Month: December 2020

The general rule is that shareholder approval by ordinary resolution is required before a company can make a loan to a director. This shareholder resolution must not be passed unless a written memorandum, setting out the nature of the transaction, the amount and purpose of the loan and the extent of the company’s liability, is made available to the members.

What transactions are caught?

The restrictions apply to four different types of transaction:

1. loans,
2. quasi-loans,
3. credit transactions, and
4. guarantees or the provision of security for any of the above.

Loans (s.197 and s.200 CA 2006)

A loan simply involves a straightforward lending of money.

Quasi-loans (ss.198 – 200 CA 2006)

The term quasi-loan is defined in s.199. An example of a quasi-loan would be where a company agreed to pay off an outstanding account owed by a director to a third party on the understanding that the director would later reimburse the company.

Credit transactions (ss.201–202 CA 2006)

A credit transaction is defined in s.202. A credit transaction includes any transaction entered into between the company and the director where the company provides goods or services on a credit basis which will be paid for at a later date. Only the company and the director will be parties to this arrangement.

Guarantee or the provision of any form of security (ss.197, 198, 200 and 201 CA 2006)

This is not defined but will be reasonably self-explanatory. An example of this type of arrangement would be where a director obtains a loan from a bank and his company stands as guarantor for the repayment of the loan or the company provides the bank with security over its assets.

Which companies are restricted?

For the purposes of the CA 2006, restrictions on loans and related financial transactions between a company and a director or connected persons of that director, it is important to distinguish between private companies on the one hand, and public companies and private companies that are associated with public companies on the other.

All companies:

No company may make loans to its directors or to directors of its holding company, or give guarantees or enter into security in connection with loans to such directors, without the transaction first being approved by the shareholders.

If the company in question is a private company that is not associated with a public company, these are the only transactions for which shareholder approval is required under the CA 2006 loan provisions.

Public companies and private companies associated with public companies:

There are additional restrictions that apply to public companies and private companies that are associated with public companies, namely:

1. Public companies or companies associated with public companies must obtain shareholder approval to make a loan to a person connected to a director of the company or a director of its holding company;
2. Public companies or companies associated with public companies also need shareholder approval to make quasi-loans to, or enter into credit transactions with, their directors and directors of a holding company or persons connected with such directors; and
3. Shareholder approval is also required for guarantees or security in respect of any such loans, quasi-loans or credit transactions by public companies or companies associated with public companies.

Definition of ‘associated companies’:

Under s.256, companies are associated if one is a subsidiary of the other or both are subsidiaries of the same body corporate. So, for example, a private company that is a subsidiary of a public company will be associated with the public company for these purposes.

Exceptions

There are a number of exceptions to the need for shareholder approval, the
principal ones being as follows:

Expenditure on company business – s.204

Shareholder approval is not required where a director is provided with a sum of money to pay for company expenses or expenses to enable him to properly perform the duties of a director.

This exception is limited to expenditure the aggregate amount of which is £50,000 or less. If the value of the transaction or arrangement cannot be ascertained, it will be deemed to exceed £50,000.

Expenditure on defending proceedings – s.205

Shareholder approval is not required where a company is providing funds (either by way of a loan, quasi-loan or credit transaction) for a director to defend proceedings in connection with any alleged negligence, default, breach of duty or breach of trust in relation to the company or an associated company or in making any relief applications in connection with s.661(3), s.661(4) and s.1157.

Minor and business transactions – s.207

Loans or quasi-loans to a director (or, under s.200, a person connected to a director) up to an aggregate amount of £10,000 can be given without the need for shareholder approval. This figure rises to £15,000 for credit transactions. There is an additional exception where the credit transaction is in the ordinary course of the company’s business and the terms of the transaction are not more favourable than the terms that the company would have offered to a person unconnected with the company. In this situation, no shareholder approval is required; this is irrespective of the value of the transaction.

Loans / quasi loans by a money-lending company – s.209

A company whose ordinary business includes the making of loans or quasiloans or the giving of guarantees or provision of security, can make any loan or quasi-loan or give a guarantee to provide security to any person; this is provided it does so under normal business terms. There is no permitted maximum amount for this.

Sanctions for non-compliance

Section 213 provides civil remedies in respect of transactions involving all companies. The transaction will be voidable at the instance of the company unless:

1. restitution is no longer possible;
2. the company has been indemnified for the loss or damage resulting from the transaction; or
3. bona fide rights have been acquired by a third party who was not a party to the transaction and such rights would be affected.

