Chapter 8: Debt Finance

Question 1

1. Debt finance

1.1 Introduction

Answer 1

In the previous topic we considered the way in which a company may raise money through the issue of shares. However, 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).

An alternative option to raise finance for any company is to borrow money (debt finance), usually from a bank. Most companies will have unrestricted power to borrow. However, it is necessary to check the company’s articles to ensure that there are no restrictions.

Question 2

1.2 What is debt finance?

Answer 2

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.

Question 3

1.3 Types of debt finance – loan facilities

Answer 3

Loan facility: 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.
* 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.
* 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.

Question 4

1.4 Types of debt finance – debt securities

Answer 4

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

Question 5

Debt Security as Bonds

Answer 5

A classic example of a debt security 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.

Question 6

1.5 The main debt finance documents

Answer 6

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.

Question 7

1.6 Debentures

Answer 7

Debenture: The word debenture has two separate meanings:

(a) Under s 738 ‘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.

(b) 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 8

1.7 Important terms in loan agreements

Answer 8

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.

Question 9

1.8 Summary

Answer 9

• Types of debt finance include loan facilities and debt securities.
• 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 are classed as either term loans or overdrafts.
• Debt securities eg bonds 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.
• The main documents required for a term loan are a term sheet, a loan agreement and a
  security document (if the loan is to be secured).

Question 10

2. Security (Protecting the creditors)

Answer 10

2.1 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.

Question 11

2.1.1 Pledge

Answer 11

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.

Question 12

2.1.2 Lien

Answer 12

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.

Question 13

2.1.3 Mortgage

Answer 13

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).

Question 14

2.1.4 Charge

Answer 14

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.

Question 15

2.2 Fixed and floating charges

Answer 15

There are two different types of security that a company may offer a lender over its assets: fixed
and floating charges. A fixed charge 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.

A floating charge ‘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. The label applied to a charge is not always determinative – it is necessary to look at the terms of the charge itself (Agnew v IRC [2001] 2 BCLC 188, PC). We will consider these types of charges in more detail below

Question 16

2.3 Fixed charges

Answer 16

Where a fixed charge is granted, 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 charged.

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 in the course of its business to generate income to meet its liabilities, including the loan interest and repayment amounts. 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. 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 17

2.4 Floating charges

Answer 17

Many companies are unable to grant fixed charges over the majority of their assets. For example,
a trading company needs to be able to continually dispose of its stock. If the stock was subject to a fixed charge, the company would be unable to dispose of it. For assets that cannot be subject to a fixed charge, a floating charge is appropriate.

A floating charge floats over a class of asset which fluctuates eg 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 [1904] AC 355

Question 18

Key case: Re Yorkshire Woolcombers Association [1904] AC 355

Answer 18

Re Yorkshire Woolcombers Association [1904] AC 355 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 19

2.5 Floating charges: crystallisation

Answer 19

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.

Whilst the effect of crystallisation on preventing the borrower dealing with assets subject to a floating charge is the same as for 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 [1963] 1 WLR 1324, CA).
Crystallisation occurs in the following situations:
(a) Common law – on a winding up, appointment of a receiver or cessation of business.
(b) 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 20

2.6 Charges over book debts – fixed or floating?

Answer 20

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.

Whether charges over book debts are fixed or floating has been the subject of much debate in the courts. In the earlier cases, the courts took the approach that a charge granted over book debts was a fixed charge, however, this approach has now been overruled.

Question 21

Summary of the key cases for Book Debts

Answer 21

Siebe Gorman and Co Ltd v Barclays Bank Ltd [1979] 2 Lloyd’s Rep 142: in this case the court held that a charge over book debts was a fixed charge because of the degree of control of the bank which could stop the company making withdrawals, even when the account was in credit.

Re Brightlife Ltd [1987] Ch 200 ChD: the court in this case clarified that a company’s bank balance is not a book debt and therefore cannot be subject to a fixed charge.

Re Keenan Bros Ltd [1986] BCLC 242: : in this case a fixed charge was created by the means of a requirement that the funds collected by the company were to be paid into a blocked account. The prior written consent of the bank was required before any funds were allowed to be withdrawn from this account. Here the court said that the charge was a fixed charge due to the fact that the
account was blocked.

