Security

Question 1

What happens if the loan is made on an unsecured basis?

Answer 1

• A lender can make a loan on an unsecured basis, but that would make the lender an unsecured creditor. If the borrower defaults and becomes insolvent, the lender’s claim against the borrower will rank alongside other unsecured creditors. An unsecured creditor only has a personal claim against the debtor and has no direct claim against the debtor’s assets

Question 2

• What is security?

Answer 2

• The aim of security is to protect a lender from the possible insolvency of a borrower. If a lender holds security over the assets of a borrower, then this increases the likelihood of the lender being repaid.
• When a lender holds security over an asset of the borrower, if the borrower defaults, then the lender can step in and take possession of that asset or sell that asset to repay any outstanding amount that is due on its loan to the borrower.
• Depending on the type of security taken, the lender may effectively ‘control’ the asset in that it cannot be disposed of by the borrower without the involvement of the lender.
• Taking security also gives lenders certain rights under insolvency legislation, for example the right for a ‘qualifying floating charge’ holder to appoint its own choice of administrator using the out-of-court procedure.
• Under insolvency law, the claims of secured creditors rank ahead of those of unsecured creditors and shareholders.
• The right for a lender to enforce its security will be triggered when a borrower defaults under the connected loan agreement.

Question 3

• Secured Liabilities is usually defined in one of two ways:

Answer 3

• all monies; or
• limited to amounts under a specific loan agreement.

Question 4

• As a simple example, with ‘all monies’ security the Secured Liabilities may be defined as:

Answer 4

• ‘all present and future liabilities and obligations of the Borrower to the Lender which are, or may become, due owing or payable on any account whatsoever’
• ‘All monies’ security is used where all the borrower’s financing arrangements are to be secured by the security and will cover the initial borrowing as well as future financing obligations (whether known or unknown at the point the security is entered into).

Question 5

• The alternative, and more common, formulation is for the Secured Liabilities to be limited to amounts owed under a specific loan agreement. This may (as a simple example) be defined as follows:

Answer 5

• ‘Secured Liabilities means all present and future monies, obligations and liabilities owed by an Obligor to the Lender, whether actual or contingent and whether owed jointly or severally, as principal or surety or in any other capacity, under or in connection with the Finance Documents, together with all interest (including, without limitation, default interest) accruing in respect of those monies or liabilities.’
• ‘Obligor’ will include the borrower and any other entity providing security and/or guarantees to the lender; and ‘Finance Documents’ will include the loan agreement, any security documents/guarantees and any separate fee letters.

Question 6

• What are the secured assets?

Answer 6

• A lender may take security over just one asset, or over all the assets of a borrower, depending on the deal.
• An important point to note is that it is not uncommon for a lender to take security over assets with a value far in excess of the amount of money lent. One reason for this could be that the lender is concerned that the value of the assets may reduce over time, or it may be driven by the desire of the lender to take security over all or substantially all the assets of the borrower in order that it has a ‘qualifying floating charge’.
• A borrower may agree to give full security as it has an “equitable right of redemption” to compel the lender to release the security as soon as the secured debt has been repaid even if the date for repayment has passed.

Question 7

• How is security documented?

Answer 7

• There will be a separate security document which will set out matters such as in whose favour the security is granted, the scope of the security (i.e., the definition of Secured Liabilities), the identity of the secured assets and the type of security taken over that asset and various other undertakings and boilerplate provisions.
• Security will also need to be ‘perfected’ i.e., brought to the attention of those who need to know about it for the security to be effective. Some examples of perfection methods include (but are not limited to) registration at Companies House, notification to third parties or registration at various other registries.

Question 8

Types of quasi-security?

Answer 8

• Guarantees
• Indemnities
• Comfort Letters

Question 9

How does quasi-security differ from security?

Answer 9

• Quasi-security differs from security as quasi-security only provides the lender with a contractual claim against the guarantor or indemnity provider.
• Unlike security, these do not give the lender ‘proprietary’ rights over the borrower’s assets- i.e., the lender has no right to take possession of or sell any of the borrower’s assets.
• However, in some cases guarantors may be required to separately provide security for the secured liabilities owed by the borrower in which case the lender would obtain proprietary rights over the assets of the guarantor.

Question 10

What is a gurantee?

Answer 10

• A guarantee is a promise by one party (the guarantor) to answer for another party’s liability on a default (i.e., if a borrower defaults under the loan agreement, the lender can pursue the guarantor directly for repayment).
• A guarantee is a secondary obligation between the parties in that its validity is dependent upon the primary obligation(i.e., the loan agreement between the lender and the borrower) being/remaining valid.
• Linked to this is the fact that if the primary obligation is void (or is discharged) the guarantee will fall away.

Question 11

Why have an indemnity as well as a gurantee?

Answer 11

creates a separate stand-alone primary obligation on the part of the guarantor to indemnify the lender for any loss if the borrower does not satisfy its obligations.
- The key point is an indemnity will survive the invalidity of the underlying loan agreement, whereas a guarantee will not.

Question 12

What are comfort letters?

