Finance documents will often include a provision that excludes a junior secured creditor’s right of marshalling, although the reasons for doing so aren’t always understood or appreciated.
What’s marshalling?
Marshalling is an equitable remedy that’s available between two secured creditors in the following circumstances:
- Two creditors (Creditor A and Creditor B) both have claims against a common debtor (Borrower) for different debts.
- Creditor A has the benefit of two securities granted by the Borrower to secure its debt: security over Blackacre and over Whiteacre.
- Creditor B only has a second-ranking security over Whiteacre (and no security over Blackacre).
- Creditor A enforces its security over Whiteacre but not over Blackacre. Creditor B therefore loses the benefit of its security, and is forced to join the ranks of general unsecured creditors.
By choosing to enforce its claim against Whiteacre, Creditor A prejudiced the position of Creditor B. In these circumstances, the doctrine of marshalling allows Creditor B to take the benefit of the security in Blackacre by allowing Creditor B to be subrogated to the rights of Creditor A in relation to that security. This means that Creditor B is entitled to use Blackacre to repay the secured debts owed to it that couldn’t be repaid out of Whiteacre (even though Creditor B had no security over Blackacre).
When is marshalling available?
The general rule is that for marshalling to be available, there must be two creditors of the same debtor (this is often referred to as the “common debtor” requirement). A recognised exception to this general rule is where a separate and independent equity exists that merits a departure from the common debtor requirement (Sarge Pty Ltd v Cazihaven Homes Pty Ltd (1994) 34 NSWLR 658; ACN 077 991 890 Pty Ltd v National Australia Bank Ltd [2007] NSWSC 358). The separate and independent equity may be (for example) a guarantor’s right to quia timet relief (that’s, a guarantor’s right to compel the primary obligor to pay the guaranteed debt so the guarantor doesn’t have to), or a guarantor’s obligation to pay the debts of the primary obligor under a guarantee.
For example:
- Creditor A and Creditor B lend money to the Borrower. Creditor A also lends money to the Borrower’s affiliate (Affiliate).
- To secure repayment of its loan to the Borrower, Creditor A obtains a first-ranking mortgage over the Borrower’s property (Blackacre).
- To secure the repayment of its loan to the Affiliate, Creditor A obtains (i) a guarantee from the Borrower and (ii) a mortgage over the Affiliate’s property (Greenacre). The mortgage over Blackacre also secures the Borrower’s obligations under the guarantee.
- To secure repayment of its loan to the Borrower, Creditor B obtains a second-ranking mortgage over Blackacre.
- The Borrower defaults on the loans from Creditor A and Creditor B. Creditor A enforces its security over Blackacre, but not over Greenacre. Creditor B therefore loses the benefit of its security, and is forced to join the ranks of general, unsecured creditors.
In this case, given the nature of the guarantor/primary obligor relationship between the Borrower and its Affiliate, Creditor B may be able to invoke the exception to the “common debtor” rule and seek to share in the security over Greenacre, even though Creditor B wasn’t a creditor of the Affiliate.
Why do we see “no marshalling” clauses in finance documents?
If you’re a junior creditor in a finance transaction, your right of marshalling is often excluded in priority and intercreditor deeds entered into with senior creditors. If you’re a guarantor in a finance transaction, some guarantees may also exclude your right of marshalling (which should only be relevant if you, as a guarantor, have also taken security and therefore assumed the role of Creditor B in the example above). The exclusion may be drafted as a statement that:
- the senior creditor has no obligation to marshal or appropriate any security in favour of the junior creditor; or
- the junior creditor waives any right of marshalling that it may have in respect of the senior creditor’s security.
It may not be immediately obvious as to why a senior creditor would require your right of marshalling to be excluded. Under Australian law, marshalling doesn’t compel the senior creditor to enforce certain securities and not others (for example, it wouldn’t require Creditor A to enforce against Blackacre instead of Whiteacre in the first scenario above). It doesn’t dictate how the senior creditor enforces its security, or affect the senior creditor’s priority position. Once the senior creditor is paid out, it should have no objection to you (as the junior creditor) exercising your right of marshalling.
There’s a potential, however, for your right of marshalling to arise (and for you to be able to exercise that right) before the senior creditor is fully paid out. This was illustrated in the English decision of Highbury Pension Fund Management Company and another v Zirfin Investments Management Ltd [2013] EWCA Civ 1283, where the second creditor wasn’t required to wait until the first creditor had been paid in full before exercising its right to marshal.
Although this wouldn’t affect the senior creditor’s priority ranking, it may trigger the senior creditor to enforce a portion of its security package earlier than it would have otherwise done so. A senior creditor will therefore wish to address this scenario (however rare it may be) by expressly restricting you from exercising any right of marshalling.
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