Blog: Enterprise goes into reverse for floating charge-holders
Bruce Wood of Morton Fraser assess the implications for Scotland of the reinstatement of the “Crown Preference” in all insolvency processes
Amidst all the hype attending the recent Budget about the £20bn windfall which befell the Exchequer and was thereafter shovelled towards the NHS, one could be forgiven for having missed the fact that the Budget also trailed the reinstatement of the so-called “Crown preference” from 6 April 2020. This means that payments due to HMRC in respect of unpaid taxes will take priority as a “preferred debt” in any insolvency process and will therefore rank ahead of the claims of any floating charge-holder and the ordinary unsecured creditors.
Whereas this re-prioritisation of the Crown in insolvency will take force throughout the United Kingdom, it is perhaps fair to say that its effects will be most keenlyfelt in Scotland where floating charge security is vital for a secured lender, particularly in the context of tangible and intangible moveable property (e.g. debts, contractual rights, goods, tools, vehicles and the like), which are notoriously difficult to subject to a fixed security interest under Scots law (1).
THE FLOATING CHARGE IN SCOTLAND
The relationship between the floating charge and Scotland can be best described as “complicated”. The floating charge began life in the 1870s as a common law creation of the English courts, utilising their equitable jurisdiction to give effect to charging documents which purported to create a charge over the whole of the present and future assets and undertaking of a company. Such charges were described by the courts as “floating” in order to encapsulate the key feature of such a charge, being that it essentially “floats” over the assets of the chargor in question until some event occurs causing it to “crystallise”, and until such time the chargor has licence to deal with its assets in ordinary course of business.
The Scottish courts, however, viewed the floating charge with a suspicion bordering on outright hostility. By way of example, in the case of Carse v. Coppen (1951) SC 233, Lord President Cooper held that (our emphasis):
“… it is clear in principle and amply supported by authority that a floating charge is utterly repugnant to the principles of Scots law and is not recognised by us as creating a security at all.”
This remained the law until the early 1960s when the UK Parliament intervened to enact the Companies (Floating Charges) (Scotland) Act 1961 and, thereafter, in the early 1970s, the Companies (Floating Charges and Receivers) (Scotland) Act 1972. The law is currently enshrined in s.462 of the Companies Act 1985 (2), and s.51 of the Insolvency Act 1986 (3).
Accordingly, since 1972 the laws in England and Scotland have been broadly the same in this regard, with the key difference being that, in England, the floating charge is derived from equity and the common law, whereas in Scotland it is derived from statute.
Despite the hostility shown to the floating charge by the Scottish courts, the reality is that its introduction into our laws and availability for use in commerce provided a substantial benefit for secured lenders, and by corollary through the smoother availability of credit, for Scottish businesses as well. This is because Scots law is comparatively inflexible when it comes to the creation of fixed security interests over different asset classes, with the rules being broadly as follows:
- Land / real estate - A “standard security” must be signed in statutory form and registered in the Land Register of Scotland
- Debts / contractual rights - An assignation of the right should be signed and thereafter this must be notified to the debtor / obligor under the assigned right in question
- Moveable assets such as stock, automobiles, tools, etc - These must be specifically “pledged” (i.e. delivered) to the secured creditor so that the secured creditor has actual or constructive possession thereof. The key to this concept of delivery is that the assets must be placed beyond the control of the pledgor
- Shares and other securities - These assets are “pledged” to the secured creditor so that title is transferred in the relevant asset. Thus, in the context of shares issued by a Scottish company, the secured creditor must be detailed in the register of members as the holder of the shares and a share certificate issued in its name.
If these steps are not taken then no security is created at all. Scots law does not have the same concept of “re-characterisation” as is applicable in English law whereby a purported fixed charge can be re-characterised as a floating charge if, for example, the charge-holder exercises insufficient control over the asset in question. There is simply no security in the absence of a floating charge to underpin the collateral package. Equally, Scots law does not recognise the concept of the creation of a fixed security (or indeed any real right at all) in “equity”. One either creates the security as a legal right or one has no security at all.
