2.5 Borrowing

2.5.1 Borrowing

All societies are required to state in their rules the terms and conditions on which they may borrow capital from members and others, including commercial sources. These terms may include details of the security offered to lenders and the maximum amount that can be borrowed. Society legislation makes an important distinction between loans and deposits: loans are used for the business purposes of the society, whereas deposits can be used for other purposes. However, deposit-taking is a regulated activity and most societies adopt rules which expressly forbid it.

There are no legal restrictions on the terms and conditions of the loan arrangements a society enters into. This is treated as a commercial decision of the society. There is no limit on the amount of money a member, or other person, may lend to a society, other than the maximum amount stated in the society’s rules. This means that members who want to invest more than the legal maximum for withdrawable share capital could lend additional capital, on terms agreed with the society. These loans can be secured against specific assets, or subject to a floating charge against all assets, or not secured at all. Both parties are free to agree whatever interest rates and repayment terms they choose. 

Sections 59 to 64 of the Co-operative and Community Benefit Societies Act 2014 make provisions for a society to register a charge against its assets with the FCA. There are separate provisions for England and Wales, for Scotland, and for Northern Ireland. In Scotland it is only possible to register a floating charge against the assets of a society. In England and Wales, it is possible to register fixed and floating charges. In both cases the provisions of the 2014 Act form one part of a complex set of legal rules which decide the effect and priority of the security given to the creditor over the society’s assets. Most secured creditors will insist on the registration of their charge with the FCA, so to this extent it is required. Also, registered charges are available for inspection on the FCA Mutuals Register, which will be of interest and reassurance to a society’s creditors and has a role in fixing the priority of charges over the society’s property.

A society seeking to raise capital through the offer of non-transferable debt instruments, including bonds, loan stock, debentures or any other form of debt instrument, is exempt from financial promotions and prospectus regulations.  Transferable debt instruments issued by societies are also exempt from financial promotion regulations, but this only applies to non-real time or solicited real time communications (see Section 7.3.3).

2.5.2 Bonds

A bond is a form of loan agreement between an individual and an enterprise. Capital is loaned in small denominations, typically between £100 and £500, and evidenced by a bond or agreement that the society promises to pay interest and to repay the capital to the bondholder on a set date. Bonds are usually transferable between third parties. Bonds are widely used by public authorities, credit institutions and companies, but are rarely used by smaller community businesses. Bonds do not confer ownership or voting rights.

Most societies prefer to issue shares rather than bonds. The reasons for this are fairly straightforward. Debt has to be repaid according to a pre-agreed schedule and normally carries a pre-arranged interest rate. Equity, particularly withdrawable share capital, is not subject to any pre-arranged repayment schedule or interest rates. 

There are, of course, situations where bonds are appropriate. As they offer greater security and certainty, bonds may be a more attractive financial proposition for investors.  Registered charities cannot issue equity that bears dividends, so bonds may be a good alternative. Other organisations, such as workers’ co-operatives, might like the idea of raising capital from their supporters without having to compromise their principles of workers’ control. Bonds provide a good solution to this problem because no voting rights are attached to them. Bonds may be attractive to members who have already invested the maximum £100,000 allowable in withdrawable share capital but still wish to invest more, although societies should be cautious about being over-reliant upon members and should normally restrict any member investing more than 10% of the share capital raised by a society. It is possible that some investors would prefer bonds with fixed interest rates and redemption periods.

Some larger co-operatives and housing associations have turned to the London Stock Exchange bonds market to raise capital, but as these issues are not targeted at the public, they cannot be considered a form of community finance.

Bonds do not provide for community engagement. Bondholders are not members, and they have no voting rights in the affairs of the society. There is not the same scope to engage bondholders in the business activities of the society as customers, volunteers or directors. Bonds do not give legal title to the enterprise or convey community ownership.

There are other disadvantages to bonds. They must be repaid by a fixed date, which means that profits will have to be made and set aside to fund these repayments. Although it may be possible to replace old bonds with a fresh issue, this means re-incurring the cost of raising capital, with the attendant risk that investors may not want to renew their bonds. Bonds can also be more expensive, especially if they are issued with a high fixed rate of interest that turns out to be more than the cost of commercial debt over the same period.

There are other ways of raising loan capital from the public, including the offer of loan stock or debenture stock: the former is fully at risk, while the latter is usually secured against a specific asset held by the enterprise. Selling any form of debt product to the public is a regulated activity, subject to the Financial Services and Markets Act 2000 and its associated Regulatory Orders, unless there are exemptions. Co-operative and community benefit societies are usually exempt.

2.5.3 Loans and loan-stock

The FCA’s registration guidance includes guidance for societies intending to issue loan-stock or similar forms of debt security. It is concerned that any rights given to the loan-stock holder or other lenders does not undermine the society’s compliance with the conditions for registration. There are three main areas of concern.

Firstly, the FCA is concerned that the loan-stock agreement does not confer any constitutional rights to the loan-stock holder or lender which could compromise member control of the society.

Secondly, although the FCA accepts that the rate of interest on any form of loan is a commercial matter, the loan agreement should not be a vehicle for distributing profits. This implies that any form of profit-sharing arrangement would not be acceptable to the FCA.

Finally, the FCA acknowledges that many loan-stock agreements include an arrangement to allow loan-stock to be converted into shares at some later stage. If such arrangements are to be included in an agreement then they must take a form that ensures the society remains compliant with the conditions for registration. This should include provisions to accommodate the legal maximum individual shareholding a member may have in a society, and the arrangements for non-user investor shares highlighted in Section 2.2.4.