Answer 12

• Comfort letters are usually seen in the context of support being given by a parent to support the obligations of a subsidiary where it may not be possible for a lender to obtain security or a guarantee and indemnity. For example, the parent company may be constitutionally or contractually prevented from doing so.
• In such circumstances the lender may agree to accept a comfort letter (also known as a support letter or letter of intent) from the parent company. Such letters are not usually intended by either party to be legally binding, however they do represent a moral obligation which will provide some reassurance to the lender that a parent will stand by its subsidiary.

Question 13

How are comfort letters written and what do they include?

Answer 13

• Care needs to be taken when drafting comfort letters, so as to make the terms non-binding.
• Usually, they include very general statements of intention and support - e.g., that the intention of comfort letter provider is to maintain investment in its subsidiary, and that it is aware of and supports its subsidiary’s borrowing.

Question 14

why would a lender want security/quasi-security?

Answer 14

it will protect a lender and give it a better chance of getting its money back. This is particularly important if the borrower is a higher credit risk to the lender.

Question 15

• If security is granted to a lender, the lender:

Answer 15

• has direct recourse to the asset over which the security was granted;
• can avoid the need for litigation if the borrower defaults;
• obtains better priority against other creditors on the insolvency of the borrower;
• and has an increased likelihood of recovering the debt.

Question 16

• Why would a borrower (or other obligor) agree to give security or quasi-security?

Answer 16

• Lack of credit history: If a borrower is a newly incorporated entity, it will not have historic financial or trading data. Without this it will be harder for the lender to assess the credit risk and the lender may require security and/or quasi-security to be given at least for an initial period of time.
• Asset specific finance: If a borrower is raising funds to acquire a specific asset it would be usual to grant security over that asset to the provider of the finance. If the asset were later sold the proceeds realised would be applied to prepay the loan.
• Weak credit status: If a borrower has a weak credit status, a lender may refuse to lend to it without the benefit of security and/or quasi-security.
• Cheaper borrowing: If a borrower is able and willing to give security and/or quasi-security, this may result in cheaper borrowing costs (the credit risk being taken by the lender is less, so a lower interest rate will usually be payable).

Question 17

• What is recourse?

Answer 17

• An important element of assessing the risk of a loan is working out where the money will come from to repay it, either from the borrower’s operations (while it is still trading) or, in the worst case, from the sale of its assets on insolvency. The term used for the lender’s claim on certain assets for repayment of the loan is “recourse”, and the lender needs to ensure it has recourse to sufficient assets.

Question 18

• Restrictions in an existing loan agreement.

Answer 18

• Negative pledge
• No further financial indebtedness
• Financial Assistance
• Articles of Association
• Commercial contracts

Question 19

How do negative pledges restrict an existing loan agreement?

Answer 19

one of the general undertakings usually found in a loan agreement and it prohibits the creation of further security in competition with the lender which has advanced funds under the loan agreement.

Question 20

How does no further contractual indebtness restrict an existing loan agreement?

Answer 20

There may also be an undertaking included that restricts the total amount of financial indebtedness incurred by a borrower. As guarantees and indemnities are likely to fall within the definition of ‘Financial Indebtedness’, the giving of these may breach any such undertaking.

Question 21

How does financial assistance restrict an existing loan agreement?

Answer 21

The borrower’s lawyers will need to be alive to whether the giving of any security or quasi-security (such as a guarantee or indemnity) as part of the transaction would amount to unlawful financial assistance under sections 677-683 Companies Act (‘CA’) 2006.

Question 22

How do Articles of Association restrict an existing loan agreement?

Answer 22

The Articles of Association of a borrower may restrict or prohibit it from granting security and/or quasi-security. While it may be possible to amend the borrower’s Articles in order to permit it to do so, this will depend on the entity in question, as for a public limited company with a large number of shareholders this may not be feasible.
- The check of a potential borrower’s Articles of Association is something that is key at the outset of a transaction and the lender’s lawyers (particularly trainees) are often tasked with checking this information. A particular concern in certain transactions will be restrictions in the Articles of Association making enforcement of security over shares problematic, such as directors having a discretion to refuse to enter a transferee (i.e., the lender) of the shares into the register of members of the borrower. Such restrictions will need to be removed from the Articles of Association.

Question 23

How do Commercial Contracts restrict an existing loan agreement?

Answer 23

It could be the case that commercial contracts may contain an absolute prohibition on assignment or prohibit security being taken over the benefit of the contract without the prior consent of the contract counterparty. In either case the issue needs to be investigated as part of the due diligence and if necessary, addressed before the security is taken.

Question 24

• What is a charge?

Answer 24

• A charge is an equitable right. It gives a proprietary interest in the asset.

Question 25

• Main types of security

Answer 25

• Assignment by way of security (e.g. borrower’s rights against a third party)
• Taking physical possession of asset:
• Pledges
• Liens
• Transferring ownership in asset:
• Mortgages
• Giving rights over assets:
• Charges

Question 26

What does a lender achieve by having a charge?

Answer 26

• A charge gives the lender the right to appropriate the charged asset and to sell it to discharge the secured debt. There is no transfer of title to the asset itself.
• The main types of charges are fixed and floating charges

Question 27

What does a fixed charge do?

Answer 27

• A fixed charge attaches to an asset as soon as the charge is created. It gives the lender a claim over the proceeds of sale of that asset in priority over other creditors of the borrower.

