Debt Finance Flashcards
What is debt finance?
Although there are many types of debt finance available under different names, they can all be classified as either:
Loan facilities or Debt securities
A lender will wish to ensure that they are protected as far as possible from the possibility that the borrowing company may be unable to repay the loan. A key method of protection is for the lender to take security over the assets of the borrowing company.
Note that it is important not to confuse the term “debt security”, which is a type of debt, with the term “security for a debt” which is something that the lender will take over the assets of the borrower in order to protect their interests.
In this element you will consider the different types of debt finance. The next element will explore the various forms of security, what happens if the company becomes insolvent and how and why security must be registered at Companies House.
Types of debt finance – loan facilities
A loan facility is an agreement between a borrower and a lender which gives the borrower the right to borrow money on the terms set out in the agreement.
Loan facilities include:
- Overdraft: this is an on-demand facility, which means that the bank can call for all of the money owed to it at any point in time and demand that it is repaid immediately. This makes overdrafts unsuitable as a long-term borrowing facility. Interest is paid to the bank on the amount that the customer is ‘overdrawn’.
- Term loan: this is a loan of money for a fixed period of time, repayable on a certain date. The lender cannot demand early repayment unless the borrower is in breach of the agreement. The lender will receive interest on the loan throughout the period. Term loans which are repayable in a single lump sum at the end of the agreement are referred to as having a ‘bullet repayment’. Alternatively, the loan may be repayable in instalments, in which case it is referred to as ‘amortising’.
- Revolving credit facility: this is a loan of money for a specified period of time, but unlike a term loan, the borrower can repeatedly borrow and re-pay loans up to the agreed maximum overall amount when it chooses. This helps the borrower keep interest payments down, by borrowing only when it needs funds and repaying loans when it has available cash. It therefore combines some of the features of overdrafts and term loans.
Types of debt finance – debt securities
Debt securities have similarities to equity securities as they are a means by which the company receives money from external sources. In return for finance provided by an investor, the company issues a security acknowledging the investor’s rights. The security is a piece of paper acknowledging the debt, which can be kept or sold onto another investor. At the maturity date of the security, the company pays the value of the security back to the holder.
A classic example is a bond. Here the issuer (the company) promises to pay the value of the bond to the holder of that bond at maturity. The company also pays interest at particular periods, usually biannually.
Bonds are issued with a view to being traded. The market on which bonds may be traded is known as the capital market. Whoever holds the bond on maturity will receive the value of the bond back from the issuer. 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.
Debt/equity hybrids
Convertible bonds Convertible bonds are bonds which can be converted into shares in the issuer. On conversion, the issuer issues shares to the bondholder in return for its agreement to give up its right to receive interest and repayment of the principal amount invested. Note that a convertible bond has the characteristics of both debt and equity, but not at the same time. It starts off as a debt security but later on, if the investor so elects (in accordance with the terms of the bond issue) the bond is swapped for shares.
Preference shares A preference share is wholly equity, but it is often called a hybrid because it has elements that make it look similar to debt. The holder of a preference share commonly has no voting rights, and will usually get a definite amount of dividend ahead of other shareholders (making it look similar to interest). If the preference share has a fixed maturity date on which the company must redeem or purchase the share and/or such preference dividend is fixed, then the preference share actually looks more like debt. However, if the preference share does not have such a fixed maturity date and/or the preference dividend will only be paid if the company declares a dividend (unlike interest, which has to be paid), then this share is more akin to traditional equity.
The main debt finance documents
Term sheet
This is a statement of the key terms of the transaction (eg 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) agreed by the lender and borrower. 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.
Security document
If a loan is secured, a separate security document will be negotiated and entered into.
Debentures
Debenture
The word debenture has 2 separate meanings:
Under s738 “debenture” covers any form of debt security issued by a company, including debenture stock, bonds and any other securities of a company, whether or not constituting a charge on the assets of the company.
A debenture is also the name of the particular document which creates a security. It is in this context that the term is generally used. The debenture is a separate document from the loan agreement. The loan agreement sets out the terms of the loan, and the debenture sets out the details of the security.
Important terms in loan agreements
Representations
Representations, usually referred to as representations and warranties, are statements of fact as to legal and commercial matters made on signing of the loan agreement and repeated periodically during the life of the loan.
Undertakings
Undertakings (or covenants) are promises to do (or not do) something, or to procure that something is done (or not done).
Event of default
Representations and undertakings are important clauses. Breach of either gives the bank contractual remedies where the breach constitutes an Event of Default. The Events of Default clause is vital in terms of giving the bank the power to call in its money early if the borrower shows signs of becoming an enhanced credit risk.
The nature of security
‘Security’, in this context, means temporary ownership, possession or other proprietary interest in an asset to ensure that a debt owed is repaid (ie collateral for a debt).
The main benefit of taking security is to protect the creditor in the event that the borrower enters into a formal insolvency procedure. It is possible to improve the priority of a debt by taking security for it. 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 - 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
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.
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, eg a trading company needs to be able to dispose freely of its stock (ie 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
- 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.
- A floating charge generally ranks below a fixed charge (and note that crystallisation does not change that) and below preferential creditors when the company’s assets are sold and the proceeds applied to 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.
- 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.
- Floating charges are capable of being avoided under s 245 Insolvency Act 1986.
- An administrator is free to deal with floating charge assets in their control without reference to the charge holder or the court and to pay their remuneration and expenses out of the proceeds of those assets. Administration is one of the insolvency procedures which will be examined in a later topic on this module.
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).
Registration of charges
Most security created by a company needs to be registered with Companies House. This includes charges created by an English company over assets located both within the UK 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 (ie 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):
- a section 859D statement of particulars set out on Form MR01 detailing:
- 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.
The Registrar allocates to the charge a unique reference code and includes it on the register with the certified copy of the charge (s 859I(2) CA 2006). The Registrar must issue a signed/authenticated ‘certificate of registration’ (s 859I(3),(4) and (5) CA 2006) which 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 (eg 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 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.
