Debt Financing

Most important aspect of this topic is case law

What is debt financing?

Company finances itself through borrowing money from creditors. They must repay the principal PLUS interest on agreed terms and is governed by security interest or charge law.

Trinidad Companies Act ss 98, 251-257, 300 etc.

What is equity financing?

Company finances itself by selling a ‘stake’ (shares in itself) to investors in exchange for capital. Shareholders become part-owners - dilution - but there is no fixed repayment obligation (discretionary dividends). It is governed by share capital rules.

Trinidad Companies Act ss 54 etc

Why does the distinction between debt and equity financing matter?

In debt financing = secured creditors paid FIRST (higher priority in insolvency). This is why debt is generally less risky for the lender and why creditors demand security charges over the company assets in the loan.

Low risk because they have a registered charge over the debtor’s specific assets, they have the right to seize and sell the collateral to recover their debt

In equity financing = if the company fails, shareholders lose their investment and are paid last in liquidation (lower priority in insolvency) pari passu (equal priority status among classes or parties of whatever funds remain after preferential creditors are paid.

High risk because they do not have any registered charges over the debt and only real recourse it to file a lawsuit to recover the funds which may or may not succeed

Relevant TCA sections on the priority of floating charge holders?

s 252 (1)(f) - The statement shall contain…in the case of a floating charge, the nature of any restriction on the power of the company to grant further charges ranking in priority to or equally with the charge thereby created

s 256 - Maximum sum deemed to be secured by the floating charge

s 300 - “Where a receiver is appointed on behalf of the holders of any debentures of a company that are secured by a floating charge….if the company is not wound up…the debts…relating to preferential payments to be paid in order of priority to all other debts shall be paid in order of priority forthwith”

What is a debenture?

A debenture is a debt security document that acknowledges a company’s debt obligation, not a cheque, letter of credit or I.O.U. A formal legal document evidencing the lending of a fixed sum of money in return for charges over company assets as security/collateral.

Relevant statutory provisions?

s 98 TCA - ‘Directors’ Borrowing Powers’ - (Directors’ Power to Issue Debentures)

Unless the company’s articles, bye-laws or unanimous shareholder agreement provides otherwise, the directors (without shareholder authorisation), may:

• Borrow money on company credit

• Issue, reissue, sell or pledge debentures of the company

• Give a guarantee on behalf of the company to secure another person’s obligation

• Mortgage, charge, pledge pr otherwise create a security interest in company property to secure company obligations

s 94 BCA

Why are debentures relevant to debt financing?

Because they contain fixed or floating charges, OR BOTH. The classification and enforceability of these charges is what gives lenders in debt financing their security.

Which provision states this?

s 288 TCA ‘Realisation of Security’ - “Debenture holders are entitled to realise any security interest vested in them or in any other person for their benefit, IF -

(a) the company fails within one month after it becomes due, to pay

i. any instalment of interest

ii. the whole or part of the principal

iii. any premium

owing under the debenture of the trust deed

(b) company fails to fulfil any of the obligations imposed on it in the debenture trust deed

(c ) any circumstances that would entitle the debenture holders to realise their security interest

(d) company goes into liquidation

What is a charge? - Sets the stage for charges essay

Burgess - a company charge is a form of proprietary assignment given as security for a company’s debt. Under a company charge, the debtor-company, as assignor, vests in the creditor, as assignee, a proprietary right of non-possessory control which extends to the debtor-company’s right of free alienation of the property appropriated to the charge

Security removes certain assets from the general pool available to unsecured creditors in insolvency. That is why REGISTRATION matters. That is why PRIORITY RULES matter. That is why floating charges are CONTROVERSIAL.

Security rearranges who bears insolvency risk.

Is a charge the same thing as collateral?

No. ‘Collateral’ is a commercial term. A charge is the legal hook for the promise made by the debtor to the creditor that will allow them to seize the asset (collateral) if something goes wrong.

What are the 2 types of charges?

Fixed and Floating

What is a fixed charge?

Sealy - A fixed or specific charge is one that restricts the debtor’s ability to use, dispose of, or otherwise deal with the specific charged assets without first obtaining the creditor’s written consent.

It is created over identified property and it’s not necessary that the property should be presently owned by the chargor: future property may be the subject of an agreement to charge provided it is sufficiently described.

Which assets can be subject to a fixed charge?

