92 the context of corporate insolvency law

Floating charges

The floating charge, as noted, attaches to a class of a company’s assets, both present and future, rather than to a stipulated item of property.96 The assets covered are of a kind that in the ordinary course of business are changing from time to time and it is contemplated that until some step is taken by those interested in the charge, the company may carry on business in the ordinary way and dispose of all or any of those assets in the course of that business.97 Central to the floating charge, accordingly, is the notion of crystallisation. The company is free to deal with the property charged until an event occurs that converts the charge into a fixed charge over the relevant assets in the hands of the company at the time. The events that the law treats as crystallising the floating charge are the winding up of the company, the appointment of a receiver, the appointment of an administrator98 and the cessation of the company’s business. Parties to a charge can, on some authorities, also agree contractually that a floating charge created by a debenture may be crystallised automatically on the occurrence of an expressly stated crystallising event.99

Floating charges are commonly given over the whole of the undertaking of the borrowing company but the company, nevertheless, may deal with or dispose of such property without the approval of, or even consultation with, the charge holder. The floating charge, as a device, raises serious issues of fairness, notably as regards the balance between the protection it offers to secured creditors and the resultant exposure of the ordinary, unsecured creditor. Such matters, however, will be returned to in chapter 15; here the focal question is economic efficiency.

96See Illingworth v. Houldsworth [1904] AC 355; Robson v. Smith [1895] 2 Ch 118; Re Yorkshire Woolcombers’ Association Ltd [1903] 2 Ch 284; Cork Report, paras. 102–10. See generally S. Worthington, Proprietary Interests in Commercial Transactions

(Clarendon Press, Oxford, 1996) ch. 4; Ferran, Company Law and Corporate Finance, pp. 507–17; R. Grantham, ‘Refloating a Floating Charge’ [1997] CfiLR 53; D. Milman and D. Mond, Security and Corporate Rescue (Hodgsons, Manchester, 1999) pp. 50–2; Carruthers and Halliday, Rescuing Business, pp. 195–210; J. Getzler and J. Payne (eds.), Company Charges: Spectrum and Beyond (Oxford University Press, Oxford, 2006).

97On freedom to deal in the ‘ordinary course of business’ see Etherton J in Ashborder BV v. Green Gas Power Ltd [2005] BCC 634, esp. para. 634.

98Under the Insolvency Act 1986 Sch. B1, paras. 2(b), 14; see further Goode, Commercial Law, pp. 681–6.

99See Goode, Commercial Law, pp. 683–4; Re Brightlife Ltd [1987] Ch 200; Cork Report, paras. 1575–80.

Why security? The economic efficiency case

Does the law’s providing for security lead to an economically efficient use of resources?100 Here again it is necessary to consider the position in relation to both healthy and troubled companies. In answering the question it will be assumed, in the first instance, that security is offered under a system of full priority – in which security interests prevail over

unsecured claims in insolvency. An extended debate has been carried out in the USA on the economic efficiency case for security101 and a number

of commentators from a law and economics background have pointed to a series of advantages of security, notably that it helps companies to raise new capital and it is conducive to economically efficient lending by reducing creditors’ investigation and monitoring costs.

Security facilitates the raising of capital A system of security, with priority, is frequently said to permit the financing of desirable activities that otherwise would not be funded.102 Thus, where a firm has a low credit rating but gains the opportunity to enter into a profitable activity subject to moderate levels of risk, it may be able to obtain funds by granting security when it would be unable to obtain unsecured loans. From the creditor’s point of view, the benefit of a security with priority reduces the risks of lending and such risk reduction will be reflected in a lower interest rate. A strong priority system, furthermore, assures the creditor that the security enjoyed will not be diluted by the debtor’s obtaining more loans by offering further security.103

100This discussion draws on V. Finch, ‘Security, Insolvency and Risk: Who Pays the Price?’ (1999) 62 MLR 633.

