i Market conditions
In 2019, loan market activity in the EMEA remained steady overall. Favourable pricing and terms continued to be on offer to many borrowers. Ongoing concerns about the macroeconomic and geopolitical outlook, including the implications of Brexit and the end of the transition period on 31 December 2020, appeared to have minimal impact on what borrowers were able to achieve.
In early 2020, the picture changed. Lending activity has increased considerably since March, with many borrowers extending existing facilities or entering into new liquidity facilities as a result of the impact of the covid-19 pandemic. Lockdown measures around the world put pressure on cashflows very quickly for many businesses. Recent refinancings have involved higher pricing and more conservative lending terms.
The effects of the covid-19 pandemic have also forced many companies to approach lenders for amendments and waivers of existing covenant terms. In return, lenders have sought rights to monitor borrowers' activities more closely. Minimum liquidity covenants, more onerous reporting requirements and in some cases, tighter restrictions on corporate actions such as dividends, acquisitions and disposals have been a feature of many consent requests.
The UK government quickly introduced a number of schemes to help businesses that were viable pre-covid-19 to meet their liquidity needs. There are two liquidity support schemes for medium and larger-sized companies: the Coronavirus Corporate Financing Facility (the CCFF) and the Coronavirus Large Business Interruption Loan Scheme (CLBILS). The CCFF enables companies with investment grade status pre-covid-19 to raise short-term finance by selling commercial paper to the Bank of England. The CLBILS allows companies adversely affected by the covid-19 pandemic to access debt facilities directly from accredited banks with the backing of a government guarantee of 80 per cent of the exposure. The UK government is also offering more bespoke support to strategically important companies facing financial difficulties, whose failure would disproportionately harm the economy. There has been a lot of interest in all of these schemes.
Most of the waivers, new liquidity facilities put in place more recently, as well as the government debt support schemes are relatively short term. A material proportion of debt market activity over the next 12 to 18 months is anticipated to be driven by borrowers needing to unwind temporary measures effected during the period of the covid-19 lockdowns.
ii Market participants and documentary developments
A mixture of participants remain active in the English-law loan market. Traditional banks still play an important and active role in the loan market, and remain dominant in investment-grade lending. In other sectors, particularly in the leveraged, real estate and infrastructure finance markets, institutional investors (collateralised loan obligations (CLOs), finance and insurance companies, hedge, high-yield and distressed funds, and loan mutual funds) are more prominent. The years since the global financial crisis have seen the rise of alternative credit providers such as direct lending funds, particularly in the mid-market. This has been fuelled by a variety of factors, including the pursuit of yield in a low-interest rate environment, the funding gap left by constrained bank liquidity and the increasingly strict regulatory capital environment applicable to banks.
Most English-law syndicated loan transactions use the Loan Market Association (LMA) recommended forms as a starting point for negotiations. In addition to various types of facility agreements and ancillary documentation for the investment-grade market (the Investment Grade Agreements) and leveraged lending (the Leveraged Finance Documentation), the LMA collection comprises multiple templates for more specialist products, including real estate, developing markets and pre-export finance.
The LMA has done a significant amount of work on documentation over the past few years, producing a number of new templates and guidance materials and making a variety of changes to the terms of its facility agreements. Much of the LMA's output reflects legal and regulatory developments; for example, the implementation across the European Economic Area (EEA) of Article 55 of the EU Bank Recovery and Resolution Directive (BRRD). It has also published material on the implications of Brexit for the loan market. Its main focus currently is on the documentary and practical implications of transitioning syndicated loans from LIBOR to risk-free rates. It has published multiple guidance notes and materials as well as exposure draft facility agreements referencing risk-free rates in place of LIBOR.
Sustainable lending, involving the alignment of pricing or other terms to the borrower's performance against certain environmental or other targets for improving the sustainability of the business, has been a key area of growth more recently. The LMA has not yet produced template terms for green or environmental, social and governance (ESG)-linked loans, but has been instrumental in the production of principles for the ESG loan market as well as a variety of guidance material. ESG-linked lending is anticipated to remain an important area of focus over the coming year.
These topics and related documentation are discussed in Section II.
II LEGAL AND REGULATORY DEVELOPMENTS
Managing the steady flow of legal and regulatory changes, remains an ongoing challenge for loan market participants. Some of the topics outlined below have been a feature of loan documentation discussions for some time. In some cases, sufficient consensus has emerged to enable them to be addressed in the LMA templates, leaving only points of detail to be negotiated. Where there remain diverging views, the contractual treatment must be agreed on a transaction-by-transaction basis.
The planned discontinuation of LIBOR is the development that has received the most attention from loan market participants over the last few years. Market participants have been told that they may not rely on the availability of LIBOR beyond the end of 2021. The bulk of the London-originated loan market is anticipated to transition to compounded risk-free rates (RFRs). The London-based working parties continue to discuss the challenges of using compounded RFRs in loans, and how RFRs will be reflected in documentation. Work on overcoming these challenges has intensified more recently, amid increasing regulatory pressure to reference risk-free rates in new transactions in place of LIBOR. The UK authorities have set a target date for the cessation of new sterling LIBOR business, recently revised in light of the covid-19 pandemic to Q1 2021.
