The leveraged finance market in England and Wales is a mature, sophisticated and developed one. Alongside New York, London is one of the key financial centres globally, and as such a huge volume of finance and leveraged finance transactions are conducted here.
Financing sources in the London market are diverse and include banks, funds, CLOs, institutional investors both domestic and international. The relatively stable political and legal framework in England and Wales lends itself to being a hub for pan-European and international finance transactions originated and executed out of London (the decision to withdraw the United Kingdom from the European Union (Brexit) notwithstanding).
Leveraged finance transactions can be and are funded through a variety of different instruments. Syndicated loans, high yield bonds (senior secured or senior subordinated/unsecured), direct lending or unitranche facilities (provided by specialist credit funds), PIK facilities, preferred equity, first lien, second lien and more besides.
II REGULATORY AND TAX MATTERS
The Financial Conduct Authority and the Bank of England Prudential Regulatory Authority oversee the financial services industry in England and Wales. Certain licences and approvals are required in relation to certain regulated activities but these are not applicable to providing loans to, or subscribing for debt instruments issued by, entities incorporated or formed in England and Wales that are not individuals and that do not relate to certain residential real estate arrangements. Therefore, bank and non-bank institutions or funds may lend to such entities or participate in ordinary course finance transactions without impediment from regulatory constraint. It is worth noting, however, that borrowers or issuers that are themselves regulated businesses (such as financial services firms or businesses that provide insurance services) will have to comply with the terms of their own approvals and licences under which they operate, which can impact on the scope of guarantees and security that they are able to provide to their financiers.
In May 2017, the European Central Bank (ECB) published its Guidance on Leveraged Transactions (the ECB Guidance), which came into force in November 2017. This is the European counterpart to the Interagency Guidance on Leveraged Lending (the US Guidance). While the US Guidance applies to all federally regulated financial institutions (including US branch of non-US banks and some non-bank lenders), the ECB Guidance only applies to significant credit institutions supervised by the ECB under Article 6(4) of the SSM Regulation. English credit institutions are not supervised by the ECB under the SSM Regulation and are, therefore, outside the scope of the ECB Guidance, albeit their Eurozone branches would be (currently at least; Brexit may impact this).
While the ECB Guidance largely follows the principles of the US Guidance, there are certain crucial distinctions between the two, such as what is considered a 'leveraged transaction' (both regimes have a 'leverage test' with varying degrees of specificity, whereas the ECB Guidance also has a 'sponsor test' that captures all types of loan or credit exposure if one (or more) financial sponsors controls or owns more than 50 per cent of a borrower's equity, for which there is no equivalent in the US Guidance) and what transactions are exempted: the ECB Guidance provides exemptions for all loans to natural persons, credit institutions, investment firms, public sector entities and financial sector entities, trade finance and loans to investment-grade borrowers, but no such exemptions exist under the US Guidance.
While the purpose of the ECB Guidance is to increase scrutiny of (and presumably reduce the prevalence of) leveraged transactions, the ECB Guidance is for the moment non-binding, and the results in practice of them being in place remain to be seen. At the time of writing, the ECB intends to submit an internal audit report to the joint supervisory team in November 2018 detailing how the ECB Guidance has been implemented in the procedures of the relevant credit institutions. It is possible this report will lead to further developments in this area in the coming months.
Finally, it is worth noting that England and Wales does have anti-money laundering, anti-bribery and sanction-related legislation and regulations that borrowers will be routinely required to comply with by the terms of their financing arrangements.
There are three main areas where tax needs to be considered: first, withholding tax on interest (whether to creditors on the loan in question or on intragroup loans that service the external debt); second, deductibility of interest and other equivalent funding costs for the borrower, coupled with the resultant utilisation of these costs for tax purposes; and third, tax issues that commonly arise on enforcement of security.
The United Kingdom imposes withholding tax (currently at the rate of 20 per cent) on payments of interest (cf. discount) that have a UK source; however, a number of exemptions are available to eliminate or reduce this withholding tax.