101See, for example, T. H. Jackson and A. T. Kronman, ‘Secured Financing and Priorities Among Creditors’ (1979) 88 Yale LJ 1143; R. Barnes, ‘The Efficiency Justification for Secured Transactions: Foxes with Soxes and Other Fanciful Stuff’ (1993) 42 Kans. L Rev. 13; J. White, ‘Efficiency Justifications for Personal Property Security’ (1984) 37 Vand. L Rev. 473; W. Bowers, ‘Whither What Hits the Fan? Murphy’s Law, Bankruptcy Theory and the Elementary Economics of Loss Distribution’ (1991) 26 Ga. L Rev. 27; F. Buckley, ‘The Bankruptcy Priority Puzzle’ (1986) 72 Va. L Rev. 1393; S. Schwarcz, ‘The Easy Case for the Priority of Secured Claims in Bankruptcy’ (1997) 47 Duke LJ 425; L. LoPucki, ‘The Unsecured Creditor’s Bargain’ (1994) 80 Va. L Rev. 1887; Triantis, ‘Financial Slack Policy’; C. Hill, ‘Is Secured Debt Efficient?’ (2002) 80 Texas L Rev. 1117; J. Westbrook, ‘The Control of Wealth in Bankruptcy’ (2004) 82 Texas L Rev. 795.

102See, for example, S. Harris and C. Mooney, ‘A Property Based Theory of Security Interests: Taking Debtors’ Choices Seriously’ (1994) 80 Va. L Rev. 2021 at 2033, 2037; R. Stulz and H. Johnson, ‘An Analysis of Secured Debt’ (1985) 14 Journal of Financial Economics 501, 515–20.

103Priority assured by registration: see Companies Act 2006 Part 25; Boyle & Birds’ Company Law (6th edn, Jordans, Bristol, 2007) ch. 10. In the USA priority is secured

94 the context of corporate insolvency law

The fixed charge may encourage institutions such as banks to advance funds to companies but the disadvantage of such a charge, in efficiency terms, is that it restricts the freedom of the company’s management to deal with the assets charged in the ordinary course of business. This might not present great difficulty where the company’s main asset is land, but where the bulk of assets is represented by machinery, equipment, trading stock and receivables104 such constraints might inhibit business flexibility at some cost. As for the fixed charge and insolvencies, enforcement issues are relatively simple, assisted by the requirement that such charges be registered.105

Turning to the floating charge, the efficiency rationale is that it allows the creation of security on the entire property of the borrowing company and so provides companies with an easy and effective way to raise money by offering considerable security to the lender. At the same time it involves minimum interference in company operations and management. For bankers, the floating charge offers an attractive way to secure loans. It gives them a broad spread of security together with priority over

unsecured creditors of the company (commonly trade creditors or customers).106 Any provider of finance to a company may ask for the

security of a floating charge but such charges are normally encountered in the case of banks lending by overdraft or term loan and the purchasers of debentures in the loan stock market. (Such lenders will usually combine fixed charge security over stipulated assets such as land or buildings with a floating charge over the rest of the company’s assets and undertaking.)107

The Cork Report noted108 in 1982 that the use of the floating charge was so widespread that the greater part of the loan finance obtained by companies, particularly finance obtained from banks, involved floating charge security and that the majority of materials and stock in trade of the corporate sector was subject to such charges.109

under Article 9 UCC by filing: see Bridge, ‘Form, Substance and Innovation’; Bridge, ‘The Law Commission’s Proposals for the Reform of Corporate Security Interests’ in Getzler and Payne, Company Charges, pp. 269–70; Bridge, ‘How Far Is Article 9 Exportable? The English Experience’ (1996) 27 Canadian Bus. LJ 196.

104See pp. 128–9 below; Oditah, Legal Aspects.

105See e.g. Boyle & Birds’ Company Law, ch. 10.

106But not with regard to the ‘prescribed part’ of funds under the Insolvency Act 1986 s. 176A: see pp. 108–10 below.

107The fixed charge will give priority over preferential creditors: see ch. 14 below.

108Cork Report, para. 104.

