Floating Charge: Has It Outlived its Usefulness in the Modern Age?
The recent development of the law relating to securitisation1 has threatened the existence of the floating charge as a security device leading to the question whether the floating charge has outlived its usefulness in this modern age. To understand this, we need first to understand what is the floating charge, its origin and why was it created and then assess its development to see whether it has met the purpose of its invention. It is therefore the aim of this article in the first place to introduce the concept of floating charge, secondly, explain its origin and purpose of its formulation, thirdly, trace its utility to see the problems it has created todate and fifthly, discuss the reaction of the Law reform Commission towards the problems and lastly be able to weight between the merits and demerits and give conclusion as to whether it is still useful or not.
The Nature and Origin of the Floating Charge.
To date there has never been a universally acceptable definition of a floating charge rather than a description of it. This is because the floating charge is the invention of the courts of equity. Many definitions were attempted2, perhaps the best is that found in the judgement of Romer, L.J in Re Yorkshire Woolcombers Association3 which described floating charge as;
“ one, if it is a charge on a class of assets of a company present and future, secondly, if that class id one which in the ordinary course of the business of the company would be changing from time to time and thirdly, if you find that by the charge it is contemplated that, until some future step is taken by or on behalf of those interested in the charge, the company may carry on its business in the ordinary way so far as concerns the particular class of assets I am dealing with”
This definition was echoed on appeal by Lord Macnaghten4 and later adopted by Lord Millet in Re Brumack Case5. Thus the hallmark of a floating charge to which the writer subscribe is the debtor’s freedom to deal with and dispose6 of the ostensibly charged assets of the company in the ordinary course of business on its own account and without reference to the charge7. The nature of the floating charge presupposes that until crystallization the security interest does not attach and the charge has no right in specie, merely an interest in a fluid fund of assets.
The Origin of the floating charge.
The floating charge first found its root in 1870 from the decisions of the Chancery division in Re Panama, New Zealand and Australian Royal Mail8 which for the first time ruled that floating charge could be created in future acquired assets affirming the previous House of Lords decision in Holroyd v. Marshall9. Before 1870s, the new companies looking around for capital found it very difficult to obtain capital not only who were prepared to subscribe for equity but also from those willing to make debt finance available by way of stock loan10. The then forms of security present ,viz mortgage of land or goods and the pledge of goods were not not enough to meet the needs of the companies because the greater part of the company’s assets would comprise raw materials, manufactured and semi manufactured goods, stock in trade, and trade debts payable to it. It was very easy for the loan stock to be secured for assets such as land which would not be disposed by the debtor in the ordinary course of business. However when it came to assets such as stock in trade the issue faced them was the necessity to enable the debtor to continue operating his business and sell those assets11. Secondly, common law on its part was very harsh on the lender as in order to create mortgage over future acquired assets it required a new act other than that of the original transaction but this were in respect of sale of goods only thus the lender acquired no legal title unless the goods were transferred to him by a confirmatory deed executed after the borrower had acquired them or unless the goods were delivered to him12. Floating charge was therefore developed as a response to the then commercial needs enabling the creditor to take security at the same time allow the debtor to deal with its circulating assets freely in the ordinary course of business13. To overcome this, investors who supplied long term capital insisted on better security for their loans. The idea was good as it overcame the administrative burden for both parties of the borrower every time to obtain consent of the creditor every time it wished to dispose an item of its stock. This was the simple, elegant and effective answer to the problem of taking security over current assets14. However, through its development floating charge has survived a number of criticism especially though case laws and various statutory enactments.
THE USA PRE ARTICLE 9 POSITION ON FLOATING CHARGE.