Question 28

What happens if the borrower sells an asset subject to a fixed charge?

Answer 28

• If the borrower sells an asset subject to a fixed charge, the buyer of that asset takes subject to the fixed charge as long as it has notice of the charge. Provided the fixed charge has been registered at Companies House in accordance with s. 859A-Q CA 2006, the buyer will have ‘actual notice’ of the fixed charge if they carry out a search of the charges register.

Question 29

What is a floating charge and how does it work?

Answer 29

• Under a floating charge, a borrower is able to deal with the charged assets in the ordinary course of its trade – e.g. to sell, hire or lease them without first obtaining the consent of the lender.
• A floating charge ‘floats’ over the charged assets until the occurrence of certain events. On the occurrence of one or more of these events, the charge ‘crystallises’ and fixes on the charged assets. The floating charge effectively becomes a fixed charge, in that the borrower no longer has the ability to deal with the assets over which the charge has crystallised without the lender’s consent.
• However, for insolvency purposes the charge itself is still deemed as a floating charge for insolvency ranking – meaning that the proceeds of sale of the assets subject to it are available to preferential creditors, the administrator/liquidator(for their costs) and the prescribed part fund before the lender with the benefit of the floating charge is paid.

Question 30

• Crystallisation can occur as a matter of law on the following certain events:

Answer 30

• on the liquidation of a borrower;
• on the appointment of a receiver; or
• if the borrower ceases to carry on business.
• A typical security document contains a list of additional triggers, for example an event of default under the loan agreement or any event which, in the opinion of the lender, would put the assets in jeopardy. If any of these events occurs then the floating charge would crystallise.

Question 31

• How to identify a floating charge?

Answer 31

a charge would be deemed floating if:
* it is a charge on a class of assets of a company present and future;
* that class is one which, in the ordinary course of the business of the company, would be changing from time to time; and
* by the charge it is contemplated that, until some future step is taken by or on behalf of those interested in the charge, the company may carry on its business in the ordinary way as far as concerns the particular class of assets.

Question 32

• Distinction between a fixed and floating charge?

Answer 32

the essential characteristic of a floating charge, which distinguishes it from a fixed charge, is that “the asset subject to the charge is not finally appropriated as security for payment of the debt until the occurrence of some future event. In the meantime, the borrower is left free to use the charged asset and to remove it from the security”. Conversely, it is an essential characteristic of a fixed charge that assets can be released from the security only with the “active concurrence” of the lender.
- Note that the substance of the charge is more important than the label applied by the parties. You need to look at the element of control over the asset granted by the charging document, and the nature of the charge evidenced by the terms of the charging document, not the name given to the document.

Question 33

• What are the disadvantages of a floating charge for a lender?

Answer 33

• The borrower is free to deal with the assets subject to a floating charge. Whilst this flexibility enables a borrower to run their business day to day, the risk for the lender is the reduction of the ‘pool’ of assets available to them on enforcement of their security. Although the lender will benefit from certain contractual protections to mitigate against this, the lender will nonetheless prefer to take fixed charges over important assets.
• Floating charges rank behind fixed charges (even those entered into after the floating charge), preferential creditors (such as employees) and the ring-fenced fund.
• Administrator/liquidator costs are taken out of floating charge assets (including any tax liability on capital gains arising from disposals made by the administrator in the course of administration.
• More stringent avoidance rules as in certain circumstances floating charges can be set aside if the borrower becomes insolvent.
• A floating charge may not be recognised in other jurisdictions.

Question 34

• What are the advantages of a floating charge for a lender?

Answer 34

• The lender obtains security, but the borrower retains flexibility to run its business day to day as it is able to dispose of assets subject to a floating charge in the ordinary course of its trading.
• Provided the floating charge is over all or substantially all of the assets of the borrower, a lender will be a holder of a ‘qualifying floating charge’ giving it the right to appoint an administrator
• Historically, a lender with a floating charge could appoint an administrative receiver with wide-ranging powers to manage the borrower and sell off the borrower’s assets to repay the lender.
• However, for floating charges created on or after 15 September 2003, the lender will only be able to appoint an administrative receiver if the charge falls into one of the ‘limited exceptions’ (e.g., the floating charge was created in relation to certain project financing or capital markets transactions).
• Therefore, if the floating charge was created on or after 15 September 2003 and does not fall within one of the ‘limited exceptions’, the lender can no longer appoint an administrative receiver, but as a holder of a ‘qualifying floating charge’ (as defined below) such a lender does have the power to appoint its own choice of administrator by using an out-of-court procedure, which is quicker and cheaper than the court-based process of appointing an administrator.
• A ‘qualifying floating charge’ is one which fulfils the requirements of paragraph 14 of Schedule B1 to the Insolvency Act 1986.
• Essentially, this means that the floating charge, together with other charges held, has to relate to the whole or substantially the whole of the company’s assets and the document creating the floating charge must state that paragraph 14 applies or purport to grant to the lender the power to appoint an administrator.

Question 35

• What is a mortgage?

Answer 35

• A mortgage is a transfer of ownership of an asset to the lender.
• In the case of a legal mortgage, it involves the transfer of legal ownership. In the case of an equitable mortgage, it involves the transfer of beneficial ownership.
• With a legal mortgage the lender then becomes the owner of the asset, subject to a right of redemption following repayment by the borrower.

