Security over Receivables after Spectrum Plus

Transcription

1 Security over Receivables after Spectrum Plus April 2007 An Update

2 Introduction The House of Lords decision in National Westminster Bank plc v Spectrum Plus Limited [2005] UK HL 41 in July 2005 is by now well-known. The Court rejected in principle the validity of a commonly used form of fixed charge over a company s present and future book debts. In doing so, it brought to an end a quarter of a century old institution which had been an extensively used feature of a bank s traditional security. Some predicted that the result would be more expensive credit, and an assault on fixed charges over other assets. In the event, much of the continuing debate has revolved around how the decision affects structured finance transactions, but it is probably too soon to say what impact the decision will have in the longer term. For convenience, we refer below to the person taking the security as the lender and the person giving it as the company. Why it matters whether security is fixed or floating It has long been held to be impossible to take a fixed charge over all the undertaking, property and assets of a trading company, since this would paralyse its business. But where the lender s security is floating rather than fixed, it may suffer a loss in realisable value on enforcement for the reasons set out below. Preferential debts: a floating charge ranks behind preferential claims on insolvency (where the assets available to pay general creditors are insufficient to meet preferential claims), whereas preferential creditors have no entitlement to assets subject to an effective fixed charge. Preferential creditors are now principally certain claims by employees, but were much wider before the recent abolition of Crown preference. The prescribed part : for a charge created on or after 15 September 2003 a proportion of recoveries under a floating charge (up to maximum payment of 600,000) goes to unsecured creditors. Effectively, following the Enterprise Act 2002, Crown preference has been replaced by an entitlement of ordinary unsecured creditors to part of the recoveries under any floating charge. Company Voluntary Arrangement (CVA): if assets subject to an uncrystallised floating charge are included in a CVA and the terms include a trust of those assets for the benefit of unsecured creditors, the lender may not be able to claim those assets ahead of unsecured creditors (Re Leisure Study Group Ltd [1994] 2 BCLC 65). Crystallisation prior to a CVA, however, may prevent the floating charge assets being included in the CVA. In passing, if the company is a small company within Schedule A1 to the Insolvency Act a provision in a floating charge making the charge crystallise as a result of anything done to obtain a moratorium or a moratorium being obtained under that Schedule is void. Costs and expenses on insolvency: these may be substantial (often exceeding preferential claims) and, in the case of administration, rank ahead of a floating charge, but effectively behind a fixed charge. An administrator may also sell floating charge assets and pay his remuneration and expenses from the proceeds. Administration may be much more expensive than administrative receivership, particularly for tax reasons. At present, in contrast, liquidation expenses are not payable out of floating charge assets in priority to the floating charge holder. This will, however, be reversed when the amendments made to the Insolvency Act by the Companies Act 2006 take effect. Vulnerability of security on insolvency: a floating (but not a fixed) charge on a company s undertaking or property is invalid on liquidation or administration if created within 12 months (2 years in some cases) before the onset of the company s insolvency, except to the extent of new money advanced or services provided to the company on or after the creation of the charge (Insolvency Act 1986, s 245). In other words, a floating charge

