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You are here: BAILII >> Databases >> The Law Commission >> REGISTRATION OF SECURITY INTERESTS: COMPANY CHARGES AND PROPERTY OTHER THAN LAND (A Consultation Paper) [2002] EWLC 164(6) (14 June 2002) URL: http://www.bailii.org/ew/other/EWLC/2002/164(6).html Cite as: [2002] EWLC 164(6) |
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FUNCTIONAL EQUIVALENTs to security
6.2 It has been widely recognised for some time that a number of transactions that are not usually treated by the law as creating a security interest do in practice act as a form of security.[1] These functional equivalents are sometimes known as ‘quasi-securities’ or ‘title finance’. Examples include hire-purchase, conditional sales, finance leases, consignment of goods and retention of title clauses. Sale and repurchase (‘repos’) also represent significant forms of financing in today’s modern markets.[2] In each case the financier retains (or in some cases obtains) full title to the assets rather than being granted a charge over the assets,[3] and if the debtor fails to pay for the assets (or in other circumstances agreed in the contract) they can be repossessed or (in the case of repos) retained or sold. In addition there are many types of receivables financing including factoring, discounting of receivables and securitisation which seem to perform a ‘security function.’ In Part VII we will consider whether, under the new notice-filing system we provisionally propose, any of these quasi-security devices should be registrable. (In fact we will argue that for practical reasons some of them, in particular many of those used in relation to receivables financing, should not be made registrable). In this Part, after explaining in general terms the possible advantages and risks of using quasi-securities rather than true securities, we give a brief description of the principal types of quasi-security used in relation to goods and then turn to the transactions used in receivables financing. Some of the latter may be unfamiliar to many readers and we explain them in some detail.
6.3 Originally transactions such as hire-purchase and conditional sales were created partly to avoid the complexities involved in creating mortgages and charges over goods as the result of the Bills of Sale Acts.[4] These Acts do not apply to charges created by companies, and registration of charges under the Companies Act 1985 is much simpler than the registration of bills of sale. However, by using hire-purchase or a conditional sale a company can avoid registration at Companies House altogether. Exemption from the current registration requirements means that quasi-security devices can be fast and cheap to use, which is particularly important in receivables financing and financial markets where the ability to trade swiftly is of the essence. In contrast the cost of registration of security proper under the current system can be burdensome, particularly for a company that creates many such interests.[5] Not having to register the transaction at Companies House also means that there may be no publicity for the transaction.
6.4 The creditor may also get another advantage through taking such a quasi-security interest: if it repossesses the asset on default or breach of condition, it can keep the surplus on any future sale of the asset.[6] Under a true security agreement, if the asset is sold for more than is owed to the creditor, the surplus must be returned to the debtor.
6.5 A further reason for preferring a quasi-security transaction may be to avoid the legal uncertainty as to whether a charge over assets that are changing is a fixed or floating charge.[7] We noted this uncertainty in relation to charges over book debts earlier.[8] In that case it is possible for the charge to be fixed provided that the creditor retains control over the proceeds. With inventory, in contrast, it would not be realistic to create a fixed charge as the debtor needs to be able to use or resell the inventory without constant reference to the creditor for permission to dispose of it. A charge that envisages the debtor disposing of the charged assets will be treated as a floating charge.[9] Even if the charge over inventory is validly registered as a floating charge[10] it is subordinated to preferential creditors and frequently to all fixed charges,[11] reducing the chances of recovery on insolvency. If a quasi-security can be employed instead of a charge, it will prevail over all other creditors.
6.6 A similar issue may arise in relation to investment securities, where it is common for the parties to want the facility to substitute other assets. By taking full title to the assets (for example via what is termed a ‘repo’[12]) rather than taking a charge over them, the financier may be able to retain that facility without the risk that the charge will be held to be no more than a floating charge.[13]
6.8 There is always some small risk that the transaction may be recharacterised by the courts. The court will treat the agreement as a disguised security, and thus subject to the law governing security, where (a) the documents do not truly record the agreement of the parties and are therefore a sham or (b) though the documents genuinely record what the parties agreed, the terms are such as to show that the transaction is in law a security transaction, even if called a sale.[14]
6.9 Sale and lease-back transactions can be difficult to distinguish from a secured transaction. Lord Justice Romer set out the essential differences in Re George Inglefield Ltd.[15] In a sale the seller has no right to recall the asset on repayment of the purchase price, whereas where a mortgage or charge is in place, until foreclosure the chargor or mortgagor has the right to the asset upon discharge of the underlying obligations. Further, a mortgagee realising the assets with a surplus has to account to the mortgagor, whereas a purchaser can sell on the asset with profit and has no liability to account back to the original seller. A mortgagor also has a liability where the proceeds of realisation produce a shortfall below the secured amount.[16]
6.11 The Crowther report defined a conditional sale agreement as an agreement for the sale of goods under which the property in the goods remains in the seller until payment of the price or performance of the other conditions specified in the agreement.[17] A similar but slightly wider definition (including the sale of land) is given under the Consumer Credit Act 1974.[18] Unlike a hire-purchaser, who merely hires the goods with an option to purchase them at the end of the hiring period, a buyer under a conditional sale is obliged under the terms of the agreement to purchase the goods.[19] However under a conditional sale agreement that is ‘regulated’ within the meaning of the Consumer Credit Act 1974, the buyer has a right to terminate the agreement before the final payment falls due.[20]
6.12 The requirements included in most conditional sale agreements are that the buyer make punctual payments of all instalments; the equipment is to be kept in the possession of the buyer and not sold or disposed of in any way; the equipment is to be insured comprehensively; and that no lien is to be created on it.[21] A provision may be made in the agreement that will allow the seller the right to terminate[22] the agreement upon the occurrence of defined events.[23] If the agreement is determined the seller may repossess the property.[24]
6.13 Under the Sale of Goods Act 1979, a buyer who has been given possession of the goods that are still owned by the seller, and who resells them to an innocent party, can in certain circumstances pass good title to the innocent buyer.[25] Thus the ‘security’ of a conditional sale can be destroyed if the goods are resold. A major reason for the development of the hire-purchase agreement was to avoid the risk that the creditor would lose title to an innocent buyer: selling goods subject to a hire-purchase agreement will not pass title (unless, in some circumstances, the hire-purchase relates to a motor vehicle).
