Business finance - Types of security (fixed and floating charges)

Learning Outcomes

This article examines the principal types of security a company can grant over its assets: fixed and floating charges. It outlines their characteristics, the process for their creation and registration, and their implications, particularly in insolvency scenarios. After reading this article, you should be able to distinguish between fixed and floating charges, understand the concept of crystallisation, appreciate the importance of registration under the Companies Act 2006, and identify the priority of these charges during a company's liquidation according to the Insolvency Act 1986. This knowledge is essential for advising on secured lending transactions in business law practice.

SQE1 Syllabus

For SQE1, you are required to understand the practical implications of different types of security used in business finance. This involves advising on the creation, perfection, and enforcement of fixed and floating charges, and their respective priorities in insolvency.

As you work through this article, remember to pay particular attention in your revision to:

• the distinction between fixed and floating charges and their attachment to company assets
• the legal requirements for creating and registering charges at Companies House under the Companies Act 2006
• the concept of crystallisation of floating charges and its consequences
• the order of priority for distributing assets to secured creditors upon a company's insolvency, including the effect of the prescribed part for unsecured creditors
• the purpose and effect of a negative pledge clause.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which type of charge typically allows a company more freedom to deal with the charged assets in the ordinary course of business?
   1. Fixed charge
   2. Floating charge
   3. Legal mortgage
   4. Equitable charge
2. What is the time limit for registering a charge created by a UK company at Companies House?
   1. 14 days
   2. 21 days
   3. 28 days
   4. No time limit
3. What event typically causes a floating charge to become fixed on the assets it covers?
   1. Creation of the charge
   2. Registration of the charge
   3. Crystallisation
   4. Repayment of the loan
4. In a company liquidation, which type of charge generally ranks higher in priority for repayment from the proceeds of the specific charged asset?
   1. Floating charge
   2. Fixed charge
   3. Unsecured loan
   4. Preferential debts

Introduction

When a company borrows money, particularly substantial amounts, the lender will often require security for the loan. Security provides the lender with rights over certain company assets, reducing the lender's risk if the company defaults on repayment or becomes insolvent. The two main types of security granted by companies over their assets are fixed charges and floating charges. Understanding their characteristics, creation, registration, and priority is essential for business law practitioners advising either lenders or borrowers. These forms of security have significant implications for the company's ability to deal with its assets and for the distribution of assets upon insolvency.

Fixed Charges

A fixed charge attaches to specific, identifiable assets owned by the company. These assets are typically tangible and relatively permanent, such as land, buildings, heavy machinery, or specific intellectual property rights like registered trademarks or patents.

Key Term: Fixed charge
A security interest granted over specific, ascertainable assets of a company. The company cannot deal with (e.g., sell or grant further charges over) the charged asset without the charge holder's consent.

The key feature of a fixed charge is the control it gives the charge holder (the lender) over the specific asset. The company (the chargor) retains ownership and possession but loses the freedom to dispose of or otherwise deal with the asset in the ordinary course of business without the lender's permission. This lack of flexibility is a disadvantage for the company but provides strong security for the lender.

If the company defaults on the loan, the fixed charge holder has the right to take possession of the charged asset and sell it, using the proceeds to satisfy the debt owed. In an insolvency situation, the holder of a registered fixed charge has a high priority claim over the proceeds of sale of that specific asset, ranking ahead of floating charge holders and unsecured creditors.

Floating Charges

A floating charge is granted over a class of assets, both present and future, which may fluctuate in the ordinary course of the company's business. Examples include stock-in-trade, raw materials, cash at bank, and book debts (receivables).

Key Term: Floating charge
A security interest granted over a class of present and future company assets which, in the ordinary course of business, the company is free to deal with until crystallisation.

The defining characteristic of a floating charge is the company's freedom to deal with the assets within the charged class without needing the charge holder's consent. For example, a company can sell its stock, collect its debts, and use cash from its bank account as part of its normal trading activities. This flexibility is essential for the company's operations but presents a greater risk for the lender compared to a fixed charge, as the value and composition of the asset pool can change.