First, UK banks (UK-incorporated or UK branches of foreign banks) and UK corporate lenders that are taxed on the interest in the UK may receive interest gross.
Second, non-UK lenders that are suitably resident in treaty-protected jurisdictions (normally excluding tax havens) can normally reduce or eliminate withholding tax. The UK has a comprehensive network of bilateral tax treaties.
Third, under the 'private placement' exemption, interest on unlisted debt securities and syndicated loans is exempted from withholding tax.
Note that these first three exemptions depend (among other things) on the characteristics (e.g., treaty residence and tax-paying status) of the lender; and double tax treaty benefits and eligibility under the private placement exemption require the submission of proof of such. Treaty 'passports' are available for many institutional treaty-protected lenders, which streamlines what can otherwise be a lengthy and bureaucratic credit rebate process.
Fourth, the 'quoted eurobond' exemption applies to interest-bearing debt that is publicly listed on a recognised stock exchange regardless of the identity of the beneficial owner of the interest (contrast the prior exemptions). Note that, in addition to the formal requirements underpinning the listing, only a public limited company may issue publicly listed securities.
The breadth of these exemptions provides a fiscal platform that is highly facilitative to the raising of funds by UK borrowers from a wide range of lenders and non-banking investors (including offshore funds – especially, in light of the quoted eurobond exemption those based in tax havens such as the Cayman Islands or Channel Island) or those who, although resident in a taxing jurisdiction, cannot avail themselves of a full exemption from the UK source withholding tax.
At the time of writing, with Brexit looming, it is not thought that, in itself, Brexit will have an adverse impact on the nature or breadth of these exemptions; but it is an area to keep under review.
Finally, of equal importance is the question of ensuring that the UK borrower that on-lends loan proceeds (or is itself a group creditor on intragroup loans that directly or indirectly service the external debt can receive corresponding interest from its internal borrowers free of source withholding imposed by the latter's jurisdictions). At present, the UK enjoys a network of favourable double tax treaties, and, under current EU legislation the Interest and Royalties Directive and (for debt service via intragroup dividends) the Parent-Subsidiary Directive. Brexit may well have an impact on this latter benefit.
Interest (including discount and other revenue funding costs) is normally tax-deductible when computing the borrower's taxable profits. As a general proposition, tax follows the accounts so that the borrower's debt service costs as per the accounts will form the starting point for the tax deductions. However, the UK's tax regime contains a number of complex rules that can limit the deductibility of interest (and also limit the extent to which unutilised tax-deductible interest costs can be carried forward for use in future accounting periods). These detailed rules are beyond the scope of this chapter, but a few basic concepts should be kept in mind.
First, as a result of the OECD's recommendations under its Base Erosion and Profit Shifting (BEPS) project, the UK, in common with most OECD members, has introduced a basic interest limitation rule that limits a UK company's deductible interest expenses to 30 per cent of its EBITDA (adjusted for certain tax-related amounts). There is a more complicated limitation ratio that applies to groups, but the detail is beyond the scope of this chapter.
Second, arm's-length transfer pricing rules apply, as generally within the OECD community, particularly to related party borrowing arrangements. This is especially important where intragroup (or related equity investor) funding arrangements apply to either the external debt or, more likely, to internal (or 'pushed-down') debt that services the external borrowings.
Third, and importantly when assessing the debt capacity of a UK group in a leveraged acquisition or refinancing scenario, the UK restricts (to 50 per cent in most cases, subject to a £5 million per annum de minimis group threshold allowance) the amount of profits against which carried-forward losses (including interest costs) can be relieved. These rules are very complex and will invariably need to be factored into any UK group tax finance cash flow model when the debt capacity is being engineered at the outset of the transaction.
