Share security – how to Box Clever with voting rights

The lender's dilemma

Lenders who take security over shares in an English company have to decide whether to take either:

• a legal mortgage by becoming registered owner of the shares
• an equitable mortgage or charge with the chargor remaining the registered owner.

A legal mortgage gives the lender the right to vote subject to the terms of the mortgage document and prevents the chargor from disposing of legal title to the shares to a third party, as the lender is the registered owner of the shares.

On the other hand, the lender has to consider the risk that becoming the registered owner of the shares may give them control of the company, with adverse consequences for the lender.

When control matters

If the mortgage entitles the lender to exercise or control the exercise of one third or more of the voting power at general meetings of the company, the lender will be an "associate" of the company for the purposes of the Insolvency Act 1986 by virtue of having "control" of it within s 435(10) of that Act.

The status of "associate" makes it easier for an insolvency practitioner to challenge pre-insolvency transactions by:

• extending the period within which preferences can be challenged from six months to two years
• presuming the company to be insolvent at the time of the transaction for the purpose of challenging a transaction at an undervalue
• extending the period within which a floating charge is invalid as to money or services provided before the date of the charge to two years, and removing the requirement to show that the company was insolvent when it gave the floating charge.

This has implications for any transactions (such as giving guarantees or charges) between the lender and any company with which the lender is connected or associated in this way.

The Pensions Act 2004 incorporates the definition of "associate" from the Insolvency Act.

The Pensions Act provides that a person who is connected or associated with a company which has a defined benefit pension scheme may be required by the Pensions Regulator to provide financial support to the scheme if it is in deficit.

This article looks at a case arising under the Pensions Act, but control of voting rights attached to shares should be considered in the context of other laws as well.

The Pensions Act and share security

There are no provisions in the Pensions Act which expressly exempt lenders who have security over shares from being liable for all or part of a pension scheme shortfall.

The Pensions Regulator responded to concerns raised by lenders in correspondence with the Financial Markets Law Committee (the FMLC), then of the Bank of England, stating that:

• a lender with security over shares could not be targeted by the Pensions Regulator to prevent recovery of a shortfall debt, where control has either not vested in the lender (eg because an event of default has not occurred), or has vested (eg because an event of default has occurred) but not actually been exercised
• it would not be reasonable financial support from a lender whose voting rights either have not vested or have vested but not been exercised.

In the Box Clever case, which pre-dates this correspondence, the chargors were permitted to continue to vote the shares until intervention by the mortgagee.

The Box Clever case

The Pensions Regulator had issued a direction to a number of companies (the Targets) requiring them to provide financial support for a pension scheme under which their subsidiaries were employers.

The direction was issued on the basis that the companies were associates of the relevant subsidiaries.

The Targets argued that the Pensions Regulator did not have power to issue the direction because, amongst other things, intermediate holding companies had given legal and equitable mortgages over shares in the employer companies which ended the required connection or association.

These arguments were rejected by the Upper Tribunal in ITV plc and others v The Pensions Regulator with Box Clever Trustees Ltd as an Interested Party [2018] UKUT 0164 (TCC).

The Targets appealed to the Court of Appeal.

The debenture

The debenture contained mortgages over the shares in five subsidiaries of the Targets.

In four cases the shares were registered in the name of the mortgagee, with a fifth continuing to be registered in the name of the mortgagor.

The debenture set out detailed provisions concerning the voting and other rights attached to the shares.

In summary these provided that, until a notice of default had been given under the loan agreement, the voting rights attached to the mortgaged shares could be exercised either:

• by the relevant chargor, or
• where the shares were registered in the name of the Security Agent, by the Security Agent as directed by the relevant chargor.

After service of a notice of default, each chargor was nevertheless entitled to continue to exercise any voting rights in the absence of a notice from the mortgagee.

Administrative receivers were appointed to the relevant companies in 2003 and 2004 (as the debenture predated the restrictions on such appointments in the Enterprise Act 2003).

Demands were made on the mortgagors as guarantors.

Were the Targets "associates"?

The Pensions Act provides that whether a person is connected with or associated with another person is determined by tests set out in s 435 of the Insolvency Act 1986.

S 435 provides a complex test for identifying associates of companies either individually or in groups. In the Box Clever case, this turned on who was entitled to exercise or control the exercise of one third or more of the voting power at general meetings of an employer company, or of another company which had control of it.

The Targets argued that:

• the provisions of the debenture meant that the mortgagee had, in fact, given notice to end the chargors' exercise of voting rights by issuing the notice of default and/or the demand on the companies
• the appointment of the administrative receivers had itself deprived the Targets of these voting rights, as they would then be exercised by the receivers.

The Court rejected the Targets' interpretation of the relevant provisions of the debenture and the demand, holding that transfer of voting rights had not been triggered by the notice of default or the demand.

The Court also found that the appointment of administrative receivers did not change the entitlement of the mortgagors to exercise voting rights in the subsidiaries, as the receivers would exercise those rights as agent of the subsidiaries.

Takeaways

The focus of the case is on the time at which voting rights would pass to the mortgagee under the terms of the debenture, with no challenge to the views of the Pension Regulator outlined in the correspondence with the FMLC.

Security over shares should clearly indicate when, if at all, voting rights will be exercisable by a mortgagee.

For example, this should require both the occurrence of an event of default and the service of a notice of intention to exercise voting rights by the lender.

Granada UK Rental and Retail Ltd v Pensions Regulator [2019] EWCA Civ 1032