Finance Industry Update October 2008

Taking stock and planning ahead

The Credit Crunch is having an adverse effect on everyone involved in the finance industry, and the lending market is undergoing a correction to loan to value rates, and the cost of borrowing money. During the correction process, when the volume of lending will be less, you ought to do what you can to preserve the value of your security, so that you are well placed when the market returns.  

A combination of lack of capital, and a more prudent view of risk, has seen loan to value rates plummet back to the historic norm of around 70-75% – some new deals will be at higher rates, but they will be few in number, and will have to be to very special customers. Margins are increasing, and now relate to LIBOR, which more accurately reflects the cost to the banks of committing the money – as with any other industry, banks are seeking to recover the increase in cost of its raw materials, which as a concept, is not unreasonable.

The optimistic view is that once all those involved in the market (being banks, borrowers and advisors) fully acknowledge the correction and the new lending parameters, then the market will start to return; but this will take some time, and when you are not lending, you need to be generating value elsewhere.  

The business model of a bank relies on the value of its security exceeding the amount borrowed, and the interest being serviced (or covered) throughout the loan. The credit approval will insist on certain security being provided and certain conditions precedents being satisfied prior to the money being released; and when this is achieved, and the borrower proceeds as per the credit paper, usually all is well.

However, in the current market, it would be prudent for the bank to review any existing commitments that have not progressed as originally envisaged and some of the actions it may wish to consider are:-

Conditions subsequent

An obvious starting point for review is where the bank may have allowed any security and/or other conditions to be satisfied post completion – now is the time to ensure that conditions subsequent and post-completion formalities have been dealt with, as opposed to when you are seeking to enforce the security that you may not have!

Time critical issues

Another consequence of the current market is that a number of borrowers are not progressing projects within the original timescales.  Often this is because the proposed end users (e.g. a purchaser of a new flat; or a retailer in a new shopping centre) are not demanding the product. This is another risk area for a bank, and a detailed review will be required to ensure that there are not any time critical issues which need to be addressed.

Planning permissions for example are time critical, and these are very important in this market where borrowers may seek to delay development, and may decide not to implement the planning permission. Historically, planning permissions were often extended, but be aware that under The Planning etc. (Scotland) Act 2006 (which should be in force in 2009), extensions will no longer be available, and if permission is allowed to lapse, a new application will have to be made under the new legislation, which arguably will be more onerous. 

Security Reviews

We have been asked to undertake a number of security reviews to protect the bank. These ensure that the bank has effective security, and highlight any potential issues that may now arise due to the transaction not proceeding as originally envisaged, including advising on the impact of any relevant time periods, and other adverse conditions. This has enabled the bank to preserve the value of its security, and "encourage" the borrower to take appropriate action, which often is also in the best interests of the borrower.

Restructuring - tightening your belt

The 2008 financial market is an interesting animal and gone are days of banks falling over themselves to lend money.  Now, with the credit crunch predicted to take hold well into 2009, businesses faced with the task of renewing their facilities are meeting a whole host of difficulties.

Not only are banks looking to impose higher interest rates and arrangement fees, but they are looking to be satisfied on the real covenant value of their customers.  If a business is looking shaky, the bank will want comfort that measures are being taken to turn things around before they will commit to new facilities.

In this new environment, it is likely that companies will be turning more and more to restructuring options.  So what can be done in times of trouble to make your company a more viable prospect to those in charge of the purse-strings?  A lot of it is common sense – tighten your belt and lose dead weight is a good starting point. 

Timing too is key – restructuring in the current market can take some time.  The benefits need to be reaped before it is too late and the worst possible thing to do is to bury your head in the sand and do nothing.  Above all, take the best professional advice on your options.

An example of good sense is the recent appointment by building giant Redrow of insolvency and restructuring specialists who have been tasked with advising on the company’s restructuring options to assist in the negotiation of new bank facilities.  This is one answer to the all-too-common position of a business, not yet in default, but facing the possibility of default in the future.  Early debt restructuring can be a way to avoid default and possible insolvency.   
 
