Hanlon and Heywood, 'Spectrum Plus and Book Debts: The Final Chapter?'

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Introduction

The House of Lords has recently in National Westminster Bank plc v Spectrum Plus Ltd [2005] UKHL 41 closed the final chapter in the “book debt” saga, which traces its roots back to 1979. The line of cases, which is the subject of this paper, represents a perplexing study on the subject of charges over book debts. Ambiguity and conflict has now, finally been resolved.

The controversy has arisen over the label attached to a charge over property as either a fixed or a floating charge. Since 1979 there have been a number of opportunities for courts (both in the UK and abroad) to investigate the accuracy of the label attached by the parties to the company charge into which they have entered. As will be seen, although the label may accurately define the intention of the parties, it has not always defined the legal consequences of the agreement. As with any metaphor, it has to be watched carefully. As Cardozo J wryly observed in Berkey v Third Avenue Railway Corporation [1926] 244 NY 84 at 94: “metaphors in law are to be narrowly watched, for starting as devises to liberate thought, they often end up by enslaving it”

Charges Generally

The availability of borrowing credit is one of the essential elements of the commercial world. As with natural persons, a company may have a need to borrow money in order to expand or further in some other way their commercial activity. Small, family type companies will often have small assets. When the company approaches a bank or other lending institution for a loan or overdraft facility, the bank will want to ensure that they will get their money back. Thus they will normally insist on a personal guarantee from the director or directors of the company. A common form of guarantee in this type of situation is granting the bank a mortgage or charge over personal property owned by the director, most commonly the family home (for land, the terms mortgage and charge can be used interchangeably). In the event of default by the company, the bank can enforce the sale of the director’s home to repay the loan.(1) Larger companies can also go down this route. They can also raise money from the loan capital market. However, a large company will normally have its own assets. These assets can be mortgaged or charged to the lending institution; this again, to counter the potential risk of default. If a lending institution (the creditor) secures its lending it will have some rights in the company’s (the debtor) property. Basically, in the event of insolvency the claim of the loan creditor must be paid before any money is returned to shareholders. For example, a loan could be secured over the company’s land. In the event of the company defaulting on repayment of the loan the creditor bank can immediately enforce its security interest, created under the contract between the parties. In company law terms, this will be a debenture contract; a debenture being “a document which either creates a debt or acknowledges it”. (Lord Chitty in Levy v Abercorris Slate and Slab Corporation [1887] 37 Ch D 260). The essence of the charge is that an enforceable interest in the property is established although title in the property does not pass. Both fixed and floating charges are created by agreement between the parties. The parties themselves determine the form of security for any particular loan. It is common practice to “label” the charge as fixed or floating. This designation, however, is only one factor, but not a conclusive factor in determining the proper classification. It is the terms generally, which will be conclusive. If the terms of the agreement are inconsistent with the label, the description will not prevail. This has been the crux of the book debt saga since 1979.

Fixed Charges

In order to create a fixed charge over an asset, the asset in question must be identifiable, although it need not be in existence at the time the charge was created. The major characteristic of a fixed charge is that once a company has granted a fixed charge over its assets (or part of them) it cannot then deal with that asset without the agreement of the chargee (usually a bank). Fixed charges are usually created over the permanent capital structure of a company, such as the business premises or land or, to a lesser extent, over fixed plant and machinery. Land is ideal as the subject matter of a fixed charge as it does not usually depreciate in value. Nevertheless, there is little doubt that for a creditor, a fixed charge confers the best type of security. Usually the creditor will endeavour to have a fixed charge. In any negotiation for the issue of a debenture the creditor, usually a bank, will be in the stronger bargaining position. The creditor will press for a fixed charge over the assets and because of the unequal bargaining position the debtor will be forced to accept the terms put by the creditor.

Floating Charges

A company may have assets that are not suitable for the granting of a fixed charge. This is because of the fluctuating nature of the asset (for example, raw materials or stock in hand) or because it would be impractical to circumscribe the use of the asset by requiring the permission of the debenture holder to deal with that asset (for example, raw materials, some types of plant and equipment and book debts). A floating charge will be taken where all or most of the fixed assets are subject to a fixed charge. In some cases there may be some advantages to a floating charge from the creditor’s point of view. The ability of the debtor to use the charged assets in the ordinary course of business may make it easier to generate the profit to repay the loan, an outcome any creditor would prefer.

Lending institutions and trading companies recognise the benefits offered by a floating charge.(2) Such a charge allows a company to carry on its business as a going concern and dispose of the asset(s) in the ordinary course of its business despite the existence of the floating charge. The company can continue to deal with the assets right up until the time the charge crystallises. Upon crystallisation the company (chargee) loses the right to deal with the assets in the normal course of business. Crystallisation may be triggered by an event allowed by law, such as the winding up of a company, the appointment of a receiver or cessation of a company’s business. However, what is important for the purposes of this paper is that the parties to the debenture can agree any terms between themselves. One of the most common terms in a debenture deed will be that a floating charge will crystallise on the occurrence of an event specified in the debenture. The event usually specified will be default in the repayment of principal or interest. When a floating charge crystallises it becomes an equitable fixed charge (Re Griffin Hotel [1941] Ch 129).(3)

