Debt Finance

Question 1

Why might debt finance be required

Answer 1

For many private companies, it may in practice be difficult to raise money through equity finance, since private companies are unable to offer shares to the public (s 755 CA 2006)

Question 2

The company’s authority to borrow

Answer 2

• Most companies will have unrestricted power to borrow
• For companies incorporated under CA 2006 (on or after 1 October 2009): Pursuant to s 31(1) CA 2006, the starting point is that unless the articles specifically restrict the objects of the company, its objects are unrestricted, so there would be no restrictions on the power to borrow.
• For companies incorporated under CA 1985: These companies had objects clauses in the memorandum which may restrict the company’s powers to borrow. However, many CA 1985 companies had general objects clauses which would allow them to borrow.
• s 28(1) CA 2006 states that objects clauses in CA 1985 companies will be treated as part of the articles, so any restrictions may be removed by altering the articles by special resolution, or by adopting the CA 2006 Model Articles

Question 3

Types of debt finance

Answer 3

1. Loan facilities

2. Debt securities

Question 4

Loan facilities

Answer 4

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.

• 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.
• Term loan: 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.
• Revolving credit facility: this is where the borrower has flexibility to borrow and repay. It allows a company to draw down money, repay it and then re-draw it down again, then repay it. Unlike a term loan, with an RCF, the borrower has flexibility to choose when it borrows and repays as against a maximum aggregate amount of capital provided by the lender.

Question 5

Debt Securities

Answer 5

• 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.
• e.g. 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.

Question 6

Debenture

Answer 6

The word debenture has 2 separate meanings:

• s738 “debenture” covers any form of debt security issued by a 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.

Question 7

A fixed charge

Answer 7

prevents the borrower from dealing with the assets subject to the charge and is the strongest form of security. A lender will normally seek a fixed charge where possible.

Question 8

A floating charge

Answer 8

“floats” over a class of assets. It does not prevent the borrower from dealing with these assets unless and until the floating charge “crystallises”, which usually happens when the borrower defaults on the loan repayments.

Question 9

Guarantee

Answer 9

not strictly speaking a form of security but has a similar commercial effect in that a guarantor (usually a director, or a parent company) provides a guarantee to pay the company’s debts in the event of a default event.

Question 10

Fixed charges : further info

Answer 10

• the lender will control the borrower’s use of the charged asset. The company cannot deal with (dispose of or create further charges over) the assets subject to the charge without the consent of the lender.
• A lender will normally want a fixed charge as it offers greater protection for the lender but this is not always appropriate; it will depend on the type of assets
• It may not be appropriate for the lender to have control over particular assets such as stock and raw materials which the borrower will need to use on daily basis
• Fixed charges are generally taken over assets such as plant and machinery.
• If the charge becomes enforceable, the lender has the ability to appoint a receiver and exercise a power of sale over that asset.The label applied to a charge is not always determinative (Agnew v IRC)
• Ashborder BV v Green Gas Power Ltd [2004]: The court said that the prevention of the chargor from freely disposing of the asset is crucial to the creation of a fixed charge.

Question 11

Floating charges: further info

Answer 11

• Many companies are unable to grant fixed charges over the majority of their assets e.g. stock
• A floating charge floats over a class of asset which fluctuates e.g. stock, raw materials. Whatever assets in that class the borrower owns at any point in time are subject to the floating charge.
• A floating charge does not give the lender control over the assets. The borrower may freely dispose of such assets unless and until the floating charge “crystallises”.
• The key case on floating charges is Re Yorkshire Woolcombers Association which defined a floating charge as a charge over:
• A class of assets, present and future; and
• Which in the ordinary course of the company’s business changes from time to time; and
• It is contemplated that until the holders of the charge take steps to enforce it, the company may carry on business in the ordinary way as far as concerns the assets charged.

Question 12

Floating charges: crystallisation

Answer 12

• When a floating charge crystallises, it ceases to float over all of the assets in a class and instead fixes onto the assets in the class charged at the time of the crystallisation. The lender then has control of those assets and the borrower is unable to deal with these assets, as if the assets were subject to a fixed charge.
• the assets subject to crystallisation of the floating charge are not treated as fixed charge assets for distribution purposes on a winding up.
• If the company receives more assets of the same class after crystallisation, these assets are automatically subject to the crystallised charge (NW Robbie and Co v Whitney Warehouse Co Ltd)

Question 13

When does crystallisation occur

Answer 13

• Common law – on a winding up, appointment of a receiver or cessation of business.
• Specified event – as defined in the loan agreement. This usually occurs where a borrower defaults on the loan repayments or interest payments, or where another lender enforces their security.

Question 14

Charges over book debts – fixed or floating?