The UK formally left the EU on 31 January 2020, and the current transition period (during which time the UK continues to be treated as an EU Member State for most purposes) ends on 31 December 2020. How the end of the transitional period will affect lending is still under review. The impact of Brexit on loan documentation was analysed in some detail in the wake of the 2016 referendum. None of the legal risks identified have prompted widespread changes to documentation terms, but as the shape of the post-Brexit relationship between the European Union and the United Kingdom is finalised, these issues will need to be revisited.
The most significant legal development of 2020 in the context of lending and secured finance is likely to be the Insolvency and Corporate Governance Act, which is anticipated to receive Royal Assent very shortly.
i Sanctions and anti-corruption laws
Increasingly aggressive enforcement action and the severity of the penalties imposed by sanctions authorities, as well as reputational concerns, have in recent years prompted lenders to seek additional and specific contractual assurances from borrowers regarding the borrower group's compliance with all sanctions and anti-corruption laws to which both the borrower group and the lenders are subject.
Initially, borrowers were resistant. Historically, these topics were addressed as part of a lender's pre-contract due diligence and, in terms of contractual protection, lenders simply relied on general representations and undertakings relating to the borrower group's compliance with applicable laws. Representations and undertakings on these topics are still resisted by stronger borrowers but have become common in the English-law loan market generally over the past few years.
When such specific contractual assurances on sanctions and anti-corruption laws were first proposed, lenders' individual formulations often varied widely. The wide-ranging phrasing and uncertain limits of the representations and undertakings proposed by some lenders led to these provisions being quite heavily negotiated. The lack of consensus among lenders on the appropriate scope of contractual provisions on these topics meant that, in many transactions, diverging views within the syndicate were difficult and time-consuming to resolve.
This remains the case in some instances, but as lenders and borrowers have become familiar with the aspects that are likely to prompt discussion, the number of points needing to be negotiated has narrowed. For example, borrowers, concerned about their ability to comply with and monitor these provisions, often seek to limit their scope by reference to specific regimes (e.g., the US Office of Foreign Assets Control regime and the EU regime) rather than any sanctions regime anywhere in the world. Limitations by reference to materiality and knowledge qualifications, particularly in relation to compliance by directors, officers and other employees, or the indirect use of proceeds, are also often sought. These points can normally be quite easily agreed. There is also evidence that lenders are tailoring their proposals more carefully to the risk profile of the borrower in question. The sanctions landscape, however, is ever-evolving. Some lenders and borrowers have had to revisit sanctions provisions in both existing and new lending transactions in light of the United States' reactivation of sanctions against Iran, and EU and UK countermeasures against those sanctions pursuant to the EU Blocking Regulation, for example.
To date, the LMA has not incorporated any specific provisions relating to sanctions compliance into its English-law forms of facility agreement, although its templates for developing markets transactions (the Developing Markets Agreements) contain skeleton definitions as a starting point for the insertion of appropriate commercial terms. All of the LMA's templates contain footnotes to the representations and undertakings clauses to remind users to consider whether express contractual protection is required. These footnotes also highlight that if representations and undertakings on this topic are agreed, the parties should consider whether amendments to those provisions should be the subject of unanimous lender consent (rather than majority lender consent), reflecting the importance that individual lenders attach to such provisions. For similar reasons, in syndicated transactions, some lenders seek to provide that a breach of the agreed sanctions provisions should enable individual lenders to determine whether they wish to be prepaid and have their commitments cancelled (instead of, or even in addition to, triggering an event of default that requires a majority lender decision to enforce the debt and exit the deal).
Representations relating to anti-corruption laws feature in some of the English-law LMA templates, for example, the Leveraged Finance Documentation and the Developing Markets Agreements. They are not included in the Investment Grade Agreements.
ii Transition from LIBOR
Market participants have been urged by regulators to proceed on the basis that LIBOR will cease to be available at the end of 2021, when the Financial Conduct Authority (FCA) will cease to support its production. The bulk of the UK loan market (certainly the syndicated loan market) is anticipated to transition to RFRs, although alternatives (for example, central bank base rates) are being considered in certain cases. There is no guarantee that forward-looking term rates (derived from SONIA or other RFRs) will be available before LIBOR is discontinued; the message from regulators is that market participants should work with the RFRs available now. The industry standard (at least for the London loan market) is anticipated to be RFRs compounded in arrears.
In February 2020, the LMA published two Exposure Draft single currency facility agreements referencing SONIA and SOFR, respectively, to act as a focal point for the development of the RFR-linked loan market. These Exposure Drafts are being used as the basis of, or at least a reference point for, London-originated RFR-linked deals, both bilateral and syndicated, although the number of completed transactions so far remains limited. The Exposure Drafts reference SONIA/SOFR compounded in arrears. This reflects as a single percentage rate per annum the cumulative effect of the application of a series of individual daily readings of the relevant RFR to any notional sum over a given period.
The Exposure Drafts acknowledge that there are a number of issues relating to the use of RFRs in loans that the market still needs to resolve. Many of these relate to the calculation methodology for the compounded RFR. As a result, the documents contain a number of options and placeholders. Resolution of the key outstanding points regarding rate calculations will enable market infrastructure, including the LMA documentation, to be finalised, to facilitate the widespread adoption of RFRs. This is expected over the course of this year, given the UK regulators' target of Q1 2021 for the cessation of new sterling LIBOR business.