The essential difference between a fixed and a floating charge(4) is that under a fixed charge the assets charged as security are permanently appropriated to the payment of the sum charged, in such a way as to give the chargee creditor a proprietary interest in the assets. So long as the loan remains unpaid, the assets can only be released from the charge with the permission of the chargee. Of course, the chargee may have a good commercial reason for agreeing to a release, partial or complete. But under a fixed charge that will be a decision for the chargee to decide. By contrast, under a floating charge, the chargee does not have the same power to control the security for its own benefit. The chargee’s interest is an interest in a fund of circulating capital and unless and until the chargee intervenes (on crystallisation of the charge) it is for the company (the charger) and not the bank, to decide how to run its business. The particular feature of a floating charge that distinguishes it from a fixed charge is that the company can continue to deal with the asset in the ordinary course of its business without having to obtain the consent of the creditor. This is the important essence of a floating charge.

There have been many judicial attempts to describe the characteristics of a floating charge. The classic description is that of Romer LJ in Re Yorkshire Woolcombers Association Ltd [1903] 2 Ch 284 at 295. He said that a charge would be a floating charge if it had the following three characteristics:

“(1) If it is a charge on a class of assets of a company present and future; (2) if that class is one which, in the ordinary course of business of a company, would be changing from time to time; and (3) if you find that by the charge it is contemplated that, until some further step is taken by or on behalf of those interested in the charge, the company may carry on in its business in the ordinary way…”

Or, as Hoffmann J (as he then was) held in Re Brightlife Ltd [1986] BCLC 353; [1987] Ch 200 the fact that the charged assets are “at the free disposal of the company is the badge of a floating charge”. The statement of Romer LJ was offered as a description and not a definition. The first two characteristics are typical of a floating charge, but they are not determinative of it. They are too, the characteristics of a fixed charge. It is the third characteristic which is the hallmark of a floating charge and which distinguishes it from a fixed charge. The existence of a fixed charge would make it impossible for a company to carry on its business in the ordinary way without the consent of the charge holder. Therefore, the ability to carry on business without the consent of a charge holder is not consistent with a fixed charge (Re Brumark [2001] 1 BCLC 353; [2001] 2 AC 710, per L Millett at para 13.).

It should be noted that for both fixed and floating charges, there is a requirement, set out in s.395 of the Companies Act 1985, to register such charges within 21 days after its creation, failing which it will be void against a liquidator or any creditor of the company. The failure to register in effect means that the charge holder would become an unsecured creditor of the company.

The Relevance of the Distinction

There are various reasons why it is important to be able to distinguish between fixed and floating charges. The first reason is rather obvious; a company may have a mix of charges, both fixed and floating, and so the parties will need to know which assets are subject to which type of charge. A most important reason for distinguishing between a fixed and floating charge is that, generally, a fixed charge will have priority over a floating charge. This will be especially important in the insolvency of a company.

When fixed charge assets are realised (i.e. sold) the charge holder will receive the proceeds of those assets after deducting only the costs of the realisation. In contrast, the proceeds of a floating charge realisation will be subject to the costs of the realisation, the expenses of the insolvency procedure, preferential creditors and the “prescribed part” (a percentage of the proceeds of the company’s floating charge assets, up to a maximum of £600,000) (Section 176A IA 86 for floating charges registered on or after 15/09/03. Inserted into IA 86 by Article 1 of Insolvency Act (Prescribed Part) Order 2003 (SI 2003/2097).). It is only when these costs have been deducted that the charge holder will receive the remaining funds.

Certain statutory provisions have a bearing on charges and whether they are fixed or floating. In an insolvency, certain “preferential debts” will rank before a floating charge but after a fixed charge Insolvency Act 1986, ss 107, 115,175, 386, Schedule 6 and rule 4.181). At the same time, by virtue of sections 19(5) and (6) of the Insolvency Act 1986 a floating charge will come behind the expenses of the liquidator or administrator. Thus in some cases preferential debts will have to be paid out of assets comprised in the floating charge.

A disadvantage of a floating charge is that it may be invalid if it is created within a specified period before the onset of any insolvency procedures (s.245 Insolvency Act 1986). In some cases this will be twelve months prior to the onset of the chargor’s insolvency and for cases involving “connected persons” that period is extended to two years. It may well be that the crucial disadvantage of a floating charge is that the fluctuating value of the assets which make up the security interest falls below the amount of the loan secured by the charge. This will not matter much while the charge “floats” over the assets. It might have a devastating effect if the value of the assets is below the amount of the loan at the time that a floating charge crystallises. The difference between the amount owed under the charge and the (lesser) amount realised by the assets would rank for payment as an unsecured creditor.

Book Debts

For at least the last twenty years, lenders have made many attempts to draft a debenture that would give them a fixed charge over book debts. A book debt is an uncollected debt owed to the company and the realised proceeds of such debts (i.e. the debt itself and the monies when collected). Book debts can vary wildly from any one accounting period to the next. At one time the debts will be high but the debts will be settled and the proceeds paid into a bank account. This will reduce the amount of the book debts. By the next period the debts could have accumulated again. The reason for the need to want to grant a charge (and to take a charge) is because book debts are often the largest asset owned by a company. Indeed, some companies (e.g. those in service industries) may have little else than book debts to offer as collateral.

