Overviewi Market conditions
2021 was a busy year for the EMEA loan markets as the threat of the covid-19 pandemic began to recede, allowing businesses to restart transactions that had paused as a result of the pandemic, or take advantage of opportunities that had emerged, alongside more general refinancing activity.
The increase in event-driven financings was more muted than expected in the first half of the year, with refinancings dominating; however, towards the end of the year M&A activity picked up. Good liquidity and generally favourable conditions for borrowers, coupled with an increase of overseas and private equity investment, were the main drivers for the increase in activity. The direct lending markets also saw significant levels of activity, with private credit funds moving out of the midmarket to target larger transactions over €1 billion (either alone or as part of a club), as a result of a record year for fundraising.
Key themes in 2021 remained the transition from LIBOR to risk-free-rates (RFRs), a process that is now largely complete for most LIBOR tenors and currencies, although some work remains to be done in relation to some currencies, in particular US dollar transactions (see further Section II.i). Environment, social and governance (ESG) transactions also continued to dominate in 2021, with corporate refinancings in particular focusing on the inclusion of ESG mechanics. However, ESG considerations are becoming more common in the leveraged and event-driven markets as well. ESG loan debt may be structured as a sustainability-linked loan, which links the pricing of a facility to ESG objectives without directing the use of proceeds to those objectives, or a green or social loan, which restricts the use of proceeds to particular green or social objectives (sustainability-linked loans are the most commonly seen throughout all markets).ii Market participants and documentary developments
A mixture of participants remain active in the English-law loan market. Traditional banks continue to play an important and active role in the loan market, and remain dominant in investment-grade lending. In other sectors, particularly in the leveraged, real estate and infrastructure finance markets, alternative credit providers such as direct lending funds and institutional investors (collateralised loan obligations (CLOs), finance and insurance companies, hedge, high-yield and distressed funds, and loan mutual funds) are more prominent.
Most English-law syndicated loan transactions use the Loan Market Association (LMA) recommended forms as a starting point for negotiations. In addition to various types of facility agreements and ancillary documentation for the investment-grade market (the Investment Grade Agreements) and leveraged lending (the Leveraged Finance Documentation), the LMA collection comprises multiple templates for more specialist products, including real estate finance, developing markets lending and pre-export finance. The LMA has updated the majority of its documentation to reflect the transition from LIBOR to RFRs.
The LMA does not maintain template terms for green or environmental, social and governance (ESG)-linked loans, but has published a variety of principles and guidance for both green, social and sustainability-linked loans, and is very active in the development of the standardisation of the market. ESG-linked lending is anticipated to remain an important area of focus over the coming year.
These topics and related documentation are discussed in Section II.
Legal and regulatory developments
Managing the steady flow of legal and regulatory changes remains an ongoing challenge for loan market participants. Some of the topics outlined below have been a feature of loan documentation discussions for some time. In some cases, sufficient consensus has emerged to enable them to be addressed in the LMA templates, leaving only points of detail to be negotiated. Where there remain diverging views, the contractual treatment must be agreed on a transaction-by-transaction basis.i Transition from LIBOR
From 1 January 2022, publication of 24 LIBOR settings ceased; going forward, only six 'synthetic' sterling and yen LIBOR settings are available for the duration of 2022, and five US dollar LIBOR settings are available until mid-2023. However, these remaining settings are intended for legacy use only. All new loans should now reference the appropriate RFR from day one (including all new US dollar loans), and, for sterling and most other LIBOR currencies, the LMA's templates for RFR lending are now widely used in the market, with documentation available for both investment-grade and leveraged transactions. While the transition has been successful so far, there is still some work to be done concerning some currencies, most notably US dollar transactions, where there a range of options still available and market consensus has yet to emerge. It is also worth noting that the transition to RFRs from non-LIBOR benchmarks is now gaining momentum, with the Canadian Dollar Offered Rate (CDOR) likely to be the next rate to transition.ii Sustainable finance
Sustainable impact investing is an important driver for many financial institutions, which, over the past few years, has fuelled an increase in ESG-linked lending. Sustainable or ESG loans look to align terms to the borrower's performance against an agreed set of ESG-related performance targets. For example, the margin on an ESG facility may adjust depending on whether those targets are met (upwards or downwards). An independent opinion provider is typically engaged by the borrower to verify whether those targets have been satisfied.