One final tax issue to be aware of when structuring a leveraged financing is the tax consequence of enforcing security on a UK group of companies. The UK permits tax consolidation within a corporate group; this allows UK group members to surrender losses, and reallocate gains, between each member on a current year basis. This group tax optimisation thus allows deductible interest expense in one UK company to be offset against income of another group member: so the borrowing need not be incurred in the tax-profitable company. This allows, among other things, for debt to be structurally subordinated without jeopardising the tax efficiency of the overall arrangements. Furthermore, the tax grouping rules allow assets to be transferred intragroup on a tax-neutral basis. However, the group relationship will be broken upon enforcement of third party lender security such as share pledges over group company debtors where security is enforced at a level below the tax parent (thus preventing future loss offset) and enforcement-triggered degrouping charges can be crystallised where latent capital gains are recognised in respect of pre-enforcement intragroup transfers of capital assets. Thus, when assessing the impact of a complex security package, the tax effect of enforcement against companies inside or outside the security field needs to be carefully considered.
III SECURITY AND GUARANTEES
Taking guarantees and security from companies incorporated in England and Wales is usually very straightforward and free from significant limitations and formalities.
Guarantees must be in writing (as required by Section 4 of the Statute of Frauds 1677) and provided in return for consideration or executed as a deed. Otherwise downstream, upstream and cross-stream guarantees are routinely given in financings involving English companies. Under English law, the directors of English companies owe duties to the company for which they are director. Many of these duties have been codified now in the Companies Act 2006 (CA 2006). In particular, Section 172 of the CA 2006 provides that each director must act in a way that 'would be most likely to promote the success of the company for the benefit of its members as a whole', that is, in the best interests of the company. In practice these considerations in the context of providing guarantees (and security) to support financing incurred to acquire a new business for the purpose of generating value for shareholders will rarely if ever be an issue.
Security packages will typically include all assets since it is straightforward for a company to grant security interests over all assets in one overarching security agreement or what is sometimes referred to as a debenture. Certain steps will need to be taken in order to perfect, protect or assist with any future enforcement. The most important is registration at Companies House, which must be carried out within 21 days of execution otherwise the security interests will be void. The registration process is quick (it can be done online), cheap and easy. Other steps may include registration at certain asset-specific registries (real property, intellectual property, aircraft and ships), the giving of notices to contract counterparties or account banks and the delivery of share certificates and executed blank stock transfer forms.
A key feature of any English law security agreement or debenture may be a floating charge that covers all or substantially all of the assets of a company. This will, therefore, constitute a 'qualifying floating charge' for the purposes of Paragraph 14 of Schedule B1 to the Insolvency Act 1986, meaning that the beneficiary thereof can appoint its own administrator that can take control of the affairs of the company in order to act in the interests of the company's creditors in a restructuring situation.
Security in English law finance transactions will typically be granted in favour of a security agent or trustee that will hold the benefit of the security on trust for the lenders as a group. Therefore, there are no issues with transferring debt between lenders as the security will continue to be held for the benefit of the class of lenders identified as beneficiaries of the trust from time to time.
As noted below, financial assistance rules do exist, meaning that UK public companies (and their direct and indirect subsidiaries) are prohibited from providing 'financial assistance' (which would include providing guarantees or security, or both) in connection with the acquisition of shares in that public company. Any transaction entered into in breach of the financial assistance restrictions would be void and unenforceable. It is typical to reregister a public company post acquisition as a private company in order to permit financial assistance to be granted.
There are also restrictions as to distributions and capital maintenance in the CA 2006 which mean that a company can only make distributions to the extent that they are made from distributable profits. There has been some debate and concern that providing a guarantee in respect of a shareholders obligation may constitute a distribution and therefore could be unlawful if there were insufficient distributable profits to cover the amount of the guarantee. However, the generally held view is that unless the company concludes that the guarantee will inevitably be called (or is likely to be called) then the guarantee ought not to be viewed as a distribution.