At first sight, it would seem impractical that a book debt could be the subject of a fixed charge. A book debt is an asset that fluctuates all the time. After all, the main characteristic of a fixed charge is that the holder of the charge has an immediate proprietary interest in the assets subject to the charge. Unless it obtained the consent of the holder of the charge, the company would be unable to deal with its assets. As Lord Millett put it in Re Brumark [2001] 2 AC 710: “In short, a fixed charge over all of a company’s assets, [including its book debts], would deprive a company of access to its cash flow, which is the life blood of a business.” (at para 7). On the other hand, a floating charge grants a security upon a class of assets, at the same time leaving the company free to deal with its assets and pay its trade creditors in the ordinary course of business without reference to the holder of the charge (at para 8). It is the general priority position of a floating charge that makes it less attractive for a creditor to take such a security. The preferred method for creditors, where at all possible, is to take a fixed charge. To this end, creditors have sought to place a fixed charge on book debts. However, they have often been unsuccessful in these attempts. This is because a court must construe a debenture contract to determine the true nature of the charge. In many cases a debenture has attempted to create a fixed charge; the debenture may even expressly refer to the charge as being fixed. Nevertheless, a court may hold that despite the express “label” as fixed, the parties have in fact created a floating charge. This is the crux of the case law to which we now turn our attention.

The Cases

It is generally agreed that Re Yorkshire Woolcombers was the first case to deal specifically with book debts. The question was whether a charge on uncollected book debts was fixed or floating. At every level of the decision it was held to be a floating charge ([1903] 2 Ch D 284 per Farwell J at p 288, in the Court of Appeal per Romer LJ and Cozens-Hardy LJ at p 297; in the House of Lords sub nom Illingworth v Houldsworth [1904] AC 355 per Lord Halsbury LC at p 359). The critical factor in reaching this decision was the company’s freedom to receive the book debts for its own account and deal with the proceeds without reference to the charge holder. The classification of a security as a floating charge was a matter of substance and not a matter of drafting. In Evans v Rival Granite Quarries Ltd, [1910] 2 KB 979, Fletcher Moulton LJ observed that:

“…at an early period it became clear to judges that this conclusion did not have to depend on the special language used in the particular document, but because the essence and nature of a security of this kind.” (at p 993).

As Lord Millett said in Re Brumark, “the law was settled to this effect for the next seventy years.” (at para 19). Yet, as his lordship went on to say, by the 1970s the banks were becoming disillusioned with the floating charge. It had always been possible to take a fixed charge over specified debts. But it had not been considered possible to take a fixed charge over a fluctuating class of present and future book debts. There were two reasons for this. A commercial reason was that book debts were part of the circulating capital of a company and constitutes an important source of its cash flow, which makes it difficult to subject them to a fixed charge without paralysing the business. The second reason was a conceptual one: it is a characteristic of a floating charge that it is a charge on fluctuating assets, therefore a charge on fluctuating assets must be a floating charge.

These commercial and conceptual factors were challenged in 1979 in Siebe Gorman and Co Ltd v Barclays Bank Ltd [1979] 2 Lloyd’s Rep 142. This case was a breakthrough decision. It was concerned with the proceeds of book debts over which the company has purported to grant its bank a fixed charge. The company was prohibited from disposing of the uncollected debts, and although it was free to collect them it was required to pay the proceeds into an account in its name with the bank. Slade J decided that if the charge on the borrower company included sufficient controls on the disposal of the book debts prior to their collection, then the charge on the book debts could be fixed. Sufficient controls on the disposal of book debts prior to collection essentially meant that the company was only permitted to receive payment of book debts and could not assign, factor, discount, sell, charge or otherwise deal with them. Post-collection controls began with an obligation on the company to pay collected book debts into a bank account. This account could be with the chargee (lender) bank or any other bank. After that the company could not be granted unrestricted access to that account. In terms of post-collection control, the important factors identified by Slade J were that the book debts were paid into a designated account to which the company did not have unrestricted access. This became the major point of future argument. Slade J found that, on a proper construction of the debenture, the company was not free to draw on its account without the consent of the bank even when the company was in credit. Accordingly he held that the charge on the uncollected book debts and their proceeds was a fixed charge.

It should be noted that the debenture placed no express restrictions on the company’s right to draw on its account, which was the company’s ordinary business account. Yet Slade J held that there was an implied restriction on drawing on the account. In fact, it was this restriction, even if only implied, that was important. If Slade J had accepted that there was an unrestricted right to deal with the proceeds of any book debt paid into the account, he “would have been inclined to accept the conclusion that the charge on such book debts could be no more than a floating charge.”(at p 158).

The decision in Siebe Gorman was followed by the Supreme Court of Ireland in Re Keenan Bros Ltd [1986] BCLC 242. However, in this case the bank’s degree of control over the book debts was far stronger than that in Siebe Gorman. The debenture between the bank and the company prohibited the company from disposing of its book debts or creating other charges over them without the consent of the bank (this, so far, is a similar restriction as in Siebe Gorman). The debenture deed allowed the company to collect the book debts but required the company to pay the proceeds into a designated account with the bank from which the company could not make any withdrawals without the written consent of the bank. This requirement was an express restriction and went much further than any implied restriction that may have existed in Siebe Gorman. The bank account in Re Keenan Bros was, in fact, a blocked account.