Section 214 allows for the arrangement to be affirmed by the shareholders of the company and the holding company (where relevant) by ordinary resolution within a reasonable period. If it is affirmed, the arrangement may no longer be avoided under s.213.

Irrespective of whether the transaction has been avoided, the director (and the person connected to the director, if relevant) and any other director who authorised the transaction must account for any gain made directly or indirectly from the transaction and indemnify the company for any loss or damage resulting from the transaction (s.213(3) and (4)).

Is there any defence/exemption?

If a transaction contravenes ss.200, 201 or 203 and is entered into with a person connected with a director, that director will not be liable if he took all reasonable steps to ensure the company complied with those sections (s. 213(6)).

There is also a defence under s.213(7) for any connected person (if relevant) and any director that authorised the transaction who can show they had no knowledge of the circumstances constituting the contravention.

Wholly owned subsidiaries: approval is not required by the members of any company which is a wholly-owned subsidiary of another company.

What is a substantial property transaction?

Section 190 CA 2006 controls any arrangement whereby:

1. a director or connected person acquires a non-cash asset from a company, or
2. a company acquires a non-cash asset from a director or connected person.

If the non-cash asset is a substantial non-cash asset, then the arrangement must either be approved by an ordinary resolution of the company or be conditional on such approval being obtained. Where an arrangement is conditional on approval being given, the company must not be subject to any liability for failure to obtain the approval (s.190(3)).

Anything to which a director is entitled under his service contract is excluded from being a substantial property transaction (s.190(6)).

Who is a connected person?

Under s.252 a connected person is (broadly speaking):

1. a member of the director’s family (being a spouse, partner, civil partner, child or step child or a parent of the director, as specified in s.253(2));
2. a company with which the director is associated (a company in which the director and persons connected with him together own at least 20% of the share capital);
3. a trustee of a trust in which the director or a person connected to a director have an interest; or
4. a person acting in the capacity of a partner of the director, or of a person connected to a director.

What is a non-cash asset?

Section 1163 defines a non-cash asset as ‘any property or interest in property other than cash’.

What is a ‘substantial’ non-cash asset?

This is explained in s.191.

• An asset worth £5,000 or less is not a substantial asset.
• An asset worth more than £100,000 is a substantial asset.
• An asset worth more than £5,000, but not more than £100,000 is a substantial asset only if it is worth more than 10% of the company’s net asset value. A company’s net asset value is that shown in its most recent statutory accounts.

If the company is only recently incorporated and no accounts have yet been prepared, then the net asset value is taken to be the amount of the company’s called up share capital.

What happens if the directors do not obtain shareholder approval?

The transaction is voidable by the company (s.195) unless:

1. restitution is no longer possible;
2. the company has been indemnified by another person for the loss or damage suffered by it; or
3. bona fide rights have been acquired by a third party who was not a party to the transaction and such rights would be affected by the avoidance of the transaction.

Section 196 allows for the arrangement to be affirmed by the shareholders of the company and the holding company (where relevant) by ordinary resolution within a reasonable period. If it is affirmed, the arrangement may no longer be avoided under s.195.

And

Irrespective of whether the transaction has been avoided, the director (and the person connected to the director, if relevant) and any other director who authorised the arrangement are liable to account to the company for any gain made directly or indirectly out of the transaction, and to indemnify the company for any loss or damage resulting from the transaction (ss.195(3) and 195(4)).

Is there any defence/exemption?

If the transaction is between a company and a person connected with a director, and the director concerned shows that he took all reasonable steps to ensure the company’s compliance with s.190, the director will not be liable under s.195(6).

There is also a defence under s.195(7) for any connected person (if relevant) and any director who authorised the transaction who can show they had no knowledge of the circumstances constituting the contravention.

Wholly owned subsidiaries: Under s.190(4)(b), approval is not required by the members of any company which is a wholly-owned subsidiary of another company.

Companies are owned by shareholders but for the most part are managed by a board of directors.

CA 2006 reserves certain important decisions for shareholder approval, such as changing the company’s name (unless the articles provide otherwise), amending the articles of association, removing directors and so on.

Directors’ authority to manage the company

Outside of this finite number of decisions which are reserved for shareholder approval, the board is usually free under a company’s articles to make decisions for the company on all other matters.