Question 36

• A legal mortgage involves a transfer of legal title to an asset to the lender, subject to:

Answer 36

• an implied obligation to transfer the asset back to the borrower on repayment of the loan (known as the ‘equity of redemption’); and
• a right to take possession of and sell the asset on default.

Question 37

How are mortgages over land created?

Answer 37

“charge by deed expressed to be by way of legal mortgage”

Question 38

Is there a difference between a fixed charge and equitable mortgage?

Answer 38

There is no practical difference between an equitable mortgage and a fixed charge – both will give the lender a proprietary interest in the asset concerned.

Question 39

Why should equitable mortgages be registered at Companies’ House?

Answer 39

• A ‘bona fide’ purchaser for value without notice of an equitable mortgage would buy the asset free of the mortgage. Registration of the equitable mortgage at Companies House is therefore very important (and is a requirement pursuant to s.859A CA 2006 in any event).
• This will ensure a purchaser has ‘actual notice’ of the equitable mortgage by searching the charges register. The law is unclear as to whether registration itself would operate as ‘constructive notice’ on a purchaser who hasn’t carried out a search of the charges register, but further consideration of this is point outside the scope of this knowledge stream.

Question 40

• The differences between mortgages, charges and charges by way of legal mortgage:

Answer 40

• The theoretical difference between these three types of security is that:
• a mortgage is the conveyance of an asset to the lender - i.e., the transfer of title (either legal or beneficial) to the asset. The lender becomes the owner of the asset subject to a right of redemption – i.e., the lender has to transfer it back to the borrower following repayment of the underlying loan.
• a charge gives the lender proprietary rights in the asset, but there is no transfer of title to the asset itself.
• a charge by way of legal mortgage (applies to land only) does not transfer title to the asset. Instead, it grants the lender the same powers, protection and remedies as if the mortgage had been created by way of a lease for a term of 3,000 years.

Question 41

What is a pledge?

Answer 41

• A pledge arises where a lender takes actual or constructive delivery of an asset until repayment of a debt. An example of constructive delivery is where the lender receives the keys to a safe deposit box which contains the relevant asset. No other formalities are required, but to avoid any argument that an item has merely been deposited for safekeeping, a letter of pledge or a memorandum of deposit is usually provided. There is an implied power to sell the asset if the debt is not repaid.
• The borrower loses possession of the asset for income-generating purposes.

Question 42

What is needed for a pledge to be valid?

Answer 42

• To be valid, the pledge must provide the lender with control of the asset. The lender taking a pledge has liability as bailee and it must keep safe custody of the asset alongside ensuring that the asset is insured.

Question 43

What is a lien?

Answer 43

• A lien is a right to retain another’s property until that person meets an obligation such as payment for services. This is different from a pledge where an asset is delivered to and retained by a lender until a debt is repaid. The right arises automatically by operation of law and typically (although not always) involves possession of the property.

Question 44

What is assignment by way of security?

Answer 44

• The borrower’s rights under a contract (also referred to as a ‘chose in action’) can be a valuable asset over which the lender may wish to take security. Examples of a borrower’s contractual rights against a third party include where a borrower has (i) the benefit of an insurance policy with an insurance company, or (ii) is owed interest and principal under a loan it has made, or (iii) has a valuable income-stream under a supply contract with a third-party (the contract counterparty).
• The borrower can create security over the benefit of each of these arrangements in favour of a lender.
• This is subject to checking first whether the consent of the counterparty is required for an assignment, or whether a contract contains a prohibition on assignment. This issue needs to be addressed before security is taken. If consent cannot be obtained at the time of enforcement, then there was little point in taking the security in the first place.
• Security over contractual rights is usually taken in the form of an assignment by way of security or a fixed charge – this will generally be a matter of preference for the lender.
• An assignment will either be legal or equitable depending on how it is created, as discussed below.

Question 45

What is legal assignment?

Answer 45

• If the assignment satisfies the criteria set out in s. 136 LPA 1925, it will be a legal assignment (or a ‘statutory assignment’) and will be equivalent to a legal mortgage in that the ownership of that right passes to the lender. However, because the assignment is only intended to serve as security, the security document will also contain a proviso for re-assignment on satisfaction of the secured obligation by the borrower.

Question 46

• Section 136 LPA 1925 sets out the requirements for a legal assignment. It must be:

Answer 46

· in writing;
· an absolute assignment (subject to a proviso to re-assign) in that the whole of the existing debt must be assigned, not just part of it;
· signed by the assignor; and
· notified to the original debtor/contract counterparty.

Question 47

What is an equitable assignment?

Answer 47

• An equitable assignment will arise if the parties intend to create an assignment, but one or more of the elements of s. 136 LPA 1925 are not satisfied. The element most likely to be missing in an assignment by way of security is notice to the original third party involved in the arrangement. For practical purposes, it is less important whether an assignment is legal or equitable and more important whether notice has been given.