This is to be contrasted with 'green' or 'social' lending, which focuses on the use of proceeds, with a requirement that they are used to invest in green or social projects within pre-agreed parameters. Verification is also required for green and social loans, to assess the merits of the particular project for which the funding is intended.
To assist the development and standardisation of the sustainable lending market, the LMA (in conjunction with the Asia Pacific Loan Market Association (APLMA) and the Loans Settlement and Trading Association (LSTA)) has produced the following documents:
- the Green Loan Principles (GLP), published in 2018, comprising voluntary recommended guidelines that seek to promote consistency and integrity in the development of the green loan market by clarifying the criteria for which a loan may be categorised as 'green'. To aid consistency with the green bond market, the GLP build on and refer to the Green Bond Principles published by the International Capital Markets Association (ICMA);
- the Sustainability Linked Loan Principles (SLLP), published in 2019, which provide a framework for lending to incentivise the borrower's achievement of predetermined sustainability performance targets (SPTs). Similarly to the GLPs, the SLLPs are intended to promote consistency within the sustainability-linked market, covering topics such as setting the SPTs as well as reporting and review of the borrower's performance against those SPTs; and
- most recently, in 2021, the Social Loan Principles (the SLP) were published, which provide a framework for market standards and guidance for social loans, where the proceeds of the loan are used for predetermined social projects, building on the Social Bond Principles published by the ICMA. The SLPs cover topics such as the use of proceeds and process of evaluation and selection of social projects, together with guidance on the monitoring and reporting on the project and proceeds of the loan.
Alongside each set of principles, the LMA has also published guidance notes to aid interpretation of the principles in the market covering matters such as, for example, guidance for company advisers in relation to ESG disclosure in leveraged transactions. Most recently, at the start of 2022, the LMA has published guidance on the external review and verification process. The LMA continues to take a very active role in the development of the market, providing regular updates to the principles and guidance to reflect developing market practice.
Sustainability-linked financing in particular continued to grow in the UK throughout 2021, both in the context of investment-grade corporate working capital facilities and, increasingly, in the leveraged loan market (including some event-driven financings). As mentioned above, sustainability-linked loans contain ESG-related SPTs, typically referred to as key performance indicators (KPIs), selected by the borrower. KPIs may relate to, for example, reductions in emissions or diversity targets within the borrower group. Depending on whether or not the KPI targets are achieved by the borrower, the margin will adjust upwards or downwards. In addition, the lenders will usually expect ongoing information on the borrower's performance in relation to the KPIs during the life of the loan. This reporting can be provided either by the borrower or by an external opinion provider appointed by the borrower. To smooth the process, one or more of the lenders may act as a sustainability coordinator to assist with negotiating the KPIs and liaising with the borrower on behalf of the lenders on ESG-related matters. The sustainability coordinator will not, however, assume any fiduciary duties to the rest of the syndicate. Negotiations generally focus on the setting of the KPIs, together with the nature and extent of the reporting and verification of the borrower's performance.iii Pension Schemes Act 2021
Defined benefit (DB) pension liabilities have received renewed focus in corporate and financing transactions since the enactment of the Pensions Schemes Act 2021 (PSA). The PSA is intended to strengthen the powers of the UK Pensions Regulator to intervene in corporate activities that threaten DB pension scheme benefits and recoveries (referred to as the 'moral hazard' regime).
The 'moral hazard' regime was introduced by the Pensions Act 2004, which granted powers to the Pensions Regulator to protect the position of DB pension schemes by requiring employers to provide additional support to schemes in certain circumstances. These powers allow the Pensions Regulator to issue contribution notices (CNs) and financial support directions (FSDs) to either the scheme employer or a person 'associated or connected'2 with the scheme employer. FSDs are more general in nature and permit the UK Pensions Regulator to require employers to provide additional financial support for the pension scheme's obligations where the Regulator believes it is reasonable to do so. CNs focus on specific actions (or failures to act) that have negatively affected the DB pension scheme.
