In National Westminster Bank plc v Spectrum Plus Ltd  UKHL 41 (2005) 149 SJ 835, the House of Lords ruled on the question of whether common-form fixed and floating charges, as commonly adopted by banks in the UK, operate so as to create fixed charges or alternatively floating charges over the book debts of the chargor company. The House has ruled that, so far as book debts are concerned, it is floating charges which are created. The purpose of this article is to outline the Spectrum decision itself and to describe its practical consequences so far as a company’s debtors are concerned, in particular with regard to questions of set-off.
The question that arose in Spectrum was first addressed in Siebe Gorman & Co Ltd v Barclay’s Bank Ltd  2 Lloyd’s Rep 142. In that case, Slade J held at first instance that under common-form charges of the kind under consideration here, charges over the book debts operate as a fixed charge. This decision was later followed in the Court of Appeal in Re New Bullas Trading Ltd  1 BCLC 485. Doubts about the correctness of Siebe Gorman eventually found expression in the Privy Council case of Agnew v Commissioners of Inland Revenue  2 AC 710. At first instance in Spectrum, Sir Andrew Morritt V-C (as he then was) refused to follow Siebe Gorman and instead followed Agnew. The Court of Appeal (Lord Phillips, Jonathan Parker and Jacob LJJ) overruled the Vice Chancellor and reinstated Siebe Gorman. The House of Lords has now overruled the Court of Appeal as well as Siebe Gorman.
The question, ‘Fixed charge or floating charge?’ is important because, in comparison with fixed charges, floating charges have distinct disadvantages so far as the chargee is concerned. Chief among those disadvantages for the chargee is that the preferential creditors take in priority to a floating charge, whereas they do not take in priority to a fixed charge – s 175, Insolvency Act 1986. In the case of a charge created after 15 September 2003, moreover, a proportion of the company’s assets are to be made available to the unsecured creditors in preference to the holders of a floating charge ( s 176A,the Insolvency Act 1986). The proportion, in the case of a company whose assets exceed £10,000, is 50 per cent of the first £10,000 and 20 per cent of the balance, provided that the sums made available to the unsecured creditors in preference to the floating chargees shall not exceed £600,000 – see the Insolvency Act 1986 (Prescribed Part) Order 2003, SI 2003/2097.
Under the charge in Spectrum, the company purported to grant the bank a fixed charge over the book debts. The wording of the charge itself was fully consistent with the requirements of a fixed charge and prima facie inconsistent with the requirements of a floating charge. It provided:
"5. With reference to the book debts and other debts hereby specifically charged [Spectrum] shall pay into Spectrum’s account with the Bank all monies which it may receive in respect of such debts and shall not without prior consent in writing of the Bank sell factor discount or otherwise charge or assign the same in favour of any other 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.."
In other words, the charge was expressed to deprive the chargor of any power to dispose of the book debts and it required him to pay those debts, when collected, to the chargee.
The strictness of the terms of the charge was in contrast to the terms upon which Spectrum was allowed to operate the account into which the book debts were required to be paid. The account was a current account, and Spectrum was permitted to draw on it for business purposes up to its overdraft limit, albeit firstly the bank’s borrowing terms allowed the bank by notice to withdraw or reduce the facility, and secondly the amounts outstanding on the account were payable on demand. As matters turned out, Spectrum paid its book debts into that account, the account was never in credit, and the overdraft limit was never exceeded, but Spectrum eventually went into voluntary liquidation, at which time it was indebted both to the bank and to various preferential creditors.
The decision of the Court of Appeal that the charge was what it purported to be – namely a fixed charge – was based upon the terms of the charge cited above, namely that the charge forbade the chargor from disposing of the book debts, and required the chargor to pay the proceeds of the book debts, beneficially, to the chargee as soon as they were collected. The existence of a separate arrangement between the customer/chargor and the bank, whereby the customer/chargor was entitled to borrow further monies through operating its current account at the bank, was held to be irrelevant.
