The Lending and Secured Finance Review: United Kingdom - England & Wales
i Market conditions
Corporate lending activity in the first half of 2020 was dominated by the covid-19 pandemic, with amendments and waivers, extension requests and short-term liquidity facilities being sought by many borrowers to deal with the immediate effects of the global lockdowns. The UK government put in place support initiatives, including the Coronavirus Corporate Financing Facility (CCFF) and the Coronavirus Large Business Interruption Loan Scheme (CLBILS). The government also made temporary and permanent changes to the UK insolvency regime in response to the pandemic in the form of the Corporate Insolvency and Governance Act 2020 (discussed below in Section II.iii). Further lockdowns towards the end of 2020 and beginning of 2021 prompted predictions of a further wave of covenant breaches and amendment transactions. Levels of activity turned out to be generally more muted than expected. Corporate lending volumes increased in the second half of the year, and have continued to rise in 2021 so far. Many borrowers are still favouring amend and extend transactions over full refinancings, with tenors of three to five years typically on offer, depending on the sector and credit strength of the borrower.
Event-driven financings resumed in the second half of 2020 for both investment-grade and leveraged borrowers, across all sectors and deal sizes. Purchasers either restarted transactions that had paused as a result of the pandemic, or took advantage of the opportunities for merger and consolidation that emerged as a result. These conditions are expected to continue during the remainder of 2021, as covid-19 restrictions are gradually eased and global economies look to recovery.
Key themes during 2020, which are expected to remain dominant during 2021, were the transition from LIBOR to risk-free rates and the increasing prominence of sustainability-linked finance. There has been a sharp rise in both risk-free rate (RFR) linked lending and LIBOR transition transactions since the beginning of the year, which is set to continue as the deadlines from which LIBOR will cease to be available become imminent (see further Section II.iii). Environmental, social and governance (ESG) features proliferated in working capital facilities during 2020. More recently, ESG features have started to emerge in event-driven financings (including leveraged loans). The growth of the ESG market has been supported by increasing focus from regulators, trade associations and market participants (see further Section II.iii).
ii Market participants and documentary developments
A mixture of participants remain active in the English-law loan market. Traditional banks continue to 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, alternative credit providers such as direct lending funds and institutional investors (collateralised loan obligations (CLOs), finance and insurance companies, hedge, high-yield and distressed funds, and loan mutual funds) are more prominent.
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 finance, developing markets lending and pre-export finance. The LMA's documentation library is currently in the process of being updated to reflect the transition of the syndicated loan market from LIBOR to RFRs.
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 both green and social loans and 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.
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.
i Transition from LIBOR
The Financial Conduct Authority (FCA) confirmed on 5 March 2021 that most LIBOR rates will cease publication in their current form on 31 December 2021. Certain US dollar LIBOR tenors will continue to be published until the end of June 2023 for the purpose of supporting the run-off of legacy transactions. The FCA's announcement, combined with targets set by working groups and regulators for the cessation of new LIBOR business, means that the bulk of new lending transactions must now reference RFRs rather than LIBOR, or at least contain provisions that facilitate the transition to RFRs at an appropriate future date. Work is also underway to amend the body of existing loans referencing LIBOR that extend beyond the cessation deadlines to accommodate RFRs.
In the first months of 2021, the impending cessation of LIBOR was addressed mostly by the incorporation of 'rate switch' provisions into facility documentation. A rate switch loan references LIBOR initially, but provides for an automatic switch to the appropriate RFR at the earlier of an agreed date, or the date upon which the LIBOR becomes unavailable for use. As the deadline for the cessation of new sterling LIBOR business has passed, the rate switch structure is no longer available for sterling loans, which must instead reference SONIA from the outset.
In September 2020, the Sterling Working Group on UK Risk Free Rates recommended conventions for referencing SONIA in loans including the use of SONIA compounded in arrears, with a five banking day lookback period (the Sterling Loan Conventions). The five banking day lookback involves compounding the RFR over an observation period, which is equivalent in length, but starts and ends five banking days before the relevant interest period. This convention enables interest to be determined in advance of the end of the interest period, to facilitate the timely mobilisation of payments. The Sterling Loan Conventions suggest that the compounding methodology is adopted without the observation shift convention, although recognise that the use of an observation shift may be a robust option. The observation shift denotes the approach to weighting the RFR for days on which it is not published (i.e., weekends and bank holidays). If the observation shift method of calculation is adopted, the RFRs published during the period are weighted according to the number of calendar days in the observation period. If there is no observation shift, the RFRs published during the period are weighted according to the number of calendar days in the interest period.
