Standard Legal Charges

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What are standard legal charges?

A charge is a security taken over an asset, giving the lender rights over it such as a right to sell the asset in order to obtain the proceeds and discharge the underlying debt. Security is registered over assets by the lender or financier. A charge agreement outlines the transfer to the lender of a proprietary interest in an asset or class of assets, constituting a security. However, unlike other types of security, charges do not transfer a right of ownership to the lender but only an equitable interest.

Fixed Charges versus Floating Charges

Fixed charges vs floating charges

Two types of charges can be taken, fixed or floating, depending on the related assets. The nature of the charge will be of particular importance when the borrower is insolvent.

Fixed charges involve a determined asset, which has to be ascertained and definite. The key characteristic of this type of security lies in giving the lender a control over the asset. Specifically, the lender will be given the rights to:

  • Prevent the borrower from disposing of the asset without the lender’s consent
  • Sell the asset in case of default of the borrower under the loan agreement
  • Claim the proceeds of the sale of the asset in priority over other lenders

Concerning floating charges, they are granted over a pool of changing assets, such as stocks. The charge will involve present and future assets of a company which are varying from time to time, and thus are defined in general terms. A floating charge can only be created by a company or a limited liability partnership (LLP).

Under this type of security, the borrower keeps the right to dispose of the assets, for instance by acquiring further assets in the ordinary course of its business. Therefore, flexibility is a key element of floating charges and certainly its main advantage. However, this flexibility may be difficult to handle for the lender in that he cannot dispose of these assets and may have issue to stop the borrower from disposing of these assets.  

Implications of the distinction

The main implication of this distinction lies in the fact that in case of a default of the borrower, a floating charge ranks behind the rights of preferential creditors while a fixed charge takes priority over all unsecured claims.

Further, fixed charges have several advantages over floating charges:

  • floating charges need to be registered at Companies House, subject to being unenforceable against the liquidator or any creditor of the company (borrower) while a fixed charge needs to be registered only when taken over a pool of assets listed in the Companies Act 2006
  • many foreign legal systems, especially civil law countries, do not recognized the notion of floating charges
  • the sale of an asset subject to a floating charge will take effect free from that charge while a fixed charge can only be defeated where the asset’s legal title is sold to a genuine purchaser for value
  • as mentioned above, under a floating charge, the lender has limited ability to control the secured assets as the borrower can carry on its business related to such assets

On the other hand, floating charges have three main advantages:

  • it allows the bank to take a security over assets without unduly restricting the borrower’s ability to carry on its daily business regarding the secured assets
  • since the assets secured by a floating charge are defined in general terms, it allows cover of all the borrower’s assets
  • for the purpose of the Insolvency Act, in case of liquidation of the borrower’s company, the lender will be able to appoint an administrator without applying to court for an order

In light of this comparison, despite fixed charges being a stronger form of security to take over an asset, floating charges offer flexibility for the parties and especially the borrower. Therefore, lender will commonly use a combination of both charges contained in a document, called a debenture.

Debentures

A debenture is a document by which a lender will create a fixed charge over specific assets of the borrower, such as land, machinery, intellectual property rights or uncalled capital, and a floating charge over all other assets. This combination will help the lender in obtaining the most adequate security over the asset, while allowing the borrower to carry on its business, especially by selling its stock, due to the floating charge.

References:

https://www.lexisnexis.com/uk/lexispsl/bankingandfinance/document/391289/55KB-65S1-F185-X1PM-00000-00/Types_of_security_overview  – 29/10/2018

https://www.out-law.com/topics/financial-services/banking/security-in-finance-transactions/  – 29/10/2018

https://www.fortunelaw.com/giving-security-by-way-of-a-charge/  – 29/10/2018

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