With the advent of the floating charge, however, secured creditors could add a layer of security which would capture any asset or right which had not been subjected to a fixed security interest, thus elevating the floating charge-holder above the ordinary unsecured creditors in any insolvency of the Scottish company in question in respect of any asset subject to the floating charge.
So far, so helpful. However, the UK Parliament was to intervene again in the form of the Enterprise Act 2002…
THE FLOATING CHARGE AS THE ENEMY OF “ENTERPRISE”
Prior to the coming into force of the Enterprise Act 2002, the main enforcement mechanism for a floating charge-holder in a default scenario was to place the chargor into a process known as “administrative receivership” (4). The Government at the time felt that this enforcement procedure was “anti-enterprise” since it was perceived to favour the appointing charge-holder at the expense of the continuation of the business as a going concern because the administrative receiver’s key duties were owed to the floating charge-holder and his or her priority responsibility was to recover sums due to such floating charge-holder. The Government favoured more of a rehabilitative approach and it cast admiring glances in the direction of the US “Chapter 11” process, with its “safe harbour” provisions protecting a US company in “Chapter 11” from creditors’ action (5).
Thus, the Enterprise Act 2002 introduced a series of measures which altered the Insolvency Act 1986 (and related legislation) so that the following package of changes was introduced:
- Administrative receivership was removed as an enforcement option for secured creditors holding a floating charge save in a limited category of circumstances (6).
- The process for appointing administrators was substantially revised and, in particular, the holder of a “qualifying floating charge” (a “QFC”) (7) was given the right to appoint an administrator without the necessity of making an application to a court for an administration order. Instead the holder of a QFC can appoint an administrator (and thus place a company into administration) by using an expedited procedure that involves the lodging of certain forms at court once a QFC has become enforceable. By contrast any creditor who does not hold a QFC (whether secured or unsecured) and who seeks to place a company into administration must make an administration application at court (which is a lengthier and more expensive process).
- The Crown preference was abolished so that debts due to HMRC in respect of unpaid taxes were paid as ordinary unsecured debts of the company and therefore ranked behind any floating charge holder.
- As the quid pro quo for the abolition of the Crown preference, the concept of the “prescribed part for unsecured creditors” was introduced under which a percentage of the net property of a company is paid to the unsecured creditors of the insolvent company ahead of any floating charge-holder. The “prescribed part” is:
- 50 per cent of the net property of the insolvent company up to £10,000; and
- 20 per cent of anything thereafter, but subject to an overall cap of £600,000.
This was therefore presented to the market as a package of measures under which secured creditors would “win” and “lose” to a certain extent. They would lose the entitlement to utilise administrative receivership as a distress mechanism, but they’d gain an expedited out of court process to appoint an administrator; they would benefit from the abolition of the Crown preference, but they’d become subject to the priority of unsecured creditors capped at £600,000.
THE 2018 BUDGET
Viewed in this historical context, the insolvency priority proposals trailed in the 2018 Budget will represent a “quadruple whammy” for floating charge-holders when they come into force on 6 April 2020:
- First - Crown preference is reinstated moving the claims of HMRC above those of a floating charge-holder without any limitation or cap
- Second - The “prescribed part for unsecured creditors” will not be abolished to cushion the blow
- Third - In fact, the burden of the “prescribed part for unsecured creditors” for floating charge-holders will be intensified by an increase in the cap from £600,000 to £800,000
- Fourth - Administrative receivership will not be reinstated as an enforcement option for floating charge-holders
It does therefore appear that the Government has left floating charge-holders in a substantively weakened position. Whilst the market may view this as regrettable, it is perhaps tolerable in England where it is possible to take a fixed charge or assignment in equity where the applicable legal requirements have not been adhered to, provided that the charge-holder exercises sufficient control over the collateral in question. Accordingly, if priority is a key concern in any financing, then under English law a secured creditor can take some relatively straightforward steps to ensure that its fixed security is created in equity over key assets and thereby protect the priority of its claim in respect of the realisation of those assets.
