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  • Sebastián Boada Morales

Welcome to the Jungle: How Collateral-Trust Structures are Eroded in Insolvency

Updated: Dec 17, 2018

by Sebastián Boada Morales, Editorial Board of the IJICL's Blog

The latest Colombian case dealing with collateral-trust structures in insolvency was handed down last October. Decision number 400-013438 by the Colombian Bankruptcy Court decided the reorganization of Jungla Kumba Entretenimiento SAS, a closed corporation which provides entertainment services. This ruling constitutes yet another troubling precedent for financiers in the Colombian market. Together with the 2016 decision of Panthers Machinery SAS, the two cases serve as a recent reminder of the wild risks taken by secured lenders in Colombia.

Upon a reorganization event (similar to Chapter 11 in the US), the bankruptcy judge has effectively undermined a widely used security structure: the collateral-trust. Systematically, the judge has ordered the return of the full amount of assets transferred to the trust to the insolvent company, excluding trust-administration expenses. The troubling aspect of these cases is that the assets in the trust are not the property of the debtor; thus, they should not be available for its use in its reorganization, as they have been effectively transferred to a third party trust estate.

Collateral-trust explained

Collateral-trust schemes are widely used in Colombia as security for all sorts of bank and securities financing schemes. Common transactions are structured as follows. The debtor, in its capacity as grantor, constitutes a collateral-trust with a third party trustee. Such trust is deemed, under local law, as an independent estate – a separate patrimony in Civil Law terms[1] – distinct from that of the debtor.

The debtor transfers the assets that will serve as security into the collateral-trust, and mandates that any payments made by its customers are to be automatically credited to such trust. In these cases, the assets will be income streams generated by the business activity of the debtor.[2] The trust is registered as security interest for the debt incurred, for the benefit of the creditor. A "payment waterfall" is incorporated into the trust, whereby the income streams flowing are first used to pay for the trust expenses, then to service the debt, and finally they are released for use of the debtor. It is common to stipulate that upon an event of default, the trust will retain all moneys flowing into it, and shall not permit the funds to flow out into the estate of the defaulted debtor.

The Jungla Kumba and Panthers decisions

In the October 2018 Jungla Kumba case, the debtor claimed that the funds credited to the trust were essential for its business and, as such, they should be paid back to it. According to the company, further lock-down of such funds in the trust would lead to its liquidation (similar to Chapter 7 in the U.S.). This claim by the company effectively undermined the contractual undertaking it entered into when raising the debt. Notably, by the time the company was admitted into reorganization, there was no payment default under the debt. The bankruptcy judge accepted the motion and ordered that the funds flowing into the trust estate be paid back to the debtor.

The facts of this case show how, by virtue of the initiation of a reorganization proceeding, the parties' intent in setting up the collateral was denied by the bankruptcy judge; albeit with the complicity of the debtor who acted in a way contrary to its previous undertaking.

The bankruptcy judge asserted that there are two key legal principles that allow him to order the return of funds to the debtor: universality and equality. The principle of universality states that all creditors must concur to the insolvency, and the principle of equality mandates that all creditors are to be treated equally, but taking into account their relative preferences, such as security and others. Likewise, in the Panthers case, it was asserted that the insolvency regime is "exceptional and temporary", allowing the judge to deny the preference awarded by the trust structure.

Such statements blatantly ignore the fact that, by virtue of contract and the Law, the assets transferred to the trust are part of an independent patrimony; which is separate from that of the debtor as grantor, and is subject to the specific objective agreed by the contracting parties.[3] Furthermore, the Code of Commerce clearly states that the assets transferred to the trust are not part of the patrimony of the debtor / grantor, and merely serve the contractual purpose as stipulated by the parties when establishing the trust.[4]

Strangely, the bankruptcy judge questioned the effectiveness of the Commercial Code by first reducing the blackletter law to mere theory in the following passage: "Theoretically [the trust structure] seeks to separate the assets in the trust from those of the debtor and which serve to pay its creditors." Then, he stripped down the trust structure from its core characteristic by stating: "However, this contractual device [the trust] does not function upon the initiation of an insolvency proceeding, given that allowing such scheme would benefit some creditors, undermining the insolvency principles of equality and universality." This conclusion is not derived from statutory law.

With its statements, the Bankruptcy Court effectively altered the contract entered into by the parties by transforming it into a different kind of agreement. The essential trait of this type of trust (known as the fiducia mercantil) is the title transfer of property. Consequently, by annulling such transfer, the judge altered the contract and turned it into a fiduciary mandate (encargo fiduciario in Spanish), whereby no title transfer takes place.[5]

Judges usually recharacterize the contractual undertakings of the parties when they find a misalignment between actions and intentions.[6] However, what the court did in Panthers, Jungla Kumba and their progeny is quite different; here, collateral-trust agreements are effectively stripped down of their main trait, in order to call back the assets to the insolvent estate. Such transformation does not look into parties' actions and intentions, it rather takes place every time there is a reorganization.