Whereas in English law the idea of floating charge has its history back in 1870s in USA before the enactment of article 9 floating charge was not recognised for the main reason that it is impossible to create security over property not yet owned by the debtor and secondly that there should be a cushion of free assets for payment of unsecured debts. It was ruled that to allow the debtor to deal freely with the assets was incompatible with the creation of genuine security interest and was fraud on the creditors15. However, now through article 9-205 the security is not invalid although the debtor has freedom to use or dispose assets16. The US law technically incorporates the concept of floating charge by allowing security in after acquired property17. In USA as opposed to English law the question of priority has been solved by the principle “the first to file has priority except form purchase money security interest”. However, in Countries which follow the line of article 9,the floating charge has been abolished18 by having a unitary system of security in which floating and fixed charge are treated as equal19 and according to Catherine20 in PPSA regime security interests attach on the debtors acquisition of rights in the collateral.
The Distinction between floating charge and Fixed Charge.
There have been many judicial efforts to distinguish between floating and fixed charge21, According to Calnan22 it has been the intervention of the statute since the end of the nineteenth century which has required the courts to draw a distinction between floating and fixed charges. Attempts have been made to distinguish between the two23. These attempts have led to confusion. In theory the distinction between the two is straight forward. What distinguishes between floating and fixed charge is the power of the chargor to dispose of the assets free from the charge unless and until some further crystallising event occur24 whereas a debtor which has created a fixed charge requires the specific authority of the creditor each time it wishes to deal with the assets concerned. As rightly argued by Picarda25, it is relevant to distinguish between floating and fixed charge first, in order to know in case of a mixed charge what assets are subject to which type of charge, secondly, there are certain specific statutory provisions26 which only apply to a charge if as created was a floating charge. Furthermore, fixed and floating charge are two different charges attaching to different type of assets with different extent of control, while the former restrain the debtor’s power to dispose assets the later gives freedom to the debtor to dispose freely assets in the course of business while the company is still a going concern. Moreover, fixed charges usually have priority over floating charges27. However sometimes it is very difficult in practice to draw a line between the two especially when it comes to the charges over book debts28 as power to use appear both in fixed and floating charge.
Is the Charge over Book Debt and its proceeds Floating or Fixed?
It follows that no particular form of words is necessary to distinguish between floating or fixed charge over book debts. It suffices that the agreement manifests intention of the parties to charge over present and future assets of the company with debtor’s freedom to deal with them as he wishes in the ordinary course of business. Courts look at the overall tenor of the documents and beyond the document to the substance of the transaction. As to whether charges over book debts create fixed or floating charge, the latest decision of the Privy Council in Re Brumark29 which ruled that in order to constitute a charge on book debts, it is sufficient to prohibit the company from realising the debt itself whether by assignment or collection and that there were no need to distinguish between book debts and its proceeds finalises the debate.
The author in this article concurs with their Lordships in the above case that, there is no difference between book debts and its proceeds as a books debt without its proceeds is equal to an empty shell. Indeed there is no need of distinction. However as Pearce30 argue there is no legal obstacle to the creation of fixed or floating charge over both present and future book debts and it is the extent of the debtor’s right to use the proceeds of the debt which is determinative of the nature of the charge over the debt.
The Effects of the Law Commission Recommendations in the Usefulness of the Floating Charge.
The Law Commission recommendations apart from retaining the floating charge as noted by Mc Cormack31 has further complicated the law. It follows that the commission reached a point where it could not decide which path to follow, thus it ended in compromising between the wishes of English lawyers and its own vision. A close examination of the report shows that the commission wanted to protect more the borrower by following the concept behind section 245 of the Enterprises Act, 2002. By protecting the borrower the Act aims at survival of the companies by way of giving them another chance to reform instead of rushing to liquidation. It is from this point of view that creditor’s power of appointing the administrative receiver has been curtailed. However, this aim have not been met as problems still exists, creditors now feel unsecure compared to their borrowers. A good thing about the law commission recommendation is adoption the first to file principle for the purposes of determining priorities. So if the floating charge is such a terrible security device, why is it taken? This leads us to another part to see whether it has any usefulness.
Application of the floating charge and problems created.