The LMA's new recommended forms of facility agreement referencing RFRs reflect the Sterling Loan Conventions (and for simplicity, apply them to all RFR currencies). The interest and related provisions in the LMA's RFR facilities are being widely adopted, in most cases with minimal adjustment, and, mostly, compounded RFRs are being calculated without observation shift. The key discussion points in current transactions include the structure; whether the loans should (or must) reference RFRs from the outset; and whether to adopt a rate switch mechanism, or even, in some cases, an agreement to renegotiate the benchmark provisions at a later date. Much depends on the currencies required. Other discussion points include pricing and related issues, in particular how to calculate the spread between LIBOR and the compounded in arrears RFR and whether that should form a separate component of the pricing, as well as the operation of zero floor provisions and market disruption provisions in the context of RFRs.
ii Sustainable finance
Throughout 2020, 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' or 'social' lending, which focuses on the use of proceeds, with a requirement that they are used to invest in green or social projects within pre-agreed parameters. Verification is also required for green and social loans, to assess the merits of the particular project for which the funding is intended.
To assist the development and standardisation of the sustainable lending market, the LMA (in conjunction with the Asia Pacific Loan Market Association (APLMA) and the Loans Settlement and Trading Association (LSTA)) has produced the following documents:
- the Green Loan Principles (GLP), published in 2018, comprising voluntary recommended guidelines that seek to promote consistency and integrity in the development of the green loan market by clarifying the criteria for which a loan may be categorised as 'green'. To aid consistency with the green bond market, the GLP build on and refer to the Green Bond Principles published by the International Capital Markets Association (ICMA);
- the Sustainability Linked Loan Principles (SLLP), published in 2019, which provide a framework for lending to incentivise the borrower's achievement of predetermined sustainability performance targets (SPTs). Similarly to the GLPs, the SLLPs are intended to promote consistency within the sustainability-linked market, covering topics such as setting the SPTs as well as reporting and review of the borrower's performance against those SPTs; and
- most recently, in 2021, the Social Loan Principles (the SLP) were published, which provide a framework for market standards and guidance for social loans, where the proceeds of the loan are used for predetermined social projects, building on the Social Bond Principles published by the ICMA. The SLPs cover topics such as the use of proceeds and process of evaluation and selection of social projects, together with guidance on the monitoring and reporting on the project and proceeds of the loan.
Alongside each set of principles, the LMA has also published guidance notes to aid interpretation of the principles in the market.
Sustainability-linked financing in particular saw a significant increase in lending in the UK throughout 2020, both in the context of investment-grade corporate working capital facilities and, increasingly, in the leveraged loan market (including some event-driven financings). As mentioned above, sustainability-linked loans contain ESG-related SPTs, typically referred to as key performance indicators (KPIs), selected by the borrower. Depending on whether or not the KPI targets are achieved by the borrower, the margin will adjust upwards or downwards. In addition, the lenders will usually expect ongoing information on the borrower's performance in relation to the KPIs during the life of the loan. This reporting can be provided either by the borrower or by an external opinion provider appointed by the borrower. To smooth the process, one or more of the lenders may act as a sustainability coordinator to assist with negotiating the KPIs and liaising with the borrower on behalf of the lenders on ESG-related matters. The sustainability coordinator will not, however, assume any fiduciary duties to the rest of the syndicate. Negotiations generally focus on the setting of the KPIs, together with the nature and extent of the reporting and auditing of the borrower's performance.
iii The Corporate Insolvency and Governance Act 2020
In June 2020, the Corporate Insolvency and Governance Act 2020 (CIGA) was enacted. The CIGA introduced (among other things) permanent reforms to the insolvency and restructuring regime, including: (1) a new moratorium procedure; (2) the introduction of a new restructuring plan; and (3) a ban on the operation of 'ipso facto' clauses.
New restructuring plan
The restructuring plan introduced by the CIGA is similar in some respects to the existing English law scheme of arrangement: creditors and members are divided into different court-sanctioned classes and required to vote on a restructuring plan proposal, which then itself requires court sanction. However, a key feature of the new plan is that it will be possible for the court to exercise its discretion to sanction a plan even if one or more classes of creditors votes against this – thus enabling cross-class cramdown (or potentially cram up) of creditors.
New moratorium procedure
The CIGA's moratorium procedure is designed to give a company breathing space to present a rescue plan. Once a company has entered into the new moratorium, a monitor (who must be an insolvency practitioner) is appointed to oversee the moratorium. The directors remain in control of day-to-day operations, but their powers are constrained in some respects and various actions require the consent of the monitor.