6.14 A hire-purchase agreement is an agreement for the hire of goods under which the hirer is given the option - although not the obligation - to purchase the hired goods at a certain point (usually after all repayments have been made).[26] It may alternatively be the case that the property will pass automatically when all the payments have been made; provided the hirer has the right to terminate before the date of final payment, this will not amount to a contract of sale.[27] The property in the goods remains with the owner whilst the agreement subsists and the hirer has no power to dispose of the property.[28] Usually, hire-purchase agreements allow the hirer to terminate the agreement at any time, by notice in writing; the hirer is then required to return the property to the owner in good order and to compensate the owner for any loss suffered as a consequence of the termination.[29]
6.15 A lease of goods is a hire contract, with the essential characteristic of goods being bailed by one party to the other party in exchange for payment of rent.[30] Although the term ‘lease’ has no particular legal significance, the ‘finance lease’ is recognised as having a fundamentally different purpose to the shorter-term hire of goods often referred to as an ‘operating lease’.[31] The finance lease is a financial tool, a characteristic being that the minimum period of the lease is approximate to the estimated working life of the equipment, so that there is only one lessee.[32] In addition, responsibility for maintenance of the equipment rests with the lessee, and the rental is calculated on a basis that will enable the lessor to recoup the capital expenditure of the asset, together with interest. Although by the end of the lease the equipment is likely to have a low residual value, a finance lease should not contain provision for the lessee to acquire the equipment: to do so would turn the transaction into a hire-purchase agreement (although an option to renew the lease may be given).[33]
6.16 The forms of quasi-security described so far are used principally to enable the debtor to obtain possession of an item that it is expected to retain and use for a significant period of time. It is also possible for a supplier to retain title to goods that are supplied on the understanding that the buyer will resell them or use them in its production process, in other words for materials, ‘stock-in-trade’ or ‘inventory’. Although always possible in theory, such clauses did not come into common use until after the decision of the Court of Appeal in Aluminium Industrie Vaassen BV v Romalpa Aluminium Ltd.[34] In that case the court was faced with a clause in the conditions of sale of a Dutch company which in effect provided for the retention of title by the plaintiff, even if its goods were subsequently mixed or incorporated into other goods, and that the defendant had to account for the proceeds of sale of such goods. It was held that such a clause was, on the facts, not a registrable charge and was effective to give the supplier the right not only to the goods that were still in the buyer’s possession but also to the proceeds of goods that had been resold. Such clauses are therefore often called ‘Romalpa’ clauses.
6.17 In its simplest form the Romalpa clause merely entitles the supplier to repossess goods supplied for which the buyer has failed to pay. However there are many variants and extensions of this simplest model. One writer identifies five types of clause.[35] The crucial question is how far the clause may reach without becoming a charge that must be registered if it is to be valid in the event of the buyer’s insolvency.[36]
6.18 First, the supplier may retain title to the goods supplied not only until the particular goods have been paid for but also until other obligations, whether under further sale contracts or otherwise, have been discharged. It has been held by the House of Lords in a Scottish case that such an ‘all monies’ clause does not convert the transaction into a charge and thus the clause need not be registered in order to be valid.[37]
6.19 Secondly, the clause may purport to give the supplier the property to products made using the goods supplied. It has been said in the Court of Appeal that such a provision may in theory be valid and not constitute a registrable charge,[38] though in practice this outcome is unlikely. This is because it would mean that the supplier would be exclusively entitled to the new goods despite the input of labour and possible materials by the buyer and of materials by other suppliers, which is not thought to be a result that the parties would have intended. It will almost invariably be found that the parties cannot have intended that the supplier should be entitled to a greater interest in the goods than would reflect what is owing to it - which constitutes a charge that must be registered if it is to be valid.[39]
6.20 Thirdly, the clause may purport to give the supplier the right to any proceeds of re-sale of the goods. Although in the Romalpa case itself it was held that such a clause was effective on the basis that the buyers were bailees of the goods, sold them as agents for the suppliers and were fiduciaries of the money received, this aspect of the case is now doubtful. A ‘proceeds’ clause is more likely to be construed as a charge on book debts in that the assumed intention is that the seller will receive or retain only such part of the proceeds as equals what is due to it.[40] Moreover, if, as is usually the case, the supplier has given the buyer a period of credit during which the buyer would normally be free to use any proceeds already received as it wishes, it is much more likely that the buyer will be held to resell the goods in its own name and to enter a debtor-creditor relationship with the supplier rather than holding the proceeds for the supplier.[41]
6.21 It seems clear that the Romalpa clause is functionally similar to a security over the goods supplied and new goods or proceeds. However, the courts will sometimes interpret such clauses in a way that would prevent the creditor being able to take property worth more than the amount owed, or, if the property repossessed was worth more, to retain the excess. This happened in the case of Clough Mill Ltd v Martin,[42] where Robert Goff LJ held that if the seller of goods chose to exercise its power under a retention of title clause to repossess goods that were worth considerably more than the outstanding debt, an implied term would prevent it repossessing and reselling more than was necessary to pay the outstanding debt. If it were to sell more it would have to account for the surplus.[43] This ‘contractual’ solution to the problem of the surplus was relied on by Robert Goff LJ to show that the retention of title clause need not be construed as giving rise to a charge that would have to be registered under the Companies Act 1985, although the case also shows how the courts have sometimes tried to reduce the differences in effect between quasi-securities and security proper.
