Debentures are a common way for business lenders in the UK, especially for traditional lenders such as banks, to grant a loan to a company or limited liability partnership, providing the lender with security in the event that the company defaults on its repayments.
As a business owner looking for external lending, it is important to understand what a debenture is, how this works and what this might mean for your business if it becomes insolvent.
What is a debenture?
A debenture is a written agreement between lender and borrower which not only documents the terms and conditions of lending, but also grants the lender security interests over a broad range of assets as collateral for the borrower’s obligations.
Lenders use debentures to secure their interests when providing any kind of finance and where it is desirable to take security over a company’s assets because they believe there is a risk to them.
In essence, the term ‘debenture’ refers to a form of umbrella document that provides the lender with security over the assets subject to the debenture charge should the company be unable to repay its debts. In this way, the lender has priority over other creditors in respect of those assets in the event of the company’s failure.
The debenture agreement should cover all the relevant legal and commercial aspects of the lender/borrower relationship, clearly setting out the position of both parties. Typically a debenture agreement is a comprehensive document, but will include clauses relating to:
- the specifics of the loan, including the rate of interest and repayment date
- the charges secured on the loan and when these crystallise
- the borrower’s undertakings and covenants
- the borrower’s representations and warranties
- enforcement and powers of sale
Once signed, the debenture agreement will then need to be registered at Companies House, either at the point the loan is taken out, or within 21 days of creation of the charge.
In the context of secured lending, a debenture should not be confused with a debenture within a corporate context. In the latter case, a debenture is not a security document but rather an instrument that either creates or acknowledges a debt.
What is a debenture charge?
There are two types of debenture charge: a fixed or floating charge.
A fixed charge is a charge secured on an identifiable asset, typically freehold or leasehold property, or fixed plant and machinery. A fixed charge applies from when it attaches to the property. It affords the lender, ie the ‘charge holder’, immediate security over that property, meaning the debtor cannot sell or otherwise deal with the charged property without the consent of the lender.
As a fixed charge holder, the lender will become a secured creditor, taking priority over all other types of creditors in the event of insolvency, including floating charge holders.
In contrast, a floating charge can either be held over all of the company’s assets, or over certain classes of asset, representing a flexible form of security for lenders. Floating charge assets are items not caught by the fixed charge, and are typically movable assets such as the company’s trading stock, raw materials, equipment, furniture, or fixtures and fittings.
A floating charge is fluid in nature. This means there are no restrictions on the use of these assets when the company is solvent, where these can be moved or sold in the normal course of business. The charge is ‘floating’ as some of the assets may be changing on a daily basis. It is only if a company becomes insolvent that the lender is able to take action to recover its money.
When a company becomes insolvent, the floating charge is said to crystallise. This means that if the company is liquidated, the charge becomes fixed on the asset’s value at that point in time and the asset is effectively frozen. This means it can no longer be dealt with by the company without express permission from the lender.
Qualifying floating charge holders, where the charge secures the whole or substantially the whole of the company’s assets, have the right to appoint an administrator without going to court if the company becomes insolvent. Once appointed, the administrator will be responsible for realising the company’s assets and paying off its creditors in order of priority.
What is a fixed and floating charge?
Sometimes referred to as a ‘fixed and floating charge’, a debenture will often be registered on both a fixed and floating charge basis to provide additional security for the lender. This will create a fixed charge over the assets of the company which are not disposed of in the ordinary course of business and a floating charge over the rest of the company’s undertaking.
Even though a fixed charge ranks before a floating charge in the order of repayment on an insolvency, lenders will often also take a floating charge over general classes of asset, where they are looking to take security over all of the assets of a company. In this way, the entire asset base of a company is included within a single debenture registered at Companies House.
While a debenture can be used to charge all of a company’s assets under one umbrella document, the security interest created over each type of asset is distinct. The debenture will usually set out different representations and warranties, covenants and undertakings relating to each category of asset, designed to maintain and protect the value of these assets and the secured party’s interest in them.
What is the ranking of creditors on insolvency?
Both a fixed or floating charge will give the debenture holder priority rights for repayment should the company become insolvent. However, even though secured creditors with a fixed charge rank first in the order of priority on insolvency, the repayment priority for floating charge holders is not absolute as against all other creditors.