The moratorium protects companies against winding-up petitions and most types of legal proceedings, provides a payment holiday in respect of certain liabilities incurred before it came into force, and limits creditors' ability to take enforcement action (including in relation to the enforcement of security). However, there are limitations on the moratorium's scope: (1) certain debts are excluded from the payment holiday and must continue to be paid (including amounts due under financial services contracts, which is defined to cover loans, derivatives, securitisations and most debt capital markets transactions); and (2) not all companies are eligible for the moratorium (for example, banks are excluded).
Restrictions on the operation of 'ipso facto' clauses
The CIGA also introduced restrictions on the operation of certain clauses triggered by a party's entry into insolvency proceedings (the 'ipso facto' clauses). The CIGA renders of no effect any provision that has the effect of terminating or allowing the supplier to terminate or do any other thing in relation to any contract for the supply of goods or services upon the entry into of certain insolvency procedures by the recipient or purchaser. The supplier is required to continue to make supplies during the relevant insolvency procedure and cannot make payment of outstanding debts a condition of continued supply. Suppliers are also prohibited from terminating contracts where the right arose before the company entered into the insolvency procedure, but was not exercised. There are broad exclusions to this restriction, most notably for a wide range of financial contracts that include lending, derivative, securitisation and most DCM arrangements (but not, significantly, unsecured or unguaranteed bonds) and for arrangements where either the supplier or the company is a 'person involved in financial services' (which is a broad exemption covering, among other things, insurers, banks, investment banks and investment firms, securitisation companies, payment institutions and recognised investment exchanges).
The CIGA also introduced temporary measures (which have most recently been extended until 30 June 2021), designed to mitigate the short term impact of the covid-19 pandemic, including:
- restrictions on the presentation of winding-up petitions; and
- amendments to the wrongful trading provisions for certain companies, providing that, while the courts can still find a director liable for wrongful trading, the court must assume when assessing any financial penalty that the director is not responsible for any worsening of the company's or its creditors' financial position that occurs in the period from 1 March 2020 to 30 September 2020, or from 26 November 2020 to 30 June 2021.
Impact on financing terms
The introduction of the CIGA led lenders to examine whether the new insolvency processes are within the scope of customary insolvency-focused representations, undertakings and events of default. The measures (both permanent and temporary) introduced by the CIGA have not resulted in any changes to the LMA's recommended forms of facilities agreement. There have been some minor adjustments to security documentation, to take account of the new moratorium procedure, and a review of intercreditor terms (in particular the ability of senior creditors to direct the voting rights of junior creditors), as a result of the new cross-class cramdown mechanism introduced by the new restructuring plan.
iv Pension Schemes Act 2021
Defined benefit (DB) pension liabilities are likely to receive renewed focus in corporate and financing transactions when provisions in the newly-passed Pension Schemes Act 2021 (PSA) take effect. The PSA was enacted after a consultation process that started in 2018, and is intended to strengthen the powers of the UK Pensions Regulator to intervene in corporate activities that threaten DB pension scheme benefits and recoveries (the 'moral hazard' regime). The consultation was prompted by recent high profile corporate restructurings and collapses where DB pension schemes were negatively affected, together with criticism of the UK Pensions Regulator: the resulting PSA is intended to boost the UK Pensions Regulator's existing powers while introducing additional criminal and financial penalties to further deter reckless or intentional behaviour that prejudices a DB pension scheme.
The majority of the new powers are likely to come into force in autumn this year.
The 'moral hazard' regime was introduced by the Pensions Act 2004, which granted powers to the Pensions Regulator to protect the position of DB pension schemes by requiring employers to provide additional support to schemes in certain circumstances. These powers allow the Pensions Regulator to issue contribution notices (CNs) and financial support directions (FSDs) to either the scheme employer or a person 'associated or connected'2 with the scheme employer. FSDs are more general in nature and permit the UK Pensions Regulator to require employers to provide additional financial support for the pension scheme's obligations where the Regulator believes it is reasonable to do so. CNs focus on specific actions (or failures to act) that have negatively affected the DB pension scheme.
To issue a CN under the Pensions Act 2004, the Pensions Regulator has to be of the (reasonable) opinion that one of two tests have been met: (1) the target of the CN must have been a party to, or 'knowingly assisted' in, a deliberate act or failure to act, the main purpose of which was to prevent recovery of a DB pension scheme debt; or (2) the target's act or failure to act has 'detrimentally affected in a material way' the likelihood of accrued DB pension scheme benefits being received. Defences are available if (in summary) the target of the CN can show that it considered the DB pension scheme and took reasonable steps to mitigate the effect of the act. A voluntary clearance procedure is also available, whereby the UK Pensions Regulator can confirm that it would not be reasonable to issue a CN or FSD.
