Since the provisions came into force in April 2016, there has been much discussion amongst practitioners as to how they impact lenders in the context of taking security over shares in a relevant company which is incorporated in Scotland and whether or not this new legislation triggers requirements for lenders to be entered in the company's PSC register. There is no settled position in Scotland, where some law firms believe the new legislation is triggered and others do not.
The Department for Business, Energy & Industrial Strategy (BEIS) has indicated that it will be reviewing the PSC regime in early 2019, but in the meantime, how should lenders deal with the legislation? Does taking fixed security over shares in a Scottish company trigger registration? Why is this such a concern in Scots law, but less so in English law? How might a lender trigger the PSC regime? And in any event, is being included on a PSC register a material detriment?
Fixed security over shares in Scottish companies
Unlike English law, Scots law does not recognise the concept of an equitable security interest. In England, most lenders will rely on an equitable fixed charge over shares, which is usually supported by taking possession of the share certificate and a signed blank and undated stock transfer form. If the same steps are taken in Scotland, this would be regarded as inchoate and incomplete such that it would not grant the lender any security interest at all in the applicable shares as a matter of Scots law.
In order for a fixed security over the shares in a Scottish company to be created, a shares pledge document must be duly executed by the pledgor in favour of the lender and title to the shares must be transferred to the lender (or its nominee) through a signed and dated stock transfer form, with the lender (or its nominee) thereafter written-up in the register of members of the company and a share certificate issued in its name. In other words, the equivalent of the English law concept of a legal mortgage must be created.
Registration under the PSC register
If a lender is holding a properly-constituted shares pledge over shares in a relevant company incorporated in Scotland, and assuming this security is constituted over more than 25% of the issued shares, then it appears that a lender must be registered in the PSC register of that company.
"Person with significant control"
A person with significant control over a relevant company is an individual who meets one or more of the conditions set out in paragraphs 2 to 6 of Part 1 of Schedule 1A CA 2006. The specified conditions are as follows:
- First condition: "[The individual] holds, directly or indirectly, more than 25% of the shares in [said company]";
- Second condition: "[The individual] holds, directly or indirectly, more than 25% of the voting rights in [said company]";
- Third condition: "[The individual holds] the right, directly or indirectly, to appoint or remove a majority of the board of directors of [said company]";
- Fourth condition: "[The individual] has the right to exercise, or actually exercises, significant influence or control over [said company]"; or
- Fifth condition: "(i) The trustees of a trust or the members of a firm that, under the law by which it is governed, is not a legal person meet any of the other specific conditions (in their capacity as such) in relation to [said company], or would do so if they were individuals and (ii) the individual has the right to exercise, or actually exercises, significant influence or control over the activities of that trust or firm."
Only one of the above conditions need be met by a person to qualify as a PSC.
The drafting appears to only capture "individuals" (that is to say, natural persons). However, the effect of sub-sections (5), (6) and (7) of section 790C CA 2006 is such that a "legal entity" (being a body corporate or a firm that is a legal person under the law by which it is governed) can be a "registrable relevant legal entity" (RRLE) in certain circumstances. Whilst the intent behind the legislation is to identify 'individuals' with control of a relevant company who may otherwise be 'hidden' through tiers of opaque ownership vehicles (e.g. trusts or companies incorporated in jurisdictions where company information is difficult to access), the legislation takes effect so that there is no requirement to register such an individual in the PSC register of a company if he or she holds his or her shares indirectly through one or more legal entities over which that individual exercises significant control and one of which is "subject to its own disclosure requirements".
The meaning of "subject to its own disclosure requirements" is set out in section 790C(7) CA 2006. For the purposes of this article, the key categories are as follows:
- section 790C(7)(a), which covers other relevant companies and persons which are subject to Part 21A CA 2006; and
- sections 790C(7)(b) to (d), which cover a legal entity which has voting shares admitted to trading on an applicable market.
Where such a RRLE is interposed between an individual and/or another legal entity and a relevant company, it is sufficient for the RRLE to be registered on the PSC register of the relevant company. In other words, where the UK Parliament has taken the view that corporate governance and disclosure rules applicable to a legal entity are sufficiently robust to allow the chain of ownership to be readily ascertained by other means, there is no need to proceed any further up the chain of ownership for the purposes of the PSC register of a relevant company.
