84 the context of corporate insolvency law

Mezzanine financing also has a role in corporate rescues when the creditors of a troubled company may be persuaded to raise leveraging and to effect recapitalisation by accepting a mixture of shares and mezzanine finance – where the high returns attaching to the latter reflect the high risks involved in advancing credit to the firm. ‘Junk bonds’ involve high risk / high return characteristics and their use has grown dramatically in the USA since the 1980s.68 The high-yield bond market is, however, yet to develop to the same extent in Europe.

Turning to notes, a medium-term note undertakes to pay the holder a specified sum on the maturity date and interest in the meantime. Such notes are unsecured and may vary widely in terms. A medium-term note programme may provide for the issuing of further bonds under the same documentation (though with a variety of terms and conditions) and this avoids the costs of producing new papers for each stand-alone note (or bond).69 Finally, note should be taken of securitisation. This involves the marketing of repackaged debt – as where a mortgage lender bundles together its claims to repayment and sells these ‘asset-backed securities’ to participants in the credit market. This increases liquidity (by replacing long-term assets with cash) but it places a new distance between the borrower and the lender and this may have implications for the monitoring of management and for potential rescues in times of trouble.70 These matters will be returned to below in discussing the significance of those developments that can be called ‘the new capitalism’71 and in the examination (in part III) of rescue strategies and processes.

Equity and security

Bearing in mind the above fundamentals of borrowing, it is time to consider in more detail how corporate activities can be financed by either equity or credit means and to explore the ways in which different devices serve the needs of healthy and of troubled companies.

68Where over $100 billion of new issues are now introduced annually. Ibid., p. 415.

69Ibid., p. 441. ‘Commercial paper’ involves shorter terms than the usual medium-term note and promises to the holder that a sum will be paid in a few days and the consideration for the loan is set out by giving the amount paid on redemption a higher value than that of the money advanced for the paper. A high credit rating on the borrower’s part is usually required as there is routinely no security involved.

70On securitisation see further Fuller, Corporate Borrowing, pp. 124–8. See also pp. 133–5 below.

71See pp. 133–40 below.

86 the context of corporate insolvency law

above, smaller firms may find it much more difficult to finance through equity due to the relatively high transaction and risk appraisal costs in their small-scale offerings. When firms are new, moreover, the market may prefer to look to those with a known record and reputation.

Taxation regimes may also make financing through equity shares less attractive than through loans.73 If funds are raised through borrowing, the interest paid on a loan can be deducted before payable corporation tax is calculated. Such a deduction will not apply in the case of the rate of return that has to be earned in order to satisfy investors. Loan capital may, as a result, prove cheaper than equity financing and there may accordingly be a bias towards borrowing rather than equity financing. In regard to small businesses it may be the case that investors are reluctant to purchase equity (for reasons discussed above) but, in addition, businesses may be slow to seek financing through equity. Three reasons mooted for such low uptake are the lack of understanding of equity finance among small businesses, the desire of many UK entrepreneurs to avoid sacrificing any degree of ownership, independence or control, even if this could produce higher profits,74 and a set of cultural factors found in the UK. On the last point, the Bank of England has suggested that a ‘fear of failure’ may deter business owners from seeking venture capital.75 To these reasons may be added a fourth: the failure of banks to offer competitively priced equity financing. The Cruickshank review76 of March 2000 highlighted a number of key barriers to entry in the SME equity markets (including asymmetric information), confirmed the existence of an equity gap for firms which aim to raise between £100,000 and £500,000, and criticised the Small Firms Loan Guarantee Scheme for not

73For discussion see J. Samuels, F. Wilkes and R. Brayshaw, Management of Company Finance (6th edn, International Thompson Business Press, London, 1995) pp. 443, 540–9; Arnold, Handbook of Corporate Finance, p. 455.

74See Bank of England 2001, p. 44; White Paper, Our Competitive Future: Building the

Knowledge Driven Economy (Cm 4176, December 1998) para. 2.27. See also P. Poutziouris, F. Chittenden and N. Michaelas, The Financial Development of Smaller Private and Public SMEs (Manchester Business School, Manchester, 1999), who reported that only 25 per cent of private companies said that they would consider a flotation on the stock exchange as a way of raising funds for expansion. On the reluctance of US owner-managers to relinquish control see R. Scott, ‘A Relational Theory of Secured Financing’ (1986) 86 Colum. L Rev. 901, 914; M. C. Jensen and W. H. Meckling, ‘Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure’ (1976) 3

Journal of Financial Economics 305.

75Bank of England 2001, p. 44.