Question 48

Practical steps to take when taking security over shares include checking that:

Answer 48

• the directors do not have the right to refuse to register a transferee (i.e., the lender) in the register of members of the company; and
• pre-emption rights do not apply to a transfer of the shares on enforcement.
• If there is a right to refuse a transfer or pre-emption rights do apply, the Articles of Association of the relevant company must be amended before the relevant security is granted. This type of check is done at the outset of the deal through due diligence and can be a common trainee task. The Articles of Association (with any amendments) will be one of the conditions precedent documents.
• Will the lender become a person of significant control (‘PSC’) (as covered in Business Law on the SQE 1 preparation course), giving rise to a registration requirement on the borrowing company’s PSC Register. A company is required to request information from any legal entity it knows or reasonably believes to be a PSC required to be registered on its PSC register. If a legal entity with a relevant interest in the company (i.e. shares) fails to respond to the request, the company may issue a restrictions notice freezing the relevant interest. From a debt finance perspective, this is relevant in the context of taking security over shares. If a restrictions notice is issued, it could affect whether the security over shares can be taken, enforced or whether voting rights can be exercised.
• Will the grant of security over shares trigger a mandatory notification requirement to the Secretary of State for Business, Energy and Industrial Strategy under the National Security and Investment Act 2021.
• Further checks to make include:
• Are the shares in an unlimited liability company? In this situation, the liability of the shareholder is not limited to the nominal value of the shares but is unlimited.
• Is there any amount unpaid on the shares?
• Are there any liens over the shares?
• Does the company whose shares are mortgaged or any of its subsidiaries operate a defined benefit pension scheme? If so, the lender needs to be advised that, should the scheme be in deficit at the time, or after enforcement, of the legal mortgage, the lender may be liable for that deficit if it is ‘associated’ or ‘connected’ with the company (see below). This can be the case even if the liability is in a subsidiary of the company whose shares are mortgaged.

Question 49

What is the strongest form of security which can be taken over shares?

Answer 49

Legal mortgage

Question 50

• In order to perfect a legal mortgage over shares, the borrower will

Answer 50

execute a stock transfer form in favour of the lender and the lender will then be registered in the register of members of the company whose shares are being charged.
- The lender will also receive share certificates in its name – in other words, the lender becomes the legal owner of those shares, subject only to the right of redemption.
- This means the lender has the right to receive notices to vote, to receive dividends, to receive bonus shares, is treated as a member of the company and can more easily, effect a quick sale of the company’s business as a going concern.

Question 51

• However, there are disadvantages to a lender in taking a legal mortgage of shares, namely:

Answer 51

• being a member of the company will involve a degree of administrative duties such as attending meetings and voting. A lender may appoint a nominee for this purpose;
• if the shares are partly paid, the lender (as new owner) will be liable for the uncalled amount;
• there is a risk to the lender of the company whose shares have been mortgaged to it becoming a subsidiary for the purposes of the CA 2006, or an associate company of the lender for the purposes of the Insolvency Act 1986;
• the risk to the lender that it becomes liable for a deficit in a defined benefit pension scheme or for environmental issues; and
• the risk to the lender that it becomes subject to the PSC regime (under Part 21A CA 2006).

Question 52

• In order to perfect an equitable mortgage/fixed charge, the lender will usually require

Answer 52

the company creating the security to provide it with a signed, but undated, stock transfer form as well as the relevant share certificates.

• The charging document will generally also contain a security power of attorney. The intention is that the lender is able to date the stock transfer form and present it to the company whose shares are secured at such time as the lender wishes to become the registered holder of those shares on enforcement of the security.

Question 53

• Assignment by way of security/fixed charge over contractual rights:

Answer 53

Where a contract has been assigned, it may provide for payments to be redirected so that they are paid by the contract counterparty directly to the lender from the date of the assignment in which case clearly notice of the assignment will need to be given to the contract counterparty.

Question 54

• Security over insurance contracts?

Answer 54

The lender may wish to take security over insurance contracts by way of an assignment by way of security or a fixed charge

Question 55

The main types of insurance contract over which a lender will take security are:

Answer 55

• ‘Keyman’ insurance (this covers the risk to the borrower of something happening to an individual who is key to the business); and
• buildings insurance.

Question 56

How are insurance contracts entered into?

Answer 56

• Insurance contracts are entered into on the basis of utmost good faith. If the insured misrepresented facts when entering into the contract, the policy will be void. Non-payment of premium will also invalidate the policy.

Question 57

How do lenders protect themselves in insurance contracts?

Answer 57

• Lenders may try to overcome these two issues with a clause in the security document and a specific agreement with the insurer that states that misrepresentation or non-payment will not invalidate the insurance policy. This is normally strongly resisted by insurers.
• Lenders will generally not want to be ‘jointly insured’ with the borrower, as this may increase their potential liability (e.g. they may be liable to pay the premium, and there is the risk that the lender may do something which invalidates the policy).
• Equally, being ‘noted’ on the insurance policy is not sufficient protection for the lender, as it will not be a party to the insurance policy and will not be able to enforce the policy directly. The best position for the lender is for it to be referred to as “co-insured in respect of its separate rights and interests”. This means that the cover provided is ‘composite’ (i.e., the policy contains two contracts of insurance (1) between the insurers and the borrower and (2) the insurers and the lender). If the borrower’s interest falls away – for instance as a result of the borrower having failed to disclose something relevant or in the event of the borrower’s insolvency – then the lender’s interest should still stand.
• As an absolute minimum, the lender will want to ensure that its interest is noted on the insurance policy so that the bank is notified if the policy is varied in a material way, cancelled or not renewed and the insurers are aware that the bank may be able to claim the charged insurance monies directly or that they may be held by the borrower on trust.