The decisions of the Bankruptcy Court are based on Article 17 of the Insolvency Statute.[7] Traditionally, such rule has been construed as defense of the principles of universality and equality in insolvency. The unrestrained application of such rule to collateral-trusts may well be questioned in light of the blackletter law on trusts commented above. Local commentators have stressed that the debtor's insolvent estate must be available for all credits on an equal basis. However, it should not be forgotten that the collateral-trust is not part of such debtor's estate.

The fact that the judge has qualified the effect of the statute as mere "theory" is worrisome, to say the least. Notably, the Commercial Code states that the assets transferred to the trust may not be pursued by other creditors of the grantor, other than those prior to the granting of such trust. In essence, there are two different and distinct patrimonies: (i) one of the debtor; and (ii) the other of the trust. Technically, under Civil Law, each patrimony is the total sum of the debtors' rights and liabilities, attached to such person for the satisfaction of her economic needs, and which are subject to the execution for the benefit her creditors.[8] Regrettably, the bankruptcy judge is denying the effects of the collateral-trust in insolvency; precisely when they are needed the most.

Consequences of these decisions

What are the effects of these decisions? Evidently, creditors feel wholly unprotected by the collateral-structures which they set-up. Colombia's legal regime blindly reiterates anachronistic structures based on Napoleonic law, which are overly protective of the insolvent entity, to the detriment of its creditors. This preference hinders the development of the local financial markets.

This state of affairs will arguably result in higher cost of credit for local debtors, damaging the economy as a whole by slowing the growth and investment that would be possible with leverage. The effect is pernicious: all companies which wish to raise money via bank finance are affected higher rates, as a result of the mechanisms implemented to protect certain creditors of a few insolvent companies.

Alternative structures?

So what alternatives are there for creditors? Both the statute and the rulings of the Bankruptcy Court provide a few insights into how collateral-trust structures may be protected in the future:

1. In the Jungla Kumba case, the insolvent company requested that the assets in the trust be paid back to the company. Evidently, this act contradicts its previous contractual undertaking when raising incurring the debt and setting up the security interest. Notably, it could be claimed that the company is subject to a kind of estoppel by contract, which would fall under a principle of good-faith-dealing under local law.[9] Consequently, the debtor could not possibly request the return of the assets, when it expressly acquiesced to the transfer of such assets to an autonomous trust estate.

2. In the Jungla Kumba case, the company was not in default before the initiation of the reorganization proceeding. The bankruptcy judge repeatedly invoked this as justification for its decision, adding that the contractual payment waterfall established that funds were to be transferred to the company after servicing the debt.

Reorganization proceedings are triggered by objective situations of default of a certain amount of obligations and/or failure to meet future payments. Parties may, in the future, establish "trip-wire" event of default clauses, whereby the debtor is in default before the objective situations giving rise to insolvency are met. Consequently, the debtor will be in default before a request for insolvency is made, and the contractual lock-down of the funds may be respected by the judge. If such lock-down occurs before the initiation of the insolvency, the judge may not easily mandate that the whole funds be paid back.

Additionally, it may be agreed in the trust contract that only a trickle will fall out of the trust; that which is strictly necessary for the minimum operation of the company.

3. Whenever possible, the main debtor should be the trust, and the company should be a guarantor of such indebtedness. This is made possible in project financing structures where any available assets are property of the trust as debtor. Consequently, the trust should not be affected by the bankruptcy of the grantor. Covenants should be included to limit the ability of the trust to incur future indebtedness, as to restrict the possibilities that the trust itself is subject to insolvency proceedings.

[1] According to the Black's Law dictionary, the meaning of "patrimony" in Civil Law is: "all of a person's assets and liabilities that are capable of monetary valuation and subject to execution for a creditor's benefit".

[2] Of Course, other assets may be transferred to the trust for security of the credit, such as real estate, patents, machinery, receivables etc.

[3] Article 1233 of the Commercial Code. In this vein, local scholars assert that such independence is the undeniable essential characteristic of the Latin American trust. See Rodriguez-Azuero, Sergio, The Anglo American Origin of the Latin American Fideicomiso (Trust): Reasons and Implications (July 31, 2017). Instituto Iberoamericano de Derecho Finanzas (IIDF) Working Paper Series 3/2017. Available at SSRN:

[4] Article 1227 of the Commercial Code.

[5] See Regulation n 29/14 issued by the Superintendence of Finance, Chapter I, Title II, Part II.

[6] See Michael Bridge & Jo Braithwaite (2013) Private Law and Financial Crises, Journal of Corporate Law Studies, 13:2, 361-399, DOI: 10.5235/14735970.13.2.361. In Colombia see Bankruptcy Court decision n 400-002306 issued on November 27, 2017.

[7] Law 1116 of 2006.

[8] See e.g. Creech v. Capitol Mack, Inc., 287 So. 2d 497 (1973, Louisiana Supreme Court). In Colombia see article 2488 of the Civil Code.

[9] Article 1603 of the Colombian Civil Code and article 871 of the Commercial Code.

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