There can be little surprise that the court held that the charge was a fixed charge. In Re Keenan Bros, McCarthy J confirmed that “mere terminology” was not determinative of whether a charge was fixed or floating. One had to look “not to the declared intentions of the parties alone, but to the effect of the instruments whereby they purported to carry out that intention.” (at p 247). The critical feature, which led the court to find that the charge was a fixed charge, was that the proceeds of the book debts had to be paid into a blocked account, from which withdrawal was impossible without the written consent of the bank. Henchy J explained:

“It seems to me that such a degree of sequestration of the book debts when collected made these monies incapable of being used in the ordinary course of business…I am satisfied that assets thus withdrawn from ordinary trade use, put in the keeping of the debenture holder, and sterilised and made undisposable save at the absolute discretion of the debenture holder, have the distinguishing feature of a fixed charge. The charge was not intended to float in the future on the book debts; it was affixed forthwith and without further ado to those debts as they were collected…” (emphasis added) (at p 246).

Siebe Gorman has been followed by a number of cases (Chalk v Kahn [2000] 2 BCLC 361 sub nom Re CIL; Realisations Ltd [2001] BCC 300, William Gaskell Group Ltd v Highley (Nos 1, 2 and 3) [1994] 1 BCLC 13, Re Portbase Clothing Ltd [1993] Ch 388 and Re New Bullas ltd [1993] BCLC 13898, [1994] 1 BCLC 449 CA). However, it has also been avoided in other cases, both in England and abroad. The first case to signal some uncertainty over the Siebe Gorman decision was Re Brightlife Ltd [1987] Ch 200. In this case the debenture granted the bank a fixed charge over its present and future book debts (and a floating charge over other assets). The company was not permitted to sell, factor or discount debts without the bank’s written consent. The company was free to collect the debts and pay them into its ordinary bank account. The company could draw on the account as it wished. Hoffmann J held that, even though the charge was expressed as a fixed charge, it should be characterised in law as a floating charge. He explained:

“In this debenture, the significant feature is that [the company] was free to collect its debts and pay the proceeds into its bank account. Once in the account, they would be outside the charge over debts and at the free disposal of the company. In my judgment a right to deal in this way with the charged assets for its own account is a badge of a floating charge and is inconsistent with a fixed charge” (at p 209).

Hoffmann J distinguished Siebe Gorman on the ground that the debenture holder in that case was a bank and required the company to pay the collected debts into the company’s bank account with that bank. In Re Brightlife the debenture holder was not a bank and there was no similar restriction. New Bullas Trading [1993] BCLC 1389 at first instance followed Re Brightlife. Re Brightlife was also followed, although in a different context, in Re Cosslett (Contractors) Ltd [1998] Ch 495.

In the New Zealand case of Supercool Refrigeration and Air Conditioning v Hovard Industries Ltd [1994] 3 NZLR 300 the facts were indistinguishable from those in Siebe Gorman. Indeed, Tomkins J noted that “the relevant provisions of the security in Siebe Gorman and the present one are, for practical purposes, the same.” (at p 318). Nevertheless, he held (following Hoffmann J in Re Brightlife) that the charge was a floating charge. The reason for this was because:

“…a requirement to pay the proceeds of the book debts into the company’s account without any restrictions on how the company may use the proceeds does not give effective possession of the proceeds to the Bank. It does not, without more, fasten the charge onto those proceeds.”(at p 321)

New Bullas Trading

It is normal for a company to pay its proceeds (from whatever source) into its bank account and then draw on that bank account in the normal course of its business. That is not a problem for either a company or a bank. No bank wishes to monitor a company’s business account to the extent that it has to give its written permission whenever the company wished to make a withdrawal. Commercial life could not survive with such an arrangement. However, with book debts (and other receivables) the banks wanted the best of both worlds. They wanted to have a fixed charge on book debts, but at the same time allowing the company to have the freedom to use the proceeds that it would have if the charge was a floating charge. The problem was, that in all of the previous cases the relevant debentures had treated book debts and their proceeds indivisibly.

The case of New Bullas Trading [1994] 1 BCLC 449 adopted a new approach. For the first time the debenture set out deliberately to distinguish between the book debt and its proceeds. The draftsman “deliberately and conscientiously” (at p 487) set out to subject uncollected book debts to a fixed charge and the proceeds to a floating charge. The debenture purported to create two distinct charges, a fixed charge on the book debts while they remained uncollected and a floating charge on their proceeds. Until the charge holder intervened the company could continue to collect the debts (though not assign or factor them). The debt was collected would cease to exist. The proceeds that took their place would be a different asset, which had never been the subject of a fixed charge and would from the outset be subject to a floating charge. The question in New Bullas was whether the book debts that were uncollected were subject to a fixed charge or a floating charge. At first instance, ([1994] 1 BCLC 1389) Knox J, following Re Brightlife held that they were subject to a floating charge. The judge held that the transaction that had been entered into was of a different nature from the label that had been given to it. As he graphically explained: “If a transaction is a cow and has cloven hooves, the parties cannot turn it into a horse by using equine terminology or saying that it is a horse” (at p 1395). The indivisibility, or otherwise, of book debts and their proceeds was not addressed at first instance. The Court of Appeal overturned the first instance decision. The judgment of Nourse LJ, who gave the only opinion, was that the intention of the parties had to be taken into account. There were no public policy grounds to prevent the parties from making any agreement they liked. Therefore, the question was one of construction. The intention of the parties (so long as it was lawful) would be ascertained from the terms of the debenture and must prevail. It was clear from the descriptions that the parties attached to the charges what charges they intended to create. On book debts while they were uncollected there was a fixed charge and on the proceeds there was floating charge. It was open to the parties to reach this agreement and freedom of contract must prevail. In support of this argument Nourse LJ cited with approval, Lord MacNaghten’s dictum to the same effect in Tailby v Official Receiver [1888] 13 App Cas 523:

“Between men of full age and competent understanding ought there to be any limit to the freedom of contract but that imposed by positive law or dictated by considerations of morality or public policy? The limit proposed is purely arbitrary and I think meaningless and unreasonable” (at p 492 of New Bullas).

The reason why the debenture had been drafted in the manner it has been was because it was important for the lenders to establish that its charge on uncollected book debts was a fixed charge. If the charge was “merely” a floating charge then under the Insolvency Act 1986 s 175 the banks claim on those debts would be postponed to come after preferential creditors. To some extent, New Bullas can be seen as another step (along with Siebe Gorman) in an attempt to combine the advantages to both parties of the fixed and the floating charge. Up until New Bullas, book debts and their proceeds had been held indivisible and it was how the proceeds were dealt with that was determinative of the nature of the charge. Leaving a company free to collect the debt and then use the proceeds in any way it pleased is wholly inconsistent with the existence of a fixed charge. This was the very point made by Hoffmann J in Re Brightlife. However, in New Bullas, Nourse LJ did not even mention Re Brightlife.

The judgment in New Bullas has been subject to much academic criticism.[5] Nor was it followed by a court in Re Pearl Maintenance Services Ltd [1995] 1 BCLC 449. In this first instance case, Carnwath J rejected the argument that New Bullas had replaced the traditional approach with a “charge as labelled” approach. The judge held that the creation of a New Bullas split security required words to that effect in the debenture. The judge distinguished New Bullas as confined to its own particular facts and wording and preferred to follow the traditional route as set out in Re Brightlife. Pearl Maintenance was followed on that issue by Hart J in Chalk v Kahn [2000] 2 BCLC 361.

Re Brumark

The decision in New Bullas was subject to even greater criticism in a case emanating from New Zealand. That case was Agnew v Commissioner of Inland Revenue, better known as Re Brumark [2001] 1 BCLC 353; [2001] 2 AC 710: [2001] UKPC 28. The case concerned a debenture containing essentially the same terms as that in New Bullas. At first instance, ([1999] 19 NZTC 15, 159) the judge Fisher J held that there could be a fixed charge over uncollected present and future book debts and a floating charge over their proceeds. The judge based his argument mainly on the authority set by New Bullas. In addition, he cited and rejected the view of Millett LJ in Royal Trust Bank v National Westminster Bank plc [1996] 2 BCLC 682 that it was impossible “to separate a debt and other receivables from the proceeds of its realisation” (at p 704). When the case was appealed to the New Zealand Court of Appeal, ([2000] 1 BCLC 353, NZCA) the first instance decision was overturned. The Court held that book debts and their proceeds were indivisible and that it was not possible to have a fixed charge on uncollected debts and a floating charge over the proceeds. It was put plainly by Gault J:

“We consider that the general principal remains that if the true nature of the arrangement is that the chargor is free to deal with the charged book debts, the charge cannot be a fixed charge. That does not involve…characterising the charge over book debts by what may be done with the proceeds. It involves determining whether or not the charged book debts are under the control of the chargee. We do not accept that there is a distinction between dealing in the uncollected debts by disposal to third parties and dealing by collection. We find no basis for such distinction in the authorities or in logic.”

The case next came to be considered by the Privy Council, where Lord Millett delivered the judgment. He held that the critical feature which distinguished a floating charge from a fixed charge lay in the company’s ability, freely and without the bank’s consent, to control and manage the charged assets and withdraw them from the security. In deciding whether the charge was a fixed or a floating charge, the court was engaged in a two-stage process (at para 13). First, it had to construe the charge, not depending on what the parties had intended, but on what rights and obligations they had conferred upon one another. Having done that, as a matter of law, it was for the court to decide how to categorise that charge according to those rights and obligations. Here Lord Millett drew an analogy with construing a document to see whether it created a licence or a tenancy. His Lordship referred to Street v Mountford [1985] AC 809 in which case it was held that a court must construe the grant to ascertain the intention of the parties; but the only intention that is relevant is the intention to grant exclusive possession. So, in the present case, when it came to construing a debenture to see whether it created a fixed or a floating charge:

“…the only intention which is relevant is the intention that the company should be free to deal with the charged assets and withdraw them from the security without the consent of the holder of the charge; or, to put the question another way, whether the charged assets were intended to be under the control of the company or the charge holder.”(at para 32)