Most LIBOR-referencing documentation will need to be amended to accommodate compounded RFRs (or an appropriate alternative). Current fallbacks (Reference Bank Rates or lenders' cost of funds) are not designed to cater for a situation where a rate is discontinued or materially altered. Since 2018, LMA provisions that permit changes to a syndicated loan agreement to accommodate a successor to LIBOR with majority lender consent (rather than the unanimous lender consent normally required for changes to interest rates) have been widely adopted. This potentially provides a smoother path to the completion of amendments to syndicated facilities, but does not dispense with the need for amendments altogether.
The LMA has published an Exposure Draft Reference Rate Selection Agreement, to help parties manage the amendment of syndicated loans. The Reference Rate Selection Agreement envisages a two-stage process whereby the commercial terms of the transition to an RFR rate are agreed using a 'tick-box' checklist that also authorises the agent and the borrower to determine the necessary changes to implement those terms in a full agreement. The agent and borrower then negotiate a full-form agreement (most likely using the appropriate form of LMA RFR agreement, as discussed above), converting the loan into an RFR-linked facility.Reaction to this agreement is as yet unclear. In an attempt to shrink the volume of legacy LIBOR transactions, the loans working parties in the UK (and in the US) have also been working to develop 'hardwired' fallback language that, if adopted, will allow facilities to fall back to an RFR-linked rate, without further amendment. Publication of LMA-endorsed hardwired fallback language will be a step forward, but will obviously only facilitate the transition of new LIBOR transactions or those which are amended specifically to include hardwired fallbacks.
In summary, although a number of difficult issues remain to be resolved, the loan market is moving towards a conclusion on how to work with RFRs.
iii IFRS 16 (lease accounting)
IFRS 16 was a major accounting change, which has had (and will continued to have) an impact on financial definitions and ratios used in loan and other finance documentation. Adoption is mandatory and has been since 1 January 2019.
In summary, leases could be accounted for in different ways under historical rules (IAS 17). In the lessee's accounts, finance leases were essentially treated as borrowings. The leased asset appeared on the asset side of the balance sheet and a discounted amount in respect of the obligation to pay rent appeared as a liability, as if the lessee had bought the asset and incurred debt to pay for it. Assets leased under an operating lease, in contrast, did not appear on the balance sheet.
IFRS 16 did not substantially change the IAS 17 lessor accounting regime, but was a major alteration to the previous approach to lessee accounting. Broadly, under IFRS 16, all leases – including leases that were previously classified as operating leases – are accounted for on-balance sheet.
This change had the potential to affect loan documentation in a number of ways: the balance sheet recognition of operating lease commitments affects loan terms that reference the lessee group's total assets; for example, asset-based financial ratios and guarantor coverage tests. EBITDA calculations are affected owing to the additional charges to interest and depreciation on leases previously classified as operating leases. Particular attention has focused on provisions that purport to measure indebtedness. Historic loan market practice was to treat only finance lease obligations as borrowings, in line with the IAS 17 accounting treatment.
The potential for uncertainty means that for some time prior to the introduction of IFRS 16, borrowers with loan facilities extending beyond its implementation date chose to provide expressly that any provision that incorporates the concept of a finance lease shall be interpreted as that term would have been interpreted on the date the facility was entered into. This has the effect of preserving the exclusion of pre-IFRS 16 operating leases from measures of indebtedness by freezing GAAP for lease purposes at a date prior to IFRS 16 coming into force.
The widespread inclusion of this wording means that since IFRS 16 has been implemented, affected borrowers have had to prepare accounts that distinguish between finance and operating leases in order to illustrate to lenders that any limits on lease liabilities in their loan documentation have been complied with. A number of companies are still relying on this approach notwithtstanding that most have produced their first sets of IFRS 16 compliant accounts.
In some cases. specific amendments have been made to loan documentation to accommodate the effects of IFRS 16. However, this remains a developing area and the market has not yet indicated a clear preference (for example, as to whether affected covenants targets should be revised or whether the effects of IFRS 16 should be excluded from the calculations and if so, in which instances). Amendments tend to be designed on a case-by-case basis depending on existing loan terms and the precise impact of IFRS 16 on the borrower's financial statements and metrics, which in turn depend on the size and characteristics of its lease portfolio.
iv Brexit – documentation issues
The legal and regulatory changes that could flow from the United Kingdom's departure from the European Union (as well as the potential commercial implications of Brexit) have been analysed in some detail. These issues include, for example, the impact of Brexit on dispute resolution options, the use of references to the European Union and to EU legislation in lending documentation and the tax implications of leaving the European Union for payments under loan documentation.
In general, none of these identified risks have, to date, prompted changes to documentation terms that are being adopted on a market-wide basis, save for references to the European Union, where the parties may specify whether that term is intended to include the United Kingdom.
In relation to a number of these points, this inaction is because closer analysis has led to the conclusion that Brexit is unlikely to present an issue, at least from a UK perspective. For example, the application of the UK withholding tax regime as it affects payments under a loan agreement (discussed further in Section III) is not predicated on EU membership.