MAs 3 and 5 deal with the power of the directors to manage the company.

The directors can therefore, on behalf of the company, employ individuals and decide what they will be paid, enter into contracts with customers and suppliers, buy and sell company property, raise funds by borrowing from banks and authorise the company’s assets to be used as security. The directors are also responsible for putting together company accounts and for supplying information to auditors. These are just a few examples of the decisions directors are free to make without shareholder approval.

Directors’ accountability

The power delegated to the directors is therefore extremely wide and, if this power were left unchecked and unregulated, the less ethically minded might start using companies as a medium for a variety of corrupt practices. Certain directors may, for example, decide to lend themselves company funds on very favourable terms, award themselves excessively large salaries, acquire company property at an undervalue or award contracts with the company to their family businesses or associated companies on lucrative terms. They may
even give false or misleading statements in the accounts to make the company look more attractive to investors or banks. In order to prevent such practices and to ensure companies are run for the benefit of, amongst others, their shareholders and for the protection of the company’s creditors, directors’ actions and powers are restricted and regulated by statute. The key provisions are included in Part 10 of CA 2006, which includes directors’ general duties and other specific restrictions.

Directors can be, and very often are, made to account for wrongs done through civil and criminal actions taken against them for breaching the Companies Acts. They have also been found guilty of criminal actions and sentenced under other legislation.

The type of offences directors can and have been found guilty of include:

1. the general offence of fraud under the Fraud Act 2006, and/or offences under the Theft Act 1968;
2. insider dealing under the Criminal Justice Act 1993;
3. money laundering under the Proceeds of Crime Act 2002;
4. market abuse, making misleading statements or carrying on regulated activities without authorisation under FSMA 2000;
5. wrongful and fraudulent trading under the Insolvency Act 1986; and
6. bribery offences under the Bribery Act 2010.

Directors’ duties

A director of a company owes duties to the company and is subject to obligations which derive from statute, for example under the CA 2006 and Insolvency Act 1986. In this post, we are considering a director’s general duties under the CA 2006 (specifically ss.170–177). It is important to note that s.170(5) CA 2006 provides that the general duties of directors apply to shadow directors where and to the extent that they are capable of so applying.

Under a company’s articles, directors are generally empowered to exercise all the powers of a company in order to manage the company’s business on a day-to-day basis. Directors must exercise these powers in accordance with their statutory duties.

Statutory duties under CA 2006

The statutory duties under CA 2006 are:

• to act within their powers;
• to promote the success of the company for the benefit of the members as a whole;
• to exercise independent judgment;
• to exercise reasonable care, skill and diligence;
• to avoid conflicts of interest;
• not to accept benefits from third parties; and
• to declare any interest in a proposed transaction.

Under the statutory duty to promote the success of the company, there is a list of non-exhaustive factors to which the directors must have regard. These include ‘the interests of the company’s employees’ and ‘the impact of the company’s operations on the community and the environment’.

Remedies for breach of duty against directors

Directors owe their duties to the company, rather than to individual shareholders. If directors breach their duties, it is obvious and established that the company has a claim against them in law.

Under s.178, the consequences of a breach of directors’ duties are the same as for breach of the corresponding common law or equitable principles. With the exception of the duty to exercise reasonable care, skill and diligence under s.174, the statutory duties are enforceable in the same way as fiduciary duties owed by directors to their company.

The remedy for a breach of the duty of care, skill and diligence is therefore usually damages. Remedies for breaches of other general duties include:

• an injunction;
• setting aside of the transaction, restitution and account of profits;
• restoration of company property held by the director; and/or
• damages.

A breach of duty could also be grounds for the termination of an executive director’s service contract or for disqualification as a director under the Company Directors Disqualification Act 1986.

However, given that the directors are in day to day control of the company and are its directing minds, they may not be inclined to cause the company to bring proceedings against them. For this reason, shareholders are in some cases permitted to institute a derivative action against the directors. This would be an action seeking relief on behalf of the company, in respect of a cause of action vested in the company, but where the claim is instituted by the shareholder(s).

Section 260 gives shareholders an express right to bring a derivative claim where directors have, for example, breached their statutory duties or acted negligently. This applies even if the directors have not benefited personally from their actions or default.