6.22 A consignment is also a form of title retention. A pure consignment occurs where goods are supplied to a dealer on the condition that title is retained by the supplier until the goods are sold or otherwise disposed of by the dealer, as authorised by the supplier; but the dealer does not incur any liability to the supplier for the price, unless and until the dealer sells the goods.[44] Thus the risk that buyers will not be found for the goods is borne by the supplier rather than the dealer. Once the goods have been sold the supplier may obtain title to the proceeds of sale, which are held by the dealer as agent for the supplier; or the relationship may simply be one of debtor-creditor.
6.24 A major part of the assets of many businessesis in the form of obligations owed to the business, or ‘receivables’.[45] Receivables form a very important asset from which the business may wish to raise finance by granting security or otherwise. This may take the form of a charge on, or assignment of, the receivables as security. We saw earlier that fixed or floating charges may be granted over book debts.[46] Receivables financing also can take the form of an outright assignment in discharge or reduction of an existing indebtedness (effectively a sale), under arrangements commonly known as factoring and discounting of receivables.
6.25 Often in commercial transactions the practical distinction between the outright sale of receivables and their transfer by way of security is blurred. If the debt is ‘sold’ but on a recourse basis (so that if the debtor fails to pay, the seller must re-purchase the debt or make good the loss) or if a similar effect is achieved through warranties given by the assignor,[47] the arrangement is functionally very much like a mortgage of the receivables. However, a mortgage of receivables is usually registrable whereas a sale is not.[48]
6.26 Companies use factoring in order to improve their cash-flow, as it enables the company to obtain funds faster than through awaiting payment from customers.[49] The factoring relationship is governed by a factoring agreement between a factor and a client who supplies goods and services to trade customers. The factor may merely provide a service of collecting the debts, or it may advance money to the client in advance of the debts being collected. The factor purchases the trade debts of the client.[50] Ownership of the debt is transferred to the factor by way of an assignment.[51]
6.27 An assignment may be either legal or equitable and the relevant interest may also be legal or equitable. Once there has been a legal assignment, the factor acquires the legal right to the debt (subject to equities having priority), all legal and other remedies for the debt and the power to give a good discharge for the debt without the concurrence of the assignor. However a legal assignment requires a writing under the hand of the debtor and express notice in writing to the debtor,[52] and it cannot be effective until the debt comes into existence. An equitable assignment, in contrast, can be of future debts and may be purely informal without even notice to the debtor. However a debtor who pays the assignor before learning of the assignment will be discharged. For this and other reasons[53] a factor may still want to give notice of an equitable assignment to the debtor. In contrast to an assignment at law, any form of notice is sufficient, provided the fact of the assignment is definitely brought to the mind of the debtor.[54] It is sufficient to show that the debtor has had knowledge of the assignment, regardless of the mode or source of that knowledge.[55]
6.30 Securitisation has been described as a hybrid between a sale and a sub-charge of receivables,[56] or a sophisticated form of factoring or discounting of debts.[57] The term ‘securitisation’ describes a process whereby the revenue stream on a segregated pool of receivables or other income producing assets, rather than being assigned as security or sold to individual financiers, is repackaged into tradable securities[58] issued to investors.[59] The identity of the investors may thus change over the life of the notes. The trust device is the usual method by which this is achieved.
6.31 A standard transaction will involve the sale of the receivables by the owner (the ‘Originator’) to a purchaser, often a specially incorporated company or a specially established trust (the ‘Special Purpose Vehicle’ or ‘SPV’) that is structured so that it will not be affected should the Originator become insolvent.[60] The SPV will fund the purchase through the issue of debt securities, which are secured on the receivables by virtue of a security interest granted to a security trustee, who acts for the investors in the debt securities.
