Summary
Wording which, for 25 years, had been thought to
create a fixed charge over book debts is declared by
the House of Lords not to work. The charge is only
a floating one and therefore preferential creditors
have priority. The crucial question for those involved
in real estate financing is whether the decision might
have any impact on security over rental income
under leases. Unfortunately the decision is not clear
in this respect.
Background
In 1979 the High Court confirmed that
certain wording in a security agreement created an
effective fixed charge over book debts, even though
the borrower was left free to deal with the proceeds of
the book debts. The special requirement was that the
book debt proceeds be paid into an account with the
lending bank. The advantage of a fixed charge, of
course, is that it is paid before all other debts. Banks
have, therefore, been using similar wording ever
since in circumstances where the bank lender is a
clearing bank.
The House of Lords decision
A number of cases in
recent years have started to question the correctness of
the original 1979 decision and the House of Lords has
now overruled it. If the borrower remains free to use the
proceeds of the charged asset and to remove the
proceeds from the security (eg by withdrawing the
proceeds of the book debts from the account and
spending them) then the charge is only a floating one.
Consequences of decision: The court's finding
moves the lender down the list of creditors when the
borrower becomes insolvent. Instead of being at
the top, other fixed charges, the expenses of an
administration and preferential creditors take priority.
Preferential creditors are now mostly the employees
and claims by the pension fund. Crown debts, such as
tax and national insurance, have been removed from
the category. However, a percentage of the floating
charge assets must be ring-fenced for distribution to
unsecured creditors before payment of any floating
charge, further depleting the amount available to pay off
the holder of a floating charge.
What next?
It is unusual for a floating charge over
book debts to be the only security given by a borrower,
but it may be a significant element where the business
has a high income but few substantial assets.
Commentators have suggested that small and
medium-sized enterprises would be particularly hard
hit, as lenders may look for additional security. In
particular, directors may be asked to give personal
guarantees of the bank debt backed up by charges
over their own homes.
To be a fixed charge the account would have to be
blocked, with the borrower only able to deal with the
money with the consent of the lender on each occasion.
The cash flow consequences make this unacceptable
to borrowers and even lenders will probably not wish to
become involved in such detailed administration. The
hunt is now on for a new structure which will meet both
sides' needs.
Jennifer Marshall, a senior associate in the
global restructuring group, was a member of
the A&O team which advised the lender in the
recent case. She comments:
This case
concerned amounts due from customers under
supply agreements, where the debts due to the
company turned over on a frequent basis in the
ordinary course of business. However, concerns
have been expressed that a company's right to
rental income under a lease might also be treated as
a book debt for these purposes so that, if a borrower
grants security to its lenders over that rental income
and, prior to a default, the borrower is entitled to use
the rental income in the ordinary course of its usiness, the security over both the rental income
when paid and the lease (ie the rights to future rent)
might be construed as a floating charge. There is
currently a Court of Appeal decision which
distinguishes security over leases from the typical
book debt cases and there is nothing in the House of
Lords' decision which directly calls into question this
distinction. However, this is a very fluid area of the
law and so advice should always be sought when
taking security over leases and rental income.
Source
National Westminster Bank Plc v Spectrum
Plus Ltd and ors [2005] UKHL 41
Siebe Gorman & Co
Ltd v Barclays Bank Ltd [1979] 2 Lloyd's Rep 142
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