We are increasingly seeing requests from borrowers to carve-out assets from the scope of a lender's otherwise all asset English security package. Whilst there may be commercially sensible reasons for this request, lenders should be aware of the potential impact on their enforcement rights before agreeing to this.
It is relatively common for lenders in England and Wales to take security over all of the assets of a borrower or obligor in the form of a debenture, particularly in leveraged finance transactions. A debenture typically contains a combination of security interests, including fixed and floating charges over different classes of assets.
Fixed charges will typically be taken over specific types of assets, in respect of which the lender can exercise the requisite amount of control required under English law to make a fixed charge valid. Whether or not a lender has a fixed charge over an asset will depend on the level of control exercised over that asset by the lender in practice, rather than what the security document says. Realisations from fixed charge assets will have a higher priority status in the order of distributions in an insolvency in England and Wales, so lenders are often keen for as many assets as possible to be subject to a fixed charge.
Assets typically covered by a fixed charge will include assets such as real estate, plant and machinery, subsidiary shares, and intellectual property. Accounts of the borrower/obligor may also be included, however those accounts will generally need to operate as blocked accounts with sufficient lender control in order to be classified as a fixed charge (which may not be practicable in the context of an account required by the borrower for trading purposes and hence why market practice often dictates that these accounts are only "blocked" following a default or enforcement).
A floating charge, on the other hand, essentially "floats" over the assets it secures, generally enabling the borrower to deal with those assets in the ordinary course of business until the floating charge is "crystallised" under the terms of the security document and/or by operation of English law (which will often happen where certain enforcement action is taken, for instance). Crystallisation essentially removes the borrower/obligor's freedom to deal with the relevant assets. Realisations from floating charges in an insolvency will be subject to various statutory deductions under English law before they are distributed to the lender. However, the strict control requirements for a fixed charge often mean that floating charge security is the best security a lender can expect to obtain over certain asset classes.
Lenders will often take a sweeping floating charge over all of the borrower/obligor's assets which are not already subject to a fixed charge. This provides the benefit of having a security interest over all of the borrower/obligor's assets (and so priority on returns from those assets over unsecured creditors, subject to the required statutory deductions), but it also has the benefit of providing the lender with a qualifying floating charge (discussed below).
There might be many reasons why a borrower asks a lender to exclude assets from a floating charge, including:
Some of these circumstances may be insurmountable and require the lender to decide whether to acquiesce to the request of the carving out of the relevant assets from the security package. However, lenders who are considering such requests should be aware of the consequences. Carving out assets from a floating charge will mean:
1. The lender will not have any security over the relevant assets. The lender would therefore not get priority over unsecured creditors in respect of realisations from those assets on insolvency.
2. The lender may not have a "qualifying floating charge".
A qualifying floating charge is a charge which covers "the whole or substantially the whole" of the relevant company's property. Currently there is no English case law as to what specific threshold would need to be met for the charge to cover "substantially the whole" of the company's property. Therefore, carving out any assets from the floating charge runs the risk of the charge not being a qualifying floating charge (the implications of which are discussed below).
It has been suggested that the company's assets could be valued and then a view reached on the percentage of assets that would need to be charged for the lender to have a qualifying floating charge. However, there are practical issues with this in terms of valuation. It may be unlikely that the borrower has had all of its assets valued at the point it grants the security, so it may be difficult to ascertain the proportionate value of the assets being carved out. Even if the assets had been recently valued, asset values can change over time, and the point at which the lender is required to have a charge over "the whole or substantially the whole" of the relevant company's assets in order to have a qualifying floating charge is not clear. It could be argued that it should be assessed when the lender seeks to enforce the charge. Conversely, a purist view would be that the valuation should take place at the time at which the charge was granted.
A lender who has a qualifying floating charge has an additional, and important, enforcement route of being able to appoint an administrator via an out-of-court appointment process. Administration is one of the key insolvency processes in England and Wales, which involves an administrator being appointed to take control of a company with the aim of either rescuing it or realising its assets for the benefit of creditors. Administrators have broad powers, including the ability to run a company and to sell its assets and wind it down. Often an administration is used in order to achieve the statutory objective of making a distribution to the company's secured creditor(s), i.e. administration can be a means by which a secured creditor enforces and realises its claims.
There are two routes to put a company into administration:
1. The directors of the company or the holder of a qualifying floating charge can use the "out-of-court" process to appoint an administrator, which is a simple, paper-based exercise. Relatively short, prescribed form documents are filed at court, with the administrator's appointment taking effect when the documents are stamped by the court office. There is no court hearing required and the process can be completed in an extremely short timeframe.
2. The directors or any creditor (whether holding security or not) can use a court process to appoint an administrator. There would need to be a court application and then a hearing, where the court would need to be satisfied that: (i) the company is or is likely to become unable to pay its debts; and (ii) the administration is reasonably likely to achieve the statutory purposes of administration. Generally this process involves more time, cost and uncertainty than the out-of-court route.
If the best enforcement route for a lender is via administration, it is therefore preferable for it to have a qualifying floating charge so that it can use the simple out-of-court route.
In addition, even where a lender is not the party actually placing the company into administration, e.g. the directors of a company propose to put the company into administration, the holder of a qualifying floating charge is entitled to receive prior notice of the intended appointment. Whilst that lender may not be entitled to block the appointment of an administrator per se, it does have the ability to select its own preferred administrator. This often means that lenders with a qualifying floating charge are brought to the table at an earlier stage in a company's distress to ensure the qualifying floating charge holder is supportive of the chosen administrator and that administrator's strategy.
Lenders will need to assess on a case-by-case basis whether they are comfortable with the impact of carving assets out of their floating charge security. It may be that the borrower's situation means that it is impossible for it to grant security over all of its assets, but this should be tested and considered carefully by the lender, as it could have the effect of weakening the lender's position on enforcement.