109In the three banks studied by Franks and Sussman more than 80 per cent of all client companies involved in the rescue study had a floating charge held by the bank and the

As indicated, security offers a way to reduce loan costs by reducing the risks faced by lenders: if the company does meet trouble, the lender with security has a better chance of recovery than would be the case if all creditors drew from the same pool.110 Such considerations are at their strongest where the form of security offers a level of risk reduction that is quantifiable. In the case of the floating charge there are, however, uncertainties inherent in the device and the relevant law (to be discussed below) which reduce the degree to which such quantification is possible.111

Security reduces investigation and monitoring costs A further reason why security is claimed both to encourage lending and to produce economically efficient lending is, as noted, that it can offer the creditor a far more economical means of managing the risks of lending than is potentially provided by an investigation into the creditworthiness of the debtor.112 The creditor granted a security that covers the amount of the loan is thus well positioned to extend credit at an appropriate interest rate but is not obliged to calculate the probability of default or the

overall security value over the main bank debt averaged 99 per cent: see J. Franks and O. Sussman, ‘The Cycle of Corporate Distress, Rescue and Dissolution: A Study of Small and Medium Size UK Companies’, IFA Working Paper 306 (2000) p. 3. In a further study of 542 distressed private SMEs (‘Financial Distress and Bank Restructuring of Small to Medium Size UK Companies’ (2005) 9 Review of Finance 65) Franks and Sussman found that ‘in almost every case the bank was the prime lender … Virtually all of the banks’ loans were secured by either a fixed or floating charge or – often – both’: ‘The Economics of English Insolvency: Recent Developments’ in Getzler and Payne, Company Charges, p. 257. On limitations on the attractiveness of the floating charge post-Enterprise Act 2002 see ch. 9 below.

110R3’s 12th Survey, Corporate Insolvency in the United Kingdom (R3, London, 2004), indicated that in 2002–3 (before the reforms of the Enterprise Act 2002) the overall returns from CVAs were 50% to secured creditors, 17% to unsecured creditors and 100% to preferential creditors; from administrative receivership the returns were 49.9% to secured creditors, 5.4% to unsecured creditors and 37.4% to preferential creditors; from liquidations (compulsory and creditors’ voluntary) they were 53.4% to secured creditors, 10% to unsecured creditors and 50.2% to preferential creditors; from administration they were 53% to secured creditors, 6.3% to unsecured creditors and 17% to preferential creditors. Franks and Sussman (‘Cycle of Corporate Distress’) reported that recovery rates for banks were 77% compared with ‘close to zero’ for trade creditors and 27% for preferential creditors and that, regarding the SMEs surveyed (‘Economics of English Insolvency’), the banks recovered on ‘average around 75% (median of 94%) of the face value of their debt’ with ‘other creditors, such as trade creditors, recovering very little, about 3%, unless their loans are secured against specific collateral’.

111See pp. 117–20 below.

112See Bebchuk and Fried, ‘Uneasy Case’, p. 914; Buckley, ‘Bankruptcy Priority Puzzle’, pp. 1421–2.

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expected value of its share of the borrower’s assets in insolvency.113 What the taking of security does not rule out, however, is the need to calculate the probability that corporate managers will devalue that security by such practices as asset substitution.

Security has also been said to reduce the risks of lending by encouraging broadly beneficial monitoring. Security, it is thus argued, can help to counter the tendency to produce overall efficiency losses when a firm’s shareholders and managers pursue certain activities in an attempt to maximise shareholder returns but in doing so increase the expected losses to creditors as a whole by a greater amount than the expected shareholder gains.114 Monitoring provides a response to such risks. Thus the creditor with security can seek to acquire information from the company in order to determine the probability of, say, asset substitution and, in doing so, may bring pressure on the company in a manner that encourages fiscally prudent behaviour.115 Such a secured creditor may accordingly demand the production of periodic financial statements and may go so far as to place a representative on the debtor company’s board.116 This creditor may react to such information by adjusting its estimation of risk and changing the interest rate charged or even adjusting the period of the loan to demand early repayment.117 In more interventionist mode, the creditor may take the additional precaution of imposing contractual limitations on the kinds of conduct or dealings that the debtor may engage in. Where the security exists but is incomplete (or where a secured creditor is reluctant to enforce security because

113This point assumes that the lender is not concerned about the resource or reputational costs of having to enforce their security.

