Business Money – Finance and Banking for Business

Invoice finance - the final decision

June 2005

DLA Piper Rudnick Gray Cary's Global Services Bulletin looks at the UK's House of Lords ruling on book debts

The UK’s House of Lords has held that a charge on book debts cannot be characterised as fixed where the company granting the security can freely draw on the proceeds of the book debts. The Lords declined the banks’ invitation to apply their judgment prospectively only. The decision will therefore apply to all past and future cases where a bank has purported to take a ﬁxed charge over book debts but failed to exercise control over their proceeds. The judgment conﬁrms that a charge on book debts is ﬁxed where the bank has exercised absolute control over the proceeds of the book debts. In practice, this would deprive most companies of the main source of their cashﬂow. However, the Lords have provided no guidance as to whether any lesser degree of control would sufﬁce to achieve the banks’ objective. As such, it merely represents the ﬁrst drop in what will inevitably be an ocean of litigation.

An unusual Appellate Committee of seven Law Lords considered the appeal. The number is thought to reﬂect the importance, not just of the distinction between a ﬁxed and ﬂoating charge, but also the jurisprudential signiﬁcance of a submission by NatWest that, if the House should not uphold the validity of its ﬁxed charge, the Lords are empowered to, and should, make an order which would be expressed only to apply to future cases.

Lords Hope, Scott and Walker gave the leading opinions regarding the correct characterisation of Nat West’s charge.

The Lords favoured the approach taken by the Privy Council, which held that attempts to distinguish a book debt from its proceeds make “no commercial sense”. Despite the Court of Appeal’s enthusiasm to regard them as two, separate assets, Lord Walker said that: “The categorisation depends upon the commercial nature and substance of the arrangement, not upon a formalistic analysis of how the bank clearing system works”.

In his opinion, the essential characteristic which must be present for there to be a ﬂoating charge and which, when present, renders it impossible for there to be a ﬁxed charge is the company’s ability to use the assets for its normal business purposes, unless and until the charge holder intervenes.

The Lords clearly acknowledged that it is possible to create a ﬁxed charge over book debts and suggest that it would sufﬁce for the debts to be paid into an account which is ‘blocked’ – by which they appear to mean that the company should have no access to the funds in the account or, in the company’s case, the overdraft facility attached to the account. Lord Walker noted the difﬁculties which can arise when seeking to determine whether any lesser degree of control should sufﬁce to create a ﬁxed charge. He referred to the post script added to the Master of the Rolls’ judgment in the Court of Appeal. In a laudable attempt to provide the parties with some practical solutions to the issues before the court, the Master of the Rolls said that he considered it to be ‘beyond doubt’ that a tandem account arrangement (where book debt proceeds are paid into one account, to which the company has no access, but are periodically transferred to another account, to which the company has unrestricted access) would be sufﬁcient to give rise to a ﬁxed charge. Unfortunately, even this has been thrown into the realms of uncertainty. Lord Walker said that whilst such an arrangement would clearly be appropriate in some cases, it would not necessarily provide a simple solution in every case.

The Lords varied in their degrees of enthusiasm to consider whether it is open to the House of Lords to make an order expressed only to take effect in the future. Their common approach to the question is best summarised in Lord Nicholls’ words: “Never say never”. They were unanimous, however, in their view that the circumstances of this case did not justify such a radical departure from the status quo.

Insolvency practitioners are currently holding book debt realisations in several hundred cases, waiting for the outcome of this case. In the majority of cases, as the market understandably relied upon the authority of Siebe Gorman, no practical control was operated by the lenders over the book debt proceeds. In all but a few of these cases, therefore, the money can now be released to those afforded statutory priority – principally, the Crown, or in some cases, in respect of ofﬁce holders’ remuneration.

As the Lords declined to make an order which would have prospective effect, it will be open to preferential creditors to challenge payments which have been made to banks in reliance upon their purported ﬁxed charge, regardless of how long ago the payments were made. In 2002, the relevant Crown departments issued a statement saying that they will not seek to challenge any such payments made before the Privy Council decision in June 2001. However, that would not preclude a company’s liquidator or other preferential creditor from bringing such an action.

There is a greater risk that parties who have guaranteed a company’s debt to the bank will be called upon to meet any shortfall which the bank suffers. This concern was insufﬁcient to persuade the Lords to limit the retrospective nature of their order.

Scant guidance is provided on whether any techniques adopted by banks, in an effort to impose a workable level of control over a borrower’s account, would be sufﬁcient to create a ﬁxed charge. Where book debts comprise a valuable component of a company’s assets, factoring or similar arrangements are likely to produce the most attractive solution.

In this case the House of Lords’ consideration was limited to a charge over book debts. That the same principles might apply to other assets is only brieﬂy touched upon in the judgment. The Privy Council’s approach to categorising a ﬂoating charge has already been applied by the House of Lords to a charge over a substantial item of plant and also to consideration of whether a charge over shares was ﬁxed or ﬂoating. It seems likely, therefore, that future courts will adopt the same principles in relation to all types of assets over which a lender may seek to take security. But it is impossible to predict how the principles will be manipulated to ﬁt those circumstances: what is the equivalent of a blocked account in relation to shares? Or intellectual property rights? Or a stock of vehicles?

The Lords’ decision will enable insolvency practitioners to conclude several hundred cases which have been held in abeyance pending the small degree of clariﬁcation which the judgment has provided. Following a recent Law Commissioners’ report, any prospect of legislative interference or enhancement of this area of the law appears remote. Insolvency practitioners and banks should therefore brace themselves for a future scattered with further uncertainty, delays and test cases before the court. It has taken four years to come this far. It is likely to take many more before the full scope and effect of the judgment can be realistically ascertained.

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Invoice finance - the final decision