For any lender, the decision to enforce a security interest that has been granted to it is a difficult one. This is the ultimate sanction available to a lender, and it may have the result that the company that granted the security will cease to exist as a going concern.
Upon the provision of debt facilities to a borrower, a lender will often take security over assets of the borrower – and frequently of other members of the borrower’s group of companies – as collateral for the performance by the borrower of its payment and other obligations to the lender. In relation to companies incorporated in England, this security will typically take the form of fixed and floating charges over all of the assets of the company. These charges should be registered against the relevant company at Companies House and on any relevant title register – for example, in the case of land, at HM Land Registry, and in the case of certain categories of intellectual property, the UK Intellectual Property Office.
Most lenders will become aware that a borrower is in difficulty through the early warning systems that are built into their lending documentation in the form of representations and covenants. Covenants may be informational (for instance the delivery of the annual accounts of the borrower each year), financial (for instance a measurement of the tangible net worth of the borrower or the group) or general (for instance a prohibition on the granting of security to a third party). Compliance with these obligations is usually tested by a review of financial information delivered on a regular basis by the borrower. Breach of the representations and covenants usually constitutes an event of default, which will entitle the lender to exercise certain rights, including the right to demand payment or repayment of the amount of the facilities that are outstanding and to enforce guarantees and security granted in respect of the borrower’s obligations and liabilities.
Rights of the lender following an event of default
Upon either the discovery of facts or circumstances amounting to an event of default or receipt of confirmation from a borrower that an event of default has occurred, the lender will be faced with a decision as to how to react.
The rights and remedies available to the lender following the occurrence of an event of default are contractual. These rights are additional to any other rights to which the lender may be entitled at common law or in equity as a consequence of the breach by the borrower or the client of the credit agreement.
Many events of default are of a minor or technical nature and, in practice, may be either overlooked by the lender or made the subject of a formal waiver at the borrower’s or client’s request.
If the event of default relates to a cash flow issue of the borrower, the lender may choose to make additional funds available to the borrower or to restructure the existing indebtedness to ease the burden of repayment on the borrower; this option may be suitable for a borrower that is going through a re-organisation or a temporary or seasonal cash flow shortage.
Demanding repayment, termination of the facilities and enforcement of the security must nevertheless be considered in respect of a serious breach of the facilities that can not be remedied or where the borrower has entered or is under threat of commencement of insolvency proceedings. However, this course of action represents the remedy of last resort for any lender as the enforcement of security will usually entail the cessation of a borrower as a going concern, even if options may exist to salvage the whole or part (or parts) of its business. It is unlikely that the borrower itself can continue, ultimately, to exist as a legal entity, even if the business or assets can be life-boated out in some manner.
Immediate practical steps
The first step for any lender that is considering enforcing its security following an event of default is to establish exactly what rights it has and where it has those rights. This is not as obvious a point as it sounds. English case law is littered with examples of lenders that found themselves in the wrong despite having, no doubt, considered themselves to have been entirely within their rights to take enforcement steps.
A forthcoming book, Asset-Based Lending and Insolvency, by my colleagues Andrew Knight and Grant Jones, contains a review of the relevant law. The English court decisions serve to caution lenders that, even if an event of default appears clear and objective on its face, it is still capable of being declared wrongfully by the lender.
In and of itself, an invalid declaration of an event of default or termination event is a nullity and creates no legal liability upon the lender. Since the declaration has no effect, it can not constitute a breach of contract. This frequently surprises those who assume that an invalid demand must necessarily impose a liability on the lender (even if only for defamation, by analogy with the old case law on the wrongful dishonouring of cheques, although in truth the analogy is somewhat stretched). The reasoning is simply that the borrower is entitled to disregard the declaration and the resulting demand, and therefore suffers no damage. Nevertheless, the scope for damage to the borrower is considerable, especially if the effect of the lender’s declaration is to trigger cross-default provisions in other financing agreements to which the borrower or client is party or to cause its suppliers to refuse to continue supplying to it on credit terms.
The lender will, however, incur liability for the consequences of its own actions following a wrongful declaration. Since the lender’s obligations under the credit agreement will not have been validly terminated because the declaration of the event of default or termination event was a nullity, the lender will commit a breach of contract if:
- it seeks to enforce its rights in its security or collateral; and/or
- it refuses to continue advancing funds to the borrower on the basis that it believes that it is entitled to cancel its commitment to provide finance.
A documentation review – commonly referred to as a “security review,” although, in truth, it is somewhat more extensive than that – is usually recommended in order to provide the lender with the requisite comfort that its security is valid and enforceable, and that the lender is entitled to enforce the security in the particular circumstances. The lender’s legal counsel will typically also comment on the range of enforcement options available to the lender, so that the lender can begin to consider the practicalities of enforcement. This review will have the added advantage of ensuring that the advisors to the lender are fully up to speed with the current situation of the borrower.