114Bebchuk and Fried, ‘Uneasy Case’, p. 874.

115On security being taken for ‘active’ rather than ‘passive’ reasons see Scott, ‘Relational Theory’, p. 950: ‘the function of secured credit is conceived within the industry as enabling the creditor to influence debtor actions prior to the onset of business failure. This conception is markedly different in effect from the traditional vision of collateral as a residual asset claim upon default and insolvency.’

116See Finch, ‘Company Directors’, pp. 189–95. On creditor monitoring and corporate governance see G. Triantis and R. Daniels, ‘The Role of Debt in Interactive Corporate Governance’ (1995) 83 Calif. L Rev. 1073. On creditor control over financially embarrassed corporations see S. Gilson and M. Vetsuypens, ‘Creditor Control in Financially Distressed Firms: Empirical Evidence’ (1994) 72 Wash. ULQ 1005.

117Another option may be to purchase insurance to cover losses arising from default: see Cheffins, Company Law, p. 75. Yet a further strategy for the creditor is to reduce risks by diversification in the lending portfolio. As noted, however, a creditor’s incentive to monitor will reduce as the number of its debtors increases and the average loan sum diminishes.

of high transaction costs or reputational concerns) it might be expected that restrictions on management might, as noted, deal with limits on dividend payments, the maximum gearing of the company and the disposition of assets. Such clauses, however, can only offer incomplete protection for creditors since anticipating the kind of conduct that may prejudice their interests can be extremely difficult and it may be costly to draft such terms and to monitor and enforce compliance.118 Competition in the loan market may, furthermore, limit the creditors’ ability to impose such constraints: the average trade creditor, for instance, does not normally attempt to draft contracts on a transactionspecific basis. Normal trading arrangements may involve sums of money that are too small and timescales that are too short to justify extensive contractual stipulations.119 The dilution of assets may also be subject to legal restriction120 but those in control of a firm may still enjoy considerable discretion in deciding whether to transfer assets to shareholders and, without the probability of sustained monitoring and enforcement, legal restrictions may offer only weak deterrence.

At this point it is worth considering when a creditor will possess an incentive to monitor a debtor’s behaviour.121 Here the key is the balance between monitoring costs and the size of the loan. Monitoring will be worthwhile if it costs less than the anticipated gain in risk reduction where the latter is calculated by multiplying the diminution in the probability of non-recovery that monitoring will produce and the size of the potential non-payment. It follows that small loans will justify only modest levels of monitoring.

Security is said to be liable to reduce the overall costs of creditor monitoring where a number of creditors have different levels of preexisting information and monitoring costs.122 Some creditors (for

118See generally Day and Taylor, ‘Role of Debt Contracts’; Smith and Warner, ‘On Financial Contracting’.

119See V. Finch, ‘Creditors’ Interests and Directors’ Obligations’ in S. Sheikh and W. Rees (eds.), Corporate Governance and Corporate Control (Cavendish, London, 1995)

pp.133–4; Bebchuk and Fried, ‘Uneasy Case’, pp. 886–7.

120See Companies Act 2006 ss. 641, 645, 646, 648–53; Second Council Directive 77/91/EEC of 13 December 1976, OJ 1997, No. L26/1; Insolvency Act 1986 ss. 238, 239, 423. See also P. L. Davies, ‘Legal Capital in Private Companies in Great Britain’ (1998) 8 Die Aktien Gesellschaft 346.

121See Jackson and Kronman, ‘Secured Financing’, pp. 1160–1. See further J. Armour, ‘Should We Redistribute in Insolvency?’ in Getzler and Payne, Company Charges, pp. 208–12.

122Jackson and Kronman, ‘Secured Financing’, pp. 1160–1; Scott, ‘Relational Theory’,

pp.930–1.