There are a number of categories of potentially vulnerable transactions that could be investigated by an administrator or liquidator and, if the relevant conditions met, set aside. Vulnerability periods range between six and 12 months depending on the nature of the transaction and the relationship between the company and the relevant creditor or creditors. Key headings of vulnerable transaction are: transactions at undervalue,2 preferences,3 defrauding creditors,4 extortionate credit transactions5 and avoidance of floating charges.6 For a transaction to be set aside under any of these headings, the relevant company generally (although not in all cases) has to have been insolvent at the time, or became insolvent as a result, of the relevant transaction. There are also other potential safe harbours (as well as the passage of time), so in the context of an ordinary course bona fide financing transaction these considerations ought not cause any issues in practice.
IV PRIORITY OF CLAIMS
In an insolvency, creditors will be paid in the following order:
- fixed charge holders: Fixed charge holders will be paid from the proceeds of realisation in respect of any assets over which a fixed charge has been granted. Fixed charges (as opposed to floating charges) are loosely speaking, security interests which provide a degree of control over what the chargor can do with the assets. If the chargor can freely dispose of assets it is likely that (even if it is called a fixed charge) the charge over it will be classified as a floating charge and the priority on insolvency will be affected accordingly;
- liquidator and administrator expenses;
- preferential creditors (i.e., employees with unpaid wage claims, unpaid contributions to pension schemes);
- floating charge holders: Floating charge holders will be paid from the proceeds of realisation in respect of any assets over which a floating charge has been granted, subject to a certain portion of those proceeds called the 'prescribed part' that is reserved for unsecured creditors. The prescribed part is calculated as a percentage of the floating charge proceeds and is capped (at the moment) at £600,000; and
- unsecured creditors: This includes trade and other creditors and creditors that had security but whose claims exceed the proceeds realised from the assets that were subject to their security.
Equitable subordination is not a feature of English law. Contractual subordination is routinely utilised in English law intercreditor agreements to regulate claims amongst third party creditors but also to subordinate the claims of intragroup or shareholder lenders to the claims of external third party creditors. It is a fundamental principle of English law that creditors in an insolvency must be treated on an equal basis such that distributions are made to creditors pari passu. Notwithstanding this, however, certain cases have established that contractual subordination does not offend this principle.
The basic rule under English law (now EC Regulation 593/2008 – 'Rome I',7 subject to certain common law rules that still apply in certain cases) is that a choice of English law (or the law of some other jurisdiction) as the governing law of a contract or part of a contract will be effective. Although the parties' choice of law may, in a limited number of cases, be ineffective or overridden, it is worth noting that in the context of complex cross-border transactions involving a number of finance parties from different jurisdictions, the relevant provisions of Rome I are very unlikely to operate to override the parties' choice of English law as the governing law of any of their contracts.
However, common law rules may still be relevant as Rome I does not automatically apply to all contracts. In particular, it does not apply to arbitration agreements, trusts, certain insurance contracts and negotiable instruments, nor does it affect issues relating to companies and their capacity, or the ability of agents to bind a principal. Where Rome I does not apply to a particular contract, the ordinary common law rules on choice of law under English common law is that an express choice of English law as the governing law of a contract will be effective unless the choice is not 'bona fide and legal' or is contrary to public policy. This rather vague formulation is in fact very narrow in its application as there are few circumstances that can be envisaged where a choice of governing law is not bona fide.
The granting of exclusive jurisdiction to English courts in respect of any disputes that may arise will be given effect to in accordance with Article 25(1) of EU Regulation 1215/2012 (the Brussels I Regulation (recast)). It is common to provide for 'exclusive' jurisdiction even though Article 25(1) of EU Regulation 1215/2012 provides that if the parties provide for courts to have jurisdiction then that jurisdiction will be treated as being exclusive unless the parties have agreed otherwise. Non-exclusive jurisdiction clauses ought to be avoided since an English court will be obliged to stay proceedings before it if proceedings involving the same cause of action and between the same parties have already been brought in the courts of another member state of the European Union and may stay its proceedings in certain other circumstances.
