When a borrower is granted a loan from a bank, the bank will often want security for the loan it makes. Taking effective security over an asset means that the bank can, on the insolvency of the borrower, take possession of that asset, sell it and use the proceeds to repay the loan. This puts the bank in a stronger position than creditors who do not have security.
Depending on the circumstances, the bank has the option of taking security over specific assets of the company or over all the assets of the company. If the bank chooses to do the latter a debenture will be used to create fixed and floating charges over all the property and assets of the company.
Under English law there are several types of security interest which are favoured by banks. This Guide will look at what these involve, along with their advantages and disadvantages.
Under a mortgage, ownership of an asset is transferred (by way of security for the loan) on the express or implied condition that it will be returned when the loan is repaid. What distinguishes a mortgage from an outright sale with a right of repurchase is that the transfer is only intended to secure the repayment of the debt. Transferring ownership enhances the lender's ability to sell the asset and receive cash in return if necessary, and prevents the borrower from disposing of the asset. A mortgage does not require the delivery of possession and so any kind of asset whether tangible (such as houses, ships or planes) or intangible (such as copyrights or patents) is capable of being mortgaged.
A mortgage can be legal or equitable. Under a legal mortgage, legal ownership of the property is transferred to the lender. An equitable mortgage is usually created where either a transaction does not meet the formal requirements of a legal mortgage but is recognised in equity (for example, a mortgage over property which the mortgagor does not yet own – a legal mortgage can only be created over property which exists at the time); or where the mortgage concerns property only recognised in equity (for example, an interest in a trust fund – a legal mortgage cannot be taken over property which is only recognised in equity).
Legal mortgage: This is the most secure and comprehensive form of security interest. As we have seen, it transfers ownership to the bank (the mortgagee) and so prevents the borrower (the mortgagor) from dealing with the mortgaged asset whilst it is subject to the mortgage. The formalities required for creating a legal mortgage depend on the type of property being secured, but include:
- the creation of a legal mortgage over land, which must be done by deed;
- a legal mortgage over debts or choses in action - rights under contracts – which is created by an absolute assignment, in writing, by the assignor which is not intended to be by way of charge. Written notice of this assignment must be given to the debtor, trustee or other person from whom the assignor would have been entitled to claim the debt or choses in action;
- legal mortgages over chattels – personal property – which do not generally require any formalities to make them effective providing that there is a valid agreement and the intention to create a legal mortgage;
- a legal mortgage over registered securities which is created by transferring those securities into the name of the mortgagee by novation – in essence, a new contract. The mortgagee should be registered as the new holder of those securities;
- a legal mortgage of registrable intellectual property rights, which is created by entry of the details of the mortgage into the relevant register.
A legal mortgage transfers ownership of the asset to the mortgagee so it cannot be sold to a third party without the mortgage being released and ownership being transferred back to the mortgagor. Alternatively the purchaser can agree to acquire the property subject to the existing mortgage, which is unusual.
Equitable mortgage: An equitable mortgage only transfers a beneficial interest in the asset to the mortgagee, with full legal ownership remaining with the mortgagor. In general, an equitable mortgage will arise where one of the following applies:
- the formalities necessary to create a legal mortgage have not been complied with;
- the mortgagor's interest in the asset being mortgaged is an equitable interest;
- the parties have merely entered into an agreement to create a legal mortgage in the future over the asset in question, rather than formally creating such a mortgage;
- the property to be mortgaged is recognised only in equity - for example, an interest in a trust fund.
Equitable mortgages and charges can be taken in a number of ways, some of which offer very little protection against third parties obtaining an interest in the charged asset and can make enforcement over the charged asset very difficult. It is preferable to take a legal mortgage or charge wherever possible.
The term 'charge' is often used as a generic term for all types of security interest, but specifically it represents an agreement between a creditor and a debtor in which a particular asset or class of assets can be used to satisfy a debt. A charge creates an encumbrance or interest which attaches to the asset and travels with it into the hands of any third parties. The only exception to this is a genuine, arms-length purchaser of the full legal ownership for value and without notice, who will acquire the asset free of the charge.
A charge does not involve the transfer of ownership or possession of an asset. For practical reasons most lenders will not want to take possession of the borrower's assets and nor will the borrower want to lose control of them, especially if those assets are used in the day-to-day running of the business. Accordingly a lender (chargee) will instead want to take security by obtaining rights over specific assets of the borrower (chargor) as security for the loan. The chargee then has a right to resort to that asset to repay the debt.
Charges can either be fixed or floating. The nature of a charge (whether fixed or floating) is particularly important if the borrower becomes insolvent. Under a fixed charge an asset which is ascertained and definite, or capable of being ascertained and defined, can be used to satisfy a debt immediately or once the lender acquires an interest in it.
A floating charge, on the other hand, hangs over a class of assets or future assets and acts as a deferred right to use those assets to satisfy a debt. Until an event occurs which causes the floating charge to fix to those assets, the borrower is free to dispose of and add to the assets in the ordinary course of its business. When the event occurs and the floating charge becomes fixed, it attaches to the assets that make up that class at that point.
It should be noted that the label attached to the charge is not conclusive in determining whether it will be regarded by a court as fixed or floating. To be confident that a court will regard a charge over assets as fixed, the lender must demonstrate that it has exercised control over the charged assets to the extent that the charge does not 'float' over the assets but is fixed to them. In practice, this means implementing clear restrictions on the ability of the borrower to deal with the assets and enforcing those restrictions.