3 taken to secure existing indebtedness of a company in financial difficulties may be ineffective. Moreover, the practical significance of whether the security is fixed or floating goes beyond this. If substantially all the company s valuable assets are subject to fixed charges, the lender may have considerable practical influence over any administration. The prospects of a rescue of the company (as opposed to a realisation of assets) are greatly reduced unless floating charge assets are available to fund administration costs and expenses, although this should not be overstated. Many restructurings take place outside the context of an administration or other formal insolvency procedure. A little background The so-called fixed charge in Spectrum was in a very common form, based on that introduced by Barclays Bank in the 1960 s, and upheld by Justice Slade (as he then was) in the High Court in the case of Siebe Gorman & Co Ltd v Barclays Bank Ltd [1979] 2 Lloyds LR 142. The court saw no reason not to give effect to the expressed intention of the parties. It held that a specific charge over all book and other debts plus covenants to pay the proceeds to the company s current account with the bank and not to assign or charge them created a fixed charge in favour of a clearing bank. The Court appears to have concluded that, on the proper construction of the debenture, the company was not free to draw on its account without the consent of the bank, even when the account was in credit. The bank had a lien over the proceeds of book debts in the account and could refuse to release them from the account. It is also worth mentioning briefly the Court of Appeal s decision in Re New Bullas Trading Ltd [1994] BCC 36 (CA). The lender (which was not a bank) took a split charge in its debenture: a fixed charge over book debts until collection coupled with a covenant to pay them to a specified bank account, and a floating charge over the proceeds in the account following collection. This was held to create a valid fixed charge over the uncollected book debts (which was, of course, where the value in the security lay when the company fell into financial difficulty). The decision was controversial, but was relied on by non-clearing bank lenders, who would not be in a position to exercise the kind of control over a current account assumed to be available by Siebe Gorman. Debentures in this form are still encountered, although it had been apparent for some time that the approach taken by the Court of Appeal in New Bullas was unsustainable, particularly in the light of the decision of the Privy Council in Agnew and Another v Commissioner of Inland Revenue (otherwise known as Brumark) [2001] 2 BCLC 188. The decision in Spectrum The decision in Spectrum itself demonstrated an interesting difference of approach as it progressed through the courts. The High Court had held the bank s charge over book debts to be floating, but this was reversed by the Court of Appeal, in a decision that caused considerable surprise but was well received by some practitioners. Quite apart from regarding itself as bound by its own earlier decision in New Bullas, the Court of Appeal considered that the decision in Siebe Gorman was at least arguably correct. In effect the company could not dispose of its book debts before collection, given the negative pledge and requirement to pay the proceeds to its account with the bank nor, on the terms of the debenture, of their proceeds, which on collection became only a contractual entitlement to payment against the bank at which the relevant account was held. In any event, the form of charge should be regarded as creating a fixed charge by customary usage, having been relied on by banks and, no doubt, by those guaranteeing the relevant indebtedness. A seven strong House of Lords preferred the reasoning on the High Court, and held the charge over book debts to be floating. In short: a charge on a company s book debts taken by a clearing bank in a debenture in the Siebe Gorman form takes effect only as a floating charge where the proceeds are paid into the company s current account

4 Siebe Gorman was overruled and New Bullas held to have been wrongly decided. The categorisation of a charge over book debts cannot ignore the rights of the chargor over the money received in payment of those debts to create a fixed charge, the assets charged as security must, in Lord Walker s words, be permanently appropriated to the payment of the debt which the charge is given to secure in such a way as to give the lender a proprietary interest in the assets, such that the assets cannot be released without the express concurrence of the lender a fixed charge over present and future book debts is possible, but if the company is free to operate the account and use the proceeds of book debts as a source of cash flow/working capital ahead of any default or enforcement the charge is floating. It makes no difference whether the account is overdrawn or in credit the label used in a debenture to describe the charge (as fixed or floating) is no more than indicative. The court will adopt a two stage approach by first ascertaining from the document the nature of the rights and obligations which the parties intended to grant each other in respect of the charged assets, and secondly characterising them to achieve a fixed charge, the lender must effectively exercise control over the account. In the words of Lord Millett in Agnew a blocked account must be operated as one in fact the bank s submission that the ruling should not apply retrospectively was rejected the Crown indicated that it would not seek to recover distributions incorrectly made before 5 June 2001 (the date of the decision in Agnew) under what are now known to have been floating charges, but that if any other creditors successfully attacked a pre-agnew distribution the Crown would accept any relevant distribution due to it. The Crown expected funds wrongly distributed since 5 June 2001 in reliance on Siebe Gorman to be repaid by lenders and distributed correctly. Pre-insolvency tax credits would only be paid to companies subject to insolvency procedures, in preference to other Crown creditors, in cases where the charge over book debts was a fixed charge on the face of Lord Scott s judgement in Spectrum, even an assignment of a specific debt may be floating if the company is free (until notice) to collect the debt and to use the proceeds, though his remarks were, perhaps, intended to apply principally where the charged assets are to be viewed as a circulating class of assets. Achieving a fixed charge over book debts after Spectrum Fixed security over book debts (or, in a wider sense, receivables) may be crucial in some lending. They may be the borrower s main asset, or a significant element in a structured financing. It is therefore important to appreciate that the courts have not said that a lender cannot achieve a fixed charge over book debts (although where the borrower is an individual or a partnership the need to comply with the bills of sale legislation makes a general assignment of trade debts impracticable). As explained by Lord Walker: if the terms of the debenture were such as to require the trader to pay all its collected debts into the bank and to prohibit the trader from drawing on the account (so that the account is blocked), a charge on debts, described as a fixed or specific charge, would indeed take effect as such. The lender will also need a restriction on the company disposing of or charging book debts. But in order to take a fixed charge a lender must achieve and actually exercise the necessary degree of control. And since the relevant provisions of any debenture will only be effective to create a fixed charge if they are actually implemented at the outset, Spectrum cannot be treated simply as an obstacle to be drafted around. Perhaps not surprisingly the House of Lords gave no clear practical guidance as to what level of control by the lender is required to achieve a fixed

