It was recently reported that UK banks must raise about £390 billion in 2011 just to maintain their existing funding. A combination of maturing bonds and the restriction of Government guarantee funding is resulting in a general squeeze on the availability of debt finance.
Figures from the Bank of England confirm that lending to corporate borrowers fell by almost £5 billion in the last quarter of 2010. Although the main banks have recently signed up to the Project Merlin agreement, which commits them to increasing available credit during 2011, concerns have already been expressed as to whether companies will be able to afford to access this credit.
Companies who have been refused bank facilities, or find them being offered on unrealistic terms, are increasingly looking at lenders closer to home. As a firm, we have seen a significant increase of instructions from directors and/or shareholders (for the purpose of this article the “Lender(s)”) who have agreed to advance funds to their own companies (the “Borrower(s)”). This trend also extends to members lending to their clubs; parents lending to their childrens’ schools etc.
Here are our top ten suggestions for this form of DIY lending, to ensure that the process runs as smoothly as possible.
1. Agree terms
Before entering into a loan arrangement, most banks will issue a “Term Sheet” which sets out the main proposed terms of the loan.
A Lender should sit down with other directors/shareholders to agree not only the commercial terms, but also structuring issues e.g. are parties going to be legally represented; who is paying the costs of the exercise; proposed timetable etc.
2. Build in flexibility
An example. A Lender wants to lend £500k to his company. This is documented and the funds advanced, but a few months later the parties realise that the loan was not enough. As the facility and security agreements only recorded the £500k loan, the whole lending exercise will need to be repeated for the proposed additional sum.
This could have been avoided if the facility had been drawn up with some headroom (as to the amount of the loan) and the security drawn up on an all-monies basis.
Using the above example, the facility letter could have been originally prepared in the total amount of, say, £1m with the first £500k being lent as a “Tranche 1” with further tranches to be advanced at the discretion of the Lender.
3. Have you the authority?
Under the Companies Act 2006, it is no longer necessary for a company to have a memorandum of association (let alone a specific authority to borrow).
However it is still good practice to check the Borrower’s constitutional documents to ensure, for example, that there is no borrowing limit.
Also, if the Borrower is subject to a shareholders agreement, it is likely that prior shareholder sign off will be required to any borrowing, grant of security or arrangements with a connected party.
4. Contact your bank
On the subject of consents, the Borrower’s bank will often have restrictions built into its documentation which require it to give its consent to any other lending/security. This form of negative pledge can be perceived as slightly harsh if the reason for the transaction in the first place is that the bank is refusing to extend its facilities.
Often consent will be given but a pre-condition will be the entering into of a deed of priority/subordination/postponement, making it clear that the bank’s facilities rank ahead of any other lending.
If a Lender is prepared to take the risk and advance funds, it is only appropriate to consider whether security is granted to them. If security can be taken, it should ensure that the Lender is ranked ahead of ordinary creditors, if the Borrower subsequently goes into insolvency.
When the charge/debenture is signed, the parties have 21 days to register it on a form MG01 at Companies House (otherwise it will be void against any subsequently appointed liquidator).
6. An appropriate return
As well as questions of security, the parties will also need to agree what is the appropriate interest rate; is there is an arrangement fee; should there be a default rate of interest if payment terms are breached etc.
Consider offering the opportunity to co-lend to other directors/shareholders. If they are not prepared to lend, it is a lot harder for them to object to the terms agreed with a lender who is prepared to get out his cheque book.
7. The facility letter
It is common to see facility letters from banks that can run to 200+ pages.
Clearly the terms of a loan from a shareholder/director do not need to go into that level of detail/complexity. However they should set out key terms such as amount, purpose, repayment date, interest, basic warranties, events of default and conditions precedent.
One of the most common traps for the unwary is that the security and loan documentation will be put in place after the loan has already been made.
There is a very good reason why banks will only lend when all the paperwork is in place, namely the Insolvency Act 1986. It is far easier for any subsequently appointed liquidator to challenge the granting of the security to a connected party, if the security is taken after the loan has already been advanced.
Parties can often address this problem by ensuring that a loan is repaid and a subsequent loan re-granted (after the paperwork is signed).
9. Signing off the loan
Once the paperwork is ready to be approved, it is good practice to ensure that a board meeting of the Borrower is convened to approve the documents. If the Lender is a director, care should be taken to read the articles of association to see if the Lender can take part in the deliberations/vote on the proposals. If quorum is not an issue, it is better that the Lender is excluded from such negotiations. His interest in the arrangements should also be formally disclosed/minuted.
10. Take advice
As well as instructing lawyers to review the proposals and prepare the documentation, it is sensible for the Borrower to speak to its accountant. There may be transfer pricing issues if loan terms are off market.