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example, trade creditors) with continuing and day-to-day relationships with their debtors may enjoy low monitoring costs and may reduce their lending risks by utilising their stock of knowledge on debtor creditworthiness. Where such monitoring serves to encourage financially prudent management this will benefit the whole body of creditors.123 Other creditors, such as banks, may not possess such bodies of information and it may be cheaper for them to reduce risks by taking security than by detailed monitoring.124 Providing potential creditors with the choice of secured or unsecured loans thus may encourage economically efficient lending by allowing creditors to choose the lowest-cost ways of reducing risks and so of lending. The end result, it is suggested by proponents of security, will be a reduction of total monitoring and lending costs.125

A further suggested economic efficiency offered by security is the opportunity for creditors to develop an expertise in monitoring a particular asset or type of asset and, accordingly, to limit monitoring costs by avoiding the need to monitor the total array of the company’s financial activities.126 Finally, it can be argued that, at least in some circumstances, the granting of security can serve to demarcate monitoring functions in a manner that proves more economically efficient than regimes in which many creditors all replicate monitoring efforts. Thus, where security is fixed over a key asset and control of this will benefit all creditors by fostering prudent management more broadly, there is an avoidance of duplicated monitoring and the markets will reward monitors and nonmonitors appropriately by compensating secured monitors with prior interests in the debtor’s assets and by allowing unsecured non-monitors to charge low interest rates that do not have to reflect monitoring costs. The overall efficiency arises because even if such ‘key asset’ arrangements are not the norm, the opportunity of offering security allows the market to choose such arrangements where they lower costs all round.

Would such monitoring efficiencies not be achieved in the absence of security? Would the parties involved not simply negotiate the

123See Triantis and Daniels, ‘Role of Debt’, p. 1080.

124See, however, ibid., pp. 1082–8, where banks are seen as playing the ‘principal role in controlling managerial slack’; Scott, ‘Relational Theory’.

125See, for example, Jackson and Kronman, ‘Secured Financing’.

126See D. G. Baird and T. Jackson, Cases, Problems and Materials on Security Interests in Personal Property (Foundation Press, Mineola, N.Y., 1987) pp. 324–8; White, ‘Efficiency Justifications’; Armour, ‘Should We Redistribute in Insolvency?’, p. 211.

contractual arrangements that best allow them to reduce risks?127 The argument for security here is that it provides lower transaction costs than other arrangements.128 This is argued to be the case not least because any attempts by creditors to negotiate priority relationships between themselves would be beset by free-rider and hold-out problems, especially where a firm’s creditors are numerous.129

The efficiency case against security

The incentive to finance economically efficiently The core objection to the provision of security is that when corporate debtor A arranges a secured loan with creditor B this may prejudice the interests of non-involved third parties C, D and E and may create incentives to corporate economic inefficiency. Such an arrangement has the effect of transferring insolvency value from C, D and E to B because C, D and E are not in a position to adjust their claims against A or the interest rates they charge.130 This inability to adjust may occur for a number of reasons. The creditor may be involuntary, as where a party is injured by the company and is a tort claimant with an unsecured claim against the company. Such involuntary creditors cannot adjust their claims to reflect the creation of a security interest.131

The inability to adjust may also be a practical rather than a legal matter. Thus, voluntary creditors with small claims against the firm (for example, trade creditors, employees and customers) may not have interests of a size that would justify the expenses involved in adjusting the terms of their loans with the company and in negotiating these changes with the company. Such expenses, indeed, might be considerable and would involve expenditure to gain information on the company’s level of secured debt, its likelihood of insolvency, its expected insolvency value and the extent of its own unsecured loan.132 In practice, small

127See Jackson and Kronman, ‘Secured Financing’, p. 115; Day and Taylor, ‘Role of Debt Contracts’.

128Compare with A. Schwartz, ‘A Theory of Loan Priorities’ (1989) 18 Journal of Legal Studies 209.

129See S. Levmore, ‘Monitors and Freeriders in Commercial and Corporate Settings’ (1982) 92 Yale LJ 49, 53–5; Scott, ‘Relational Theory’, pp. 909–11; Armour, ‘Should We Redistribute in Insolvency?’, pp. 212–15.

130See Bebchuk and Fried, ‘Uneasy Case’, pp. 882–7.

