UK: Spectrum Plus - House of Lords decides that the bank´s charge over book debts was floating rather than fixed

The Lords unanimously upheld the Vice Chancellor’s first instance decision and found that the bank’s debenture created a floating charge over book debts (as opposed to a fixed charge).

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The House of Lords judges gave their decision in National Westminster bank plc v Spectrum Plus Limited and others [2005] UKHL 41. The Lords unanimously upheld the Vice Chancellor’s first instance decision and found that the bank’s debenture created a floating charge over book debts (as opposed to a fixed charge). A summary of the case is set out below.

The debenture in question created what was labelled a "specific charge" over book (and other debts). "Specific charge" in this context was a term used to mean "fixed charge". The debenture contained provisions restricting Spectrum’s ability to deal with its book and other debts, as follows:

"with reference to book and other debts hereby specifically charged [Spectrum] shall pay into [Spectrum’s] account with the Bank all moneys which it may receive in respect of such debts and shall not, without the prior consent in writing of the Bank sell factor discount or otherwise charge or assign the same in favour of any person or purport to do so and [Spectrum] shall if called upon to do so by the bank from time to time execute legal assignments of such book debts and other debts to the Bank."

Spectrum’s book debts were paid into an overdrawn account with the bank. However, Spectrum remained free to draw on the account until the overdraft limit was reached.

In deciding whether or not the book debts were subject to fixed or floating charges, the House of Lords considered what characterised a charge as floating as opposed to fixed. Although the nature of a floating charge has been widely considered by the courts, no full definition has ever been given (a description was given in Re Yorkshire Woolcombers Association ([1903] 2 CH 284) which has been widely used since – but the judge in that case stated that he did not intend to give a definition of the term floating charge).

The House of Lords decided that the essential characteristic of a floating charge is that:

"the asset subject to the charge is not finally appropriated as a security for the payment of the debt until the occurrence of some future event. In the meantime the chargor is left free to use the charged asset and to remove it from the security."

Book debts are usually needed by a company in order to fund continued trading. The difficulty faced by those wishing to create a fixed charge over book debts has been to give the borrower sufficient freedom to use its book debts to fund its business while at the same time giving sufficient control to the chargor in order to satisfy the control requirements of a fixed charge.

The Lords agreed with earlier decisions - that it is conceptually possible to create a fixed charge over book debts, and listed the possible ways. These all involve preventing the chargor from dealing with book debts (so that they are preserved for the benefit of the chargee’s security):

1. assigning the book debts to the chargee;
2. requiring the borrower to pay proceeds to the chargee in reduction of the chargor’s outstanding debt;
3. requiring the borrower to pay the collected proceeds into a blocked account with the chargor bank; or
4. requiring the borrower to pay the collected proceeds into a separate account with a third party bank over which the chargee has a fixed charge.

The House of Lords considered that the method selected in this case came closest to the blocked account structure.

The Lords considered that the key question in this case was whether the account was one which allowed Spectrum to continue to use the proceeds of book debts as a source of cash flow or whether it was one that kept the proceeds intact for the benefit of the bank’s security. In short, the crucial question was whether or not the account was blocked.

The House of Lords decided that Spectrum’s continuing contractual right to draw out sums equivalent to amounts paid in to the account meant that the account was not blocked. Spectrum’s right to draw on the account was "wholly destructive" of the argument that there was a fixed charge over the uncollected proceeds of book debts.

The House of Lords thus approved Lord Millett’s reasoning in Re Brumark - that formal provisions for a blocked account are not enough "if [the account] is not operated as one in fact."

The bank sought to argue that because the proceeds were paid into an overdrawn account, and the bank was entitled to refuse to allow Spectrum to draw on the account at any time, the bank had "control" over the proceeds (which was sufficient to create a fixed charge over book debts). The Lords rejected this argument. The company effectively remained free to deal with the book debt proceeds by drawing out equivalent amounts (until the bank exercised its right to prevent it from so doing).

Book debts can comprise a large part of a company’s assets, so the issue of whether or not they are subject to a fixed or floating charge can have a significant impact on the returns to a charge holder.

This is mostly to do with the returns a charge holder can expect to receive in a formal insolvency in respect of fixed and floating charge assets. When fixed charge assets are realised, the charge holder is entitled to the proceeds of those assets after effectively deducting only the costs of realisation.

In contrast, the proceeds of floating charge assets are subject to the costs of realisation, expenses of the relevant insolvency procedure (most likely to be administration or liquidation), preferential creditors (following the Enterprise Act 2002, mostly employees), and the prescribed part (a percentage of the company’s floating charge asset proceeds – capped at £600,000). Only after these costs have been deducted is the floating charge holder entitled to receive any remaining funds.

The debenture in the Spectrum case was drafted in similar terms to a debenture that, in Siebe Gorman, was held to create a fixed charge. One of the considerations for the House of Lords was whether or not they should overrule Siebe Gorman. They decided that Siebe Gorman was wrongly decided and should be overruled.

Clearing banks have drafted their standard form debentures in reliance on the Siebe Gorman case for 25 years. Therefore, the bank requested that if Siebe Gorman was overruled, the House of Lords should rule that such a decision would only have prospective effect. The House of Lords stated that although they would never say it would never be appropriate to make a prospective over-ruling, this case did not warrant such treatment.

The final chapter in this long-running and important debate has now been decided in favour of the Crown. Their Lordships rejected the technical legal analysis of bank accounts argument in favour of the more pragmatic approach. Without special blocked account restrictions, borrowers who pay book debt proceeds into their bank accounts (whether in credit or overdraft) expect to be able to (and indeed usually can) draw an equivalent amount out again (provided in the case of an overdrawn account, the borrower is within his agreed limit). This means that borrowers in the position of Spectrum can in practice use their book debt proceeds in the ordinary course, making the charge over them floating.

And so their Lordships overruled the 25 year old judgment of Slade J in Siebe Gorman, albeit reluctantly in deference to the respect in which they generally held his other judgments. The Court of Appeal’s decision in In re New Bullas Trading Ltd ([1994] 1 BCLC) 485 befalls the same fate. Lord Millett’s judgment sitting in the Privy Council in Agnew was adopted.

It seems that to some degree their Lordships were influenced by the purpose of the legislation in favour of preferential creditors giving them priority over floating charge holders. This was originally introduced back in 1897 to meet the problem in the early days of floating charges where floating charge holders were able to "sweep off everything" leaving nothing for the unsecured employees. If book debts in cases like Spectrum were subject to a fixed charge, this would often leave preferential creditors with next to nothing, defeating the priority enjoyed by preferential creditors for two centuries.

This important judgment therefore clears up a long-debated issue and the certainty it creates is definitely to be welcomed. The 100s of outstanding receiverships, administrations and liquidations that have been held up pending this judgment can now be closed.

Outside the immediate parties in Spectrum, the potential victims of the decision are all the stakeholders involved in cases that have long since been closed in reliance upon Siebe Gorman. It was with these in mind that their Lordships considered at some considerable length whether they could make their ruling with only future effect. Their Lordships ultimately decided that they could not do so in this case. All is not completely lost for those involved in past cases where book debts were treated in accordance with what was then believed to be the law, but we now know was not. Apart from arguments of limitation, they may also be able to rely on a defence that they have changed their position and therefore argue that their case should not now be reopened. It remains to be seen whether anyone will bring such a case.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 01/07/2005.