The floating charge 'floats' or 'hovers' over the identified class of assets until a specific event occurs which causes it to 'fix' or attach to the assets within that class as they exist at that moment. This process is known as crystallisation.

Key Term: Crystallisation
The event upon which a floating charge ceases to 'float' and attaches ('fixes') to the specific assets within the charged class at that time, restricting the company's ability to deal with them.

Crystallisation typically occurs upon:

• The company going into liquidation or administration.
• The appointment of a receiver.
• The company ceasing to trade.
• Any other event specified in the charge document (the debenture).

Once crystallisation occurs, the floating charge effectively becomes a fixed charge over the assets then present in the class, and the company can no longer deal with them freely.

Worked Example 1.1

Innovate Ltd, a manufacturing company, grants a floating charge over its stock to SecureBank plc. The charge document states crystallisation will occur if Innovate Ltd defaults on loan repayments. Innovate Ltd sells finished goods from its stock daily. It then defaults on a loan repayment. What is the effect on the stock?

Answer: Before the default, Innovate Ltd could freely sell its stock as part of its business. The default is a crystallisation event specified in the charge document. Upon default, the floating charge crystallises and becomes a fixed charge attaching to the stock held by Innovate Ltd at that precise moment. Innovate Ltd can no longer sell that stock without SecureBank plc's consent.

Creation and Registration of Charges

Both fixed and floating charges are typically created by deed, often contained within a document called a debenture.

Key Term: Debenture
A document issued by a company evidencing a debt, which often includes provisions creating fixed and/or floating charges over the company's assets as security for that debt.

For a charge created by a UK company to be valid against liquidators, administrators, and other creditors, it must be registered at Companies House. Section 859A of the Companies Act 2006 (CA 2006) requires that particulars of the charge, along with a certified copy of the instrument creating it (if any), must be delivered to the Registrar of Companies within 21 days beginning with the day after the date the charge is created.

Key Term: Registration of charges
The process of filing particulars of a charge created by a company, together with the charging instrument, at Companies House within a statutory time limit (usually 21 days) to ensure its validity against third parties in insolvency.

Consequences of Non-Registration

Failure to register a charge within the 21-day period has severe consequences under s 859H CA 2006:

• The charge becomes void against any liquidator, administrator, or creditor of the company.
• The security conferred by the charge is lost, meaning the lender becomes an unsecured creditor in relation to that debt.
• The money secured by the charge becomes immediately payable by the company.

Worked Example 1.2

BuildCo Ltd creates a fixed charge over its main office building in favour of Lender A on 1st March. On 10th March, it creates a floating charge over its stock in favour of Lender B. Lender A registers its charge on 25th March. Lender B registers its charge on 15th March. BuildCo Ltd goes into liquidation in June. What is the status of the charges?

Answer: Lender B registered its floating charge within the 21-day limit (15th March is within 21 days of 10th March). Lender A failed to register its fixed charge within the 21-day limit (25th March is more than 21 days after 1st March). Therefore, Lender A's fixed charge is void against the liquidator and other creditors. Lender A becomes an unsecured creditor. Lender B's floating charge is valid (assuming it met all other requirements).

Negative Pledge Clauses

Lenders taking a floating charge often seek to protect their position against subsequent fixed charges by including a negative pledge clause in the debenture.

Key Term: Negative Pledge Clause
A contractual clause in a floating charge document prohibiting the company from creating subsequent charges (especially fixed charges or other floating charges ranking equally or ahead) over the same assets without the floating charge holder's consent.

A negative pledge clause does not prevent the company from creating a later charge in breach of the clause. However, if the holder of the later charge (e.g., a fixed charge) had actual notice of the negative pledge clause when they took their charge, their charge will rank behind the floating charge, despite the usual priority rules. Constructive notice (e.g., simply because the floating charge containing the clause was registered) is generally not sufficient; actual knowledge is required. Registration of the charge document containing the negative pledge at Companies House makes it highly likely a subsequent lender conducting proper due diligence will have actual notice.

Priority of Charges in Insolvency

The ranking of charges is critical when a company becomes insolvent, as it dictates the order in which creditors are paid from the proceeds of realised assets.