6.32 The intended economic advantages of securitisation can be numerous: for example, lower cost of funds through credit arbitrage;[61] under contractual terms the Originator can continue to retain the benefit of the surplus income from the assets and may only bear losses up to a pre-determined limit, and most importantly balance sheet considerations.[62]
6.34 Partly because rating agencies will rate the credit risk of the transaction on the assumption that immediately following the sale the Originator will become insolvent, structures must be devised to ensure that the transfer of receivables will survive the liquidation of the Originator and that the assets cannot be clawed back by the liquidator or any of its creditors. It is important that a liquidator should not be able to argue that the transaction was not a sale at all, but rather a secured financing arrangement that has not been properly perfected, for example by registration. This is known as recharacterisation risk.[63]
6.35 We have seen already that the courts may recharacterise what they see as a security agreement that has been ‘disguised’ as a sale or other quasi-security, but only when it is clear that this is the case. Where this happens the security would usually be void for want of registration. Under English law it has been established that a sale of receivables even with recourse is not a loan secured on the receivables requiring registration.[64] Other methods of transfer such as novation or subparticipation may also be used; it is not thought that these involve any increase in the risk of recharacterisation.
6.36 A particular problem for some forms of securitisation relates to the way in which priority can depend upon the date on which notice was given to the debtor. We focus here on assignment. In practice in securitisations, notice is not normally given to debtors because of the administrative burden, involving time and expense, and because the Originator may wish to maintain a commercial relationship with the debtors and to continue to collect the receivables. If no notice is given to the debtor the assignment will be equitable.[65] This does not prevent it being valid as against the Originator should the latter become insolvent. However, we have seen that with assignment of debts, which does not amount to a registrable charge,[66] priority depends on the date of notice to the debtor.[67] Thus if notice of the assignment to the SPV is not given, the SPV may lose priority if the Originator charges the assets further or sells them to a third party who does not know of the earlier securitisation assignment and the third party gives notice to the debtor before the SPV does. In addition, debtors without notice can continue to acquire set-off rights and defences that can be exercised against the assignee.
6.38 ‘Repos’ (the current market terminology for sale and repurchase arrangements) are a form of title finance whereby a seller raises capital on an asset by selling it to a buyer, with the seller paying a repurchase price equal to the purchase price and a financing charge.[68] The agreement requires the seller to repurchase the assets, or equivalent assets, at a future date or possibly upon demand.[69] Repos are normally used where the assets are investment securities (by which we mean instruments that a borrower uses to acknowledge debt) or investments such as shares, debentures, stock, bonds, bills of exchange and other forms of tradable debt.[70]
6.39 The repo mechanism can be employed for a variety of purposes, not all of them related to security. For example, the buyer may wish to have title to a block of shares temporarily, in order to gain control of the accompanying voting rights.[71] More usually however a repo is a way of raising capital or is used for purchasing a particular portfolio of securities or indeed for both purposes together. It may also be used to provide security to minimise the risk inherent in financial market transactions. They can be very short term. Arrangements may be established under a master agreement between two parties, under which a number of transactions are secured or supported by the same ‘collateral’ arrangement and pool of ‘collateral’ assets. The collateral arrangement is designed to secure or support the net exposure of a party. In some circumstances this net exposure varies over time, so that at different times a party may be a net debtor or a net creditor. Therefore the collateral arrangements may be bilateral, in that at any given time during the term of the master agreement either party may be required to provide collateral (in the form of security or by transfer of title) to the other party.
6.42 Were the parties to employ a charge agreement under which the chargor had the right to continue to deal in the investment securities, the charge would probably have to be a floating charge. The disadvantages of floating charges in terms of priority and status vis-à-vis preferential creditors[72] mean that in practice they are not favoured.
6.43 There is doubt whether it is possible to use a fixed charge in this situation. One might envisage it as a charge over a pool of assets that remains under the chargee’s control,[73] but the right of use raises problems under English law in relation to the characterisation of the charge.[74] If title is conferred along with equivalent redelivery provisions, and the chargee may dispose of the original securities free of any interest of the chargor, it is questionable whether the chargor retains the equity of redemption in the securities it charged. Naturally this is a topic of intense current interest to lenders, such as ‘prime brokers’, who provide finance for securities dealing operations and take portfolios of securities as their security. Further, even if the charge were fixed rather than floating there would be uncertainty whether it would be registrable on the basis that debt securities or equity share dividend rights are book debts.
