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Focus: Insolvency – July 2005

Can you have a fixed charge over book debts? UK book debts decision – implications for Australia

In brief: A House of Lords decision in relation to fixed charge over book debts is an important development that could have implications for Australian insolvency practitioners, particularly those that deal with priorities in voluntary administrations and liquidations. Partners Diccon Loxton(view CV) and Michael Quinlan(view CV) report.

Readers of the Allens Arthur Robinson Annual Review of Insolvency & Restructuring Law will recall last year's decision of the English Court of Appeal in National Westminster Bank Plc v Spectrum Plus Ltd & Ors.1  That decision was some comfort to financiers as it reversed the decision at first instance and affirmed that a fixed charge over book debts was indeed possible, at least where the charge was in the form analysed in the 1979 decision in Siebe Gorman.2 In an appeal, from the English Court of Appeal's decision, the House of Lords has now held that the purported fixed charge over book debts contained in the typical form of an all assets charge used in finance transactions does not create a fixed charge but only 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 it is a very important development that Australian insolvency practitioners need to be aware of, particularly when dealing with priorities in voluntary administrations and in liquidations. Although many charges contain automatic crystallisation clauses under which a floating charge becomes fixed on defined events, 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. Insolvency practitioners therefore need to regularly determine whether a charge is fixed or floating. While the decision is not binding in Australia, the unanimous views of the English House of Lords will obviously carry some weight with Australian courts if they are asked to consider the question.

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The decision

National Westminster Bank plc v Spectrum Plus Limited [2005] UKHL41 was a test case. According to the House of Lords, hundreds of English 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 that was common in England and in Australia, particularly since the decision of Justice Slade in Siebe Gorman. 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 the realisation of the book debts by payment was 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.
  2. To require the proceeds of the book debts to be paid into an account with the chargee, or another party, which may not necessarily be blocked.

The arguments here were that there was a sufficient restriction on the chargor dealing of the proceeds. Once the proceeds were in an account with the chargee, 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 case for a prospective judgment (something that has not been adopted by the High Court of Australia), this was not one.

The issue of whether or not a fixed charge over book debts is possible 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). 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).

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What now?

Unless and until the High Court resolves the question, in response to an insolvency practitioner's application for directions or otherwise, insolvency practitioners will continue to face the difficult task of dealing with the day-to-day challenge of categorising charges over book debts as fixed or floating. Unfortunately, while the position may now be more certain in England, at least in relation to the Siebe Gorman form of charge, that is not yet so here, where the question of whether a charge over book debts that purports to be fixed is in fact fixed or floating remains unclear and an area ripe for disputes. While this is of course good news for Australian lawyers, it is not such good news for financiers and practitioners.

Footnotes
  1. [2004] 1All ER 981 (Chancery); Allens Arthur Robinson Annual Review of Insolvency & Restructuring Law 2004, pages 71-72. 
  2. Siebe Gorman & Co Ltd v Barclays Bank Ltd [1979] 2 Lloyds Reps 142 per Justice Slade. 

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