The argument against this conclusion was that it was artificial to look only at the terms of the charge itself and to ignore its wider commercial context. The House of Lords accepted this argument. A fixed charge operates by attaching to an asset when the charge is granted or, if later, as soon as the charged asset comes into being. Where there is such a charge, an asset that is subject to it cannot be disposed of without the consent of the chargee or the redemption of the charge, and it is not open to the chargor to remove the asset at will from the security which he has created. A fixed charge, therefore, cannot attach to assets which are by their nature circulating, which are replaced in the course of a business and constantly changing and which above all are subject to be withdrawn from the security without reference to the chargee. For assets such as these, only a floating charge is possible. A floating charge is one that "applies to every item comprised in the security, but not specifically affecting any item until some event occurs or some act on the part of the mortgagee is done which causes it to crystallise into a fixed security" Evans v Rival Granite Quarries Ltd>  2KB 979.
Although it is possible to create a fixed charge over book debts, such a charge will not be created in practice where the collected proceeds are credited to the bank’s customer and where the bank’s customer is then permitted to draw on the account to the extent of the sums credited. This is so, even if the debt itself cannot be assigned by the chargor and even if its proceeds have to be paid into an account that the customer maintains with the chargee.
As Lord Scott observed at paras 116 and 117:
"The categorisation depends upon the commercial nature and substance of the arrangement, not upon a formalistic analysis of how the bank clearing system works. If part of the arrangement is that the chargor is free to collect the book debts but must pay the collected money into a specified bank account, the categorisation must depend, in my opinion, on what, if any, restrictions there are on the use the chargor can make of the credit to the account that reflects each payment in…. The critical question, in my opinion, is whether the chargor can draw on the account."
See also at para 119: "The monies in the bank account were assets subject to the charge. If the account had been treated as a blocked account, so long as it remained overdrawn, it would be easy to infer from a combination of that treatment and the description of the charge as a fixed charge that Spectrum had no right to draw on the account until the debit on the account had been discharged. But the account was never so treated. The overdraft facility was there to be drawn on by Spectrum at will… The bank could, by notice, have terminated the overdraft facility, required immediate payment of the indebtedness and turned the account into a blocked account. Pending such a notice, however, Spectrum was free to draw on the account. Its right to do so was inconsistent with the charge being a fixed charge and the label placed on the charge by the debenture cannot in my opinion, be prayed in aid to detract from that right."
Some consequences of Spectrum
Bank charges over book debts often stipulate that the chargee is entitled to call for a formal written assignment by the chargor of the book debts as they accrue. Where a charge operates as a fixed charge over the book debts, any charge containing an entitlement to call for an assignment would operate as an assignment in equity of any book debt at the moment when that debt is created – see Spectrum at para 104. On the other hand, if a charge operates only as a floating charge, the assignment will not be effected until crystallisation of the charge occurs – see Business Computers Ltd v Anglo-African Leasing Ltd  2 All ER 741 at 745.
Because of Spectrum, it is now apparent that many book debts are assigned to chargees later than had previously been supposed – on crystallisation of the charge rather than upon creation of the debt. Therefore, it is necessary to see in what circumstances, if any, a company’s debtor would now be able to assert a set-off where previously he would not have been able to do so. Before dealing directly with this question, it is first necessary to review the basics of the law of set-off.
There are three types of set-off:
legal set-off, the origin of which is certain non-insolvency statutes;
equitable set-off; and
set-off in insolvency (created by a series of statutes bearing on insolvency).
Equitable set-off affects the substantive rights of the parties. Where one debt can be set off thus against another debt, the amount of the one debt is reduced by the other. Equitable set-off is only available, however, where it is established, first, that the cross claim is at least closely connected with the same transaction as that giving rise to the claim; and secondly, that the relationship between the respective claims is such that it would be manifestly unjust to allow one to be enforced without regard to the other – see Hanak v Green  2 QB 9. Legal set-off by contrast does not reduce the value of either debt. It "addresses questions of procedure and cash flow. As a matter of procedure, it enables a defendant to require that his cross-claim (even if it is based upon a wholly different subject matter) be tried together with the plaintiff’s claim instead of having to be the subject of a separate action. In this way it ensures that judgment will be given simultaneously on claim and cross- claim and thereby relieves the defendant from having to find the cash to satisfy a judgment in favour of the plaintiff (or in the 18th century go to a debtor’s prison) before his cross-claim has been determined" Stein v Blake  1 AC 243, 251.