In most cases, if a majority of shareholders support action against the director for breach of duty, a derivative action will not be necessary. This is because the directors will cause the company to bring a claim in any event, knowing that, if they do not do so, the majority of shareholders can remove intransigent directors from the board and appoint more co-operative individuals who are prepared to bring the claim.

A derivative action is likely to be commenced, therefore, where only a minority of shareholders want to take action in a case, for example, where the majority are prepared to accept the director’s behaviour or where the delinquent directors hold sufficient shares to block any moves against them.

Section 260 is wider than under the previous law and some commentators expressed concern that it would lead to a raft of claims by activist shareholders. So far it would seem that the worst predictions of the litigation floodgates opening have not materialised. However, the legislation includes a requirement to obtain permission from the Court to continue such a claim (proving a prima facie case) and provides that claims cannot be brought where a majority of shareholders approved the directors’ conduct in advance or where the shareholders have since ratified that conduct. A further reason why these fears do not seem to have been well founded is that damages awards under s.260 CA 2006 are made for the benefit of the company and not for the benefit of the shareholder(s) who brings the claim.

Former common law duties of directors

Before CA 2006 was introduced, directors’ duties derived, for the most part, from common law and equity. These sources of law are still valid to the extent not expressly provided for in CA 2006. Indeed, CA 2006 provides that the statutory duties shall be interpreted and applied in the same way as the common law duties. The duties under the former regime were as follows:

• common law duty of skill and care;
• fiduciary duties / duties in equity, e.g.:
  • duty to act bona fide in the interests of the company;
  • duty to act within powers and for proper purposes and not for any collateral purpose (e.g. not for personal gain or with a conflicting interest);
  • duty not to misapply company property (e.g. making a prohibited loan to a director);
  • duty to account for a secret profit (i.e. a profit made by virtue of one’s office, perhaps involving a contract between the director and a third party, which is not approved by the company);
  • duty to avoid conflicting interests and duties; and
  • duty not to fetter their own discretion.

Issuing debt securities

I previously covered the restrictions on the issue of shares under s.755 CA 2006 and the Financial Services and Markets Act 2000 (‘FSMA’).

These restrictions also apply to the issue of debt securities. Therefore, private companies can only issue bonds to targeted investors and not to the public indiscriminately. To do otherwise risks contravention of s.755 CA 2006. Similarly, if a private company makes an ‘offer to the public’ of bonds within the meaning of s.85 FSMA and cannot take advantage of an exemption, it will be required to produce a prospectus.

However, the other formalities of share issues, such as authority to allot and disapplication of pre-emption rights, do not apply to debt securities (unless they are convertible into shares).

Giving advice on financing – FSMA

If you are giving your client advice in relation to their financing requirements you should bear in mind the rules governing such advice under FSMA (which will be considered in detail in the Professional Conduct and Regulation module). Shares and bonds are regulated (‘specified’) investments and ‘advising’ is a specified activity if the advice concerns the merits of the investments e.g. making a recommendation relating to a particular bond or share, rather than simple abstract advice as to the difference between bonds and shares.

Simplified order of priority between creditors

This order of priority is a simplified version.

1. Creditors with fixed charges – entitled to the first call on the proceeds from the sale of those assets charged to them under a fixed charge.
2. Preferential creditors – primarily wages (up to £800 per employee) and occupational pensions.
3. Creditors with floating charges (which will have crystallised, if not before, upon commencement of the winding up). For floating charges created on or after 15 September 2003, a proportion of the proceeds of the floating charge assets will be set aside for payment to unsecured creditors. This is commonly referred to as the ’prescribed part fund’.
4. Unsecured creditors, to the extent not paid off from the prescribed part fund.
5. Shareholders (according to the rights attaching to their shares).

Priority among secured creditors

The rules of priority are complex but, in general, if more than one creditor has a fixed charge over the same assets, the first fixed charge created has priority (provided it was properly registered in accordance with s.860 or s.859A CA 2006). Similarly, if more than one creditor has a floating charge over the same assets, the first floating charge created has priority (provided it was properly registered).

However, this order can be varied by agreement between the creditors through a document known as a Deed of Priority, an Intercreditor Agreement or a Subordination Agreement. Such an arrangement has the benefit that creditors can make specific provision for the order in which they will rank and do not need to rely on the complex and sometimes uncertain rules mentioned above.

Priority among unsecured creditors/shareholders

Shareholders and unsecured and preferential creditors rank equally among themselves (subject to any preferential rights attached to certain classes of share).

