What is asset based lending, in a nutshell?

The asset based lending (ABL) market continues to grow at pace, both in this jurisdiction, in Germany and internationally. 

ABL is a form of lending in which a percentage of the realisable value of a portion of the borrower's assets will be used to determine the sums to be advanced by the lender. The percentage set will be determined by the sum the lender is willing to lend money against in order to ensure that value of the loan never exceeds the realisable value of those assets, with reserves being created against the loan sum to reflect third party claims to the assets (for example retention of title or liens) that may reduce their overall value, and in relation to UK borrowers, certain preferential claims in UK insolvency proceedings. The value, quality and, crucially, liquidity of the assets (which could include receivables, stock, land, machinery and equipment) are as such paramount, particularly given that enforcement is likely to involve the lender taking control of the assets and converting them into cash.  This type of financing suits companies who are rich in receivables and stock and is particularly useful where financing is required on a flexible basis for example for companies whose returns are seasonal or those that are making strategic investments and acquisitions.  Borrowing companies may benefit from fewer covenants and favourable pricing depending on the nature and quality of the underlying assets.

In this article, which is the first in a series considering and comparing jurisdictions in the ABL space, we take a close look at the jurisdictional issues and key risks for an ABL lender in the UK and in Germany and how such issues may affect their decision to lend to corporates in that jurisdiction.  Lenders considering making funds available by way of asset-based loans will need to consider various factors including: (1) the types of security that may be taken in the jurisdiction and the ability to enforce the security in a default scenario in the manner the lender wishes; (2) restrictions applicable to the asset (for example non assignment provisions) which prevent the lender from taking the security it seeks; (3) the perfection requirements which if not satisfied may impact the validity and effectiveness of the security; (4) other creditors having priority over its security interests on insolvency or there being competing claims to the assets; (5) vulnerabilities of the security on insolvency and (6) third party costs involved in taking security in that jurisdiction.  Lenders will also need to get under the skin of the complexities of lending in the specific jurisdictions such as: any legal restrictions on the granting of security and any applicable regulatory (for example licensing) requirements which may affect a lender's ability to lend in that jurisdiction plus any hidden costs involved in the taking and perfecting of security.  Consideration of applicable regulatory requirements is beyond the scope of this article.  

What types of security can be taken under English and German law and what do they allow the lender to do on enforcement? 

Under English law, various options are available: 

• Plant and machinery: A fixed charge may be taken over plant and machinery, potentially in the form of a standalone mortgage over chattels or as part of a debenture. 
• Receivables: Security is usually taken by the creation of a mortgage over the receivables, which is usually done by way of an assignment. This can be legal or equitable under English law. An assignment will be a legal assignment if it complies with the requirements of s.136 of the Law of Property Act 1925 (the LPA) (ie must be in writing, absolute, not purport to be by way of charge only and be notified in writing to the third party against whom the assignor could enforce the assigned rights). If any of these requirements fails, there is an equitable assignment which can still be perfected at any point.  Future receivables are typically secured by way of an equitable assignment. Notice of the security should be given to the relevant third party (the security provider's debtor). If notice is not given the assignment will be equitable only.  Alternatively, charges are also commonly taken over receivables. With a charge, there is no transfer of title involved. The right over the receivable remains with the chargor, but the chargee has a right, if the charge becomes enforceable to appropriate the asset. It may be helpful to take a charge instead of an assignment where for example, the underlying document prohibits assignment (although the lender’s counsel should interrogate the assignment restriction and make sure it doesn’t also extend to charges).  There are two types of charge, fixed and floating. If a fixed charge is taken over receivables it can impair a company's ability to trade as the chargor will (amongst other things) be prevented from disposing of the asset without the lender's consent. 
• Inventory: Security is usually taken by way of mortgage in the form of an assignment or a floating charge – these types of non-possessory security allow the company to operate in the usual course. 
• Real Estate: Security is generally taken by way of charge by way of legal mortgage, which will need to be registered at the Land Registry (where the land is registered) or at the Land Charges Department (where the land is unregistered). However, security interests over unregistered land protected by the deposit of title deeds do not need to be registered.

