Neil Murray
A company wishing to borrow money from a bank or other financial institution to finance the acquisition or development of real property will have to provide adequate security for repayment or discharge of all its obligations to the lender.
The most common form of security for property lending is a legal mortgage of the relevant property, although additional security may be required having regard to the purpose of the lending and the availability of other assets.
In the case of finance for property development, for example, the lender may require fixed charges, or assignments by way of security, of the benefit of any building contract, “forward-sale” agreement or agreement for the grant of a lease or leases in respect of the whole or part of the property. Where the covenant of the borrower is not considered to be sufficiently strong, a guarantee of the borrower’s obligations is usually required. Furthermore, in cases where the borrowing is by a company which does not itself own the property or other assets comprising the proposed security, it is common practice among banks to require that the company in which the property or relevant asset is vested should guarantee the borrower and charge the property or other assets as security for its liabilities.
This article examines the impact of the Insolvency Act 1986 (“the Act”) from the point of view of a lender (in this article referred to as “the bank” or “lending bank”). It is hoped, however, that this discussion will assist property companies and others involved in property finance towards an understanding of the reasons why lenders may now require different forms of security, and why they may be particularly concerned as to the circumstances surrounding the giving of guarantees.
Effect of the Act on fixed charges
One of the aims of the Act is to discourage the taking of fixed or specific charges (which will include legal mortgages of real property). The Act confers more wide-ranging powers on the holders of “floating charges” over the whole of the undertaking of a corporate borrower, and it is now not unusual that a lender will require a floating the corporate borrower — often in the form of a debenture — which will incorporate specific first legal charges of property identified in a schedule to the debenture or other form of charge document. Property companies (particularly plcs) have already shown a reluctance to create floating charges over their undertaking, particularly where the finance is required in relation, for example, to a single development site or a portfolio of investment properties comprising a limited proportion of the total assets of the company. Such companies do not wish to see unnecessary references to debentures in the charges register at the Companies Registry, and will certainly not wish to be hampered in any subsequent transactions unrelated to the specific lending transaction for which the security was required, through having to obtain any consents from the lending bank holding the security.
How will the lending bank be disadvantaged if it has taken only a legal mortgage rather than a full debenture/floating charge? The principal disadvantage is the fixed charge holder’s susceptibility to the powers of an “administrator” under the Act. An administrator, a new officer created by the Act, is neither a receiver nor a liquidator. The new administration procedure is intended to provide a means by which a company in financial difficulty, or which anticipates such difficulty, can be given a period of grace to sort out its affairs without the risk of a winding-up petition being presented or a chargee appointing a receiver. The appointment is by order of the court upon the petition of the company itself, or a director or any creditor. The court may take an order if it is satisfied that the company is likely to be unable to pay its debts and the making of the order would achieve the survival of the company and the whole or part of its undertaking as a going concern.
An order cannot be made if a company is already in liquidation. The administrator is given comprehensive powers to manage the affairs of the business and property of the company as agent for the company. In particular, he can deal with property which is the subject of a fixed charge, leasing or hire purchase agreement as if it were not so subject. Moreover, the ability of fixed charge holders to enforce their securities (eg to sell the property, “build out” developments and possibly appropriate any income from the property) will be suspended for so long as an administrator has jurisdiction over the assets of the company.
That is not to say that the bank holding a legal charge will cease to be a secured creditor. It will still be entitled to sufficient money out of any sale proceeds of the mortgaged property in or towards the discharge of the moneys secured by the legal charge. What will be of concern, however, is the mortgagee’s loss of control over the manner in which the mortgaged property is dealt with. The only recourse of the bank following the appointment of the administrator is for the bank to apply to the court for an appropriate order if it considers that it has been “unfairly prejudiced” by the action (or inaction) of the administrator.
A floating charge holder, on the other hand, would have the advantage of being able to pre-empt the appointment of an administrator by utilising its ability to appoint an “administrative receiver”. An administrative receiver is another new officer created by the Act, and any receiver appointed by a floating charge holder (who need not, incidentally, first obtain a court order) will be an administrative receiver subject to the following requirements being satisfied.
These requirements illustrate the principal differences between an administrative receiver and the receiver referred to in the Law of Property Act 1925 (or expressly in a mortgage or other security document). First, an administrative receiver must be appointed by the holder of a charge which, as created, was a floating charge. This is not the case with an LPA receiver who may be appointed under a specific mortgage or fixed charge. Second, the administrative receiver’s statutory powers (as set out in Schedule 1 to the Act) are far more comprehensive than the receiver’s powers under the LPA, although most security documents considerably extend the powers of a receiver by express terms. Third, an administrative receiver must be an “authorised insolvency practitioner” (see sections 388-398 of the Act). A person accepting an appointment without being authorised is liable to imprisonment or a fine, or both! Fourth, although an LPA receiver may be appointed to deal with a single charged property or other specified assets, an administrative receiver will not qualify as such under the Act unless the appointee has, by virtue of the document under which he is appointed, control over the “whole or substantially the whole” of the undertaking of the company (see s 29).