6.46 In stock or securities lending a lender transfers securities to a ‘borrower’ with an agreement to replace the securities in due course on a specified future date. A typical agreement would require the ‘borrower’ to pay a fee to the lender and also provide collateral in the form of cash or other securities. The collateral is transferred through a title transfer arrangement, which enables the collateral to be further used. It is usual to require the value of the collateral to be adjusted to the market value of the main securities during the term of the agreement. If this is a two-way collateral transfer, if either party defaults the other party can set off the obligation against the assets that are held.[75] Stock lending is commonly used by institutional investors. We do not think that it is in essence a quasi-security although we understand from practitioners that it may be employed to serve this purpose in specific (but uncommon) transactions.[76]
6.48 Contractual set-off is usually aimed at extending rights of set-off beyond those given at law[77] or in equity. A contractual set-off is not a security interest as it gives no right over the debtor’s property, merely an entitlement to set-off one personal obligation against another; the Re Charge Card case held at first instance that it was not therefore a registrable interest.[78] However, contractual set-off may fulfil a security function.[79] A bank that wishes to lend against the ‘security’ of the borrower’s money reserves may require that these be paid into a deposit account with it, and give itself the right to set-off the amount loaned against the sums it is bound to repay to the borrower under the deposit account.[80]
6.49 In addition to (or instead of) taking a charge over a bank deposit or employing contractual rights of set-off, banks now may stipulate that sums deposited can only become repayable once all underlying obligations which are identified have been discharged. The sums deposited are then commonly referred to as ‘flawed assets’. The effect is to qualify the bank’s repayment obligation without giving it any rights over the credit balance. It is possible for such an arrangement to provide perfectly good security without operating as a charge.[81]
6.50 Goode describes a subordination agreement as the obverse of a negative pledge; that is, instead of trying to obtain priority over other parties the creditor voluntarily agrees to subordinate its right.[82] For example, a subordinated creditor might agree that it should not be paid by the debtor until other specified creditors (that is, the ‘senior’ creditors) have been paid. This may be in the subordinated (‘junior’) creditor’s interest, if the borrower has a better chance of doing well if it receives additional funds that the junior creditor is unable or willing to advance but that the senior creditor will lend provided that it has priority. Clearly then it is of paramount importance that the subordination agreements are effective prior to and upon the insolvency of the debtor.[83]
6.53 In ‘contractual’ subordination a creditor agrees with a debtor to postpone its right to be paid upon the insolvency of the debtor until the senior creditors have been paid in full. This is often a feature of documents surrounding bond issues in financial markets. An undertaking not to prove in the debtor’s winding up has been held not to contravene any principle of insolvency law[84] as the subordination agreement is merely a contractual variation of pari passu rights as between junior and senior creditors.[85]
6.54 However an undertaking to account for dividends may be intended to take effect as a trust under which the junior creditor holds sums received from the borrower in trust for the senior creditor. The question of whether the agreement ought to be registered (as a charge against the junior creditor, rather than as against the borrower) is dependent upon whether the entitlement to a dividend in a winding up is a book debt. Goode contends it is not, as the book debt is that which produced the dividend rather than the dividend itself.[86] However, on the approach we advocate in Part V, under which any charge would be registrable unless exempted, such trusts might be registrable.
6.55 ‘Turnover’ subordination is where the subordinated creditor agrees to hand over any monies paid in satisfaction of the subordinated debt to the senior creditor until the senior debt has been discharged. Commentators and practitioners view this as taking effect as a trust or a proprietary transfer of proceeds which confers on the senior creditor an in rem claim effective upon the junior creditor’s insolvency and against its creditors.[87] On the approach we propose in Part V, this also would seem to amount to a registrable charge.
[2]It has been suggested to us that stock-lending arrangements may also have a security purpose but we are not sure whether this is correct. See further below, para 6.46.
[3]Hence such transactions are not registrable as charges under the Companies Act 1985.
[4]See, principally, the Bills of Sale Act 1878 and the Bills of Sale Act (1878) Amendment Act 1882. On this see further below, Part VIII.
[5] See our recommendations for notice-filing where one financing statement can cover a multitude of transactions: see above, paras 4.116-4.117.
[6]Although in practice there can be contractual requirements to account for the surplus, or the parties can vary the surplus rules contractually. Such a provision could in theory be one element in assessing whether there is a risk of ‘re-characterising’ the transaction as a disguised security: see below, paras 6.8-6.10.
[7]Culminating in the recent ‘Brumark’ case: Agnew v Commissioner of Inland Revenue [2001] 2 AC 710, PC.
[8]See above, para 2.18.
[9]See Re Bond Worth [1980] Ch 228.
[10]We will see that in the retention of title cases, the clauses in question were usually not registered.
[11]This depends on whether the subsequent fixed chargee takes with notice of a negative pledge clause, see above, para 2.42.
[12]See further below, paras 6.38 ff.
[13]See further below, paras 6.41-6.42.
[14]See Welsh Development Agency v Export Finance Co Ltd [1992] BCC 270 for a discussion of the law of recharacterisation.
[15] [1933] Ch 1.
[16][1933] Ch 1, 27-28. However, a similar result would also seem to be achieved under a sale and lease-back, where the lease was terminated for non-payment, leaving a shortfall.
[17]Crowther report para 1.2.14.
[18]The Consumer Credit Act 1974, s 189 defines such an agreement, for the purposes of the Act, as “an agreement for the sale of goods or land under which the purchase price or part of it is payable by instalments, and the property in the goods or land is to remain in the seller (notwithstanding that the buyer is to be in possession of the goods or land) until such conditions as to the payment of instalments or otherwise as may be specified in the agreement are fulfilled.”
[19]This distinction can have an effect on the rights of third party purchasers: see Chitty on Contracts (28th ed 1999) para 38.423.
[20]See the Consumer Credit Act 1974, s 99(1).
[21]R Goode, Commercial Law (2nd ed 1995) p 764.
[22]As an alternative to termination and repossession, some conditional sale agreements provide that the seller may elect to pass the property in the goods to the buyer and recover from the buyer the unpaid balance of the purchase price of the goods. See Chitty on Contracts (28th ed 1999) para 38.403.
