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The Security Review: A Review for Lenders
- A security review is a key document to enable a lender to take informed decisions in relation to its future dealings with a borrower and its internal reporting/provisioning.
- Mistakes in security suites are common, but do not often by themselves lead to worse outcomes. However, in rare cases they can lead to drastically different outcomes for a lender whether in relation to the time to, or amount of, the recovery.
- Security reviews inform the exit strategy from an early stage and provide the chance to put things right before the borrower enters the twilight period before insolvency.
- The UK economy is facing many headwinds, meaning that lenders will be closely scrutinising the information supplied by their borrowers and looking to put their books in good order. This article is intended as a timely reminder of the purpose of the security review, when it is needed and some common issues encountered.
The security review is often an essential element in a lender’s strategy to recovery the of its money from a borrower. It allows a lender to identify issues relating to its lending documents which have either existed since their creation or arisen during the course of the loan. The identification of such issues early on is likely to impact on the lender’s dealings with the borrower, guarantors and other secured creditors. Its findings may dictate the tone of the approaches made to these persons and other stakeholders.
The UK economy is facing many headwinds. Whether from a Hard Brexit, Covid-19 or the structural changes facing the high street economy. Most lenders will now be reviewing their books to identify borrowers in exposed industries ahead of the usual warning triggers of breached covenants and missed payments. This article is intended as a timely reminder of the purpose of the security review, when it is needed, and some common issues encountered.
The Security Review
At its heart the security review is a legal review of the following:
- the loan document including amendments, side letters and any existing reservation of rights;
- the security documents including any guarantees and associated security;
- the corporate authorisations and company constitutions of the borrower entities;
- inter-creditor deeds, deeds of postponement, deeds of priority and similar documents;
- quasi-security documents such as any collateral warranties relating to key contracts; and
- the key public registries including Companies House, winding-up and bankruptcy lists/registers and the Land Registry.
Following the review a report is produced which summarises any issues identified, comments on the enforceability of the security/guarantees and advises on any issues of process which may arise during the course of any enforcement.
The style of the report differs firm to firm, but usually there is an attempt to make the document user friendly by listing assumptions and exclusions in a schedule or as part of the engagement terms. The assumptions/exclusions will inform the reading of the report so it is important for the lender to understand at the outset what these are. For example, it is not uncommon for there to be an assumption that the borrower has complied with all formalities required of it by the Companies Act and its Articles. Which, if assumed, may mean that the review of articles, due execution, board minutes etc. has not been carried out and thus not highlighted in the body of the report.
When it is needed
A security review will necessitate the lender incurring the legal costs associated with the production of the report as well as taking up management time in its consideration. Although it should be possible to pass the legal costs (and in most cases the management costs too if they can be quantified) on to the borrower, there is an understandable reluctance of lenders to do so unless the borrower is actually in default. This sometimes means the report is put off until there is a default. While understandable, the delay in the production of the report can mean that opportunities are missed to rectify the security while the borrower (or the other secured creditors) is being co-operative. Each lender’s credit policy will be different, but the general rule is that the earlier a report is instructed and issues identified, the better.
Some other examples of when a security review (in varying forms) is needed are:
- by a receiver or administrator for the validation of their appointment pursuant to the power of a lender given under a security document;
- by a receiver or administrator wishing to make a distribution to a secured creditor and/or to understand the nature of the realisation (fixed/floating);
- by an unsecured creditor considering a winding up petition and wishing to understand the potential distribution to unsecured creditors in a winding up;
- by a purchaser of assets from an insolvency officeholder so as to (i) understand that that officeholder is validly appointed and thus able to give good title to the assets and/or (ii) to ensure that the proper releases are obtained from secured creditors so that the title to the assets is passed unencumbered; and
- by a purchaser of a portfolio of secured debt.
Common issues encountered in security reviews
It is expected that the readership will be familiar with the types of security taken and the purpose and powers granted in that security. Therefore this section simply highlights some of the issues which a security review can identify, how these can impact on strategy/tactics and possible solutions.
The Loan Document
Depending on the style of the lender, the loan document may be a two page sheet which relies substantively on the security documents for general terms as to borrower conduct of assets or it may be the main document containing all the covenants in relation asset use, finance testing and development conditions (if any). The wide variance in approaches means that the loan document needs careful consideration in any security report as its terms may impact significantly (or not) on the terms and utilisation of the security documents.