As noted above the main aim of the floating charge since its genesis was to protect the lender and enable the borrower to obtain credit for his business32. By protecting the lender, who was the main creditor, it meant giving him control over the debtors assets and realise them in case of default or liquidation. However through the period of development from 1870’s todate, economic and legal development has made floating charge applicability difficult i some instances in which case here we will refer them as challenges or problems.
First, The floating charge ranks behind not only a later fixed charge over the same asset but also behind statutory preferential claims, and the provisions of the Enterprises Act reduced its priority to nothing thus there is no need to continue with floating charge33. The preferential creditors have right to receive payment in Insolvency in priority to other unsecured creditors also over floating charge34. Furthermore the abolition of crown preference was accompanied by an arrangement by which unsecured creditors have been given certain limited rights of priority over floating charge but not fixed charges as a result certain percentage of floating charge realisations up to a maximum amount of £600,000, has to be set aside for unsecured creditors. This is considered another blow to floating charge35.
Secondly, Uncertainty of the charge36. It is argued that, the floating charge holder can not even know which assets it has security over and how much they are worth. This is described as key weakness of floating charge as a security device and it is the outcome of free disposal of the assets and their fluctuating nature.
Thirdly, floating charge is more vulnerable security to be set aside in a liquidation or administration of the debtor than a fixed charge. It is argued that a fixed charge can only be set aside in insolvency if it amounts to a preference37. A floating charge is more vulnerable, for instance a floating charge created within a year before the beginning of the insolvency will be set aside if the debtor was insolvent at the time of creation38. Furthermore according to the new Enterprises Act, an administrator is entitled to use floating charge assets in the administration and can pay his expenses out of them39. This is considered an exploitation of the lender.
Fourthly, floating charge is exploitative. Floating charge is considered as a mechanism peculiarly to the transfer of Insolvency wealth from unsecured creditors40.That is the reason why it is the charge over present and future assets of the debtor in order to ensure that the rate on the secured loan is increasingly advantageous to it. It is further argued that these interest rates are excessively profitable because the floating charge holder’s ability to exploit its positions ensures risks are loaded onto unsecured creditors.
However, Mokal strongly opposes this view; in his view floating charge is exploitative in the sense that it exploits the lender than the borrower. That is why it lacks priority, it is more vulnerable to liquidation and furthermore the Enterprises Act has killed its usefulness41.This view is also supported by Calnan42 who writes “the concern now is more likely to be the ability of an administrator to use floating charge assets for the purpose of running the debtors business and paying his expenses43” what if the administrator trades at loss in which case floating charge assets diminishes its value rapidly, that means the floating charge holder is always at loss.
Mokal44 concludes by saying that floating charge should now be abolished as it has lost its usefulness and the reasons for its abolition are that, one, the beneficial role played by the floating charge under the pre-Enterprises Act law has now been rendered useless. Even if the Enterprises Act, retains certain functions for the floating charge but these do not depend on anything to do with its essential nature as they could as well be performed by other means and lastly that the retention of the floating charge in the Enterprises Act is unnecessary as it will now cause it to operate, if only in a small proportion of Insolvencies, in a wholly exploitative manner. However apart from these deficiencies Calnan wants retention of the floating charge with correction of the mistakes done by the law at the moment as floating charge is very important element in the law of security in England. It is from these problems, it can be argued that floating charge has outlived its usefulness in the modern age because it has failed to serve its purpose.
Advantages of the floating charge.
In response it is intended to show that floating charge is not such a terrible, exploitative and malignant security device. It is from its usefulness in trade financing that it has survived a lot of criticism since its genesis45.Floating charge’s benefit rests to its usefulness as a residual management displacement device rather than a priority device in that it gives the holder the right to control the company in case of default through the appointment of the administrative receiver while at the same time if the company is doing well the debtor is left free to deal with assets46. This is the reason why floating charge has survived todate and to make it effective it has always been taken in combination to the fixed charge so that when the company defaulted due to management related reasons, the floating charge would be used to mop up control, proprietarily over those assets which could not be the subject of the floating charge.
