Debt FInance

Question 1

What are the two main types of debt finance, and why might businesses use them?

Answer 1

1. Main Types:
   * Loans: A business borrows money from a bank, directors, shareholders, or other lenders. Examples include overdrafts, term loans, and revolving credit facilities.
   * Debt Securities: IOUs issued by a company to investors, requiring repayment with interest by an agreed future date.
2. Uses:
   * To start trading by purchasing necessary assets (e.g., equipment).
   * To expand operations.
   * To manage temporary cash flow challenges.

Question 2

What should a company check before borrowing money?

Answer 2

1. Constitutional Restrictions:
   * Check the company’s articles of association and, for pre-2009 companies, the memorandum of association for borrowing restrictions.

• If restrictions exist, they must be removed via a special resolution under s 21 CA 2006.

2. Directors’ Authority:
   * Directors’ authority to borrow is derived from Model Articles (MA 3) or bespoke articles, which may impose limits or require shareholder approval.
3. Key Steps for Borrowing:
   * Verify that there are no restrictions in the constitution.
   * Ensure directors are authorized to act on behalf of the company.
   * Comply with relevant contract law, as debt finance is primarily contract-based.

Question 3

How do secured loans differ from unsecured loans?

Answer 3

1. Secured Loans:
   * Require security over assets, such as property or equipment, which the lender can seize and sell if the borrower defaults.

• Offer lower interest rates as the lender’s risk is reduced.

2. Unsecured Loans:
   * No security is provided.
   * Lenders charge higher interest rates to compensate for the increased risk.

Question 4

What are the features, advantages, and disadvantages of an overdraft facility?

Answer 4

1. Features:
   * Temporary loan allowing businesses to overdraw from their current account up to a pre-agreed limit.
   * Known as an uncommitted facility: repayable on demand by the bank.
2. Advantages:
   * Flexibility: Amount borrowed varies daily based on the business’s needs.

• Minimal Formalities: Quick and easy to arrange.

3. Disadvantages:

• Expensive: High-interest rates, often calculated on a compound basis.
• Uncertainty: Repayment can be demanded at any time.

Question 5

What are the characteristics of term loans, and how do they differ from overdrafts?

Answer 5

1. Key Features:
   * A fixed amount is borrowed for a specified period (term) and repaid with interest.
   * Terms may be:
   * Short-term: Up to 1 year.
   * Medium-term: 1–5 years.
   * Long-term: Over 5 years.
2. Secured vs. Unsecured:
   * Term loans are often secured with assets pledged as collateral.
3. Advantages:
   * Certainty: Repayment is governed by the contract, unlike overdrafts, which are repayable on demand.

• Control: Fixed repayment schedule gives the borrower clarity.

4. Disadvantages:

• Cost and Time: Negotiating legal documentation is expensive and time-consuming.
• Once repaid, the funds cannot be re-borrowed.

Question 6

How does a revolving credit facility work, and why is it useful?

Answer 6

1. Definition:
   * A flexible loan where the business can borrow, repay, and reborrow funds multiple times during the agreed facility term.
2. Key Features:
   * Combines characteristics of overdrafts (flexibility) and term loans (structured terms).
   * Maximum loan amount is agreed, and interest is charged on amounts borrowed.
3. Advantages:
   * Flexibility: Borrow as needed and repay when funds are available.
   * Cost Efficiency: Reduce borrowings to minimize interest costs.
4. Disadvantages:
   * High Fees: Arrangement fees and legal costs.
   * Complexity: Requires significant time to negotiate contracts.

Question 7

What are the key clauses in a facility agreement for term loans or revolving credit facilities?

Answer 7

1. Loan Details:
   
   • Amount, currency, type (term loan or revolving credit).
   • Periods of availability.
     2. Repayment Terms:
   • Bullet Payment: Full repayment at the end of the term.
   • Amortisation: Equal instalments.
   • Balloon Repayment: Unequal instalments with a large final payment.
   3. Interest Rates:
      * May be fixed or floating (variable, adjusted periodically).
      * Default interest clauses apply if scheduled payments are missed.
   4. Covenants:
      * Restrictions to ensure the business remains solvent and able to repay the loan (e.g., limits on dividends, no unauthorized asset disposal).

Question 8

What are “events of default” in facility agreements, and what are the consequences?

Answer 8

1. Definition: Breaches of the facility agreement terms, triggering the lender’s right to terminate the agreement.
2. Examples:
   * Failure to make payments when due.
   * Insolvency or commencement of insolvency proceedings.
   * Breach of financial or non-financial covenants.
3. Consequences:
   * The lender may terminate the agreement, demand repayment, and enforce security over the borrower’s assets.

Question 9

What is a debenture, and why is it used?

