Floating Charges - a limited safety net?
SOURCE: SCOTTISH BANKER, OCTOBER / NOVEMBER 2005
"Unable to pay its debts" – these are the words that you do NOT want to hear in connection with any of the customers within your portfolio. However, despite all efforts to minimise any potential insolvency risks (such as obtaining a financial reference at the outset, and using well constructed financial covenants combined with effective monitoring), insolvency can occur. So what else can a bank do to minimise its exposure should a customer become insolvent?
A comprehensive security package is important to reduce the credit risk of a bank. Floating charges and fixed securities (e.g. standard securities) are the usual securities obtained. Depending on the quality of the assets secured and assuming that the bank has priority, you would expect a reasonable recovery from the fixed securities. However, if there is a shortfall, the bank would usually have to rely on its floating charge; but, the effectiveness of a floating charge has changed since the implementation of the certain provisions of the Enterprise Act 2002 on 15 September 2003 ("Commencement Date").
Under an "old" floating charge, the holder would usually appoint an administrative receiver who would realise the assets primarily for the benefit of the creditors that appointed the receiver and would have reasonable control over the whole process. However, with a floating charge created after the Commencement Date, the right to appoint an administrative receiver is greatly restricted, and in most cases the holder would only be entitled to appoint an administrator. The administrator has a duty to all creditors and the primary objective of administration is to rescue the company as a going concern. If there is no possibility of the company being rescued, the administrator can realise the property of the company if that will achieve a better result for the company's creditors as a whole (i.e. not just the floating charge holder); and only failing which, can the administrator realise assets to allow a payment to be made to secured or preferential creditors.
All floating charges created after the Commencement Date are restricted so that a certain proportion of the net proceeds realised by the floating charge are ring-fenced for unsecured creditors, and are therefore not available for the charge-holder.
Where possible, a bank should ensure that it retains the benefit of all floating charges created before the Commencement Date as this will enable it to appoint an administrator receiver and recover more cash. When re-financing, you should consider whether the existing security should remain in place with suitable amendments, as opposed to new security being taken. As the amount that can be realised by a new floating charge will be reduced, it will be worth considering whether there are any other assets that can be secured by way of a fixed security (e.g. intellectual property rights).
Inevitably, there will be situations where the bank will have to obtain a floating charge that has been created post the Commencement Date, and in that case, the bank should ensure that the floating charge is created as a "qualifying floating charge" (certain criteria must be met including expressly stating that paragraph 14 of Schedule B1 to the Insolvency Act 1986 applies to the charge). This will allow the charge holder to choose its own administrator rather than allowing the company or its directors to do so (which may provide the bank with slightly more influence over the process).
This is a brief overview on the effectiveness of floating charges and you should always seek specific advice on each transaction.
author: alex innes