Following recent case law, banks now need to seek additional collateral security when lending to corporate customers – or do they?

An accountant I know, contacted me recently saying that a worried client had called him to inform him that his company’s bankers had advised him that they were no longer able to afford his company the current level of borrowing without him providing an increased personal guarantee and that this guarantee would now need to be supported by security over the client’s home. The company was trading well and there were no signs of impending difficulty. The bank cited a recent legal decision as the reason for their requirement. The accountant asked if I could shed any light on this unexpected and apparently unreasonable request from the bank.

Like all Insolvency Practitioners, before giving an answer I gave the accountant a history lesson.

For around thirty years, banks have been able to provide funding to companies, utilising the security provided by what has become known as a Siebe Gorman debenture. This type of debenture created fixed and floating charges over the assets of the company and notably incorporated a fixed charge over the proceeds of book debts owed to the company.

A fixed charge is similar to a mortgage on a house in that it is possible to sell the asset but the charge has to be satisfied out of the sale proceeds. The introduction of the concept of a fixed charge over an asset, which by virtue of its very nature was changing all the time, was surprising, but in the late 1970s the Court decided in the Siebe Gorman case that this was possible and that is the basis upon which most corporate bank lending was made from then onwards.

As with all types of security, debentures of this type were taken out to protect the lender in the event that the company failed. The advantage that a fixed charge has over a floating charge is that the latter ranks lower in priority in Insolvency proceedings. In general terms a floating charge ranks below the costs of the insolvency proceedings and the claims of preferential creditors, but above the claims of trade and other unsecured creditors. By being able to take a fixed charge over the proceeds of book debts, the lender was effectively able to participate in the realisation of the asset ahead of the preferential creditors and was able to dictate the level of costs incurred in the realisation of the book debts.

Since Siebe Gorman there have been a number of other cases relating to the availability of fixed charges over book debts, but these had little effect on the position of bank lenders who remained able to rely upon the Siebe Gorman type of charge.

In the summer of 2001, the Privy Council heard a New Zealand case Re: Brumark and ruled that a fixed charge could not exist over the proceeds of book debts if the borrower was allowed unfettered access to the funds. It was suggested that were the funds paid into a separate blocked account and the sanction of the lender required to enable the company to access the funds, then a fixed charge could exist.

The Brumark case was significant since, whilst it was a New Zealand Case and consequently not binding in the United Kingdom , the Privy Council, which is the Commonwealth equivalent of our House of Lords, is actually made up of Law Lords from the House of Lords. It therefore seemed logical that the same body wearing its United Kingdom hat would probably reach the same conclusion.

However a further four years of uncertainty followed until the case of Spectrum Plus came to the United Kingdom courts on the same point of law. The lower court ruled that the decision in Brumark was correct and binding within our jurisdiction, whilst the Court of Appeal disagreed. The case finally came before the House of Lords and in the summer of 2005 the inevitable decision was reached that a fixed charge cannot apply to the proceeds of book debts unless the lender has control of the funds and again reference to a blocked account was made.

On the face of it, this decision placed the banks in the same position that they had been in before Siebe Gorman. Now, once more, their security on the proceeds of book debts ranks below the costs of insolvency proceedings and the claims of preferential creditors and since in most insolvency proceedings the costs are determined by the non preferential, unsecured creditors, the banks appeared to no longer have any control over these costs.

When Siebe Gorman was decided it was not at all unusual to find preferential creditors’ claims, consisting mainly of liabilities to the Crown, to be represented by substantial amounts. Even at the time of the Brumark decision, this was still the case. However in September of 2003 the Crown’s preferential status was abolished and preferential claims now consist mainly of certain employee liabilities and relatively low limits are applied. It is unlikely therefore that many small to medium sized companies will have sizeable preferential claims, unless they have a very large work force.

Also in one of the Leyland Daf cases in March 2004, it was ruled that in liquidation proceedings the liquidator’s remuneration is limited to the costs of realisation and agreeing the claims of preferential creditors, although this anomaly is likely to be amended in forthcoming legislation. However the current practice is for the liquidator’s remuneration to be set by the preferential creditors, if there is to be a shortfall in distribution to them, or by the floating charge holder (the bank) if preferential claims are to be paid in full. On the face of it therefore the bank does not appear to be in a much worse position than it would have been before the Spectrum Plus decision.

The Enterprise act 2002 does however provide a requirement for an insolvency practitioner to ‘ring fence’ a fund for distribution to non-preferential creditors where a bank’s floating charge is created after 15 September 2003 . This could place the bank in a worse position, but it is debatable whether this would be more disadvantageous than before Crown preferential status was abolished.

So, what does all of that mean?

Banks are faced with greater uncertainty under the present regime and have a duty to their shareholders to minimise losses. It is therefore not at all surprising that they will seek additional security and that this will inevitably be in the form of off balance sheet assets. Whether it is an excessive step to take will depend upon the outcome of individual scenarios, but let’s not lose sight of the fact that the security will only be called upon if the company is unable to meet its debt to the secured lender.

It would appear that the traditional source of company finance will now be less attractive and companies will be more likely to turn to factors and invoice discounters, where the book debts are assigned and still provide good security to the lender. Perhaps also more tangible asset based finance and equity funding will be seen in the future.

Who knows? If Siebe Gorman had gone the other way, perhaps by now we would already be very much more accustomed to these and even more alternative finance sources, which necessity will no doubt invent.