Land, Fixed Plant and Machinery

Land - Equitable and Legal Mortgages

Eg. corporate HQ site, office building, vacant land for future store construction

Legal Mortgage - A legal mortgage is the formal transfer of legal ownership of an asset from the borrower (mortgagor) to the lender (mortgagee) as security for a debt. The borrower retains possession and use of the asset, but the legal title sits with the lender until the debt is repaid

Equitable Mortgage - Arises where the formal requirements for a legal mortgage are NOT met (e.g. no executed deed), but there is still a CLEAR INTENTION to create a security interest. Equity intervenes to recognise the security interest even without formalities as failure to do so would be unjust.

Historically = legal mortgage

Nowadays = legal transfer of title is impractical for the lending bank in modern business transactions so the lender merely takes a legal charge over the property

Fixed Plant and Machinery

Eg Machinery and equipment, vehicles, furniture and fixtures - assets not regularly replaced

Case Law for Fixed Plant and Machinery

• Re HiFi Equipment (Cabinets) per Harman J

• National Bank of New Zealand v CIR

• Tudor Heights v United Dominion Corpn Finance

Re HiFi Equipment (Cabinets Ltd) per Harman J

‘Fixed plant and machinery’ is to be construed as containing a single item, and that it connotes plant and machinery which is in some way firmly attached to the company’s premises.

National Bank of New Zealand v CIR

A specific charge over fixed plant and machinery did not include computer software

Tudor Heights v United Dominion Corp Finance

Expression did not connote ‘fixtures’ as that term used in land law but merely meant assets which would be expected to be retained by the company in its business

What are the advantages of a fixed charge?

(a) Maximum protection for the lender = specific asset subject to lender’s control

(b) High priority in insolvency = fixed charge holders are paid BEFORE floating charge holders - s 435 TCA ‘Preferential Payments’

(c ) Easier to enforce - the asset is identified and cannot disappear

What are the disadvantages of a fixed charge?

(a) Company’s loss of freedom to use the asset in business - restricts operational freedom

(b) If the asset is one the company needs to use or sell regularly, a fixed charge is commercially impossible

(c ) Requires ongoing consent mechanism - administratively burdensome

What is a Floating Charge and its DISTINGUISHING FEATURE?

A floating charge permits the debtor the freedom to deal with the charged asset in the ordinary course of business (use, sell, replace) without recourse to the creditor for approval. This liberty to deal with the charged assets continues until the floating charge CRYSTALLISES into a fixed charge upon a triggering event

It HOVERS (AMBULATORY) over a class of assets but does not attach to any SPECIFIC asset. This is why floating charges are ideal for circulating assets like stock, inventory, book debts - which all constantly change (cannot stifle the debtor’s business ie ability to repay the loan while still providing security)

The parties can nominate in the charge document the conditions or time at which this will happen. The charge will crystallise by operation of law if the debtor-company ceases to carry on business for any reason

What analogy is used to remember a floating charge?

Claw machine at an arcade - The claw hovers above the prizes (assets) without gripping any particular one. Only when something is triggered to make the claw descend (crystallisation) does it grip a specific prize

Which case gave the classic 3 characteristic test that defines a floating charge and which other case was cited in the same judgment?

Illingworth v Houldworth per Lord McNaughten (approved in subsequent cases)

A floating charge is:

1. A charge on a class of assets of a company, present and future

2. Which class is, in the ordinary course of the company’s business, changing from time to time; and

3. Until the holders enforce the charge, the company may carry on business and deal with the assets charged

“I should not have thought there was much difficulty in defining what a floating charge is in contrast to a specific charge… a floating charge is ambulatory and shifting in nature, hovering over and floating with the property which it is intended to affect until some event occurs or some act is done which causes it to settle and fasten on the subject of the charge within its reach and scope.

In Illingworth v Houldworth, he also cited the dicta of the Earl of Halsbury in re Yorkshire Woolcombers Association Ltd

• “Something which is to float, not be put into immediate operation, but such that a company should be allowed to carry on its business…contemplates the possibility of those book debts being extinguished by a payment to the company, and that other book debts should come in and take the place of those that had disappeared”

Cases that help determine whether there is a floating charge?