Fixed charges attach immediately to the charged asset, providing that the asset is or is capable of being ascertained and definite. They can be granted by anyone including companies, limited liability partnerships (LLPs), traditional partnerships and individuals.
The key characteristic of a fixed charge is that it gives the lender control over the charged asset. This control is crucial to the nature of a fixed charge - without sufficient control, the charge will be deemed to be floating. Typically, a document which creates a fixed charge will give the lender the right to:
- prevent the borrower from disposing of, or otherwise dealing with, the asset without the lender's consent;
- sell the asset if the borrower defaults under the loan;
- require the borrower to maintain the value of the asset while it remains in the borrower's possession; and
- claim the proceeds of the sale of the charged asset in priority to other creditors.
The charge document should ensure that the charged assets are identified as precisely as possible.
Fixed charges have a number of important advantages over floating charges:
- a floating charge given by an insolvent company within the 12 months before the onset of insolvency (two years if the chargee is a 'connected person' with an interest in the chargor) is void except to the extent that the insolvent company has acquired new assets since the security was granted;
- a floating charge ranks behind the rights of preferential creditors if the company goes into administration, receivership or liquidation, while a fixed charge takes priority over all unsecured claims, preferential or otherwise;
- the sale of, or any encumbrance or burden created over, an asset which is subject to a floating charge will as a general rule take effect free from that charge, while a fixed charge can only be defeated if the asset is sold to a genuine, arm's length purchaser of the legal title of that asset for value without notice;
- many foreign legal systems, particularly civil law jurisdictions such as those in Europe, do not recognise floating charges;
- all floating charges given by a company need to be registered at Companies House, otherwise they cannot be forced against the liquidator, administrator or any creditor of the company. A fixed charge is only registrable if taken over a class of asset specifically listed in the Companies Act.
Floating charges, as the name suggests, hover above a shifting pool of assets. While fixed charges can be created by anyone, floating charges can only be created by companies, LLPs and, under the Agricultural Credits Act, farmers. Individuals cannot grant floating charges over their assets.
A floating charge has the following characteristics:
- it is a charge on a class of assets, present and future, of a company;
- that class is one which, in the ordinary course of the company's business, would change from time to time;
- it is understood that, until some future step is taken by or on behalf of the chargee, the company may carry on its day to day business as far as it concerns that particular class of assets.
Unlike assets secured by a fixed charge, the assets secured by a floating charge are described in very general terms – for example, the borrower's 'trading stock' or its 'undertaking and assets'. This group of assets may fluctuate from time to time either through the borrower disposing of them in its ordinary course of business or by it acquiring further assets in that class after the floating charge was created. This flexibility is the great advantage of a floating charge, but the freedom to deal with assets presents the lender with the problem of how to stop the borrower from disposing of all of those assets. For this reason, lenders prefer to take fixed charges over specific assets where possible. Lenders do have limited ability to control floating charge assets in some circumstances – a floating asset will fasten onto the charged assets which are in existence when a certain event occurs, either by operation of law or by agreement of the parties, which fixes the charge. At that point, the floating charge stops hovering over the pool of assets and instead becomes fixed to those assets which exist at that time.
Despite the inherent weaknesses of a floating charge, it is usually important for a lender to take a floating charge wherever possible. A floating charge has three important advantages:
- it allows the bank to take security without unduly restricting or affecting the borrower's ability to carry on its business, including the buying and selling of assets;
- providing the charge is a 'qualifying floating charge' for the purposes of the Insolvency Act, the holder will be able to appoint an administrator without applying to court for an order;
- it acts as a catch-all, sweeping up intangible assets which cannot be specifically charged or assets which the lender is unaware of.
Banks will usually get the best of both worlds by using a combination of fixed and floating charges in one document, known as a debenture. This document usually creates fixed charges over certain assets of the company – land, plant and machinery, goodwill, uncalled capital, intellectual property rights, book debts, non-trading account bank balances – and a floating charge over all the other assets. By using this combination a bank can obtain adequate security for its loan, safe in the knowledge that all the borrower's key assets apart from stock in trade are subject to fixed charges. At the same time the company is free to carry on its business in a relatively unhindered manner, and can sell its stock in trade in the ordinary course of business without having to obtain the bank's consent for every sale.
Assignment by way of security
A borrower's rights against third parties, such as the right to receive payment for debts on its own books, can be assigned to a third party as a way of selling those rights – this is an absolute, or direct, assignment. It is also possible to carry out an assignment by way of security over a borrower's choses in action – rights the borrower is entitled to under contracts – as security for that borrower's debts. As with any assignment, an assignment by way of security can be either legal or equitable. An assignment will be legal if it is:
- in writing and executed by the borrower (the assignor);
- absolute - that is, unconditional and for the whole amount; and
- notified in writing to the person against whom the assignor could enforce those assigned rights, usually the debtor of the borrower company.
As a result, a legal assignment should be expressed as an absolute assignment with a provision that those rights will be reassigned once the relevant debt is satisfied. If, however, an assignment is made 'by way of charge' rather than by way of security then it will take effect in equity only.
A legal assignment can only assign debts which already exist. Only an equitable assignment can assign rights under future contracts.