Article.

Hardening Periods: Is your security safe?

15/04/2020

At a glance

The vast majority of loans entered into between lenders and borrowers will involve some form of security, a fundamental concept under debt transactions and key to providing lenders with comfort when advancing large sums of money. However, although formal documentation is drawn up and executed, if the lender seeks to enforce its security at a later date, in certain circumstances there is a possibility that the security created by these documents may be challenged.

In this first article of a two part series, we look into the situations whereby security granted by a corporate entity can be set aside by an insolvency practitioner and aim to help make sense of the various criteria to look out for, as well as the defences available. In the second article, the focus will be on the commercial thinking behind any decision to refinance a loan, considering the consequences associated with hardening periods.

Hardening Period

A ‘hardening period’ is the term used to describe the period of time during which security is liable to be set aside if the company (the entity granting the security) enters into insolvency proceedings. The length of the hardening period and the defences available will depend on the circumstances for which the insolvency practitioner seeks to set aside the security.

Circumstances where security can become void

In a situation where a borrower has entered into insolvency proceedings, an insolvency practitioner has the power to look back over the transactions undertaken by the borrower and unwind any such transactions that fall foul of the Insolvency Act 1986 (the “Act”). The purpose of this is to protect the wider pool of creditors, as it prevents borrowers from granting friendly parties security over assets in order for them to artificially jump ahead in the order of repayment on insolvency (as a secured creditor will be paid out ahead of any unsecured creditors).

Preference transactions

A transaction will be considered preferential if the company takes any action which has the effect of placing a creditor into a better position than it would have found itself in on the insolvency of the company. An example of this would be one similar to the situation described above, whereby a borrower grants security over its assets to a friendly lender in order for that lender to leapfrog the wider creditor pool, or if a borrower selectively repays loans to directors or lenders that it wishes to maintain a relationship with.

In addition to this intentionally broad requirement, the action that created the preference must have occurred within six months of the borrower going into liquidation. This period is extended to two years in circumstances where the transaction involved a connected person (e.g. a director, or spouse of a director).

Fortunately for lenders who have the benefit of security, even if their position has been improved and this occurred within the relevant hardening period, this does not necessarily mean a preference transaction will have been constituted, as the insolvency practitioner will need to prove that the borrower was influenced by a desire to put the lender in a better position than they would have otherwise achieved on insolvency. Although this desire need not be the dominant intention of entering into the transaction (it will suffice if it was only part of the reason for transacting with the creditor), this can be difficult to prove and, if the security was granted as part of an arm’s length commercial transaction, should not be an issue.

Transactions at an undervalue

An insolvency practitioner may also set aside security in situations where there has been a transaction at an undervalue. This is where a company made some form of gift, or entered into a transaction on terms that either provided that company with no consideration whatsoever or consideration which was significantly less than the value of consideration provided by the company. Granting a legal mortgage over a property whose value is much higher than the loan being provided may fall within this category.

Similarly to a preference transaction, the company granting the transaction at an undervalue must be insolvent at the time of the transaction, or become insolvent as a result of entering into the transaction.

The relevant hardening period associated with a transaction at an undervalue differs to that of the preference transaction however, as this is set at two years from the time of the company’s insolvency, whether or not the transaction involved a connected party.

It is possible to defend claims of a transaction at an undervalue if the following two circumstances apply:

  1. the company that entered into the transaction in good faith and for the purposes of carrying on its business; and
  2. at the time it did so there were reasonable grounds for believing that the transaction would benefit the company.

Once the undervalue is established, it is necessary for the party on the other side of the transaction (i.e. the lender) to justify the transaction by demonstrating the grounds given in (1) and (2) above are satisfied.

Avoidance of a floating charge

The Act also makes a specific provision which allows for an insolvency practitioner to set aside a floating charge. This avoids situations where a borrower, again in the twilight of its solvency, grants a floating charge to a creditor to sweep up any and all of its assets.

The relevant hardening period taken into consideration by the insolvency practitioner will be either where a floating charge is granted within a year of the company’s insolvency, or two years of the company’s insolvency in situations involving connected parties.

Not all floating charges will fall foul of the insolvency practitioner’s remit. Instead, a specific type of charge must be created by the company in order to be deemed valid by the Act in circumstances where the company faces insolvency and is made within the relevant hardening period. Such a charge must contain a floating charge, in that it secures all of the company’s assets from time to time, but, crucially, the charge must be created for some form of new consideration. This requirement is necessary to avoid the situation where a lender has previously lent money to a company without such a charge and, due to the borrower’s impending insolvency, has taken a floating charge to secure its position without increasing the amounts being lent. Therefore, the lender must provide further funds, or some other form of valid consideration, if it is to successfully create a valid floating charge which is not susceptible to later challenge by an insolvency practitioner.

Conclusion

As evident from the above, drawing up and entering into security documents may not lead to absolute comfort in the security created, considering the statutory hardening period that will attach itself to such security. In the next article, we will explore the practical impacts hardening periods may present when making certain commercial decisions, particularly in relation to refinancing a loan.

Please do not hesitate to contact the Memery Crystal Banking and Finance team if you have any questions on the content of this article, or if you require any assistance when negotiating documents to take into account hardening periods.

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