5 charge: for example how frequently transfers can be made from a blocked account to a current account, what level of intervention or authorisation is required from the lender, and what effect netting arrangements between the accounts might have. An automatic weekly or monthly pre-determined sweep of the balance on the collection account into a current account is unlikely to constitute sufficient control. The safe approach from the lender s point of view is for its consent to be required for each release from the blocked account, for it to have an unfettered discretion to refuse consent, and for the arrangement to be actively operated. In practice a sufficient level of control may be commercially unacceptable to a corporate borrower, as it is likely to disrupt its cash flow and be expensive for the lender to operate, and lenders will have to settle for a floating charge. It may prove difficult to persuade the courts that any transaction by which a company purports to continue to be able to trade while having handed over control of its main source of income to a third party is a genuine one. The use of such blocked account mechanisms is therefore more appropriate in the context of structured financing (see below). If a fixed charge is required, consideration should also be given to including additional restrictions on what the company can do with uncollected book debts - for example on granting time for payment, releasing or compromising debts, or accepting non-cash consideration. Counsel for the Crown attacked the debenture in Spectrum as lacking such controls, but the court did not need to deal with this issue to decide the case. As a general rule, the nature of a charge is characterised as the outset Miller v Whitworth [1970] 1 All ER 796, and references in the Insolvency Act to a floating charge are generally to one which was a floating charge on its creation. So, if a fixed charge is required, it should be taken and implemented as such at the outset. On that basis, a charge which has taken effect as a floating charge over book debts cannot be converted into a fixed charge simply by subsequently requiring the proceeds to be paid into a blocked account. The position is different if a fresh assignment by way of security of a debt is taken (which the debenture may well allow the lender to require), registered and notice is given to the debtor. Some commentators have detected a tension between the approach in Spectrum that a blocked account must be operated as one in fact and the principle mentioned above, that the nature of a charge should be characterised at the outset, unless later events show the document to be a sham or pretence. It is, however, clear that stated restrictions in a security document will not suffice if they amount to window dressing or were never intended to be observed. How far does Spectrum go? A debenture will typically contain fixed charges over specific categories of asset, including book debts, and a floating charge over all the assets of the company, or more often over all the assets not subject to an effective fixed charge. For the time being, it seems likely that lenders will leave a fixed charge over book debts in their standard form debentures, even if it may be ineffective. Some, however, are beginning to drop such charges from their general corporate debentures, and a number of borrowers are successfully requiring their deletion. One of the reasons for lenders leaving their forms of debenture unchanged is, perhaps, that if the fixed charge over book debts is vulnerable, the same may be said for other heads of fixed charge. Lenders (and their lawyers) are understandably reluctant to see a wholesale deletion of fixed charges from their debentures, and in general a purported fixed charge which fails will take effect as a floating charge, or the relevant assets will be caught by the residual floating charge, in any event. The issue is not entirely a new one, but certain other fixed charges are undoubtedly vulnerable to challenge following Spectrum. A charge is likely to be floating in any case where the company is free to remove the charged assets from the security or, perhaps, where it has a right to substitute other assets as security. Obvious candidates are uncalled capital (where the possibility that such a charge will only be floating was noted in Agnew), plant and machinery, goodwill, chattels, licences, and a portfolio of shares. The point should not, however, be overstated. Spectrum was a case involving security over a