Accordingly, the Privy Council’s decision may be summarised. If a debenture prevents the borrowing company from disposing of its book debts in any way and thus leaves the company with no option but to collect payment of those debts, that constitutes a necessary (but not a sufficient) step towards a conclusion that a fixed charge has been created over book debts. In addition, and importantly, it will also be necessary for there to be sufficient post-collection control on the use of the proceeds of those debts, so that the borrowing company cannot use the proceeds in the ordinary course of its business. Lord Millett did not make clear how much control is necessary. Payment of the proceeds into a bank account from which the company is free to make unrestricted withdrawals will not amount to sufficient control to create a fixed charge. On the same basis, the absence of any obligation to pay collected book debts into any account will not be sufficient. What seems to be contemplated is that collected book debts be paid into a blocked account from which the company is not free to make withdrawals in an unrestricted way, as in Re Brightlife. It is only this level of control that would justify a fixed charge. Lord Millett also made it clear “that it is not enough to provide in the debenture that the account is a blocked account if it is not operated as one in fact.”(at para 48) The Privy Council also disposed of the argument in New Bullas that it is possible to separate book debts and their proceeds. “Any attempt to separate the ownership of the debt from the ownership of their proceeds (even if conceptually possible) makes no economic sense.” (at para 46). Thus, “[t]heir Lordships consider that New Bullas was wrongly decided.” (at para 50). Although decisions of the Privy Council do not on the strict theory of precedent, bind the Court of Appeal, New Bullas has for all practical purposed been overruled. The decision was also taken seriously in banking circles as although Re Brumark did not overrule Siebe Gorman, it cast doubts as to its continuing authority. The problem, highlighted in Re Brumark, was that there was little evidence in Slade J’s judgment in Siebe Gorman as to why he reached his conclusion on the central issue. (at para 21). An important area of commercial law was now uncertain. It was reported in the Financial Times (25/04/05) that hundreds of insolvencies had been frozen because of the legal uncertainty of who ranked first for repayment. Liquidators had been unwilling to pay out funds because they were uncertain whether banks holding Siebe Gorman type debentures had a superior claim to preference creditors. ([2004] Ch 337, as per Sir Andrew Morritt VC, at p 342)

Spectrum Plus

(At first instance [2004] 1 All ER 981; [2004] EWHC 9 (Ch). Court of Appeal [2004] EWCA Civ 670; [2004] Ch 337. House of Lords [2005] UKHL 41)

Spectrum Plus was a manufacturer of dyes and other chemical products for the paint industry. It had an account with a bank (National Westminster) with an overdraft facility of £250,000. The account was never in credit. To secure its indebtedness to the bank Spectrum executed a debenture, essentially along the lines of the debenture in Siebe Gorman. In 2001 Spectrum entered into voluntary liquidation. Spectrum’s unsecured debts included £16,136 due to preferential creditors, mainly the Crown creditors. The bank argued that the debenture was a fixed charge; the Crown creditors said it was a floating charge. If it was a floating charge Spectrum’s preferential creditors would be entitled to have their debts paid out of the proceeds of the book debts in priority to the bank (per Lord Scott at para 76). If it was not a floating charge the preferential creditors had no such priority and the bank would be entitled to all of the proceeds of the book debts. Although the amount at stake in this case was relatively trivial, this was a test case.

The task of the Vice Chancellor, at first instance was to re-examine the Siebe Gorman case and decide whether Siebe Gorman debentures created fixed or floating charges over book debts. The Vice Chancellor considered the test as set out by Lord Millett in Re Brumark. First he examined the wording of the debenture to establish the rights and obligations that the parties intended to grant each other in respect of book debts. These were found to be, first, a charge over the book debts; second a requirement to pay the proceeds into an account with the bank; and, third, a prohibition on disposing of the book debts to any other party without the consent of the bank. The borrowers account with the bank was its ordinary business account with no further restrictions on the use of the account. The second part of the test was to ascertain (from the terms of the contract) whether it was the intention of the parties 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 found, as a matter of fact, that there were no restrictions on the borrower’s use of the money, so long as the terms of the overdraft were observed. The third and most important step was then to consider whether such an intention was consistent with the charge as categorised in the debenture (i.e. as a fixed charge). However, the Vice Chancellor concluded that the proper categorisation of the charge was that it was a floating charge and that Siebe Gorman was wrongly decided. (at para 39).