Answer 9

1. Definition: A written loan agreement between a borrower and lender that is registered at Companies House, often secured by a charge over the borrower’s assets.
   
   2. Key Features:
      * Provides security for the lender.
      * Used primarily by companies and LLPs; sole traders and partnerships cannot issue debentures.

Question 10

How do secured creditors differ from unsecured creditors during insolvency?

Answer 10

1. Secured Creditors:
   * Have priority over specific assets pledged as security.

• Can seize and sell secured assets to recover their debts.

2. Unsecured Creditors:
   * Repayment is governed by the pari passu principle: debts are reduced pro rata if there are insufficient funds to pay all creditors.

Question 11

Why do businesses grant security, and how does it benefit both the lender and borrower?

Answer 11

1. For Lenders:
   * Reduces the risk of non-repayment by allowing access to secured assets if the borrower defaults.
2. For Borrowers:
   * Often results in lower interest rates.
   * Increases the likelihood of loan approval.
3. Disadvantage:
   * Restrictions on the use or disposal of secured assets.

Question 12

What steps must a company take before granting security for a loan?

Answer 12

1. Check Authority:
   
   • Ensure the company’s articles do not restrict granting security.
   • Verify directors’ authority under Model Articles (MA 3) or bespoke articles.
     2. Amend Articles if Needed:
   • If restrictions exist, pass a special resolution under s 21 CA 2006 to amend the articles.
     3. For Pre-2009 Companies:
   • Check the memorandum of association for restrictions (treated as part of the articles under s 28 CA 2006).
     4. Lender’s Checks:
   • Review articles, board resolutions, and property title (e.g., Land Registry) to ensure no prior charges exist on secured assets.

Question 13

What types of assets can a company or LLP use as security for borrowing, and why are they important?

Answer 13

1. Land:
   
   • Includes freehold, leasehold, and any fixtures or fittings.
   • High-value and relatively stable, making it a preferred asset for lenders.
     2. Tangible Property:
   • Examples include machinery, vehicles, and stock.
   • Often used in fixed charges but may also be subject to floating charges for assets that fluctuate, like stock.
     3. Intangible Property:
   • Bank Account Balances: Funds in accounts can be used as collateral.
   • Debts Owed (Book Debts): Money due from customers can secure borrowing.
   • Shares: Ownership in other companies can be pledged.
   • Intellectual Property (IP): Trademarks, patents, and copyrights are increasingly valuable assets for lenders to secure.

Question 14

What are the primary types of security for a company or LLP?

Answer 14

1. Mortgages:
   
   • Transfers legal ownership of the asset to the lender (mortgagee) until the loan is repaid.
   • Commonly used for land, buildings, and high-value items like aircraft or ships.
     2. Fixed Charges:
   • Secures specific assets such as machinery, shares, or buildings.
   • Restricts the borrower’s ability to deal with the asset without lender consent.
     3. Floating Charges:
   • Secures a class of fluctuating assets (e.g., stock, receivables).
   • Allows the borrower to use and sell these assets until the charge crystallizes.
     4. Other Security Mechanisms:
   • Pledges, liens, personal guarantees, and retention of title

Question 15

What are the features of a mortgage, and why is it considered the highest form of security?

Answer 15

1. Legal Ownership Transfer:
   
   • The lender (mortgagee) holds ownership of the asset until repayment.
   • Ownership is transferred back to the borrower (mortgagor) upon full repayment.
     2. Key Features:
   • Can cover land, machinery, shares, and high-value assets.
   • Provides immediate possession rights to the lender in case of borrower default.
   • Requires separate mortgages for each asset.
     3. Land Mortgages:
   • Often referred to as “charges by deed by way of legal mortgage.”
   • Gives the lender the right to sell or take possession of the land in case of default.

Question 16

What are fixed charges, and how do they work?

Answer 16

1. Definition:
   
   • A security over a specific asset (e.g., machinery, vehicles, shares) where the borrower retains ownership but cannot sell or deal with the asset without lender consent.
     2. Lender’s Rights:
   • Priority over unsecured creditors and floating charges during insolvency.
   • Requires borrower to maintain the asset in good condition.
     3. Multiple Fixed Charges:
   • If more than one fixed charge exists over the same asset, priority is determined by the date of creation (first charge has priority).
     4. Key Benefits for Lenders:
   • Offers greater control and security, as the asset is “locked” until repayment or lender consent.

Question 17

What are floating charges, and how do they differ from fixed charges?