Registration of charges created on or after 6 April 2013

Changes to the CA 2006 dealing with the formalities for registering security at Companies House came into force on 6 April 2013. The relevant provisions are found in s.859A-Q CA 2006, which replaces ss.860-892 CA 2006. The ‘new’ registration regime is summarised below:

Registration formalities

Most security created by a company needs to be registered on that company’s file with Companies House. This includes charges created by an English company over assets located both within the United Kingdom and abroad. Pursuant to s.859A(2) CA 2006, the Registrar of Companies (the ‘Registrar’) shall register any security created by a company at Companies House provided that the company or any person interested in the charge (i.e. the lender) delivers to Companies House (either electronically or by paper filing) within 21 days beginning with the day after the day on which the charge is created (s.859A(4) CA 2006) the following:

• a section 859D statement of particulars in relation to the charge. This will be set out on Form MR01 (available on the Companies House website), and includes details of:
  • the company creating the charge,
  • the date of creation of the charge,
  • the persons entitled to the charge, and
  • a short description of any land, ships, aircraft or intellectual property registered (or required to be registered) in the UK which is subject to a fixed charge;
• a certified copy of the charge (s.859A(3) CA 2006); and
• the relevant fee (currently £23 for a paper filing or £15 for an electronic filing).

On receipt of the relevant documents, the Registrar must allocate to the charge a nique reference code and shall include on the register (i) a note of the unique reference code and (ii) the certified copy of the charge (s.859I(2) CA 2006). The Registrar must issue a signed/authenticated ‘certificate of registration’ stating the registered name and number of the company in respect of which the charge has been registered and the unique reference code allocated to the charge (s.859I(3),(4) and (5) CA 2006). This is conclusive evidence that the charge has been correctly registered.

Who registers?

Section 859A(2) CA 2006 provides that the s.859D statement of particulars may be delivered either by the company that created the charge or any person interested in that charge. The latter would include the lender. In practice it will usually be the lender’s solicitors who will complete the registration formalities, as it is the lender who has most to lose in the event of non-registration.

Effect of failure to register

Under s.859H CA 2006, if the charge is not registered at all, or is not registered within the 21-day period referred to in paragraph 5.1.1 above:

• the charge is void against a liquidator, administrator and any creditor of the company; and
• the debt becomes immediately payable.

As security is taken as protection against the effects of insolvency, the fact that the charge is not valid as against a liquidator or administrator means that the security will effectively be worthless if not registered.

Records to be kept by a company

Under s.859P CA 2006, a company must keep available for inspection a copy of every charge and a copy of every instrument that amends or varies any charge. Such copies may be certified copies rather than originals.

These documents must be kept at either the company’s registered office or such other location as is permitted under the Companies (Company Records) Regulations 2008 (s.859Q(2) CA 2006). A company must inform Companies House of the place where such documents are available for inspection and of any changes to that place (s.859Q(3) CA 2006). These documents must be available for inspection by any creditor or member of the company free of charge and by any other person on payment of a prescribed fee (s.859Q(4) CA 2006). If a company refuses such inspection then the court may order that the company allows an immediate inspection.

Under s.859Q(5) CA 2006, failure to comply with any of the above requirements will be an offence and the company (and every officer of the company who is in default) will be liable to a fine.

In practice

Registration of security is common trainee work. An organised and efficient trainee will have Form MR01 drafted in advance and will register the security as soon as possible after execution of the charge. This will allow time for any errors in the documents to be remedied. It is important to note that Companies House will return Form MR01 if it is incomplete or incorrect, but the 21-day period will continue to run.

Failure to register security within the 21-day period will require the parties to re-execute the security documents and re-attempt a Companies House registration (although this can be legally problematic in view of the insolvency related challenges that can be made, particularly under s.245 Insolvency Act 1986). If other security has been granted in the interim, the lender will lose its priority. In this event, or if the filing is forgotten altogether, the mistake may result in major financial loss for a lending client. This will doubtless be followed by a claim against the law firm.

The nature of security

It is possible to improve the priority of a debt by taking security for it. ‘Security’, in this context, means temporary ownership, possession or other proprietary interest in an asset to ensure that a debt owed is repaid (i.e. collateral for a debt). Be careful not to confuse security for a debt with a ‘debt security’.

