The nature of security
It is possible to improve the priority of a debt by taking security for it. ‘Security’, in this context, means temporary ownership, possession or other proprietary interest in an asset to ensure that a debt owed is repaid (i.e. collateral for a debt). Be careful not to confuse security for a debt with a ‘debt security’.
The main benefit of taking security is to protect the creditor in the event that the borrower enters into a formal insolvency procedure. It should not normally be necessary to enforce security if the borrower is still able to pay, although in some circumstances enforcing security may be a simpler way of obtaining repayment than suing the borrower.
The following are all forms of security.
- Pledge – With a pledge, the security provider (usually the borrower or occasionally another company in the borrower’s group) gives possession of the asset to the creditor until the debt is paid back. Pawning a watch or an item of jewellery is a form of pledge.
- Lien – With a lien, the creditor retains possession of the asset until the debt is paid back. An example is the mechanic’s lien. This arises by operation of law and allows a mechanic to retain possession of a repaired vehicle until the invoice is paid.
- Mortgage – With a mortgage, the security provider retains possession of the asset but transfers ownership to the creditor. This transfer is subject to the security provider’s right to require the creditor to transfer the asset back to it when the debt is repaid. This right is known as the ‘equity of redemption’. A type of mortgage (known as a charge by way of legal mortgage) is usually taken over land (although, unusually, ownership will remain vested in the security provider in this case).
- Charge – With a charge, as with a mortgage, the security provider retains possession of the asset. However, rather than transferring ownership, a charge simply involves the creation of an equitable proprietary interest in the asset in favour of the creditor.
As well as this equitable proprietary interest, the charging document will give the lender certain contractual rights over the asset – for example to appoint a receiver or administrator to take possession of it and sell it (or, exceptionally, to take possession of it itself to sell), if the debt is not paid back when it should be.
Fixed and floating charges
There are two types of charge: fixed charges and floating charges. From a creditor’s perspective, fixed charges are generally a better form of security, but not all assets are suitable for charging by way of fixed charge.
Fixed charges
A fixed charge is normally taken over assets such as machinery and vehicles. The key element of a fixed charge is that the creditor can control what the security provider can do with the fixed charge assets. This is usually done by the security provider undertaking not to dispose of, or create further charges over, the charged assets without the creditor’s consent. Note that ‘control’ in this context means the borrower can generally still use the asset in the ordinary course of business but is restricted from disposing or charging it.
If the charge becomes enforceable, the creditor will have the ability to appoint a receiver of that asset or to exercise a power of sale of the asset.
Floating charges
It is not always practical for a security provider to undertake not to dispose of its assets. For example, a trading company needs to be able to dispose freely of its stock (i.e. the products it sells).
In that case, a floating charge may be appropriate. A floating charge ‘floats’ over the whole of a class of circulating assets. Whatever assets in that class happen to be owned by the security provider at any given time are subject to the floating charge, and the security provider is free to dispose of the assets as it wishes until ‘crystallisation’.
Crystallisation means that the floating charge stops floating and fixes to the assets in the relevant class which are owned by the security provider at the time of crystallisation. The creditor thus acquires control of those assets and to this extent a crystallised floating charge is like a fixed charge. Crystallisation may occur by operation of law or may be triggered by certain events as contractually agreed between the creditor and security provider. Crystallisation will usually occur when the borrower has breached certain significant terms of the loan agreement (including by reason of its insolvency).
Disadvantages of the floating charge from the creditor’s perspective
- As the security provider has freedom to dispose of the assets in the ordinary course of business, the creditor will not be sure of the value of the secured assets – they might all have been sold before crystallisation occurs.
- A floating charge generally ranks below a fixed charge (and note that crystallisation does not change that) and below preferential creditors on the winding-up of the company. However, if the floating charge document contained a term prohibiting the creation of a later fixed charge (a ‘negative pledge’ clause) but the company nevertheless created a later fixed charge, the floating charge will have priority if the later fixed charge holder had notice of this restriction.
- Floating charges created on or after 15 September 2003 are subject to a part of the proceeds of the assets being set aside. This is known as the ‘prescribed part fund’ for unsecured creditors.
- Floating charges are capable of being avoided under s.245 Insolvency Act 1986.
- An administrator is free to deal with floating charge assets in his control without reference to the charge holder or the court and to pay his remuneration and expenses out of the proceeds of those assets.