[23]This includes breach of the obligations of the buyer and bankruptcy.
[24]Although this is subject to the principle of relief against forfeiture: for a recent example, see the decision of the House of Lords in On Demand Information plc v Michael Gerson (Finance) plc [2002] 2 WLR 919.
[25]See the Sale of Goods Act 1979, s 25(1); but note s 25(2), which for this purpose prevents a buyer under a conditional sale agreement that is a consumer credit agreement within the meaning of the Consumer Credit Act 1974 from using s 25(1).
[26]See Chitty on Contracts (28th ed 1999) para 38-267, and see also the Crowther report para 1.2.14. However, see Forthright Finance Ltd v Carlyle Finance Ltd [1997] 4 All ER 90, where what was described as a hire-purchase agreement, which contained an option to purchase following payment of all the instalments, was held to be a conditional sale agreement.
[27]Helby v Matthews [1895] AC 471, HL. The Consumer Credit Act 1974, s 189 defines a hire-purchase agreement, for the purposes of that Act, as “an agreement, other than a conditional sale agreement, under which - (a) goods are bailed or (in Scotland) hired in return for periodical payments by the person to whom they are bailed or hired, and (b) the property in the goods will pass to that person if the terms of the agreement are complied with and one or more of the following occurs - (i) the exercise of an option to purchase by that person, (ii) the doing of any other specified act by any party to the agreement, (iii) the happening of any other specified event.” However, this Act does not control all hire-purchase agreements. For a statutory exception relating to motor vehicles and covering both hire-purchase and conditional sale, see the Hire-Purchase Act 1964, ss 27-30.
[28]No disposition by the hirer even to a good faith purchaser exception will pass a good title to the latter; the rule that the seller cannot pass a good title unless he has a good title applies. The exception to this rule under Sale of Goods Act 1979, s 25 applies only to a buyer who is in possession of the goods.
[29]R Goode, Commercial Law (2nd ed 1995) p 767.
[30]R Goode, Commercial Law (2nd ed 1995) p 776.
[31]Statement of Standard Accounting Practice No 21 (referred to in On Demand Information plc (in administrative receivership) v Michael Gerson (Finance) plc [2000] 4 All ER 734, 737, CA) sets out the distinction thus: “The distinction between a finance lease and an operating lease will usually be evident from the terms of the contract between the lessor and the lessee. An operating lease involves the lessee paying a rental for the hire of an asset for a period of time which is normally substantially less than its useful economic life. The lessor retains most of the risks and rewards of ownership of an asset in the case of an operating lease. A finance lease usually involves payment by a lessee to a lessor of the full cost of the asset together with a return on the finance provided by the lessor. The lessee has substantially all the risks and rewards associated with the ownership of the asset, other than the legal title. In practice all leases transfer some of the risks and rewards of ownership to the lessee, and the distinction between a finance lease and an operating lease is essentially one of degree.” See also Chitty on Contracts (28th ed 1999) para 33-078.
[32]In contrast to the operating lease, which typically has a series of lessees.
[33]R Goode, Commercial Law (2nd ed 1995) p 777. For more details on the finance lease, see ibid ch 28. See also the Crowther report para 1.2.14.
[34][1976] 1 WLR 676.
[35]These are the simple clause; the current account clause; the extended (or ‘continuing’) clause; the tracing (or ‘prolonged’) clause; and the aggregation (or ‘enlarged’) clause. See G McCormack, Registration of Company Charges (1994) pp 68-69.
[36]As the buyer is expressly or impliedly permitted to use or dispose of the goods without further reference to the supplier, any charge would be a floating charge: Re Bond Worth Ltd [1980] Ch 228.
[37]Armour v Thyssen Edelstahlwerke AG [1991] 2 AC 339.
[38]Clough Mill Ltd v Martin [1985] 1 WLR 111, 119-120.
[39]As was held in the Clough Mill case itself.
[40]See E Pfeiffer Weinkellerei-Weineinkauf GmbH & Co v Arbuthnot Factors Ltd [1988] 1 WLR 150.
[41]See Re Andrabell [1984] 3 All ER 407.
[42][1985] 1 WLR 111. The case involved the sale of yarn.
[43]However, if the buyer’s delay in paying were to amount to a repudiation of the contract which the sellers were to accept, the sellers would then be entitled to repossess and resell the whole of the yarn still in the buyer’s possession. Robert Goff LJ said that in these circumstances the sellers would “be bound to repay any part of the purchase price already paid by the buyer which must be appropriated to the goods sold, because such sum would be recoverable by the buyer on the ground of failure of consideration”: [1985] 1 WLR 111, 117-118. Oliver LJ expressed provisional agreement with these solutions: ibid, p 124.
[44]W J Gough, Company Charges (2nd ed 1996) pp 513-514. In other words, the goods are on ‘sale or return’. Cars are frequently supplied by manufacturers to dealers on a sale or return basis. There is generally a provision that the dealer is deemed to purchase if it has not appropriated the goods within a certain time (such as 12 months, the latest point to which payment of Value Added Tax can be deferred). This deferment is one of the advantages of consignment. For further reading in this area, see, eg, R Goode, Commercial Law (2nd ed 1995) p 798.