In other cases, there is consensus as to the nature of the risk, but whether the risk needs to be addressed contractually depends on the United Kingdom's exit arrangements. For example, there is some incentive for the remaining EU Member States to agree some form of reciprocal arrangement as part of the United Kingdom's exit negotiations to ensure their own judgments remain enforceable in the same circumstances as currently in the United Kingdom (as well as a number of legal options that the United Kingdom is preparing to take itself if no withdrawal agreement is agreed). Further, even in the absence of a negotiated solution, English judgments will remain enforceable under the local laws of most of the remaining EU Member States. Accordingly, in most instances the general conclusion is that current market practice should be maintained.
This is reflected in the LMA's response to adjusting documentation generally. Although it has published some helpful guidance material and some slot-in 'designated entity' language (see below), it has not yet recommended any changes to its template documentation. As a result, the need for and extent of any Brexit-related adjustments is likely to require attention in most loan transactions until there is greater certainty with regard to the shape of the United Kingdom's withdrawal from, and future relationship with, the European Union (even if the conclusion, as in most cases currently, continues to be that no action is required).
v Brexit – loss of passporting rights and 'designated entities'
Commercial lending is not a regulated activity in the United Kingdom; however, that is not the case in all EU countries. At the end of the transition period on 31 December the 'passporting' rights of UK lenders to provide facilities under the EU Capital Requirements regime will cease. If those rights come to an end (and local regulation in the relevant country requires the lender to be locally authorised to continue to participate in the relevant facility), a UK lender that holds its commitment or participation, or both, through its UK entity and lends to borrowers in relevant EU countries in reliance on its passporting rights may need to transfer its commitments to an appropriately authorised local entity or exit the deal. It is clear that EU passporting rights will not continue for UK firms after the end of 2020. UK firms' authority to conduct regulated business in the EU is anticipated to be based on the European Union's 'equivalence' regime for third countries.
The impending loss of passporting rights is a risk the financial sector has been anticipating and taking steps to address for some time. Most firms will have re-organised their assets to manage the issue. However, in any event, LMA terms provide lenders with a certain amount of flexibility to manage their participations in syndicated loans: transfers and assignments to affiliates do not require borrower consent, and lenders are entitled to be prepaid and their commitments cancelled if it becomes unlawful for them to continue to participate in the facility. In April 2017, the LMA also published a slot-in mechanism that permits lenders to designate locally authorised affiliates to participate in particular loans under a syndicated facility. This 'designated entity' language enables lenders to have appropriately authorised local affiliates ready to step in to take on particular loans, without the need (subject to applicable regulatory requirements) to pre-allocate capital in the relevant countries or undertake a full transfer process.
vi Sustainable finance
Throughout 2019, sustainable impact investing became an important driver for many financial institutions, fuelling an increase in ESG-linked lending. Sustainable or ESG loans look to align terms to the borrower's performance against an agreed set of ESG-related performance targets. For example, the margin on an ESG facility may adjust depending on whether those targets are met (upwards or downwards). An independent opinion provider is typically engaged by the borrower to verify whether those targets have been satisfied.
This is to be contrasted with 'green' lending, which focuses on the use of proceeds, with a requirement that they are used to invest in 'green' projects. Verification is also required for green loans, to assess the merits of the particular project for which the loan is intended. To aid standardisation within the market, the LMA, APLMA and LSTA maintain a Green Loan Principles framework, which provide guidance on what will constitute a 'green' investment.
While there is widespread support for green and sustainable financial products, there remains a lack of clear regulatory or legislative guidance, although this is under active consideration. The UK government's plans for a green economy are set out in its Green Finance Strategy (published in July 2019), supported by the FCA, the Prudential Regulation Authority, the Financial Reporting Council and the Pensions Regulator. A further report is expected in 2020, which may shed light on future legislative steps. The FCA has also published (in 2018) a consultation looking at potential steps around developing common standards and metrics, with a further consultation expected in 2020. In addition, traditional rating agencies have begun to include ESG metrics into their rating profiles; for example, Fitch Ratings launched an 'ESG Relevant Score' that discloses how ESG factors directly affect a company's credit rating. At a European level, the European Commission published (in April 2020) a consultation document outlining its proposals to adopt a renewed sustainable finance strategy. The consultation builds on the Commission's action plan on financing sustainable growth, which was published in March 2018. The renewed strategy aims to provide a roadmap of actions to increase private investment in sustainable projects, support the implementation of its 'European Green Deal' (which was published in December 2019 with the aim of increasing sustainability of the EU's economy to become the world's first climate neutral continent by 2050) and to manage and integrate climate and environmental risks into the financial system.
While the covid-19 pandemic may slow the pace of progress to an extent, sustainable finance is expected to develop further in the United Kingdom (and beyond) during 2020.
III TAX CONSIDERATIONS
i UK withholding tax
Payments of interest by a UK borrower or UK branch of a foreign borrower, or that otherwise have a UK source and that are made on a loan that is capable of being outstanding for more than one year, are subject to UK withholding tax, currently at a rate of 20 per cent, unless an exemption applies. The UK tax regime provides for lenders to receive interest payments free of UK withholding tax if they are UK banks or UK branches of overseas banks that bring that interest into account for UK corporation tax purposes, UK tax-paying companies or partnerships, or UK building societies.