131See LoPucki, ‘Unsecured Creditor’s Bargain’, pp. 1898–9; J. Scott, ‘Bankruptcy, Secured Debt and Optimal Capital Structure’ (1977) 32 Journal of Financial Law 2–3; P. Shupack, ‘Solving the Puzzle of Secured Transactions’ (1989) 41 Rutgers L Rev. 1067, 1094–5.

132Bebchuk and Fried, ‘Uneasy Case’, p. 885.

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creditors may suffer from a degree of competition in the marketplace that rules out the negotiation of arrangements that adequately reflect risks.133 If a small supplier of, say, tiles for roofing work is considering adjusting the terms on which credit is offered, that supplier may anticipate that competing small tile firms, who are ill-informed and cavalier concerning risks, may be willing to offer terms that undercut it in the market. The supplier will, accordingly, feel that it cannot adjust and, indeed, that resources spent on evaluating the need for adjustment (and its rational extent) would be wasted.

Trade creditors tend not to look to the risks posed by individual debtors but will charge uniform interest rates to their customers. It could be argued, nevertheless, that those trade creditors who are successful are those who build into their prices an interest rate element that, in a broad-brush manner, reflects averaged-out insolvency risks. They may, for instance, adjust their prices periodically until they produce an acceptable return on investment.134 The effect is to compensate, at least over a period of time, for difficulties of adjustment. This, it could be contended, is economically efficient because, within reasonable bounds, even small, unsecured creditors manage to attune rates to reflect average risks.

A first difficulty with this argument, however, is that it assumes a level of stability in the trade sector and leaves out of account those trade creditors who have gone out of business through their failures to adjust, perhaps in their early weeks and years. These lost enterprises involve costs to society. The argument also leaves out of account those illinformed and involuntary parties who cannot adjust by averaging processes or by learning from the market. Many trade creditors, for example, will operate in dispersed, changing markets in which learning is difficult, the process of matching prices to risks may take a long time and may be delayed, distorted or prevented by changes of actors and the arrival in the market of numbers of unsophisticated operators who fail adequately to consider risks. As LoPucki concludes: ‘With a constant flow of new suckers and poor information flows, there is no a priori reason why the markets for unsecured credit cannot persistently underestimate the risk, resulting in a permanent subsidy to borrowers.’135

133See J. Hudson, ‘The Case Against Secured Lending’ (1995) 15 International Review of Law and Economics 47.

134See Buckley, ‘Bankruptcy Priority Puzzle’, pp. 1410–11 and cf. LoPucki, ‘Unsecured Creditor’s Bargain’, pp. 1955–8.

135LoPucki, ‘Unsecured Creditor’s Bargain’, p. 1956; Armour, ‘Should We Redistribute in Insolvency?’, pp. 212–15.

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act so as to increase value to shareholders and secured creditors even if such increases are less than the losses to non-adjusting creditors in the form of diminutions in their expectations on insolvency.137 A system of full priority, moreover, will give debtor company A an incentive to create a security so as to transfer value away from non-adjusting creditors in circumstances where the effect is to reduce the total value to be captured by all creditors on an insolvency.

As for the decision-making incentives of corporate managers, a further economic inefficiency may arise in so far as biases in favour of secured creditors may lead both to an excessive resort to secured loans (a resort encouraged by the ‘subsidy’ from non-adjusting creditors) and to excessively risky decision-taking. Excessive risk taking is liable to occur because a corporate manager, in calculating the risks attaching to any decision, will give insufficient weight to the interests of unsecured creditors. Thus, in balancing the company’s potential gains versus losses in any given transaction, the prospect of having to repay non-adjusting creditors less than the full sum borrowed will distort the decision.138 In social terms, the bearing of excessive risks by unsecured creditors may be especially undesirable since these creditors are frequently small and less able to survive losses than larger creditors, such as banks, who tend to be secured.139

Investigation and monitoring The argument that security encourages information-gathering practices that conduce to economic efficiency can be pressed too far. It has been contended that security benefits all creditors in so far as the ability to gain credit on the basis of security evidences in itself a degree of creditworthiness.140 A major proponent of

137On the extent to which different non-adjusting creditors are hurt by the creation of a new security interest see ibid., pp. 894–5; LoPucki, ‘Unsecured Creditor’s Bargain’,

pp.1896–1916. For discussion of the point that numbers of ‘non-adjusting’ creditors may be too small to be significant see Armour, ‘Should We Redistribute in Insolvency?’,

pp.214–15.

