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The recent decision by the Determinations Panel of the Pensions Regulator in relation to The Box Clever Pension Scheme has reignited the debate on the risks of taking security over shares. Lenders typically take such security in a number of types of financing transaction. In acquisition finance, the lender finances the acquisition of a company (or group of companies) as a going concern. As has been seen in the recent downturn, the greatest returns from an enforcement of the security for such transactions is from the sale of the shares of the acquired company (or parent of the group) rather than a sale of individual assets. In structured real estate transactions, security is often taken by lenders over the company acquiring the real estate asset as there may be advantages in enforcing the security for the transaction by sale of the shares of such a company rather than by selling the real estate asset itself.

Shares in a company are essentially a package of rights in favour of the shareholder. One of the key rights of a shareholder is the right to vote to approve ordinary and special resolutions of the company – these rights can be used for a variety of purposes including the appointment and removal of directors and making changes to the constitutional documents of the company. The English law documents that create security over shares typically expressly deal with the circumstances in which the person giving the security and the lender can exercise voting rights in respect of the shares subject to such security.

The Pensions Regulator has broad ranging powers under the Pensions Act 2004 to implement anti avoidance measures, including the statutory power of the Pensions Regulator to issue contribution notices and financial support directions to parties (both individuals and corporate bodies) who are "connected" or "associated" with an employer in relation to an occupational pension scheme.

In the Box Clever case the Determinations Panel considered whether a financial support direction should be issued to five members of the ITV group (the "Targets") in respect of pension liabilities of certain members of The Box Clever group of companies (the "Employer Companies") which had gone into administrative receivership in 2003 leaving the Box Clever Pension Scheme with a significant deficit.

In order to issue a financial support direction to the Target Companies, the Pensions Regulator had to satisfy the Determinations Panel that the four statutory tests/conditions set out in section 43 of the Pensions Act had been satisfied. The key issue in the case was whether the third of the four statutory tests was satisfied by virtue of the Target Companies being "associates" of the Employer Companies.

That issue was complicated by the fact that the shares of three of the Employer Companies had been transferred by way of legal mortgage to a bank in the capacity of security agent under a debenture that secured both a securitisation of The Box Clever group's revenues and a bridge facility. An event of default under the terms of the financing documents that were secured by the debenture had arisen by the time the matter was before the Determinations Panel.

The definition of "associate" under section 43 of the Pension Act incorporates the definition of that term under sections 249 and 435 of the Insolvency Act 1986.

Under these provisions a person is deemed to be an associate of a company if it is entitled to exercise, or control the exercise of, one third or more of the voting power at a general meeting of that company or another company that has control of it.

The Targets argued at the hearing before the Determinations Panel that they were not associates of the three Employer Companies whose shares were subject to the security created in favour of the security agent under the debenture, as under its terms voting rights and hence "control" in respect of these shares had passed to the security agent.

The Determinations Panel concluded that, on proper construction of the debenture, voting rights passed to the security agent when two conditions were satisfied:

(a)     an event of default had occurred and the senior agents had exercised their rights under the clause 24.2 of the bridge facility agreement; and
(b)     the security agent had given notice to the provider of the security (the beneficial shareholder) that it intended to exercise voting rights in respect of the shares.

The Determinations Panel concluded that only the first of these two conditions had been satisfied but noted (in relation to the argument of the Targets that in the present circumstances only the first of the two conditions needed to be satisfied in order for voting rights to pass to the security agent) that the relevant provisions of the debenture were not easy to interpret.

Although this point was not expressly addressed at the determination hearing, the concern for lenders is that if voting rights had passed to the security agent under the debenture, and therefore the Employer Companies are treated as "associated" to it, the security agent and/or the lenders it acted for, are at risk of being issued with a financial support direction.

In 2005, the Financial Markets Law Committee Working Group on the Pensions Act wrote to the Pensions Regulator requesting clarification on the circumstances in which a lender holding security over shares might be at risk of being issued a contribution notice or a financial support direction. The Pensions Regulator responded to this letter stating:

"Where either control has not vested in the holder of share security or where control has vested in the holder of share security but has not been exercised:

  • the party holding the security would not be party to an act upon which to base the issue of a contribution notice, i.e. an act that had one of its main purposes avoiding pension liabilities; and
  • it would not be reasonable to serve a financial support direction upon the holder of the security."

The response from the Pensions Regulator is not binding but does give comfort that, even if voting rights have vested in the security agent under a debenture, lenders may not be targets of the Pensions Regulator where they have not in fact exercised voting rights in respect of the relevant shares. Nevertheless, the case has resulted in certain law firms revisiting the terms of their standard form security documents to make clear that voting rights do not pass until the beneficiary of the security has given written notice of its intention to exercise these rights.

