the Office of the Regstrar of Compaies as mentioned above. No other filing or registration or recording in any public office (such as the Land Registry) or elsewhere is necessary.

6 The documents usually obtained in the creation of a a mortgage of a ship would be the Instrument of Mortgage of the Ship, Deed of Covenant containing certain undertakings by the borrower, Assignment by the borrower in favour of the lender of earnings and insurances arising from or in respect of the ship, as additional security. Where the mortgaged ship is the subject of a charter, it is also usual for the lender to obtain an assignment in favour of the lender of the rights of the borrower in respect of such charter, as additional security (This could be included in the Deed of Covenant) (o) Vehicles; Motor vehicles can be mortgaged. The Mortgage Act also contains special provisions in regard to mortgage of motor vehicles. A mortgage of motor vehicles should be registered (within 21 days) at the relevant Land Registry. The charge must be registered (within 21 days) in the Register of Mortgages and Charges at the Office of the Registrar of Companies. In terms of the Mortgage Act, it is necessary to register the mortgage with the Registrar of Motor Vehicles. (p) Business as an ongoing concern. It is not possible to mortgage a busines as a going concern. But the same result can be achieved by taking from the company a mortgage over all the assets of business, including immovable and movable property, and, if the mortgagor is an incorporated company, by taking from the share holders of the Company a mortgage of all (or a substantial part) of the shares so that in the event of an enforcement, the Lender or his nominee can gain control of the company as a going concern. In regard to costs on the security docuement, stamp duty is payable on mortgage bonds over any property at the rate of Re.1 /- per Rs.1000/- Mortgage of food crops, ships and aircrafts are exempt from stamp duty. 5. Please explain briefly for each type of assets the procedure for enforcement (judicial and extra-judicial). Is it possible to enforce security governed by another jurisdiction? If yes, what is the procedure? Hypothecary Actions The Mortgage Act contains provisions for the institution of hypothecary actions in respect of both immovable and movable properties. A particular feature of the law of mortgage of Sri Lanka is that, generally, a lender who has obtained the security of a mortgage of land could, in the enforcement of such mortgage by the institution of a hypothecary action, obtain a decree of Court for the sale of the mortgaged land only, and no other property whatsoever. Other than the mortgaged land, could be sold in the execution of such decree even if there is a shortfall in the amount realized from the sale. (Section 46 of the Mortgage Act). [Where a lender takes a mortgage of movable property, there is no such restriction affecting him. After selling the mortgaged

7 movable property, the lender can proceed against the other assets, movable or immovable, of the Mortgagor for the recovery of the deficiency]. The restrictive provision in Secton 46 of the Mortgage Act was amended in the year 1990, by bringing in the following new laws (debt recovery laws) so as to provide a measure of protection to lending institutions Mortgage (Amendment) Act No.3 of 1990 Provision has been made by Section 3 of the Mortgage (Amendment) Act No.3 of 1990 to enable a mortgagor of land in favour of a lending institution to renounce the benefit of Section 46 of the Mortgage Act. The effect of such renunciation (which should be by a special declaration of the Mortgagor, executed strictly in accordance with the relevant legislation) is that, in addition to the mortgaged property, any other property belonging to the mortgagor, subject to certain exceptions (which are set out in Section 218 of the Civil Procedure Code) was liable to be ordered to be sold under the decree in an action upon the mortgage; but no process could be issued for the seizure and sale of any property of the mortgagor, other than the mortgaged property, until the mortgaged property is sold and the proceeds thereof applied in satisfaction of such decree. Lending institutions as defined in the Act included Licensed Commercial Bank within the meaning of the Banking Act No.30 of 1988 and the other financial institutions specified in that Act. Recovery of Loans by Banks (Special Provisions) Act No.4 of 1990 as amended by Act No. 24 of 1995 By the above Act, provision was made for the recovery of a loan ( which term has been defined to mean a loan of money and include any overdraft or advance or any other monetary accommodation by whatever name or designation called ) granted by a bank (as defiend in the Act) on the mortgage of property, whether movable or immovable, without such a mortgagee having to enforce such mortgage by the institution of an action in the appropriate court. This special statutory right of a bank is referred to as Parate Execution. The above Act sets out the procedure to be followed by the lending institution in the exercise of the statutory right of sale of the mortgaged property (ie. passing of a board resolution, and their due publication, due publication of notices of sale, sale by public auction etc., ) Debt Recovery (Special Provisions) Act No.2 of 1990 as amended by Act No.9 of 1994 This Act enables the lending institution as defined in that Act, which includes licensed commercial Banks, to recover the loan by the institution of action in Court in a more expeditious manner. The process of enforcement under this Act involves, filing of supporting documents, the Court issuing a decree nisi, the