On enforcement: A security package along the lines of the above will allow a lender to enforce its security over the assets on default, using the options available to it in the security document (and generally at law).  Enforcement options are likely to include the appointment of receivers, the exercise of the power of sale over the assets and taking possession of the secured assets where appropriate.  The proceeds from realisation of the assets will then be applied towards expenses incurred during enforcement and followed by repayment of the debt. A key point for lenders to note in relation to assignments is that with an equitable assignment, the assignee cannot sue the third party against whom the assignor has rights in its own name; an assignee under an equitable assignment is normally required to join the assignor in any action it brings against the relevant third party. With a legal assignment, the mortgagee is allowed to use the counterparty/account debtor and the mortgagee can enforce the chose in action against the counterparty in its own name, without having to join the mortgagor in the action.  It should be noted that to appoint an administrator out of court the security holder must have a qualifying floating charge, and lenders may be prevented from enforcing their security when an application for administration has been made or the company has gone into administration.

By contrast, under German law, the following options are available:

• Plant and machinery: Security may be taken in the form of a security transfer (see below for inventory). If the borrower is unable to repay the loan, the lender has the right to realise the asset and thus obtain economic satisfaction. However, there is a risk for the lender if the machinery and equipment that was transferred as collateral is located on the borrower's property and a third party enforces execution (eg on the basis of a mortgage or land charge in favour of the third-party) on the property. In this scenario, the machinery and equipment may under certain circumstances fall within the scope of the mortgage or land charge as an accessory to the property pursuant to Sections 97 and 1120 of the German Civil Code, Bürgerliches Gesetzbuch (BGB), with the consequence that the lender can no longer obtain satisfaction from the items. 
• Receivables: Security may be taken in the form of an assignment. Third party debtors should be notified according to German market practice (at the date of the assignment or upon occurrence of an event of default). If third party debtors have not been notified, they can still pay to the assignor with discharging effect.
• Inventory: With regard to inventories, a security transfer is considered. In connection with the security transfer asset lists and/or site maps of security areas where the assets are located should be delivered to properly identify (it is not sufficient that the assets are identifiable) and describe these assets, otherwise the transfer may be invalid. Also, lenders need to note that third party’s (extended) retention of title agreements and statutory liens (eg the landlord’s statutory lien) might lead to a situation where a certain portion of the inventory is not available for security for the lenders and thus reduces the security value of the security transfer of inventory.
• Real Estate: The relevant real property must be listed in the land register and the security taken, generally by way of a non-accessory land charge, must be notarised and registered with the competent land register. 

On enforcement: In Germany, the rights available to the lender in the security documents may be used following default as set out in the relevant security document and as provided under German law. In contrast to the UK, the German enforcement regime appears to be more borrower-friendly with certain mandatory provisions to be followed in an enforcement scenario. In general, enforcement of security instruments therefore requires prior written notice (Androhung) of the lender’s intention to enforce the collateral while there are circumstances where such notice may not be required under German law, eg if the company has ceased making payments generally or has filed for insolvency or if insolvency proceedings have already commenced. The questions if, when and how to enforce the security interest at hand of the lender(s) need to be thoroughly assessed in advance given that an enforcement which was not done in accordance with German law principles might lead to damage claims against the lender(s).

How effective is a contractual restriction on assignment?

Security in ABL is commonly taken by way of assignment. The governing law of the security will depend on the governing law of the underlying asset. Under English law, if the relevant formalities are followed and the assignment is valid as a legal assignment, this will have the effect of taking the asset outside of the borrower’s estate in an insolvency scenario. Non-assignment clauses applicable to the relevant assets can present a significant hurdle, but are they always effective? Both the UK and German legal systems have mechanisms which may assist a lender who wishes to take an assignment where the asset is subject to a non-assignment clause. 

