Debt Finance

Question 1

When lending, what is a bank’s primary concern?

Answer 1

That interest will be paid on the amount it has lent in full and on time;

that it receives back the principal (money lent) in full and on time.

Question 2

What can the bank do to protect itself if there is a late payment or a complete failure to pay?

Answer 2

Ensure there is a term in the loan agreement that whenever there is a late payment, or a complete failure to pay, the whole loan becomes repayable immediately.

Question 3

How can the bank obtain information about the borrower to mitigate risks of default?

Answer 3

Than bank can add a term into the loan agreement under which the borrower has to disclose to the bank lots of its business or financial state on a regular basis so that the bank is in a good position to know if non payment is likely.

Question 4

How can the bank protect itself if it realises from that the company is not doing well financially as indicated by their quarterly financial statements?

Answer 4

The bank can add a term into the loan agreement which makes the whole loan repayable if:

• the borrower’s financial position becomes materially worse;
• it becomes insolvent; or
• it falls short of certain financial targets by reference to actual figures in the borrowers accounts.

These terms can be referred to as events of default.

Question 5

What can a bank do to guarantee some sort of repayment if the company in which it lent money to goes bankrupt?

Answer 5

The bank can take security over the assets of the borrower in respect of any money owed to it.

The terms of such security would be set out in a separate document.

A common type of security would be a fixed or floating charge.

Question 6

What else can the bank do to guarantee repayment if they are not 100% confident that the company in which they are lending money to will have sufficient funds or assets to repay if they are wound up in the future?

Answer 6

The bank can take a guarantee from a parent company who will be obliged to step in and pay.

Question 7

How can the bank monopolize the assets of the borrower and prevent other lenders from taking a security over their assets?

Answer 7

A bank can put a term in the loan agreement under which the borrower promises not to give security to any other lender (negative pledge).

Question 8

What is the central feature of a security in a debt financing context?

Answer 8

It is the possibility of a bank being able to sell assets of a borrower to recover money owed to it under a loan.

Question 9

What else is a security document known as?

What are the features of a charge?

Answer 9

A charge, a mortgage, a debenture or security agreement.

A charge is a type of security agreement that gives a creditor an interest in the property without the transfer of ownership or possession of that property.

Question 10

What does a security document do?

How do you give effect to a security document?

Answer 10

A security document sets out the terms of any SECURITY that may be given to the lender by the borrower.

It must be registered with Co. House under s859A-859R CA 2006.

Company must also keep a copy of the security document available for public inspection at its registered office under s859P CA 2006.

The loan agreement itself doesn’t need to be registered, therefore sensitive information such as interest rates will still remain confidential.

Question 11

What is an example of a debt security?

What does it do?

What is a feature of a debt security?

Answer 11

A bond is a type of debt security.

A company could raise money by borrowing from a bank, or by issuing bonds. The company as issuer would then be obliged to pay the money back to the bondholder on a specified date.

A debt security is tradable.

Question 12

What is a security for a debt?

What are examples of a security for a debt?

Answer 12

It arises where the borrower agrees to give the lender ownership of, or rights over, an asset(s) to protect the lender against non payment or insolvency.

Lender can sell the asset if the borrower fails to repay loan. If borrower repays loan on time, then the rights over the asset will be returned to borrower.

Some examples are fixed and floating charges.

Question 13

What is the difference between a security agreement and a loan agreement?

Answer 13

A security agreement sets out the terms of any security that may be given to the lender by the borrower.

Whereas a loan agreement sets out the terms on which the borrower borrows and the lender lends.

Question 14

In what circumstances will there be no security document?

Answer 14

Where a loan is unsecured.

Question 15

What terms must be included in a security document?

Answer 15

It is important to draft:

What type of security is given over which assets

When the assets can be sold to repay the debt

When can the borrower regain complete control over their assets again

Question 16

What are two types of charges and what are their main features?

Why would a company choose to have one charge over another?

Answer 16

There are fixed charges and there are floating charges.

A fixed charge gives the lender control over the property which means the borrower cannot sell or deal with that property without consent of the charge holder. Hence, a fixed charge gives the holder prior rights to the sale proceeds of the charged assets over the claims of other creditors.

A floating charge enables the borrower to give security over a fluctuating pool of assets which the borrower can dispose of in the ordinary course of business without having to get consent of the lender (asa fixed charge). This is why a floating charge can be far more preferable than in a fixed charge in certain situations.

Question 17

If a bank wanted to sell the secured assets, who must they appoint first?

