What is a "financial institution"?

By Brian Salter.

Key Points:
The commercial background in which the Loan Facility Agreement was originally signed was vital to determining the meaning of the expression "financial institution".

There has been a great deal of debate on the meaning of the expression "financial institution". In many funding agreements and structured transactions, a participant will only be permitted to transfer their interest to a "bank or other financial institution". A recent decision of the English High Court, The Argo Fund Limited v Essar Steel Limited [2005] EWHC 600 (Comm), provides guidance to the meaning of this expression.

The application to the Court was made by Argo Fund Limited, a mutual fund investment company incorporated in the Cayman Islands, whose principal activities involved trading investments in debt securities and lending to emerging market governments and corporations. It engaged in these activities in both the primary and secondary markets although it was principally involved in the secondary market. Argo commenced proceedings in UK Commercial Court against Essar Steel Limited claiming repayment of various tranches of debt under a syndicated Loan Facility Agreement. Argo acquired the distressed debt from several original members of the syndicate after Essar had failed to honour its commitment under the Loan Facility Agreement.

The Loan Facility Agreement provided that a syndicate bank member was entitled to assign its rights and benefits under the Loan Facility Agreement with notice to Essar or it could transfer all or any of its rights and obligations in accordance with the procedure specified in the Loan Facility Agreement (which effectively involved a novation with Essar's consent given in advance in the Loan Facility Agreement), subject to the condition that the transferee was a "bank or other financial institution".

Argo acquired its interest in the second of the two ways contemplated by the Loan Facility Agreement (ie. by novation). Essar failed to repay the debt to Argo claiming the purported transfers were ineffective and the original lenders had repudiated the Loan Facility Agreement. Essar argued that Argo did not satisfy the requirements for transfer under the Loan Facility Agreement as Argo was not a "bank or other financial institution". Essar also claimed that there was no assignment of rights and benefits as an ineffective transfer or novation could not serve as an operative assignment. Argo argued that the syndicate banks had validly transferred their rights and obligations to it in compliance with the Loan Facility Agreement.

The principal issues

• What is the meaning of "bank or other financial institution"?
• Was there an effective transfer of the tranches of debt to Argo?
• Could Argo otherwise argue that it had taken an assignment of the rights of the original lenders?

The decision

The Court first established whether the Loan Facility Agreement limited the class of person or entities to whom the bank syndicate members could transfer to those falling within the phrase "bank or other financial institution". Justice Aikens answered this question in the affirmative considering the text of the Loan Facility Agreement along with the intention of the parties.

The meaning of "bank or other financial institution"

Justice Aikens held that the commercial background in which the Loan Facility Agreement was originally signed was vital to determining the meaning of the expression. This included taking into consideration the fact that any borrower should have anticipated that its loan would be traded in the secondary market in 1997 and that non-bank investors played a part in this market for debt.

The Court held that "financial institution" was intended to share the following common characteristics with banks:

• They must be lenders of money;
• They should have a lending office;
• They must maintain accounts which will be evidence of the money;
• Because transfer was permitted before drawdown, the transferee must have capabilities - financial, technical and legal - of lending money during the drawdown period; and
• The transferee must have a legally recognised form and transact business in commercial finance. It is not limited to entities whose principal activity is the provision of finance in the primary lending market.

While these requirements are relevant in the sense that they may provide some indication into the factors that the court will consider when defining a "financial institution", they are a result of a textual analysis which will ultimately vary with and reflect the particular provisions in a transaction agreed upon by the parties.

Were the transfers effective?

Argo was held to be within the ambit of "other financial institution" by satisfying the above requirements. The transfers were therefore effective and Argo was entitled to the various tranches of debt under the Agreement.

If the transfers were ineffective, was there an operative assignment?

Argo argued in the alternative that if the transfers by way of novation were invalid, it could nonetheless claim the debt from Essar as the syndicate banks had assigned to Argo the tranches of debt and Essar had notice of such assignment in accordance with the Loan Facility Agreement.

The Court held that the legal arrangements between a novation and assignment were so distinct that an intention to undertake a novation was incompatible with an intention to assign rights. The distinction was grounded in the following factors:

• a novation requires the consent of all three parties involved whereas an assignor can assign without consent of either assignee or debtor;
• a novation involves the termination of one contract and the creation of a new one whereas the contract remains the same in an assignment;
• a novation involves the transfer of both rights and obligations to the new party whereas an assignment only concerns the transfer of rights; and
• the termination and creation of new contract in novation requires consideration for both acts whereas legal assignment (at least) can be completed without the need for consideration.

It appears from this decision that the courts will adhere to a strict interpretation of the distinction between novation and assignment. It is unlikely that where a transfer (by way of novation) is unsuccessful a party can argue in the alternative that they have had those rights assigned. A separate intention to assign must be demonstrated.

Thanks to Maya Greenberg for her help with this article.