Whether or not an administrative receiver has such degree of control is a matter of fact. It is not good enough if the relevant appointee is appointed under a floating charge, but the combined total of the assets comprised in all fixed and floating charges contained in the security documents do not add up to the “whole or substantially the whole”. There is no point, therefore, in assuming that the receiver appointed under, for example, the floating charge over plant and machinery commonly included in a legal mortgage, will be an administrative receiver, unless the mortgaged property, with the plant and machinery, happened, at the time of appointment, to constitute practically everything the company owned.
The importance of the ability to appoint an administrative receiver is that the appointor may pre-empt the appointment of an administrator, since an administrator cannot be appointed without first giving notice to all those floating charge holders who have the right under the Act to appoint an administrative receiver. Such persons will then have five days to take appropriate action (eg appoint an administrative receiver to protect their own security interests) before the appointment of the administrator is confirmed. Through the administrative receiver (who, although legally the agent of the company in receivership, will be accountable to the appointor), the charge holder will be able to retain control over its security throughout the receivership.
Whether or not the lending bank will be able to live without the ability to enforce its security by way of the appointment of an administrative receiver largely depends on the view which it is prepared to take on the issue of control over its security and the manner of enforcement thereof.
The timing as to a disposal of property comprised in the bank’s security may be of critical importance, and the control aspect is particularly relevant in property development situations where, at the time of any proposed enforcement of the bank’s security, the development may be half-built and the action to be taken by the bank, which will have vetted the proposal in the first place, is again of critical importance. In these circumstances the bank is most likely to run into difficulties with the borrower. The bank will be asking for a debenture or some other document creating a floating charge and the borrower will be reluctant to execute such a document. How is this best resolved?
Perhaps one result of the Act, particularly with reference to property development loans, is that banks will encourage property companies to carry out individual developments through “single-asset” or “special purpose” companies. This will involve the setting-up of a company whose only assets throughout the term of the loan will comprise the property and assets which are to form the subject of the security in favour of the lending bank. There should therefore be no difficulty in the special purpose company charging the whole of its undertaking by way of a floating charge to the bank (probably by way of a debenture including, for example, a mortgage of the property and fixed charges over specified assets or rights, together with a general floating charge).
In addition, it may be desirable to include a provision in the memorandum and articles of association of the special purpose company to provide that the company would not have power to undertake any other business apart from the development in question, or acquire further assets, at least while the security remains in place. If the bank ever wished to appoint an administrative receiver with control over the whole property and assets of the company, it would at least want to be sure as to the extent of the company’s undertaking at the time of appointment, as would any prospective appointee!
Such special purpose companies have in any event been used in certain “off-balance sheet” financing transactions, where a new off-balance sheet company is set up, in whose name the borrowing is made, and in which the property or other assets comprising the proposed security are vested.
Finally, note that, just as the statutory powers of an administrative receiver (as set out in Schedule 1 to the Act) are more extensive than a receiver’s powers under the LPA, so too are the duties imposed upon him under the Act. Having regard to the qualifications and obligations upon an administrative receiver, it remains to be seen whether all persons who hitherto have been happy to take on the duties of an LPA receiver will be equally happy to be appointed as an administrative receiver.
Inter-company guarantees
The importance of there being adequate commercial benefit to a company in return for incurring a contingent liability under a guarantee given by it is fairly well known (see, Charterbridge Corporation v Lloyds Bank [0] Ch 62 and Rolled Steel (Products Holdings) Ltd v British Steel Corporation [1985] 3 All ER 52). The absence or inadequacy of commercial benefit may result in the guarantee being capable of being set aside at the instigation of a liquidator, the members of the company or possibly other creditors. What bearing do the provisions of the Act have on the issue of commercial benefit, and the giving of guarantees?
Section 238(iv) of the Act refers to transactions being “at an undervalue” where the company enters into a transaction on terms whereby the company receives no consideration, or the consideration, whether in money or money’s worth, is significantly less than the value in money or money’s worth of the consideration provided by the company. The giving of a guarantee will come within the section where a company incurs a contingent liability under the guarantee in return for which it receives inadequate consideration from the beneficiary of such guarantee. In such cases it will be open to an administrator or liquidator of the company to apply to the court in order to restore the position to which it would have been if the company had not entered into the transaction.
