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Cambridge University Press
0521826705 - Secured Credit under English and American Law - by Gerard McCormack
Excerpt

1 The essence and importance of security

This book compares and contrasts American and English approaches towards the recognition and enforcement of security interests in personal property. United States law is found almost exclusively in the Uniform Commercial Code (UCC), whereas English law is derived from a variety of sources, both statutory and non-statutory. If one could compare the two systems in a word, one might say that the US approach is functional whereas the English approach is pragmatic though the overall tendency is to be facilitative and enabling. There are almost no limits on the category of assets that may be used as security, and the procedures for the creation of security interests are quite flexible and informal. The law is pragmatic rather than functional, as transactions that serve the same economic ends are often visited with different legal consequences. The latter state of affairs has attracted criticism but so far the legislature has resisted efforts to recast English law along the lines of Article 9 of the US UCC. Article 9 attempts to apply similar rules to all transactions that in economic terms are intended to serve as security. Moreover, Article 9 embodies a near-comprehensive registration obligation, i.e. public notice of security interests must be given. Under English law, by contrast, certain transactions that in economic terms might be regarded as creating a security interest are not subject to any public registration or filing requirements that might alert other potential creditors - or, indeed, the world at large - to the existence of the security interest.

The definition of security interests

The contrasting approaches between England and the US are even manifest when one considers a necessary starting-point for any analysis: the definition of security. The term 'security interest' is defined in Article 1(37) of the UCC as meaning an interest in personal property that secures either payment of money or the performance of an obligation and also the interest of a buyer of accounts. By contrast, there is no statutory definition of 'security interest' in England and so one must fall back on judicial interpretations that, necessarily, are conditioned and qualified by the circumstances of a particular case.¹ A notable example is provided in the judgment of Browne-Wilkinson V-C in Re Paramount Airways Ltd,² where the following definition of security was accepted: 'Security is created where a person (the creditor) obtains rights exercisable against some property in which the debtor has an interest in order to enforce the discharge of the debtor's obligation to the creditor.'

Clearly this is not a comprehensive definition, for it does not recognise the fact that security may be granted to secure the obligations of somebody other than the grantee. Professor Sir Roy Goode, acknowledging the 'third party' issue, has defined a security interest as a right given to one party in the asset(s) of another party to secure payment or performance by that other party or by a third party.³ On his analysis a security interest:⁴

(1) arises from a transaction intended as security;

(2) is a right in rem;

(3) is created by a grant or declaration, not by reservation;

(4) if fixed, or specific, implies a restriction on the debtor's dominion over the asset;

(5) cannot be taken by the creditor over his own obligation to the debtor.

These characteristics ascribed to a security interest cannot be accepted in their entirety - in particular point 5, which suggests that it is a conceptual impossibility for a bank to be granted a charge over its own indebtedness to a customer.⁵ There is a strong contrary view that a debt is simply an item of property and, like any other item of property, it may be charged to anybody that the creditor wishes.⁶ This pragmatic approach appealed to Lord Hoffmann in Re BCCI (No. 8),⁷ who spoke for a unanimous House of Lords in categorically rejecting the doctrine that it was conceptually impossible for a security interest to be taken by a creditor over his own obligations to the debtor. In Lord Hoffmann's view, the law should be slow to declare a practice of the commercial community to be conceptually impossible given the fact that the law was fashioned to suit the practicalities of life. He added that legal concepts such as 'proprietary interest' and 'charge' were no more than labels given to clusters of related and self-consistent rules of law. Such concepts did not have a life of their own from which the rules were inexorably derived. In fact, English law has long taken a non-doctrinaire view towards the recognition and enforcement of security interests in property. Lord Hoffmann highlighted the example of the charge which, as he pointed out, is a security interest created without any transfer of title or possession to the beneficiary. An equitable charge could be created by an informal transaction for value and over any kind of property.⁸ The workhorse of the secured credit industry in England has traditionally been the charge, particularly the floating charge,⁹ but there are many different types of security right recognised under English law. The law on both sides of the Atlantic is similar in generally granting secured creditors priority over unsecured creditors. Priority over other creditors in the event of debtor insolvency is commonly identified as the most important reason behind the taking of security, but there are other important reasons why a creditor might wish to take security. The rest of the chapter will look at these reasons and also ask why the law permits the taking of security as well as whether the recognition of security is economically efficient.¹⁰

Finally the chapter will consider the fate of proposals, in both England and the United States, to limit the full priority of secured credit.