6 circulating pool of assets (and ones which could be freely utilised by withdrawing the proceeds from the current account), and some caution is required before applying the decision to other assets. That is particularly so where in practice an express release of the security will be required from the lender on any disposal. One of the first decisions following Spectrum was Re Beam Tube Products Limited [2006] EWHC 486 (Ch), in which the High Court applied Spectrum and held that a charge over book debts in the New Bullas form was a floating charge. It was irrelevant that a blocked collection account was set up four months after execution of the debenture, since on the date of creation of the charge it was clearly floating. The all or nothing approach Another basis on which a purported fixed charge can be challenged is what is sometimes referred to as the all or nothing approach to the construction of a charging clause. In ASRS Establishment [2002] BCC 64 the Court of Appeal left open whether the lower court had been correct to adopt such an approach to the construction of a charging clause; in other words that a single clause purporting to create a fixed charge over different categories of asset might create nothing more than a floating charge unless an effective fixed charge was created over all of them. This point was taken up and applied in the Beam Tube Products case, in which it was held that since a purported fixed charge in a debenture over plant and machinery (and other assets) included some items which were clearly subject only to a floating charge, the clause created a floating charge over all the assets covered by the relevant charging clause. The result has been a tendency for the charging clauses in debentures to proliferate, with a separate clause or sub-clause for each category of asset, and also for the asset and income from it. Capital and income streams Spectrum has undoubtedly increased the uncertainty for lenders requiring fixed charges over receivables in certain structured deals, such as securitisations and project and asset financings. For example, does the inclusion of the usual payment cascade (or waterfall ) mechanism in a project finance or securitisation transaction constitute sufficient control to make the security fixed? And must rent be paid into a blocked account to achieve a fixed charge over commercial investment property? A similar issue arises in any form of fixed security where there is a previously agreed release mechanism for part disposals or the income stream. A starting observation is that Spectrum was a case involving book debts, and some caution is required in seeking to apply the same reasoning to other assets. Unlike book debts paid into the company s account with the lender, the disposal of many other fixed charge assets would require an express release from the lender. Land and securities In the case of land the distinction between the capital asset and income from it (in the form of rent) is well established. A legal mortgage over land is not a floating charge just because the company is free to collect the rent (or occupy the land) until the lender intervenes by taking possession, requiring rent to be paid to it, or appointing a receiver, as is clear from Re Offshore Ventilation Ltd [1988] 5 BCC 160. On enforcement, the lender becomes entitled to future rental payments. On the other hand, if the lender requires a fixed charge over the rental income itself ahead of enforcement, it is probably safer to include a specific charge in its security document over rent and a covenant to pay it into a blocked account (or some arrangement with the managing agent having an equivalent effect). The position is probably similar with a charge over shares and intellectual property, at least where substantial capital value remains in the charged asset, and is not exhausted by the income from it. A charge over specified shares and the income from them will, it appears, be fixed if there is a restriction on disposals, even if the company is free to enjoy the income and voting rights from the shares until default Arthur D Little (in Administration) v Ableco Finance LLC [2002] EWHC

7 701 (although this decision is sometimes now questioned). It may, however, be otherwise if the company is free to dispose of and substitute the charged shares, which are in effect a fluctuating pool of assets, and particularly if the company s business involves trading in shares. Leasing agreements In the case of assets such as leasing agreements there is more uncertainty. The cases of Re Atlantic Computer Systems [1990] BCC 859 and Re Atlantic Medical Ltd [1992] BCC 653 are authority that assignments of scheduled (and also, more controversially in the latter case, future) subleases and their sub-rents may create fixed charges even though the company is free, before enforcement, to collect the sub-rents and to use the proceeds in its business, but it is an open point whether these decisions can now safely be relied on. A charge is likely to be floating if the company is free to deal with the income in the ordinary course of its business and the leasing agreements are a class of circulating assets - in other words, where the charge is effectively over an income stream. If a fixed charge is required over capital assets of this type, they should be specified in the security document and the borrower should not be given the right to deal with them. Some would argue that it would also be safer to ensure that the income is paid into a blocked account. Fixed security over the income stream from the leasing agreements will require a separate fixed charge over it and a requirement for income to be paid into a designated charged blocked account controlled by the lender and operated as such. Structured financings Where fixed security is required in structured financings, mechanisms are being put in place which, for example, sweep funds in the collection account in excess of a certain balance into a blocked account on a regular, sometimes daily, basis. Withdrawals from the blocked account will then require the express consent of the lender/ security trustee, or may be used to pay down debt, or may follow the agreed payment cascade (though in the latter case it is uncertain how much risk there is of reclassification of the security as floating). Clearly, obtaining the necessary control to achieve a fixed charge, and actively monitoring the relevant accounts, is far more practicable in such cases that where receipts are paid into the current account of an ordinary trading company. Alternatives for the lender Lenders might be expected to have adjusted their position or practice in various ways; for example by implementing a true blocked-account mechanism where such an arrangement is workable, or by reducing their exposure to certain companies, or by taking personal guarantees. In practice it appears that many lenders have simply decided to settle for a floating charge over book debts. The result of Spectrum may be to encourage more asset backed lending, with lenders taking a fixed charge over specific assets, and more structured receivables financing arrangements involving a lender s commercial finance arm (usually another company in the group). In particular, factoring or invoice discounting may be more widely used, though there has as yet been little evidence of this. In such cases, instead of a loan secured on receivables, finance is provided by the lender purchasing them. For example, under a factoring arrangement, the body providing finance purchases and collects trade debts (with or without recourse to the company if debtors fail to pay). Invoice discounting involves the financier purchasing the debts, but the company collects them and the debtors are not notified. Contact For further information please speak to Andrew Evans or Robert Cooke or your usual contact at FFW. e: [email protected] e: [email protected]

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