• Government Stock Investment and Securities Co v Manila Co Rly per Lord McNaughten

• Holroyd v Marshall

• Re Bond Worth

• Re Cosslett (Contractors) Ltd

Case Story -

Government Stock Investment and Securities Co v Manila Co Rly per Lord McNaughten

“A floating security is an (1) equitable charge on the assets for the time being of a going concern. It attaches to the subject charged in the (2) varying conditions in which it happens to be from time to time. It is of the essence of such a charge that it remains (3) dormant until the undertaking charged ceases to be a going concern”

Holroyd v Marshall

Facts: A company tried to mortgage assets it did not yet own. The question was whether you could grant a security over future assets

Held: HL held it was possible to create an equitable interest in future (after-acquired) property. The Court confirmed the debtor could deal freely with the assets until the lender took steps to enforce - establishing the conceptual basis of the floating charge.

Key Principle: The ORIGIN of the floating charge concept - future assets can be charged and freedom to deal is a characteristic of the floating charge. The language of the document, labelling it ‘fixed’ or ‘floating’ is NOT conclusive - it is the NATURE of the charge that the court examines

Re Bond Worth per Slade J

Facts: A seller of synthetic fibres supplied goods on terms that title (ownership) would remain with the seller until full payment. The buyer used the fibres to manufacture carpets and went into receivership. The question was whether the retention of title clause gave the seller a security interest

Held: Slade J held that the arrangement constituted a floating charge over the goods and proceeds. This charge was VOID because it had not been registered at Companies House.

Key Principle: A commercial arrangement that FUNCTIONS LIKE a security interest may be treated AS a security interest by the Courts, REGARDLESS OF HOW IT IS LABELLED. SUBSTANCE OVER FORM.

(Important point for judicial overreach)

Re Cosslett (Contractors)

Facts: A construction company granted the employer the right to use its plant and equipment if the company defaulted, and to sell it and apply proceeds to the debt.

Held": The plant and materials on-site were considered to a fluctuating body of assets subject to change in the ordinary course of the contractor’s business. Even though the council restricted the removal of equipment, these restrictions were for operational reasons (to ensure the work was finished) rather than to maintain the value of the security.

Key Principle: Degree of control the lender exercises over the assets per Millet LJ. Because the contractor could still use the assets in its business until a default occurred, the interest was properly characterised as a floating charge. Void against the liquidator for non-registration. SUBSTANCE OVER FORM.

What are some more focused tests to determine whether a charge is fixed or floating?

1. Agnew v IRC (Re Brumark) — 2-stage test + 3 characteristics from Illingworth v Houldworth

2. Re Spectrum Plus

Agnew v IRC (Re Brumark)

Facts: Brumark granted a charge over uncollected book debts as a ‘fixed’ charge and over the proceeds as a ‘floating’ charge. The company was free to collect the debts and use the proceeds in the ordinary course of business.

Held: Lord Millet held that the charge over the uncollected book debts was actually a floating charge. The company’s freedom to collect and use the proceeds was inconsistent with a fixed charge.

Key Principle: 2 stage test

1. Construe the agreement to identify the INTENTION of the parties and the RIGHTS it confers

2. Categorise the charge as a MATTER OF LAW based on its nature and characteristics of the rights created and not on the label assigned by the parties. SUBSTANCE OVER FORM

Re Spectrum Plus

Facts: Bank lent money to a company secured by a ‘fixed’ charge over book debts. The company was required to pay proceeds into an account at the bank but was free to draw on that account in the ordinary course of business.

Held: HL OVERRULING Siebe Gorman held this was a floating charge. The critical determinant is control = the freedom of the company to use the assets in the ordinary course of business, NOT the nature of the assets charged: because the company could freely draw on the account, the bank lacked the control over the assets necessary for a fixed charge

Key Principle: CONTROL is now the central determinant of whether a charge is fixed or floating.

Fixed = the chargee must maintain control of the asset — the chargor cannot deal with it freely

Floating = the chargor retains the freedom to deal

This is the CURRENT LAW combined with Re Brumark = {3 characteristics from Illingworth v Houldwoth/Re Yorkshire Woolcombers} 2 stage test - intention + matter of law + control test from Re Spectrum

What are book debts?

Book debts or receivables are amounts owed to the company (by customers) as a result of the supply of goods and services (on credit eg. hire purchase) by the company in the course of its business. They represent outstanding invoices - money earned but not yet received - recorded in a company’s books.

