9. Debt finance Flashcards
gearing
ratio of debt: equity
(if high = seen as credit risk to banks)
long term debt (non-current liabilities) / equity
x 100 = gearing
EQUITY FINANCE - effect on balance sheet and future ability to raise money
- total equity on BS increases (b/c cap increases)
- gearing decrease (more attractive to banks)
- earnings per share decrease (less attractive to equity investors in future?)
DEBT FINANCE - effect on balance sheet and future ability to raise money
- non-current liabilities on BS increases
- gearing increases
- possibly harder to raise debt finance (might need security which is not available or req, discharge of earlier loan)
EQUITY FINANCE - funding cost
- dividends only payable if declared by board (board can postpone if insufficient distributable profits)
- dividends not tax deductible
DEBT FINANCE - funding cost
- Fixed amount payable regardless of profitability of the company (interest payments due)
- BUT floating rate interest - if interest rate low, debt might be cheaper than equity
- loan interest payments = tax deductible
EQUITY FINANCE -
Restrictions on Company affecting ability to raise funds
- SH resolution to allot new shares (SH might not want to dilute their shares)
- ltd cannot offer to public (s.755)
- limited market/investor base for private company shares
DEBT FINANCE -
Restrictions on Company affecting ability to raise funds
- possible borrowing restriction in company’s constitution
- contractual restriction in other loan agreements
- run out of assets to use as security
- gearing too high (seen as risky)
EQUITY FINANCE - degree of regulation and procedure
- company procedure for share issues (SR/OR/PMM)
- opposing SH can use voting power to obstruct
- FSMA 2000
DEBT FINANCE - degree of regulation and procedure
- no specific regulation or statutory procedure to follow when setting up a loan (unless in constitution - e.g. borrowing limits)
- if security required - must be reg. at CH (s.859A)
- negotiation of contract and security, keep records, FSMA
EQUITY FINANCE - Effect on balance of power within the company
- DILUTION of economic and/or voting power
DEBT FINANCE - Effect on balance of power within the company
- NO impact on balance of power within company (no voting rights - no direct say in decision making)
- BUT LOAN AGREEMENT MAY GIVE SIGNIFICANT CONTROLS over how company manages its affairs (undertakings, covenants)
EQUITY FINANCE - Degree of scrutiny of company affairs
- not on day-to-day management (dir) but on key decisions (which require SH approval)
- if new investor has significant voting power this can influence direction of company (e.g. block SR, appoint new directors)
- action against directors in case of mismanagement
- derivative action
DEBT FINANCE - Degree of scrutiny of company affairs
- loan agreement may contain REPRESENTATION, UNDERTAKINGS, EVENTS OF DEFAULT so that the borrower can be monitored closely
- security places restrictions on comp’s ability to dispose of assets freely
EQUITY FINANCE - future profitability
- profits can be ‘locked away’ as reserve on balance sheet (need not be distributed as a dividend)
DEBT FINANCE - future profitability
- regular interest payments must be made (harder to build up reserves on balance sheet)
EQUITY FINANCE - Risk for company if experiencing financial difficulties
- no risk, no obligation to declare dividends if insufficient profits
- impairs capital value of shares if bad performance
DEBT FINANCE - Risk for company if experiencing financial difficulties
- comp may breach financial covenants (loan agreement may contain financial performance targets)
- bank may call event of default for payment defaults or breach of rep or undertaking (which can lead to acceleration of loan, enforcement of security, or comp being placed into insolvency procedure)
BORROWING MONEY - STEP 1
PRE-CONTRACT STEPS (before instructing lawyers)
- B decides source of finance to use
- Bank checks financial status of borrower
- Bank carries out anti-laundering checks and ninternal compliance procedures on B and directors
- bank sends over draft term sheet (heads of term)
- both parties instruct lawyers
BORROWING MONEY - STEP 2
PRE-CONTRACT STEPS (after instructed lawyers)
- B’s solicitor checks borrower has no provision in constitution restricting power to borrow money
- B’s solicitor checks no restrictions placed on directors in articles (and they can act)
BORROWING MONEY - STEP 3
NEGOTIATION
- negotiate loan agreement and security doc
2. directors convene BM to review documentation and pass BR to enter loan agreement and security doc
BORROWING MONEY - STEP 4
SIGNING AND POST SIGNING
- signing of both docs
- fulfil conditions precedent before money is available
- bank’s solicitor registers security at CH and any other applicable reg (e.g. LR)
- CH - 21 days beginnign with date of creation
- other reg - during priority period - borrower keeps copy of security doc and related docs at offices
- borrower gives notice to company registrar of where docs are kept
BORROWING MONEY - STEP 4
DURING THE LOAN AGREEMENT
- Borrower makes interest payments to lender in accordance with loan agreement
- Borrower either:
- repays loan, or
- refinances loan on maturity (re-borrowing same amount on renegotiated terms from same bank)
- defaults under loan
if borrower defaults
lender can call its money in early and is either (1) repaid or (2) enforces security to satisfy debt
if event of default, bank can
(1) demand immediate repayment (acceleration)
(2) enforce security (satisfy debt)
OR if loan unsecured, apply to court to wind up borrower
what is not required to borrow money
