Loan capital

This article will consider how companies raise capital through borrowing. It will also look at the manner in which companies can provide security for any loans and the legal procedure for registering such securities and its effect. Borrowing It is common for the memorandum of association of companies to contain an express power allowing the company to borrow money, but in any event such power is implied as incidental to the conduct of the business of any trading company. Nonetheless, it should be noted that public limited companies are prohibited from using their borrowing powers until they have been issued with a trading certificate under CA 1985 s.117. It is also possible for the articles of association to attempt to limit the borrowing powers of the directors, to whom the general power to borrow is delegated. Again it should be remembered that, as a consequence of Section 35, any such purported limitation remains an internal issue and is not effective as against an outsider. Loans may be provided simply by a company's bank extending an overdraft facility. Alternatively, however, the company may use special facilities to borrow from individuals, either individually or as a group. In either case the lender is likely to require that security is given for the loan in order to allow them to recover the value of the loan from the company if it defaults on its interest payments or its final repayment. Even where the lender is given such security, it is essential to realise that borrowing, even when it is secured, does not give the lender any interest in the company but represents a claim against the company. The relationship between company and the provider of loan capital is the ordinary relationship of debtor/creditor, even where specific mechanisms exist to facilitate the borrowing of companies and to secure the interests of their creditors. Debentures In strict legal terms a debenture is a document, which acknowledges the fact that a company has borrowed money. The use of the term debenture, however, has been extended to cover the loan itself. A debenture may be issued to a single creditor or to a large number of people, in which case each of the creditors has a proportionate claim against the total debenture stock. As creditors of the company, debenture holders receive interest on their loans and are entitled to receive payment whether the company is profitable or not. As regards repayment, debts rank in order of creation, so earlier debentures have to be paid before those created later. Where debentures are issued as part of a series, it is usual for a pari passu clause to be included in the document creating the debt, with the effect that all of the loans made within the series rank equally with regard to repayment. Debentures which have no security are referred to as unsecured loan stock. It is usual, however, for debentures to provide security for the amount loaned. Security means that if the company is wound up, the secured creditor will have priority in terms of repayment over any unsecured creditor. There are two types of security for company loans: fixed charges and floating charges. Debentures may be issued in a variety of ways. Single debentures A debenture may be issued to a single creditor, for example a bank or other financial institution or indeed an individual. The debenture document will set out the terms of the loan: interest, repayment and security. Debentures issued in series

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Alternatively, the company may raise the specific capital it requires from a number of different lenders. In this case the global sum of the loan is made up from all of the individual loans. In such a situation the intention is that each of the participant lenders should rank equally (pari passu) in terms of rights, and security. Thus, although each lender receives a debenture, they are all identified as being part of a series and consequently have equality of rights. Debenture stock This third method is the way in which companies raise loans from the public at large. The global sum of the loan is once again raised from a large number of people, each of whom holds a proportional part of the total loan stock. The indivual lender receives a debenture stock certificate, which in some ways is similar to a share certificate, at least to the extent that such debenture stock is freely transferable and may be dealt with on the Stock Exchange. The loan and the rights appertaining to it are set out in a deed of trust and a trustee for the debenture stockholders is appointed to represent and pursue the interests of the individual stockholders. In law, it is the trustee, rather than the individual lenders, who is the creditor of the company, and the individual debenture stockholders have no direct relationship with the company. In this way the individuals are relieved of the need to pursue their own causes and the company is relieved of the need to deal with a multiplicity of lenders. Of course, if the trustee fails to pursue the interests of the beneficiaries they can have recourse to the courts to instruct him to pursue his duties. The content of the trust deed sets out the terms relating to the loan, and in particular it will detail any security and the powers of the trustee to act on behalf of the lenders to enforce that security. Specific points to note about debentures: they may be issued as redeemable, or irredeemable under s.193 of the CA 1985; they may carry the right to convert into ordinary shares at some later time; they may be transferred from the current holder to another party subject to the proper procedure under s.183 of the CA 1985; with regard to repayment, debts rank in order of creation, so earlier debentures have to be paid before those created later. Where debentures are issued in a series a pari passu clause is introduced into the document expressing the debt. As stated above, this has the effect that all of the loans made within the series rank equally with regard to repayment.

It is, however, essential to distinguish debentures from shares in the following respects: debenture holders are creditors of the company; they are not members as shareholders are; as creditors they receive interest on their loans; they do not receive dividends as shareholders do; they are entitled to receive interest whether the company is profitable or not, even if the payment is made out of the company's capital; shareholders' dividends must not be paid out of capital; debentures may be issued at a discount, i.e., at less than their nominal value; whereas shares must not be issued at a discount and the company must receive the equivalent to the share's nominal value.

