Fixed Charge vs Floating Charge: Legal Definition, Attachment, Crystallization and Priority
What is a Fixed Charge and Floating Charge?
A fixed charge is a type of security interest attached to specific, identifiable assets of a borrower (typically a company), while a floating charge is a security interest over a pool of changing assets, which crystallizes into a fixed charge upon certain events like default or liquidation.
Legal Definition of Fixed and Floating Charge
Fixed Charge vs Floating Charge: Understanding the legal difference between fixed charges and floating charges is essential for both lenders and borrowers in the realm of secured lending.
Fixed Charge: A fixed charge is a type of security interest attached to specific, identifiable assets of the borrower, like real estate, machinery, or vehicles. The key features include:
- Specificity: It is attached to specific assets.
- Control: The borrower cannot sell or dispose of the asset without the lender’s consent.
- Precedence: In the event of default, fixed charge holders have priority in repayment over floating charge holders and unsecured creditors.
Floating Charge: Unlike a fixed charge, a floating charge is a dynamic form of security, not attached to any specific asset. It ‘floats’ over a class of assets, like product inventory or receivables. Its characteristics are:
- Flexibility: It allows the borrower to use, sell, or trade the secured assets in the ordinary course of business.
- Crystallization: The charge ‘crystallizes’ into a fixed charge upon certain events like default or liquidation, attaching to the assets then held.
Legal Implications of Fixed Charge vs Floating Charge
Creation and Perfection: The creation of a fixed or floating charge requires a formal agreement between the lender and borrower. However, the perfection process, involving registration and public notice, can vary depending on jurisdiction and the nature of the charge.
Priority in Repayment: Fixed charge holders generally have a higher priority over floating charge holders. This means they are more likely to recover their investment in case of default or insolvency.
Crystallization of Floating Charges: The moment a floating charge crystallises, it becomes a fixed charge on the current assets. This change can be triggered by contract terms or events like cessation of business or appointment of a receiver.
Advantages and Disadvantages of Fixed and Floating Charge
For Lenders:
- Fixed Charge: Offers higher security and priority but less flexibility in terms of the borrower’s ability to manage assets.
- Floating Charge: Provides a broader security base covering a fluctuating pool of assets, though with lower priority.
For Borrowers:
- Fixed Charge: Imposes restrictions on asset management, potentially affecting liquidity and operational flexibility.
- Floating Charge: Allows freedom in handling current assets but may lead to issues upon crystallization, affecting a broader range of assets.
What Types Of Assets Are Typically Subject To A Floating Charge?
Floating charges typically cover a company’s current, changeable assets, such as inventory, accounts receivable, and cash. These assets are integral to daily business operations and fluctuate in value and quantity over time.
A floating charge allows the company to use and trade these assets freely in the normal course of business until an event like default or liquidation causes the charge to crystallize into a fixed charge, attaching to specific assets available at that time.
Fixed Charge vs Floating Charge
| Aspect | Fixed Charge | Floating Charge |
|---|---|---|
| Attachment to Assets | Specific, identifiable assets (e.g., real estate, machinery) | General assets pool (e.g., inventory, receivables) |
| Flexibility for Borrower | Limited, as assets cannot be sold or disposed of without lender consent | High, assets can be used or sold in normal business operations |
| Crystallization | Not applicable (charge is already fixed on certain assets) | Occurs upon specific events, converting to a fixed charge |
| Priority in Repayment | Higher, repaid first in case of default or insolvency | Lower, repaid after fixed charge holders and preferential debts |
| Asset Management | Restricted, borrower must seek lender approval for asset transactions | Flexible, borrower can manage assets freely until crystallization |
| Ideal for | Securing loans with stable, valuable assets | Securing broader, fluctuating asset base typical in ongoing business operations |
| Risk for Lender | Lower, due to specific asset collateral and higher repayment priority | Higher, due to its general nature and lower repayment priority |
| Enforcement | Directly on the specific charged assets | Upon crystallization, similar to fixed charge enforcement |
Practical Considerations of Fixed and Floating Charge
- Risk Assessment: Lenders must assess the risk associated with fixed and floating charge, considering the borrower’s financial stability and the nature of the secured assets.