- usually no GM required (no SH approval required unless specific requirement in articles if borrowing in excess of X amount)
types of debt finance
LOAN FACILITIES - agreement between borrower and lender giving borrower a right to borrow money on terms set out in agreement
DEBT SECURITY (e.g. bond) - investor provides finance and company issues piece of paper acknowledging investor's rights against the company (this can be sold or kept)
types of loan facilities
- overdraft
- term loans
- bonds
- convertible bonds
- preference shares
overdraft
- Usually standard T&C (shorter and less onerous clauses)
- On demand (not committed facility so lender can ask for money to be repaid at any time)
- Not used as a long-term borrowing facility
- More flexible
- Higher interest
- Interest is paid to the bank on the amount the customer is ‘overdrawn’
•Should only be used as a fall-back if borrower is facing short term cash flow problems
term loans
- Usually borrowed for a fixed set term (e.g. 5-7 years) and repaid on a certain date (maturity date)
- Lender cannot call for repayment before agreed repayment date unless the borrower breaches terms of loan agreement
- Interest is paid to lender on amount borrowed for duration of the loan
- Lender sets interest rate and other things
- More onerous controls and provisions in documentation
• Set repayment schedule
Bullet repayment - If repayable as single lump sum (other than interest)
Amortising - repayable on instalments
NB. banks usually do not like early repayment because it messes up their arrangements and they get less interest too
bonds
- Bond is a debt security
- represented by a piece of paper (a bond security) which records the rights of the investor
- Bonds are a form of debt - rights similar to rights of lender under loan facility
- Issuer promises to repay value of bond to the holder of the bond at maturity – until then, issuer pays interest to holder on a periodic basis (usually bi-annually)
- Bonds issued with view of being traded – markets that these bonds are traded are called ‘capital markets’
- Holder of bond might sell if they want lump sum now or if they think there is a risk of no repayment
security interest
borrower agrees to give lender proprietary rights over the assets to protect lender against non-payment
If borrower fails to repay his debt in full and on time lender can exercise a number of remedies
E.g. appoint administrator or fixed charge receiver
If borrower pays back debt in full and on time, security interest of lender in borrower’s assets come to an end
reg requirements under CA 06 (changes came into force 6 April 2013)
within 21 days beginning on day after the day on which charge is created (s.859A(4)) - period can be extended in certain circumstances (s.859F)
Registrar will register security if person interested in charge or comp delievers:
- statement of particulars (MR01)
- certified copy of charge
- relevant fee (£13 paper, £10 electronic)
STATEMENT of particulars
details of:
- date of creation
- company creating charge
- persons entitled to charge
- description of land/ships/aircraft/IP reg in UK subject to fixed charge
who registers security?
either by company or any person interested in the charge (this includes the lender) - S.859A(2)
usually lender - more to lose if no-reg
consequences for failure to reg
S.859H – if charge is not registered at all (or is not registered within 21-day period):
- Charge is void against liquidator, administrator, and any creditor of the company
- Debt becomes immediately repayable
Also, solicitor = negligent
records to keep re: security
company must keep available for inspection (s.859p)
- charge and copy of every instrument that amends/varies charge
- at reg. office
- inspection for free if member/creditor, for charge for others
fail to comply = fine
reg requirements pre-6 April2013
original doc sent to CH where it was stamped (acknowledged) and returned to company
types of security
- fixed charge
- floating charge
- charge by way of legal mortgage
- pledge
- lien
- charge
fixed charge
- preferred over floating
- to be fixed charge, charge holder must be able to demonstrate sufficient control over charged property (usually by borrower/security provider undertaking not to dispose or create further charges over charged assets)
FLOATING CHAGES
- Used if assets are sold/spent on a regular basis (i.e. constantly fluctuating)
- Borrower needs to be able to use these assets freely to trade/run the business
- Impractical to ask lender’s consent every time you want to dispose of 1 piece of stock
CHARGE BY WAY OF LEGAL MORTGAGE
(normal way of creating security over property)
- security provider retains possession but ownership transferred to creditor
- transfer subject to security provider’s right to require creditor to transfer asset back when debt repaid (equity of redemption)
- usually over land
- but if over land, ownership remains vested in security provider
pledge
- possessory security
- security provider gives possession of asset to creditor until debt paid back
e.g. pawning
lien
- possessory security
- right arising from law
- creditor retains possession of asset until debt paid back
E.g. mechanics lien
charge
non-possessory security
- main security interest
- security provider retains possession of asset
- Instead of transferring ownership, charge creates equitable proprietary interest in asset in favour of creditor
- There is also a charging document which will give lender contractual rights over the asset (e.g. to appoint receiver or administrator to take possession of it and sell it, or exceptionally, to take possession of it itself to sell) if debt is not paid back when it should be
fixed charges (over what?)