It is common for the security document to contain its own events of default as a trigger for enforcement, but equally common for those events to be set out in the loan document. Although often presumed, careful reading is sometimes needed to determine if a breach of the facility terms is in fact an event upon which the security can be enforced. For example, in poorly drafted security documents the enforcement relies upon a payment default and fails to link up with an “Event of Default” under the facility or generally a breach of a “Finance Document”.
The Secured Liabilities - Does the definition of the liabilities secured by the security documents cover the loan drawn by the borrower?
Most definitions of secured liabilities begin with the words “all monies”. However, there has been a trend in recent years for this wording to be narrowed later in the definition with wording such as “incurred under the Loan Document”. The narrowing of the definition in this way and its interplay with other definitions (e.g. of Loan Document/Finance Documents) can mean that older security documents do not act as security for refinanced loans, second loans or other forms of parallel credit. The solution is to attempt to have the issue rectified by the creation of new security to cover all lending, the possibility of which will depend on the timing of the request in the borrower’s credit cycle.
On the other hand, sometimes the definition of secured liabilities can be made too wide, so that the security is granted for the liabilities of all group companies and any guarantor (sometimes a director or other non-group company associated therewith) but without there being a proper consideration of the corporate authorisations necessary to approve such a grant. For example, where a company is giving security for its director’s liabilities there are sometimes Companies Act requirements for shareholder approval which are overlooked due to a lack of understanding of the consequences of a wide definition of “Secured Liabilities”.
There is much variation in the drafting of security clauses in security documents. Each lender has its own style. Some lenders are still utilising drafting which predates Re Spectrum Plus Limited  UKHL 41. Some still include drafting which pre-dates the 2002 Enterprise Act and modern administration regime, relying on the power to appoint an administrative receiver as the translated power to appoint an administrator out of Court.
The outcome is that careful reading of each security document is needed combined with an understanding of what the lender’s intended asset of main recourse is, so that security report delivering real added value is delivered. Without that understanding and insight the security report can sometimes appear perfunctory and deliver little added value to a lender.
Lending backed up with security over real property (a mortgage) can appear simple. But added complications arise with lending based on the income of an underlying lease. Complications arising out of rent assignments and blocked rent accounts persist in relation to the drafting of the clauses, missed post-completion notices of assignment and the blocked account not being truly operated as such. The security review should identify these issues and may impact on the estimated outcome statement by virtue of the classification of, say, monies in an unblocked “blocked account” as floating charge realisations.
Are the security documents registered at the relevant registries, for example at Companies House, Land Registry and other specialist registries (e.g. aircraft, ships etc.)? If not, this can usually be rectified by way of applying for registration (at Court in the case of Companies House), but the report should include comment as to whether the non-registration has impacted adversely upon the lender’s priority to the asset(s) in question.
The review of the historical articles and consideration of the director’s historic positions is a relevant consideration in any security review. The outcome of that review impacts on the potential challenges which may be raised to the security, for example by a liquidator/administrator of the borrower/guarantor. Therefore it is worth checking whether the security report includes a review of the corporate authorisations/execution of documents, or whether they are matters dealt with by way of assumptions in standard terms.
For example, did the companies have the necessary authority in their articles to take the loan and grant the security/guarantees in question? Were there sufficient directors on the board to take a quorate decision? Are the directors able to refuse to register share transfers transferred under a share charge?
Contemporary suites of loan documents based on Loan Market Association precedents invariably cross refer and incorporate definitions and clauses between themselves. In most cases this is unproblematic. But it can lead to issues where suites are reused from previous heavily negotiated deals. Common issues can be that key clauses necessary for the enforcement of security documents are dropped or amended, in the context of the loan document in which they sit, without proper consideration of the impact of the change when that clause is read into the security document reliant upon it.
A similar issue can arise in the case of amended payment waterfalls within inter-creditor deeds which, when read into a security document, may conflict with the waterfall in that security document, or the statutory waterfall in s109 Law of Property Act 1925. Thus creating uncertainty potentially necessitating Court directions as to distribution by an officeholder.