General Order of Priority:

1. Fixed Charges: Holders of validly registered fixed charges are paid first from the proceeds of the specific assets over which their charge is held.
2. Expenses of Insolvency: The costs and fees of the liquidator or administrator.
3. Preferential Creditors: Certain debts have statutory priority, including some employee entitlements (wages up to a limit, holiday pay) and certain sums due to HMRC (from December 2020).
4. Prescribed Part: A portion of the assets subject to floating charges set aside for unsecured creditors (see below).
5. Floating Charges: Holders of validly registered floating charges are paid from the remaining assets subject to their charge, after the prescribed part is deducted. Charges rank in order of creation date, subject to registration and any subordination agreements or negative pledge effects.
6. Unsecured Creditors: Paid from any remaining funds, including the prescribed part. They rank equally amongst themselves (pari passu).
7. Shareholders: Receive any surplus after all other creditors are paid in full (rare in insolvency).

The Prescribed Part

Section 176A of the Insolvency Act 1986 requires a liquidator or administrator to set aside a 'prescribed part' of the company's net property (assets subject to floating charges, after costs of realisation and preferential debts) for the benefit of unsecured creditors. This fund is calculated as:

• 50% of the first £10,000 of net property available to floating charge holders; plus
• 20% of the net property above £10,000. This is subject to a maximum cap (currently £800,000 for charges created on or after 6 April 2020). The prescribed part is paid to unsecured creditors before the floating charge holder receives payment from the remaining funds covered by their charge.

Key Term: Prescribed Part
A statutory fund carved out from assets subject to a floating charge in an insolvency, set aside for the benefit of unsecured creditors before the floating charge holder is paid.

Worked Example 1.3

Construct PLC is in liquidation. After paying insolvency expenses and preferential creditors, £100,000 remains available from assets covered only by a floating charge created in 2021. How much will be set aside as the prescribed part for unsecured creditors?

Answer:

• 50% of the first £10,000 = £5,000
• 20% of the remaining £90,000 (£100,000 - £10,000) = £18,000
• Total prescribed part = £5,000 + £18,000 = £23,000. This £23,000 will be made available to unsecured creditors. The floating charge holder will receive the remaining £77,000 (£100,000 - £23,000).

Avoidance of Floating Charges

Under Section 245 of the Insolvency Act 1986, a floating charge created within a certain period before the onset of insolvency may be invalid, except to the extent of any new money or value provided to the company at the time of, or after, the charge's creation. This prevents companies granting floating charges to secure past debts shortly before insolvency, potentially preferring one creditor over others.

The relevant time period ('hardening period') is:

• 2 years ending with the onset of insolvency if the charge was granted to a person connected with the company (e.g., a director).
• 12 months ending with the onset of insolvency if the charge was granted to an unconnected person.

For unconnected persons, the company must also have been insolvent at the time the charge was created, or become insolvent as a result of the transaction creating the charge. This insolvency requirement does not apply to charges granted to connected persons.

Summary

Fixed vs Floating Charges

Key Point Checklist

This article has covered the following key knowledge points:

• Fixed charges attach to specific assets, restricting the company's ability to deal with them, while floating charges cover a class of changing assets, allowing the company operational freedom until crystallisation.
• Crystallisation converts a floating charge into a fixed charge, typically upon insolvency events.
• Both fixed and floating charges must be registered at Companies House within 21 days of creation under the Companies Act 2006 to be valid against liquidators, administrators, and other creditors.
• Failure to register a charge within the time limit renders it void against these parties, and the secured debt becomes immediately payable.
• In insolvency, fixed charges generally have priority over floating charges regarding the specific assets charged.
• Floating charge proceeds are subject to deductions for insolvency expenses, preferential debts, and the 'prescribed part' set aside for unsecured creditors before the floating charge holder is paid.
• A negative pledge clause in a floating charge can affect the priority of subsequent charges if the later charge holder has actual notice.
• Floating charges created shortly before insolvency for past debt may be invalidated under s 245 Insolvency Act 1986.

Key Terms and Concepts

• Fixed charge
• Floating charge
• Crystallisation
• Debenture
• Registration of charges
• Negative Pledge Clause
• Prescribed Part