Question 58

What is perfection of security?

Answer 58

• Where a borrower is still in possession of the secured assets, the borrower may try (fraudulently) to sell them – to help protect a lender from such a scenario there is the process of ‘perfecting’ the security.
• This is done so by bringing the security interest to the notice of third parties and helps to overcome the problem that equitable security interests (which will include all fixed charges) can be ignored by a bona fide purchaser (including a subsequent lender) for value without notice.
• The manner and method of perfecting security will vary depending on the nature of the security interest taken over the asset and the type of asset.

Question 59

• Perfection methods include:

Answer 59

• physical possession (as with a pledge);
• transfer of legal or beneficial title to the security holder (as with mortgages);
• notice to a relevant third party (such as to a contract counterparty in the case of assignments by way of security/fixed charges over contractual rights);
• registration at Companies House (in practice this will relate to all security); and
• registration with central registries relating to specific assets (such as the Land Registry for charges by way of legal mortgage over land).

Question 60

When to register securities at Companies House?

Answer 60

within 21 days beginning with the day after the day on which the charge is created

Question 61

• To register the security, the company or any person interested in the charge (such as the lender) must deliver to Companies House (either electronically or by paper filing, though now mostly electronically) the following:

Answer 61

• a section 859D statement of particulars in relation to the security. This will be set out on Form MR01 available on the Companies House website;
• a certified copy of the security document (s. 859A(3) CA 2006); and
• the relevant fee.

Question 62

What happens when the relevant docs for registering security are sent to Companies House?

Answer 62

• On receipt of the relevant documents, the Registrar will allocate to the security a unique reference code and will include on the register (i) a note of the unique reference code and (ii) the certified copy of the security document (s. 859I(2) CA 2006). The Registrar will issue a ‘certificate of registration’ stating the name and number of the company in respect of which the security has been registered and the unique reference number allocated to the security (s. 859I(3)(4) and (5) CA 2006).

Question 63

• Under s. 859H CA 2006, if the charge is not registered at all, or is not registered within the 21 day period:

Answer 63

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

Question 64

• How is security released?

Answer 64

• The security document will provide for the release of the security once the secured debt is repaid. There are no strict formalities for the release of security, except for security over registered land for which the requisite form needs to be filed at the Land Registry

Question 65

• To register a release of security, the following steps need to be completed:

Answer 65

• the chargeholder (the lender) should execute a ‘Deed of Release’ and execute any other documents required to release security over specific assets (such as a Form DS1 to release a charge by way of legal mortgage over registered land, which should be registered at the Land Registry);
• the company must deliver to the Registrar, with respect to the registered charge, one of the statements set out in s. 859L(2) CA 2006, being (i) a statement that the debt secured by the charge has been paid or satisfied in whole or in part (using Form MR04) or (ii) a statement that all or part of the property or undertaking charged has been released from the charge or ceased to form part of the company’s property and undertaking (using Form MR05). In addition, the company must include in the relevant form the particulars listed in s. 859L(4); and
• the Registrar, following receipt of either Form MR04 or Form MR05, must include in the register in relation to the released charge (i) a statement of satisfaction in whole or in part; or (ii) a statement of the fact that all or part of the property or undertaking has been released from the charge or has ceased to form part of the company’s property or undertaking (as the case may be) (s. 859L(5) CA 2006).

Question 66

• Security over certain assets will need to be registered in other registers as well as being registered at Companies House.
• This relates to the following assets:

Answer 66

• Land
• Shares
• Aircraft
• Ships
• Intellectual property

Question 67

• Other points to consider when taking security

Answer 67

• Financial assistance
• Corporate benefit
• Corporate power and authority
• Maintenance of capital

Question 68

• Financial Assistance?

Answer 68

where a loan is being provided to finance an acquisition of shares, depending on the nature of the proposed security and/or quasi-security and the details of the overall transaction being contemplated, there could be financial assistance issues arising for public companies and private companies that are subsidiaries of public companies.

Question 69

• Corporate power and authority?

Answer 69

additional questions should be asked relating to the company’s power to enter into any security, such as does the company have the corporate power to enter into the security and/or quasi-security document? Before taking any security, you need to check for any restrictions in the company’s Articles of Association. If there are any such restrictions, a special resolution will be needed to amend the company’s Articles of Association in order to permit it to do so, before the security is granted. The bank will also want to see copies of any such resolutions and any amended Articles of Association, as well as board minutes approving the execution of the security document. These will be required as conditions precedent in the loan agreement.

Question 70

• Corporate benefit?

Answer 70

the lender should ensure the company granting the security (and/or quasi-security) derives some corporate benefit for the purposes of s.172(1) CA 2006 (the duty to promote the success of the company). This is particularly important where the company is not the borrower, for example where the security is being given by a subsidiary in respect of its’ parent’s obligations (‘upstream’) or in respect of the obligations of another company at the same level in the group (‘cross-stream’). Common conditions precedent to the financing are board minutes and resolutions confirming that the directors of the company have considered this issue.

