United Kingdom | Publication | October 2022
In this article (first published in the Journal of International Banking and Financial Law 2022 Volume 37, Issue 9), Rebecca Oliver considers how the further market guidance published in July 2022 by the Department for Business, Energy and Industrial Strategy (BEIS) – which includes commentary on the application of the National Security and Investment Act 2021 (NSIA) to security arrangements – helps secured lenders. The article considers where lenders still need to be wary of the NSIA implications and suggests how lenders and their advisers might limit NSIA risk in lending structures.
The National Security and Investment Act 2021 (NSIA) came into force on 4 January 2022 giving the government broader powers to assess and intervene in investments and other acquisitions of control that may give rise to national security risks. The NSIA significantly expanded the types of transactions covered by national security reviews to include acquisitions of voting rights and assets including land and intellectual property. Failure to comply may result in heavy sanctions including turnover-based fines and criminal liability, as well as the risk of transactions subject to mandatory notification being void. As outlined in previous articles in this publication, there have been considerable concerns as to the impact of the NSIA on the taking of, and enforcement of, security over entities and assets within the remit of the Act, and in particular, the extent to which the transfer of voting rights in connection with share security supporting corporate lending may trigger notification obligations. In July, the Department for Business, Energy and Industrial Strategy (BEIS) published further market guidance including commentary on the application of the NSIA to security arrangements and this article considers how the guidance helps secured lenders, where lenders still need to be wary of the NSIA implications and suggests how lenders and their advisers might limit NSIA risk in lending structures.
As noted in earlier articles, where acquisitions of entities or assets posing a potential national security risk are being funded, lenders must consider voluntary notification as part of the due diligence process to avoid the risk of later exercise of call-in powers that could undermine the acquisition, as well as result in penalties for buyer side parties. Similarly, lenders will be aware that enforcing security over businesses in risk areas, will require further clearances for sales to third parties. Outside of direct acquisition funding, share security has been the greatest area of uncertainty for secured creditors with stakeholders questioning whether notifications are triggered when:
It has generally been the accepted view in the market that mere creation of share security would not of itself trigger notification requirements unless the security was created by title transfer. This view has been confirmed in the July guidance from BEIS:
"The granting of types of share security where title to the shares is not transferred to the secured lender (or its nominee) is not a notifiable acquisition requiring mandatory notification, even if it involves an entity carrying on activities covered in the Notifiable Acquisition Regulations. "
So, whilst legal mortgages of shares where lenders become registered owners of the shares, or in Scots law security arrangements similarly involving title transfer, will trigger notification prior to their creation, equitable mortgages and charges will not. Legal mortgages of shares in English companies are not the norm and the guidance notes that whilst non-title transfer security undoubtedly conveys rights to the secured party, it does not constitute an increase in shareholding or voting rights at the point of creation. This is welcome news for English lawyers at least and thanks go to the City of London Law Society and other stakeholders for pursuing this area of uncertainty. The guidance makes it clear though that if legal title or control is passed in relation to shares falling within the Notifiable Acquisition Regulations, then notification before completion is required, so title transfer security is intended to be notifiable in cases of national security risk.
In addition, where security over shares leads to the transfer of voting rights following a default event, or where shares are sold on enforcement of the security, notifications may be required. This is a logical conclusion given the mischief of the NSIA is to enable transparency and review of those with control over national security risk entities and assets prior to their acquisition.
So, what steps can lenders take to avoid these potential pitfalls?
Lenders need to understand whether entities and assets they are financing have the potential now, or in the future, to be operating in areas of national security concern. Although it is the acquiror at risk of penalty, lenders will not want to fund acquisitions potentially falling within the scope of the NSIA that have not been notified and cleared in advance to avoid the risk of their later being called-in and set aside, therefore detailed due diligence is of equal importance to the lenders as it is to the buyer. Ultimately, the board of directors should have the best knowledge and understanding of what a business is doing, or plans to do, and whilst board resolutions that an acquisition is not within the realms of the NSIA will not influence whether BEIS takes a different view, documenting their considerations as a board will focus their attention and help to flush out any concerns at an early stage. Where lenders identify a risk of falling within the NSIA, either the acquisition agreements, or the funding agreements, or both, will need to be conditional on notification and clearance, and the time to complete this process factored into the closing timetable.
In leveraged lending it is common to restrict future acquisitions without lender consent, but similar restrictions should be considered for any borrower group where acquisitions of entities or assets, might fall within the ambit of the NSIA.
Section 8(5) of the NSIA relates to an increase in voting rights and the July guidance notes that where lenders are entitled to exercise voting rights, a notifiable event does not occur until the trigger event providing control happens. It is rare for lenders to hold voting rights under share security arrangements unless and until a default event occurs under the associated loan, and that is because lenders do not generally want the administrative burden of voting the shares. Default events in loan arrangements enable lenders to exert some control over how a borrower group will operate whilst loans are outstanding in order to limit the risk of businesses being badly managed. They entitle lenders to demand early repayment in circumstances where credit risk deteriorates. Although lenders often do not exercise those rights to demand early repayment, they need those rights to accelerate debt repayment in order to enforce their security and discharge the debt. Where share security is held, lenders may want to exercise voting rights to protect the value of the share security. For example, if the nature of the default gives lenders cause for concern as to how the company is being managed, voting the shares would enable a change of directors, or an appointment of an administrator. Equally there may be factual circumstances where lenders want to exercise voting rights to veto certain shareholder decisions.
