Skip to content.

Home

Allens Arthur Robinson

Focus: Banking & Finance – July 2005

House of Lords makes life more difficult for fixed charges over book debts

In brief: The House of Lords has held that the purported fixed charge over book debts contained in the typical form of all assets charge used in finance transactions only gives rise to a floating charge (at least where the chargee does not take control of the proceeds). The decision may or may not be followed in Australia, but parties should examine their security on the assumption that it is.

Having a fixed charge over book debts is particularly important in the context of cash flow lending, project finance and LBOs. The reason for this is that floating charges can rank after other creditors. Some of these issues are mitigated by automatic crystallisation clauses under which a floating charge becomes fixed on defined events, but if a charge is not fixed from the beginning it will still rank after preferential claims such as employees, and after a voluntary administrator's lien.

National Westminster Bank plc v Spectrum Plus Limited [2005] UKHL41 was a test case. According to the House of Lords, hundreds of insolvency administrations were waiting for the outcome. It involved the ranking of claims between a bank claiming a fixed charge over book debts, and preferential creditors. The fixed and floating charge document was in a form which was common in England, and in Australia, particularly since the decision of Justice Slade in Siebe Gorman v Barclays Bank Ltd [1979] 2 Lloyd's Rep 142. It provided that there was a 'specific charge' over book debts, and that the proceeds must be paid into the mortgagor's account with the bank.

Siebe Gorman had decided that such a charge was a fixed charge. The general notion has been that in order to have a fixed charge over book debts, there must be some restriction on the use of the proceeds, for example, a payment into a blocked account. Though the judgment on this point is brief, Justice Slade apparently decided that the requirement that it be paid into an account with the bank was a sufficient block.

The notion arose because of the classic statements of what is a floating charge, by Lord Romer in In re Yorkshire Woolcombers Association Ltd [1903] 2 Ch 284 at 285 and by Lord MacNaghten in Illingworth v Houldsworth [1904] AC 355 at 358, that the nature of a floating charge was one where the chargor was left free to deal with the assets.

While a chargee wants a fixed charge over book debts, a chargor needs to be able to have access to its cash flow, for its ongoing business. Two mechanisms have been used to achieve this:

  1. To identify two distinct assets: the 'tree' – the book debt – and the 'fruit' – the proceeds.

    Charges are often drafted to recognise the distinction: preventing dealing with the book debts, and providing that it is fixed over the book debts, but floating over the proceeds. This approach was supported in an English Court of Appeal case, In re New Bullas Trading Ltd [1994] 1 BCLC 485, but was not followed in a Privy Council case on appeal from New Zealand, Agnew v Commissioner of Income Tax [2001] 2 AC 710 (also known as the Brumark Case). In that case, the Privy Council held that if the charge is floating over proceeds it is floating over book debts. They said that the realisation of the book debts by payment is a method of dealing with them; the charge over the book debts is worthless without the proceeds; and because the chargor is free to deal with the proceeds, it is effectively free to deal with the book debts and therefore the charge is floating.
  1. To require the proceeds of the book debts to be paid into an account with the chargor, or another party, which may not necessarily be blocked.

    The arguments here were that there was a sufficient restriction on the chargor dealing with the proceeds. Once the proceeds were in an account with the chargor, their nature changed. If the account was in credit, they were replaced by a debt owing by the bank to the chargor. If the account was in debit, they disappeared entirely. That was consistent with the Siebe Gorman case. It was the reasoning that persuaded the English Court of Appeal in Spectrum Plus to decide that the charge was fixed.

That approach did not find favour with the House of Lords. Because of the practical importance of the issue, seven Law Lords heard the appeal. Unanimously they decided that the charge was floating.

In that case, the account was a current account. The Lords pointed out that contractually, if the account was in credit, the chargor/customer was entitled, at any stage, to draw the money out. If it was in debit as an overdraft account, contractually, the chargor/customer was entitled to redraw funds up to the overdraft limit. The chargor, therefore, was still able to have access to the proceeds.

