A Bluffer's Guide to ABL Legal Issues in the United Kingdom (or some bits of it anyway)

You have been called to a meeting with a new prospect company. They want to talk to you about financing their businesses which include subsidiary operations in the United Kingdom You've never done business there before.

Relax. Take a

Geography

Let's start with the basics. You need to find out where in the United Kingdom the subsidiaries are incorporated and/ or the business and assets are located. As everyone will know, the United Kingdom's full name is "The United Kingdom of Great Britain and Northern Ireland" and it is made up of three principal legal jurisdictions:

1. England and Wales (yes, that is one jurisdiction, but don't get the Welsh started on how that came to be);

2. Scotland;

3. Northern Ireland.

A picture might help - see above.

Great Britain itself is the combination of Scotland, England and Wales. The Channel Islands and the Isle of Man are separate legal jurisdictions similar in many ways to the Caymans (in a legal sense only; they are very different as holiday destinations). Confusingly, though, they are part of the British Isles, but that is completely irrelevant for your purposes.

While many people refer generically to "UK companies", you will need to find out the actual jurisdiction of incorporation of the relevant subsidiary. Much like the States in the U.S., each jurisdiction has its own way of doing things and slightly different ways of taking security over assets. In most cases, you will find that the company concerned is incorporated in England and Wales. That is exceptionally good news for me as it is the only one of the jurisdictions in which I am licensed to practice law.

Is there an acquisition involved?

The financial assistance prohibition: The next question you should ask is whether you will be funding or refinancing the acquisition of shares in die relevant subsidiary. The reason: there is a prohibition on English companies (and there is a similar prohibition for Scottish and Northern Irish companies, too) giving what we call "financial assistance" for the purchase of its shares or the shares in any holding company. The statute says:

"...where a person is acquiring or is proposing to acquire shares in a company, it is not lawful for the company or any of its subsidiaries to give financial assistance directly or indirectly for the purpose of that acquisition before or at the same time as the acquisition takes place."

In an ABL deal, the most obvious time this will crop up is where the transaction involves the purchase of an English company and you want to get a cross guarantee from that company and security over all of its assets as collateral for the acquisition debt. You also need to be careful as the prohibition gets triggered where you are refinancing acquisition debt from a previous deal.

So what? Where a transaction is consummated in breach of the prohibition, the directors of the company involved are guilty of a criminal offence and could be sent to jail. On the downside, your guarantees and security will be invalid.

So what do I do? Get some further information:

* The prohibition only applies to acquisition of shares in an English company. If the actual target is incorporated outside of the UK and the English company is a subsidiary of the target, then the prohibition won'tapply;

* In our part of the world we have two types of companies: public and private. If the company is a private one, then the "whitewash" procedure may be available to solve the issue. If the company is a public one it may be able to be re-registered as a private company to go through the "whitewash"

* There are some exceptions which may be useful. In particular, the prohibition doesn't apply to dividends, so you may be able to structure the deal so that a loan to the target is upstreamed by way of dividend as part of the funds flow.

What on earth is a "whitewash "? The legislation allows a private company to give financial assistance for the purchase of its own shares if certain tests are met. Essentially:

* The company has "net assets" (mat is, its assets exceed its liabilities, including its contingent liabilities;

* The assistance being given by the company will not reduce the amount of those net assets or, if it will reduce them, is covered by the company's distributable reserves.

If those tests are met, there is then a legal and accounting procedure which the company can go through to "whitewash" the giving of the financial assistance. The procedure involves the directors (and, in many cases, the shareholders) of the company approving the transaction. As part of that determination, the directors are required to certify that the company meets the tests above and that they are of the view that the company will be able to pay its debts as they fall due over the next 12 months. In addition, the company's auditors need to confirm that they believe that the directors' statements are reasonable.

Borrowers have a habit of trying to run interference on the uninitiated ABL in these circumstances. Be prepared for the following:

* "We can't give you guarantees and security. That's illegal financial assistance." While the second sentence is technically correct, as you now know, that's not the end of the story. The whitewash procedure is common in this part of the world.

* "We don't want to do the whitewash because it is prohibitively expensive." While it is true tiiat adding a whitewash to proceedings will increase complexity and deal costs to a certain extent, it is unlikely to result in a materially prohibitive cost.

How would you like your security, fixed or floating?

From a very technical point of view, English law has a variety of different types of security which can be taken over assets. For the rest of this article, I refer generally to "charge" or "security" to describe security interests much like you would use the term "lien". In practice, the key thing for an ABL to work out is whether that security will be classed as "fixed" or "floating" in respect of the relevant collateral.

Why does that matter? The distinction is of critical importance because, while both fixed and floating charges provide valid security for a lender, mere is a very different set of priorities on the distribution of the proceeds of enforcement of the security.

If an asset is subject to fixed security, then the secured lender takes the first priority position (after the deduction of any reasonable costs of enforcement). However, if an asset is only subject to a floating security, then the secured lender's priority position is much weaker.