The main benefit of taking security is to protect the creditor in the event that the borrower enters into a formal insolvency procedure. It should not normally be necessary to enforce security if the borrower is still able to pay, although in some circumstances enforcing security may be a simpler way of obtaining repayment than suing the borrower.

The following are all forms of security.

• Pledge – With a pledge, the security provider (usually the borrower or occasionally another company in the borrower’s group) gives possession of the asset to the creditor until the debt is paid back. Pawning a watch or an item of jewellery is a form of pledge.
• Lien – With a lien, the creditor retains possession of the asset until the debt is paid back. An example is the mechanic’s lien. This arises by operation of law and allows a mechanic to retain possession of a repaired vehicle until the invoice is paid.
• Mortgage – With a mortgage, the security provider retains possession of the asset but transfers ownership to the creditor. This transfer is subject to the security provider’s right to require the creditor to transfer the asset back to it when the debt is repaid. This right is known as the ‘equity of redemption’. A type of mortgage (known as a charge by way of legal mortgage) is usually taken over land (although, unusually, ownership will remain vested in the security provider in this case).
• Charge – With a charge, as with a mortgage, the security provider retains possession of the asset. However, rather than transferring ownership, a charge simply involves the creation of an equitable proprietary interest in the asset in favour of the creditor.

As well as this equitable proprietary interest, the charging document will give the lender certain contractual rights over the asset – for example to appoint a receiver or administrator to take possession of it and sell it (or, exceptionally, to take possession of it itself to sell), if the debt is not paid back when it should be.

Fixed and floating charges

There are two types of charge: fixed charges and floating charges. From a creditor’s perspective, fixed charges are generally a better form of security, but not all assets are suitable for charging by way of fixed charge.

Fixed charges

A fixed charge is normally taken over assets such as machinery and vehicles. The key element of a fixed charge is that the creditor can control what the security provider can do with the fixed charge assets. This is usually done by the security provider undertaking not to dispose of, or create further charges over, the charged assets without the creditor’s consent. Note that ‘control’ in this context means the borrower can generally still use the asset in the ordinary course of business but is restricted from disposing or charging it.

If the charge becomes enforceable, the creditor will have the ability to appoint a receiver of that asset or to exercise a power of sale of the asset.

Floating charges

It is not always practical for a security provider to undertake not to dispose of its assets. For example, a trading company needs to be able to dispose freely of its stock (i.e. the products it sells).

In that case, a floating charge may be appropriate. A floating charge ‘floats’ over the whole of a class of circulating assets. Whatever assets in that class happen to be owned by the security provider at any given time are subject to the floating charge, and the security provider is free to dispose of the assets as it wishes until ‘crystallisation’.

Crystallisation means that the floating charge stops floating and fixes to the assets in the relevant class which are owned by the security provider at the time of crystallisation. The creditor thus acquires control of those assets and to this extent a crystallised floating charge is like a fixed charge. Crystallisation may occur by operation of law or may be triggered by certain events as contractually agreed between the creditor and security provider. Crystallisation will usually occur when the borrower has breached certain significant terms of the loan agreement (including by reason of its insolvency).

Disadvantages of the floating charge from the creditor’s perspective

1. As the security provider has freedom to dispose of the assets in the ordinary course of business, the creditor will not be sure of the value of the secured assets – they might all have been sold before crystallisation occurs.
2. A floating charge generally ranks below a fixed charge (and note that crystallisation does not change that) and below preferential creditors on the winding-up of the company. However, if the floating charge document contained a term prohibiting the creation of a later fixed charge (a ‘negative pledge’ clause) but the company nevertheless created a later fixed charge, the floating charge will have priority if the later fixed charge holder had notice of this restriction.
3. Floating charges created on or after 15 September 2003 are subject to a part of the proceeds of the assets being set aside. This is known as the ‘prescribed part fund’ for unsecured creditors.
4. Floating charges are capable of being avoided under s.245 Insolvency Act 1986.
5. An administrator is free to deal with floating charge assets in his control without reference to the charge holder or the court and to pay his remuneration and expenses out of the proceeds of those assets.

Guarantees

Strictly speaking, guarantees are not security, as guarantees do not give rights in assets. However, as their commercial effect is similar to security, security and guarantees tend to be treated together.

A guarantee for a loan means an agreement that the guarantor will pay the borrower’s debt if the borrower fails to do so.

Guarantees can come from companies or individuals (such as directors).

