Don’t bank on it

The ruling by Vice Chancellor Sir Andrew Morritt in Re Spectrum Plusin January this year overturned a conventional wisdom which helped put banks at the front of the queue of creditors in insolvency cases. An appeal has been held and a decision is awaited.

The case has also paralysed the insolvency profession, with practitioners holding up the distribution of funds to creditors while they await the outcome. Apart from the direct impact on the banks, the judgment could have wider implications for the business community should lenders become more reluctant to provide finance for expansion.

At the heart of the issue is the banks’ ability to secure a fixed charge on book debts. Although the Spectrum case was an unpleasant surprise to the banking industry, fixed charges on book debts have been the subject of debate for a quarter of a century.

Book debts – typically income that is awaited from sales – are considered to be part of a company’s standard assets. For many years banks, when lending money to businesses, have taken a fixed charge over their book debts for the sake of their own financial security.

If the company becomes insolvent, a fixed charge gives the bank the right to get paid first, before the insolvency practitioners and the preferential creditors such as the Inland Revenue and Customs & Excise.

The principle of a fixed charge was confirmed in the case of Siebe Gorman & Co Ltd v Barclays Bank Ltd(1979). The terms of its agreement with Barclays insisted that the company paid all its book debts into its Barclays bank account. The company was not allowed to assign them to a third party and, if called upon to do so, had to legally assign them to the bank. However, in the meantime, the company was free to use the money as and when it wished.

The judge ruled that it was possible to create a fixed charge over book debts and the terms of the Barclays agreement had done so.
It is also worth mentioning the case of Keenan Bros (1986).
Here it was decided that the bank did have a fixed charge because the agreement in place required the company to ask permission before withdrawing money from its account. This requirement, said the judge, made it “plain beyond doubt that the charge was fixed”.

For almost two decades the banks have continued to put their faith in the fixed charge and insolvency practitioners have continued to distribute funds giving priority to fixed charge-holders.

Then, in 2001, a decision by the Privy Council in an appeal by the courts in New Zealand sent shockwaves through the financial community in the UK. They could see that the Brumark ruling (Agnew v Commissioner of Inland Revenue (2001)) could have widespread implications in this country. It was only a matter of time
until the principles could be tested in the UK court. This test came in the shape of the Spectrum case earlier this year.

As with Brumark, the judge in Re Spectrum Plus(2004) scrutinised the agreement between the parties. Spectrum, a paint manufacturer, was in a similar position to Siebe Gorman almost a quarter of a century earlier, in that it was required to pay sales income into its account with NatWest, yet was free to make withdrawals as it wished.

The judge began with the definition of a floating charge in the case of Re Yorkshire Woolcombers Association (1903), in which Judge Farwell had ruled that, if the lender was free to do what it wanted with book debts, there could be no fixed charge. The essence of a fixed charge was whether the lender took “possession” of book debts.

This issue of possession raises practical difficulties, as we shall see later.

The judge considered whether both parties intended for book debts to be under the bank’s control and decided that they did not; therefore, the agreement had not created a fixed charge.

As a result of the Spectrum case, insolvency practitioners have temporarily halted the distribution of funds to creditors until the appeal decision is announced.

So what implications is the decision likely to hold for the banks and the wider business community?

The first thing to note is that Spectrum did not question the principle of fixed charges. It certainly did not challenge the decision in the Keenan case, where the charge was considered “plain beyond doubt”, because the bank had to consent to withdrawals.

The argument appears to centre on the very narrow issue of whether the contract leaves the borrower free to use book debts. Until we know otherwise, it would be wise for lenders, in their agreements, to insist that companies have their consent for the use of proceeds – a similar concept to legal assignment and factoring.

However, if the Court of Appeal concerns itself solely with this, there are wider issues which may not be resolved.

At one end of the scale there is the question of whether the whole issue of fixed versus floating charges should be reviewed. After all, the very concept of a current account including an overdraft run within limits is to give businesses the flexibility to withdraw money as and when they require it. It is also hard to imagine that the banks would ever want to have control of a company’s working capital, even if they have an agreement to say so. It may be that a fixed charge consistent with the Brumarkruling is simply unworkable.

At the other end of the scale, there is the possibility of a challenge to the definition of a floating charge given by the judge in Yorkshire Woolcombers. The question of whether ‘possession’ is the essence of a fixed charge is the subject of lively academic debate, on the basis that an equitable fixed charge does not give the right of title or possession.

Clarification of the issues is in the interests of both lenders and borrowers. Without security on book debts, banks could become less willing to lend and businesses may face difficulty in securing funding or may have to pay higher costs to do so. It remains to be seen how these issues will be resolved.

Whatever the Spectrum decision might be, the Crown has said that it will not affect distributions in insolvency cases that
took place before the Brumark ruling on 5 June 2001.

As for the banks, their position is also affected by the Enterprise Act 2002. While they will benefit from the decision by the Crown to give up its preferential creditor status, it also means that any money secured by a floating charge will have to be shared with unsecured creditors.

It also looks as if the concept of floating charges versus fixed charges is here to stay. Section 252 of the Enterprise Act, in making the “prescribed part” of property secured by a floating charge available to unsecured creditors, shows that the law still makes the distinction.

Anthony Elleray QC and Mark Cawson QC are barristers at Exchange Chambers