Secondly, The receiver’s in personam powers to manage the business having ceased upon the initiation of the winding up, floating charge provided the receiver with the in rem powers.Thus the floating charge would prevent the liquidator taking possession of these assets thus preserving any synergetic value47.
Thirdly, as noted by Lord Millet48 the floating charge provides the creditor by single instrument an effective and comprehensive security upon the entire undertaking of the debtor company and its assets from time to time while at the same time leaving it free to pay its creditors in the ordinary course of business. This means that the company is able to run its activities, it can settle small debts, pay judgment debtors and worker’ salaries without seeking the creditors consent, floating assets being the heart of the company’s business. And according to Lord Millet assimilating floating and fixed charge would disadvantage preferential creditors unless some alternative is put in place to safe guard their interests. However, this can be cured by adopting the position in the US bankruptcy code recognising unsecured and preferential creditors as general creditors49. However if this is adopted still preferential creditors will be in jeopardy as they will be last to be paid whereas their bargaining power is low, so to my view should not be preferred.
Fourthly, if the author may add, Floating charge gave more security to the lender, in that on realising assets under the fixed charge if they are not enough probably by reason of depreciation in value, wear and tear or anything else, the secured lender’s loss would be compensated by realisation of the assets crystallised under the floating charge. This is the main reason why always floating and fixed charge turned out to be two sides of the same coin. A good lender would not prefer floating charge alone or fixed charge in isolation with the other.
Fifthly, as traditionally understood fixed charge was always taken in the assets of immovable nature whereas floating charge would attach to the assets of a movable nature. This being the case, it appears that some borrowers have not immovable assets. Most of the movable assets they have are either rented or leased so floating charge would best cover these scenarios and furthermore assets have a tendency to fall in market value or depreciate so having a floating charge is advantageous in the sense that before losing value the company is able to dispose and replace with new asset. It is through floating charge that some companies have even managed to repay their debts without going to liquidation.
Conclusion.
1 The Case laws, The English Enterprises Act,2002, the Article 9 of the American Uniform Commercial code,the companies Act, 2006 and the Law Commission recommendations
2 H. Picarda “ Labels: A voyage Round Fixed and Floating Charges” in (2001) 3 JIBL 114 at pg 2 and Lord Mac Naghten’s definition in Illingworth v. Houldsworth[1904] AC 355 at p.358
3 Re Yorkshire Woolcombers Association Ltd[1903] 2Ch 284 at pg 295 and Re Agnew[2001] 2 AC 710
4 Illingworth v. Houldsworth[1904] AC 355 at p.358
5 [2001] 2AC 710 at pg717
6 See also Evans v. Rival Granite Quarries Ltd[1910] 2KB 979 at p.999
7 See also Robert Walker, “ Fixed and floating charge-The debate Continues”, (20020Insolvency Law Journal 78
8 [1870] 5 Ch. App. 318
9 (1862) 10 H.L.C.191
10 See R.R. Pennington, “The Genesis of Floating Charge”(1960) 23 MLR 630 and also Lord Millet in Agnew v. Commissioner of Inland Revenue[2001] 2AC 710 at pg717
11 R.Calnan, “Floating Charge: A Proposal for Reform” (2004) 9 JIBFL 341
12 The Legal Problems of Credit and Security(2nd ed.,1988)
13 “The Floating charge is dead; Long Live the floating charge” in Mugasha, A,(eds), Perspectives on Commercial Law