Answer 17

1. Definition:
   
   • A security over a group of changing assets (e.g., stock, receivables) that allows the borrower to use and sell the assets in the normal course of business.
     2. Key Characteristics:
   • Assets are described generically (e.g., “stock”).
   • Borrower retains freedom to deal with assets until the charge crystallizes.
     3. Crystallisation Triggers:
   • Occurs when the borrower:
   • Goes into liquidation or receivership.
   • Ceases trading.
   • Breaches specific terms outlined in the charge agreement.
     4. Advantages:
   • Flexible, allowing businesses to use secured assets for operations.
   • Maximizes borrowing potential.
     5. Disadvantages:
   • Lower priority than fixed charges.
   • Certain creditors (e.g., employees) have precedence in insolvency.

Question 18

How can book debts be secured, and what are the implications for lenders?

Answer 18

1. Definition:
   
   • Book debts are money owed to the company by its debtors.
     2. Security Options:
   • Floating Charge: Covers the fluctuating nature of book debts.
   • Fixed Charge: Possible if the lender controls both the debts and proceeds (e.g., debtor remits payments directly to the lender).
     3. Implications:
   • Floating charge provides flexibility but offers weaker protection in insolvency.
   • Fixed charge provides stronger rights to the lender but limits borrower control.

Question 19

What other types of security or security-like mechanisms can companies or LLPs use?

Answer 19

1. Personal Guarantees:
   
   • Directors or partners personally guarantee the loan.
   • Lenders can claim personal assets if the business defaults.
     2. Pledges:
   • Physical delivery of an asset to the lender (e.g., jewelry, goods) until repayment.
   • Lender can sell the asset after sufficient notice if repayment is not made.
     3. Liens:
   • Lender retains possession of an asset until repayment (e.g., a repaired vehicle).
   • No right to sell the asset unless otherwise agreed.
     4. Retention of Title:
   • Seller retains ownership of goods until the buyer pays the full price.

Question 20

How is the priority of charges over an asset determined in insolvency?

Answer 20

1. Order of Priority:
   
   • Fixed Charges: Always take precedence over floating charges.
   • Multiple Fixed Charges: Priority is determined by the date of creation.
   • Multiple Floating Charges: Priority is determined by the date of creation.
     2. Subordination Agreements:
   • Creditors can agree to alter priority via a deed of priority.
     3. Impact of Non-Registration:
   • Failure to register a charge within 21 days renders it void against administrators, liquidators, and third-party creditors.

Question 21

What is a negative pledge clause, and why is it important for floating charge holders?

Answer 21

1. Definition:
   
   • Prohibits the borrower from creating subsequent charges that would take priority over an existing floating charge.
     2. Enforcement:
   • If the new lender has actual knowledge of the clause, their fixed charge will rank subordinate to the floating charge.
     3. Disclosure:
   • Included in the charging document filed at Companies House.
     4. Practical Use:
   • Protects the floating charge holder from losing priority over future fixed charges.

Question 22

Why is the registration of charges critical, and what happens if it is missed?

Answer 22

1. Mandatory Registration:
   
   • Must be filed at Companies House within 21 days of creation.
     2. Consequences of Failure:
   • Charge becomes void against administrators and liquidators.
   • The lender loses priority and cannot enforce the security.
     3. Court Extensions:
   • Possible under s 859F CA 2006 for accidental failures, but priority may still be lost.
     4. Accuracy:
   • Errors in registration can lead to similar consequences as non-registration

Question 23

What are the key clauses included in a security document?

Answer 23

1. Security Clause: Specifies the type of charge and the assets covered.
   2. Representations and Warranties: Borrower must confirm assets are free from other charges unless disclosed.
   3. Covenants: Borrower promises to maintain asset value (e.g., insurance, upkeep).
   4. Enforcement Clause: Lists default events and grants lender powers to sell secured assets.

Question 24

What is the process for registering a charge under CA 2006, and what are the key steps involved?

Answer 24

1. Filing Requirements (Within 21 Days):
   
   • File Form MR01 at Companies House.
   • Include a certified copy of the instrument creating the charge and pay the required fee (CA 2006, s 859A).
     2. Registrar’s Role:
   • The Registrar reviews the documents and registers the charge if compliant (CA 2006, s 859A(2)).
   • Provides a Certificate of Registration, which serves as conclusive evidence of proper registration (CA 2006, s 859I).
     3. Public Record:
   • Form MR01 and the certified charge document are added to the company’s file, making them available for public inspection.
     4. Validity of the Charge:
   • If submitted on time, the charge is valid against creditors, administrators, and liquidators of the company.
     5. Retention of Documents:
   • A copy of the charge must be kept at the company’s registered office or SAIL for public inspection (CA 2006, s 859P).
   • Failure to do so is a criminal offence but does not invalidate the charge.
     6. Fixed Charges on Land:
   • If the charge is over land, it must also be registered with the Land Registry.
   • Failure to register could allow a buyer to acquire the land free of the charge, even if they are aware of its existence.