Reasons for the taking of security

An important point to note in this connection is that security is pervasive. The law does not require the taking of security but nevertheless as one American commentator puts it, banks pursue the taking of security with apostolic zeal.¹¹ Commonly banks argue for stronger, broader and more effective security rights but not for narrower and weaker ones. The controversy over security rights in deposit accounts provides a good example. In both England and the US courts recognised banks as having rights of set-off in situations of mutual indebtedness, i.e. a bank could set off a customer's deficit on its loan account with credit balances on other accounts the customer might have with the bank.¹² Nevertheless, because of possible weaknesses in set-off rights vis-à-vis third parties banks in both countries pressed for legislative or judicial recognition of full-blown security interests in deposit accounts and their wishes were realised with the decision in Re BCCI (No. 8)¹³ and the revision of Article 9.¹⁴ It seems that the appetite of banks for secured credit has expanded over the years. One leading US commentator has spoken¹⁵ of a

dramatic increase in the number and size of firms that rely on secured credit as their principal means of financing both ongoing operations and growth opportunities. Previously, with a few exceptions . . . , secured financing principally had served second-class markets as the 'poor man's' means of obtaining credit. Now, it has become the linchpin of private financing, prompting even large firms to employ leveraged buyouts as a means of fleeing public equity markets for the safe harbors of Article 9.

Put simply, the taking of security maximises the creditor's prospects of recovery in the event of the debtor's insolvency. This is commonly identified as the first, and most important, reason for the taking of security. When a company or other debtor declines into insolvency there is, by definition, insufficient money in the corporate kitty to satisfy everybody. The basic principle of insolvency law is one of 'equality of misery' or equality of treatment of creditors, i.e. pari passu distribution of available assets amongst creditors.¹⁶ This hallowed principle of insolvency law is, however, in fact somewhat hollow.¹⁷ Amongst other things, the law of insolvency in some jurisdictions - England included - privileges certain categories of claims by according them preferential status. The categories of preferential debt are set out in Schedule 6 to the Insolvency Act 1986 and, until the reforms introduced by the Enterprise Act 2002, have basically comprised certain tax and employee claims.¹⁸ A variety of arguments have been advanced for recognising claims by particular categories of creditors to preferential status.¹⁹ As far as claims by governmental entities are concerned, such creditors are said to be involuntary and not consciously to have assumed the risk of the debtor's insolvency.²⁰ It is also arguable that they are not in a position effectively to monitor the debtor's behaviour and to assess the risk of default or insolvency. The main justification for according employees preferential status centres on inequality of bargaining power and rests on the fact that employees lack the economic strength to bargain for security rights and, consequently, may lose out in their employer's insolvency. The Enterprise Act 2002²¹ abolishes Crown preference (but not employee preference²²) as part of an 'integrated package of measures' whereby in return secured creditors lose some of their existing entitlements.²³

Preferential creditors are paid ahead of general creditors and also one type of secured creditor - the floating-charge holder - but not other secured creditors. Financially distressed firms commonly use the Revenue as effectively an additional source of credit and an expansion in the volume of preferential debts has led secured lenders to push forward the frontiers of the fixed-charge security into territory that has traditionally been occupied by the floating charge.²⁴ These efforts may have been stymied by the decision of the Privy Council in the Brumark case.²⁵ Be that as it may, the failure on the part of a bank to take security will not only reduce the bank to the category of unsecured creditor but also means that its claim will rank after preferential creditors.

The taking of security maximises a creditor's possibilities of recovery, whereas placement in the ranks of the ordinary unsecured creditor may leave a person with little hope of recovering anything. Judicial utterances to this effect are well borne out by the empirical evidence. According to data from the Society of Practitioners of Insolvency, on average 75 per cent of cases return nothing to unsecured creditors and in only 2 per cent of cases can they expect to receive 100 per cent returns.²⁶ More recent findings suggest recovery rates for banks in the order of 77 per cent, and this compares with 27 per cent for preference creditors and negligible returns for unsecured trade creditors.²⁷

Security serves a raft of other functions as well as maximising the prospect of recovery in a debtor's insolvency.²⁸ The second reason for taking security focuses on control. If a lender takes security over a specific asset of the borrower then the borrower relinquishes exclusive control over that asset. The borrower may be more likely to pay the lender than general creditors because failure to pay may result in the loss of an asset that is essential to the conduct of the borrower's business. In certain circumstances this factor may be the primary reason behind the taking of security by the lender. In the American legal literature this point has been highlighted in the setting of equipment financing. As Professor Baird puts the matter:²⁹

In other contexts, the primary purpose of a security interest may be to give a secured creditor a priority over a firm's other creditors in the event that the firm encounters financial distress and cannot meet its fixed obligations. In the case of the equipment financier, however, the security interest may serve a different purpose. A lender may lend because it is confident that the procedures available to it in the event of default will allow it to realise much of the amount of the loan in the event of default. Thus, the lender may take a security interest in large part because its rights upon default against the debtor are greater than they would be if it did not take security.