76D. Cruickshank, Competition in UK Banking: A Report to the Chancellor of the Exchequer

(HMSO, London, 2000).

addressing these market imperfections. The evidence nevertheless indicates that small businesses will only consider equity finance after internal sources and debt finance have been exhausted. Equity finance, in any event, is seldom used for raising sums of less than £30,000.77

From the above there emerge two messages for insolvency lawyers: first, that how shareholders are dealt with in an insolvency will depend very much on the efficiency with which creditors’ interests are processed within an insolvency and, second, that there are scant grounds for assuming that corporate financing through the equity route does or will ever do away with a system of credit that can deal efficiently with the needs of both going concerns and companies in trouble.

Secured loan financing

Companies can borrow funds by offering security or by seeking an unsecured loan. The essence of a security interest is that it gives the holder a proprietary claim over assets in order to secure payment of a debt. In contrast, the unsecured creditor will have lent funds to the debtor but will have a personal claim to sue for payment of the debt and the power to use legal processes to enforce any judgment against the debtor. A security interest may, as noted above, be consensual – where it results from the agreement of the parties – or non-consensual – where it arises through the operation of law. Consensual securities include pledges, mortgages, charges and contractual liens. Non-consensual securities can be divided into liens, statutory charges, equitable rights of set-off, equitable rights to trace and procedural securities.78 It should be emphasised that charges can be equitable or legal. Equitable charges do not involve the transfer of possession or ownership that gives creditors the right to have a designated asset appropriated to discharge their debt. An equitable charge is thus a mere encumbrance and does not involve any conveyance or assignment at law: it can exist only in equity or by statute.

Security may involve establishing real rights over one, some or all of the debtor’s assets (a real security) or rights of recourse from a third party who has guaranteed payment to the lender in the event of the debtor’s

77There may, however, be substantial barriers to entry into the public equity markets in the form of fees charged by investment bankers, securities buyers and accountants, and these costs may not be justified where financing needs are modest: see Scott, ‘Relational Theory’, p. 916.

78See further Ferran, Company Law and Corporate Finance, ch. 15.

88 the context of corporate insolvency law

default (a personal security).79 In this section we consider why security is asked for by creditors and the extent to which the existing legal framework for security serves the needs of healthy and of troubled companies.

Creditors are interested in security as a means of reducing the default risks they face. Before taking security or other protective measures they will be concerned about their position in insolvency and more particularly about the ways in which the shareholders and managers of the company may transfer wealth away from lenders and dilute their potential claims. A number of fears may loom large in their minds.80 A first worry is that excessive dividend payments may be made, thereby reducing the value of the firm.81 Second, excessive borrowing may occur when new debt is raised – which may affect the claims of prior debt or, if subordinate, may increase the insolvency risk of all creditors by changing the level of gearing and thus the risks associated with capital structure.82 Third, assets may be taken outside the company and out of the reach of creditors in an insolvency.83 Fourth, asset substitutions may occur in a way that alters the risk profile of the firm and disadvantages the creditor (for example, where a move from tangible fixed assets to

79 See further Snaith, Law of Corporate Insolvency, chs. 2–6. Since 1981 the UK Government has, as noted, operated a government-guaranteed loan scheme designed to encourage bankers to lend to small and medium-sized companies that have exhausted normal financing channels. The Government guarantees the banker that, in the event of a default, the Government will repay 75 per cent of outstanding sums. Personal security from the borrower will not be taken but business assets will be expected to be offered as security. The guarantor may or may not go beyond guaranteeing payments and undertake liability for performance of non-monetary obligations. See generally Goode,

Commercial Law, ch. 30.

80See J. Day and P. Taylor, ‘The Role of Debt Contracts in UK Corporate Governance’ (1998) 2 Journal of Management and Governance 171; C. Smith and J. Warner, ‘On Financial Contracting: An Analysis of Bond Covenants’ (1979) 7 Journal of Financial Economics 117; M. Barclay and C. Smith, ‘The Priority Structure of Corporate Liabilities’

(1995) 50 Journal of Finance 899; G. Triantis, ‘Financial Slack Policy and the Law of

Se cured T ransactions’ ( 200 0) 2 9 Jou r nal of Legal S tudies 35 . O n agency see Jensen and Meckling, ‘Theory of the Firm’.

81I.e. if cash flows are directed to dividends rather than investment or the repayment of debt or if assets are sold (for example, by sale and lease-back arrangements) and the proceeds paid in dividends thereby reduce the value of assets available to creditors on break up: see Day and Taylor, ‘Role of Debt Contracts’, p. 176.

82Ibid., pp. 176–7.

