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How to minimize conflict of interest in security custodial services

Security custodial Services are services that involve a neutral party (Trustees) in a transaction to hold the secured assets in trust for the benefit of the lenders involved in a multiple lending/syndication transaction.

Although the secured assets are held in trust for the benefit of the lenders, the Trustee acts in the interest of both parties and owes fiduciary duties to both the lender and the borrower.

The involvement of the trustees minimizes conflict of interest for both parties as the assets pledged as collateral for the facility are taken out of the control of the parties and held by the trustees in trust for the benefit of both parties.

This benefit can be a sale in furtherance of the lender’s interest where the borrower is unable to pay back the loan or a handover of the debtor’s security documents to him when he has fully discharged his obligations under the agreement.

Security custodial services are mostly used in syndicated loans transactions (such loans are often required for working capital or expansion of operations).

A syndicated loan transaction is a mechanism in which two or more banks (lenders) come together and provide a loan to a single borrower primarily because the loan is either too large for a single bank to provide or the loan is outside the limit/risk-exposure of that bank. The loan is covered by a single Agreement/documentation and all the banks are entitled to the collateral on a pari passu basis. Usually, loans granted in a syndicated loan transaction must be secured and as the interests of several lenders are at stake, a trustee is introduced into the transaction to hold the security/collateral documents in trust for the parties.

Since a syndicated loan arrangement involves several lenders and a single borrower, conflict of interest is bound to arise in the transaction if the security documents are kept in the custody of one of the lenders. In the case of default by the borrower, the lender in the custody of the title documents is likely to act immediately and use the security documents to pay its portion of the debt without consideration for the other lenders and or the borrower.

In default actions, therefore, it is the trustees that take the necessary enforcement actions on behalf of the lenders.

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The trustee will ensure that the last option that can be exercised by the parties is to sell the security, and where a sale is inevitable, it is also beneficial to the borrower.

The trustee also performs other administrative functions as an intermediary between the lenders and the borrower. It acts as the primary point of contact between the parties and is equally responsible for managing the flow of communication between the lenders and the borrower.

The trustee also conducts due diligence and ensures the worth/sufficiency of the securities deposited as collateral for the loan. The Trustees coordinate and also monitor the transaction. Trustees are experienced in tracking the management of the loan facility arrangement and, without them, the mechanics and management of the arrangement are bound to fail as they ensure the securities deposited as collateral is not compromised during the pendency of the transaction.

The Trustees also ensures that the assets are insured with a reputable firm and the Trustees noted as ‘’Loss Payee’’

The trustee as the facility agent and security custodian prepares the Trust Deed which binds the arrangement between the parties and ensures neither of the parties default on their obligations and where there is a default, sanctions, and liabilities are effected on the defaulting party.

The Trustees must not be under the illusion that it has to protect only the interest of the providers of capital. Its duties include protecting both parties and therefore the trustees must also include protective clauses in the Trust deed that protects either the lender or the borrower where certain events (that are outside the control of either of the party) occur that can affect the financial stability of either of the parties. Where for instance, force majeure events prevent either party from fulfilling its obligations, the Trustees must bring this to the attention of the other party and ensure that necessary mitigants are put in place to prevent allegations of breach of the agreement. It would be wrong in force majeure situations for the parties to insist on the strict application of the agreement and it is the duty of the trustees to strike a balance between the rights of both parties.

The trustees thus facilitate communication between the parties and negotiate a rearrangement on the next steps necessary. The lenders in this situation cannot hold the security documents of the borrower as “blackmail” because it was never in their possession in the first instance.

The role of the security trustee is to ensure that there is no potential conflict of interest in the transaction. The security trustee is expected to take into consideration the scope of his duties and be aware of the party to whom he owes those duties. The trustee as a neutral party to the transaction has no interest at stake. Both the lenders and the borrower have interests at stake – the borrower wants to ensure the preservation of the assets that are used as security to the transaction while the lenders seek the repayment of the loan given to the borrower with the interests which accrued on it. If the security documents are left to either party, conflict of interest is inevitable as the party would act to enforce his interest, even at the detriment of the other party.

Greenwich Trustees Limited, a firm of professionals with expert knowledge in custodial Security Services has assisted numerous borrowers and lending institutions to collateralize or secure their positions using single collateral assets.

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