• Under English law: Such a clause may be used to prohibit the assignment of the benefit of the contract and any accrued rights, subject to the Business Contract Terms (Assignment of Receivables) Regulations 2018, SI 2018/1254 (the Regulations), to the extent they apply. The effect of the Regulations is that, in certain situations when they apply, any contract term that prohibits or restricts the assignment of receivables is rendered ineffective. In general terms, the Regulations negate any ban on assignment of receivables (i) in B2B contracts created on or after 31 December 2018 for the supply of goods, services or intangible assets; (ii) where at least one of the parties has entered into the contract in the ordinary course of carrying on business in the UK; and (iii) where the party entitled to the receivable is an SME which is not an SPV (test applied at the time of the assignment, not when the contract was entered into). Certain categories of contract are excluded, eg regulated and Consumer Credit Act regulated contracts. If a restriction on assignment is found to be applicable and is not rendered ineffective by the Regulations, this may result in the lender seeking security by way of charge rather than by way of assignment over the relevant asset. 
• Under German law: According to the general rules of BGB, an assignment may be invalid. However, section 354a of the German Commercial Code (HGB) provides for an exemption to that principle. The assignment of monetary claims cannot be contractually excluded, if the parties to the agreement are commercial parties (Kaufleute) and the underlying agreement between the contracting parties constitutes for both of them a commercial transaction (beiderseitiges Handelsgeschäft). Even though the assignment of the relevant receivable is therefore valid, the prohibition of assignment continues to apply contractually between the parties and a violation thereof might lead to damage claims. However, the assignment is effective despite this prohibition. It should be noted that such third-party debtor will (even after notification of the assignment of the claim) be able to make payment to the assignor with discharging effect.

What perfection requirements are there and what happens if the security is not registered at an appropriate registry?

Under English law; All security granted by an English incorporated company, LLP or limited partnership (where the security is granted by its general partner and that general partner is a company or an LLP) must be registered at Companies House within 21 days of the security being granted (section 859A of the Companies Act 2006). A failure to register renders the security void against any administrator, liquidator or creditor of the company. When a charge becomes void, the money secured by it immediately becomes payable. The permission of the court (and an order providing the same) would be required to register security past the statutory cut off. It is worth noting that even if the governing law is not English, if the chargor is an English incorporated company or partnership, the registration requirement still applies.

Under German law: There is no central security registry under German law but asset specific registrations may be required. Perfection requirements under German law depend on the relevant security, the underlying assets and include, among others: 

• with respect to land charges: notarisation or at least notarial certification (Beglaubigung) and registration with the competent land register.
• with respect to the security transfer of inventory: transfer by delivering asset lists and/or site maps of security areas where the assets are located. The assets have to be properly identified (it is not sufficient that the assets are identifiable) and described, otherwise the transfer may be invalid. The Security Transfer Agreement is German market standard because it has the advantage that the debtor remains in direct possession of the secured assets and can continue to work with them, while the lender is allowed to have indirect possession via the debtor (Besitzkonstitut).
• with respect to the assignment of receivables: certain third party debtors should be notified according to German market practice (at the date of the assignment or upon occurrence of an event of default). If third party debtors have not been notified (which is common for third party debtors of trade receivables), they can still pay to the assignor with discharging effect. To protect the lenders, the notification of third party debtors of trade receivables is often triggered by an event of default or other triggers.

Do other creditors have priority on insolvency and can there be competing claims to the assets themselves? 

Under English law: The order of priority is broadly as follows: Fixed charge holders, administrator/liquidator fees, preferential creditors (HMRC/tax authority rates and taxes owing plus employee wages and salaries and accrued holiday remuneration), prescribed part (up to £800,000), floating charge holders, unsecured creditors and shareholders. To the extent that a lender takes part of its security package by floating charge there will therefore be claims that take priority over its claim and a portion of the floating charge realisations will be applied towards the prescribed part. 

In Germany: There are also claims that will take priority over a secured creditor in an insolvency of the relevant company: the order is broadly: persons entitled to segregation due to security interests, persons entitled to separation due to valid security interests, mass creditors, ordinary insolvency creditors and lastly subordinated creditors. Certain tax authorities are preferential. There is no equivalent of the UK prescribed part. German insolvency law generally provides for the subordination of shareholder loans and “claims arising from legal acts economically equivalent to such a loan” in the insolvency of the company. Lenders therefore, in general, have a statutory priority over holders of an equity interest in the insolvent company.

Retention of title/reservation of title clauses are recognised under both English and German law and may impact the pot of assets available to the asset based lender. As such reserves to address potential retention of title claims may be built into the facility in both jurisdictions.