In addition, the Pensions Act 2004 introduced a series of 'notifiable events', intended as an early warning system for the Pensions Regulator of the occurrence of events relating to either the DB pension scheme or the scheme employer, which may impact on the DB pension scheme as a creditor. Examples include a breach by the employer of financing covenants and certain changes of control, with non-compliance potentially triggering fines or being considered as a ground for issuance of a CN or both. If an event occurs, it must be notified in writing to the UK Pensions Regulator as soon as reasonably practicable.
In relation to the above, the PSA introduces the following key changes:
- new grounds for issuing CNS: Two new tests have been introduced to allow the UK Pensions Regulator to issue CNs, the 'employer insolvency' test, and the 'employer resources test'. Both these new tests look to the strength of the DB pension scheme employer (rather than the scheme itself), focusing on the effect the proposed act will have on the employer's resources or on the employer's hypothetical insolvency in the context of the potential recovery by the DB pension scheme as a creditor. These new tests expand the circumstances in which CNs can be issued and are likely to be easier for the UK Pensions Regulator to enforce;
- new criminal and civil offences: One of the more controversial elements of the PSA is the criminal offences it introduces. Two new criminal offences have been enacted to help enforce the moral hazard regime, both of which can apply to any 'person', including individuals (such as directors), regardless of whether that person has any connection to, or association with, the DB pension scheme or its employer: (1) conduct that results in avoidance of employer debt to a DB pension scheme, where the person intended that this is the outcome; and (2) conduct that detrimentally affects in a material way the likelihood of accrued DB pension scheme benefits being received where the person knew or ought to have known that this would be outcome. Defences are available, if the person had a 'reasonable excuse' for their actions: the UK Pensions Regulator is currently consulting on its policy for investigating and prosecuting the new powers, including what will constitute a 'reasonable excuse'. Conviction under these offences can result in up to seven years imprisonment or unlimited fines, or both. It is worth noting that there are no specific exceptions to these offences for lenders or financing transactions where there is a DB pension scheme within the group; and
- new notifiable events: There are expected to be further notifiable events published in secondary legislation later in 2021, requiring notice to be given of: (1) a sale of a material proportion of the assets of a scheme employer with responsibility for at 20 per cent of scheme liabilities; and (2) the granting of security on indebtedness which has priority over the DB pension scheme. New notice requirements are also to be introduced, requiring notice to be given to the UK Pensions Regulator (and pension trustees) as soon as reasonably practicable after the person giving the notice becomes aware of the notifiable event, together with details of any adverse effect on the scheme, any proposed mitigation and what communication there has been with the trustees and scheme members. This is intended to give the UK Pensions Regulator and DB pension scheme trustees greater involvement at an earlier stage. A new financial penalty for breach of these obligations of up £1million is introduced, along with expansion of the existing criminal liabilities.
Since the 2004 Act has been in force, DB scheme issues have routinely formed part of the due diligence and credit risk assessment for financing transactions, together with liaising with the scheme trustees (where appropriate) to determine the extent of any additional support required to mitigate the impact of the transaction on the scheme. While due diligence plays a key role in assessing the existence of any actual or potential DB scheme liabilities, contractual protections, by way of representations or undertakings regarding the existence of and liabilities associated with a DB scheme, together with undertakings relating to compliance with the DB scheme obligations and provision of information to the lenders are also often seen. For some transactions, receipt of a CN or FSD may trigger an event of default, or obtaining clearance from the Pensions Regulator may be a condition precedent.
The changes introduced by the PSA are likely to result in an increased focus on the above provisions and the structuring of financing arrangements. Those involved in restructuring transactions are likely to pay particularly close attention to the PSA's new provisions: early engagement with pension trustees and detailed preparation and professional advice will all be required to minimise the risk of potential liability. Further guidance and regulations are expected to be forthcoming during 2021, which will help interpret the PSA's provisions, so this is an area to watch over the course of the coming year.
v National Security and Investment Act 2021
The National Security and Investment Act 2021 (the NSIA) introduces a new regime which seeks to expand and modernise the government's powers to scrutinise and intervene in certain transactions that threaten the UK's national security. In a financing context, it is likely to be relevant where debt is required to back the acquisition of a qualifying entity or asset that falls within the scope of the legislation. This is not limited to foreign investment, entities which have activities in, or supply goods or services to the UK are potentially in-scope.