For example, if an individual holds and controls >25% of the shares in a relevant company (company A) indirectly through another relevant company (company B), that individual need not be detailed in the PSC register of company A, but does have to be detailed in the PSC register of company B (and company B would have to be detailed in the PSC register of company A). However, if a >25% ownership chain between an individual and a relevant company consists entirely of unlisted companies incorporated in, say, Botswana, then it will be necessary for that individual to appear in the PSC register of that relevant company.
A lender as RRLE
In a UK context, most lenders will fall within the ambit of Part 21A CA 2006 either because:
- the lender is itself subject to Part 21A CA 2006 (because it is a UK company whose shares are not listed); or
- the lender's shares are listed on an applicable market.
In such circumstances, the lender itself must be registered in the PSC register of a relevant company in which it holds >25% of the issued shares or over which it exerts control.
In the context of a duly constituted shares pledge held by a lender over >25% of the issued shares of a relevant company incorporated in Scotland, that lender (or its nominee) will be detailed in the register of members of that company as the holder of those shares and will, to that extent, be a "member" of the company (see Farstad v Enviroco).
Accordingly, it seems clear that the first condition specified above is engaged - "[the lender] holds…. more than 25% of the shares in [said company]". As the legislation is clear that only one of the conditions need be engaged, it follows that, in these circumstances, the lender will be an RRLE and will need to be entered into the PSC register accordingly. We believe this is an unintended consequence of the drafting. The legislation is directed towards the mischief of ultimate beneficial ownership of UK companies being disguised in order that the true owner might avoid certain responsibilities and duties which might otherwise apply (such as paying tax). In this context, "control" (as opposed to bare ownership) appears to be the determinative emphasis, certainly insofar as the second, third, fourth and fifth conditions are concerned. Paragraph 23 of Schedule 1A CA 2006 is notable as regards "control" since it deals specifically with share security:
"Rights attached to shares held by way of security provided by a person are to be treated for the purposes of this Schedule [1A] 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 releasing 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 releasing it, the rights are exercisable only in that person's interests."
Paragraph 23 appears quite helpful from a lender's perspective. However, it relates to "[rights] attached to shares" and therefore arguably only qualifies the second, third, fourth and fifth conditions, and does not obviously qualify the first condition. Thus, a lender holding an equitable charge over shares in a relevant company incorporated in England appears to be excluded from the PSC regime since it is not a RRLE (at least until the point of enforcement or the occurrence of an event of default) because:
- the lender does not "hold" any shares so as to engage the first condition;
- as far as the second condition is concerned, paragraph 23 of Schedule 1A CA 2006 makes clear that the voting rights will, per typical drafting appearing in most share charge documents, be deemed to be held by the chargor and not the lender; and
- typically, the third, fourth and fifth conditions will not be engaged.
The key difference with a duly constituted pledge over shares in a Scottish company is that the first condition is engaged because the lender does 'hold' the shares and that condition is not obviously qualified by paragraph 23 of Schedule 1A CA 2006.
Since the obvious literal interpretation of the legislation is that a lender holding a duly constituted shares pledge over >25% of the shares of a Scottish company is a RRLE under the first condition, and since criminal penalties apply to both the RRLE and the company maintaining the PSC register if the PSC register is not kept up-to-date and accurate, the prudent approach is to adopt that literal interpretation.
Position of syndicate lenders
There is a possible anomaly in the legislation which lenders who benefit from security held under a security trust arrangement should be aware of. This results from the terms of the fifth condition as detailed above. Whilst it seems clear that a security trustee itself would, if it held the benefit of a duly constituted shares pledge over >25% of the issued shares of a relevant company incorporated in Scotland, require to be registered in the PSC register of that company, what of the lenders holding the benefit of the security trust? On the face of it, such lenders appear to be caught by the fifth condition since they have "the right to exercise, or actually [exercise], significant influence or control over the activities of [the security trust]." However, we take the view that such an outcome would yield a highly impractical and possibly even vexatious result, particularly in the context of large syndicates or a widely invested secured notes programme. We consider that the solution is found in paragraph 22(1) of Schedule 1A CA 2006, which specifies that:
"Rights that are exercisable only in certain circumstances are to be taken into account only -
(a) when the circumstances have arisen, and for so long as they continue to obtain, or
(b) when the circumstances are within the control of the person having the rights."
