Secured lending

In document Unlocking Company Law (Page 181-185)

Critical tax characteristics of debt financing

6.4.6 Secured lending

Banks are unwilling to lend large sums to companies on an unsecured basis. Revisit the example of a simple, unsecured, loan contract set out at section 6.4.2 above and consider what the bank can do if the company fails to make a payment to the bank under the agreement, ie ‘defaults’ on payment of interest, repayment of the sum lent (the capital or principal) or an instalment thereof, or both. Apart from writing letters demanding payment or renegotiating the terms of the loan, the bank may:



n sue the company to recover the sum payable under the terms of the loan agreement, seek to enforce the judgment and, if execution of the judgment debt fails, petition the court to have the company wound up;



n issue a statutory demand for payment (if £750 or more is owed) following which, if the company fails to pay, petition the court to have the company wound up.

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Provided a company has the money to pay the sum owed, receipt of a statutory demand normally results in swift payment without the need for further legal action. If, however, a company cannot repay the sum due because it does not have the money, it is likely that the company will owe money to more than one creditor. Even if there are no judgment creditors, it is likely to have a mixture of financial and trade creditors and HM Revenue

& Customs is likely to be a creditor due to unpaid taxes.

If a company cannot pay its debts as they fall due, it is insolvent, and, unless the company has a realistic opportunity to borrow more money to enable it to pay its debts as they fall due and trade its way out of insolvency, the company is likely to enter insolvent liquidation. This means that the company will be wound up (liquidated) and its assets distributed amongst its creditors. Once a company has entered into insolvent liquidation, creditors cannot bring legal actions to enforce debts owed to them but must rely on the liquidator to distribute to them their fair share of the company’s assets as determined by the application of the legally dictated order of distribution in Chapter VIII of the Insolvency Act 1986 and the pari passu principle.

If a loan is unsecured the lender’s rights against the company are purely contractual and the right to enforce the contract is lost should the company enter into insolvent liquidation. An unsecured lender has not negotiated and secured any property rights, such as the right, in the event that the company defaults on repayment of the sum borrowed, to take possession of specified valuable property owned by the company, sell that property, and recover from the proceeds of sale the debt owed to it by the company.

In the absence of property rights, in the event of the company entering into insolvent liquidation, the unsecured lender will rank alongside all other unsecured and non-preferential creditors (trade and judgment creditors and HM Revenue and Customs) when the liquidator distributes the assets of the company.

In addition to the right to enforce the loan contract, which is a personal right the lender can assert only against the borrower, a secured lender has property rights (also referred to as real rights).

Consider the following example of a simple secured loan:



n the bank (lender/creditor/chargee);



n contracts to lend the agreed amount and secure the loan amount and any interest outstanding from time to time (the sum charged);



n against specified property (the charged property);



n owned by the company (borrower/debtor/chargor);



n by contractually requiring the company to grant a fixed charge against the specified property in favour of the bank (contractual right);



n the company, in performance of the contractual obligation, takes any and all steps (including the execution of any necessary documents) required to grant the fixed charge to the bank (the formalities);



n the bank has a property right, or real right, in the specified property.

Two key qualities of property rights, or real rights, are:



n The lender can assert its property rights against an indefinite number of people, not only the person that granted the property rights to the lender.



n The lender can take the property in which it has property rights out of an insolvency process (including the insolvent liquidation of a company).

This means that the secured creditor is entitled to retain the proceeds of sale of the property against which its loan is secured (the property in which the property rights exist), up to the value of the sum secured against the property. It is the rights of the holder of a fixed charge against one or more items of property (assets) of the company that is described here. The property rights arising out of fixed charge secured lending are illustrated diagrammatically in Figures 6.1 and 6.2.

insolvent

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Bank enforces its fixed charge by taking possession of land and factory owned by Company A Ltd

Company A Ltd

Loan in default

Bank

Company A Ltd

Loan discharged

Bank Company A Ltd

Loan

Property

owned by Fixed charge against land and

factory owned by Company A Ltd Bank

Bank sells land and factory-owned by Company A Ltd and retains part of proceeds of sale equal to the sum it is owed under the loan. Loan is discharged. Surplus proceeds are passed to Company A Ltd.

Figure 6.1 Fixed charge against real property: stages of enforcement

The distinction between secured and unsecured lending is critical because of the enhanced rights of a secured lender relative to an unsecured lender. This is the key point to appreciate here.

Within secured lending, a key distinction exists between fixed charge security and floating charge security. The property rights, or real rights, of a lender that has secured its loan to a company by taking a floating charge against company property are subordinated by statute to certain other debts (preferential debts), expenses of the liquidator and statutory charges. The rights of a floating charge holder are not as clear cut or strong as the property rights of a fixed charge holder. The most important time to analyse the rights of different types of secured lenders (basically, fixed and floating charge holders) is when a company is in insolvent liquidation. If the liquidator is to distribute the assets of the company amongst the various creditors in accordance with the statutory order of distribution provided for in Chapter VIII of the Insolvency Act 1986, he must first establish the rights of the different types of creditors, including the rights of the different types of secured creditors. For this reason, secured lending, including the distinction between fixed and floating charges, is considered in further detail towards the end of this book, in Chapter 16.

floating charge a security by way of charge over one or more specified classes of assets, present and future, prior to enforcement of which charge, the company is free to carry on business in the ordinary way in relation to those assets, including removing any assets from the security

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DEBT FINANCING: CREDITORS

6.4.7 Debentures

The term ‘debenture’ is used widely to describe a range of debts, documents evidencing debts and the security attached to debts. It is important not to ascribe too narrow a meaning to the term or to make assumptions about a debt or ‘instrument’ described as a debenture.

A partial definition of the term debenture is included in s 738 of the Companies Act 2006. The provision simply clarifies that where the term debenture is used in the Act, it includes collective debentures, ie debenture stock.

SECTION

‘738 Meaning of “debenture”

In the Companies Acts ‘debenture’ includes debenture stock, bonds and any other securities of a company, whether or not constituting a charge on the assets of the company.’

Perhaps the best explanation of the term debenture can be found in Levy v Abercorris Slate and Slab Co (1887) 37 Ch D 260.

JUDGMENT

‘[Debenture] ... means a document which either creates a debt or acknowledges it … [there is no] precise legal definition of the term, it is not either in law or commerce a strictly technical term, or what is called a term of art.’

debenture a document which either creates a debt or acknowledges it.

Usually, though by no means al-ways, a debenture is secured

Company A Ltd

Loan

Property

owned by Fixed charge

against car fleet owned by Company A Ltd

Bank

Company A Ltd

Loan discharged

Bank

Bank sells car fleet owned by Company A Ltd and retains part of proceeds of sale equal to sum owed under the loan. Loan is discharged. Surplus proceeds are passed to Company A Ltd Company A Ltd

Loan in default

Bank

Bank enforces its fixed charge by taking possession of car fleet owned by Comany A Ltd

Figure 6.2 Fixed charge against personal property: stages of enforcement

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CHAPTER 6 FINANCING A COMPANY

In document Unlocking Company Law (Page 181-185)