To issue a CN under the Pensions Act 2004, the Pensions Regulator has to be of the (reasonable) opinion that one of two tests have been met: (1) the target of the CN must have been a party to, or 'knowingly assisted' in, a deliberate act or failure to act, the main purpose of which was to prevent recovery of a DB pension scheme debt; or (2) the target's act or failure to act has 'detrimentally affected in a material way' the likelihood of accrued DB pension scheme benefits being received. Defences are available if (in summary) the target of the CN can show that it considered the DB pension scheme and took reasonable steps to mitigate the effect of the act. A voluntary clearance procedure is also available, whereby the UK Pensions Regulator can confirm that it would not be reasonable to issue a CN or FSD.
In addition, the Pensions Act 2004 introduced a series of 'notifiable events', intended as an early warning system for the Pensions Regulator of the occurrence of events relating to either the DB pension scheme or the scheme employer, which may impact on the DB pension scheme as a creditor. Examples include a breach by the employer of financing covenants and certain changes of control, with non-compliance potentially triggering fines or being considered as a ground for issuance of a CN or both. If an event occurs, it must be notified in writing to the UK Pensions Regulator as soon as reasonably practicable.
In relation to the above, the PSA introduces the following key changes:
- new grounds for issuing CNS: Two new tests have been introduced to allow the UK Pensions Regulator to issue CNs, the 'employer insolvency' test, and the 'employer resources test'. Both these new tests look to the strength of the DB pension scheme employer (rather than the scheme itself), focusing on the effect the proposed act will have on the employer's resources or on the employer's hypothetical insolvency in the context of the potential recovery by the DB pension scheme as a creditor. These new tests expand the circumstances in which CNs can be issued and are likely to be easier for the UK Pensions Regulator to enforce;
- new criminal and civil offences: One of the more controversial elements of the PSA is the criminal offences it introduces. Two new criminal offences now apply to help enforce the moral hazard regime, both of which can apply to any 'person', including individuals (such as directors), regardless of whether that person has any connection to, or association with, the DB pension scheme or its employer: (1) conduct that results in avoidance of employer debt to a DB pension scheme, where the person intended that this is the outcome; and (2) conduct that detrimentally affects in a material way the likelihood of accrued DB pension scheme benefits being received where the person knew or ought to have known that this would be outcome. Defences are available, if the person had a 'reasonable excuse' for their actions: the UK Pensions Regulator has published guidance on how it plans to exercise its new powers and what will constitute a 'reasonable excuse'. Conviction under these offences can result in up to seven years imprisonment or unlimited fines, or both. It is worth noting that there are no specific exceptions to these offences for lenders or financing transactions where there is a DB pension scheme within the group; and
- new notifiable events: There are two new categories of notifiable event introduced by the PSA: (1) the sale of a material proportion of the business or assets of a scheme employer in respect of which a decision in principle has been reached; and (2) the granting of security on indebtedness which has priority over the DB pension scheme. If a notifiable event occurs, the trustees or managers or the employer of the scheme are obliged to notify the UK Pensions Regulator as soon as reasonably practicable upon becoming aware of the notifiable event. The PSA introduces an additional notification requirement, requiring a notice and statement to be given to the UK Pensions Regulator that sets out the implications for the scheme in relation to certain employer corporate events and how any risks to the DB pension scheme are to be mitigated. This is intended to give the UK Pensions Regulator and DB pension scheme trustees greater involvement at an earlier stage. A new financial penalty for breach of these obligations of up £1million is introduced, along with expansion of the existing criminal liabilities.
Since the 2004 Act has been in force, DB scheme issues have routinely formed part of the due diligence and credit risk assessment for financing transactions, together with liaising with the scheme trustees (where appropriate) to determine the extent of any additional support required to mitigate the impact of the transaction on the scheme. While due diligence plays a key role in assessing the existence of any actual or potential DB scheme liabilities, contractual protections, by way of representations or undertakings regarding the existence of and liabilities associated with a DB scheme, together with undertakings relating to compliance with the DB scheme obligations and provision of information to the lenders are also often seen. For some transactions, receipt of a CN or FSD may trigger an event of default, or obtaining clearance from the Pensions Regulator may be a condition precedent.