In the context of most security trust arrangements, rights to instruct the security trustee to enforce the security or take other steps in respect of the collateral would only be exercisable in certain circumstances (such as, for example, where an event of default is continuing) and therefore should be taken into account only when those specific circumstances have arisen. Nevertheless, where a shares pledge is to be taken by a security trustee, we consider that the security trust provisions (whether contained in the facility agreement or an intercreditor deed) should be amended to clarify that all rights pertaining to the pledged shares are exercisable in the sole discretion of the security trustee until such time as an event of default (or such other enforcement event as may be applicable) has occurred. As a matter of fact, the same issue arises in the context of a full legal mortgage over shares in a relevant company incorporated in England.
Lenders on PSC register - Why not?
There are a number of reasons why a lender may not wish to appear on a relevant company's PSC register.
Some lenders will be concerned simply because the relevant information is made public. This objection can easily be dealt with in the context of a pledgor company incorporated in the United Kingdom, the information will be made public in any event because the shares pledge will be registered in the pledgor's charges register maintained at Companies House.
If a lender is found to be a RRLE then it must comply with a number of notification requirements and supply certain information to the relevant company.
Offences for failing to comply are severe:
- A failure to respond within a month to a relevant company serving notice on a lender that it reasonably believes, or knows, is a PSC or a registrable relevant legal entity is punishable by imprisonment/a fine.
- A failure to notify the relevant company if the lender knows or ought reasonably to know that it is registrable and that it is not as yet on a PSC register is also punishable by imprisonment/a fine.
Ongoing duties and false statements
There is a duty to keep the information on a PSC register up-to-date. Breach of this requirement is an offence and attracts imprisonment or a fine.
Should the lender make a false statement, then it is liable to imprisonment or a fine.
Removal from the PSC register
Should a lender cease to be a RRLE (where the relevant security is released, for example), it cannot simply request that the company update the PSC register at that time. The relevant entry may only be removed from the PSC register after the expiration of 10 years from the date on which the entity ceased to be a RRLE (see section 790U CA 2006).
Where a new or off-the-shelf company can be deployed, using an English company ab initio presents the easiest option.
Otherwise, an English company substitute for a live Scottish entity might be possible in certain financing transactions. Real estate finance (REF) transactions, for example, often feature borrowers that are special purpose vehicles, each holding a single property. SPV arrangements would facilitate a Scottish company transferring its assets to an English substitute. However, one would need to consider the tax implications of the 'hive-up', and any SDLT/LBTT ramifications in particular in the REF context.
It is worth noting that a transfer to an English company is unlikely to work for trading companies, e.g. in the context of a 'general corporate purposes' loan. The Scottish company will already have complex existing trading/client/supplier relationships. Transferring these to a new entity would entail an extensive repapering exercise which would not be palatable to most borrower groups. As above, there may also be an impact on the group's tax position.
Orphan companies are a feature of securitisations, where they are the vehicle of choice for issuers. The shares in the orphan are held by a trustee on a non-charitable purpose trust. Whilst the trustee is the legal owner, the orphan has no beneficial owner – hence its moniker. The attractions of orphan vehicles include bankruptcy remoteness, and the fact that they are off-balance sheet. Overseas companies are not required to keep PSC registers; and orphans are generally overseas companies.
Might it be feasible to use an orphan as the security trustee, to hold the shares in the Scottish company? The thinking behind this is that the orphan would not need to be on the PSC register. Interposing this entity in the corporate ownership structure would also break the PSC chain.
A feature of orphan companies is that on winding-up, their trustees must retain a discretion on whether to pay realisations to sponsor companies; or instead, to a charity. This should not be a concern for secured lenders, however, since their security will not form part of the orphan's own estate.
A possible downside of this solution, for now, may be a cultural issue. An orphan structure is atypical for most conventional secured debt transactions. Indeed, it is rarely used outside of securitisations. Market reservations (if genuine and persistent) would affect a deal's bankability, making syndication/transfers difficult.