14 The Legal Problems of Credit and Security(2nd ed.,1988
15 Benedict v. Ratner, 268 [1925]US.354
16 G. McCormack, Secured Transactions in English and American Law, .......................
17 Article 9-204 US Uniform Commercial Code.
18 Catherine Walsh “Floating charge is dead: Long live the floating charge” in Agasha Mugasha ed., Perspectives on Commercial Law(2000) at p 131
19 Royal bank of Canada v. Sparrow Electric Corporation[1997] 143 DLR(4TH )385
20 Catherine Walsh “Floating charge is dead: Long live the floating charge” in Agasha Mugasha ed., Perspectives on Commercial Law(2000) at p 146
21 Lord Mac Naghten’s definition in Illingworth v. Houldsworth[1904] AC 355 at p.358
22 R. Calnan “Floating Charges: A Proposal For Reform”(2004) 9 JIBFL 341
23 Evans v. Rival Granite Quarries[1910] 2KB 979 at p.999, see also Lord Buckley’s expression in Cretanor Maritime v. Irish Marine[1978] 1 WLR 966 at p.978
24 R.A. Pearce, “Fixed charge over Book Debts”,(1987) JBL 18
25 Labels: A voyage Round Fixed and Floating Charges” in (2001) 3 JIBL 114
26 For instance section 245 of the Insolvency Act, 1986 and s.396 (1) of the then Companies Act, 1985 and Preferential Claims in Bankruptcy (Amendment) Act, 1897 quoted in R. Calnan “Floating Charges: A Proposal For Reform”(2004) 9 JIBFL 341 .
27 Re Portbase Clothing Ltd(1993) Ch.388
28 (Tailby v. Official Receiver 1883) 13 App. Cases 523, Siebe Gorman vs. Barclays Bank[1979] 2 Lloyds Rep. 142, Re Armagh Shoes Ltd, [1982] N.I.59 at p.62 which ruled that the provision requiring the proceeds of the book debts to be paid into an account with the lending bank is important if a debenture is to be interpreted as creating affixed charge over book debts, however description of the parties as fixed charge was not conclusive
29 Re Brumack Investments(Agnew v. CIR) [2001] 2AC 710
30 R.A Pearce, Fixed Charge Over Book Debts,....................................
31 G.McCormack, “The Floating Charge and the Law Commission Consulation Paper on Registration of Security Interests”, (2003) Insolvency Law Journal.
32 R.R. Pennington, “The Genesis of Floating Charge”(1960) 23 MLR 630 and also Lord Millet in Agnew v. Commissioner of Inland Revenue[2001] 2AC 710 at pg717
33 R.J.Mokal, “The Floating Charge-An Elergy” in Sarah Worthington(ed), Commercial law and Commercial Practice,(Oxford: Hart, 2003)
34 R. Calnan “Floating Charges: A Proposal For Reform”(2004) 9 JIBFL 341
35 S. 252 of the Enterprises Act, 2002 and S.176A of the Insolvency Act, 1986 as introduced by EA.
36 See note 36 above.
37 S.239 of the Insolvency Act, 1986
38 See note 37 above and s. 245 of Insolvency Act, 1986.
39 Schedule B1, Para 70 and 99 of Insolvency Act, 1986.
40 R.J.Mokal, “The Floating Charge-An Elergy” in Sarah Worthington(ed), Commercial law and Commercial Practice,(Oxford: Hart, 2003)
41 ibid
42 R. Calnan “Floating Charges: A Proposal For Reform”(2004) 9 JIBFL 341
43 However recently the House of Lords in Leyland Daf case [2004] UKHL 9ruled that the liquidator has no right to remunerate himself out of floating charge
44 See note 43 at p.19 of his article.
45 See The Cork Committee, Insolvency law and Practice, Cmnd 85589 (1982),White paper from Insolvency Service of the Department of Trade and Industry, the Enterprises Act and the Law Commission Recommendations to speak a few.
46 R.J.Mokal, “The Floating Charge-An Elergy” in Sarah Worthington(ed), Commercial law and Commercial Practice,(Oxford: Hart, 2003)
47 R.J.Mokal, “The Floating Charge-An Elergy” in Sarah Worthington(ed), Commercial law and Commercial Practice,(Oxford: Hart, 2003)
48 Re Brumack Investments(Agnew v. CIR) [2001] 2AC 710
49 G.McCormack, “The Floating Charge and the Law Commission Consulation Paper on Registration of Security Interests”, (2003) Insolvency Law Journal.
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