138Bebchuk and Fried, ‘Uneasy Case’, p. 934; M. White, ‘Public Policy Toward Bankruptcy’ (1980) 11 Bell Journal of Economics 550. Security with priority thus exacerbates those distortions associated with limited liability: see Bebchuk and Fried, ‘Uneasy Case’,

pp.899–90; H. Hansman and R. Krackman, ‘Towards Unlimited Shareholder Liability for Corporate Torts’ (1991) 100 Yale LJ 1879; D. Leebron, ‘Limited Liability, Tort Victims and Creditors’ (1991) 91 Colum. L Rev. 1565.

139See Hudson, ‘Case Against Secured Lending’, p. 61.

140A. Schwartz, ‘Security Interests and Bankruptcy Priorities: A Review of Current Theories’ (1981) 10 Journal of Legal Studies 1.

this signalling theory has, however, himself come to question it on the grounds that bad debtors may be both willing and able to mimic the signals of good debtors.141 Other counter-arguments to the signalling hypothesis are that the security interest may not in reality offer a clear signal since borrowing on a secured, rather than on an unsecured, basis is usually the preference (sometimes the insistence) of the creditor rather than the debtor company, and that the offering of security signals not so much the creditworthiness of the debtor as the nervousness of the relevant lender.142 It is also doubtful whether any signalling gains outweigh the costs of secured lending.143 Other commentators, moreover, have questioned the value of signalling on the grounds that firms may seek credit as much to help with short-term cash flow problems as to finance programmes of capital expansion. Signals relating to the former, rather than the latter, may be of little value to the array of prospective creditors.144

The claim that security leads to economically efficient monitoring can also be treated with some caution. The notion that monitoring by a secured creditor will bring spill-over benefits to the advantage of creditors as a whole can be responded to by noting that those benefits are liable to be insignificant where creditors are concerned to ensure that there is no dilution of their particular security rather than to encourage good decision-making generally in relation to the company’s affairs. This point can be deployed, indeed, to turn the monitoring argument on its head. If security fixes on particular assets, it may offer a disincentive to monitor generally and, even where a specific item of equipment is monitored, the creditor may not examine whether it is being used productively. If, moreover, most small to medium-sized firms possess only one creditor who is sufficiently sophisticated to be able to monitor at all rigorously (as US evidence suggests),145 the tendency for that creditor

141Schwartz, ‘Theory of Loan Priorities’, p. 244.

142H. Kripke, ‘Law and Economics: Measuring the Economic Efficiency of Commercial Law in a Vacuum of Fact’ (1985) 133 U Pa. L Rev. 929, 969–70; M. G. Bridge, ‘The Quistclose Trust in a World of Secured Transactions’ (1992) 12 OJLS 333, 337.

143Scott, ‘Relational Theory’, p. 907, urges that proponents of security have not offered convincing reasons why security offers a means of overcoming informational barriers that is preferable to other mechanisms, such as the development of commercial reputations or long-term financial relationships. See also C. J. Goetz and R. E. Scott, ‘Principles of Relational Contracts’ (1981) 67 Va. L Rev. 1089, 1099–1111.

144See Hudson, ‘Case Against Secured Lending’, p. 54.

145See M. Peterson and R. Rajan, ‘The Benefits of Lending Relationships: Evidence from Small Business Data’ (1994) 49 Journal of Finance 3, 16.