If book debts were dealt with by realising them, the chargor remained free to deal with the proceeds, therefore it was still a floating charge.

The Lords were unanimously of the view that there could be a fixed charge over book debts, but they gave little guidance as to what would achieve it. It appears clear that there would need to be a blocked account with a real block – a restriction on the ability of the chargor to draw money out of the account. Some requirement of consent by the chargee for each payment would be sufficient, but whether, and to what extent, some lesser control would be sufficient is not clear. Lord Walker cast doubt on one suggestion in the Court of Appeal judgment that the bank could require the chargor to pay the proceeds into one (blocked) account, and then allow it to draw money out of another account that could be set off against the credit account to which the proceeds were paid.

The judgment is marked by an antipathy (particularly from Lord Walker) to a charge (despite statutory changes) being a method by which secured creditors could 'sweep away' all assets, including those that were really circulating assets, to the detriment of preferential creditors.

Interestingly, the Law Lords were asked by the bank to rule prospectively, that is, to allow the law up to the date of the judgment to remain as it was understood following Siebe Gorman, and only change the law with effect after the date of the judgment. While the House of Lords did not rule out the possibility that there might be a case for a prospective judgment (something that has not been adopted by the High Court of Australia), this was not one.

There are, as yet, no indications as to whether the Australian courts will adopt the attitude taken by the House of Lords and Privy Council, which ignore the distinction between book debts and their proceeds, and disregard the fact that the proceeds disappear and become some other form of property. It may be that, with its more critical and analytical approach, the High Court will come to a different conclusion. The analogous distinction between the fruit and the trees was promoted by the High Court in cases on equitable assignment (see Justice Kitto in Shepherd's case (1965) 113 CLR 385 at 396).

In the meantime there remain some practical and technical questions.

  1. In project financing and in some LBOs, there is a requirement for funds to be paid into a proceeds account and then to be paid out in a waterfall, but unless an event of default occurs, the borrower is usually free to pay operating expenses out of the account. That waterfall is a further restriction of sorts on the operation of the proceeds account, but if the logic of the House of Lords is followed it may not be a sufficient restriction to constitute the charge over the book debts as a fixed charge. There may need to be further restrictions, and tighter controls giving the security trustee/agent/bank day-to-day power to control payment out of the account. That may not be practicable or financially achievable.
  2. What is a book debt in the circumstances? It is quite common, particularly in project financing, for there to be one or more contracts under which the project earns its revenue. There would normally be little doubt that a bank could have a fixed charge over such a contract, but that contract contains payment obligations. It is not clear at what stage, if at all, the rights to payment under the contract would be treated as book debts, and cease to be subject to a fixed charge, or whether the reasoning of the decision would infect the nature of the charge over payment rights under the contract, and so it would just float.
  3. When do proceeds cease to be proceeds? It appears that the House of Lords still thought that the chargor was able to deal with the proceeds, despite the fact that the proceeds became another asset if there was a credit balance in the account (that is, a debt of the bank) or were used to pay off the borrower's debt (if the account was in debit). We can speculate how far this ability to 'trace' the proceeds ends. For instance, presumably if the chargor were required to expend the funds in the acquisition of a fixed asset, then there would be a fixed charge. However, if it was required or allowed to spend it in acquisition of a circulating asset, if you take the logic to its end, it may be still be a floating charge.

The issue is yet to be conclusively decided in Australia – the most germane judgment was only at first instance but did support the New Bullas approach (Whitton v ACN 003 266 886 P/L (1996) 14 ACLC 1799). The High Court may differ from the House of Lords, but until they address the question it would be desirable at least to adopt both steps described above to try to have a fixed charge over the book debts. However, you would need to recognise that on its own this may not be successful. To be sure you have an effective fixed charge over book debts, you would need to create a block on the use of the account into which the proceeds are paid, but this may pose unacceptable practical difficulties, and the risk of particular arrangements exposing the bank to 'shadow director' liabilities would need to be considered.

Return to top

For further information, please contact:

Return to top

Share with

What are these?

 

 

Recent Banking & Finance publications