If only it were as simple as swishing your wand and chanting "Wingardium Leviosa" in your best Hermione Granger voice. The question of whether a fixed charge is susceptible to being recharacterised as a floating charge has challenged the legal community since before Ms Granger was even born. In fact some of the case law would not be out of place in the Hogwarts library (although it wouldn't have done anything for JK Rowling's sales figures).

What's the difference between a fixed and a floating charge?

If a charge is fixed, the charged asset is clearly identified and will be appropriated to the satisfaction of the secured debt.

A floating charge on the other hand "hovers" above a fluctuating class of assets.  It is only when the floating charge crystallises that the assets which are then in that fluctuating class are appropriated towards the satisfaction of the secured debt.

Put bluntly, this distinction can mean the difference between enforcement proceeds from a particular charged asset being made available to the chargeholder to be applied directly in reduction of the secured debt and that chargeholder being left out of pocket because the floating charge recoveries are insufficient.

This is because under English law once assets have been realised by an insolvency practitioner the proceeds will be distributed in the order prescribed by a statutory waterfall.

A creditor who holds fixed security over an asset will receive the net enforcement proceeds from that asset.

Floating charge holders, however, are much further down the order of distribution and they will receive nothing until the following prior ranking claims have all been paid in full:

  • administration / liquidation costs and expenses (which, for example, includes any tax arising on the insolvency practitioner's sale of charged assets, rent for premises used by the insolvency practitioner and the insolvency practitioner's own remuneration);
  • the prescribed part which the insolvency practitioner has to set aside out of floating charge recoveries for the benefit of unsecured creditors (in an amount of up to £600,000 per chargor); and
  • preferential creditors, including certain employee claims.

There are other disadvantages with a charge being designated a floating charge as opposed to a fixed one. In particular:

  • A floating charge is invalid for a period of 12 months (extended to two years if the security is granted to a connected party) save to the extent of new money provided (Section 245 of the Insolvency Act 1986). Fixed charges (whilst open to challenge on other grounds such as being a preference or transaction at an undervalue) are not subject to this particular challenge. In addition, those other challenges are just that - the insolvency practitioner has to take steps to challenge the particular transaction - whereas under s.245 a floating charge which does not secure any new moneys is simply invalid if it is given within the relevant time and if the solvency defence in s.245(4) is not available. 
  • An administrator can deal with floating charge assets freely without the consent of the chargeholder or the court.

The commercial reality

However, whilst parties to a leveraged finance transaction need to appreciate the impact that this important distinction between fixed and floating charges has, there is often a clear conflict of interest between them.

The reason for this is that sponsors generally want to maintain a lot of flexibility for their portfolio businesses to deal with their assets, notwithstanding that those assets have been charged to secure the business' debt facilities.

On the other hand, chargeholders will want those charges which they intend to operate as fixed charges not to be susceptible to recharacterisation risk.

Recharacterisation risk

When reviewing the charging clauses of a security document, rather as Professor Dumbledore might say, things are not what they may at first appear.

It is tempting to think that if a charge is described as being "fixed" then it is to be treated as fixed for all purposes. Unfortunately, a long line of cases culminating in Re Spectrum Plus and Brumark have demonstrated that this is not the case, even if the parties intended a particular charge to be a fixed charge.

Instead the courts will ascertain the rights and obligations of the parties in relation to the charged assets and then characterise those rights and obligations as a matter of law to decide whether or not the charge has the characteristics of a floating charge.

There is no definition as such of a floating charge, but rather the famous (well to lawyers anyway) Yorkshire Woolcombers' case identified three characteristics borne by a floating charge. Of these, the third characteristic is given the most weight: "It is contemplated by the charge that, until some future step is taken by or on behalf of those interested in the charge, the company may carry on its business in the ordinary way as concerns that particular class of asset".  In other words, is the chargeholder in control of the charged asset or is the chargor free to deal with the charged asset notwithstanding the charge it has given?

You can see where this is going. In their drive for flexibility, many borrowers are asking for freedoms to deal with their charged assets in such a way as to be inconsistent with the chargeholder being able to uphold a fixed charge over those assets.

Whilst the cases referred to earlier all related to charges over book debts, the recharacterisation risk applies to any asset subject to a purported fixed charge. On a typical leveraged finance transaction it will not be feasible for the lenders to attempt to take a fixed charge over the receivables of the business, because to do so in a manner which would stand up to scrutiny, the business would not be given access to its cashflows which would strangle the business right from the outset. It is though usually pretty fundamental to the lenders that they obtain valid fixed security over other key assets, including real estate and shareholdings.

The conundrum is that the case law has not made clear exactly what level of control is necessary in order for a charge to be fixed.  If the chargor is given the freedom to dispose of assets subject to a purported fixed charge, that is clearly inconsistent with a fixed charge and the charge would be recharacterised as a floating charge on enforcement. If a chargor is prohibited from any dealings with the charged asset, or its proceeds whilst the security subsists, that would be a fixed charge. However, there are shades of grey (and no I'm not going to start referring to that particular book). It is very likely that the parties will agree concessions as to how the chargor can continue to deal with the charged assets which lie somewhere between these two extremes and so every case has to be assessed on its own facts.

The Dark Art bit

This hopefully explains why, when negotiating the draft finance documents, your lawyers pore over the minute detail of permitted disposals and other permissions and concessions which may cede control to the chargor and hence prejudice the effectiveness of the security package. This task is made all the more difficult because:

  • it is not possible for a chargeholder to exercise control at a later stage (say after an event of default) and for that to rectify an earlier lack of control being exercised by the chargeholder.  The case law is clear that the chargeholder needs to exert control from the very outset if the charge is to be upheld as a fixed one; and
  • the expressed control cannot be a sham.  Writing in controls which are then never exercised or which do not involve the chargeholder considering whether or not to release an asset from security (such as an automatic "sweep" of collected receivables from a chargeholder's collection account into the chargor's current account) is a tactic doomed to failure.

For reasons, which should now be clear, it is important for the parties to appreciate the reason why the distinction between fixed and floating charge matters. Commercial realities are such that the sponsor and lenders strive to find a middle ground, which requires some creative thinking and on occasion some magical drafting and it can be difficult even then to predict success categorically in borderline cases.