[45] Receivables denote a debt or contract right. An account receivable is a right to a sum of money. Documentary intangibles are receivables embodied in a negotiable instrument, eg, a bill of exchange or negotiable certificate of deposit. They can therefore be mortgaged, charged, pledged and delivered by way of lien. Pure intangibles are receivables, eg, the right to payment under a contract and are therefore not capable of pledge or contractual liens. “Receivables form an integral part of the assets of every trading company. Mortgage and charge debts, car loans, insurance premiums, credit card debts, secured consumer loans, equipment loans, freights (including sub-freights), rentals from real and personal property, debts for good sold or services rendered, are all receivables.” F Oditah, Legal Aspects of Receivables Financing (1991) p 2.
[46]See above, para 2.18.
[47]The Crowther report pointed out that even a sale without recourse may contain warranties by the assignor “designed to ensure so far as possible that the receivables assigned are not only legally enforceable but likely to be paid. Since breach of these warranties may entitle the assignee to recover his loss from the assignor the distinction between sales with recourse and sales without recourse is not as clear cut as it might appear.” Crowther report Appendix III, para 5.
[48]The distinction is important for other reasons. A sale of receivables attracts ad valorem stamp duty; and the asset sold is then off balance sheet and replaced by the proceeds of sale, which can be a major commercial reason for securitising assets. If a mortgage is used, the asset remains on the balance sheet of the mortgagor.
[49]For a more detailed discussion of factoring, see, eg, F R Salinger, Factoring: The Law and Practice of Invoice Finance (3rd ed 1999).
[50]Because the assignment is absolute, factored receivables are not currently registrable under the Companies Act 1985.
[51]Such an assignment is by way of an agreement by a creditor to transfer its rights in a debt to the factor. The factor agrees to accept those rights. The consent of the debtor is not required unless the debt itself is stated to be non-assignable: see Helstan Securities Ltd v Hertfordshire County Council [1978] 3 All ER 262, QBD; Linden Gardens Trust Ltd v Lenesta Sludge Disposals Ltd [1994] 1 AC 85, HL
[52]Law of Property Act 1925, s 136(1).
[53]To prevent the debtor being able to rely on other ‘equities’ that may arise as against the assignor, and to preserve priority.
[54]Smith v Zigurds (Owners) [1934] AC 209.
[55]Ward and Pemberton v Duncombe [1893] AC 369.
[56]F Oditah, Legal Aspects of Receivables Financing (1991) p 34.
[57]P Wood, Law and Practice of International Finance (2nd ed 1995).
[58]The term ‘securities’ here refers to the instrument which a borrower uses to acknowledge debt, or to investments such as shares, debentures, stock, bonds, bills of exchange and other forms of tradable debt.
[59] Recently reported examples of securitisations have included the future royalties on the music of David Bowie and the future admission fees to Madame Tussauds’ Wax Museum: see Business Week, March 11, 2002, p 58.
[60]The SPV is structured so that it is not classified as a subsidiary of the Originator under companies legislation and its accounts are therefore not required to appear as part of group accounts.
[61]That is, an originating company may be owed debts by other companies that are a better credit risk than is the originating company itself. If the Originator can borrow money solely against the credit risk of these receivables it will be able to borrow more cheaply than if its lenders have to take the risk of the Originator’s own default as well as any risk involved in the receivables.
[62]Prior to Financial Reporting Standard 5 (‘FRS 5’)(issued by the Accounting Standards Board in April 1994 and mandatory for accounting periods ending on or after 22 September 1994, applying to all transactions whenever they were entered into), one of the principle benefits of securitisation was to remove the securitised assets from the Originator’s balance sheet, with the proceeds then appearing as cash. FRS 5’s stated objective was to ensure the substance of a transaction was recorded. The Accounting Standards Board (a committee of the Accounting Standards Board Ltd, a prescribed standard setting body for the purposes of the Companies Act 1985, s 256(1)) expressed the view that “financial statements should represent faithfully the commercial effects of the transactions they purport to represent. This requires transactions to be accounted for in accordance with their substance and not merely their legal form, since the latter may not fully indicate the commercial effect of the arrangements entered into”: see “The Development of FRS5” Appendix III to Accounting Standards and Guidance for Members 2000. FRS 5 was therefore developed to give guidance as to how to account for these structures. It adopted new definitions of assets and liabilities which did not rely on legal ownership and gave three possible accounting treatments which must be considered for securitisations, these being off balance sheet, linked presentation and fully on balance sheet.
[63]Achieving a true sale and thus avoiding recharacterisation is not only a matter of ensuring that legal title to the receivables is properly transferred but also involves other aspects of the transaction such as recourse to the Originator, representations and warranties given by the Originator to the SPV, and the parties’ intent. Achieving a true sale is also of utmost relevance for the purposes of capital adequacy regulations of the Originator, and the taxation consequences of the transaction. The rules for determining what is a true sale in each of the above aspects differs in each case.
[64]See, eg, Olds Discount Co Ltd v John Playfair Ltd [1938] 3 All ER 275; Re George Inglefield Ltd [1933] Ch 1; Lloyds and Scottish Finance Ltd v Prentice (1977) 121 Sol Jo 847, affirmed HL, The Times, March 29, 1979; and Welsh Development Agency v Export Finance Co Ltd [1992] BCC 270.