Question 71

• Maintenance of capital?

Answer 71

if a subsidiary gives an upstream guarantee or security to guarantee or secure a loan made to its parent, then this will not result in a breach of the capital maintenance rules if the directors of the subsidiary consider in good faith and on reasonable grounds that the parent is likely to be able to repay or refinance the loan when it falls due for repayment (and so the guarantee or security is not likely to be enforced). If this is not the case, then the guarantee or security may be treated as a distribution for which the company must have sufficient distributable profits so that there will be no unlawful reduction in its capital. A lender will want to see evidence that the directors of the subsidiary giving an upstream guarantee or security have considered capital maintenance issues and concluded that the guarantee or security is not likely to be enforced and, therefore, no provision need be made in the subsidiary’s balance sheet. Usually, a lender will want to see a certified copy of the board minutes or written resolutions of the directors and a certificate addressed to the lenders/agent, or a representation in the loan agreement, that the guarantee or security will not reduce the subsidiary’s net assets by more than its distributable profits.

Question 72

• How is security documented?

Answer 72

· There are a variety of terms used in the market for describing security documents. For example, the term ‘Debenture’ is often used for security documents containing a comprehensive package of mortgages, fixed and floating charges and assignments. Other terms you may come across include ‘Mortgage Debenture’, ‘Charge’, ‘Security Agreement’ etc.
· You will see a Debenture document (adapted from the LMA form of debenture for teaching purposes) and consider some of its key clauses. The clause references below refer to the clauses in the Debenture.
· In a bilateral loan the Debenture will be executed by the borrower in favour of the lender (often referred to as the ‘Secured Party’).
· In a syndicated loan the Debenture will usually be executed by the borrower in favour of the security trustee (who may be labelled the ‘Security Agent’) for the Secured Parties(which will include all the lenders in the syndicate from time to time).
· This security trustee arrangement will create security for the syndicate as a whole, notwithstanding the identity of the lenders may change during the life of the loan.

Question 73

• Broadly speaking, the clauses in a typical Debenture can be categorised as follows:

Answer 73

· scope of security and creation of security;
· perfection of security;
· protection of secured assets;
· enforcement of security; and
· boilerplate clauses.

Question 74

• How does common law affect the drafting of security?

Answer 74

• ‘Repay/release problem’ - at common law, if a borrower repays a sum of money for which it gave security, when it repays that sum, the security will be released. This rule also operates in relation to guarantees.
• ‘Clayton’s Case problem’ - The rule in Clayton’s Case (Devaynes v Noble (1816) 8 LJ Ch 256) says that, in the absence of an agreement to the contrary between the creditor and the debtor, repayments by the debtor will be used to repay loans in the order in which they arose - i.e. the oldest debt will be paid off first.
• ‘Loss of priority problem’ - Under the rule in Hopkinson v Rolt (1861) HL Cas 514, where a borrower has granted security over its assets to two different lenders (firstly to lender X and subsequently to lender Y), the first priority of lender X in respect of any new advances made under its loan will be lost to lender Y once lender X has notice of lender Y’s security. This is particularly relevant in the case of an RCF where amounts are being continuously re-paid and re-lent during the term of the facility.

Question 75

A company is finalising a loan agreement with Bank A based on the LMA and including both a negative pledge and a no further financial indebtedness covenant, both of which apply to both the borrower and its wholly-owned subsidiary. The borrower also intends to enter into a later loan agreement with Bank B and the loan with Bank B requires security from the borrower and a guarantee from its subsidiary.

Without relevant exceptions being included in Bank A’s loan agreement, which issues would arise with Bank A’s loan agreement when the borrower enters into the proposed loan with Bank B?

The borrower’s security would breach the negative pledge in Bank A’s loan agreement and both the loan with Bank B and the subsidiary’s guarantee would breach the no further financial indebtedness covenant.

The borrower’s security would breach the negative pledge in Bank A’s loan agreement and the loan with Bank B would breach the no further financial indebtedness covenant.

Both the borrower’s security and the subsidiary’s guarantee would breach the negative pledge in Bank A’s loan agreement and the loan with Bank B would breach the no further financial indebtedness covenant.

Both the borrower’s security and the subsidiary’s guarantee would breach the negative pledge in Bank A’s loan agreement.

Answer 75

The borrower’s security would breach the negative pledge in Bank A’s loan agreement and both the loan with Bank B and the subsidiary’s guarantee would breach the no further financial indebtedness covenant.

Correct
Correct. The negative pledge is a general undertaking prohibiting the creation of further security. The no further financial indebtedness covenant restricts further financial indebtedness, which includes borrowing and guarantees.

Question 76

A private company borrower is entering into a loan agreement with a bank to fund its acquisition of 100% of the shares in a PLC. The PLC has a wholly-owned private company subsidiary. The bank requires security from the borrower, a guarantee from the PLC and security from the PLC’s subsidiary.

Which elements of the bank’s security package would constitute unlawful financial assistance?

The guarantee from the PLC only.

The guarantee from the PLC and the security from the PLC’s subsidiary.

The security from the borrower, guarantee from the PLC and security from the PLC’s subsidiary.

The security from the borrower and the security from the PLC’s subsidiary.

