- 08 July 2019
- Corporate and M&A
Charges over shares of companies incorporated under English law are not uncommon, often as part of a group banking facility, where subsidiary company shares are charged by the borrowing parent company in favour of the lender. An overriding question for the charge at the outset with any charge over shares will be the marketability of the charged shares in the event of enforcement. With a smaller private company, this may be very uncertain.
To put in place a legal charge over shares, title to the shares is actually transferred to the lender by way of security for the relevant obligations, on condition that it is re-transferred when the secured obligations are discharged. This would mean the lender/chargee actually being registered in the register of members of the company whose shares are being charged in relation to those shares.
Legal charges over shares are less common than equitable charges over shares, which are created by depositing the relevant share certificate with the chargee, accompanied by a completed, undated stock transfer form. The actual terms of the charge will be set out in a security agreement between lender/chargee and borrower/chargor which will contain many of the provisions and protections in favour of the chargee which we would expect to find in any formal charge, whatever the assets. The security agreement will provide that the chargee will only date and submit the stock transfer form for registration if the charge becomes enforceable. As a result, the charge takes effect as an equitable charge. In practice, there is little difference between an equitable charge and an equitable mortgage over shares, the terms being used interchangeably.
In the event of enforcement of an equitable charge, the stock transfer form would have to be lodged with the company whose shares were charged for registration of the chargee as the holder of the shares in question. For this reason, it is important that the articles of association of that company are checked in advance, and that provisions permitting, for example, the directors to refuse to register a transfer or standard pre-emption on transfer provisions are removed or expressed not to apply in such circumstances. In practice, chargees may also require the addition to the articles of association of provisions which specifically facilitate the right of a chargee of shares to be registered as holder of the shares in the event of enforcement.
Where a chargee takes enforcement action in relation to charged shares, it will be subject to the overriding legal obligations under English law on chargees exercising a power of sale, being to:
- Act in good faith.
- Take reasonable steps to obtain a proper price for the asset.
- Obtain the best price reasonably obtainable.
- Act with reasonable care and skill.
- Act fairly towards the chargor.
Where a power of sale arises, the issue of whether a chargee has acted in good faith may arise if the chargee decides to retain the shares in discharge or reduction of the secured debt (in essence, in this scenario, exercising the power of sale in favour of themselves). In these circumstances, there would likely need to be an independent valuation to ensure that the shares retained matched what was outstanding by way of indebtedness and costs, and the remainder of the shares would then have to remain with the chargor.
The position is not necessarily the same if the chargee is exercising the power of sale and selling the secured assets to a third party. This is a particularly important issue for the chargor to consider at the outset in the case of a charge over shares if the value of the charged shares may conceivably exceed outstanding indebtedness and the shares are readily marketable. The above general legal duties would continue to apply here, but a chargee is under no duty to refrain from exercising their rights merely because to exercise them may cause loss to the chargor. A charge will generally confer a power of sale over all the secured assets, so the chargee, subject to their legal duties, will be entitled to sell all the secured assets and then apply the statutory priorities – ie discharging any prior ranking encumbrances, then paying the expenses of the sale, then discharging the secured liabilities and then, if there is a surplus, paying it to the chargor.
To put in place a legal charge over shares, title to the shares is actually transferred to the lender by way of security for the relevant obligations, on condition that it is re-transferred when the secured obligations are discharged.
In this situation, a chargor might understandably claim that a sale of all the shares when only part actually needed to be sold was in bad faith and unfair (so in breach of the chargee’s legal duties), on the basis that it would be difficult/impossible for the chargor to recover “excess shares” not required to compensate the chargee but sold as part of the power of sale, and that any sale proceeds paid over to it would not compensate it for this loss. This would not be an easy claim, and the issue would be best addressed in advance by agreed changes to the security agreement.
For both sides involved in a charge over shares, careful thought must be given to the possible consequences of enforcement at the start. The chargee needs to ensure that the company’s articles of association do not prevent enforcement; and, as with all security arrangements, it is very important that a charge over a company’s shares receives formal board approval in advance with a proper consideration of corporate benefit issues.
This information is for guidance purposes only and should not be regarded as a substitute for taking legal advice. Please refer to the full General Notices on our website.