e.g. machinery, vehicles
- Creditor can control what security provider can do (e.g. no sell, no new charges without creditor’s consent)
- Borrower can still use asset in ordinary course of business but is restricted from disposing or charging it
- If charge becomes enforceable creditor can appoint receiver of that asset to exercise power to sell
floating charge (over what?)
e. g. cash and stock
- not practical to take floating charge (because company needs to freely dispose assets)
- floating charge over whole class of circulating assets
- whatever assets in that class owned by security provider at any given time = subject to floating charge
- security provider can dispose of it freely until crystalisation
- On crystallisation – charge stops floating and fixes to assets in the relevant class owned by the security provider at time of crystallisation (can occur by operation of law or triggered by certain events)
disadvantages to floating charge
- creditor not sure of value of secured assets (assets may be sold before crystallisation)
- ranks below fixed charge and below preferential creditors
- if created on or after 15 Sept 2003, subject to proceed of assets being set aside (prescribed part fund)
- capable of being avoided under s.245 Insolvency Act
- Administrator free to deal with floating charge assets in his control without ref to the charge holder or the court to pay his remuneration and expenses out of proceeds of those assets
priority among secured creditors
first has priority unless varied by agreement between creditors (‘deed of priority’, ‘subordination agreement’, ‘increditor agreement’)
IF REGISTERED CORRECTLY
type of security - exam structure1
- consider borrower (what is his business, what assets has he got?)
- consider borrower’s future plans (does it want to take on more debt?)
- what is commercially/practically viable for borrower (comply with terms without fuss?)
- what assets does borrower have, what is the appropriate security for that
- check loan agreement - will it have a prohibition on borrower giving further security over assets to someone else (e.g. undertaking)
best form of security?
pledge because actual posession but impractical, bank can’t take machinery, business can’t use it and bank doesn’t have space to store and doesn’t want to be responsible for it
main docs for bilateral loan
- term sheet (not legally binding)
- loan agreement
- security doc
(loan agreement and security doc = seperate docs because sd has to be registered so it isn’t confidential)
loan agreement
deals with commercial terms (e.g. interest, payment dates, fees)
- can be kept confidential (not need reg)
- used for committed facilities mostly (on-demand facilities tend to use straightforward/informal docs and bank’s standard terms)
security doc
deals with type of security and control over those specific assets
- assets given as security
- type of security over asset
- provisions/undertakings relating to secured asset
- needs to be reg and is under public inspection
term sheet
- Statement of key terms of transaction (e.g. loan amount, interest rate, fees to be paid, key representations, undertakings, events of default to be included in loan agreement/bond terms and conditions)
- Equivalent to heads of terms in other transactions
- Just a statement of understanding on which parties agree to enter the transaction
- Summary of key points
main terms in loan agreement
- conditions precedent
- representations (statement of fact, usually repeated periodically)
- undertakings (active every day - promises not to do/to do something)
- events of default
- mechanics of facility (when utilised, when repaid)
- interest rates
- protecting lender’s commercial return
if breach loan agreement
check:
- events of default
- acceleration?
- security doc (enforce? appoint reciever?)
usual events of default
non payment
mis rep
insolvency
litigation
how does bank protect itself against borrower?
in loan agreement
- events of default for late/non-payment of principal amount and interest
- acceleration for events other than non-payment (e.g. breach of financial undertakings/obligations under loan agreement, breach of obligation with another lender, borrower subject to insolvency procedure)
- undertakings requiring borrower to provide bank with financial and business information so bank can tell if non-payment likely
- undertaking requiring borrower not to give security to other lenders or incur further indebtness
- security
- guarentee from another group company
was there a breach of rep?
- check reps, check repetition clause
- will breach of rep be resolved by next reptition? if yes, no breach, if yes, breach
- if breach - consequence? event of default?
ALSO:
- check undertakings
- breach?
- consequences?
ALSO:
- event of default?
- grace period?
