Publication
TITRE
Fixed Charges on Receivables: Where Do We Stand?
DATE
2 septembre 2005
EXPERTISE
THE ISSUES
One of the hottest debates within the financial and legal community in recent years has been the ability of lenders to take effective fixed security over the receivables while accommodating a borrower's commercial need to deal freely with the cash flows generated by those receivables in the course of its business. In 1979, the landmark first instance judgment of Slade J in Siebe Gorman & Co Ltd v Barclays Bank Ltd [1979] 2 Lloyd's Rep 142 established that effective fixed security could be created over book debts where the borrower was empowered to collect the book debts and pay the proceeds into its account with the lending bank. That widely respected judgment has been relied on by the business community for 25 years and the Siebe Gorman form of debenture became established as a market standard. On 30 June 2005, however, in its defining judgment, the House of Lords dramatically overruled Siebe Gorman. Their Lordships held that where a borrower collects the charged receivables and pays them into its account with the lender, insofar as the borrower is free to draw on that account in the course of its business the security over the receivables will be categorised as floating, and not fixed, security, whatever the label attributed in the security document or the intention of the parties.
Book debts are often a major revenue source for companies, and therefore constitute an asset over which lenders will necessarily want fixed security. In a corporate insolvency, fixed security ranks ahead of preferential creditors (which now effectively constitute specified employee claims), and also ranks ahead of the potentially heavy expenses and liabilities of administrators (including tax liabilities). Floating security ranks behind these claims and, additionally, a prescribed percentage of floating charge realisations (up to £600,000) are distributed to unsecured creditors ahead of a floating charge holder.
Moreover, a floating (but not a fixed) charge may be invalidated if created within a year (or two years, where created in favour of a "connected person") of the onset of the charging company's insolvency#except where created as security for new money.
Therefore, a key aspect not only in general corporate lending but also project finance, securitisations, and structured transactions which rely substantially on the cash flows of revenue-generating assets, is to put in place arrangements which will maximise the likelihood of those revenues being subject to fixed security.
Since the Siebe Gorman judgment, the courts have been called on to pronounce on various models of security document designed to address variations on the Siebe Gorman theme. Rival lines of authority have often run counter to commercial practice and, in 2001, the Privy Council's decision in Re Brumark Investments; Agnew v. Inland Revenue [2001] 2 AC 710 led to substantive uncertainty over the scope of the Siebe Gorman principle, and necessitated a definitive clarification of the law.
The debenture in Re Brumark had followed a form previously upheld in Re New Bullas Trading [1994] 1 BCLC 485, and addressed the situation where the lender was not the borrower's clearing bank. The debenture purported to create a fixed charge over the borrower's uncollected book debts and a floating charge over the proceeds (which it could pay into its clearing bank account and otherwise deal with in its ordinary course of business), but gave the lender the right to require the borrower to pay future proceeds into an account with itself (which it never in fact exercised) and thereby appropriate them into the fixed security. The Privy Council (on appeal from the New Zealand Court of Appeal) held that the "fixed" charge over the receivables would only take effect as a floating charge, essentially because the borrower was able to collect the debts for its own benefit and use the proceeds freely in the ordinary course of its business without interference or consent from the lender. Furthermore, the attempt to differentiate between the security over the debts and the security over the proceeds was struck down on the basis that the debts only have value insofar as they can be turned into cash, so that where the borrower was free to collect the debts for its own benefit and treat the proceeds as part of its general cash flow, the charge over the uncollected debts (as well as their proceeds) would be floating.
In Re Brumark the borrower did not bank with the lender. Hence, the key question amongst lenders and insolvency practitioners was whether or not that decision had eroded the principle established in Siebe Gorman in circumstances where the debts were required to be paid into the borrower's account with the lending bank.