The first bite out of the pot of floating charge assets goes to "preferential" creditors. The categories of preferential creditors are much smaller than they used to be and there are now only two categories of practical importance. The first: sums which the debtor owes by way of unpaid contributions to occupational pension schemes and state scheme premiums. The second: category is to employees in the four months ending with the commencement of the insolvency. The amount claimable by a particular employee is limited by statute and is currently £[800].

The next slice of assets has to be applied in paying the remuneration of the administrator (or other insolvency officeholder) and all liabilities incurred during the insolvency period. For example, new supplies of goods and services made to the debtor or new borrowing obligations undertaken.

Third, a "prescribed part" of the remaining floating charge assets is set aside for unsecured creditors. The amount of the prescribed part depends on the level of floating charge realisations; it is made up of the first £5,000 of the first £10,000 of the floating charge assets and 20 percent of any additional assets. The prescribed part cannot exceed £600,000. To reach this cap, the floating charge assets would have to amount to at least £2,985,000.

The floating charge holder tiien receives the balance of what is left.

So what makes security "fixed" or "floating"? The essential difference between the two types of security is mat a fixed charge removes the right of the borrower to dispose of the asset being charged. Conversely, with a floating charge the borrower is entitled to deal with the asset until the occurrence of some future event (generally a default under the financing documents). Simply stating in the relevant security documents that the charge is to be fixed is not enough. The courts will look at whether, in practice, the borrower was able to deal with the asset without reference to me lender.

Looking at some key assets for an ABL:

* Inventory (by the way, we call it "stock"): Because the borrower will need to continue to trade, a lender will only ever be able to take a floating charge over inventory. In fact, the floating charge was originally created as a way of allowing security to be taken over a fluctuating pool of assets like inventory;

* Receivables: It is possible for a lender to take fixed security over a borrower's receivables, but there are a number of technical and practical issues to be dealt with which are discussed in more detail below.

Taking fixed security over receivables. This is an area which has received a lot of judicial attention in recent years, but the position now seems pretty settled. In order to take fixed security over a borrower's receivables, the lender must have control over the process of collection and disbursement of the proceeds of the receivables. This essentially requires the lender to take full cash dominion with the debtors paying to a lockbox controlled by the lender and which is swept to pay down the loan account.

If the borrower is entitled to collect the receivables into its operating accounts or is allowed access to funds in the lockbox prior to a trigger event (the "springing lien"), then the security over the receivables will be floating rather than fixed.

In UK domestic ABL transactions, the lender having full cash dominion in this way is not usually a problem. We often strike some practical issues, though, where the loan arrangements are based in me US. This is because, as a rule, the US lender will only make loans available in US dollars, whereas the UK subsidiary will have its receipts mainly in sterling and euros. To get the arrangements in place to allow a fixed charge on the UK receivables, the receipts from debtors need to be converted to dollars to pay down the loan. To compound the issue, the company will then need to borrow in dollars and convert diem to sterling or euros to pay its creditors, meaning it takes a double currency-conversion cost.

Retention of title

One final heads-up item: Retention of Title or "RoT".

It is very common in our part of the world for suppliers to include a provision in their standard terms and conditions which states that the goods supplied remain the property of the supplier until either those goods have been paid for in full or even until all goods supplied by that supplier have been paid for.

The courts have held that these kinds of provisions are valid and that, on an insolvency of a borrower, the assets which are subject to RoT provisions can be reclaimed by the supplier and are not part of the security granted to the lender. Some RoT provisions go further and purport to trace into the proceeds of on-sale of the goods concerned, but the courts have held that this effectively amounts to a charge over receivables. This is invalid unless it is formally registered as security (and standard searches will reveal whether this has been done I've never seen it in practice).

What this means is that your initial due diligence exercise will need to include a review of the terms of trade your prospect has witii its suppliers. If goods supplied are subject to RoT, then the relevant inventory may need to be ineligible (as they aren't, in fact, owned by the prospect and it can't give valid security over them).

I say "may" because the mere inclusion of an RoT clause in terms of trade will not work for suppliers in all circumstances. In particular:

* In order for a supplier to claim under an RoT clause, it needs to be able to identify the goods supplied as its goods. If the goods are raw materials which have been through a manufacturing process and turned into something different, then the RoT right will disappear. Whether it is still sufficiently identifiable is a matter of fact in each case. At one end of the spectrum, for example, if the goods supplied were flour which is then used to make cakes, the supplier will lose out. At the other end, however, if the goods comprise components which are clipped on to a piece of equipment and can be easily removed, then the supplier will have a valid claim.

* Also, if the supplier is one of many supplying essentially the same generic item and it isn't possible to tell which goods came from which supplier, the RoT claim may also fail.

If the presence of RoT in some key supply contracts causes a significant issue for availability, it is sometimes possible to get the relevant suppliers to waive their RoT rights to get around the problem.

So there you go

While this isn't a comprehensive guide to the perils and pitfalls of funding English collateral, hopefully this article will arm you with enough basic knowledge to get through the meeting and work out whether there is a deal to be done.