The changes introduced by the PSA are likely to result in an increased focus on the above provisions and the structuring of financing arrangements. Those involved in restructuring transactions are likely to pay particularly close attention to the PSA's new provisions: early engagement with pension trustees and detailed preparation and professional advice will all be required to minimise the risk of potential liability.iv National Security and Investment Act 2021
The National Security and Investment Act 2021 (NSIA) came into force in January 2022. The NSIA allows the government to intervene in business transactions in specified sectors, including acquisitions and the grant of security, which might reasonably raise national security concerns. Acquisitions in these 'sensitive' sectors designated in the NSIA require clearance from the UK government to proceed, which will need to be factored into the offer timetable. Transactions outside those designated sectors may also be affected. There is also a voluntary clearance procedure that may be followed in cases where there is concern that the transaction could be 'called in' by the UK government pursuant to the terms of the PSA after the event.
Where a transaction falls within the scope of the NSIA, obtaining clearance will need to be factored into the proposed timetable. Lenders may request specific contractual protections, such as making clearance a condition precedent to funding.
Tax considerationsi UK withholding tax
Payments of interest by a UK borrower or UK branch of a foreign borrower, or that otherwise have a UK source and that are made on a loan that is capable of being outstanding for more than one year, are subject to UK withholding tax, currently at a rate of 20 per cent, unless an exemption applies. The UK tax regime provides for lenders to receive interest payments free of UK withholding tax if they are UK banks or UK branches of overseas banks that bring that interest into account for UK corporation tax purposes, UK tax-paying companies or partnerships, or UK building societies.
Lenders that are tax-resident outside the United Kingdom may also receive interest payments free of withholding tax if they qualify under a double tax treaty with the United Kingdom ('Treaty Lenders', in LMA terminology). As well as satisfying the conditions in the applicable treaty, directions must be obtained from Her Majesty's Revenue and Customs (HMRC) stating that the borrower can pay interest without deducting tax. The introduction, in September 2010, of HMRC's Double Taxation Treaty Passport Scheme (DTTPS) has, where applicable, improved the time frames within which such directions can be obtained, but there remains a greater risk of withholding tax arising in the case of Treaty Lenders than in the case of UK lenders (unless the borrower is a strong credit and has been able to limit its gross-up obligation such that it does not apply if clearance is not obtained).
The scope of the DTTPS has since been extended such that for loans entered into on or after 6 April 2017 the parties no longer need to be corporates. Assuming the relevant conditions are satisfied, it can now be used if the UK borrower is an individual, a partnership or a charity or if a Treaty Lender is a sovereign wealth fund, pension fund, partnership or other tax-transparent entity, provided in the last case that the beneficial owners of the interest are entitled to the same treaty benefits under the same treaty.
The treatment of UK withholding tax risk in loan documentation is well settled and reflected in the LMA's English-law templates. In summary, the borrower is obliged to gross up the amount payable to the lenders should the borrower be required to deduct tax from such payments, provided the recipient lender was a 'qualifying lender' on the date of the agreement. The effect is to limit the circumstances in which the borrower might become obliged to deduct tax and gross up any payment to a lender to a change in law that results in a 'day-1 qualifying lender' ceasing to be exempt from UK withholding tax.ii Stamp and documentary taxes
No UK stamp or documentary taxes generally apply to loan, security or loan trading documentation where a security trustee structure is used (assuming the loan is not considered to have equity-like characteristics).iii FATCA
The conclusion of intergovernmental agreements (IGAs) between the United States and a number of countries, including the United Kingdom and most of Europe, has had the effect of largely eliminating the risk of FATCA withholding for financial institutions within the scope of those agreements.
In 2012, the LMA produced a series of riders for use with its facility documentation to allocate the risk of FATCA compliance and any tax deductions as agreed, which have since been updated a number of times. Rider 3, which entitles all parties to withhold as required, but imposes no gross-up or indemnity obligation on the borrower, has become the standard way of dealing with FATCA risk in loan documentation in Europe, regardless of whether the borrower group includes a US entity or has US-source income. Since 2014, the Rider 3 wording has been incorporated into the Investment Grade Agreements and certain other of the LMA's templates, together with information-sharing provisions designed to facilitate compliance with FATCA as well as other exchange of information regimes (such as the OECD's Common Reporting Standards (CRS) initiative). The contractual treatment of FATCA risk still requires discussion in transactions involving lenders in non-IGA jurisdictions, where there remains some variation in the agreed positions.
Credit support and subordinationi SecurityTypes of security interests
Secured lending transactions typically involve a combination of security interests. Security can be taken over all asset classes and the choice of security interest depends on the nature of the asset and its importance in the context of the security package.