[65]It would be necessary to join the Originator in any action against the debtors but this is not seen as a significant problem.
[66]Notice to the debtor is only required if there is no registration requirement or registration is not effected. Where it is, a subsequent assignee will have notice, so that the rule in Dearle v Hall (1823) 3 Russ 1 is displaced.
[67]See above, paras 6.26 ff. An assignee who knew at the time that the debt had already been assigned cannot gain priority by giving notice to the debtor before the earlier assignee, but this is not a likely situation with securitised receivables.
[68]The repurchase price therefore increases during the term of the transaction, with the increase being calculated by applying a notional interest rate (the ‘repo rate’) to the purchase price. Although the purchase price is related to the market price at the time of the initial purchase, fluctuations in the market value after the initial purchase have no impact on the repurchase price (although they may be relevant for triggering obligations in relation to the ‘margin’, whereby the net credit exposure of the parties can remain constant throughout the term of the transaction).
[69]Most repo transactions in the London market are conducted under the terms of the Global Master Repurchase Agreement of the Public Securities Association (New York) and the International Securities Market Association (Zurich), November 1995 edition (there is now an October 2000 version). Swaps and Derivatives under the Master Agreement of the International Swaps and Derivatives Association Inc can be secured either by a security interest or by a title transfer under the 1995 edition Credit Support Annex, which forms part of the main ISDA Agreement. Here, rather than effecting a sale and repurchase, the collateral is transferred if a party’s net exposure to the other exceeds a prescribed amount and retransferred where there is a surplus, called respectively the Delivery Amount and the Return Amount.
[70]Although theoretically this form of title finance may be used for land, goods or receivables.
[71]In this case the transaction is similar to a stock loan; see below, para 6.46.
[72]Such as ranking after preferential creditors,
and avoidance under the Insolvency Act 1986,
s 245.
[73]Cf the problem of the fixed charge over book debts, above, para 2.18.
[74]Some practitioners doubt the effectiveness of a right of use on the basis that it is likely to amount to a clog on the equity of redemption if the chargee may deliver back securities different from the original ones charged (ie, no continuing proprietary interest can be traced). However, others consider that the right of use, if clearly conferred, is effective on the basis that the chargee conveys both its own interest and, in an agency capacity, the chargor’s interest (a view that seems to be supported in case law: see, eg, Kreglinger v New Patagonia Meat and Cold Storage Company [1914] AC 25). The possibility of an effective right of use is also assumed in the most recent rules made by the FSA on client assets - see COB 9.4 of the FSA’s Handbook of Rules and Guidance.
[75]There is clearly a risk of recharacterisation as a security agreement. If such reclassification were to occur then the security would be void for want of registration. Even if such security were registered then the charge over it has the characteristics of a floating charge which, as stated above, carries perceived disadvantages for the parties. Recharacterisation will occur if the agreement between the parties is a sham intended to mask the true agreement between the parties: Orion Finance Ltd v Crown Financial Management Ltd [1996] 2 BCLC 78. There is a greater risk of recharacterisation in stock lending if the agreement is less than an outright assignment of the securities.
[76]The ‘security’ element is because collateral is given.
[77]Statutes of Set-Off were repealed but their effect remains in the Supreme Court Act 1981, s 49: see R Goode, Commercial Law (2nd ed 1995) p 657.
[78]Re Charge Card Services Ltd [1987] Ch 150.
[79]See R Goode, Commercial Law (2nd ed 1995) p 657.
[80]It may be preferable to take this course rather than simply using the cash itself: the value of the cash deposited may be much less than the actual borrowings and may just be one element of the security package. Moreover, the cash, even though deposited with the lender (with perhaps restrictions on withdrawal) will still feature as an asset of the borrower on its balance sheets, and as such will go some way towards meeting liquidity ratios, such as those set by the Bank of England. In the context of insolvency where contractual rights of set-off seek to extend the rights of set-off beyond those allowed under the Insolvency Rules 1986 r 4.90 it goes against the principle of pari passu distribution in that its effect would be to use a purely personal cross claim to ring-fence assets away from those available for unsecured creditors.
[81]See Re Bank of Credit and Commerce International SA (No 8) [1997] 3 WLR 909, 918E.
[82]See R Goode, Commercial Law (2nd ed 1995) p 663. For further details on the law of subordination, see P Wood, The Law of Subordinated Debt (1990).
[83]Along with the forms of subordination we mention, subordination may be achieved in other ways. For example, the ‘junior’ creditor might invest in equity in the borrower rather than lend to it, thus ranking as an unsecured creditor vis-à-vis secured creditors; or it might lend to a parent company whose assets are the shares of its subsidiaries rather than lending direct to the subsidiaries.
[84]Eg, in some jurisdictions such agreements may conflict with mandatory insolvency rules which state that unsecured debts must be paid on a pari passu basis.
[85]See R Goode, Commercial Law (2nd ed 1995) p 665.
[86]See R Goode, Commercial Law (2nd ed 1995) p 665.
[87]See R Goode, Commercial Law (2nd ed 1995) p 664.