Lenders that are tax-resident outside the United Kingdom may also receive interest payments free of withholding tax if they qualify under a double tax treaty with the United Kingdom ('Treaty Lenders', in LMA terminology). As well as satisfying the conditions in the applicable treaty, directions must be obtained from Her Majesty's Revenue and Customs (HMRC) stating that the borrower can pay interest without deducting tax. The introduction, in September 2010, of HMRC's Double Taxation Treaty Passport Scheme (DTTPS) has, where applicable, improved the time frames within which such directions can be obtained, but there remains a greater risk of withholding tax arising in the case of Treaty Lenders than in the case of UK lenders (unless the borrower is a strong credit and has been able to limit its gross-up obligation such that it does not apply if clearance is not obtained).
The scope of the DTTPS has since been extended such that for loans entered into on or after 6 April 2017 the parties no longer need to be corporates. Assuming the relevant conditions are satisfied, it can now be used if the UK borrower is an individual, a partnership or a charity or if a Treaty Lender is a sovereign wealth fund, pension fund, partnership or other tax-transparent entity, provided in the last case that the beneficial owners of the interest are entitled to the same treaty benefits under the same treaty.
The treatment of UK withholding tax risk in loan documentation is well settled and reflected in the LMA's English-law templates. In summary, the borrower is obliged to gross up the amount payable to the lenders should the borrower be required to deduct tax from such payments, provided the recipient lender was a 'qualifying lender' on the date of the agreement. The effect is to limit the circumstances in which the borrower might become obliged to deduct tax and gross up any payment to a lender to a change in law that results in a 'day-1 qualifying lender' ceasing to be exempt from UK withholding tax.
ii Stamp and documentary taxes
No UK stamp or documentary taxes generally apply to loan, security or loan trading documentation where a security trustee structure is used (assuming the loan is not considered to have equity-like characteristics).
The conclusion of intergovernmental agreements (IGAs) between the United States and a number of countries, including the United Kingdom and most of Europe, has had the effect of largely eliminating the risk of FATCA withholding for financial institutions within the scope of those agreements.
In 2012, the LMA produced a series of riders for use with its facility documentation to allocate the risk of FATCA compliance and any tax deductions as agreed, which have since been updated a number of times. Rider 3, which entitles all parties to withhold as required, but imposes no gross-up or indemnity obligation on the borrower, has become the standard way of dealing with FATCA risk in loan documentation in Europe, regardless of whether the borrower group includes a US entity or has US-source income. Since 2014, the Rider 3 wording has been incorporated into the Investment Grade Agreements and certain other of the LMA's templates, together with information-sharing provisions designed to facilitate compliance with FATCA as well as other exchange of information regimes (such as the OECD's Common Reporting Standards (CRS) initiative). The contractual treatment of FATCA risk still requires discussion in transactions involving lenders in non-IGA jurisdictions, where there remains some variation in the agreed positions.
IV CREDIT SUPPORT AND SUBORDINATION
Types of security interests
Secured lending transactions typically involve a combination of security interests. Security can be taken over all asset classes and the choice of security interest depends on the nature of the asset and its importance in the context of the security package.
Under English law, there are four types of consensual security: pledge, contractual lien, mortgage and charge.
Pledges and contractual liens
A pledge is created through transfer of possession, where the pledgee has the power to sell the secured assets and to use the proceeds of sale to discharge the secured obligation. By contrast, under a contractual lien the lienee merely has a passive right of retention until the secured obligation has been performed.
The distinction between a pledge and a contractual lien is, however, of very limited practical importance in most corporate financing transactions. The reason for this is twofold and stems from a pledge and a contractual lien being possessory security interests. First, it is not possible to create a pledge or lien over future property or land, or over intangible assets that do not fall within a very limited category of documentary intangibles (such as bearer bonds). Second, although many companies are willing to provide security as part of the price of obtaining finance, they will often wish to retain the ability to use and deal with the secured assets, which will not be possible where the secured creditor has possession of the assets in question.
Mortgages involve the transfer of title to the asset in question to the lender by way of security, with a right to the transfer back of the mortgaged property when the secured obligation has been satisfied. A mortgage is legal or equitable depending on whether legal or equitable title is transferred.2 The form of transfer will depend on the nature of the asset in question and so, for example, mortgages over a chose in action (e.g., claims or receivables) involve the assignment of rights by way of security.
The steps required to transfer legal title to an asset and to create security by way of legal mortgage add a layer of complexity that may not be required at the outset of the transaction (see further below). In general, only freehold property, significant items of tangible movable property, aircraft and ships are the subjects of legal mortgages. In relation to other types of assets, equitable security is created and the secured creditor relies on contractual further assurance clauses and a security power of attorney to facilitate the transfer of legal title upon the security becoming enforceable.
A charge involves an agreement by the chargor that certain of its property be charged as security for an obligation. It entails no transfer of title or possession to the chargee.
In practice, there is little to distinguish a charge from an equitable mortgage, as enforcement rights such as a power to take possession, sell the secured assets and appoint a receiver are routinely included in documents creating charges.3 The more significant distinction is between fixed and floating charges.