The bank immediately appealed the decision. The Court of Appeal allowed the bank’s appeal and found that the charge was a fixed charge. Lord Phillips MR gave the only judgment and Jonathon Parker and Jacob LJJ agreed with him. This was partly based on the doctrine of precedent. Lord Phillips MR was faced with the direct conflict of Re Brumark (a Privy Council Decision) and New Bullas (a Court of Appeal decision). His Lordship took the view that the Court of Appeal was bound to follow its previous decision in New Bullas. (at para 45). But independently of the doctrine of precedent, Lord Phillips MR doubted the reasoning in Re Brumark. He reduced the analysis of the case to three main issues. The first issue was whether Slade J in Siebe Gorman was right to construe the debenture as restricting the company’s freedom to draw on the account into which the proceeds of the book debts were paid when the account was in credit. This gave rise to the second issue, which was that if Slade J was right in his construction of the debenture, did the existence of that restriction justify him in categorising the charge on book debts as a fixed charge? Third, and finally, Lord Phillips MR asked if the decision in Siebe Gorman was still good law. To the first issue, Lord Phillips MR held that it was open to Slade J in Siebe Gorman to conclude that under the terms of the debenture the company would be entitled to draw on its account when in credit, unless the bank chose to exercise its right to block the account in order to secure other obligations to the bank. (This argument has been criticised as being legally flawed. See Young J, “Charge Over Book Debts: Siebe Gorman Revisited.” [2004] ICCLR 15(11) pp 327-333.) This was the limiting nature of the restriction that was placed on the use that the company could make of the proceeds of the book debts. Lord Phillips MR then held, in relation to the second issue, that the Siebe Gorman decision was justifiable because of the requirements that the book debts could not be disposed of prior to collection and that, on collection, they had to be paid into the bank itself. Here, Lord Phillips MR used banking law and the banker-customer relationship to justify his argument. His argument was that, under the authority of Foley v Hill [1848] 2 HCL 28, where a customer pays money into his bank (including the proceeds of book debts) title to the proceeds passes absolutely to the bank (see also also Lipkin Gorman v Karpnale Ltd [1989] 1 WLR 1340). The obligation on the bank is contractual; they are required by their contract with the customer to repay a similar amount as that paid into the bank account. By paying the collected book debts into the bank the company had used the proceeds to reduce its overdraft. The company never had any control over these proceeds. It was bound to permit them to be used to reduce its indebtedness. The fact that the company could immediately draw a corresponding amount from the account was a contractual right to borrow money from the bank up to its overdraft limit. This was separate and had no effect on the restriction to pay the proceeds into the bank. The requirement that a debenture holder had to pay the collected book debts into a designated account exhausted the requirements on the borrowing company. On a strict analysis, that did not mean that the charge on the book debts was a floating charge. In relation to the third part of the test, Lord Phillips MR concluded that even if Siebe Gorman was wrong, he would have held that the form of debenture in question had, by “customary usage” by banks for twenty-five years, acquired the meaning and effect that Slade J in Siebe Gorman had given it. (at para 97).

The Court of Appeal’s decision was appealed to the House of Lords. Because of the importance of the outcome, the case was heard by seven judges. The judgment immediately held that Siebe Gorman was wrong and should be overruled (as per Lord Nicholls at para 1). The Lords unanimously upheld the Vice Chancellor in the first instance decision and found that the bank’s debenture created a floating charge (and not a fixed charge) over book debts. In deciding whether or not the book debts were subject to a fixed or a floating charge the House of Lords considered what characterised a charge as floating as opposed to fixed. Although the nature of a floating charge had been widely considered by the courts, no full definition had ever been given. The House of Lords stressed that the widely used description of a floating charge given In Re Yorkshire Woolcombers Assoc was not a definition but a description. (per Lord Scott at para 99). The House of Lords then decided that the essential characteristic of a floating charge is that:

“…the asset subject to the charge is not finally appropriated as a security for the payment of the debt until the occurrence of some future event. In the meantime the chargor is left free to use the charged asset and to remove it from the security” (Lord Scott at para 111).

The Lords agreed with earlier decisions that it is conceptually possible to create a fixed charge over book debts. Lord Hope, referring to S Worthington “An Unsatisfactory Area of Law – Fixed and Floating Charges Yet Again” [2004] International Corporate Rescue, 175-182, identified the possible ways (at para 54). These all prevented the chargor company from dealing with book debts so that they were preserved for the benefit of the security. They were;

(i) assigning the book debts to the chargee;

(ii) requiring the borrower to pay proceeds to the chargee in reduction of the borrower’s outstanding debt;

(iii) requiring the borrower to pay the collected proceeds into a blocked account with the chargor bank; or

(iv) requiring the borrower to pay the proceeds into a separate account with a third party bank over which the chargee has a fixed charge.

The House of Lords considered that the method selected in Spectrum Plus came closest to the blocked account model. The Lords considered that the key question was whether the account was one which allowed Spectrum to continue to use the proceeds of the book debt as a source of cash flow or whether it was one that kept the proceeds intact for the benefit of the bank’s security. In short, the crucial question was whether or not the account was blocked. (per Lord Hope at para 55).

The House of Lords decided that the continuing contractual right of Spectrum to draw out same equivalent to amounts paid in to the account meant that the account was not blocked. The right of Spectrum to draw on the account was “wholly destructive” of the argument that there was a fixed charge. The House of Lords approved Lord Millett’s reasoning in Re Brumark that the formal provisions for a blocked account are not enough if the account “is not operated as one in fact”. The House of Lords also rejected the element of Lord Phillips’s argument based on banking law. The argument was that because the proceeds were paid into an overdrawn account and the bank could, if it wished, refuse to allow Spectrum to draw on the account, the bank had “control” over the proceeds, which was sufficient to create a fixed charge over book debts. The House of Lords held that the company effectively remained free to deal with the book debt proceeds by drawing out equivalent amounts from its account with the bank (per Lord Hope at para 61).

Prospective Overruling

In the appeal to the House of Lords the “bank had a second string to its bow.” (per Lord Nicholls at para 2). The bank contended that if the Lords decided that if Siebe Gorman was wrongly decided the Lords should overrule the decision only for the future. The bank contended that the Siebe Gorman decision should continue to apply to all transactions entered into until the date of the House of Lord’s judgment in Spectrum Plus. This was to protect the banks who had drafted their standard form debentures in reliance on Siebe Gorman for 25 years. The arguments surrounding prospective overruling, which are to be found at paragraphs 1-43, are beyond the scope of this article but the House of Lords rejected this argument. The Lords stated that although they could never say it would never be appropriate to make a prospective overruling this case was “miles away” from the exceptional category in which alone prospective overruling would be legitimate. Lord Nicholls put it succinctly:

“No doubt over the years the clearing banks…have to some extent relied on the Siebe Gorman decision when formulating and using their standard for of charges on book debts. But banks…who lend money on the security of charges on a company’s undertaking are sophisticated operators. There is no reason to suppose this decision lulled them into a false sense of security. Siebe Gorman was a first instance decision. It cannot have been regarded as definitively settling the law in this field” (per Lord Nicholls at para 43).