Question 22

Re Brumark Investments Ltd [2001]:

Answer 22

In this case a company attempted to create a fixed charge over its book debts. The court held that the proceeds of book debts received by the company were excluded from the fixed charge unless the bank had ordered payment into an account that the company could not operate freely, which was not the case. It was held that the key issue was who
had control of the proceeds and the answer determined the type of charge.

Here the company’s freedom to collect and use the proceeds of the book debts as it wished without requiring the lender’s consent was inconsistent with the nature of a fixed charge. This was a Privy Council case, which means that it is persuasive but not binding.

Question 23

House of Lords in National Westminster Bank plc v
Spectrum Plus Limited and others [2005] UKHL 41,

Answer 23

It is now very difficult to demonstrate the requisite level of control over book debts for a fixed charge. This would require at the least a blocked account.

Question 24

2.7 Book debts: current position

Key case: National Westminster Bank plc v Spectrum Plus Limited and others [2005] UKHL 41

Answer 24

In this case the charge in issue was stated to be a fixed charge. However, the company collected its book debts, put them in an account and then drew on the account as it wished. The House of Lords held that the charge was a floating charge, agreeing with the Privy Council in Brumark.

Question 25

Lord Scott

Answer 25

The essential characteristic of a floating charge, the characteristic that distinguishes it from a fixed charge, is that the asset subject to the charge is not finally approved as a security for the payment of the debt until the occurrence of some future event. In the meantime, the charger is
left free to use the charged asset and to remove it from the security.

Following this case, 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 26

2.8 Guarantees

Answer 26

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).

Question 27

Example

Answer 27

A bank is intending to lend £20,000 to a company which was recently incorporated by an entrepreneur who is the majority shareholder in the company and is its managing director. The bank will be granted a fixed charge over certain assets.

However, the bank is concerned that the value of the assets might depreciate rapidly, leaving it
exposed. As the company is newly incorporated, it may not have substantial assets. The bank could also look to take a personal guarantee from the entrepreneur if they have valuable assets.

If the company defaulted, the bank could call on the guarantee and, if the entrepreneur refused to pay, sue them for the money. They may also give security for the loan (eg by granting a mortgage over their home, subject to any rights of any other person living there with them).

Question 28

2.9 Order of priority on winding up (liquidation)

Answer 28

The reason why it is so important to determine whether a charge is fixed or floating is that in liquidation, when a company is wound up, the assets are distributed in a specific order. On a liquidation, a company’s assets fall into two groups:
(a) Those subject to a fixed charge
(b) Those subject to a floating charge

Question 29

Fixed Charge Holders are paid first

Answer 29

Fixed charge holders are paid first in the order of priority on insolvency and are entitled to the whole of their debt from the fixed charge fund. If there is a shortfall, they may receive assets from the floating charge fund. The insolvency rules require a proportion of the floating charge assets to be set aside for the unsecured creditors.

In addition, preferential debts (those payable to employees) are also paid out of the floating charge fund before the floating charge holders are
paid. The unsecured creditors are paid after the floating charge holders, and any remaining assets are paid to the shareholders

Question 30

Recouping money

Answer 30

Most banks therefore require a fixed charge and a floating charge, giving themselves the greatest chance to recoup their money if the company goes into liquidation. You will learn more about the order of priority on a winding up in the insolvency topic.

Question 31

2.10 Registration of charges

2.10.1 Registration formalities:

21 period deadline

Answer 31

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
most at risk if it is not registered.

Question 32

2.10.2 Effect of failure to register:

Answer 32

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 and the debt becomes immediately payable. This means that the holder of the charge is reduced to an unsecured creditor. It is therefore crucial to register the security on time so that it is enforceable in priority to other
creditors.

Question 33

2.10.3 Records to be kept by the company:

2.11 Remedial measures in the case of non-registration

Answer 33

Although the obligation to register a charge is strict, 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.

Question 34

Register to be rectified

Answer 34

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 [2001] 2 BCLC 316).

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. An example of this is the case of Victoria Housing Estates Ltd v Ashpurton Estates Ltd [1982].

