Welcome to the World of Loan Capital!
In our previous studies, we looked at how companies raise money by selling "pieces" of themselves (shares). But what if a company wants money without giving away ownership? That is where Loan Capital comes in! Think of this as the company taking out a professional "IOU." By the end of these notes, you will understand how companies borrow money, how they protect lenders, and what happens if things go wrong. Don't worry if this seems a bit technical at first—we will break it down piece by piece!
1. What is a Debenture?
The most important term in this chapter is the debenture. In simple terms, a debenture is a document issued by a company that acts as evidence of a debt. It acknowledges that the company has borrowed money and promises to pay it back with interest.
Did you know? Even though we often use the word "debenture" to mean the loan itself, legally, it is actually the piece of paper (or digital record) that proves the loan exists.
There are three main ways debentures are issued:
- Single debenture: A simple loan from one person or one bank.
- Debenture stock: A large loan divided into smaller units (similar to how share capital is divided into shares).
- Series of debentures: Multiple loans issued at different times but usually on the same terms.
Key Takeaway
A debenture is simply a receipt for a loan that shows the company owes money and explains the terms of repayment.
2. Shares vs. Debentures: What's the Difference?
Students often get these confused, but they are very different animals! Think of Shareholders as the "Owners" and Debenture Holders as the "Lenders."
1. Ownership: A shareholder is a member/owner of the company. A debenture holder is a creditor (someone the company owes money to).
2. Income: Shareholders get dividends (only if the company makes a profit). Debenture holders get interest (which must be paid even if the company makes a loss!).
3. Voting: Shareholders usually have voting rights. Debenture holders usually have no voting rights.
4. Repayment: If the company closes down (liquidation), debenture holders are paid before shareholders. Shareholders are the last in line.
Quick Review: Remember, interest on a loan is a debt, while a dividend is a gift from the profits. You must pay your debts, but you only give gifts if you have enough "spare" money!
3. Security: Protecting the Lender
If you lent someone £1,000,000, you would want some "security" or "collateral"—something you can take and sell if they don't pay you back. In company law, this security is called a Charge.
A. Fixed Charges
A Fixed Charge is attached to a specific, identifiable asset (like a building, a piece of heavy machinery, or a specific patent).
- The company cannot sell this asset without the lender's permission.
- It is like a mortgage on a house: you live there, but the bank has a "grip" on the property until the loan is paid.
B. Floating Charges
A Floating Charge is much more flexible. It "hovers" or "floats" over a class of assets that change all the time (like stock-in-trade, raw materials, or cash in the bank).
- The company can sell and replace these items in the ordinary course of business. (Imagine if a supermarket had to ask the bank every time they sold a loaf of bread! A floating charge prevents that headache).
- Crystalization: This is a fancy word for when a floating charge "stops floating" and "sinks" to become a fixed charge. This happens if the company stops trading, goes into liquidation, or fails to pay the loan.
Memory Aid:
Fixed = Firm (Attached to one specific thing).
Floating = Fluid (Moves around over many changing things).
Key Takeaway
Fixed charges are "stronger" because the company can't sell the asset easily. Floating charges are "flexible" because they allow the company to keep doing business while still providing some security to the lender.
4. Registration and Priority: Who Gets Paid First?
This is a very common exam area! When a company creates a charge (security), it must tell the Registrar of Companies.
The 21-Day Rule
Most charges must be registered at Companies House within 21 days of being created.
What happens if the company forgets?
- The charge becomes void (useless) against a liquidator or other creditors. This means the lender loses their "priority" and becomes an unsecured creditor—at the back of the line!
- The money borrowed usually becomes immediately repayable.
The Priority Rules (The "Who Wins" List)
If a company doesn't have enough money to pay everyone, we follow these rules:
1. Fixed Charges usually beat Floating Charges.
2. Between two Fixed Charges, the one created first usually wins (if both were registered on time).
3. Between two Floating Charges, the one created first usually wins.
4. Negative Pledge Clause: Sometimes a floating charge has a special rule saying the company cannot create a later fixed charge that takes priority. If the later lender knows about this rule, the floating charge might actually win!
Common Mistake to Avoid: Don't assume the date of registration decides priority. It is usually the date of creation, provided it was registered within the 21-day window.
5. Borrowing Powers and Remedies
Does a company have the right to borrow?
- For trading companies, the power to borrow is implied.
- The Directors usually exercise these powers on behalf of the company.
What if the company defaults (stops paying)?
If the company fails to pay interest or the loan itself, the debenture holder has several options:
- Sue: Take the company to court for the money.
- Appoint an Administrator: Someone to take over the company to try to save it or sell it.
- Seize the Asset: If they have a fixed charge, they can take the asset and sell it to get their money back.
- Petition for Winding Up: Ask the court to close the company down entirely.
Summary Checklist
Before you move on, make sure you can answer these:
- Can you define a debenture? (Evidence of debt)
- Do you know the 21-day rule? (Time limit for registration)
- Can you explain Crystalization? (Floating charge becomes fixed)
- Do you know who gets paid first in a conflict? (Usually Fixed over Floating)
Great job! You've just mastered the essentials of Loan Capital. Keep this momentum going as you head into the next chapter!