Insolvency set-off is of much wider scope. It applies to any claim arising out of mutual credits or other mutual dealings before, in the case of a company, the company goes into liquidation – r 4.90, Insolvency Rules 1986 (the latest version having been substituted by the Insolvency (Amendment) Rules 2005). Moreover, its effect is to eliminate the claim and cross-claim altogether and to substitute only the net balance owing by one to the other – see Stein page 255. In any case of insolvency, therefore, it is beneficial to any debtor with a potential set-off to show that his case comes within the rules governing insolvency set-off: for if he cannot do this and if he can only assert a common-law set-off, the debt he owes will not be reduced by the debt he is owed – he will only be able to set off whatever he can obtain by proving in the liquidation – whereas if he can show equitable set-off will only apply, he will only be able to get the benefit of this if the claim and cross-claim are connected with one another as described above. As an illustration, by way of contrast, as to how far the insolvency set-off provisions can extend where they apply, they entitle a guarantor of a company’s indebtedness to set off against his debt to the company the company’s debt to him, which arises out of his payment of any debt to the company which he has guaranteed to a third party creditor. This is so even if, at the time when the company goes into liquidation, no demand has yet been made under the guarantee and the guarantor’s eventual claim, the company is contingent and unquantified – see Re West End Networks Ltd, Secretary of State for Trade and Industry v Frid  2 All ER 1042.
The importance of Spectrum in cases of set-off derives from the fact that the insolvency set-off provisions do not apply to a debt which has been assigned by the company before the company has gone into liquidation. The assignment destroys the mutuality upon which the applicability of the insolvency set-off provisions depends, even where the debtor with a set-off has been given no notice of the assignment – see Re City Life Assurance Company Ltd, Stephenson’s case  Ch 191.
On the other hand, the position will be different, it is submitted, where a book debt is assigned simultaneously with the company going into liquidation. In practice, this simultaneity would arise whenever the charge crystallises by virtue of the company going into liquidation. The reason why the insolvency set-off rules would then apply is that the set-off rules are "self-executing" – that is to say, when the company goes into liquidation, the original claim and cross claim disappear and are replaced by an entitlement by the one against the other for a net balance, without anyone having to do anything to bring this about – see Stein page 255. From this it follows that the debt which is assigned in consequence of the crystallisation of the charge will constitute only the balance which results from the self-execution of the insolvency set-off provisions.
If one is dealing with equitable set-off, the importance of the timing of the assignment and the insolvency will not be quite so stark. In such cases, the general rule is that where a debt owed by a debtor D to a creditor C is assigned by C to a third party T, D will be able to set off against T an obligation owed to him by C, provided that D had no notice of any assignment of his debt from C to T – see Business Computers Ltd. Again, however, it must be remembered that the class of debts capable of set-off in equity is much narrower than that which is capable of set-off under the insolvency provisions.
The response to the Spectrum decision therefore is likely to be that chargees of the debts of a failing company will be astute in the future to instigate crystallisation by whatever means they can, or to block the company’s account prior to the company going into liquidation. On the other hand, persons who have dealings with a company against which they are likely to have substantial set-offs will be well advised to insert contractual provision for set-offs in any documents governing their dealings with the company.
Leaving aside the question of set-off, it should also be mentioned that, in the light of Spectrum, debtors will need to be careful as to whom they pay the debts which they owe to an insolvent company. In particular, the provisions of s 245 Insolvency Act 1986 apply to charges over book debts. These provisions invalidate a floating charge except in so far as it secures new monies introduced, if the charge is created (as regards persons not connected with the company) less than a year before the company becomes insolvent, and if it is created (as regards persons connected with the company) less than two years before insolvency.
These considerations now have greater practical urgency than before because, as a result of the reforms enacted by the Enterprise Act 2002, it is becoming increasingly rare for an administrative receiver to be in place at the behest of the holder of a floating charge. Therefore, if a debtor pays the debt to the chargee and the chargee happens not to be entitled to receive it so that the debt is not extinguished, the debtor may not even have the comfort of knowing that he is dealing with a licensed insolvency practitioner. To avoid complications, it would therefore be prudent for a debtor to seek the agreement of the chargee on the one hand and the administrator or liquidator on the other before paying the debt. In cases of doubt, interpleader relief can be sought under RSC O17 (which survives in the schedule to the CPR).
Vol 149 No 35 16-09-05
David Schmitz is a barrister practising from 10 Old Square, Lincoln’s Inn
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