Transactions which involve an 'acquisition of control' (described further below) within certain specified sectors will require mandatory notification to the Secretary of State. There are currently 17 specified sectors the government has identified, including energy, communications, transport and defence. The Secretary of State for Business, Energy and Industrial Strategy (Secretary of State) also has the power to call in a transaction that does not fall within the mandatory regime, but that it considers poses a risk to national security. This may be exercised for asset acquisitions, which are not subject to mandatory notification, or where a transaction does not fall within the specified sectors but the acquirer or investor raises national security concerns. There is also a voluntary notification regime that would avoid the risk of the transaction being called in at a later date.
Transactions involving the specified sectors will trigger mandatory notification under the regime if the investor increases its shareholdings or voting rights in an entity over certain thresholds, the opening level being 25 per cent. However, the Secretary of State may call in a transaction where this threshold level is not met, but where the investor acquires a material influence over the company.
Under the regime, the Secretary of State will have the power to call in transactions up to five years after the transaction completes, but only for six months from the time the government becomes aware. Unusually the legislation has retrospective effect and will apply to transactions that complete between 12 November 2020 and the date of commencement of the NSIA (expected to be towards the end of 2021). Under the mandatory regime, transactions become in-scope upon commencement of the Act and can be called in at any time if not notified, the exception being for transactions completed between 12 November 2020 and commencement, where the Secretary of State has a retrospective call in power for up to five years or six months from becoming aware of the transaction.
The timing implications for transactions will need to be considered. The government has 30 working days to assess a transaction; however, this period may be extended so will need to be factored into the transaction timetable. The penalties for completing a transaction without approval include the transaction being declared legally void, up to five years and monetary fines (the higher of 5 per cent of global turnover and £10 million).
vi Brexit – documentation issues
The UK formally left the EU on 31 January 2020, and the transition period (during which time the UK was treated as an EU Member State for most purposes) ended on 31 December 2020.
The legal and regulatory changes stemming 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 the initially identified issues have prompted changes to documentation terms that are being adopted on a market-wide basis, although some minor changes are being made, for example, to references to European Union legislation to reflect its new status under English law.
The LMA has made some minor changes to its template documentation, largely focused on legislative references. These include changes to its form of 'bail-in clause', to reflect that the UK is now a third country for the purposes of the EU Bank Recovery and Resolution Directive, and to include contractual recognition of the write down and conversion powers under the UK's stand-alone bank resolution regime.
Pre-Brexit, English judgments were enforceable in EU Member States pursuant to the EU-law framework on jurisdiction, which was a reciprocal arrangement. However, post-Brexit the EU-law jurisdiction framework no longer applies in the UK (save where proceedings were instigated before the end of the transition period). As regards enforcement of English law judgments in an EU Member State, therefore, unless the jurisdiction clause is within the scope of the 2005 Hague Convention on Choice of Court Agreements, the domestic law of that EU Member State will now apply. In order for a jurisdiction clause to fall within the Hague Convention, it must be a 'two-way' exclusive jurisdiction clause (i.e., limiting both parties to the exclusive jurisdiction of the named jurisdiction).
Historically, the LMA's recommended forms of facilities agreement have included one-sided jurisdiction clauses as standard, whereby the borrower group submits to the exclusive jurisdiction of a specified country, but the lenders retain the flexibility to open proceedings in any relevant jurisdiction; these are being retained post-Brexit, but an optional alternative two-way jurisdiction clause which conforms to the Hague Convention's requirements has been included for use where appropriate.
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.
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.3 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.4 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 certain amounts owing to Her Majesty's Revenue and Customs) 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 £800,000) 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 steps5 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,6 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.
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 undervalue7 or amounts to a preference.8 In the case of security, the most likely grounds for challenge are that the transaction constitutes either a preference or a voidable floating charge.9
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.
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, subject to borrower consent unless the transfer is to another lender or an affiliate of an existing lender, or if an event of default is continuing. In addition, it is common for pre-approved lists of permitted transferees (referred to as 'white lists') to be agreed.
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).
There are currently no other issues of note.
Outlook and conclusions
2020 was dominated by the covid-19 pandemic, and its ramifications are likely to continue throughout 2021 as borrowers look to refinance facilities put in place to deal with the effects of the pandemic. If the easing of lockdown restrictions continues as planned throughout 2021, the increase in activity seen in the second half of 2020 should continue, including the continuing focus on sustainable lending. Acquisition financing is also anticipated to remain buoyant, as further merger and consolidation opportunities emerge as a result of the pandemic.
In terms of legal and regulatory issues, 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 to be addressed in almost all loan transactions in 2021.
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 The definitions of 'connected' and 'associated' are extremely broad, potentially extending much further than the corporate group.
3 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.
4 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.
5 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.
6 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.
7 Section 238 Insolvency Act 1986 (IA).
8 Section 239 IA.
9 Section 245 IA.