Under English law, there are four types of consensual security: pledge, contractual lien, mortgage and charge.Pledges and contractual liens
A pledge is created through transfer of possession, where the pledgee has the power to sell the secured assets and to use the proceeds of sale to discharge the secured obligation. By contrast, under a contractual lien the lienee merely has a passive right of retention until the secured obligation has been performed.
The distinction between a pledge and a contractual lien is, however, of very limited practical importance in most corporate financing transactions. The reason for this is twofold and stems from a pledge and a contractual lien being possessory security interests. First, it is not possible to create a pledge or lien over future property or land, or over intangible assets that do not fall within a very limited category of documentary intangibles (such as bearer bonds). Second, although many companies are willing to provide security as part of the price of obtaining finance, they will often wish to retain the ability to use and deal with the secured assets, which will not be possible where the secured creditor has possession of the assets in question.Mortgages
Mortgages involve the transfer of title to the asset in question to the lender by way of security, with a right to the transfer back of the mortgaged property when the secured obligation has been satisfied. A mortgage is legal or equitable depending on whether legal or equitable title is transferred.3 The form of transfer will depend on the nature of the asset in question and so, for example, mortgages over a chose in action (e.g., claims or receivables) involve the assignment of rights by way of security.
The steps required to transfer legal title to an asset and to create security by way of legal mortgage add a layer of complexity that may not be required at the outset of the transaction (see further below). In general, only freehold property, significant items of tangible movable property, aircraft and ships are the subjects of legal mortgages. In relation to other types of assets, equitable security is created and the secured creditor relies on contractual further assurance clauses and a security power of attorney to facilitate the transfer of legal title upon the security becoming enforceable.Charges
A charge involves an agreement by the chargor that certain of its property be charged as security for an obligation. It entails no transfer of title or possession to the chargee.
In practice, there is little to distinguish a charge from an equitable mortgage, as enforcement rights such as a power to take possession, sell the secured assets and appoint a receiver are routinely included in documents creating charges.4 The more significant distinction is between fixed and floating charges.
Broadly, a fixed charge attaches to a specific asset and restricts the chargor from dealing with (e.g., disposing of) that asset. A floating charge generally attaches to a class of assets, and the chargor is permitted to deal with those assets in the ordinary course of business without the consent of the chargee pending an event that causes the charge to 'crystallise'. A typical floating charge will comprise the entirety of the borrower's assets, whether existing or future, and whether tangible or intangible.
The main consequence of the characterisation of a charge relates to the ranking of payments on insolvency. For example, expenses of both liquidations and administrations are paid out of floating charge assets. These costs and expenses can be considerable, and may well exhaust the floating charge assets. A floating charge also ranks behind certain claims of certain preferential creditors (broadly, certain rights of employees and certain amounts owing to Her Majesty's Revenue and Customs) and, in respect of charges created on or after 15 September 2003, the 'prescribed part', a ring-fenced fund, is also paid out of floating charge assets to unsecured creditors in priority to the floating chargee. Unlike expenses, the priority of employees dismissed promptly following the commencement of insolvency proceedings and the amount of the ring-fenced fund are, generally, reasonably finite (the latter being currently capped at £800,000) and can be roughly calculated in advance by secured lenders.
The other key difference between fixed and floating charges is that the holder of a floating charge that constitutes a 'qualifying floating charge' (broadly, a floating charge relating to the whole or substantially the whole of a company's property) enjoys very privileged appointment rights in an administration. It may appoint an administrator either in court or out-of-court at any time when the charge is enforceable, and is allowed to substitute its own preferred candidate in the place of an administrator proposed to be appointed by any other person.
These consequences have acted as a strong incentive to lenders to draft charge documents, known as 'debentures', which purportedly create fixed security over as many of the chargor's assets as possible, combined with a sweeper floating charge over all of the assets of the chargor. However, when characterising a charge as fixed or floating, the courts will have regard to the commercial substance of the relationship between the parties. The label attached by the parties themselves will be largely irrelevant and, if it is inconsistent with the rights and obligations that the parties have in fact granted one another, the security will be recharacterised.Common methods of taking security
The typical method of taking security over specific assets and any perfection steps5 depend on the nature of the asset. For example:
- Real estate: title is transferred to the mortgagee in writing alongside the title deeds if a legal mortgage is to be created. An equitable mortgagee will also generally request delivery of the title deeds.