Broadly, a fixed charge attaches to a specific asset and restricts the chargor from dealing with (e.g., disposing of) that asset. A floating charge generally attaches to a class of assets, and the chargor is permitted to deal with those assets in the ordinary course of business without the consent of the chargee pending an event that causes the charge to 'crystallise'. A typical floating charge will comprise the entirety of the borrower's assets, whether existing or future, and whether tangible or intangible.
The main consequence of the characterisation of a charge relates to the ranking of payments on insolvency. For example, expenses of both liquidations and administrations are paid out of floating charge assets. These costs and expenses can be considerable, and may well exhaust the floating charge assets. A floating charge also ranks behind certain claims of certain preferential creditors (broadly, certain rights of employees) and, in respect of charges created on or after 15 September 2003, the 'prescribed part', a ring-fenced fund, is also paid out of floating charge assets to unsecured creditors in priority to the floating chargee. Unlike expenses, the priority of employees dismissed promptly following the commencement of insolvency proceedings and the amount of the ring-fenced fund are, generally, reasonably finite (the latter being currently capped at £600,000) and can be roughly calculated in advance by secured lenders.
The other key difference between fixed and floating charges is that the holder of a floating charge that constitutes a 'qualifying floating charge' (broadly, a floating charge relating to the whole or substantially the whole of a company's property) enjoys very privileged appointment rights in an administration. It may appoint an administrator either in court or out-of-court at any time when the charge is enforceable, and is allowed to substitute its own preferred candidate in the place of an administrator proposed to be appointed by any other person.
These consequences have acted as a strong incentive to lenders to draft charge documents, known as 'debentures', which purportedly create fixed security over as many of the chargor's assets as possible, combined with a sweeper floating charge over all of the assets of the chargor. However, when characterising a charge as fixed or floating, the courts will have regard to the commercial substance of the relationship between the parties. The label attached by the parties themselves will be largely irrelevant and, if it is inconsistent with the rights and obligations that the parties have in fact granted one another, the security will be recharacterised.
Common methods of taking security
The typical method of taking security over specific assets and any perfection steps4 depend on the nature of the asset. For example:
- Real estate: title is transferred to the mortgagee in writing alongside the title deeds if a legal mortgage is to be created. An equitable mortgagee will also generally request delivery of the title deeds.
- Registered shares: a legal mortgagee of shares must be registered as the legal owner, which may have adverse tax and accounting consequences for the lenders. Security is, therefore, often taken by way of equitable mortgage or fixed charge. To facilitate enforcement, the certificates for the shares are usually deposited with the chargee together with signed but undated forms of transfer. The articles of association are amended if necessary to ensure there are no restrictions on transfer in the event of enforcement.
- Intellectual property rights: a legal mortgage or assignment of rights to intellectual property by way of security necessitates an exclusive licence back to the assignor to enable it to continue to use the rights, including a provision for reassignment on discharge of the security. It is, therefore, more common for such rights to be the subject of a charge.
The appropriate method of taking security over claims and receivables such as book debts, bank accounts and cash varies. The key question is whether it is practical to create fixed security. If the intention is to create a fixed charge, the security document will need to contain adequate restrictions on the chargor's ability to deal with both the asset and its proceeds, and those restrictions must be complied with in practice. This generally means that the proceeds of charged receivables must be paid into a blocked account. This may be achievable in relation to certain specific sums (e.g., the proceeds of a disposal that are to be used to prepay the loans). However, companies will need access to at least some of their bank accounts so fixed security will not be achievable in all cases.
Formalities and registration
Formal requirements for English-law security are minimal. For a variety of reasons, however, it is generally accepted that security documents should be executed as deeds.
Subject to limited exceptions,5 security interests created by English companies must be registered at Companies House within 21 days of creation, whether over assets in the United Kingdom or abroad and whether created under an English-law security document. If this is not done, the security will be void as against a liquidator, administrator or creditor of the company, and the secured liabilities will become immediately repayable.
In addition, certain types of assets (e.g., real property, ships, aircraft and certain intellectual property rights) may also be registered, generally for priority purposes, on specialist registers.
Registrations at Companies House and at the land and other specialist asset registries attract nominal fees.
There are no specific categories of asset over which security cannot be granted or over which it is too difficult to create security under English law. However:
- third-party consent may be required to create some types of security over certain leased items (including leasehold real estate), and other contractual rights and receivables, which may be challenging to obtain;
- the limits of the distinction between fixed and floating charges can be uncertain, in particular in its application to cash and receivables; and
- it is not possible to create a legal mortgage of future assets. However, it is possible to create equitable security (equitable mortgage or charge) over future assets. The terms of the security document may require the chargor to take steps to convert the equitable security into a legal mortgage upon acquisition of the relevant asset.
The grant of security is also subject to the legal limitations outlined in Section V.
ii Guarantees and other forms of credit support
Guarantees must be documented in writing and are usually executed as deeds to prevent the guarantor from raising any questions about the existence or adequacy of consideration. Guarantees are the most common form of credit support in both secured and unsecured English-law financings.
The legal limitations outlined in Section V apply equally to the provision of guarantees.
iii Priorities and subordination
The general rule under English law is that, as between competing security interests, the first in time normally prevails. However, this is subject in some cases to registration and other exceptions. The rules of priority are complex but might, very broadly, be summarised as follows:
- Where registration at a specialist registry is required, the priority of competing interests is generally determined by the order of registration.