Question 35

Key case: Victoria Housing Estates Ltd v Ashpurton Estates Ltd [1982] 3 All ER 66

Answer 35

In this case the charge was created in 1978. It was not discovered until 1981 that the charge had not been registered. The chargee (lender) initially decided to take no action whilst a sale was pending of the relevant assets. However, later in 1981 the chargee received notice of a meeting to wind up the company. As soon as this notice was received, the chargee applied to register the
charge.

The court refused to register the charge, stating that the chargee should have made the application as soon as they realised the mistake. If the charge was retrospectively registered this would prejudice other creditors. As the chargee had waited until they received notice of the
meeting to wind up the company, the court would not extend time to register the charge as this would reduce assets available to distribute to other unsecured creditors, thereby prejudicing their interests. The charge was therefore void and the lender was an unsecured creditor.

Question 36

2.12 Summary

Answer 36

• There are various different forms of security that may be granted for loans. The most common
  forms of security are fixed or floating charges.
• A fixed charge prevents the borrower from dealing with the charged assets.
• A floating charge floats over a class of assets. It does not prevent the borrower from dealing
  with the assets unless and until the floating charge crystallises.
• A fixed charge is a stronger form of security since the fixed charge holders are paid first in the
  order of priority in the event of a company’s liquidation.
• Charges must be registered within 21 days beginning with the day after creation under s 859A
  CA 2006 otherwise they will be void and the loan will become immediately repayable.
• The court has a discretion to allow late registration under s 859F.

Question 37

3 Comparing debt and equity finance

3.1 Introduction

Answer 37

Most companies raise the finance they need through a combination of equity finance and debt finance. We have looked in detail at the different types of finance in earlier elements. In this element we compare the considerations for companies in deciding whether to use debt or equity finance, or a combination.

Question 38

Reminder of debt and equity finance

Answer 38

Debt finance is raising money by borrowing from a lender, with a promise to repay the money (usually with interest) at a later date.

Equity finance is raising money from shareholders by the issue of shares.

You will recall that there are different types of shares: eg ordinary shares or preference shares. Investors may be issued preference shares which guarantee a right to a dividend in preference to other (ordinary)
shareholders. This is usually balanced against no voting rights.

Question 39

3.2 Return on investment

Answer 39

Equity: Shareholders will receive
dividends, provided the company is making a profit. Although a company does not have to pay dividends, it will find it difficult to attract shareholders if it does not.

• Shareholders may also
  receive a return by way of capital growth. If the company is paying regular dividends, other investors
  may be keen to purchase the shares and the investor may be able to sell the shares for a profit.

Question 40

Return on Investment

Answer 40

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

Question 41

When does the investor
receive back the amount
invested?

Answer 41

Equity: On the winding up of the
company (if there are sufficient assets). Although companies are often wound up when insolvent. Solvent companies may also be wound up and in that case the
shareholders will receive back the full
amount of their investment and
potentially a fraction of the surplus capital.

Debt: As agreed between the
parties in the loan agreement or in the terms of the bond. Usually either
in one bullet repayment on maturity or amortising through instalments. * 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 42

Priority of Winding Up

Debt

Answer 42

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
when wound up.

• Arrangements may be
  made between shareholders as to priority between themselves (eg
  preference shareholders will often be entitled to their money back before
  the ordinary shareholders).

Question 43

Priority of Winding Up

Equity

Answer 43

• 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.
  As you saw earlier, fixed
  charge creditors take
  priority over floating
  charge creditors.
• Creditors may contractually agree to give priority to some lenders and subordinate others.

Question 44

Control

Equity

Answer 44

• 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
  (eg holding over 50% of
  ordinary shares will give
  the shareholder control of ordinary resolutions and also the power to
  block a special resolution on a poll
  vote).

Question 45

Control

Debt

Answer 45

• 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
  (eg prevent the borrower from disposing of assets without lender consent).
• Security may also give the
  lender control over the assets which are subject to the security eg a fixed
  charge prevents the borrower from dealing with the charged assets.

Question 46

Other factors

Equity

Answer 46

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.

Question 46

Other Factors

Debt

Answer 46

• 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.
  This is a significant advantage of debt
  compared to equity