Multiple security trustees
PSC registration requirements are triggered when the pledged shares amount to >25% of the issued shares of a relevant company incorporated in Scotland. Could one avoid these by appointing one security trustee and then having the pledged shares held by nominees on behalf of the security trustee, each nominee holding ≤25% of the total number of issued shares? Or by setting up several security trustees, each of whom takes a duly constituted shares pledge over ≤25% of the total?
The answer is 'no'. In relation to the former, Paragraph 19 of Schedule 1A of CA 2006 makes it clear that a nominee is disregarded and the legislation looks through to the security trustee. Regarding the latter, the non-statutory guidance issued in connection with PSC registers indicates that joint arrangements where two or more people/RRLEs arrange to exercise all or substantially all their rights jointly in a way which is predetermined are caught by the PSC regime - each shareholder is deemed to hold the total number of shares held by all. Granted, a non-statutory guidance does not have the force of law; however, given that this one was issued by BEIS, it is likely to be persuasive to a court.
If it is necessary for commercial reasons to persevere with a Scottish entity, the most practical solution for creating security over its shares (whilst avoiding PSC requirements) involves combining floating charge protection, and an inchoate pledge. This is a route we have favoured in recent deals.
The parent company would enter into a debenture containing a floating charge (or a separate floating charge instrument) over all its assets – this would capture its shares in the Scottish subsidiary. Furthermore, the parent would also execute a shares pledge over the shares in the Scottish company. However, the security trustee would refrain from having the 'pledged' shares registered in its name in the Scottish company's register of members. Instead, it would take a contractual right to require such registration on the occurrence of a continuing event of default. On being registered as a member, PSC requirements would be triggered, but not prior to this. However, until being registered as a member, the lender would have only floating security over the relevant shares and would therefore rank accordingly in any insolvency process (assuming that the inchoate pledge is not perfected prior to the onset of insolvency).
The above could also be coupled with taking security from the Scottish company in the form of a floating charge over all assets and/or a standard security over land or an assignation of book debts with intimation. On default, the lender could enforce directly against the assets of the Scottish company.
Stopping short of being named on the Scottish company's member of registers renders the arrangement vulnerable to fraud or a third party sale. However, one could argue that the position is no different when taking equitable charges over shares in English companies. Yet secured lenders in England and other common law jurisdictions seem content to bear these risks.
A more significant challenge relates to insolvency hardening periods, and the fact that an inchoate pledge does not constitute security under Scots law. The commencement of 'hardening' periods in connection with unfair preferences and gratuitous alienations (the English equivalent being preferences and transactions at an undervalue) would only be triggered by registration on the Scottish company's register of members; and not before, on the taking of the inchoate pledge. This is not a downside that is shared by English law equitable charges over shares, where the clock starts upon execution and delivery of the charging deed.
Whether or not secured lenders are prepared to live with the attendant risks of the inchoate pledge route depends on commercial realities – the value of the Scottish company; the size of the lending; the security package as a whole; the strength of the borrower and/or guarantor coverage and so on.
The current position as regards Scottish shares security and the PSC regime is unsatisfactory to say the least, and may deter some lenders from providing credit to structures involving Scottish companies or assets. The fact is that none of the possible solutions specified above is likely to be palatable or commercially feasible if the Scottish company in question has significant and material value in the overall context of the secured lending transaction. It would be helpful if BEIS could provide some guidance on this to the market generally so that the position can be clarified pending amending legislation or an intervening court judgment.
In this context, it is worth mentioning that the Scottish Law Commission (SLC) published a discussion paper in June 2011 regarding possible reformation of the Scots law applicable to moveable transactions. The SLC paper proposes that a new register of moveable transactions is established and that a "shares pledge" would be capable of registration therein, thereby satisfying the "publicity principle" which is integral to Scots property law. Thus, a shares pledge could be created without transferring title to the shares to the lender. This would consequently take a shares pledge so constituted outside of the PSC regime (at least until the occurrence of an event of default). The time may have come for the Scottish Government to bring forward these proposals into enacted legislation.
This article was first published in the Journal of International Banking and Financial Law.