The Floating Charge - An Elegy
World Bank Global Initiative on insolvency and Creditor/Debtor Regimes; University College London (UCL) - Faculty of Laws; Chambers of Michael Crystal QC
COMMERCIAL LAW AND COMMERCIAL PRACTICE, Sarah Worthington, ed., Oxford: Hart, August 2003
Whether they praise or (more frequently) condemn it, commentators do not generally realise how great a puzzle the floating charge is. Consider what we ordinarily expect of a security interest. Most obviously, the secured creditor would hope to enjoy priority in the proceeds of sale of the collateral over his debtor's other creditors. However, the floating charge does a very bad job, ranking behind not only a later fixed charge over the same assets, but also behind statutory preferential claims. Once the relevant provisions of the Enterprise Act 2002 come into force, the categories of preferential creditors will shrink. However, a particular proportion of the value of the collateral subject to a floating charge will be ring-fenced for general unsecured creditors, leaving the floating charge holder's position no better off. One might also wish a security interest to encumber the collateral, so that attempts by the debtor to pass on the assets subject to the charge would be unable to defeat the charge holder's rights. With a floating charge, however, the debtor may deal with or dispose of such property without the approval of, or even consultation with, the charge holder, and as long as this is done in the normal course of business, the transferee's title is unburdened by the charge holder's rights. At the very least, a secured creditor would wish to be able to tell how much collateral it had been offered in order to carry out a risk assessment on the loan. However, the creation of subsequent fixed charges and the accumulation of new preferential claims can dilute the floating charge holder's security, as can the debtor's ability to alienate the collateral free of the charge. So the floating charge holder cannot even know which assets it has security over, and how much they are worth! No wonder this has been described as a key weakness of this device.
Security is also often said to bring efficiency benefits by allowing the secured creditor to monitor the assets subject to the charge, with the aim of deterring financial agency costs. The existence of security is said to facilitate this monitoring by creating focal points for the monitoring effort: Instead of having to keep an eye globally on the debtor's affairs, the creditor may focus simply on the presence, value, and use of the assets given as collateral. This lowers monitoring costs, and on conventional reasoning, some part of these savings might be passed on to the debtor as lower interest rates. However, as Finch notes, floating charges are generally taken over the debtor's entire undertaking, which means monitoring in order to detect misbehaviour or calculate risks could involve scrutinising the whole business. In effect on this reasoning, much of the point of taking security as an aid in monitoring is thus negated. In the result, the floating charge may offer a relatively expensive method of securing finance.
So if the floating charge is such a thoroughly inefficacious way of securing a loan from the lenders' perspective, why is it more or less ubiquitous in corporate debentures? Critics offer a worrying explanation. Not only is the floating charge a terrible security device, it is also said to be exploitative. It is a mechanism peculiarly conducive to the transfer of insolvency wealth from unsecured to secured creditors, and most likely designed for this very purpose. It is a charge upon all future property, sucking in after-acquired assets into its ambit without the injection of fresh value by the original creditor. This creates a windfall for the charge holder and ensures that the rate on the secured loan is increasingly advantageous to it. These interest rates are excessively profitable because the floating charge holder's ability to exploit its positions ensures risks are loaded onto unsecured creditors. What is more, unsecured creditors may have insufficient notice of the effects of the charge, since it might be impossible to tell from the [company charges'] register how much the floating charges secure. This deceptiveness adds to the exploitative value of this device, which is sufficiently great to make it universally popular for powerful lenders (i.e. banks) despite its many disadvantages.
This is a damning indictment. In response, I want to suggest that the floating charge is not malignant, merely misunderstood. The floating charge is unlike other security interests, first and foremost, in that it provides a very poor priority to its holder in the debtor's insolvency. Focussing on this and yet keeping in mind its ubiquity encourages a search for its true function. It is suggested here that a theory claiming to reveal this function could be considered successful only if it could explain the development of the lightweight floating charge, the reason why floating charges are usually taken over the debtor's entire estate and why they are often coupled with fixed ones, the distinction between fixed and floating charges, and the desirability or otherwise of restricting the priority position of the holders of the latter. Removing the misunderstanding as to the actual role of the floating charge would also allow us to quiet concerns that its main value has been in its ability to exploit. However, while it might not have been exploitative in the past, it will be argued that its existence will become wholly exploitative after the coming into force of the relevant portions of the Enterprise Act. It will therefore be suggested that it should now be abolished.
Number of Pages in PDF File: 25
Keywords: Administration, administrative receivership, receiver and manager, concentrated creditor theory, registration, encumbrance, financial agency costs, monitoring
JEL Classification: K11, K19, K22, K29Accepted Paper Series
Date posted: April 14, 2004
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