8 decree nisi being made absolute, and the Court making order for the seizure and sale of the property of the debtor (except those exempt from seizure) in satisfaction of the debt. In fact, under section 13 of the Act, the decree absolute entered in the action is itself the writ of execution duly issued by Court to the Fiscal for execution by the seizure and sale of the defendant s assets. Under the Mortgage Act rights are given to approved credit agencies to sell the mortgaged property over shares, book debts and life policies without recourse to Courts. When the mortgage of such property is taken in the manner set out in the Act. Certain State Banks, by their respective Statutes under which they have been established, have parate execution rights. We have discussed the matters relating to the enforcement of a security governed by another jurisdiction in question 2 above. 6. Can a trustee or security agent be used in your jurisdiction, or must security be granted in favour of all lenders? The concept of a security agent as such is not recognised in our jurisdiction. However, in certain transactions (for example: securitization and debenture issues, the mortgage over the pool of assets/asset to secure the securitizes transaction and or the debentures is created in favour of the trustee on behalf of the the investor/s. This is permissible and it is well recognised and is common. In syndicate lending involving several co-lenders, concurrent mortgage can be created in favour of a Trustee who will hold the mortgage for the benefit of the co-lenders. This is not exactly the concept of the Security Agent. The Trustee will enforce the mortgage and pay the co-lenders their entitlement on a prorated basis. 7. In bankruptcy or insolvency scenarios, what are the suspect periods, is clawback possible, and what other types of rights (tax debts, employees, etc.) have preference over security granted? A validly created and perfected first ranking security interest will have priority over all other creditors. Once insolvency proceedings have been instituted, the secured party s remedy is to enforce the mortgage/charge by making its preferential claim in the insolvency proceeding or by the institution of a hypothecary action against the liquidator. There is not here any threat or risk of a claw back. A movable mortgage gives the creditor precedence over all other creditors, except a first charge in favour of the state, ie. the claim of the Commisssioner Genreal of Inland Revenue in respect of unpaid taxes for any one year of assessment to be selected by him. It is necessary to consider the provisions contained in the Companies Act No.7 of 2007 and the Insolvency Ordinance which seek to invalidate in certain circumstances, inter alia, the creation of a charge by a company with a view to fraudulently preferring one creditor to another (the principle of fraudulent preference).

9 According to the Companies Act No.7 of 2007, a transaction by a company is voidable on the application of the liquidator if the transaction- took place at a time when the company was unable to pay its debts as they fall due. was an uncommercial transaction was engaged in a business for which its financial resources were grossly inadequate. incurs an obligation which the company is not able to perform when required to do so. or in the case of a charge over the property or undertakings of a company, if the company was unable to pay its debts as they fall due after the charge is created. An uncommercial transaction is a transaction a reasonable person in the company shall not enter into, having regard to:- - the benefits to the company - the detriment to the company - the benefits to the other party/ies to the transaction - any other relevant matter A transaction may be termed as an uncommercial transaction whether or not a creditor is party to the same or if it is given effect / required to be given effect pursuant to an order of court. Specified period in relation to the voidable transactions in the Companies Act means: Two years before the commencement of the winding up, in the case of a transaction entered into with or a chrage granted to a connected person (as defined in the Act) and; In the case of a company that is being wound up by the court, the period of two years before the filing of the petition in the court, together with the period commencing on the date of the filing of that petition and ending on the date on which the order of court was made. In any other case:- One year before the commencement of the winding up, and In the case of a company that is being wound up by the court, the period of one years before the filing of the petition in the court, together with the period commencing on the date of the filing of that petition and ending on the date on which the order of court was made. 8. In your jurisdiction, can borrowers or guarantors subordinate their claims and if so in what terms?

10 The principle here adverted to is not clear to us. It is very common for a creditor (a secured creditor or other creditor having a preference) to subordinate his claim. A guarantor who has paid on his guarantee too can subordinate his claim and the security obtained therefor so that all those assets will be available to the Lenders to execute upon. Your question looks at the opposite of this phenomenon. 9. What are the consequences of a transfer, assignment or novation of an underlying credit in your jurisdiction (is new security necessary, is the security automatically transferred, etc.) A novation simpliciter extinguishes the old debt and discharges the securities. How this consequence is avoided is by assigning at the same time the debt and the securities by one document called and Assignment of the Mortgage. In the execution of an Assignment of Mortgage, at no stage is the debt disociated from the hypothecation, and vice versa. The debt and the hypothecation cannot have an independent and distinct existence. They can exist only in association with one another. 10. Can you have on top of a security in your jurisdiction, another layer consisting of an assignment of the collateral concerned conditional upon default by the debtor? This question too is not very clear to us in the absence of an example to illustrate it. For the moment what we want to tell you is, our system of registration being based on the principle of earliest to register his instrument, all parties stand or fall according to the date of registration of their deeds. 11. Are step-in rights lawful in your jurisdiction or does any action to take control require the creditors to go through a court process? The Courts of Sri Lanka will recognize the validity of a security interest only to the extent of the mortgage/charge. An equitable mortgage which involves an outright transfer of ownership of the collateral to the mortgagee/pledgee as a condition of a security interest is not recognized in Sri Lanka. The only rights available to a secured creditor is to enforce the security/ Mortgage Bond in a hypothecary action and obtain a decree for the sale of the mortgaged property to recover the sum due to the creditor and/or exercise the parate rights, if the secured creditor is entitled to do so, under the relevant laws and sell the property without recourse to courts as mentioned above. Since there is no outright transfer of ownership of he collateral to the Mortgagee, the step in rights do not arise.