The final chapter in this long running saga has now been decided in favour of the Crown and other preferential debt holders.[6] The House of Lords rejected the technical legal analysis of bank account arguments in favour of a more pragmatic approach. Borrowers who pay the proceeds of book debts into their bank account expect to be able to draw an equivalent amount out again. In practice they usually can, subject only to their being no special blocked restrictions and to being within their overdraft limit. This means that borrowers, such as Spectrum can use their book debt proceeds in the ordinary course of their business. This makes the charge over those book debts a floating charge. There was some slight regret in the overruling of the 25 year old judgment. This was mainly in deference to the respect in which they held Slade J and his judgments in other cases. (per Lord Hope at para 64). The Court of Appeal’s decision in New Bullas was also overruled and Lord Millett’s judgment in the Privy Council in Re Brumark was adopted.

Conclusions and Why Does it Matter?

To some degree their Lordships seem to be influenced by the purpose of the legislation in favour of preferential creditors giving them priority over floating charge holders. (per Lord Scott at para 98). This was originally introduced in 1897 to meet the problems in the early days of floating charges when holders of a floating charge were able to “sweep off everything” (per Lord Scott at para 97), leaving nothing for the unsecured creditors, particularly employees. If book debts, such as those in Spectrum Plus were subject to a fixed charge, this would leave the preferential creditors often with nothing, thus defeating the priority enjoyed by preferential creditors. According to Lord Scott the definition of a floating charge must keep in mind the mischief that the legislation was intended to meet and that in particular that preferential creditors would have their debts paid in priority to a debenture holder with a (floating) charge over the assets. (at para 98).

The important judgment in Spectrum Plus finally clears up the long debated issue of book debts and the certainty it creates is to be welcomed. The hundreds of outstanding liquidations, administrations and receiverships that have been frozen pending this judgment can now be closed. There have, of course, been many liquidations etc that have long since been closed, the parties having placed reliance on Siebe Gorman. In those cases the book debts would have been treated as a fixed charge and the claims of the preferential creditors would have been defeated. We now know that this is incorrect. There may be the possibility that some preferential creditors may bring an action to regularise their treatment under the law. There may be difficulties with arguments of limitations. It remains to be seen whether anyone will bring a case.

A practical result of Spectrum Plus is that many banks relying on Siebe Gorman type debentures will now find that they have an inferior security than they supposed. This will mean that they will have to re-approach their customers and renegotiate some of the terms of their overdraft facility with their customer. The banks could adopt one or other of the methods described by Lord Hope above. Moreover, they could insist that directors give personal guarantees in order to obtain business loans in the future. This will rob many small and medium enterprises of a valuable form of security. In addition, now that banks have been pushed down the ranking of creditors to be paid out in an insolvency, the banks could demand larger assets before lending money. It may be that charges on book debts will become less used by banks and borrowers and other forms of receivables financing, such as factoring or invoice discounting, will be more commonly deployed. It may also happen that the cost of lending might increase as a result of Spectrum Plus, particularly for borrowers who seek a further loan by way of a floating charge. An increased lending rate will represent the risk premium for what is now a lower form of security.

The removal of the Crown from the list of preferential creditors by the Enterprise Act 2002 has ameliorated some of the distress felt by the banks after Spectrum Plus. Preferential creditors are now only employees who are owed unpaid wages (and even then only up to a maximum of £800 per person), accrued holiday pay owing to employees and unpaid contributions to occupational pension schemes and state pension premiums. To balance that, though, the law has been changed with respect to floating charges created after 15/09/03. By virtue of the Insolvency Act 1986 s.176A, in respect of such charges, a prescribed part of the net floating charge realisations must be made available for creditors generally. If an administrator or liquidator or provisional liquidator or floating charge receiver is appointed, the prescribed part (50% of first £10,000 and 20% thereafter up to a maximum fund of £600,000 for each company) must be ringed-fenced for creditors generally. This will obviously mean less money is available to satisfy the claims of the floating charge holder.

It may be that Spectrum Plus has limited value in that it is a case decided on its own particular facts, i.e. that it refers only to charges on book debts. In this modern age of loan finance for companies, there are many other forms of sophisticated structured types of financing arrangements. Spectrum Plus involved a general charge over all present and future debts, not security over particular contracts of the kind used in asset finance or project finance transactions. The documentation in such cases normally imposes greater controls on the use of the proceeds, but the company is normally given rights over them as well. What Spectrum Plus did not decide is how much control by the chargee is required in order to make the charge a fixed charge. Can we look forward to a new series of cases on this issue?

United Kingdom Journals

Spectrum Plus And Book Debts: The Final Chapter?

James Hanlon

Rob Heywood

Summary

Contents