74 the context of corporate insolvency law

Finally, there is a class of involuntary creditor that should not be forgotten. This is the individual or firm who is owed money because they are entitled to payment from the company in accordance with a court order. Thus victims of corporate torts may be treated as corporate creditors and will have participatory rights in an insolvency.

How to borrow

Credit arrangements are complex and, as will be discussed below, are exploding in complexity. It is, therefore, useful before proceeding further to map out the main legal methods – or building blocks – of borrowing. This will give a picture of the array of options that are open to companies seeking funds. It should be repeated first, however, that not all ways of raising money involve credit. As we will see below, companies can raise finance through the sale of equity shares – a process in which money is put into the company in return for dividends and a hoped-for increase in share value. These shareholders are not creditors of the company, who have rights against the company, but owners of the company with rights in it.20

Credit can be obtained in four main ways: by offering security; by seeking an unsecured loan; by using a sale as a de facto security arrangement; and by resort to a third-party guarantee.

Security

When borrowing companies offer security to lenders this may prove attractive to the latter because, inter alia, it reduces their loan risks by giving them privileged claims to repayment in the event of the borrowing company’s insolvency.21 The normal rule in a corporate insolvency is

20Capital in modern company law is used to cover not only share capital provided by the proprietors but also the loan capital provided by the creditors. On shareholders viewed as owners of the company see, for example, H. Butler, ‘The Contractual Theory of the Corporation’ (1989) 11 Geo. Mason UL Rev. 99. On different characterisations of the nature of a shareholder’s interest see E. Ferran, Company Law and Corporate Finance (Oxford University Press, Oxford, 1999) pp. 131–3.

21On varieties of security see generally Fuller, Corporate Borrowing, ch. 6; A. L. Diamond,

A Review of Security Interests in Property (DTI, HMSO, London, 1989) (‘Diamond Report’). Note the lack of rationality in the use of the term ‘security’ in England, i.e. the lack of distinction between the security agreement which creates the security and the property securing the obligation: see R. Cranston, Principles of Banking Law (2nd edn, Oxford University Press, Oxford, 2002) p. 399. On the effect of security in general see Cork Report, p. 12.

supposedly that all unsecured creditors are treated on an equal footing – pari passu – and share in insolvency assets pro rata according to their pre-insolvency entitlements or sums they are owed.22 Security avoids the effect of pari passu distribution by creating rights that have priority over the claims of unsecured creditors.23

Security can arise either consensually or through operation of the law. There are four forms of consensual security in English law: the pledge; the contractual lien; the mortgage; and the equitable charge. Pledges involve the creditor taking possession of the debtor’s assets (goods or documents of title to goods) and retaining these as security until payment of the debt. The early common law demanded actual transfer of possession to the creditor but the development of the doctrine of constructive possession obviated the need for this.24 Where a contractual lien is used to obtain credit, the borrower gives the creditor, by contract, a power to detain goods already in the creditor’s possession for nonsecurity reasons and to use these as security for payment. This position might arise, for instance, where the creditor possesses an item of machinery in order to carry out maintenance work. A lien differs from a pledge in conveying a power to detain the goods rather than sell them on default by the borrower.25

A mortgage of chattels transfers ownership to the creditor as security on a condition (express or implied) that there shall be reconveyance to the debtor once the secured sum has been repaid. In the case of land, however, a mortgage interest can be hived off from a fee simple so that land mortgages do not involve complete transfers of ownership and both mortgagor and mortgagee have concurrent legal estates (fee simple possession) and they can be applied to all classes of asset, tangible and intangible. They are, accordingly, of enormous utility to borrowers.

22On pari passu see chs. 14 and 15 below; D. Milman, ‘Priority Rights on Corporate Insolvency’ in A. Clarke (ed.), Current Issues in Insolvency Law (Stevens & Sons, London, 1991).

23See Cork Report, ch. 35, paras. 149–97; Goode, Commercial Law, part IV.

24See I. Snaith, The Law of Corporate Insolvency (Waterlow, London, 1990) pp. 12–13, 24–8.