SPECTRUM DECISION
The resultant uncertainty meant that judicial clarification of the effect of the Siebe Gorman standard debenture was imperative. The opportunity arose this year in National Westminster Bank plc v. Spectrum Plus Limited [2005] UKLH 41, and on 30 June the House of Lords delivered its defining judgment based on the following facts:
In 1997 Spectrum had obtained an overdraft facility of £250,000, and executed a debenture to secure its indebtedness to the bank, which was expressed to include a fixed charge on all its present and future book and other debts. It also contained a residual floating charge.
The debenture was in a recognised form which followed the form approved in Siebe Gorman, and provided that Spectrum was to pay into its current account with the bank all moneys which it received in respect of the charged debts, and that it must not (without the bank's consent) sell, factor, discount or otherwise charge or assign the uncollected debts to any third party. However, Spectrum could deal with the counterparties who owed the debts and collect the debts in the normal course of business.
The current account into which the debts were to be paid was subject to the agreed overdraft facility, and Spectrum was free to draw on the account for its business purposes, provided the facility was not exceeded (and was otherwise subject to normal overdraft terms and conditions). There was no evidence that the bank exercised any control or gave any instructions regarding Spectrum's drawings from the account.
Upon Spectrum's liquidation, the categorisation of the charge would determine whether the bank's claim in respect of the book debts would take priority over or was subordinate to the preferential creditors.
The House of Lords unapologetically overruled the 25-year authority of Siebe Gorman and also overruled the unanimous Court of Appeal decision in the present case, declaring that:
- the security over the book debts, although expressed as a fixed charge, in law only constituted a floating charge; and
- the decision would have retrospective effect, and must therefore apply not only to the case in hand but also to all existing transactions and liquidations.
The House of Lords reasoned that, while it is conceptually possible to create a fixed charge over the present and future book debts of a company, everything depended on the nature of the account into which the proceeds were paid, namely, whether it was in substance a blocked account which preserved the proceeds for the benefit of the security. Because in this case the collection account was a current account which, according to the normal contractual relationship of banker and customer, the banker could not (without giving notice) refuse to allow the customer to operate while it remained in credit or within its overdraft limit, the continuing contractual right to withdraw sums destroyed the argument that there was fixed security by virtue of the account operating as a blocked account.
Moreover, the House of Lords reinforced the decision in Re Brumark, declaring that, since the essential value of a book debt as security lies in the money that can be obtained from the debtor in payment of those debts, if a charge is expressed to be a fixed charge in relation to the uncollected debts but a floating charge in relation to the moneys received from the debtor, then the security over the book debts themselves should be categorised as floating security. The key question was in essence whether the borrower was able to collect the debts for its own benefit and use the proceeds freely in its ordinary course of business.
CONSEQUENCES OF SPECTRUM
The immediate effect of the Spectrum decision is that realisations available to administrators, preferential and general unsecured creditors will be augmented at the expense of secured creditors whose supposedly "fixed" security over book debts may now be categorised as floating security.
The Court postulated the limited number of ways to ensure that a charge over book debts is fixed. Each method prevented all dealings by the borrower with the book debts (other than their collection) and either (i) required them to be paid directly to the lender in repayment of the debt, or (ii) required them to be paid into a blocked account with the lender and preserved in that account, or (iii) required them to be paid into, and preserved in, a third party bank account over which the lender has fixed security with requisite control. In practice, each of these methods undermines the borrower's capacity to trade by substantially fettering its ability to use its cash flow and working capital in the course of its business.
Critically, however, the Court omitted to give crucial guidance on the level of restrictions or degree of control that would suffice to give rise to effective fixed security over receivables in a commercially viable manner. As such, in the context of general charges over book debts in the small/medium corporate sector, the potential impact on lenders' risk analysis and on the terms and cost of credit remains to be seen, including whether lenders will be forced to adopt alternative structures such as asset-backed or factoring arrangements, or require further layers of credit support.
