I was asked recently by a client who is looking to finance her business by way of a private loan about the different types of charges that the investor may take under the loan documentation or “Debenture” and the possible effects on her business. So I decided to put together a very basic guide which should provide a general understanding of the types of charges involved in a secured loan situation, together with an illustration of a liquidation. (Please note that the below submission should not be taken as legal advice and you should seek legal and or accounting guidance for your own particular circumstances.)
The Company Loan
When a company borrows money the lender or financial institution usually takes some form of “security” in exchange for the debt. This is designed to protect the lender’s position in the event that the borrower fails and they are forced to try to reclaim their money.
What is a Debenture?
This is the document that sets out the type of charge i.e. “fixed” or “floating” charge (see below) and the attached terms and conditions. Once this has been signed by the company, the lender sends the debenture and loan deed together with Form 397 to Companies House to register that charge. Please note that registration must take place within 21 days after execution of the documentation.
Why bother to register? Registration prevents other people getting security against the assets in question, unless a Deed of Priority is created (see below).
Fixed Charges
The bank or lender may have provided money to acquire an asset like a building or vehicle. The company cannot sell this without the lender’s permission. The debt must be repaid as per the loan agreement or facility letter.
Consider a mortgage, which is a form of fixed charge. When a borrower borrows money to buy a house, he or she does not own the house outright until the debt is repaid in full, nor can the borrower sell the property without the lender’s permission.
Another example is an assignment of a company’s debtor book through factoring or invoice discounting. In this situation, the bank purchases the outstanding invoices and lends money against them. The debtor book is then subject to a fixed charge. In effect as with a mortgage, the book debts belong to the bank or factoring company, not the company to whom the debt is owed.
Floating Charges
Fixtures and fittings, cash, stock, finished or raw material, work in progress, unfactored debtors, or assets not subject to fixed charges are the types of things that the company uses to generate business. It would not be practical to place a fixed charge over every item of stock or desks and chairs. In this situation, where security over a group of these “changing assets” of a company, a floating charge is used.
The floating charge ‘floats’ until conversion into a fixed charge, at which point the charge attaches to specific assets. The conversion to a fixed charge, called crystallisation, can be triggered by a number of events and it has become an implied term in debentures under English law that a cessation of the company’s right to deal with the assets in the ordinary course of business will lead to automatic crystallisation. Under a typical typical loan agreement, default by the borrower is a trigger for crystallisation. Such defaults typically include non-payment of the debt, invalidity of any of the lending or security documents, liquidation or insolvency.
What is a Deed of Priority? If there are a number of lenders and a number of loans a ranking of all of the loans is drawn up and the Deed of Priority sets out the order of priority in the event of a default.
What is a Deed of Postponement? Often a director will introduce money to a company and the bank will require his loans to be frozen until their debt is serviced and or paid.
A Liquidation
What happens if a company goes bust? This is where the complications begin, so it is perhaps best illustrated by way of a (fictitious) example:
1. Micronssoft Limited, a software company has a debtor book of £500,000 against which Midlands Bank have provided factoring facility of £370,000 and an overdraft of £30,000. The company has £150,000 of fixed assets and 15 employees.
2. It owes £150,000 to the inland revenue and to other miscellaneous trade creditors.
3. After losing a large client, it enters into liquidation; however, the debtors don’t always recover their loans in full! (NOTE: “Liquidation”, or more technically, “creditors voluntary liquidation” or “compulsory liquidation” meaning the end of the company when its assets are “liquidated” or turned into cash for the creditors, if possible. Creditors voluntary liquidation is the most common form of liquidation in use in the UK.). The debtor book would be collected (usually by lender and directors who have provided personal guarantees).
4. After insolvency costs, a total of £250,000 is collected in from debtors. The business is sold to a buyer for £75,000 “goodwill” and £75,000 for the assets like work in progress, PC’s, equipment etc but not debtors. So the total available in the pot to pay to the creditors is £400,000.
5. Midlands Bank, as both a fixed and floating charge holder would be paid out as follows; Debtor proceeds of £250,000 go to pay the fixed charge. The Goodwill element is also covered by a fixed charge and is paid to Midlands as well. Thus Midlands Bank has a shortfall of £45,000 on the fixed charge.
6. There are arrears of staff salaries and holiday pay of £50,000. That is paid next, to the ex-staff from the £75,000 received for the assets.
7. That leaves £25,000 available for the bank under the floating charge collection. It is still owed £20,000 under the fixed charge and also the overdraft of £30,000 remains.
8. In this simple example the bank would stand to lose £50,000, the preferential creditors i.e. the employees, are paid in full and any unsecured creditors get £0.
Conclusion
We hope you have found this summary and illustration helpful?
In practice, however, there are more complications and our advice would be don’t try this at home, or for that matter, at your place of work. It makes more sense to consult a legal advisor to make sure the above process and required documentation work for you and the other parties involved.