Note also the benefit of sound advice to Barratt Developments.  Shares in the company jumped by 30% following a successful restructure which involved job losses, withdrawal of dividends, a new £400 million loan arrangement, and a restructure of the company’s banking covenants.

Hand in hand with restructuring goes the need to increase profitability.  This will often involve the closure or sale of loss-making divisions and insolvency regimes may sometimes be the best way to “save” businesses.  The use of pre-packaged sales, followed by administration, can make them smooth and viable sale prospects.  Similarly, the protection offered by the moratorium – during which no action can be taken by creditors – in an administration, can enable a management buy-out to go ahead, effectively allowing the business to proceed, streamlined and efficient. 

Underpinning this, our key advice to those looking to renew or extend debt in the present climate is to recognise where there are issues and take advice from insolvency professionals before it is too late and also to be open to restructuring and the use of insolvency to rescue your business.

No to Nationalisation – reforming the banking system

In January 2008, responding to the continuing instability in global financial markets, HM Treasury, the Bank of England and the FSA together published a discussion paper headed "Financial stability and depositor protection: strengthening the framework" as part of a consultation process. It is expected that, subject to final exchanges with the industry on preliminary drafting, legislation will be introduced during the early part of 2009.

The stated aim of the proposals is “to improve the resilience of the financial system and support financial stability by strengthening depositor protection and dealing with banks in difficulties.”  In other words, the triumvirate is trying to ensure that if financial stability in the UK is threatened, there is a range of tools at their disposal to mitigate risk while protecting consumers and minimising the impact on the wider economy.

In terms of preventative measures, the proposals are geared towards strengthening risk management by banks through improved stress testing and liquidity management.  This would enable the Bank of England to lend in a more effective manner by improving the framework for the provision of liquidity, including allowing short-term non-disclosure of liquidity assistance to avoid depositor panic of the kind we saw with Northern Rock.  Allied to this, the proposals would allow the FSA to collect information from banks in difficulty and remove any impediments to them sharing it with the Financial Services Compensation Scheme ("FSCS") and the Bank of England or HM Treasury where relevant to maintaining financial stability.

The Governor of the Bank of England has made it clear that new access to liquidity through the proposed reforms will of course have to have a reasonable, but strict, pricing structure so as to encourage banks to manage liquidity risk in a sensible way as without the correct pricing structure, the incentives to encourage future risk taking are obvious and potentially large.

If a bank is in real difficulty, then arguably the current insolvency laws do not provide an adequate solution and in fact create a risk for other banks in terms of financial stability and for customers who cannot get access to deposits or savings.  This is to be addressed by the introduction of a 'special resolution regime' to allow the authorities to intervene when a bank gets into severe difficulties and which includes the introduction of an effective ‘insolvency’ regime for banks.

The special resolution will provide a ‘toolbox’ to the FSA on bank crisis including the ability to seize a bank’s assets to secure depositors’ savings.  There is a proposed power to transfer the banking business to a third party to facilitate a private sector solution, to appoint a suitable person/body to carry out a resolution and, if a pre-insolvency procedure is not capable of saving the bank, to work alongside the FSCS to facilitate faster and efficient pay-outs of customers claims.

So, the special resolution regime will allow the FSA to essentially seize a failing bank’s assets in order to secure the savings of the depositors, avoiding a "Northern Rock" and hopefully providing a positive alternative for the governing bodies when a bank does face difficulties. In the past, the only way to deal with a bank in crisis would have been via traditional insolvency, which is not desirable for the bank at hand and further erodes public confidence in the banking industry.

However, there is a note of caution from investment banks and the British Bankers Association have warned that the proposed regime could unintentionally assign preferred creditor status to depositors, with the knock-on effect of increasing the cost of banking transactions.  

Another issue is that the “trigger” for the regime becoming active in terms of a bank in crisis needs to be clearly set out.  This is where the detail produced to date is relatively unclear and this is one of a number of points which require to be expanded upon and carefully considered in the final consultation and drafting process. The point is acknowledged by Mervyn King in a recent statement where he observed that “a clear framework for accountability should be established to give confidence that decisions relating to the resolution regime are exercised in line with the objectives for the regime set out in legislation.”