- Registered shares: a legal mortgagee of shares must be registered as the legal owner, which may have adverse tax and accounting consequences for the lenders. Security is, therefore, often taken by way of equitable mortgage or fixed charge. To facilitate enforcement, the certificates for the shares are usually deposited with the chargee together with signed but undated forms of transfer. The articles of association are amended if necessary to ensure there are no restrictions on transfer in the event of enforcement.
- Intellectual property rights: a legal mortgage or assignment of rights to intellectual property by way of security necessitates an exclusive licence back to the assignor to enable it to continue to use the rights, including a provision for reassignment on discharge of the security. It is, therefore, more common for such rights to be the subject of a charge.
The appropriate method of taking security over claims and receivables such as book debts, bank accounts and cash varies. The key question is whether it is practical to create fixed security. If the intention is to create a fixed charge, the security document will need to contain adequate restrictions on the chargor's ability to deal with both the asset and its proceeds, and those restrictions must be complied with in practice. This generally means that the proceeds of charged receivables must be paid into a blocked account. This may be achievable in relation to certain specific sums (e.g., the proceeds of a disposal that are to be used to prepay the loans). However, companies will need access to at least some of their bank accounts so fixed security will not be achievable in all cases.Formalities and registration
Formal requirements for English-law security are minimal. For a variety of reasons, however, it is generally accepted that security documents should be executed as deeds.
Subject to limited exceptions,6 security interests created by English companies must be registered at Companies House within 21 days of creation, whether over assets in the United Kingdom or abroad and whether created under an English-law security document. If this is not done, the security will be void as against a liquidator, administrator or creditor of the company, and the secured liabilities will become immediately repayable.
In addition, certain types of assets (e.g., real property, ships, aircraft and certain intellectual property rights) may also be registered, generally for priority purposes, on specialist registers.
Registrations at Companies House and at the land and other specialist asset registries attract nominal fees.Particular challenges
There are no specific categories of asset over which security cannot be granted or over which it is too difficult to create security under English law. However:
- third-party consent may be required to create some types of security over certain leased items (including leasehold real estate), and other contractual rights and receivables, which may be challenging to obtain;
- the limits of the distinction between fixed and floating charges can be uncertain, in particular in its application to cash and receivables; and
- it is not possible to create a legal mortgage of future assets. However, it is possible to create equitable security (equitable mortgage or charge) over future assets. The terms of the security document may require the chargor to take steps to convert the equitable security into a legal mortgage upon acquisition of the relevant asset.
The grant of security is also subject to the legal limitations outlined in Section V.ii Guarantees and other forms of credit support
Guarantees must be documented in writing and are usually executed as deeds to prevent the guarantor from raising any questions about the existence or adequacy of consideration. Guarantees are the most common form of credit support in both secured and unsecured English-law financings.
The legal limitations outlined in Section V apply equally to the provision of guarantees.iii Priorities and subordinationPriorities
The general rule under English law is that, as between competing security interests, the first in time normally prevails. However, this is subject in some cases to registration and other exceptions. The rules of priority are complex but might, very broadly, be summarised as follows:
- Where registration at a specialist registry is required, the priority of competing interests is generally determined by the order of registration.
- Registration at Companies House does not directly affect priority. This registration may, however, constitute notice to third parties of the existence of the charge, which may affect the ranking of subsequent security.
- The priority of successive assignments of a debt or other chose in action is governed by a common law rule under which an assignee who takes an assignment without notice of an earlier assignment and is the first to give notice of assignment to the debtor obtains priority over the earlier assignee.
- A legal interest acquired for value and without notice (actual or constructive) of a prior equitable interest will normally rank ahead of the prior equitable interest.
- Special rules apply to floating charges. The grant of a subsequent fixed charge or mortgage takes priority over a floating charge, unless at the time the subsequent security is created the floating charge places restrictions on the creation of further encumbrances (in the form of a negative pledge, which is customarily included in English-law financing documents) and the subsequent holder has notice of the restriction. For this reason, a note of the negative pledge is included in the particulars of the charge that are registered at Companies House, the intention being that anyone who searches the register will thereby acquire actual notice of the restriction. Registration at Companies House may also constitute constructive notice.
