#3194 - Introduction To Debt Finance - Business Law and Practice

Company Law – Private Limited Companies

Introduction to Debt Finance

Definition	Lending / borrowing of money on the understanding that is will be repaid on a specific date or contingency, and on the winding up in priority to shareholders.
Capacity to borrow: Implied power / Express powers	IMPLIED: S.31 CA 2006: company has unrestricted objects Borrowing is a POWER rather than object implies the necessary powers for a company to pursue its objects. Re David Payne: Implied power to raise funds by borrowing for the purposes of the company’s business. Re Patent File: A company who has power to borrow also has implied power to give security for a loan. EXPRESS: Power is within the company Articles – making it part of the company constitution. [NB. This power is NOT in the Model Articles]
Director’s authority to exercise power	Art. 3 Model Articles: gives Director’s wide powers [e.g. act in the best interests of the company – therefore borrow money to pursue business] Always consider any Special Articles – do they impose restrictions on borrowing over a certain amount? Rolled Steel Products v British Steel Corporation (1985): directors had implied power to enter into a guarantee and debenture – BUT they had exceeded their powers because it was NOT for the best interest of the company. If the Director’s exceed their powers breach of Fiduciary Duty.
Protection for persons dealing with the company [i.e. the bank]	S.39 The validity of an act done by the company shall not be called into question on the ground of lack of capacity by reason of anything in the company’s constitution. S.40 S.40(2)(b) good faith issue! “In favor of a person dealing with a company in good faith, the power of the directors to bind the company, or authorise others to do so, is deemed to be free of any limitations under the company’s constitution”. If lender knows that there is no benefit to company (or ought to have known) then there is a risk of no good faith and lender cannot rely on S.40. Therefore guarantee may be voidable by the shareholders (or liquidator) of the company. Therefore, lenders ask for BOARD MINUTES that state Board approval of guarantee Who is authorised to sign for the company Why board considers the guarantee to be in best interest of company This will support the contention of good faith! OR Lender can request unanimous consent of shareholders to the granting of the guarantee – to show good faith and get protection of S.40.
Restrictions on borrowing	Restriction on borrowing can exist in the Articles! E.g. a maximum sum otherwise need SH approval. If breached = lender may be able to rely on S.40 – to enforce the borrower’s obligations. Contractual restriction e.g. 2 loans. Loan 1 contains a contractual restriction on further borrowing by the borrower. Loan 2 is entered into in breach of Loan 1. Lender 1 can get contractual remedies for breach of contract. If Lender 2 had notice of the restriction they may also be liable to lender 1 on the basis of procuring breach of contract.
Other issues affecting validity of borrowing	Is the borrowing illegal? Company giving loans to Directors – must comply with S.197 CA 2006. [Re. Loan to Directors]

Forms of debt finance

Loan facilities
Overdraft	Uncommitted facility bank not obliged to lend money. Repayable on demand usually bank can ask for money back any time Interest at fixed percentage above bank base rate Usually subject to an upper limit company pay penalty if they go beyond overdraft.
Term Loan	Money lent over a set period (a term) with an agreed schedule of repayment Committed facility bank cannot demand repayment of money at any time. Must comply with the schedule of repayment set out in the terms of the loan agreement. Necessary for the loan agreement to include an ‘event of default ‘ – which triggers bank to recall money back early if company cannot pay.

Security

Security interest

[i.e. guarantees]

A right given to one party [i.e. the lender / the bank] in the asset of another party [I.E the borrower / the company] to secure payment or performance by that other party or by a third party [i.e. the company]
Security gives rights over assets – not merely a personal rights

How is security given?

Agreement between the parties “consensual security” – Debenture!!

Operation of law – automatically

Why do lenders take security?

To avoid the disadvantages of unsecured debt.

Unsecured debt = where no security is given!
Without security, the lender’s remedies are limited if company goes into default / liquidation. Only available option is litigation or Petition for Winding up the company – this is not ideal (time, cost, bad publicity for the lender)

To take advantage of the benefits of security:

Lender more likely to be repaid
Establishes priority over unsecured creditors in event of insolvency
Lender has more control over assets

Types of security

Direct security
Third party security (i.e. a guarantor gives security)

3 aspects of security

Attachment: create security interest against party granting security.

Consider for consensual security:

Is there a valid agreement for the security
Is subject matter sufficiently identifiable
When does security attach – in future?

Perfection ensuring security interest is valid against third parties

Public notice
Main methods: possession of asset; registration of asset; notice to third party debtor (in case of debt)

Priority does security interest take priority over a competing security interest held by third party?

Advantages / disadvantages of debt finance [for the company]

Advantages	Lender is given no ownership interest. It does not become a member of the company so will have no membership rights. [Equity – shareholders get ownership of the company on purchase of shares]. BUT lender will be given some control via the Loan agreement [terms in the loan – e.g. curtailing company’s ability to borrow / sell assets / buy assets?] Tax benefits – interest on loan is tax deductable [dividends are not tax deductable]. Practicalities = Debt may be practically easier if company only wants investment for a limited time. Repayment of debt is not subject to statutory control. If it obtained equity for a limited time, it would have to issue redeemable shares (or buy back the shares). Financing of redemption or buy back is subject to statutory control. [Equity - investment of SH is essentially locked in – more long term] Cheap to borrow – if interest rates are low.
Disadvantages	Repayment of capital [equity – capital is locked in – unless shares are redeemable or bought back] Return of capital [pay interest – irrespective of profit]. Higher risk of insolvency is company cannot repay. [Equity – dividends only paid of distributable profits and director’s have power not to declare dividend if there is...

Advantages

Lender is given no ownership interest. It does not become a member of the company so will have no membership rights. [Equity – shareholders get ownership of the company on purchase of shares]. BUT lender will be given some control via the Loan agreement [terms in the loan – e.g. curtailing company’s ability to borrow / sell assets / buy assets?]
Tax benefits – interest on loan is tax deductable [dividends are not tax deductable].
Practicalities = Debt may be practically easier if company only wants investment for a limited time. Repayment of debt is not subject to statutory control. If it obtained equity for a limited time, it would have to issue redeemable shares (or buy back the shares). Financing of redemption or buy back is subject to statutory control. [Equity - investment of SH is essentially locked in – more long term]
Cheap to borrow – if interest rates are low.

Disadvantages

Repayment of capital [equity – capital is locked in – unless shares are redeemable or bought back]
Return of capital [pay interest – irrespective of profit]. Higher risk of insolvency is company cannot repay. [Equity – dividends only paid of distributable profits and director’s have power not to declare dividend if there is...

#3194 - Introduction To Debt Finance - Business Law and Practice

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