Guarantees
Strictly speaking, guarantees are not security, as guarantees do not give rights in assets. However, as their commercial effect is similar to security, security and guarantees tend to be treated together.
A guarantee for a loan means an agreement that the guarantor will pay the borrower’s debt if the borrower fails to do so.
Guarantees can come from companies or individuals (such as directors).
Consider the basic example of a group of three companies; A, B and C, where B and C are subsidiaries of A. A guarantee given by A of a loan made to B is a downstream guarantee. A guarantee given by B of a loan made to A is an upstream guarantee. A guarantee given by B of a loan made to C is a cross-stream guarantee.
Debentures
The word ‘debenture’ has two different meanings. Under s.738 Companies Act 2006 (CA 2006), it has a wide definition covering any form of debt security issued by a company.
However, when the term is used in this course and by bankers and debt financiers, they usually mean the document creating security (normally a collection of mortgages and fixed and floating charges over all the borrower’s assets). This document should be separate from the document creating the loan facility itself (which is usually referred to as a ‘loan agreement’, ‘credit agreement’ or ‘facility agreement’).
Whilst this may seem confusing, the context should clarify which definition is appropriate.
Examples of securities
Fixed charge
Bigbank plc has made a loan of £100,000 to Blue Moon Limited to facilitate the purchase of machinery. The loan has to be repaid over a period of five years. Blue Moon has given a fixed charge over its machinery to Bigbank.
Effect on Blue Moon
Blue Moon cannot sell the machinery or charge it to another bank without Bigbank’s consent. It can continue to use the machinery for its business as it retains possession.
Effect on Bigbank
Bigbank has rights in the machinery. If the loan is not repaid, Bigbank can appoint a receiver to sell the machinery (or, exceptionally, may itself sell the machinery) and must apply the sale proceeds to satisfy the unpaid debt.
Floating charge
Floyds Bank is the clearing bank for Blue Moon Limited, operating the company’s current account and has also provided a loan facility of £50,000 which is currently fully borrowed. To secure all monies due, Floyds Bank has a floating charge over all the assets of Blue Moon present and future.
Effect on Blue Moon
Blue Moon can continue to deal with its assets in the ordinary course of its business until such time as the floating charge crystallises.
Effect on Floyds Bank
Floyds Bank has rights in the assets, but cannot exercise control over them. If Blue Moon defaults on the loan, then Floyds Bank can crystallise the floating charge. This will give Floyds Bank control over the assets and allow it to recover its money by appointing an administrator (or exceptionally exercising its power of sale over them).
Guarantees
Northshire Bank is intending to lend £20,000 to 3dGraph Limited. 3dGraph was recently incorporated by Brian Jones to market 3d printing software which he designs. The money is to be used to purchase computer hardware which will be used in software design. The bank will be granted a fixed charge over this hardware. However, the bank is concerned that the value of the hardware might depreciate rapidly, leaving it exposed. Brian is the majority shareholder in the company and is its managing director.
As the company is newly incorporated, it may not have substantial assets. The asset over which Northshire Bank has a fixed charge is likely to quickly lose its value. Northshire Bank could take security over future assets, but this will only be useful if 3dGraph acquires valuable assets. Northshire Bank could also look to take a personal guarantee from Brian Jones if he has valuable assets. If the company defaulted, Northshire Bank could call on the guarantee and, if Brian refused to pay, sue him for the money. Brian may also give security for the loan (e.g. by granting a mortgage over his home, subject to any rights of any other person living there with him).
Lending money to a company – a typical package
Southern Bank plc has been asked to provide finance for a new company called Workskill Videos Limited (‘WV’). It is 100% owned by Workskill Training plc, the holding company for a very successful group of companies dealing in areas such as the training of various groups of professionals in personal skills. WV is seeking £200,000 to finance the purchase of a studio, editing suite and miscellaneous video equipment.
Southern could look to take a fixed charge over (amongst other assets) the new and future equipment and a floating charge over all other assets of WV. This is a typical security package. It would be documented in a debenture. In addition, the bank may want to take a guarantee from the parent company (Workskill Training plc). The guarantor may also grant security. In this case, such security might take the form of a fixed charge over Workskill Training plc’s shares in WV, allowing Southern to enforce its security through the sale of WV if both WV and Workskill Training defaulted.