There is a view however that banks themselves will benefit from strengthening of the FSCS which is primarily aimed at making the financial system safer for consumers. By doing so, depositors will not feel as concerned at investing savings with a bank and thus, liquidity within any bank will have less chance of “running dry”.

The Northern Rock crisis and the resulting flood of customers removing their savings to a great extent resulted from the FSCS guaranteeing only a maximum compensation pay out of £31,700, which in October 2007 was increased to £35,000. This could be increased again on expansion of the scheme, but this is currently a matter of much debate and we will all have to wait until the draft Bill is released.

On this front, the Governor has suggested that an element of pre-funding would be beneficial to the compensation scheme.  He said recently that “a degree of pre-funding is one of those ideas that is bound to be unpopular before the fund is called upon, but seems decidedly wise after the event as it lessens the burden on the banking system in a time of stress.”

So, in stark contrast to recent events, the intention of the new legislation is that in future the authorities will be able to take decisive action, allowing people to have continued access to banking functions or rapid and orderly depositor payment.  As ever with proposals of this nature however, there is a danger that legislation is rushed through without full consideration of the potential consequences and so the general view within the banking sector has been that the Government should take time to consider the opinions of the regime and furthermore the consequences that it may carry.

Natural selection for Directors

Every director and company secretary of a limited company in the UK should be aware of important changes to the appointment of directors which came into effect on 1 October 2008 with the next stage of the implementation of the Companies Act 2006 ("CA 2006").

The main change is that any company incorporated on or after 9 November 2006 must have at least one "natural person" (i.e. living individual) as a director by 1 October 2008 if they have not already done so.  So if one of your companies falls into this category then you need to move fast to select a natural person to join the board of directors. 

For companies being incorporated from 1 October 2008 there must be at least one natural director or else the registration will be refused by Companies House.  For companies incorporated before 9 November 2006 there is a transitional period so that they require to appoint a "natural person" to the board by 1 October 2010.

These provisions effectively bring to an end the position where a company can have all its directors as corporate entities.  This is most often seen in trustee companies or joint venture companies because it is convenient to appoint a corporate director, which itself has a number of natural directors, so that any one of those natural directors can attend board meetings and there is no delay in conducting the affairs of the company if a natural director is on holiday or ill. 

The Companies Act 2006 provides that if a company is in breach of the requirement to have at least one natural director then the Secretary of State can direct the company to rectify the situation.  The time period for complying is not less than one month but not more than three months after the date on which the direction is given.  Failure to comply with any such direction is an offence subject to a fine and or criminal liability on the offending company and each of its officers.

Strangely, the provisions whereby a director can request that a service address (rather than his/her residential address) is used on the company's register of directors (and thus on the annual return and public registers) do not come into force until 1 October 2009.  Until then, the natural director's residential address must be given.  When the service address provisions come into force, a director will still require to give Companies House his/her residential address but this is kept on a separate register – for more details on this, watch this space…

So why did the government take away the ability to have companies in which all the directors are non-natural persons?  Will this have any real effect in making the management and corporate governance of UK companies better than they were prior to 1 October 2008?  Or will we find junior members of staff appointed as nominees, without being aware of the responsibilities or potential liabilities of directorship?  This change is likely to have no real impact on the management of companies, but is certainly further evidence of the blame culture in the UK which demands to be able to identify an individual to take the blame for any health and safety accidents or bad economic performance.

1 October 2008 is also a noteworthy date because three more of the new directors' duties came into force, namely:-

1. the duty to avoid conflicts of interest;
2. the duty not to accept benefits from third parties; and
3. the duty to declare any interest in a proposed transaction or arrangement with the company.

For further information on these and the other new duties on directors please see our briefing on directors duties .  

Another less noteworthy change that came into effect on 1 October 2008 is that all directors must be at least 16 years old.  If a person under 16 is appointed as a director before this provision comes into force then he / she will cease to be a director from 1 October 2008.  From experience, we do not expect too many of our clients to be affected by this change!

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