- Documentation: Clear, comprehensive legal documentation is essential to define rights, responsibilities, and procedures for both types of charges.
- Monitoring and Enforcement: Regular monitoring of the borrower’s financial health and asset status is crucial, especially for floating charges.
How Do Fixed And Floating Charges Affect A Company’s Ability To Use Its Assets?
Fixed charges attach to specific, identifiable assets, restricting a company’s ability to freely use, sell, or lease these assets without the lender’s consent. This can limit operational flexibility and potential liquidity from these assets – see Illingworth v Houldsworth (1904).
In contrast, floating charges cover a pool of changeable assets, such as inventory or accounts receivable, allowing the company to use, sell, or trade these assets in the normal course of business.
However, when a floating charge crystallises (due to events like default or insolvency), it restricts the company’s use of the assets under the charge, similar to a fixed charge, impacting broader asset management and operational activities.
Can New Loans Be Secured By Assets Already Under A Fixed Charge?
Securing new loans with assets already under a fixed charge is generally challenging. The first lender’s permission is often required because they hold a primary claim over the specific assets. If consent is granted, the second loan might be secured with a subordinate charge, meaning it has a lower priority in claim.
This arrangement increases the risk for the second lender, as their chances of recovering the loan amount are reduced if the borrower defaults or goes insolvent.
What Is The Relationship Between A Debenture And Fixed And Floating Charge
A debenture often encompasses both fixed and floating charges as instruments of security for the loan it represents.
The fixed charge within a debenture is attached to specific, tangible assets like property or equipment, whereas the floating charge covers general assets like inventory or accounts receivable.
This combination allows lenders to secure a broader range of the borrower’s assets, enhancing their security while offering the borrower flexibility in asset management until certain events, like default, trigger the crystallisation of the floating charge – see Re Spectrum Plus Ltd (In Liquidation) (2005).
What Happens To A Fixed And Floating Charge In The Event Of A Borrower’s Insolvency?
In the event of a borrower’s insolvency, the treatment of fixed and floating charges follows distinct legal processes due to their different natures.
For fixed charges, the secured creditor has a priority claim on the specific assets to which the charge is attached.
These assets are sold, and proceeds are used to repay the fixed charge holder before other unsecured creditors.
The creditor’s rights to these specific assets are generally clear-cut and take precedence over other claims, including floating charges.
Floating charges, on the other hand, cover a range of current, fluctuating assets.
Upon the borrower’s insolvency, floating charges usually crystallize, meaning they convert into fixed charges on the assets they cover at that time. However, the priority of floating charge holders is lower.
They are repaid after fixed charge holders and certain preferential creditors, like employees.
The introduction of a “prescribed part” in some jurisdictions ensures a portion of the assets is set aside for unsecured creditors, reducing the amount available to floating charge holders.
This dynamic often results in floating charge holders receiving a smaller proportion of their claim compared to fixed charge holders.
Conclusion: Fixed Charge vs Floating Charge
The choice between a fixed and floating charge depends on various factors, including the nature of the borrower’s assets, the business operations, and the risk appetite of the lender.
Understanding the legal nuances of each is essential for making informed decisions in secured lending transactions.
This overview provides a foundation for understanding the complex legal landscape of fixed and floating charges. However, it’s always advisable to consult legal professionals for specific advice tailored to individual circumstances.
References
- Cerqueiro, G., Ongena, S. and Roszbach, K., 2016. Collateralization, bank loan rates, and monitoring. The Journal of Finance, 71(3), pp.1295-1322.
- Pennington, R.R., 1960. The genesis of the floating charge. The modern law review, 23(6), pp.630-646.
- Worthington, S., 1994. Floating Charges—An Alternative Theory. The Cambridge Law Journal, 53(1), pp.81-103.