- Registration at Companies House does not directly affect priority. Such registration may, however, constitute notice to third parties of the existence of the charge, which may affect the ranking of subsequent security.
- The priority of successive assignments of a debt or other chose in action is governed by a common law rule under which an assignee who takes an assignment without notice of an earlier assignment and is the first to give notice of assignment to the debtor obtains priority over the earlier assignee.
- A legal interest acquired for value and without notice (actual or constructive) of a prior equitable interest will normally rank ahead of the prior equitable interest.
- Special rules apply to floating charges. The grant of a subsequent fixed charge or mortgage takes priority over a floating charge, unless at the time the subsequent security is created the floating charge places restrictions on the creation of further encumbrances (in the form of a negative pledge, which is customarily included in English-law financing documents) and the subsequent holder has notice of the restriction. For this reason, a note of the negative pledge is included in the particulars of the charge that are registered at Companies House, the intention being that anyone who searches the register will thereby acquire actual notice of the restriction. Registration at Companies House may also constitute constructive notice.
Ranking and subordination
Subordination in banking transactions is typically effected by the use of structural subordination (where ranking is determined by which company in the group is a debtor (either as a borrower or guarantor) to the junior and senior creditors) and contractual subordination (where creditors contractually agree to the ranking as among themselves). Contractual subordination is generally achieved through the use of an intercreditor or subordination agreement.
Contractual subordination is often coupled with a turnover trust as a fallback to maximise the recoveries of the senior creditors in an insolvency of the debtor. Under a basic trust subordination arrangement, the junior creditor agrees that any money it receives from the debtor in insolvency (e.g., in the event of mandatory insolvency set-off or other mandatory distribution contrary to the intercreditor agreement) will be held on trust for the senior creditors to the extent of the senior debt. If effective, this has the advantage of giving the senior creditors a proprietary claim against the junior creditor, and means the senior creditors will not be exposed to credit risk on the junior creditor.
It is generally agreed that, as a matter of English law, contractual subordination should be enforceable as between the contracting parties.
In jurisdictions where trusts are not recognised, there is a risk that a junior creditor trustee will be treated as sole owner of the turnover property. There is also a limited risk that, in the event of an insolvency, the turnover trust provisions may be recharacterised as a security interest, which would be void for lack of registration. There is case law support for the proposition that a turnover trust provision will not be recharacterised as a charge if it is limited to the amounts required to pay the senior creditor in full and it is, therefore, generally thought that this risk can be mitigated with careful drafting.
V LEGAL RESERVATIONS AND OPINIONS PRACTICE
i Limitations on validity and enforceability of guarantees and security
The key issues when considering the validity and enforceability of guarantees and security are capacity and corporate benefit, financial assistance rules and the clawback risks that may arise in insolvency. These issues, which are discussed below, are frequently of theoretical concern only and are usually able to be dealt with as a practical matter in a typical transaction.
ii Capacity and corporate benefit
To grant valid guarantees and security, the grantor must have the requisite capacity and there must be adequate corporate benefit.
The corporate benefit analysis must be done on a company-by-company basis and any benefit received by other members of the group may not be relevant unless, for example, there is an element of reliance and financial interdependence between the companies. As well as carefully minuting the perceived benefits, if there is any doubt the security provider or guarantor may seek the approval of its shareholders. For a company that is solvent at the time of granting the guarantee or security, a unanimous shareholder resolution will act to ratify a transaction that might otherwise fall outside the scope of the directors' powers, and is usually required by secured creditors as a condition precedent to funding in relation to upstream or cross-stream guarantees and security.
iii Financial assistance
The Companies Act 2006 restricts the provision of financial assistance, including security and guarantees, as follows: if the target is an English public company, neither the target nor any of its subsidiaries (public or private) may (1) provide financial assistance for the purpose of the acquisition of the shares of the target or of reducing or discharging a liability incurred therefor; or (2) if the target is a private holding company, no English public subsidiaries of the target may provide financial assistance for such purpose.
A number of exceptions apply but they are often not relevant in the context of secured lending. In practice, if security and guarantees are required from the target group following the acquisition, the relevant public companies in the target group will be re-registered as private companies before the financial assistance is given.
iv Clawback risks
Under English insolvency laws, the court has wide powers to set aside certain transactions.
Guarantees and security provided by an English company or any foreign company subject to English insolvency proceedings may be at risk of being challenged by the insolvency officer if given within a certain period prior to commencement of liquidation or administration, and if certain other conditions are satisfied.
In the case of a guarantee, the most likely ground for challenge is that it represents a transaction at an undervalue6 or amounts to a preference.7 In the case of security, the most likely grounds for challenge are that the transaction constitutes either a preference or a voidable floating charge.8
The vulnerability periods differ depending on the ground for challenge and are: six months for preferences (two years if the counterparty is a connected person); two years for transactions at an undervalue; and one year for a voidable floating charge claim (two years if the counterparty is a connected person).