Answer 17

A charge holder may appoint a receiver to deal with the selling the secured assets.

Question 18

How can you determine whether a charge is a fixed charge?

Answer 18

If the charge holder can demonstrate sufficient control over the borrower’s use of the charged assets.

Question 19

If you were a charge holder claiming priority over a fixed charge, what must you consider?

Answer 19

A fixed charge also ranks in order of creation (i.e. execution of the relevant security document, provided the charge is registered within the 21 day limit.

So you must look to see whether other fixed charges have been registered before you.

And you need to make sure there were no other priority agreements or agreements altering the ranking of you and the other creditors.

Question 20

Who can give floating charges?

Answer 20

A limited liability partnership or a company.

Question 21

What happens if a charge is not registered properly?

Answer 21

It will be void against a liquidator, administrator or creditor of the company and the debt will become immediately repayable.

Also the security will become void against a liquidator, administrator, or creditor. And the debt becomes immediately repayable. s859H(3) and (4).

Question 22

How do you register a charge?

Answer 22

You set out the particulars of the charge in a prescribed form MR01

Pay registration fee to co.’s house and send a certified copy of the security agreement

Question 23

Can the bank enforce security if the borrower fails to pay interest under the loan?

Answer 23

The security can be enforced if there is an “event of default”, which should be defined in the loan agreement which may set out more than one events triggering default.

Question 24

Explain the key steps in arranging a loan agreement:

Answer 24

1) Borrower makes a decision with regard to the source of loan finance it intends to use - it will approach different banks to gauge different offers available

• 2) Bank checks financial standing of borrower by reference to accounts

• 3) Bank consults its credit committee to decide whether to grant the loan - internal risk
management which will decide what interest rate and (if applicable) what security the borrower
should give the bank

• 4) Bank carries out anti-money laundering checks - Know Your Customer (KYC) checks

• 5) Bank sends over draft term sheet to the borrower - a non-binding statement of the main terms
of the loan

• 6) Both parties instruct lawyers
• 7) Borrower’s solicitor checks:

A) That the borrower has no provision in its constitution restricting its power to borrow money - note that in the absence of a specific restriction in the articles, a company is deemed to have unlimited objects under s31(1) CA 2006

• B) That the company has no provision in its articles restricting its power to grant security
• C) That the directors have authority to approve the loan agreement
• 8) The loan agreement and, if security is being granted, separate security document are negotiated

• 9) Directors convene board meeting to review the documentation, and resolve to enter into the
loan agreement and security document

• 10) Loan agreement and security document are signed - can be signed by any two directors/one
director and company secretary/one director in presence of a witness/one director who has been given authority to sign on behalf of the borrower under s44 CA 2006

• 11) Money not available to borrower until certain conditions precedent are met - e.g. likely to focus on the purpose of the loan (e.g. buying a property)

• 12) Money wired to borrower’s bank account

• 13) Bank’s solicitors have 21 days from the execution of the security document to register the security at Companies House, and at any other applicable register (e.g. Land Registry) under
s859A-859R CA 2006

• 14) Security document available for inspection at company’s registered office - s859P CA 2006
• 15) Borrower makes interest payments to lender in accordance with loan agreement
• 16) Borrower either:
• A) Repays loan with own cash; or

• B) Refinances the loan on maturity by reborrowing the same amount again from the same
bank on renegotiated terms; or

• C) Borrows from another bank and uses the sum to pay off the original bank
• 17) If the borrower defaults:

A) Lender calls in money early, is repaid, and lends to less risky customer; or

B) Lender calls in money early, borrower is insolvent and therefore the lender enforces its security to get its money back; or

C) If loan is unsecured, lender files petition to the court to wind up the company, and hope it gets back as much of the debt as possible through process of liquidation

Question 25

What are the key features of an overdraft?

Answer 25

Over drafts are:

• not as formal, and are based on lender’s standard terms
• can be set up quite quickly
• high interest rate as borrower is paying extra for the flexibility of borrowing and repaying at wll
• lender has alot of control over when and if to make money availble so very uncertain
• over draft can be terminated at any time and immediate repayment may be demanded
• lender’s control is only limited to the fact that it can call in money at any time

Question 26

What are the key features of a loan agreement?

