By James Croke, Jerry De Melo, partners in the Capital Markets group of Cadwalader, Wickersham & Taft; James Douglas, partner in the Financial Restructuring group; and Elisa Kerr, associate in the Capital Markets group
A recent test case in the Chancery Division has focused on the proper characterization of a charge over book debts (in American parlance, accounts receivables). On Jan.15, in his judgment rendered in the case of National Westminster Bank vs. Spectrum Plus Limited, the Vice-Chancellor has dealt with this issue in a manner consistent with the reasoning applied by the Judicial Committee of the Privy Council in Agnew and Bearsley vs. The Commissioner of Inland Revenue and Others, re Brumark Investments Limited, which had cast some doubt on the prevailing authority.
The characterization of a charge as a fixed or floating charge and the related legal effects of such characterization in the context of financings of book debts, whether in relation to a traditional bank (or asset-backed commercial paper conduit) financing of receivables, a whole business securitization or a leveraged buyout, will fundamentally affect a lender's rights to the charged collateral. The Spectrum decision is therefore of critical importance to lenders and other creditors, not just in the context of traditional bank financings of customer book debts, but potentially far beyond.
Background on charges
Some security interests taken by lenders over assets in the U.K. contain both fixed and floating charge elements. A fixed charge becomes attached, at inception, to specific assets, which form the subject matter of the charge. A borrower that provides a lender with a fixed charge over an asset cannot deal with the asset without the agreement of the lender. The lender's "control" over the assets and related collections is thus a key element of the proper characterization of the charge as a fixed charge.
When lenders require security over assets that are likely to change over time in the ordinary course of business (e.g. cash), they often take security pursuant to a floating charge over such assets. This charge remains floating on such assets until it "crystallizes" in favor of the lender upon the occurrence of certain specified events. Until this crystallization occurs, the borrower is free to deal with the assets in the ordinary course of business.
Where a borrower's book debts represent a material portion of assets charged to a lender or securitization investor (as is typically the case in trade receivable financings and often the case in whole business securitizations), a prudent lender (or investor, as the case may be) may want greater control over the book debts of the borrower in order to minimize the risk of loss. To the extent the security holder is able to maintain sufficient control over the book debts and related collections, the security holder is more likely to be able to effect a fixed charge over the book debts of the borrower.
The importance of a fixed charge
Whether a charge is characterized as a fixed or floating charge will have a significant effect on the rights of the lender vis-a-vis other creditors in the event of an insolvency of the borrower. The holder of a valid fixed charge over property will have priority with regard to the proceeds of a disposition of such property over all other creditors, including any floating charge holders, any preferential creditors and all unsecured creditors. Recent changes introduced by the Enterprise Act of 2002 (and the secondary legislation promulgated thereunder) have also had an impact on the nature of floating charges. While the Enterprise Act of 2002 has abolished the preferential status of the Crown as a creditor (thereby abolishing the preference of debts due to the Inland Revenue and HM Customs and Excise and those related to social security contributions), the holder of a floating charge will still be subject to the prior claims of certain other preferential debts (including unpaid contributions for occupational pensions and certain employee wage liabilities). Moreover, holders of floating charges created after Sept. 15, 2003 now face the priority of their claims being made subject not only to the prior payment of preferential debts (narrowed to exclude Crown claims as noted above) but also to the payment of a prescribed portion of proceeds to be set aside for the benefit of all unsecured creditors (which will in most cases include the Inland Revenue and HM Customs and Excise).
In Brumark, the Privy Council considered the terms of a debenture granted by the company to its bank where a charge over the book debts was expressed to be fixed but the charge over the proceeds of the book debts was expressed to be floating. The court identified the issue in question as being whether a charge over the uncollected book debts that left the company free to collect them and use the proceeds in the ordinary course of its business was a fixed charge or a floating charge. The Privy Council concluded that such a charge was a floating charge. While Privy Council decisions do not constitute binding authority in the English courts, they are considered persuasive. The Brumark decision, therefore, had cast considerable doubt on English legal authority regarding the creation of a fixed charge on present and future book debts.
In Spectrum, the National Westminster Bank applied to the Companies Court in London for a declaration that its debenture over the assets of Spectrum Plus Limited, a company now in liquidation, created a fixed charge over the realization of book debts.
In considering whether the debenture in question effected a fixed or floating charge over the book debts and proceeds charged thereunder, the court explained that the most significant factor in determining whether a charge is fixed or floating in nature is whether the rights and obligations conferred (both through the terms of the documents and in practice) disclosed an intention that the company should be free to deal with the book debts and withdraw them from the security without the consent of the bank. The Vice-Chancellor concluded that it was clear from the facts in Spectrum that collections in respect [to] the book debts were under the control of, and available for the use of, the company. As there was no express restriction on the operation of the bank account to which the book debts were paid, the court found that the label of "fixed charge" was not consistent with the nature of the transaction, even though it was described as such. The charge in question was thus held to constitute a floating charge only.
In adopting the reasoning in Brumark, Spectrum has confirmed that in order for a lender (such as a bank or asset-backed commercial paper conduit) to obtain a fixed charge over uncollected book debts, the lender must maintain sufficient control over the proceeds of such book debts in order to support a characterization of the charge as a fixed charge (rather than a floating charge). If the lender maintains sufficient control of the proceeds (even where the borrower, as agent for the lender, collects such proceeds), then the charge over unrealized book debts and the proceeds therefrom will constitute a fixed charge. If a borrower maintains control over the proceeds of the book debts, then the charge over unrealized book debts and the proceeds therefrom will constitute a floating charge.
The reasoning adopted in Spectrum thus significantly impacts the security arrangements to be implemented in the context of any transaction involving security over book debts and, in the case of transactions where receivables represent a significant portion of the collateral (such as trade receivables financings or whole business securitizations), the need for the security holder to ensure that it has obtained a sufficient degree of control over the charged assets becomes that much more important.
The Spectrum judgment has provided some guidance as to what may constitute sufficient "control" for the purpose of deciding on the nature of the charge in question. Any party to any type of secured lending transaction (whether or not in relation to a securitization) should be aware that:
* the description given to a charge in a loan or security agreement is largely irrelevant, because a charge which in form is a fixed charge but which in substance is a floating charge will be enforceable as a floating charge only, even though the parties may have described it as a fixed charge;
* to constitute a fixed charge on book debts, it is imperative that the agreement requires that the proceeds be segregated and placed under the lender's control, and that the lender actively ensures that this segregation of the borrower's funds occurs;
* the prerequisite that the lender receive or control the proceeds may be problematic in terms of the creation of second or subsequent charges on book debts; and
* difficulties may occur in relation to the creation of a fixed charge on book debts to secure contingent liabilities such as guarantees, where it would be expected by the parties that the rights of the chargee to receive the proceeds would only be exercised on a default.
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