25See Goode, Commercial Law, p. 585; but see Re Hamlet International plc [1998] 2 BCLC 164, where a contractual possessory lien over goods, granted by a customer to a company, coupled with a contractual right entitling the company to sell such goods to pay sums owed to it by the customer, did not constitute a charge registrable under the Companies Act 1985 s. 395 (see now Companies Act 2006 s. 860). On registration of company charges generally see H. Beale, M. Bridge, L. Gullifer and E. Lomnicka, The Law of Personal Property Security (Oxford University Press, Oxford, 2007).

76 the context of corporate insolvency law

The use of an equitable charge allows debtors to agree that certain specific items of their property will be available as security for loans. Such a charge does not involve a transfer of ownership or possession; instead it gives the creditor a right to have the designated asset sold to discharge the debt. The equitable charge may be fixed on a particular asset or may be floating. With fixed charges the debtor may dispose of the asset only with the creditor’s consent (or by repaying the debt). The floating charge hovers over a stipulated class of assets in which the debtor has present or future interest. The debtor is, however, free to deal with particular assets within the class while the charge remains floating, that is until the point when the charge crystallises and fixes on all the assets then in the fund.26

As for security arising through operation of the law (‘non-consensual security’), this may be anticipated by the potential corporate debtor and used as a way of establishing a credit arrangement. The main forms of security thus arising are the lien, the statutory charge, the noncontractual right of set-off, the equitable right to trace and procedural securities.27

Liens, as noted, give persons in possession of the property of others for the purposes of work a right of retention until the work at issue has been paid for. Liens may arise through the operation of the common law,28 equity29 or statute.30 A statutory charge gives the chargee a right to apply to the court for an order of sale where a debt has not been paid.31 Both law and equity allow mutual debts between parties to be set off.32 Equitable tracing allows a person whose asset has been wrongfully

26Or on assets of the specified description subsequently acquired by the debtor: see Goode, Commercial Law, p. 587. Crystallisation arises on the occurrence of a number of events, e.g. the commencement of the winding up of the company, the chargee appointing a receiver under the terms of the charging document or the chargee taking possession of the assets. Crystallisation will also occur where an administrator is appointed by a qualifying floating charge holder under the Insolvency Act 1986 Sch. B1, paras. 2(b), 14.

27See generally Snaith, Law of Corporate Insolvency, ch. 6; Goode, Commercial Law, pp. 619–23.

28Some general liens may extend to all goods in the lienee’s possession whether the sum payable relates to work done on those goods or other work. Thus solicitors, bankers and others enjoy these liens: see Goode, Commercial Law, p. 619.

29Which does not require possession, as with the vendor of the land’s lien to secure the purchase price.

30See also the maritime lien: Goode, Commercial Law, p. 621; D. Jackson, ‘Foreign Maritime Liens in English Courts: Principle and Policy’ [1981] 3 LMCLQ 335.

31E.g. the Legal Aid Act 1988 s. 16(6) gave the Law Society a charge on money and property recovered in proceedings by a legally aided litigant to secure payment of Law Society costs.

32See ch. 14 below.

disposed of by another to assert a claim to the proceeds received in exchange for it. Finally, procedural securities may operate at law so that a company making a claim through the legal process can apply to have certain of its opponent’s assets taken into the custody of the court as security for satisfaction of the claim at issue or, inter alia, an order for costs.33

Unsecured loans

A company can seek a loan without offering security but in such an arrangement the lender bears the risk that if the debtor company becomes insolvent its own debt will be satisfied after the secured creditors have been paid. The unsecured creditor, moreover, has no enforceable interest in the debtor’s property prior to bankruptcy or winding up, only a right to sue for money owed and to enforce a court judgment against the debtor.

Like a secured loan, an unsecured loan may constitute ‘loan credit’ – the loan of money – or it may be ‘sale credit’ – where goods or services are supplied to the debtor but payment of the price for these is allowed to be delayed. In practice, however, sale credit in the normal course of trade is more likely to be unsecured than secured. Companies, moreover, may seek either fixed-sum or revolving credit.34 With the former the debtor takes a fixed amount for a stated period but with revolving credit there is an ongoing facility to draw varying sums within agreed limits.