Particular concern, however, will attach to major enterprise financings, including big ticket project and development finance, asset finance, securitisations and other structured transactions, where a critical element of the security package will be the cash flows receivable under the major revenue-producing contracts, concessions, leases, off-take agreements, etc., where borrowers must be permitted to use revenues to meet specified project costs up to agreed limits. Such transactions are structured on a special purpose basis, where the claims of employees and general unsecured creditors will not require protection in the same way as in the small/medium corporate sector.
In this context, the legal system which is relied upon by the international business community must be consistent and predictable, and it would be a nonsense if the borrower's permission to deal with the proceeds of its revenue-producing contracts (including the obvious need to use revenues to pay operating expenses) would have the effect of re-characterising the security over those contracts as floating security.
THE SOLUTION?
Clearly, there will be no definitive solution until a judicially endorsed "control" test is determined (or the legislature intervenes). Nonetheless, as the lines of judicial authority currently stand, the following propositions may be made:
- The greater the degree of control exercised by the lender, on the face of the security document and through its practical implementation, the greater the likelihood of satisfying the requirements to establish fixed security.
- Requiring the proceeds to be paid into a blocked account will make the charge fixed, but it will not be enough to provide that the account is blocked if it is not, in fact, operated as such.
- The categorisation as fixed security should not be threatened by the borrower seeking, and the lender granting, consents to withdrawals on a case-by-case basis.
Clearly it is distinctly damaging to the international financial market if an effective fixed charge over receivables can only be created under English law where the proceeds are paid into a blocked account controlled by the lender and released only with the lender's specific case-by-case consent on an unfettered discretionary basis; the borrower needs to be comfortable that its cash flow and freedom to deal is not substantially impaired in this way.
One question, therefore, is whether multiple, or standing, consents will threaten the fixed nature of the security interest if the "standing" consent is contractually given, subject to specific conditions being met. Although the decision in Spectrum leaves the question of control (and consent) undetermined, from a conceptual standpoint there should be no reason why a pre-agreement to give consents on a case-by-case basis should undermine the fixed nature of the security. The giving of consent is indicative of control, and any contractual requirement to do so is not relevant to the quality of the security. However, the practical requirement for case-by-case intervention (whether or not contractually agreed) imposes burdensome procedures and costs which may be commercially unacceptable.
In the context of big-ticket project and structured finance arrangements, project lenders and their advisers will need to assess those provisions that allow withdrawals from blocked project accounts up to an agreed budget in order to meet specified project costs. Indeed, lenders will wish to ensure that amounts held in operating accounts over which reduced control is exercised by the lender (or by the security trustee on behalf of the lending syndicate) are minimised.
In cases where the lender is not the borrower's clearing bank, there have been devised dual or even triple account structures involving releases (with consent of the lender on a case-by case basis) from a blocked collection account (held with the lender or with the third party clearing bank) into the company's operating account with the third party clearing bank, which itself is subject to fixed security and full control by the lending bank. This, again, can be costly and administratively burdensome to a degree that negatives the value of the fixed security.
CONCLUDING COMMENT
The House of Lords' clarification as to whether effective fixed security can be taken over receivables where the proceeds are paid into the borrower's current account with the lending bank will be welcomed insofar as distributions held back in several hundred insolvencies pending resolution of the issue will now be released. However, the ongoing concern surrounds the inter-relationship between the judicial process and commercial practice, and the lack of guidance afforded by the courts on critical issues serves only to exacerbate the uncertainty about the extent to which they will give effect to commercial intentions of the parties.
The purpose of this document is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of Ogilvy Renault LLP or any member of the firm on the points of law discussed.
For further information, please contact one of the following lawyers:
Nicola Ezra +44 (0)20 7776 7522
nezra@ogilvyrenault.com
Brian C. Kelsall +44 (0)20 7776 7524
bkelsall@ogilvyrenault.com
Ella Plotkin +44 (0)20 7776 7525
eplotkin@ogilvyrenault.com