For a transaction to be vulnerable as a preference, not only must it have been entered into within the specified period but the company must have been influenced by a desire to produce a preferential effect and must have been insolvent (as defined by statute) at the time of the transaction or become so as a result of entering into it.
vi Transactions at an undervalue
For a transaction to be vulnerable under Section 238 of the IA, it must have been a transaction at an undervalue within the meaning of Section 238(4) of the IA and entered into within the vulnerable period. Further, the company must have been insolvent (as defined by statute) at the time of the transaction or have become so as a result of entering into it. In practice, this ground for challenge is of relatively limited concern in most secured loan transactions because of the good-faith defence that is available. This defence applies if it can be shown that the transaction was entered into by the company in good faith and for the purposes of carrying on its business, and at the time it did so there were reasonable grounds for believing that the transaction would benefit the company.
vii Avoidance of certain floating charges
Under Section 245 of the IA, a floating charge may be set aside except to the extent of the value given to the company at the same time as or after the creation of the charge. If the parties are not connected, it is a defence if the company was solvent (within the statutory definition) when the charge was created and did not become insolvent as a result of the transaction.
Transactions, including security arrangements, may be vulnerable to challenge on other grounds, including that they offend the common law anti-deprivation principle, which invalidates, as a matter of public policy, any agreement providing for assets belonging to a company to be removed from its estate on insolvency.
viii Legal opinions practice
The practice of delivering legal opinions and the content of those opinions is well established in the English-law loan market. As a condition precedent to funding, lenders require opinions on the capacity and authority of each borrower and guarantor, and on the enforceability of the facility documentation, including any security documents.
The general expectation in loan transactions is that counsel to the creditors will deliver any legal opinions. This is usually the case in domestic transactions. In some circumstances, however, the borrower's counsel will be called on to provide an opinion.
Syndicated loan opinions are typically addressed to the agent and the lenders forming part of the primary syndicate. Sometimes, where primary syndication takes place after the signing date (e.g., in the case of an underwritten acquisition facility), lenders who join the syndicate within a short period of the date of the agreement (e.g., three months) will be permitted to rely on the opinion.
Market practice has for some time been to permit the opinion to be disclosed to, but not relied on by, those who buy participations in the loan (or exposure to participations in the loan) on the secondary market.
No further reliance on or disclosure of the opinion is generally permitted without the opinion-giver's consent.
VI LOAN TRADING
English-law syndicated loan participations are regularly traded, most commonly by way of transfer by novation, assignment or sub-participation.
Novation is the simplest and most common method and involves an outright sale of the participation. All of the seller's rights and obligations in relation to the loan are cancelled and discharged, and are assumed by the buyer.
If a facility is secured in favour of the lender directly, the security will be released on the novation of the lender's participation to a new lender. Security for syndicated facilities is, however, usually created in favour of a security trustee, who is appointed as trustee for the lenders from time to time. Use of a security trustee structure permits lenders to trade their participations without disturbing the effectiveness and priority of the security.
An assignment of rights to drawn loan participations (coupled with an assumption of equivalent obligations) is sometimes used as a hybrid method if transfer by novation would disturb security or guarantee arrangements, for example, in relation to certain foreign law governed arrangements.
The LMA's facility agreement templates contain a framework to permit trading by novation or assignment.
The LMA templates do not restrict sub-participation or other trading methods such as trust or derivatives arrangements that do not involve a change to the lender of record under the facility agreement. Some borrowers negotiate those restrictions, but in most cases these trades can be effected without borrower consent. These methods of risk transfer should not disturb any security or guarantees provided in favour of the lender of record (or a security trustee acting on its behalf).
VII OUTLOOK AND CONCLUSIONS
The ongoing impact of the covid-19 pandemic means that, at best, the outlook for 2020 might be described as uncertain. The ability of corporates to meet liquidity needs and comply with covenants will be a continuing theme for the rest of this year and potentially beyond, together with planning how to manage the post-covid working and trading environment as lockdown restrictions are eased. A particular concern will be how best to meet refinancing needs as government support evolves and is, eventually, withdrawn. Corporates are likely to look at a range of options including loans, private placement products and the capital markets.
In terms of legal and regulatory risks, the transition from LIBOR to risk-free rates will be the main area of focus for most market participants. It involves considerable changes to lending operations, pricing models and documentation and will be a topic that all lenders and those borrowers who have not done so already, will need to get to grips with as the year progresses.
1 Azadeh Nassiri is a partner, Kathrine Meloni is a special adviser and Rhiannon Singleton is a professional support lawyer at Slaughter and May.
2 An equitable mortgage arises either where the necessary requirements for a legal mortgage have not been met or where there is an agreement to create a legal mortgage. In practice, the distinction between legal and equitable mortgages, which is of relevance when determining priority rights, is reasonably straightforward to establish.
3 There are very few situations in practice in which it would be necessary to distinguish between the two. The reason for this is that the priority position of a fixed charge is virtually identical to that of an equitable mortgage, and the registration requirements are the same.
4 Under English law, perfection steps (other than registration at Companies House) generally relate to priority, and failure to take such steps does not mean a security interest will be invalid.
5 The main exemption is for interests in shares and financial instruments, cash and credit claims that constitute 'security financial collateral arrangements' under the Financial Collateral Arrangements (No. 2) Regulations 2003. However, this exemption is not generally relied on in practice because of uncertainty as to how to interpret the requirement that the security asset must be within the control of the collateral-taker.
6 Section 238 Insolvency Act 1986 (IA).
7 Section 239 IA.
8 Section 245 IA.