Quasi-security

Companies can enter into a number of legal relationships that, on their face, appear to be sale arrangements but which operate in practice as security devices.35 These arrangements may merit the close attention of insolvency lawyers since they can be seen as having roles both in supplementing and in circumventing legal rules and principles covering corporate insolvency. They may, for example, not require registration and the assets involved may not be caught in the insolvency net. The main

33See Goode, Commercial Law, pp. 622–3; D. Milman, ‘Security for Costs: Principles and Pragmatism in Corporate Litigation’ in B. Rider (ed.), The Realm of Company Law (Kluwer, London, 1998) ch. 9. See also ch. 13 below.

34See Goode, Commercial Law, p. 581. On ‘running account credit’ see Consumer Credit Act 1974 s. 10(1) (as amended by Consumer Credit Act 2006).

35See F. Oditah, Legal Aspects of Receivables Financing (Sweet & Maxwell, London, 1991) p. 11; M. G. Bridge, ‘Form, Substance and Innovation in Personal Property Security Law’ [1992] JBL 1.

78 the context of corporate insolvency law

devices are reservations of title;36 hire purchase agreements; sale and lease back; sale and repurchase; and discounting of receivables.37 The key aspect of these agreements is that the debtor company is able to raise funds by allowing ownership to rest with the ‘creditor’ rather than offering security, and the ‘creditor’ avoids having to compete for insolvency assets with other creditors because he or she holds title or has not passed title in the assets at issue to the insolvent company.

With reservations of title, for instance, the goods will be sent to the ‘debtor’ company by the seller, ‘creditor’ A, but ownership, it will be stipulated, will not pass until the full price has been paid. If the debtor company becomes insolvent, the goods, whose title remained with A, do not form part of the insolvency assets.38 In a sale and lease back a similar effect is achieved by the debtor selling an asset to the creditor in return for a sum of money and continuing to use the asset (for example, a warehouse) by leasing it back under a hire or hire purchase agreement.39 The creditor retains the title throughout and the warehouse does not form part of the insolvency assets or estate. Sale and repurchase offers another variation in which the company sells goods to the debtor company for a price to be paid in instalments. The agreement states that where the debtor defaults, A may repurchase the goods after deducting the amount outstanding from the purchase price. Finally, discounting of receivables (or factoring) involves the purchase of invoiced receivables (sums due under outstanding invoices) at less than their face value. The

36Surveys reveal that the majority of suppliers employ retention of title clauses in their conditions of sale. J. Spencer, ‘The Commercial Realities of Reservation of Title Clauses’ [1989] JBL 220, 221 surveyed fifty suppliers and found that 59 per cent of respondents said they used such clauses. Wheeler examined fifteen receiverships and liquidations and found that 92 per cent of suppliers of goods had ‘some sort of reservation of title provision’: see S. Wheeler, Reservation of Title Clauses (Oxford University Press, Oxford, 1991) p. 5.

37See Goode, Commercial Law, p. 609; Oditah, Legal Aspects, pp. 32–5, 50–5; A. Hewitt, ‘Asset Finance’ (2003) 43 Bank of England Quarterly Bulletin 207. See also Goode, Commercial Law, pp. 605 ff. on the imposition of conditions on the right to withdraw a deposit and contractual set-off. On charges over credit balances see Re BCCI (No. 8) [1997] 3 WLR 909; R. M. Goode, ‘Charge-Backs and Legal Fictions’ (1998) 114 LQR 178; G. McCormack, ‘Charge-Backs and Commercial Certainty in the House of Lords’ [1998] CfiLR 111; E. Mujih, ‘Legitimising Charge-Backs’ [2001] Ins. Law. 3.

38See generally Wheeler, Reservation of Title Clauses; I. Davies, Effective Retention of Title

(Fourmat, London, 1991); G. McCormack, Reservation of Title (2nd edn, Sweet & Maxwell, London, 1995). See also ch. 15 below.

39See J. Ulph, ‘Sale and Lease-back Agreements in a World of Title Relativity: Michael Gerson (Leasing) Ltd v. Wilkinson and State Securities Ltd’ (2001) 64 MLR 481.