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Why might a Bank ask for a legal charge over private company shares?

I’ve recently had two cases where a lender has agreed to provide a loan to a SME but have included within their security requirements a ‘legal charge over the shares of the company’ (in addition to the more normal request for a Mortgage Debenture). I’ve never encountered this in years of experience.

I found this puzzling and the shareholders involved were rightly concerned about the implications, especially when the lenders involved couldn’t explain why they wanted this. In both cases the lenders eventually ‘backed down’ after my negotiations with them and the loans were provided without this security.

This got me intrigued – in each case we couldn’t get an adequate explanation neither could the bank provide a sample ‘charge form’ so that I could understand the detail. So why could this be needed?

It is not unusual for a bank to ask for a legal charge over shares when lending against the shares of quoted companies. Often a Private Bank, for example, will lend against share portfolios (often referred to as ‘Lombard Loans’) and having a charge over the shares gives them the right to sell them in the open market if the borrower defaults.

However, the shares in a relatively small family owned business cannot be sold in an open market – they effectively have no value.

There are two logical, but technical, reasons why a bank could benefit from such a charge:

  • The first is that it would give them the legal rights to any dividends that were attributable to such shares. However in the event of a default or failure of the business it would seem unlikely that any dividends would be available, and the shareholders would normally only get any residual value after the secured creditors (e.g. the bank) had been repaid. So this doesn’t seem to be a good reason.
  • The second is more likely, but also ‘sneakier’ on the part of the bank. A legal charge over an asset is likely to include the right to appoint a Receiver in the event of default. A Receiver would ‘step into the shoes’ of the shareholder(s) and one of the rights of shareholders is to appoint or dismiss Directors. Following this through logically it would seem to give the bank the capability to change the Directors (often the owners) and take full control of a company.

This is concerning if the bank is not being transparent about this in the first instance. And would a Director in this situation be able to find this out for themselves? Even independent legal advice from their solicitor might not fully inform them of the implications here.

I’d be interested to hear from any bankers or lawyers who have any further insight on this

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