On the insolvency of a company, the monies that become available for creditors are distributed in a set order. The order of priority for repayment in an insolvency situation is as follows:
- secured creditors with a fixed charge
- preferential creditors, usually employees entitled to arrears of wages and holiday pay
- the ‘prescribed part’ of a debenture set aside for unsecured creditors
- secured creditors with a floating charge
- unsecured creditors, including HMRC, suppliers and other trade creditors
- the company’s shareholders
There are therefore various creditors who will have priority over a floating charge asset claim, including secured creditors, preferential creditors and the prescribed part of a debenture set aside for the benefit of unsecured creditors. The prescribed part is a ring-fenced fund that must be made available to unsecured creditors in a liquidation or administration, where a debenture would otherwise have caught all of the assets.
Given that secured creditors with a floating charge rank below various other creditors, lenders will often try to maximise the proportion of a loan that is covered by a fixed charge, preferring to take a fixed charge rather than a floating charge over an asset, as it is likely to result in better recovery, where at all possible.
How are debentures enforced?
A debenture charge will provide the holder with security in the event that the company defaults on the loan. The options available to a debenture holder in enforcing its security will depend upon the nature of the security granted and the type of assets secured under the debenture. For example, in enforcing a debenture which creates security over the majority of assets owned by a company, the lender will be entitled to appoint an administrator to take control of the company’s assets.
The threat of appointing an administrator can often be enough to make a company repay the debt, or agree terms to repay it, although where a company has become insolvent, the lender may proceed with putting the company into administration. The administrator appointed under the debenture must hand over the proceeds of assets caught by the debenture to the lender, where the administrator will usually sell the assets on behalf of the lender for a fee.
To be enforceable, a debenture will need to be filed at Companies House when the loan is taken out, or within a period of 21 days. If the debenture is not registered, the charge will be rendered void and the lender treated by the administrator as an unsecured creditor.
How can directors strategically use debentures?
It is not uncommon for directors to invest money in their own company. In this way they can avoid any onerous application process required for lending by banks or other financial institutions. In some cases, there may be strict criteria that the company cannot satisfy.
As such, where a director decides to lend money to their company from personal funds, they can use a debenture to secure their own interests. By setting out the terms of the loan within a debenture agreement, company directors can benefit from greater security in the event of insolvency, giving them a means of collecting the debt if the company defaults. Provided the debenture is registered at Companies House at the time of making the loan, the debenture can secure the company assets for the director in the same way as it would for any other lender.
If the personal loan is registered on a fixed and floating charge basis, this will provide a company director with considerable protection against insolvency, where the debenture will record that in any liquidation or other insolvency process, they will be repaid from company assets before any unsecured creditors.
Are multiple debentures permitted?
It is entirely possible to have more than one debenture registered against a business. The debentures will usually rank in order of the date created and registered at Companies House, unless one lender has given another a deed of priority.
A deed of priority sets out the ranking of loans and repayments, such that if the business is unable to fulfil the terms of any borrowing, it is clear which lender takes priority over the others.
If a new lender wants to create their own additional charge on business assets, they will need to liaise with other creditors to establish the order of priority payment, should default or insolvency occur. The registration of a debenture ensures that other lenders cannot take precedence without a deed of priority. In cases where a previous lender who has been repaid has not removed any debenture granted in their favour, they should be asked to remove it.
What is a debenture in simple terms?
In simple terms, a debenture is a legal document that provides loan security to the lender. It is a written agreement between a lender and a borrower which is registered at Companies House, and gives the lender security over the company’s assets by securing those assets for the lender should the company default or become insolvent.
What is a debenture and how does it work?
A debenture is a document that is executed in favour of a creditor with a covenant to pay the creditor and, in some cases, grants security over the whole or substantially the whole of a company’s assets in the event that the company fails. It is a way for banks and financial institutions to take security for their loans to protect them against the risk of insolvency.
What is an example of a debenture?
Debentures are commonly used by traditional lenders, such as banks, when providing high-value funding to companies. For example, where a business owner runs a retail store and wants to borrow money to open a new shop, the lender may agree to lend them the necessary funds, subject to a fixed charge debenture using the borrower’s current premises as security against the loan. This is known as a secured debenture.
What is the difference between loan and debenture?
There are lots of different types of loans, where a debenture is simply a form of business loan that provides the lender security over the assets of a company should it default on its repayments. In the context of secured lending, a debenture is one of the most typical forms of long-term loans that a company can take.
The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal advice, nor is it a complete or authoritative statement of the law, and should not be treated as such. Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission. Before acting on any of the information contained herein, expert legal advice should be sought.