Insolvency, Partnership & Company Law – The unsecured balance – when a floating charge is just not enough
By : Sara Benbow
Recent authority emphasises the impact of the Enterprise Act 2002 on holders of fixed and floating charges and modifies the pari passu rule
All too often the holders of a floating charge over the assets of an insolvent company are confronted by the realisation that their security will not be sufficient to discharge the debt in full. In the past, such creditors have often sought to prove the unsecured balance of the debt as if they ranked pari passu alongside entirely unsecured creditors in that regard. Since 15 September 2003 the position of floating charge-holders in the context of liquidations, administrations, provisional liquidations and receiverships has been adversely impacted by the introduction of the “Prescribed Part” fund under section 176A of the Insolvency Act 1986. That fund, taken from the part of the company’s assets which would otherwise have fallen within debentures and floating charges created after the commencement date, is to be made available for the satisfaction of unsecured debts and cannot ordinarily be used for the benefit of the charge-holders until all the unsecured debts have been satisfied.
In the recent case of Thorniley v Revenue and Customs Commissioner and another, the administrators of two associated companies applied for directions from the Court as to whether the floating charge-holder was entitled to be treated as an unsecured creditor in respect of any shortfall in the value of his security, and therefore to benefit alongside the entirely unsecured creditors from the Prescribed Part fund. Patten J considered the point in some detail, and his conclusions will have serious ramifications for all non-preferential creditors of a company in one of those forms of insolvency, whether those creditors benefit from charges over the assets or not.
The Judge defined the question in terms of the statutory provision as being “whether “unsecured debts” in s.176A(2) include the unsecured balance of the debts due to the floating charge holder or other secured creditor” . He noted that the point was only just coming up for consideration because section 176A had been introduced by the Enterprise Act 2002 and applied only to floating charges created after the implementation of the section on 15 September 2003.
In Thorniley, the Prescribed Part fund was calculated at £265,000 and the net assets left for the chargeholder were valued at £1,047,000. The debts covered by the floating charge amounted to more than £6,000,000, leaving the chargeholder with an unsecured shortfall of more than £5,000,000. The total unsecured debts of the company including the shortfall to the chargeholder were approximately £6,335,000. If the chargeholder was allowed to participate in the division of the Prescribed Part fund, he would have taken between £195,000 and £198,000 of it depending on whether or not he could include the value of the Prescribed Part fund itself as part of his shortfall, HMRC would have taken around £25,000 and only £42,000 to £44,000 would have been left for the other unsecured creditors: a realisation of only about 4p in the £. If, however, the chargeholder was not entitled to share in the Prescribed Part fund, the recovery for HMRC and the other unsecured creditors would rise to £96,000 and £168,000 respectively, or approximately 16p in the £.
Because of the novelty of the point it was necessary for the Judge to consider the purposes behind the Enterprise Act 2002 and its amendments to the insolvency regime, particularly as those amendments affected the holders of floating charges. He noted that the July 2001 White Paper described one of the principal purposes of the Act as “ the streamlining of the administration procedure and the establishment of collective procedures designed to allow all creditors to participate whilst recognising their differing rights and status”, and observed that “To this end the right of secured creditors to appoint administrative receivers was curtailed and administration promoted as the appropriate means of regulating an insolvent company where there is some prospect of a rescue.” The Judge went on to identify two significant changes brought about by the 2002 Act in this context: first the creation in paragraph 65 of Schedule B1 of an express power for the administrator to make distributions to creditors, with restrictions on doing so other than to secured or preferential creditors without the permission of the Court; and second the reduction in the number of preferential creditors by the abolition of Crown preference. In respect of the latter change he observed that “As the White Paper recognises, if taken alone the most immediate (and in many cases the sole) beneficiaries of this change will be the floating charge holders and this will be the position for all floating charges created before 15 September 2003. But beyond this transitional stage the intention behind the legislation was to benefit unsecured creditors.”
Against that background, HMRC on behalf of themselves and the other unsecured creditors submitted that the clear intention of Parliament was to take away from the holders of floating charges a proportion of what they would otherwise have expected to recover and to redistribute the whole of that portion to the other creditors of the company who did not benefit form any form of security. They argued that to permit the holders of floating charges to participate in the division of the Prescribed Part fund would be to give back the majority of what section 176A was designed to remove from them for the benefit of the other creditors.
Those submissions found favour with the Judge. He concluded that section 176A should be construed through the language and provisions of the legislation itself; that whilst there was no express exclusion of a shortfall from the meaning of “unsecured debts”, the distribution under section 176A(2) was clearly intended to be only to unsecured creditors who, on the definition in section 248 would not include the holders of a fixed or floating charge; and that this focus on the identity of the creditor rather than the nature of his debt was consistent with other aspects of the Insolvency Act and Rules. The fact that this approach could not be made to fit with the usual pari passu rule did not seem to trouble the Judge at all. Observing that the rule, although fundamental, was not to be treated as immutable, he waved aside centuries of precedent in a short paragraph, modifying the rule “so as to differentiate between unsecured creditors with no form of security and the unsecured claims of secured creditors” in order to achieve the perceived economic objective of the legislature.
The impact of Patten J’s decision on creditors of insolvent companies is immediately apparent: those with fixed or floating charges will often see their percentage recovery significantly reduced and may therefore be more prepared to contemplate an alternative such as a CVA, whereas the unsecured creditors can be more confident of receiving at least some degree of payment through the administration or liquidation routes. However, given the abolition of Crown Preference and inclusion of HMRC in the category of ordinary unsecured creditors, the likelihood is that the government coffers will be the greatest beneficiary of this ruling in the vast majority of cases.
By Sara Benbow
presently defined by the Insolvency Act (Prescribed Part) Order 2003 [S.I. 2003/2097] as 50% of the company’s net property where the value of the net property is less than £10,000 and otherwise 50% of the first £10,000 plus 20% of the rest up to a maximum of £600,000
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