The application of rights of set off may also deplete the assets available to the lender. In the UK, the laws of set off are however favourable to a lender provided in an insolvency scenario there is mutuality of obligations. German law is also protective to debtors and security providers, applying principles of good faith. Furthermore, a prohibition to set-off cannot be upheld by the German courts if the counterclaim in question is undisputed or has been recognised by declaratory judgment. 

What are the key vulnerabilities of security on insolvency? 

Under English law: Assuming that the lender is not "connected" to the company, security may be set aside (1) within 2 years of the onset of insolvency if the administrator/liquidator declares it was a transaction at an undervalue; (2) where granted within 6 months of the onset of insolvency, the transaction may be void for being a preference or (3) within 1 year of insolvency a floating charge may be set aside if not granted for appropriate consideration. 

In Germany: Security may be subject to challenging rights by the security grantor's insolvency administrator in case of insolvency. There are several cases in which the collateral may be contested in insolvency within certain specific time limits, in particular – of course – where the granting of security is wilfully to the disadvantage of other creditors. Also, security can be contested if the total value of the aggregate security granted by the company on day 1 is initially more than 150% of the value of the secured obligations or there is deemed to be a lack of consideration (initial overcollateralisation). 

What are the standard third party costs involved in taking security or a guarantee in the jurisdiction? 

Under English law: Any security documents written in a foreign language need to be fully translated before being filed at Companies House. The filing fee at Companies House is nominal. 

Under German law: Typically, certain security interests, such as the pledge over shares in a German limited liability company (GmbH) or the creation of a land charge require the involvement of a German civil law notary. The fees of such notary are not negotiable but are mandatorily fixed and depend on the value of the security.

Are there any local law restrictions on a resident company granting security or a guarantee in favour of a lender? 

Under English law: There aren't any such restrictions, subject to the constitutional documents of the company and the terms of any investor/shareholder agreement permitting such transactions, and subject to the company being able to demonstrate the required corporate benefit for entering into the transactions.

Under German law: There are outright restrictions:

• If the total value of the aggregate security granted by the company on day one is initially more than 150% of the value of the secured obligations (initial overcollateralisation), the security will be invalid.
• If overcollateralisation occurs whilst the security is outstanding, the company can demand a partial release of the security (subsequent overcollateralisation).
• Depending on the type of company, there may be corporate law restrictions such as a prohibition on the disbursement of assets necessary to maintain the share capital of a GmbH. In case of violation, the managing director(s) can be held liable for damages.

A loan agreement and the guarantees and/or security interests securing such loan may be void pursuant to section 138 para. 1 BGB (usury-like transaction – wucherähnliches Geschäft) or section 138 para. 2 BGB (usury – Wucher) if (i) there is a conspicuous disproportion between performance and consideration and (ii) subjectively, there is a reprehensible attitude on the lender’s side. The German Federal Court of Justice (Bundesgerichtshof) has consistently held that there is a conspicuous disproportion if the effective contractual interest rate exceeds the normal market effective interest rate by around 100% in relative terms or by 12% in absolute terms, although in individual cases the requirements of section 138 para. 1 BGB may also be met if the relative interest rate difference is only between 90% and 100%, based on an overall assessment of all other business circumstances. 

What about financial assistance issues?

Under English law: Whilst guarantees can be set aside for unlawful financial assistance, this only applies to a public company (or its subsidiary) giving financial assistance of the purpose of the acquisition of shares of a public parent company. This is therefore unlikely in the context of a typical ABL financing. 

Under German law: The regulations are similar – an Aktiengesellschaft (AG), a German form of public company similar to a plc in the UK, is prohibited from providing financial assistance by way of granting of security to a potential buyer of its shares. Any such financial assistance will be void. The return of contributions to shareholders is also prohibited. 

Concluding comments

Understanding the risks and vulnerabilities of lending by way of ABL and taking associated security in an unfamiliar jurisdiction will be of crucial importance to a lender, when making the decision to lend. The factors considered above are not exhaustive, but aim to provide a detailed starting point for lenders, to assist them in this process. This is, as mentioned above, the first in a series of articles in which we compare ABL in the UK with various other jurisdictions, so please watch this space for the next in this series!

To discuss the issues raised in this article in more detail, please contact a member of our Banking and Finance team.