Hong Kong: House of Lords Judgment Clarifies the Distinction between Fixed Charge and Floating Charge in "Spectrum Plus"
On 30 June 2005, the House of Lords delivered its judgment in National Westminster Bank plc v. Spectrum Plus Limited & others  UKHL 41. The case has resolved a controversial legal issue concerning the distinction between a fixed charge and a floating charge. Fixed Charges and Floating Charges It may be helpful first to describe the basic difference between the operation of a fixed charge and that of a floating charge. Under a fixed charge, the debtor is restricted from managing and disposing of the charged assets freely. However, under a floating charge, the debtor is permitted to manage and dispose of the charged assets in the ordinary course of his business without the consent of the charge holder until the ‘crystallisation’ of the charge. When the charge ‘crystallises’ (i.e. when some event occurs such as default by, or insolvency of, the chargor), the creditor may terminate the chargor’s permission to deal with the charged assets and assert his security rights over them. The above distinction between a fixed charge and a floating charge was affirmed by Lord Millett in Agnew v. Commissioners of Inland Revenue (Re Brumark Investment Ltd)  3 WLR 454. This case also stands as authority for the principle that the description of the charge as fixed or floating in the debenture is immaterial. Instead, the court will examine the intention of the parties from the terms of the debenture in order to determine whether it is fixed or floating. Importance of “fixed or floating” distinction The distinction between a fixed charge and a floating charge is important because it has profound implications for the order of payment to creditors from the assets of a company in liquidation. A fixed charge holder has priority over statutorily preferred creditors, such as the employees of the company. On the other hand, the rights of a floating charge holder in receiving payment are subordinate to those of these preferential creditors. The Previous Position under the Law In Siebe Gorman & Co. Ltd v Barclays Bank Ltd  2 Lloyd’s Rep 142, it was held that where the debenture required the charged book debts not to be disposed of prior to their collection and the proceeds to be paid into a specific bank account upon their collection, such restrictions would be sufficient for the purposes of constituting a fixed charge. As a result, under Siebe Gorman, a charge was fixed even if the debenture did not prohibit the debtor from withdrawing money from the account into which the proceeds were deposited without the bank’s consent, so long as the other restrictions were present. The problem with this decision was highlighted in Spectrum Plus, where the debtor, after paying the proceeds of the book debts into the account, drew on the account up to its overdraft limit. Following the decision in Siebe Gorman, the Court of Appeal held that the charge was a fixed one since the debenture stipulated restrictions in the ways by which the debtor could manage the assets (i.e. the book debts could not be assigned and the proceeds were to be paid into the chargor’s account with the bank). In the view of the Court of Appeal, there were sufficient restrictions in the debenture to constitute a fixed charge, and after the proceeds had been paid into the bank’s account, any further overdraft was governed by the contract between the bank and the debtor. The bank could have terminated the overdraft facility at any time but took no such step. Therefore, the fact that the debtor was able to draw on the account up to its overdraft limit did not mean that the fixed charge became a floating one. The Court also felt constrained to follow Siebe Gorman because that decision had been accepted as correct by the banking industry for 25 years or so. The House of Lords Judgment in Spectrum Plus The decision of the Court of Appeal in Spectrum Plus was overturned by the House of Lords which held that the charge was a floating one. It was decided that in order to preserve the status of a charge as a fixed one, the bank must be able to exercise actual control over the blocked account. However, since the debtor in the case was not prohibited from overdrawing from the account into which the proceeds were deposited, the bank did not have effective control The House of Lords looked into the contractual relationship with regard to the account between the bank and the company and decided that an account from which the company could withdraw money at will within the agreed limits of any overdraft was not a blocked account. Since this was inconsistent with the status of the charge as fixed (as the company was able to use the proceeds in the ordinary course of its business without the consent of the charge holder), the charge was found to be a floating one. In reaching this decision, the House of Lords also relied on, amongst others, the New Zealand authority of Hoverd Industries Ltd v Supercool Refrigeration & Air Conditioning (1991) Ltd  3 NZLR 577, which decided that an obligation to pay the proceeds of the book debts into the company’s account without prohibiting the company from using the proceeds in any manner did not give the bank effective control of those proceeds. Prospective overruling The House of Lords considered whether its judgment should have only future effect. It decided that it should not. In its opinion, as Siebe Gorman was only decided by a first instance court (the Chancery Division), banks and other lenders which had modelled their security on the debenture form approved in Siebe Gorman should not have expected that the judgment be regarded as settled law. Moreover, if the House of Lords’ decision was given prospective effect only, many preferential creditors of existing liquidations would be deprived of the priority which the legislature intended that they should have. On the other hand, “back dating” their decision might result in challenges to distributions made in accordance with Siebe Gorman. Under such circumstances, defences of limitation and change of position would likely become pertinent considerations. This is a controversial decision and will no doubt be criticised by some commentators. It does seem a little unfair to penalise banks and their advisors for what was, after all, an incorrect decision by the judiciary. The effect of Spectrum Plus in Hong Kong Hong Kong has generally followed the English position with regard to the distinction between a fixed charge and a floating charge. In view of this, the House of Lords’ most recent decision in Spectrum Plus is likely to be extremely persuasive in the courts of Hong Kong. Conclusion In future, if a fixed charge is required, the debenture should contain at least three specific controls to reinforce the security: (i) a restriction against disposals of the charged debts before and after receipt; (ii) an obligation to pay them into an account with the bank on receipt; and (iii) an agreement not to withdraw money from this account without the bank’s consent (which is implemented in practice). As for existing debentures in Siebe Gorman form, banks will need to consider whether they need to be amended to take into account the House of Lords’ decision. As for debentures that have been enforced on the basis of the Siebe Gorman decision, banks will need to keep these under review as preferential creditors may be able to overturn distributions of assets made on the basis of the old law.