English courts will generally recognise and enforce foreign judgments. The precise rules and limitations, however, will depend on the jurisdiction of the courts that have issued the relevant judgment. European regulations and conventions, domestic legislation or common law rules may apply.
VI ACQUISITIONS OF PUBLIC COMPANIES
When funding acquisitions of public companies in the United Kingdom, there are additional issues and considerations for lenders to those faced when funding private companies, in particular the issues that arise from the requirements of the City Code on Takeovers and Mergers (the Code) and the provisions of the CA 2006 relating to financial assistance and the compulsory acquisition of shares following a successful offer.
i The Code
Broadly speaking, the acquisition of any (1) public limited company, (2) private company previously listed in the past 10 years or (3) societas Europaea, in each case that has its registered office in the United Kingdom, Jersey, Guernsey or the Isle of Man and is either listed in any of those jurisdictions or has its place of central management and control in any of those jurisdictions will be subject to the Code. The Code is administered by the Panel on Takeovers and Mergers (the Panel). Acquisitions can be made by takeover offer (where a bidder makes an offer to the target's shareholders to buy their shares that they accept or decline on an individual basis) or by way of a scheme of arrangement (where the approval of the relevant percentage of the target's shareholders is obtained at a court-convened meeting, and then separately sanctioned by the court).
ii Due diligence and access to information
For acquisitions that are subject to the Code, due diligence and access to information is much more limited (particularly if the offer is hostile or if there is a competing bid). Targets can also be reluctant to share information owing to the obligation in the Code to make any information provided to one bidder available to any other competing bidders. This means that lenders may well not have access to the same level of due diligence as would typically be carried out by the purchaser and its advisers in a private acquisition, and may have to rely on public information (which may be out of date or not fully comprehensive) to assess the credit risk of the enlarged group.
If details of a possible offer leak into the market before the purchaser makes the formal offer, an automatic 28 day 'put up or shut up' deadline may be triggered, which limits how much due diligence can be carried out before the financing is finalised to enable the bid to be made.
If potential lenders hold or may hold shares in the target, there can also be issues because of the Code requirements on equality of information to target shareholders, publishing material information provided to shareholders and special deals with shareholders. There is also risk that the lenders could be determined to be acting in concert with the bidder to obtain control of the company, which would mean their shareholdings would count when determining if the 30 per cent threshold for a mandatory takeover offer has been reached (but note that where shares have been charged as security for a loan and, as a result of enforcement, a lender breaches the threshold, the Panel will not normally require an offer if disposals are made within a limited period to take the lender and persons acting in concert with it below the 30 per cent threshold). As a result, if a potential lender may also hold shares in the target, it must either establish effective information barriers between those making debt-financing decisions and those making equity investment decisions or give an undertaking that no member of its group will acquire shares in the target, save for certain limited circumstances.
iii Certain funds and conditionality
The Code contains certain funds provisions which only allow an offeror to announce a bid after ensuring any cash consideration can be fulfilled. These provisions also require the bidder's financial adviser to confirm that the bidder has sufficient cash resources to do so. Offers cannot normally be made subject to any financing condition.
In practice, this requires the loan documentation to be fully negotiated and signed before the offer is made, with the conditions to drawdown either satisfied or in agreed form and within the bidder's control, with limited circumstances in which a lender can refuse to lend (with the usual drawstops, such as events of default or breaches of representations or undertakings not applying). This requires lenders to be fully committed early in the offer process and remain committed for the duration, which can have cost implications for borrowers. It is also very difficult for bidders to rely on conditions such as material adverse change to exit the offer process once it starts, as this can only be done with Panel consent, which the Panel only gives in exceptional circumstances (e.g., the Panel did not permit bidders to rely on their MAC conditions as a result of the stock exchange crash following the attack on the World Trade Centre on 9/11), so conditionality in the financing documents will also be restricted in that regard. The two exceptions to this are the minimum acceptance condition and UK or European antitrust clearance.