Consider the basic example of a group of three companies; A, B and C, where B and C are subsidiaries of A. A guarantee given by A of a loan made to B is a downstream guarantee. A guarantee given by B of a loan made to A is an upstream guarantee. A guarantee given by B of a loan made to C is a cross-stream guarantee.

Debentures

The word ‘debenture’ has two different meanings. Under s.738 Companies Act 2006 (CA 2006), it has a wide definition covering any form of debt security issued by a company.

However, when the term is used in this course and by bankers and debt financiers, they usually mean the document creating security (normally a collection of mortgages and fixed and floating charges over all the borrower’s assets). This document should be separate from the document creating the loan facility itself (which is usually referred to as a ‘loan agreement’, ‘credit agreement’ or ‘facility agreement’).

Whilst this may seem confusing, the context should clarify which definition is appropriate.

Examples of securities

Fixed charge

Bigbank plc has made a loan of £100,000 to Blue Moon Limited to facilitate the purchase of machinery. The loan has to be repaid over a period of five years. Blue Moon has given a fixed charge over its machinery to Bigbank.

Effect on Blue Moon

Blue Moon cannot sell the machinery or charge it to another bank without Bigbank’s consent. It can continue to use the machinery for its business as it retains possession.

Effect on Bigbank

Bigbank has rights in the machinery. If the loan is not repaid, Bigbank can appoint a receiver to sell the machinery (or, exceptionally, may itself sell the machinery) and must apply the sale proceeds to satisfy the unpaid debt.

Floating charge

Floyds Bank is the clearing bank for Blue Moon Limited, operating the company’s current account and has also provided a loan facility of £50,000 which is currently fully borrowed. To secure all monies due, Floyds Bank has a floating charge over all the assets of Blue Moon present and future.

Effect on Blue Moon

Blue Moon can continue to deal with its assets in the ordinary course of its business until such time as the floating charge crystallises.

Effect on Floyds Bank

Floyds Bank has rights in the assets, but cannot exercise control over them. If Blue Moon defaults on the loan, then Floyds Bank can crystallise the floating charge. This will give Floyds Bank control over the assets and allow it to recover its money by appointing an administrator (or exceptionally exercising its power of sale over them).

Guarantees

Northshire Bank is intending to lend £20,000 to 3dGraph Limited. 3dGraph was recently incorporated by Brian Jones to market 3d printing software which he designs. The money is to be used to purchase computer hardware which will be used in software design. The bank will be granted a fixed charge over this hardware. However, the bank is concerned that the value of the hardware might depreciate rapidly, leaving it exposed. Brian is the majority shareholder in the company and is its managing director.

As the company is newly incorporated, it may not have substantial assets. The asset over which Northshire Bank has a fixed charge is likely to quickly lose its value. Northshire Bank could take security over future assets, but this will only be useful if 3dGraph acquires valuable assets. Northshire Bank could also look to take a personal guarantee from Brian Jones if he has valuable assets. If the company defaulted, Northshire Bank could call on the guarantee and, if Brian refused to pay, sue him for the money. Brian may also give security for the loan (e.g. by granting a mortgage over his home, subject to any rights of any other person living there with him).

Lending money to a company – a typical package

Southern Bank plc has been asked to provide finance for a new company called Workskill Videos Limited (‘WV’). It is 100% owned by Workskill Training plc, the holding company for a very successful group of companies dealing in areas such as the training of various groups of professionals in personal skills. WV is seeking £200,000 to finance the purchase of a studio, editing suite and miscellaneous video equipment.

Southern could look to take a fixed charge over (amongst other assets) the new and future equipment and a floating charge over all other assets of WV. This is a typical security package. It would be documented in a debenture. In addition, the bank may want to take a guarantee from the parent company (Workskill Training plc). The guarantor may also grant security. In this case, such security might take the form of a fixed charge over Workskill Training plc’s shares in WV, allowing Southern to enforce its security through the sale of WV if both WV and Workskill Training defaulted.

An investor invests £1,000 in Blue Moon Limited by buying 1,000 ordinary shares of £1 each issued by the company.

By way of illustration (and assuming no other figures are relevant), this would show on the company’s balance sheet as follows:

 Blue Moon Limited then takes out a loan of £750, repayable over five years:

 The accounts above show that when a company takes out a loan, the net assets figure is not affected. The company’s liabilities are increased by the amount of the loan but, as the company’s assets (cash and cash equivalents) are also increased by the loan funds, the net assets remain unchanged. Also, because the company has taken out a loan (debt) rather than issued new shares (equity), total equity is also unchanged.