Thirdly, security over specific assets may enable the lender to sell off or take possession of the assets without having to seek judicial or other official intervention. This basically remains the position under the Enterprise Act 2002. Under existing law before the reforms introduced by the Enterprise Act 2002 take effect, the holder of a floating charge over the whole or substantially the whole of a company's assets may appoint an administrative receiver who may carry on the running of the business of the company with a view to optimal realisation of assets.³⁰ Although designated by statute as an agent of the company,³¹ the basic function of the receiver is to realise the assets of the company for the benefit of the secured lender who made the appointment. The Enterprise Act abolishes administrative receivership in the generality of cases³² but still allows a floating-charge holder to make an out-of-court appointment of an administrator.³³ An administrator has somewhat wider duties than an old-style administrative receiver, including a duty to rescue the business of the company if at all viable.³⁴ Nevertheless, the essential point remains that even under the new regime a secured lender will retain a substantial measure of control over realising the assets of financially distressed firms. Timing the sale of secured assets is important from the point of view of increasing recoveries and it also avoids giving the appearance of a 'forced sale'. If the lender can control the time and manner of realisation of secured assets, then this strengthens his hand greatly both from a negotiating position vis-à-vis the borrower and in terms of optimising value from the security. As one US observer has noted aptly:³⁵ 'Security is desirable because it makes available summary legal procedures that bypass the slowness with which the mills of justice sometimes grind.' 'Self-help' and other extra-judicial remedies remain controversial in many jurisdictions, however, and England appears to be something of an exception, up to now, in allowing out-of-court enforcement of security by a secured lender.

Fourthly, there is an argument that the taking of security obviates the need to conduct a possibly detailed and expensive investigation into the financial circumstances of the borrower. In theory, all that the lender need do is to check the value of the secured property so as to ensure that it serves as adequate security for the loan. Of course, the prudent lender will allow for a certain excess in the value of the security over the amount of the loan to cover for legal and practical obstacles to enforcement as well as unfavourable enforcement timing and conditions. In the words of one commentator, secured lending substitutes information about the secured property offered by the borrower for information about the borrower himself:³⁶

At its extreme, secured lending makes a nearly total substitution: a pawnshop, for example, asks no more information about the borrower than is necessary to identify the borrower in the event that the borrower has stolen the pawned good. Rather, the pawnshop operator must know the value of the collateral and the price than can be realised from selling that collateral. The history of the borrower and the purpose of the loan are immaterial.

During the government review of company rescue and business reconstruction mechanisms that preceded the Enterprise Act, banks, however, were concerned to emphasise that they advanced funds based on an assessment of the viability of the borrower's business plans rather than on a simple calculation of the value of the property offered as collateral. The British Bankers' Association (BBA) said:³⁷ 'There is a perception . . . that banks are effectively pawnbrokers, lending only against security; or collateral. The truth is that banks principally lend against viability and cashflow. Collateral is taken as a contingency if things do not work out as planned.' Numerous respondents to the DTI consultation exercise stressed that the real worth of security rights, and in particular the floating charge, was the control rights it gave the holder in the event of a default by the borrower.

While the achievement of priority over other creditors in the event of the debtor's insolvency is often identified as the single driving force behind the taking of security, it certainly seems that the focus on force and liquidation outcomes is to present too simplistic a picture. An important empirical study that highlights the cycle of corporate distress with a concentration on small and medium-sized UK companies suggests a more complex pattern of lender behaviour.³⁸ In short, the variety of security devices available to a bank lender place it in a powerful position from where it can exert pressure over the company in financial distress, both within formal insolvency procedures, and in informal rescue contexts. This study demonstrates the existence, even in the case of small and medium-sized companies, of an elaborate rescue process outside formal procedures:

About 75% of firms emerge from rescue and avoid formal insolvency procedures altogether (after 7.5 months, on average). Either they are turned-around or they repay their debt by finding alternative banking sources. . . . Turnarounds are often accompanied by management changes, asset sales, and new finance or directors' guarantees. There is evidence that these changes significantly influence the bank's response and the likelihood of a successful outcome.³⁹

Banks, it appears, use their control rights to encourage or force financially distressed firms to undergo restructuring that would include downsizing and management replacement.

As far as larger quoted companies in the UK are concerned, a well-established but informal rescue procedure exists: the so-called 'London Approach'.⁴⁰ The details of the procedure will vary from case to case but the basic outline remains the same. Essentially the 'London Approach' applies to multi-banked companies which are experiencing financial difficulties. The respective lenders agree to facilitate an attempt for a non-statutory resolution of the company's difficulties. The lenders will commission an independent review that addresses the issue of the company's long-term viability, with the review team making use of all the relevant information made available by all the lenders. During this review period, the lenders agree to maintain existing lending agreements in place and a moratorium on the enforcement of claims against the company. The second phase of the 'London Approach' involves agreement upon and implementation of a restructuring plan. Typically, the restructuring will involve either an element of debt forgiveness and/or a debt-for-equity swap. Moreover, new loans are accorded priority over existing debt but in so far as lenders have to share losses then generally the pre-existing entitlements of secured creditors will be respected. Again, while the company does not proceed to the stage of administration or liquidation a lender's security rights will enable it to exert an element of control over the terms of the corporate workout.