There are, however, various “defences” to any claim that the transaction was at an undervalue. Section 238(v) provides that the transaction will not be at an undervalue if the court is satisfied that the company entered into the transaction in good faith and for the purpose of carrying on its business, and that at the time there were reasonable grounds for believing that the transaction would benefit the company.
Furthermore, the effect of s 240(1)(a) and (b) of the Act is that the transaction will not be at an undervalue unless entered into at any time within a period of two years ending with the “onset of insolvency”, and even if entered into during such period, the company will have a defence if, at the time of the transaction, it was either able to pay its debts (within the meaning of s 123 of the Act), or at least it did not become unable to pay its debts in consequence of the transaction (eg by virtue of having incurred the liability under the guarantee). The company must show that it was able to pay its debts at the relevant time and that it continued to be able to pay its debts after the giving of a guarantee. This will be a matter of fact, supported by views of the bank’s advisers and the company’s auditors, having regard for example to the likelihood of the guarantee being called and the extent of the provision which should be made on account of the contingent liability under the guarantee.
Note that the defence that the company was able to pay its debts is not available in the case of transactions at an undervalue with a “connected person”.
Section 249 defines a connected person as a director or shadow director or an associate of the company. Section 435 defines “associate”. A bank will become an associate of a customer if it has control of such customer. A person entitled to exercise one-third or more of the voting power at any general meeting is deemed to have control, as is a person if the directors of the company are accustomed to act in accordance with his direction or instructions. The lending bank should therefore take care to ensure that it is not an associate of the company, particularly in relation to certain “off-balance sheet” lending schemes where the bank or its nominee may be called upon to take a shareholding in the borrowing company.
Of the defences available, reliance on s 238(v) concerning transactions entered into in good faith or which were reasonably expected to benefit the company is likely to afford least certainty from the bank’s point of view. Concepts such as “in good faith” and “benefit” to the company are not precisely defined, and will presumably be interpreted by reference to such cases as Charterbridge and Rolled Steel cases.
Alternatively, where reliance is placed exclusively on the statutory defence that, at the relevant time the company was able to pay its debts, the common law “commercial benefit” tests must still be passed in addition to the statutory provision. In practice it will still be necessary to show that commercial benefit exists in relation to the giving of the guarantee even if the company could pay its debts. If, however, exclusive reliance is placed on the “good faith”/”benefit to company” exclusion in s 238(v), then not only are the common law commercial benefit tests likely to have been passed, but, as it is only necessary to satisfy either the “good faith” test or the ability to pay debts, it will not be necessary to show that the company could pay its debts at the relevant time.
Last, if the transaction was not within the two-year period referred to above, then only the common law commercial benefit tests will be relevant. It is not, of course, possible to project the likelihood of insolvency to the expiration of the two-year period, therefore close attention should be paid to the availability of the relevant defences.
Avoidance of certain types of security
It is important to distinguish the above provisions regarding transactions at an undervalue from the provisions of s 239 (regarding fraudulent preferences) and s 245 of the Act (regarding avoidance of certain floating charges), both of which sections operate wholly independently of the above provisions.
Section 239 provides that, if a company puts or allows one party to be put in a better position in the insolvent liquidation of the company than that party would otherwise have been in, then an administrator or liquidator may apply to the court to restore the position prior to the preference having been given. This may involve the avoidance of security given to a lending bank.
The preference must have been given within six months, ending on the “onset of insolvency”, but this period is extended to two years in the case of a transaction with a “connected person” (see above). The only defence is that the company could pay its debts (within the meaning of s 123 of the Act) at the time of the giving of the preference, but this defence is not available in the case of connected persons, where it is presumed that the company could not pay its debts at the relevant time, and it is also presumed that a voidable preference has occurred.
Section 245 provides that, unless the company could at the time of creation of a floating charge pay its debts within the meaning of s 123, the floating charge will be invalid except to the extent of money paid or goods or services supplied or the discharge or reduction of any debt of the company (and interest thereon in each case) at the same time as or after the giving of the charge.
It is important to realise, therefore, that when requiring a floating charge or security (particularly in the light of the matters discussed above), the bank must accept that such charge will only secure new money advanced at or after the creation of the charge. Perhaps it is of some comfort, however, that the avoidance provisions will not apply unless the floating charge was created within 12 months ending with the “onset of insolvency”, although the relevant period is increased to two years in the case of “connected persons” (see above). Furthermore, as for s 239 regarding preferences, the defence that the company could at the relevant time pay its debts within s 123 is not available in the case of a floating charge created in favour of a connected person.