83On asset dilution see Smith and Warner, ‘On Financial Contracting’, p. 118; G. Triantis, ‘Secured Debt under Conditions of Imperfect Information’ (1992) 21 Journal of Legal Studies 225, 235.

intangibles takes place).84 Fifth, underinvestment may occur where managers forgo investments that would benefit lenders85 (they may, alternatively, engage in inefficient strategies because their central aim is to preserve managerial jobs). Finally, managers may engage in excessive risk-taking.86 They may borrow money for stated purposes but divert those funds towards use on projects presenting higher financial risks – projects the creditor would not have funded at the given interest rates or perhaps at all.

In responding to these potential problems, creditors can seek security; obtain price protection by trading debts, where possible; spread risks by diversifying; shorten repayment periods;87 and use covenants in debt contracts.88 The clauses of the latter can, for instance, be used to restrict levels of dividends or asset disposals or levels of debt.

A major reason for taking security,89 in this risk-laden context, is thus to establish claims that, on distribution of the insolvent company’s assets, will rank above the claims of unsecured creditors. Creditors may also take security in order to gain access to information. This can be achieved by using the threat of realising the security to obtain access to company decision-making. The creditor can thus become privy to managerial decisions, may even be represented on the board90 and may engage in informed monitoring in order to protect their security.91 Security may, in addition, give the creditor a right of pursuit so that where the debtor disposes of property that is subject to a charge, a claim may be advanced

84See R. Green and E. Talmor, ‘Asset Substitution and the Agency Costs of Debt Financing’ (1986) 10 Journal of Banking Law 391; M. Miller, ‘Wealth Transfers in Bankruptcy: Some Illustrative Examples’ (1977) 41 Law and Contemporary Problems 39.

85See S. Myers, ‘Determinants of Corporate Borrowing’ (1977) 5 Journal of Financial Economics 147.

86See L. Bebchuk and J. Fried, ‘The Uneasy Case for the Priority of Secured Claims in Bankruptcy’ (1996) 105 Yale LJ 857, 873–5; Triantis, ‘Secured Debt under Conditions of Imperfect Information’, pp. 237–8.

87See B. Cheffins, Company Law: Theory, Structure and Operation (Clarendon Press, Oxford, 1997) p. 74.

88See Day and Taylor, ‘Role of Debt Contracts’.

89See R. M. Goode, ‘Is the Law Too Favourable to Secured Creditors?’ (1983–4) 8 Canadian Bus. LJ 53. See also Diamond Report (1989). Security may also be attractive to creditors because it gives powers of enforcement (fear of which often leads debtors to give priority of performance to secured creditors); it allows the secured creditor to prevent seizure of secured assets by other creditors; and it may also allow pursuit where the secured assets are sold to another party. See Diamond Report, pp. 9–10.

90See further V. Finch, ‘Company Directors: Who Cares About Skill and Care?’ (1992) 55 MLR 179, 189–95.

91On monitoring see pp. 95–9, 102–6, 121 below.

90 the context of corporate insolvency law

against the proceeds of that disposition. The creditor may also seek security in order to increase their influence over the market behaviour of the debtor. A charge, for instance, may be so all-embracing as to give the charge holder what amounts in practice to an exclusive right to supply the debtor with credit in that potential second financiers will be deterred from lending by the breadth of the existing charge. A creditor may, furthermore, take security as an alternative to expending resources on gaining such information as will allow him or her to quantify the financial risk involved in lending. Both the taking of security and the collection and analysis of information provide ways to limit and calculate risks, but in some circumstances the former route may be preferred to the latter on the grounds that it involves lower costs and greater certainty. Finally, a creditor (A) may fear that if it is unsecured, some other, more aggressive, unsecured creditors will act too quickly against the debtor company when it faces hard times and that this may prejudice the company’s survival and the repayment of the debt owed to creditor A. Creditor A may thus be motivated to seek security in order to discourage or protect against such precipitate action by unsecured creditors.

Bearing in mind the above attractions of security, it might be asked: why do not all creditors always demand security when advancing goods or money?92 A first reason is that the costs of negotiating security may be excessive given the financial risk involved. Thus, where a trade creditor advances, say, a small stock of timber to a building firm for later payment, the sums involved may not justify the costs of drawing up a security agreement.93 Other reasons for not taking security may be the unfamiliarity of the small trade creditor with legal arrangements; the custom of informality within trading relationships; the timescales being worked to (with a large number of items being supplied at a high frequency); and the anticipated high costs of monitoring security arrangements.94

Finally, the relative bargaining positions of the debtor and creditor may come into play and large corporate debtors with unimpeachable creditworthiness may insist on loans without security. If both parties are rational and informed, however, even the most powerful debtor is likely

92See Carruthers and Halliday, Rescuing Business, p. 163.

93Supplies may, however, be delivered under retention of title clauses: see pp. 125–7 and ch. 15 below.

94See Carruthers and Halliday, Rescuing Business, pp. 305–6; Cheffins, Company Law, p. 82.