However, in Scotland these reforms arguably give rise to a disproportionately adverse effect for secured creditors. Let us take, by way of example, a vehicle fleet financing arrangement under which the vehicles in the fleet are to be subjected to a right in security for the facilities made available to the borrower, and consider the effect of these reforms in England and Scotland respectively:
The vehicles are charged to the asset financier, typically under a “debenture” deed which contains a fixed charge provision over the vehicles (amongst other assets) and a floating charge over any assets not effectively covered by the fixed charges. The “debenture” will likely contain a schedule detailing the vehicles and, if the vehicle fleet fluctuates over time, then it may also contain a mechanism for supplemental charges to be created from time to time over the updated fleet of vehicles specified. The “debenture” may also contain the following provisions:
- a negative covenant under which the borrower agrees that it will not sell, transfer, create security over or otherwise deal with the charged vehicles without the prior consent of the asset financier;
- a term under which any relevant documents pertaining to the vehicle fleet must be delivered into the possession of the asset financier (e.g. in a UK context this would comprise the DVLA Form V5C for each vehicle in the fleet); and
- a further assurance clause under which the asset financier is entitled to require the borrower to create a full legal mortgage over the vehicles in the fleet by transferring title to the vehicles to the asset financier with a licence to use granted back to the borrower (perhaps on the occurrence of a trigger event, such as default by the borrower under its financial covenants or a failure to pay).
The security is created at the outset as a fixed charge in equity. Subject to competing equities, were the borrower to go into an insolvency process then the asset financier would have the first priority claim in respect of any realisation proceeds arising from the sale of the vehicles. If this equitable fixed charge failed for any reason, it would be re-characterised as a floating charge and the asset financier would rank accordingly.
The practical reality is that only floating charge security is possible for the asset financier at the outset in respect of any vehicles in the fleet which are situated in Scotland. This is because the only method for creating fixed security over “corporeal moveable property” (or “chattels” in English parlance) is by way of pledge under which the pledged asset needs to be delivered to the asset financier, either actually or constructively, but in any event so that the pledged asset is put beyond the control of the pledgor. This clearly precludes any fixed security in Scotland over the vehicles since the entire point of the financing is to finance the acquisition of a fleet of cars by the borrower for its executives and staff to use for business purposes. Therefore, the borrower grants a floating charge in favour of the asset financier, and perhaps also an inchoate pledge with an obligation to deliver the vehicle fleet to the asset financier in a default scenario. If the inchoate pledge is not converted into a full pledge with delivery prior to the borrower going into an insolvency process, then the asset financier will rank as follows:
- first - the administrator or the liquidator for the expenses of the administration or the liquidation;
- second - all preferential debts, which from April 2020 will now include the Crown preference without limit or cap;
- third - the “prescribed part for unsecured creditors”, which from April 2020 will be increased to a cap at £800,000;
- fourth - the asset financier for all floating charge realisations; then
- fifth - the ordinary unsecured creditors of the borrower.
Similar difficulties arise in the context of other assets classes too.
Absent a change in the UK Government, it seems unlikely that the position as regards the priority of claims in corporate insolvencies trailed in the 2018 Budget will be altered. Accordingly, the Scottish market looks set to suffer a disproportionate adverse effect as a result.
However, this need not necessarily be so. In June 2011, the Scottish Law Commission published a Discussion Paper on Moveable Transactions (8), which proposed sensible reforms to the Scots law in this area, including the creation of a new register in which transfers of, and the creation of security over, moveable property could be registered thus creating the real right and establishing insolvency priority accordingly. The Scottish Law Commission thereafter produced a further Report on Moveable Transactions in December 2017, Volume 3 of which includes a draft Bill of the Scottish Parliament which, if enacted, would give effect to the Commission’s ‘devolved’ recommendations (9).
It is therefore within the gift of the Scottish Parliament to implement this long needed reform, which would not only alleviate the practical difficulties encountered as a result of the comparative inflexibility of Scots law in this area, but would also ameliorate some of the deleterious implications of the 2018 Budget for secured creditors in Scotland. We can but hope that the Scottish Law Commission’s draft Bill will be enacted in the near future, and preferably prior to 6 April 2020.