Subordination in banking transactions is typically effected by the use of structural subordination (where ranking is determined by which company in the group is a debtor (either as a borrower or guarantor) to the junior and senior creditors) and contractual subordination (where creditors contractually agree to the ranking as among themselves). Contractual subordination is generally achieved through the use of an intercreditor or subordination agreement.
Contractual subordination is often coupled with a turnover trust as a fallback to maximise the recoveries of the senior creditors in an insolvency of the debtor. Under a basic trust subordination arrangement, the junior creditor agrees that any money it receives from the debtor in insolvency (e.g., in the event of mandatory insolvency set-off or other mandatory distribution contrary to the intercreditor agreement) will be held on trust for the senior creditors to the extent of the senior debt. If effective, this has the advantage of giving the senior creditors a proprietary claim against the junior creditor, and means the senior creditors will not be exposed to credit risk on the junior creditor.
It is generally agreed that, as a matter of English law, contractual subordination should be enforceable as between the contracting parties.
In jurisdictions where trusts are not recognised, there is a risk that a junior creditor trustee will be treated as sole owner of the turnover property. There is also a limited risk that, in the event of an insolvency, the turnover trust provisions may be recharacterised as a security interest, which would be void for lack of registration. There is case law support for the proposition that a turnover trust provision will not be recharacterised as a charge if it is limited to the amounts required to pay the senior creditor in full and it is, therefore, generally thought that this risk can be mitigated with careful drafting.
Legal reservations and opinions practicei Limitations on validity and enforceability of guarantees and security
The key issues when considering the validity and enforceability of guarantees and security are capacity and corporate benefit, financial assistance rules and the clawback risks that may arise in insolvency. These issues, which are discussed below, are frequently of theoretical concern only and are usually able to be dealt with as a practical matter in a typical transaction.ii Capacity and corporate benefit
To grant valid guarantees and security, the grantor must have the requisite capacity and there must be adequate corporate benefit.
The corporate benefit analysis must be done on a company-by-company basis and any benefit received by other members of the group may not be relevant unless, for example, there is an element of reliance and financial interdependence between the companies. As well as carefully minuting the perceived benefits, if there is any doubt the security provider or guarantor may seek the approval of its shareholders. For a company that is solvent at the time of granting the guarantee or security, a unanimous shareholder resolution will act to ratify a transaction that might otherwise fall outside the scope of the directors' powers, and is usually required by secured creditors as a condition precedent to funding in relation to upstream or cross-stream guarantees and security.iii Financial assistance
The Companies Act 2006 restricts the provision of financial assistance, including security and guarantees, as follows. If the target is an English public company, neither the target nor any of its subsidiaries (public or private) may: (1) provide financial assistance for the purpose of the acquisition of the shares of the target or of reducing or discharging a liability incurred therefor; or (2) if the target is a private holding company, no English public subsidiaries of the target may provide financial assistance for this purpose.
A number of exceptions apply but they are often not relevant in the context of secured lending. In practice, if security and guarantees are required from the target group following the acquisition, the relevant public companies in the target group will be re-registered as private companies before the financial assistance is given.iv Clawback risks
Under English insolvency laws, the court has wide powers to set aside certain transactions.
Guarantees and security provided by an English company or any foreign company subject to English insolvency proceedings may be at risk of being challenged by the insolvency officer if given within a certain period prior to commencement of liquidation or administration, and if certain other conditions are satisfied.
In the case of a guarantee, the most likely ground for challenge is that it represents a transaction at an undervalue7 or amounts to a preference.8 In the case of security, the most likely grounds for challenge are that the transaction constitutes either a preference or a voidable floating charge.9
The vulnerability periods differ depending on the ground for challenge and are: six months for preferences (two years if the counterparty is a connected person); two years for transactions at an undervalue; and one year for a voidable floating charge claim (two years if the counterparty is a connected person).v Preferences
For a transaction to be vulnerable as a preference, not only must it have been entered into within the specified period but the company must have been influenced by a desire to produce a preferential effect and must have been insolvent (as defined by statute) at the time of the transaction or become so as a result of entering into it.vi Transactions at an undervalue
For a transaction to be vulnerable under Section 238 of the IA, it must have been a transaction at an undervalue within the meaning of Section 238(4) of the IA and entered into within the vulnerable period. Further, the company must have been insolvent (as defined by statute) at the time of the transaction or have become so as a result of entering into it. In practice, this ground for challenge is of relatively limited concern in most secured loan transactions because of the good-faith defence that is available. This defence applies if it can be shown that the transaction was entered into by the company in good faith and for the purposes of carrying on its business, and at the time it did so there were reasonable grounds for believing that the transaction would benefit the company.vii Avoidance of certain floating charges
Under Section 245 of the IA, a floating charge may be set aside except to the extent of the value given to the company at the same time as or after the creation of the charge. If the parties are not connected, it is a defence if the company was solvent (within the statutory definition) when the charge was created and did not become insolvent as a result of the transaction.