This is important because the ratio of liabilities to shareholder funds (total equity in the balance sheet), or in simpler terms, the ratio of debt to equity, is an important indicator of the financial health of a company. This ratio is known as a company’s gearing (or leverage). The higher the ratio of debt to equity, the more highly a company is geared.

Gearing is calculated by the formula:

Long term debt (Non-current liabilities) x 100%
Equity (Total Equity)

Looking at the example above, the gearing ratio of Blue Moon Limited after it has taken out the loan for £750 is as follows:

750 x 100% = 75%
1000

This illustrates that, at this moment in time, Blue Moon Limited has a very high level of gearing, i.e. the amount of long-term loan capital is very high compared to the amount of shareholder funds (total equity in the balance sheet) in the company.

Highly geared companies are seen as more of a credit risk by banks, so they might find it more difficult to raise further loans in the future. This is because they have less equity to absorb any losses the company might make. Because shareholders are paid last in the statutory order of priority on a winding up of a company, a company with a lot of equity can make substantial losses before it runs out of money to pay back its creditors. A highly geared company has less equity to protect the creditors and so poses a higher risk.

In addition, a highly geared company will need to make more profits before interest and tax (PBIT) in order to meet the demands for interest payments. This can be especially dangerous when economic conditions are bad or interest rates are high. All of a company’s profit could be swallowed up by the interest payments which need to be made under the terms of any loan agreements. Also, a company with a lot of debt is less likely to have assets which can be secured in favour of any new lender(s) (as these will probably already have been secured in respect of the existing debt).

You might be wondering why a company would choose to be highly geared. Suppose a company has a highly profitable investment opportunity available to it. By borrowing money, it can make a far bigger investment than it could have made if it was just using its own resources. If the investment performs well, all the profit from that investment (after interest has been paid on that debt) will belong to the company. It will have made more money than it could have done if it had only used its own resources. On the other hand, if the investment performs badly, it will have lost more money and it will still have to pay the interest on the debt.

Increasing gearing can also enhance the return to shareholders because raising money through debt finance does not require share dilution through the issue of new shares. A finance professional within a company will often recommend that debt finance should be raised due to the fact that this will have no effect on the returns to shareholders. Issuing more shares on the other hand will mean that the profits are shared between more shareholders.

Consider the following example:

 The high level of loan capital compared to equity in the higher geared company improves the earnings per share of the shareholders (earnings is the same as profit).

However, in bad times, gearing works in reverse and is therefore risky. Higher gearing increases the scope for a company to make larger losses, by increasing the size of the company’s operations compared to shareholders’ funds. If borrowed capital is deployed badly, the company may lose much more than if it had deployed only its own money. In addition, the loan interest has to be paid whether a profit is made or not.

Term sheet

At the start of the financing transaction, the bank and the borrower (or issuer in the case of the bond issue) will agree a term sheet. This is a statement of the key terms of the transaction (e.g. loan amount, interest rate, fees to be paid, key representations, undertakings and events of default to be included in the loan agreement/bond terms and conditions). The term sheet is equivalent to heads of terms in other transactions. It is not intended to be a legally binding document, rather a statement of the understanding on which the parties agree to enter into the transaction.

Loan agreement

The loan agreement sets out the main commercial terms of the loan such as amount of interest, dates on which interest will be paid, the date(s) on which principal needs to be repaid and any fees due. It will also include most of the other information from the term sheet but in much more detail. The loan agreement is one of the most heavily negotiated documents in a debt finance transaction.

This type of loan agreement tends to be used primarily for committed facilities (i.e. term loans). On-demand facilities on the other hand (i.e. overdrafts) tend to use much more straightforward and informal documentation. They are often signed up on the bank’s standard terms which are rarely negotiated and include minimal information in relation to interest rates (which tend to be high) and other payment obligations.

Debt securities have their own set of documentation which includes extensive information to enable investors to make an informed decision on whether or not to invest.

Security document

If a loan/bond is secured, a separate security document will be negotiated and entered into. This document will set out what assets are being given by way of security and the specific type of security which will be taken over each asset. It will also set out any specific provisions or undertakings relating to the secured assets (for example, an obligation to insure any property and a restriction on the chargor’s ability to sell the assets).