The NSIA does provide a carve out for this sort of lender action in para 7 of Sch 1 which states:
"Rights attached to shares held by way of security provided by a person are to be treated as held by that person -
(a) where apart from the right to exercise them for the purpose of preserving the value of the security, or of realising it, the rights are exercisable only in accordance with that person’s instructions, and
(b) where the shares are held in connection with the granting of loans as part of normal business activities and apart from the right to exercise them for the purpose of preserving the value of the security, or of realising it, the rights are exercisable only in that person’s interests.”
It will be important though, that lenders consider carefully: (i) when their voting rights arise; and (ii) how they exercise voting rights, to stay within the parameters of the para 7 carve-out.
If the lenders’ rights are not expressed to be limited in this way in the share security documents, and they arise automatically on the occurrence of a default, then there is concern that notification will be impossible before that automatic increase in voting rights. Possible drafting options to avoid this situation would be:
(i) limit the voting rights of the lender to only being exercisable on the terms permitted by the para 7 carve-out – then if they arise automatically following a default, it does not matter; or
(ii) do not grant lenders voting rights automatically following a default, but only where they give notice that they want to exercise voting rights – this gives lenders the time to notify under the NSIA and seek clearance where they consider it necessary; or
(iii) suspend voting rights of lenders unless they have any necessary NSIA clearance.
The Loan Market Association real estate finance security documents have adopted method (iii) in drafting changes made in their template in June:
"The Security Agent shall not be entitled to exercise any voting rights or any other powers or rights […] if and to the extent that:
(i) a notifiable acquisition would, as a consequence, take place under section 6 of the National Security and Investment Act 2021 (the NSI Act) and any regulations made under the NSI Act; and
(ii) either:
(A) the Secretary of State has not approved that notifiable acquisition in accordance with the NSI Act; or
(B) the Secretary of State has approved that notifiable acquisition in accordance with the NSI Act but there would, as a consequence, be a breach of the provisions of a final order made in relation to that notifiable acquisition under the NSI Act."
Any of the suggested drafting methods will work to ensure there is no automatic accidental NSIA notification requirement triggered by a default simply occurring. It is the author’s suggestion that drafting method (ii) gives the lender the most discretion to exercise voting rights in a way in which they need to in the given circumstances, and to decide whether a notifiable transfer of control will occur or not by exercising those rights. It is also drafting that works for other similar legislative purposes – for example, to avoid association or connection which may give rise to liability for pensions liabilities under the moral hazard powers of the Pensions Regulator, and in fact many existing security arrangements may already be drafted in this way for that very reason. Where borrower groups are distressed, it is vital for secured lenders to be able to act quickly and with confidence on the basis of advice they receive at the time in the given circumstances with clarity of their rights to act. It is worth remembering that the review powers under the NSIA are not limited to English incorporated entities, but extend to overseas companies connected with activities carried on, or the supply of goods or services, in the UK, so it is not just the terms of English law share security under review.
The NSIA does allow administrators or creditors of a company in insolvency proceedings to exercise rights without triggering a change of control review, whereas the appointment of a liquidator or receiver does not receive the same carveout. This division of insolvency processes is perhaps justifiable where an administrator’s role is to manage an ongoing period of trading whilst attempting an agreement with key creditors to facilitate a longer-term rescue plan and a handing back of control to the existing management. However, a considerable proportion of administrations result in a sale of part of a business as a going concern, and that subsequent sale whilst an administrator is at the helm, would, if in the NSIA notification sectors, still require review and clearance. A liquidator in contrast is not managing ongoing trading, there is no expected rescue, their task is to collect and sell assets on a piecemeal basis for the benefit of all creditors. However, whilst it is obvious why a subsequent sale may warrant review, it is not immediately obvious how a review at the stage of appointment of a liquidator, at a time when there is no particular purchaser for relevant assets in mind, is helpful. The same applies in relation to a receiver appointed to sell particular assets to derive value for the secured creditor – at the time they are appointed, there is not usually a known purchaser waiting in the wings, so how useful can a review at that point be? Time is of the essence for secured creditors seeking to enforce security, as the value of the secured assets plummets as news of insolvency breaks, and reviews before willing buyers can be found will inevitably make security enforcement more onerous. The more subtle intention of the difference in treatment may be to encourage administration processes with seamless ongoing operation of entities in the mandatory notification sectors for public policy reasons to enable potential purchasers to be reviewed without a pause in operations and trading. But ongoing trade requires funding, and administration is not always possible or justifiable.
Over time, as the government publishes final orders made under the NSIA, a clearer picture should emerge for secured lenders. In the meantime, it may make it harder, and more expensive, for businesses operating in risk sectors to raise funding.
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