Security is rarely the most exciting aspect of a banking transaction and will not generally be the most important point for discussion at the term sheet stage. However, for both sides, once it is agreed that security will be provided for a loan, it is important that the differences between fixed and floating security are understood and the risk of a fixed charge being re-characterised as a floating charge is adequately mitigated.
Fixed – floating – what’s the difference?
A fixed charge will attach itself to an asset from the point of creation whereas a floating charge will “float” above a changing pool of assets until a specific event occurs (when it will attach).
At the point of creation a floating charge should contemplate that until some future trigger event occurs (ie, insolvency or a default under the loan), the borrower will carry on its business in an ordinary way, including disposing of assets which are subject to the floating charge.
Floating charges therefore allow the borrower a greater degree of freedom on the one hand but potentially leave a lender exposed as recoveries for a floating charge holder may be significantly less than a fixed charge holder.
On a borrower's insolvency, a fixed charge holder will get paid out of the proceeds of sale of the assets subject to the fixed charge before all other creditors (including preferential creditors such as employees and occupational pension schemes).
However, a floating charge holder (which includes the holder of a re-characterised fixed charge – see below) is only paid out once the following have been satisfied:
- Holders of fixed charges
- Preferential creditors
- Expenses of the insolvent estate
For certain floating charges there may also be a percentage based ring-fenced amount for the benefit of unsecured creditors.
It’s all about control
For understandable reasons, a lender will generally want to take a fixed charge over all the assets of a borrower. However, no matter what the lender and borrower agree in writing, if the lender does not in fact have sufficient control over an asset which is expressed to be subject to a fixed charge then a fixed charge runs the risk of being re-characterised as a floating charge.
For many fixed and immovable assets such as real property, plant and machinery there is a low risk of re-characterisation as generally these assets will not be subject to disposal during the life of the loan (and are often fixed to the ground). These are ideal candidates for fixed charges. However, contracts, balances on bank accounts, receivables, stock and inventory all run the risk of re-characterisation as they are a class of asset where the actual assets within the pool may be changing over time as part of the borrower’s everyday business activities.
At the point it matters (insolvency of a borrower), whether a lender has a fixed or floating charge will be assessed by reference to the facts of how the lender and the borrower have dealt with the assets between them over time. So, even where a borrower agrees to grant a fixed charge over bank accounts or stock, if the bank is not in day to day control of the assets or balances (for example giving permission for disposals of stock or withdrawals of cash) then it is likely that the charge will be treated as floating and the lenders’ entitlement to recoveries from such assets adjusted accordingly.
David Varnham recently joined Mills & Reeve to lead our banking team in Birmingham. David moved from the banking team of Allen & Overy LLP where he spent over 10 years.