Answer 76

The guarantee from the PLC and the security from the PLC’s subsidiary.

Correct
Correct. The financial assistance legislation prohibits a PLC target company and any of its subsidiaries (public or private) from giving financial assistance (which includes security and guarantees) to the bank. The security from the borrower is not caught by the financial assistance legislation as it does not prohibit the borrower from giving financial assistance.

Question 77

A chargor grants the following security interests to a chargee:

A legal mortgage over their shares in their subsidiary;

A fixed charge over shares the chargor owns in an unrelated UK company; and

A fixed charge over the chargor’s patents.

Which registers, in addition to the Companies House register of charges, would these security interests need registering in to be perfected?

The chargor’s register of members and the UK company’s register of members.

The subsidiary’s register of members and the Intellectual Property Office’s register of patents

The Intellectual Property Office’s register of patents only.

The subsidiary’s register of members, the UK company’s register of members and the Intellectual Property Office’s register of patents.

Answer 77

The subsidiary’s register of members and the Intellectual Property Office’s register of patents

Correct
Correct. In addition to registration at Companies House, the legal mortgage over shares in the chargor’s subsidiary needs registering in the subsidiary’s register of members (as the chargee is now the legal owner of the shares in the subsidiary, subject to the equity of redemption) and the fixed charge over the chargor’s patents needs registering at the Intellectual Property Office in the register of patents there. Remember, as a legal mortgage transfers legal title to the shares to the mortgagee (i.e. the chargee), this transfer must be registered in the register of members of the company whose shares have been mortgaged (N.B. NOT the register of shareholders of the company creating the security over those shares (the chargor)). The fixed charge over shares the chargor owns in an unrelated UK company is a beneficial/ equitable interest and so cannot be noted on the register of members of the UK company (that would only happen if the chargee was the owner of the legal title to the shares).

Question 78

A borrower entered into a secured loan with a bank last year. The security included a fixed charge over future property and this year the borrower acquired new warehouse premises. The bank wants a charge by way of legal mortgage over the new warehouse premises as it is a stronger form of security interest.

Which clauses in the existing loan agreement and/or debenture will enable the bank to achieve this?

The power of attorney in the loan agreement and the provision of notices to third parties provisions in the debenture.

The charging clause in the debenture.

The further assurances undertaking in the loan agreement.

The further assurances undertaking and the power of attorney in the debenture.

Answer 78

The further assurances undertaking and the power of attorney in the debenture.

Correct. The further assurances clause is an undertaking from the chargor to take any steps and execute any documents the chargee may require to create, perfect and protect any security, allowing the chargee to require the chargor to give a charge by way of legal mortgage over the new warehouse premises. The power of attorney enables the chargee to accomplish this by signing documents as attorney for the borrower if the borrower refuses. These clauses appear in the debenture not the loan agreement.

Question 79

Three years ago, a borrower entered into a secured RCF with a bank. Earlier this year, the same borrower entered into a secured term loan with the same bank. All the security was properly registered. The debentures for the RCF and term loan both contained ‘all monies’ and ‘appropriations’ wording.

The borrower makes a repayment to the bank with no indication as to which loan it is repaying and the bank wishes to apply it to the outstanding amount under the term loan. Is the bank able to do this and why?

No, the bank cannot do this because the term loan is a further advance which has been ‘tacked’ on to the RCF

Yes, the bank can do this because the ‘all monies’ wording allows the bank to apply repayments to whichever of the borrower’s loans it wants.

No, the bank cannot do this because the rule in Clayton’s Case means the repayment must be applied to the earliest loan first (the RCF).

Yes, the bank can do this because the ‘appropriations’ clause allows the bank to apply repayments to whichever of the borrower’s loans it wants.

Answer 79

Yes, the bank can do this because the ‘appropriations’ clause allows the bank to apply repayments to whichever of the borrower’s loans it wants.

Correct. The appropriations clause overrides the rule in Claytons Case (in the absence of agreement to the contrary, repayments go to pay earlier loans first), allowing the bank to apply repayments to a more recent loan if they wish.

Question 80

A borrower enters into a secured RCF with a bank. The debenture contains ‘all monies’, ‘continuing security’, ‘appropriations’ and ‘ruling off’ wording and the security is properly registered. The borrower makes a repayment of part of the outstanding amount under the RCF.

Which wording prevents the security being released for the amount that has been repaid?

‘Continuing security’ wording.

‘Appropriations’ wording.

‘Ruling off’ wording.

‘All monies’ wording.

Answer 80

Continuing security’ wording.

Correct. If the security is described as ‘continuing’, it will not be discharged by repayments of the loan but will instead continue for the entire term of the loan regardless of any intermediate repayment and re-borrowing.
The ‘appropriations’ wording is relevant where the same bank has entered into more than one loan with the same borrower and it allows the bank to override the rule in Clayton’s Case and to apply repayments to a more recent loan first (rather than the earliest loan first).
The ‘all monies’ wording means that the security will cover subsequent lending arrangements between the borrower and bank.
The ‘ruling off’ wording is relevant where there are two (or more) banks (not the case here) and it keeps first ranking priority for the amount of the debt owed to the first bank on the date they receive notice of the security granted to the second bank.