Company charges As has been stated previously, it is usual for debentures to provide security for the amount loaned. Security means that in the event of the company being wound up the creditor with a secured debt will have priority as regards repayment over any unsecured creditor.

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There are two types of security for company loans: fixed charge; and floating charge.

Fixed charge In this situation a specific asset of the company is made subject to a charge in order to secure a debt. Once the asset is subject to the fixed charge the company cannot dispose of it without the consent of the debenture holders. The asset most commonly subject to fixed charges is land, although any other long-term capital asset may also be charged. It would not be appropriate, however, to give a fixed charge against stock-in-trade, as the company would be prevented from freely dealing with it without the prior approval of the debenture holders. Such a situation would obviously prevent the company from carrying on its day-to-day business. If the company fails to honour the commitments set out in the document creating the debenture, such as meeting its interest payments, the debenture holders can appoint a receiver who will if necessary sell the asset charged to recover the money owed. If the value of the asset that is subject to the charge is greater than the debt against which it is charged then the excess goes to pay off the rest of the companys debts. If it is less than the value of the debt secured then the debenture holders will become unsecured creditors for the amount remaining outstanding. Floating charge This category of charge is peculiar to companies and represents one of the advantages of the company over other business forms. The floating charge is most commonly made in relation to the undertaking and assets of a company and does not attach to any specific property whilst the company is meeting its requirements as stated in the debenture document. The security is provided by all the property owned by the company, some of which may be continuously changing, such as stock-in-trade. Thus, in contrast to the fixed charge, the use of the floating charge permits the company to deal with its property without the need to seek the approval of the debenture holders. However, if the company commits some act of default, such as not meeting its interest payments, or going into liquidation, the floating charge is said to crystallise. The value of the assets subject to the charge may be realised in order to pay the debt owed to the floating charge holder, although the Enterprise Act 2002 introduced a new procedure to limit the powers of floating charge holders to appoint administrative receivers and requires them to make use of the general administration procedure. Registration of charges All charges, including both fixed and floating, have to be registered with the Companies Registry within 21 days of their creation. Failure to register the charge as required has the effect of making the charge void, i.e. ineffective, against any other creditor, or the liquidator of the company. The charge, however, remains valid against the company, which means in effect that the holder of the charge loses their priority as against other company creditors. In addition to registration at the Companies Registry, companies are required to maintain a register of all charges on their property. Although a failure to comply with this requirement constitutes an offence, it does not invalidate the charge. In relation to properly registered charges of the same type, they take priority according to their date of creation. However, as regards charges of different types, a fixed charge takes priority over a floating charge even though it was created after it. In addition to registration at the Companies Registry, companies are required to maintain a register of all charges on their property (CA 85 s.407). Such a register has to be available for

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inspection by members and creditors of the company. Failure to comply with this requirement constitutes an offence but it does not invalidate the charge. Priority of charges In relation to properly registered charges of the same type, charges take priority according to their date of creation. Thus although it is perfectly open for a company to create a second fixed or floating charge over assets that are already subject to such pre-existing charges, it is not possible for the company to give the later charge equality with, let alone priority over, the charge already in existence. However, with regard to charges of different types, a fixed charge takes priority over a floating charge even though it was created after it. Generally, there is nothing to prevent the creation of a fixed charge after the issuing of a floating charge, and, as a legal charge against specific property, that fixed charge will still take priority over the earlier floating charge. The reason for this lies in the whole purpose of the floating charge. As has been seen the floating charge was designed specifically to allow companies to continue to deal with their assets in the ordinary course of their business, without being subject to the interference of the holder of the floating charge. Consequently, the courts have held that this freedom extended to the ability to create fixed charges over the assets in order to secure later borrowings in the course of the business (Wheatley v. Silkstone and Haigh Moor Coal Co. (1885)). It is possible, however, for the debenture creating the original floating charge to include a provision preventing the creation of a later fixed charge taking priority over that floating charge. The question then is whether the registration of that restriction has any effect on subsequent debenture holders. The current position is that for such a restrictive provision to be effective it is necessary that the holder of the subsequent charge should have knowledge of the specific restriction in the original debenture. As registration has been held only to give constructive notice of the existence of a debenture, and not its contents, it is likely that the courts will maintain the position that subsequent charge holders are not subject to limitations contained in previous debentures, unless they actually have knowledge of the existence of such restrictions. Sections 92-107 of the Companies Act 1989 set out procedures to deal with this particular problem amongst others in relation to the operation of the registration process for debentures, but unfortunately due to several inadequacies of the proposed alterations, it was decided that the new procedures would not be introduced.

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