The offer document or scheme document produced in connection with an acquisition that is subject to the Code will need to contain specified details on how the offer is to be financed and the sources of finance, including any fees and expenses to be incurred. Documents relating to the financing have to be made available on a website from the announcement of a firm intention to make an offer until the end of the offer, though the Panel may be willing to allow redaction of, or delayed disclosure of, commercially sensitive provisions such as headroom for potential increases to offers and market flex arrangements.
The Code may also impact the creation of the financing group and the ability to syndicate. Before an offer is announced, lenders can only be approached if it is necessary to do so and after consultation with the Panel, and there are tight limits on how many lenders can be approached by a bidder (before the bidder has been publicly named, the number of external parties approached (which includes shareholders, equity providers and lenders) is restricted to six). Even once announced, the requirement for certain funds (as described above) together with the limited available information and access to target management may mean syndication only once the offer has been declared unconditional or the scheme has been sanctioned by the court.
vi Squeeze out
A successful offer does not necessarily mean that a bidder will acquire 100 per cent of the target from the start. If the offer is not by way of scheme, the required level of acceptance can be as low as 50 per cent of the voting shares. Lenders will usually seek a minimum 90 per cent acceptance threshold, which will enable a squeeze-out process under the CA 2006 to be undertaken to remove minorities. However, this threshold may not be obtainable in practice, so lenders typically will accept a 75 per cent threshold instead as this will, unless successfully challenged by minority shareholders, typically permit reregistration of the target as a private limited company and will enable ordinary and special resolutions to be passed – in particular to delist and avoid the onerous financial assistance rules below.
vii Financial assistance
Until such time as the target is reregistered, it will not be able to be part of any security package for any financing that relates to making the offer owing to financial assistance restrictions in the CA 2006 that prevent an English public company whose shares are being acquired from giving financial assistance for the purpose of that acquisition unless certain exceptions apply. Financial assistance is broadly defined and includes the granting of security or the provision of guarantees and assistance to reduce or discharge a liability incurred for the purposes of the acquisition.
VII THE YEAR IN REVIEW
Activity levels this year have remained strong. There has been lots of investor demand fuelled in part by high levels of CLO issuance (which has been much higher than last year), meaning that sponsors and borrowers or issuers continue to be able to raise funds on favourable terms.
Credit funds continue to win market share, albeit on the smaller transactions, in terms of volume of deals being financed with privately placed unitranche and other private debt deals.
Covenant packages continue to move in favour of sponsors or borrowers. In particular, loan terms continue to converge with high-yield bond terms. Loan volumes have, perhaps as a result of this and the lack of call protection, this year outstripped high yield issuance.
At the time of writing, Brexit and Brexit negotiations dominate the headlines. March 2019 rapidly approaches, at which point the UK government has committed to withdraw from the European Union. What the agreement will be, whether there will be an agreement and any transition arrangements remain undecided at this point. If Brexit does go ahead then there may well be changes to the laws that apply through direct EU Regulations, albeit one would expect it unlikely that the government will seek to repeal all such Regulations immediately.
The next six months will be an interesting time in the UK, and there may yet be another referendum that could reverse the decision to leave the EU.
1 Neil Caddy, Russell Jacobs and Mark Stamp are partners and Mitali Ganguly and Francesca Mosely are associates at Milbank, Tweed, Hadley & McCloy LLP.
2 Section 238 of the Insolvency Act 1986.
3 Section 239 of the Insolvency Act 1986.
4 Section 423 of the Insolvency Act 1986.
5 Section 244 of the Insolvency Act 1986.
6 Section 245 of the Insolvency Act 1986.
7 Contracts entered into before 17 December 2009 are governed by the Rome Convention of 1980 (incorporated into the Contracts (Applicable Law) Act 1990), which is beyond the scope of this chapter.