Answer 26

• a loan agreement is negotiated and a security document may also be negotiated if the loan is secured
• more complicated as you need to wait for negotiations, conditions precedence to take effect
• interest rates and arrangement fees will be negotiated but cheaper than overdraft
• as long as the borrower is not in default, borrower knows exactly when it will have to repay and when interest is due so there is alot of certainty
• funds will be available for the duration of the term loan, provided that the borrower is not in default of payment.
• lender usually has alot of control through undertakings of the borrower’s company

Question 27

What are some of the advantages of equity financing from the perspective of a company?

Answer 27

1) Issuing new shares will strengthen balance sheet by reducing the gearing - i.e. the amount of debt in relation to equity capital

Stronger balance sheet makes company more attractive to potential investors

2) Company does not have to repay the capital invested, unlike debt financing - the risks are with the shareholders

Company only has to pay dividends if it has sufficient profits

3) New investors will be concerned to ensure the company performs well, in order to maximise dividend payments for himself/herself - therefore he/she may be able to contribute particular expertise towards the company
4) Good publicity - people want to buy shares in the company

Question 28

What are the disadvantages of equity financing from a company’s perspective?

Answer 28

1) Existing shareholders may resist any dilution of their voting and dividend rights

2) Dividends paid to shareholders are not a tax deductible expense for the company, whereas
interest paid on a loan is tax deductible

3) The increase in the number of shareholders increases the likelihood of disputes in the
general meeting

Question 29

What are the advantages of debt financing from a company’s perspective?

Answer 29

No shareholder consents are required, subject to any restrictions on borrowing without shareholder consent in the articles or a shareholders’ agreement

The interest paid on a loan is a tax deductible expense, reducing the overall tax burden of the company

Question 30

What are the disadvantages of debt financing from a company’s perspective?

Answer 30

• The company will have to repay the loan at the end of the loan term

• Furthermore, interest must be paid on the loan, even if the company is not making profits

• Debt financing will increase the gearing of the company, and therefore could make the company less attractive to potential investors

• The terms of the loan will place restrictions on how the company runs its business (e.g. through the use of undertakings)
• If the loan is secured, the company’s use of its assets will be restricted
• If loan is secured - no confidentiality, as the security document must be available for public inspection under s859P CA 2006

Question 31

What are the advantages of equity financing from the view of existing shareholders?

Answer 31

• An issue of new shares reduces the company’s gearing - therefore will contribute to the
long term stability of the company

• If new shareholder has expertise which they are prepared to contribute to the company, this could lead to overall increase in profitability in the company
• Good publicity - people want to buy shares in the company

Question 32

What are the disadvantages of equity financing from the view of existing shareholders?

Answer 32

• An issue of further shares with voting rights will dilute the voting and dividend rights of the existing shareholders
• Sense of being frozen out of the company - particularly for smaller, family-run companies

Question 33

What are the advantages of debt financing from the view of existing shareholders?

Answer 33

• Rights of existing shareholders will not be diluted

* Existing shareholders do not have to share any increase in profits with the new investor

Question 34

What are the disadvantages of debt financing from the view of existing shareholders?

Answer 34

• Increase in pressure on profits, as interest must be paid on the loan, even if the company is not making a profit
• Company will have to find money to repay the loan at the end of the term - places further pressure on profits
• If company becomes insolvent, then the rights of the lender will take priority on a winding up - due to fixed charge

Question 35

What are the advantages of equity financing from the view of the investor?

Answer 35

• Advantages of equity financing:

• Investor will have a say in the running of the company through voting rights (however
note that a minority shareholding may not enable the investor to have that big a say)

• An issue of shares will strengthen the balance sheet by reducing gearing - therefore help
contribute to long term stability of the company and thus the security of the investment

• Possibility of sharing in increased future profits and/or capital growth

Question 36

What are the disadvantages of equity financing from the view of the investor?

Answer 36

• If company becomes insolvent, investor may lose entire investment because creditors will
all rank higher than shareholders in the winding up of a company

• No return on investment through dividends if the company doesn’t turn a profit
• No return of capital other than by selling the shares - also note it is very difficult to sell a minority shareholding in a private company

Question 37

What are the advantages of debt financing from the view of the investor?

Answer 37

• Better ranking on a winding up than equity
• Possibility of taking security

• Investor is entitled to a regular return on investment in the form of interest, even if the
company is not making a profit

• The investor will still be able to exercise some form of control over the company - e.g. through undertakings in the loan agreement

• Also, if the loan is secured, the investor will also be able to control the company’s use of
its assets

Question 38

What are the disadvantages of debt financing from the view of the investor?

Answer 38

• No share in profits or capital growth if the company is successful
• Debt financing will increase gearing of the company