Shadow Director
When putting forward arguments on the proper construction of the relevant terms of the debenture, Counsel appearing for the pension trustee for the Employer Companies stated that the security agent and the lenders would not wish the security agent to gain the right to control voting of the occurrence of a Declared Default for fear of being seen as shadow or de-facto directors. A reputable lender would not purport to hold itself out as being a director of a company or, indeed, allow a company to hold that lender out to be a director and it would, therefore, be unusual and unlikely to find a lender being held to be a de-facto director. As Millet J describes in Re Hydrodam (Corby) Ltd (in liquidation), The Times 19 February 1994 the concepts of de-facto directors and shadow directors do not overlap, they are mutually exclusive. Under section 251 of the Companies Act 2006 a shadow director is defined as a person in accordance with whose directions or instructions the directors of the company are accustomed to act. The consequence of a lender being held to be a shadow director of a company is that under Section 214 (Wrongful Trading) of the Insolvency Act 1986 on a liquidation of the company it may be liable to make a contribution to the assets of the company if it knew, or ought to have concluded, that there was no reasonable prospect that the company would avoid going into insolvent liquidation. The Court will not make such an order if it is satisfied that such person took every step with a view to minimising the potential loss to the company's creditors as it ought to have taken. In some cases the practical reality makes it difficult to distinguish between commercial pressure which lenders may apply, particularly in distressed circumstances, and instructions upon which directors are accustomed to act. A situation in which lenders are entitled to exercise voting rights under a security document may muddy the waters further, making the distinction even harder to draw. Fortunately for lenders, the case of Triodos Bank NV v Dobbs & anor [2004] EWHC 845(Ch) affirms a high threshold for the assertion that a lender is liable as a shadow director of a company to which it lends. The Triodos case establishes that a lender is not considered part of the corporate structure of a company in acting in defence of its own economic interests. This provides reassurance to lenders that they can be proactive in situations where their funds are at stake.

A lender should also bear in mind environmental liabilities attached to land which a company over which security is taken, in certain circumstances, may incur. Lenders have had to keep pace with the growth of environmental legislation over the past two decades which has impacted substantially on the potential liabilities of, and ultimately the value of, the companies to which they lend.

Lending criteria have been adapted to meet the changes in environmental legislation and lenders have focussed on liability that may arise as a result of taking security over land or over the shares of a company that owns land. Part 2A of the Environmental Protection Act 1990 which came into force in England in April 2000, deals with the liability associated with historically contaminated land. The Environmental Protection Act was later extended in August 2006 to cover the liability for radioactive contaminated land and is administered jointly by the relevant local authority or the Environmental Agency depending on the type and significance of the harm to the environment.

The local authority in question will identify contaminated land and form a view as to who should be required to carry out remediation works. The persons identified (also known as "appropriate persons") will be served with a remediation notice which, in some cases, will be served on more than one party with costs being apportioned between them in accordance with statutory guidance.

In identifying appropriate persons, the Environmental Protection Act establishes two categories, the first is a Class A person who is regarded as the appropriate person because they caused or knowingly permitted the pollutant to be in on or under the land and the second is a Class B person who is regarded as an appropriate person because no Class A person could be identified and they are the owner or occupier of the land. There is a risk that secured lenders – even before they enforce their security – can fall foul of these provisions. That is because loan documentation typically includes provisions concerning the carrying out of environmental reports, together with the reporting of incidents or investigations and power to require the borrower to carry out remediation or in default to carry out remediation at the borrower’s cost.

These powers, though useful to lenders, can cause them to have sufficient knowledge of site conditions and the power to cause their clean up, such that they could be regarded as “knowing permitters” of pollution if they fail to require (or possibly, carry out) remediation.

Furthermore, an enforcement of security could expose that lender to Class B liability under the Environmental Protection Act. This is not just a theoretical risk as Midland Bank discovered when it was served with a remediation notice to clear around 13,000 tyres from a site it repossessed. Lenders may also find the value of their shares held as security significantly reduced by any environmental liabilities incurred by the company.

It is vital for lenders to protect themselves from such instances by carrying out due diligence on sites that they intend to finance and, should they discover any potential contamination, make remediation a condition of financing as well as ensuring they have direct recourse to the parties carrying out such remediation. Any covenants from which they are entitled to benefit should be expressed as being transferable to future owners and lenders.

A risk often overlooked when a charge or mortgage over shares is first agreed is the extent to which it may confer control over the company concerned and so have competition law implications, either at the time the agreement is signed or at a later stage. In this context "control" could include the ability to exercise voting rights in respect of the relevant shares. Due diligence is advisable in these circumstances. In most jurisdictions, the acquisition of control over any business above a certain size must be notified to and cleared by the relevant competition authority before being completed. The requisite size of the business differs between jurisdictions, so the rules in each jurisdiction in which the company does business should be checked before establishing or exercising any charge or mortgage over shares. Most jurisdictions provide for substantial financial penalties for the failure to notify acquisitions of "control" required by their applicable laws. The parties to such acquisitions will be liable to pay such penalties and can suffer poor publicity and loss of reputation which could detriment future requested merger clearances from the relevant competition authorities.

The relevant competition authorities include the European Commission in Brussels, which generally reviews large transactions with a cross-border European dimension. The European Commission's rules allow financial institutions to trade in securities without having to seek merger clearance if those institutions only hold those securities on a "temporary" basis and without exercising voting rights with a view to determining the competitive behaviour of the investee companies. Financial institutions may only exercise voting rights to provide for the disposal of those securities within one year of their acquisition. In each of the 27 EU Member States, national competition authorities exercise their jurisdiction over transactions triggering their own national rules. It should be to noted that the rules governing minority interests differ at EU and national levels and need to be checked on a case by case basis.

The Box Clever case has served as a useful reminder to lenders or other secured parties that the taking of security over shares can lead to them incurring liabilities (some of which may not be immediately obvious) which should be considered at the time of drafting the security document. Although the decision in the Box Clever case was favourable to the security trustee, it reminds us all that an evaluation of such risks should be properly considered to avoid potentially damaging consequences.