Answer 14

• A book debt is an unpaid invoice ie a sum owed to the company in respect of goods or services supplied by it. Book debts are a fluctuating asset (such debts come into existence and are then paid off) and may be a significant asset of a company.
• National Westminster Bank plc v Spectrum Plus Limited: a book debt is a floating charge because the chargor is left free to use the charged asset
• it is only possible to have a fixed charge over book debts if they are paid into a blocked account which gives the lender the degree of control required.

Question 15

Registration of charges created after 6 April 2013

Answer 15

• All charges created on or after 6 April 2013 must be registered at Companies House.
• Registration formalities: Section 859A(4) states that the charge must be registered within 21 days beginning with the day after the date of creation of the charge.
• Any person interested in the charge may complete the registration formalities. In practice, this is usually done by the lender, since it is the lender that is protected by the charge and most at risk if it is not registered.
• Effect of failure to register: If the charge is not registered within the 21 day period, under s 859H(3), the charge is void as against a liquidator, administrator or creditor of the company. The holder of the charge is reduced to an unsecured creditor.
• Certified copies of all charges must be kept at the company’s registered office (s 859P).

Question 16

Remedial measures in the case of non-registration

Answer 16

• under s 859F, the court has the power to extend the period for registration where the grounds under s 859F(2) are met. These grounds are:
• (a) that the failure to deliver those documents -
  (i) was accidental or due to inadvertence or to some other sufficient cause, or
  (ii) is not of a nature to prejudice the position of creditors or shareholders of the company, or
  (b) that on other grounds it is just and equitable to grant relief.
• The court will tend to allow the register to be rectified provided this does not prejudice any other charges created between the date of creation of the unregistered charge and the date of eventual registration (Barclays Bank plc v Stuart Landon Ltd)
• However, there have been cases where the court has refused to allow a charge to be registered late, where the time elapsed is too long e.g. Victoria Housing Estates: the chargee should have made the application as soon as they realised the mistake.

Question 17

Registration of charges created prior to 6 April 2013

Answer 17

• registration formalities were set out in s 860 CA 2006 (now repealed). The key difference was that there was no requirement for Companies House to keep a copy of the document creating the charge (which there is now).
• Charges were void if not registered in time, but the debt would remain valid although immediately repayable. The company had to retain a register of charges (which is no longer required – instead companies are required to keep a copy of each charge available for inspection at the registered office).

Question 18

Factors to consider when comparing debt and equity finance

Answer 18

• Return on investment
• When the investor receives back the amount invested
• Priority on winding up
• Control
• Other factors

Question 19

Return on investment

Answer 19

Equity: Shareholders receive dividends. They may also receive a return by way of capital growth. The company does not have to issue dividends although will find it difficult to attract investors if they don’t.

Debt: Interest. The lender has a contractual right to receive interest whether or not the company is making profit.

Question 20

When the investor receives back the amount invested

Answer 20

Equity: On the winding up of the company (if there are sufficient assets). On the sale of their shares. If the company buys back its own shares. On a successful unfair prejudice claim if the other shareholders buy out the claimant.

Debt: As agreed between the parties in the loan agreement or in the terms of the bond. On the sale of the debt. Bonds are usually tradeable by the investor before maturity. Loans can also in some circumstances be sold by the lender.

Question 21

Priority on winding up

Answer 21

Equity: Shareholders are paid back their investment only after all other creditors have been paid. In practice this means that shareholders are highly unlikely to receive the full amount of their investment if the company is insolvent. Arrangements may be made between shareholders as to priority between themselves (eg preference shareholders)

Debt: Creditors (those owed money by the company) are paid before the shareholders. Creditors can improve their priority by taking security for the debt. Secured creditors have priority over unsecured creditors on a winding up. Creditors may contractually agree to give priority to some lenders and subordinate others.

Question 22

Control

Answer 22

Equity: Shareholders may have voting rights. The existence and extent of these will depend on the rights granted upon the issue of the shares. The number of shares held will also influence the control that a shareholder can exercise

Debt: Lenders often require the borrower to give undertakings. These are promises made by the borrower or issuer (for debt securities) to do, or not to do, certain things in the running of its business. Security may also give the lender control over the assets which are subject to the security eg a fixed charge.

Question 23

Other factors

Answer 23

Equity: New shareholders must be found in order for a share issue to succeed. This means that share market conditions, as well as the financial position and type of company, may influence the method chosen to raise finance. Dividends are an allocation of profit and not a deductible expense for tax purposes.

Debt: Banks may not be willing to lend on attractive terms, or at all, if the company is too highly geared. Gearing is the ratio of debt to equity. Highly geared companies have a lot of debt compared to equity and are seen as more risky to lenders. Existing loan agreements/bonds would need to be checked for undertakings which would prevent the borrower from borrowing money or granting security. Interest is a deductible expense for tax purposes.