Transactions, including security arrangements, may be vulnerable to challenge on other grounds, including that they offend the common law anti-deprivation principle, which invalidates, as a matter of public policy, any agreement providing for assets belonging to a company to be removed from its estate on insolvency.viii Legal opinions practice
The practice of delivering legal opinions and the content of those opinions is well established in the English-law loan market. As a condition precedent to funding, lenders require opinions on the capacity and authority of each borrower and guarantor, and on the enforceability of the facility documentation, including any security documents.
The general expectation in loan transactions is that counsel to the creditors will deliver any legal opinions. This is usually the case in domestic transactions. In some circumstances, however, the borrower's counsel will be called on to provide an opinion.
Syndicated loan opinions are typically addressed to the agent and the lenders forming part of the primary syndicate. Sometimes, where primary syndication takes place after the signing date (e.g., in the case of an underwritten acquisition facility), lenders who join the syndicate within a short period of the date of the agreement (e.g., three months) will be permitted to rely on the opinion.
Market practice has for some time been to permit the opinion to be disclosed to, but not relied on by, those who buy participations in the loan (or exposure to participations in the loan) on the secondary market.
No further reliance on or disclosure of the opinion is generally permitted without the opinion-giver's consent.
English-law syndicated loan participations are regularly traded, most commonly by way of transfer by novation, assignment or sub-participation.
Novation is the simplest and most common method and involves an outright sale of the participation. All of the seller's rights and obligations in relation to the loan are cancelled and discharged, and are assumed by the buyer.
If a facility is secured in favour of the lender directly, the security will be released on the novation of the lender's participation to a new lender. Security for syndicated facilities is, however, usually created in favour of a security trustee, who is appointed as trustee for the lenders from time to time. Use of a security trustee structure permits lenders to trade their participations without disturbing the effectiveness and priority of the security.
An assignment of rights to drawn loan participations (coupled with an assumption of equivalent obligations) is sometimes used as a hybrid method if transfer by novation would disturb security or guarantee arrangements, for example, in relation to certain foreign law governed arrangements.
The LMA's facility agreement templates contain a framework to permit trading by novation or assignment, subject to borrower consent unless the transfer is to another lender or an affiliate of an existing lender, or if an event of default is continuing. In addition, it is common for pre-approved lists of permitted transferees (referred to as 'white lists') to be agreed.
The LMA templates do not restrict sub-participation or other trading methods such as trust or derivatives arrangements that do not involve a change to the lender of record under the facility agreement. Some borrowers negotiate those restrictions, but in most cases these trades can be effected without borrower consent. These methods of risk transfer should not disturb any security or guarantees provided in favour of the lender of record (or a security trustee acting on its behalf).
Most recently, the LMA has published revised versions of its standard terms and conditions, trade confirmations and forms of participation agreement for secondary market trades, to reflect the transition in the primary market from LIBOR to RFRs (see further Section II.i).
There are currently no other issues of note.
Outlook and conclusions
The increase in activity seen at the end of the 2021 had been expected to continue in 2022, buoyed by good liquidity in the markets and relatively benign borrowing conditions. However, the invasion of Ukraine by Russia has cast significant doubt on this, with the fallout as the world deals its ramifications likely to bring continued volatility to all markets, and so it is difficult to predict with any certainty what the implications for financing transactions will be.
In terms of legal and regulatory issues, while the transition from LIBOR is nearing an end, the market will continue to focus on reaching a consensus in relation to US dollar transactions and the transition of non-LIBOR currencies. The growth in ESG lending is expected to continue, across the investment grade and leveraged markets, for both working capital and event-driven financings.