Restrictive/defective inter-creditor documents
The terms of an inter-creditor document are a result of the negotiating strengths of the various creditors which are party thereto. So, necessarily, there is a wide scope of possible drafting outcomes. A detailed understanding of the inter-creditor documentation is crucial to determine the strategy adopted, particularly when it comes to anticipating an enforcement event and to measure estimated outcomes. The key points the security review should cover are:
- Are there any restrictions or consultation time periods? Sometimes a standstill period can be imposed which is longer than, say, the statutory notice a second ranking debenture holder has to give to the first ranking debenture holder.
- What exactly does the clause containing the order of priority say and is it still relevant in light of any previous asset disposals?
- Are there any powers to sign/execute documents for other lenders who are out of the money but not otherwise co-operating with a release of security? What do those provisions say? When can they be invoked? Is there a valid power of attorney granted to back up such powers?
- Are there any unusual deal specific clauses impacting on distributions or accounting between lenders themselves in relation to recoveries?
- Is the borrower obligated to do anything or granted any ability to receive notice of enforcement? Sometimes this may not be intended, but an obligation to consult with the “parties” prior to enforcement may include a borrower who is party to the document.
Most guarantees follow a standard form. However, as with inter-creditor deeds, the guarantee can sometimes be a product of the parties’ negotiating strengths. Indeed it is much more common to see that a guarantee is amended/limited rather than, say, a mortgage. Therefore guarantees should always be given special attention and addressed fully in a security review. Indeed, it can quite often be the case that the lender is relying on a recovery from the guarantor as its primary source of a recovery.
In the case of group guarantees, it is sometimes the case that they contain an agreement, as between the guarantors, not to prove in each other’s insolvency. This makes such guarantees into a quasi-inter-creditor deed binding on an insolvency officeholder. The impact of such clauses, whether in favour of the lender or a trade supplier, can have a drastic impact on estimated outcome statements since it effectively may freeze/postpone inter-company claims until every unsecured creditor is paid in full.
It is usual for a development finance security suite to include the grant of collateral warranties from key contractors in favour of the lender. These are needed in the case that the lender decides to take control of the development and build it out itself, or in the case that a purchaser of a stalled development requires the collateral warranty assigned to its own lender. These documents become important in the case that the works are partially completed and the incoming buyer wishes to rely (in some cases has to rely) on the work completed to date. Without these documents the value obtained for the site can be dramatically impaired. However, given the importance of a full suite of collateral warranties in certain situations, it is surprisingly common to find that they are undated, incorrectly executed, lack proper powers of attorney, contain short limitation periods (sometimes 3 years) or include an inadequate provision of professional indemnity insurance to cover the risk in the work.
As a further consideration, but not itself part of the report, the underlying contractor appointment documents/contracts should be reviewed in the case that a lender identifies that a collateral warranty holds the key to value in a site. This is because the collateral warranty is usually only as good as the underlying appointment/contract that it warrants.
Pledges, for example of documents of title (international trade documents, bills of sale etc.), are relatively rare, but if the effort is taken to obtain one from a borrower it can be assumed that it is an important element in the lender’s security package. It is therefore important that the priority afforded to a pledge is considered in the context of any other creditor positions.
Reviews of specialised businesses should identify the special considerations in relation to them. For example:
- in relation to lending to a firm of solicitors a comment should be made in relation to the statutory charge in favour of the Solicitors Regulation Authority over key assets to fund its intervention and the priority thereof; and
- in relation to lending to providers of social housing should provide comment on the ability to appoint an administrative receiver (which survives for such entities) and the statutory moratorium on enforcement under the Housing Acts.
A security review which is instructed at the right time and produced by an informed lawyer can be priceless to its recipient. Sometimes it may be the difference between being able to get funds out of a borrower and/or avoiding painful expensive arguments with other creditors/insolvency office holders.
It can inform the exit strategy from an early stage and provide the chance to put things right before the borrower enters the twilight period before insolvency where director’s duties mean the grant of new security is scrutinised and perhaps declined.
An informed lender will usually utilise the security review in conjunction with a report from an insolvency practitioner to maximise its outcome from a borrower in difficulty, or at least to provision early on for any issues highlighted therein.