THE LENDERS’ APPROACH TOWARDS FLOATING CHARGE AS A SECURITY DEVICE: AN ENGLISH LAW PERSPECTIVE
[Oiswarjya Basu is a lecturer at Jindal Global Law School, Sonipat]
English law broadly recognises four types of security interest: mortgages, charges, pledges and liens. Charges are an equitable proprietary security interest and in the commercial world, possibly the most common one. A charge is created when parties agree that certain property or assets belonging to the debtor or a third party-party guarantor will be appropriated to the discharge of the debt or other obligation when the occasion arises (e.g. the machinery in a factory may be charged in favour of repayment of the loan that funded its purchase, or, alternatively, a loan granted for an entirely separate purpose). In other words, a company that has borrowed monies from say, a financial institution shall have to provide security of its assets and may create a lien on the properties of the company equivalent to the sum borrowed. The company may alternatively choose to issue debentures to raise funds which may give rise to a right in favour of the lender onto the assets of the company. A charge is, thus, the interest or right created for the lender and extended by the borrower symbolizing that the latter’s properties are secured as collateral for the amounts payable to the former. There can be two distinct types of charges – fixed and floating.
If a debt is subject to a fixed charge, the borrowing will be secured against a substantial and identifiable ‘fixed’ asset. Such assets are often immovable ones like land, plant and machinery but they also may be intangible assets like copyrights and trademarks. The charge is simply a right of the lender created over the said fixed asset. In a scenario where the borrowing company defaults in making timely payments or deviates from the terms of the finance agreement, the lender will take charge of the asset and even sell it in order to recover the sum owed. However, it is pertinent to note, that a charge does not confer any right of possession over the secured asset, as clarified by the landmark judgment in Bank of Credit and Commerce International SA (No 8)  AC 214.
A floating charge is conferred upon to assets with a quantity and value that can fluctuate from time to time, such as stock and inventory, trade debtors and movable machinery. A distinct quality of the floating charge is that the company can continue to use the assets and can buy and sell them in the ordinary course of business. It gives the borrowing business much more freedom than a fixed charge because the business can sell, transfer or dispose of those assets without seeking fresh approval from the lender or having to repay the debt first. Moreover, it creates an equitable interest over a class of assets, both past and future.
Floating charges essentially hover above changing assets and transform into fixed charges through a process known as ‘crystallisation’, in the following circumstances: a) The company has defaulted on the repayment and the lender takes action to recover the debt; b) The company is about to be wound up; c) The company has appointed the receiver and d) The company will cease to exist in the foreseeable future.
Why is Floating Charge dubbed the inferior charge?
Prof. Alan Dignam has, time and again, poignantly remarked that a floating charge makes for a less secure type of lending because the lender has no way of knowing whether the assets left in the stockroom when the charge 'crystallises' will even cover the debt owed. In the words of Prof. Paul Davies, “the company may dissipate the assets subject to the charge, arguably the most serious risk that the charge holder faces.” It is pertinent to note that while a floating charge is attractive to a borrower as it allows a company to be leveraged without a specific asset, this often backfires for the chargor as its money. Furthermore, when company goes into liquidation, floating charge can be more easily set aside compared to a fixed charge by virtue of Section 245 of the Insolvency Act, 1986 which states that a charge created 12 months before the insolvency procedures started is summarily invalid.
Another major downside of floating charge is its considerably low ranking compared to the fixed charge in the insolvency ‘waterfall’ structure. This is to say, that if a floating charge and a fixed charge are respectively held over the same asset, the fixed charge will have a higher priority and shall allow the lender with a fixed charge to recover its money first. In the case of floating charge, creditors need to wait before it can try to recoup its stake. While this incentivises a debtor, it is known to make a creditor more cautious when lending the money protected by a floating charge. Under Chapter VIII of the Insolvency Act 1986, the Order of Priority for repayment in insolvency proceedings stands as follows: (a) The liquidator’s fees and expenses; (b) Secured creditors with a fixed charge; (c) Preferential creditors (typically employees with wage arrears); (d) Secured creditors with a floating charge; (e) Unsecured creditors.
This only emphasizes the fact that fixed charge holders, preferential creditors such as employees as well as the insolvency practitioner come before floating charge holders in line for repayment after sale of the borrower’s assets. It so happens that when the turn of floating charge holders does come, there may not be enough funds remaining to indemnify their debts entirely or at all. Furthermore, the company may issue a subsequent floating charge and thus, the first floating charge will be deferred to later fixed or floating charges which are not over the same assets. This is the modern practice despite the judgement in Griffiths v Yorkshire Bank plc  1 WLR 1427 wherein the Court held that crystallization of a later floating charge had priority.
In the paper, ‘The Floating Charge – An Elegy’, Prof. Rizwaan Mokal address another exasperating problem of floating charge that, “at the very least, a secured creditor would wish to be able to tell how much collateral it had been offered in order to carry out a risk assessment on the loan. However, creation of subsequent fixed charges and the accumulation of new preferential claims can dilute the floating charge holder’s security, as can the debtor’s ability to alienate the collateral free of the charge. So the floating charge holder cannot even know which assets it has security over, and how much they are worth!”
Lastly, another administrative burden for a lender is that he must ensure that their floating charge is promptly registered according to the procedure stipulated in Companies Act 2006. Failure to register leads to the charge being invalidated. While all floating charge must be registered, only a handful forms of the fixed charge are required to be registered under English Law. The first registered charge is ranked higher to the second and so forth. This too places a burden on the lender to control the borrower regarding registration of the charge and conduct independent research to ensure that the same asset has not been already registered with another lender. Unregistered charges make the lenders completely unsecured and can cost them their entire sum of lending.
Are there any advantages of Floating Charge for lenders?
The prospects of floating charge are not all bleak. There are a few incentives to prefer a floating charge over fixed charge. For instance, small companies often do not own enough fixed assets to hold as security. In these circumstances, floating charge may all they have to secure a loan from a lending institution. Moreover, floating charge holders may have better chances of protecting themselves against other lenders using negative pledges.
Furthermore, floating charge holders are able to enforce the charge at will which gives the lending institution some control over the borrowing company. For small companies, the impact of the floating charge holder enforcing their rights would result in cessation of business if the charge crystallises into a fixed charge. Hence, small companies demonstrate a stimulus to keep the floating charge holders satisfied. Lastly, the power to appoint an administrative receiver bypassing the appointment of an administrator if the company becomes insolvent proves advantageous for floating charge holders as liquidations will ensure maximum return to them.
In the light of the discussions above, it is fair to ascertain that floating charge is not as satisfactory for lenders when compared to fixed charge. Floating charge can be beneficial in certain ways but the advantages are heavily lop-sided in the favour of borrowers. It often fails to meet the ordinary expectation of a secured creditor to have adequate security over its lending. Thus, under the English Law, floating charge is known to largely demonstrate a paradoxical effect in terms of statutory interventions as well as general utility for lenders.