104 the context of corporate insolvency law

to be the secured creditor means that any inclination to monitor may be easily exaggerated. It can further be objected that it is rash to assume that those in possession of security are well positioned to monitor management behaviour. There may, indeed, be circumstances in which unsecured, but well-informed, trade creditors may be better placed to monitor.146

Other factors may also militate against monitoring by secured creditors. They may have little interest in improving the profitability of their

debtor company, since, unlike shareholders, they will not enjoy a proportion of profits but face a fixed rate of return.147 Creditors who lend to

a large number of debtors may be reluctant to devote resources to detailed monitoring of each of their debtor companies, and lending institutions may lack the expertise and specialised trade knowledge necessary for assessing managerial performance effectively.148 Creditors, moreover, may be ill-disposed to monitor because they may consider that a corporate insolvency may result from causes other than mismanagement149 and that monitoring at best offers only partial protection against insolvency. The creditor may be interested in security principally as a means of limiting the financial consequences to them of insolvency rather than as a mechanism allowing them to intervene in order to prevent corporate disaster.

Close inspection should also be made of the argument that security provides an economically efficient way for different creditors to coordinate their monitoring activities and avoid inefficient duplications of effort. If, as noted, small and medium-sized firms tend not to borrow from more than one creditor who is capable of monitoring, there is little need for such co-ordination and its value, accordingly, may be easily overstated.150 The notion, moreover, that one creditor will benefit from the monitoring signals sent out by another creditor has to be treated with care.151 Thus, a large creditor such as a bank may end a relationship with

146Bridge, ‘Quistclose Trust’, p. 339; cf. Triantis and Daniels, ‘Role of Debt’; Scott, ‘Relational Theory’. Nor should it be assumed that monitoring is inevitably beneficial: this will not be the case where the negative effects of monitoring activity (for example, interference and managerial resources expended on responding to monitors) exceed positive effects as exemplified by increased pressures to act prudently.

147F. H. Easterbrook and D. R. Fischel, ‘Voting in Corporate Law’ (1983) 26 Journal of Law and Economics 395, 403.

148See Finch, ‘Company Directors’; Cheffins, Company Law, pp. 75–6.

149See discussion in ch. 4 below.

150See Bebchuk and Fried, ‘Uneasy Case’, p. 917.

151See Triantis and Daniels, ‘Role of Debt’, pp. 1090–1103.

a debtor and so may send out a signal, but the action may have been taken for reasons unrelated to any assessment of managerial performance (the bank may have negotiated an unfavourable agreement). A bank may, in another context, appear to be happy with management but in reality it is content with its security; it may give distorted signals because it has taken discreet steps to increase its security or shift risks; or a bank may have negotiated policy concessions with the debtor that, again, are unknown to other creditors. Nor can it be assumed that different classes of creditors have common interests that lend harmony to their monitoring efforts. When the debtor company is healthy there may be a degree of commonality in their desires to reduce managerial slackness but when the debtor firm approaches troubled times the different classes of creditors will have divergent interests and misinformation and concealment may infect the monitoring and signalling processes.152

Incentives to monitor may, moreover, be undermined by free-rider and uncertainty problems.153 Thus, in the case of the floating charge, monitoring is liable to be expensive because such a charge commonly covers the entire undertaking of the debtor and this may mean that monitoring in order to detect misbehaviour or calculate risks could involve scrutinising the whole business. It is not possible, as with a fixed charge, to keep an eye on the stipulated asset alone. The competitors of a creditor who spends time and money on monitoring will be able, at little cost, to benefit from such scrutinising and any resultant signalling (for example, through observed adjustments in the interest rates charged by the monitoring creditor). The competitors, accordingly, will be able to undercut the creditor on, for example, the pricing of loans.154 This freerider problem gives the initial creditor a disincentive to monitor the debtor’s misbehaviour and to compensate for the higher risks that nonmonitoring brings by imposing higher rates of interest. The overall effect is that the floating charge may offer a relatively expensive method of securing finance.

Legal difficulties may also compound the problems of those creditors who are secured by floating charges and who wish to lower risks (and interest rates) by monitoring. Close monitoring may render the creditor liable to a wrongful trading charge on the basis of their operating as a

152Ibid., p. 1111.

153See generally Levmore, ‘Monitors and Freeriders’, pp. 53–5; Scott, ‘Relational Theory’.

154See Levmore, ‘Monitors and Freeriders’, pp. 53–5; Scott, ‘Relational Theory’.