On a more practical level, the lender will require an appraisal of its collateral – for example, an up-to-date, on-site audit of the tangible assets, such as an inventory of plant and machinery, combined with a desktop audit of all intangibles, such as outstanding receivables, comprised within the collateral. Lenders vary in their approach to such appraisals and audits, but in cases where tangible assets have a material value or offer particular challenges – for example, in the case of retail inventory – they will frequently instruct external specialists to conduct the appraisal, in addition to advising on best strategy for realising cash from the assets. In the overwhelming majority of cases, there will be a trade-off between the speed of realisation and the price at which assets can be liquidated.
The legal review and the appraisal, taken together, will provide the lender with a clear picture of both its rights to enforce and the possible means of enforcement. A lender that typically holds fixed and floating security over all of the borrower’s undertaking and the assets may tend to consider that the appointment of an administrator represents the most comprehensive solution. Ideally this decision should be deferred, if time permits, until after the lender has been able to consider the various reports as these may suggest alternative enforcement options that would not otherwise have been taken into account by the lender.
As a separate and independent step, the asset-based lender should, as soon as it becomes aware of any event of default, issue a “reservation of rights” letter to the borrower. If the lender fails to do so and continues to operate the credit agreement (as opposed to taking immediate action to accelerate, terminate and/or enforce) it may be deemed to have waived its rights in relation to the particular event. The risk exists regardless of any “no waiver” clauses that may have been included in the credit agreement with the precise intention of avoiding just such a problem. In the 2009 case of Tele2 International Card Company SA and others v Post Office Ltd, the English Court of Appeal found that a “no waivers” clause would not be sufficient to override the innocent party’s continued conduct of an agreement notwithstanding a breach or default of that agreement by the other party.
Non-insolvent borrower
If a formal insolvency process has commenced, the practical options available to the lender will be more or less limited in scope according to the type of insolvency proceedings to which the borrower or client is subject. If, conversely, a formal process has not yet commenced, the lender’s decisions are, if anything, more difficult. It may be asked to support a workout or restructuring outside a formal insolvency process. Since such a process frequently involves continuing to provide financial accommodation to the borrower, the lender must assess whether the rescue plan presented to it is a realistic one and whether, if the plan fails, the lender may be in a worse position as regards its ultimate recovery of funds advance than if it had used the brief period before formal proceedings began as an opportunity to exercise its rights under the relevant financing documents.
Similar considerations may apply if the borrower has committed an event of default that is capable of remedy and seeks the lender’s agreement to continue to provide support while the remedy is implemented.
In either case, any rescue, turnaround or remedial action must be examined carefully in order to establish any issues that may arise upon a subsequent insolvency, in particular the setting aside of that security. For instance, an administrator of an England-based company may set aside security that it deems has been granted as a preference in the six months prior to insolvency or constitutes a transaction in the two years prior to insolvency.
This exercise may be expensive in terms of both time and fees. The scope of any such review should be established from the outset. In particular, if the review needs to be carried out across a number of jurisdictions, the lender should carry out an initial cost/benefit analysis and ensure that it is kept up to date in relation to the costs that accrue. It can be startlingly easy for the lender to find itself presented with unexpected invoices for fees in such cases, and although it would be normal for the borrower to indemnify the lender for those costs, that will be of scant comfort if the quantum claimed is large enough to cause fresh financial difficulties for the borrower.
Insolvent borrower
If the borrower is formally insolvent, the lender will need to decide the best course of action for the protection both of the assets over which it has taken security and of its security rights themselves. Once again, advice should be taken from legal counsel and financial advisors as to any particular requirements in a jurisdiction that need to be satisfied (such as the location of inventory within the prescribed area for the enforcement of security over the same in Germany).
An essential part of any connected security review will be the examination of the relationship between the lender and any other creditors, in particular any intercreditor or priority agreements, to confirm whether it is possible for the lender to compel them to take action (or indeed whether the lender may be compelled to take action). The results of this examination will determine how the lender approaches such parties, or indeed, if it approaches them at all.
The lender may wish to approach the other creditors to agree how they should proceed. This course of action would have the advantage of ensuring that all creditors aim towards a single goal, however, the approach to the other creditors may tip them off that the lender is planning to take enforcement action and they may take pre-emptive steps, for instance, if the borrower in question is based in England, another creditor may apply for the appointment of an administrator. The appointment of an administrator would mean that a moratorium upon enforcement would come into effect and it would not be possible for the lender to enforce its security.
Another party that the lender should approach as soon as possible is the prospective insolvency practitioner who is to be appointed over the borrower. The identity of this party will vary between different jurisdictions – in England, it is likely that the insolvency practitioner will be appointed by the lender and be well known to it, while in other jurisdictions this may be a court-appointed official. In any event, as soon as the identity of this party is known to the lender, the lender should take steps to contact the insolvency practitioner and explain its claim against the company and its position as a secured lender, particularly in relation to any particular assets over which it has security (for instance a particular property or piece of equipment).
Other parties that the lender may wish to engage in discussion, particularly if the review of the business has shown potential retention of title claims or has revealed that the insolvency office-holder can not trade without ongoing key supplies, are the suppliers to the borrower. An early approach to such parties may serve to highlight any claims that they have and ensure that they will continue to supply goods or services to the borrower on such terms as it may be possible to agree on under applicable insolvency laws during the initial trading period following the commencement of insolvency proceedings.
