UK Court characterizes loan agreements as debentures - Implications under the Financial Services and Markets Act 2000

June 26, 2014

The recent UK Court of Appeal decision in Fons Hf v Corporal Ltd and Pillar Securitisation - which found that a loan agreement even if undrawn, is an instrument which evidences or acknowledges debt and consequently a debenture - has created significant legal uncertainty as to whether certain UK loan transactions may be regulated under the Financial Services and Markets Act 2000 (FSMA). 

Pursuant to the FSMA, debentures are “specified investments” subject to the financial regulation regime arising from sections 19 and 21 of that statute. Breach of this regime is a criminal offence and renders any relevant agreement unenforceable by the party in breach. 

The established understanding prior to Fons was that, while loan agreements may create a contractual framework under which loans are advanced, they did not themselves constitute a debenture or other investment creating or acknowledging indebtedness and accordingly were outside the scope of the FSMA (other than in respect of certain consumer credit and mortgage contracts). 

It should be noted that Fons was not concerned with the FSMA or the regulatory regime established by it and therefore did not consider whether loan agreements constitute debentures specifically for purposes of the FSMA.

Fons will be of primary concern to UK based banks and lenders, who will need to consider whether they and their borrowers are required to be in compliance with the regulatory regime under the FSMA. Overseas lenders (such as Canadian banks), may also want to seek advice from UK counsel in connection with loan agreements entered into by UK borrowers.


Fons concerned the interpretation of a security agreement and whether security granted over “debentures” included the security provider’s rights as a lender under certain loan agreements.

The Court of Appeal found that a loan agreement, even if undrawn, created an acknowledgement of debt and was thus a “debenture”. While, the Court of Appeal did not consider the FSMA regulatory framework’s treatment of debentures, the ruling nevertheless gives rise to the concern that loan agreements may fall within that framework.

While exemptions from the regulatory framework in the FSMA exist, they do not cover all circumstances relevant to borrowers and lenders under loan agreements. The City of London Law Society (which represents City lawyers, including some of the largest international law firms in the world) has accordingly written to HM Treasury asking for urgent clarification and legislation, noting in their submission that the inclusion of loan agreements as regulated investments under the FSMA would appear to be “inconsistent with the nature of the financial regulatory framework and might be unintended”.

Section 19 FSMA – Regulated Activities

The uncertainty created by Fons primarily arises from the application of Section 19 FSMA and the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO) to debentures. RAO sets out various “regulated activities” which if carried out in or from the UK in relation to a “specified investment” as specified in RAO must by virtue of section 19 FSMA be carried out by a person authorised or exempt under FSMA.

Regulation 77 RAO expressly includes as specified investments “debentures and other instruments acknowledging indebtedness” but loans and loan agreements are not specifically referred to in RAO outside the context of consumer credit or mortgage loans.

However, if loan agreements are “debentures” for purposes of the FSMA then any person carrying out a “regulated activity” in or from the UK in respect of a loan agreement would need to be FSMA authorised or exempt unless an exemption is available (and the exemptions do not appear to have been drafted with loans in mind and do not cover all possible loan-related regulated activities). “Regulated activities“ are broadly defined and, if loan agreements were determined to be debentures for purposes of the FSMA, could include:

  • that of being a borrower party to a loan agreement as to do so could be “dealing as principal” by creating a debenture. Although there is an exemption for a person “issuing its own debentures” it is not clear that this is the same as entering into a loan agreement;
  • that of being a lender party to a loan agreement. Although most bank lenders in the UK will already be FSMA authorised, other non-bank lenders may not be and available exemptions for “accepting an instrument” again  do not easily fit with entering into a loan agreement;
  • the activities of those who advise on or arrange or administer loans. Exemptions are available but may not cover all relevant activities;
  • the activities of secondary market buyers and sellers of loans who would be dealing as principal or agent in the loans and again available exemptions are difficult to apply to “loans” or only partial;
  • the discretionary management of portfolios which include loans.

The costs of obtaining and maintaining an FSMA authorisation would be material if an exemption is not available and given the possibility that UK borrowers (even if lenders are based outside the UK) could also have to be authorised, Fons accordingly has the potential to create significant disruption in the UK loan markets.

Section 21 FSMA – Financial Provisions

In addition, the promotion of loans and loan agreements to persons in the UK would be subject to the provisions in section 21 FSMA which requires that any (verbal or written) invitation or inducement issued in, from or into the UK to engage in an “investment activity” must be issued or approved by an FSMA authorised or exempt person. If loan agreements are debentures for purposes of the FSMA then any such communications which invite or induce persons to enter into a loan agreement or to buy or sell rights under loan agreements would be subject to section 21 FSMA. Again while certain exemptions are available under the Financial Services and Markets Act 2000 (Financial Promotions) Order 2005 (FPO) they may not cover all relevant loan-related circumstances.

Consequence of breach of the FSMA regulatory regime

Breach of sections 19 or 21 FSMA is a criminal offence and any transaction entered into in breach of those sections is unenforceable by the party in breach, who may also have to pay compensation for any loss suffered.

Fons may be relevant to non-UK lenders

The uncertainty that Fons creates as regards the application of the FSMA regulatory regime to loan agreements may be relevant even if lenders under the loan agreement are located outside the UK (if the borrower is located in the UK):

  • An overseas lender (such as a Canadian bank) without any presence or place of business in the UK will generally not be concerned with Section 19 FSMA and RAO as its activities as lender will not be carried out in or from the UK. Section 19 FSMA may, however, still be relevant if the borrower is in the UK as an overseas lender concerned with complying with the FSMA would want to ensure it only communicates with potential borrowers in the UK who fall within available exemptions.  Exemptions are available under FPO where a borrower is an FSMA regulated entity or a high net worth company and may be available for other borrowers who enter into loan agreements in connection with businesses carried on by them. No exemptions exist for communications with individuals or other non-business borrowers which do not require the involvement of an FSMA authorised person and an exemption for “one off” transactions may be difficult to apply.
  • An overseas borrower will generally not be concerned with Fons as any adverse regulatory consequences will be those of the UK based lender who would be unable to enforce any loan agreement entered into with an overseas borrower which arises from breaches of Section 19 or 21 FSMA and obliged to pay compensation for any loss suffered by that borrower.

Sale of goods and services and group activities

Exemptions to sections 19 and 21 FSMA are available under RAO and FPO in relation to transactions relating to the sale of goods and supply of services as well as transactions between members of the same group, which may be relevant to certain loan agreements or arrangements. However, they are subject to detailed requirements and may again not be available in all circumstances.

Other matters

Fons may also have an impact on other aspects of loan transactions, including legal opinions and related matters given the uncertainty it has created around the characterization of loan transactions and potential issues with their enforceability.

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