They are listed as current assets on the company’s balance sheet and it can use these unpaid invoices as security for bank loans - income stream for the debtor-company over which creditors may take security, but which SIMULTANEOUSLY constitute an important part of the company’s cash flow (recorded on sales ledger)

They are constantly changing, liquid asset - money comes in daily as invoices are paid. The company NEEDS to collect and use these debts to function - you cannot freeze them

‘Book debts’ is not a legally defined term but are referred to debts that are entered in the well-kept books of a business - might vary on industry

Point of Contention — Book Debts — Do they fall squarely into either category?

Courts struggled with what type of charge could attach to something so intangible and fluid. The practical and judicial challenge rested on a balancing act — reconcile the creditors’ wish for fixed security to gain priority on insolvency AND company’s wish to have some control over the use of the proceeds of book debts in its day-to-day business.

AKA securing an IMMEDIATE security interest over future assets of the company WHILE leaving company at liberty to deal with its assets in the ordinary course of business as it thinks fit, BEFORE CRYSTALLISATION, at the same time

Cases on Evolution of Book Debts Tests? Is there enough control to be subjected to a fixed charge?

1. Siebe Gorman & Co v Barclay’s Bank

2. Re Spectrum Plus

(use as a pair to show approval then rejection)

1. Re New Bullas Trading

2. Re Brumark

(use as a pair to show approval then rejection)

VERY IMPORTANT - Case Story

1. Siebe Gorman (overruled - bad law)

Changed the assumption that a fixed charge could not be created over assets of a shifting character such as book debts.

Facts: A charge in a debenture which prohibited the debtor-company from disposing of the charged debts (1) without the plaintiff’s consent, (2) which also required that the proceeds of the debts be paid into a blocked account (3) but which left the debtor-company fre to use the funds in the account

Why did the Court say the charge was fixed initially?

Because the bank had a degree of control over the debts, the company wasn’t completely free to deal with them and the money had to go into a specific account. So they Court said a fixed charge CAN be created.

Siebe Gorman seemed logical at the time because the bank required debts not be assigned without consent and proceeds paid into a specific account which SOUNDED like control.

Why was this not enough?

Courts realised that control must be real, not theoretical. Yes, the money had to go into a designated account, but the company was still free to withdraw and use that money however it wanted. In reality, it could collect debts, use the cash, spend it daily in business, which is exactly how a floating charge works.

This became a big issue because the difference between fixed and floating charges determines priority in insolvency law. Summary of priority ranking in the TCA;

1. Fixed Charge Holders: Paid from the specific assets secured by the charge

2. Liquidator/Insolvency Costs: Expenses of the winding-up process

3. Preferential Creditors: Includes wages, salaries, and statutory contributions (NIS, taxes)

4. Floating Charge Holders: BEHIND — paid only after the above categories are satisfied and subject to ‘ring-fencing’

5. Unsecured creditors - paid from remaining general assets

This is why there is a duty to register the TYPE of charge BEFOREHAND = s 258 TT Companies Act

Court reasoned if it allowed something to be called ‘fixed’ when it was floating —company can freely use the money — it facilitates banks jumping the queue unfairly

2. The Turning Point — Re Spectrum Plus —Strict Control Threshold — Current Law

Company had to pay all its money into its account with the bank and required prior consent from the bank to sell factor discount. However, once the overdraft limit was not exceeded, company was FREE TO DRAW on the account in the ordinary course of business.

Key Principle: Overruled Siebe Gorman. HL held that the charge was not a fixed charge but floating because it did not impose any restrictions on the company’s right to operate the account. Re Spectrum Plus did not deny that a fixed charge can be created over book debts.

Rather, the case was a particular application of the general principle that a charge is to be regarded as fixed, if and ONLY IF, it imposes a legal obligation on the chargor to preserve the charged assets, or their permitted substitutes, for the benefit of the chargee.

Substance over form - matter not the label on the document but what actually happens in practice/how it actually functions. If the company proceeds freely, then the bank does NOT have sufficient control = floating charge. SOME CONTROL IS NOT ENOUGH

What are the conditions Re Spectrum Plus set for book debts to be considered ‘fixed’?

For a fixed charge to exist over book debts, the bank must control (1) the collection of the debts AND (2) the use of the PROCEEDS — ie. moneys go into a blocked account and company cannot freely withdraw it to use as normal working cash

If the company is free to collect the book debts and use the proceeds in its business, the charge is FLOATING — regardless of what the document says. The practical consequence is that most charges over book debts are FLOATING charges. Very few GENUINE fixed charges on book debts in practice

3. Re New Bullas Trading (Similar to Siebe Gorman because it was later overturned bcus classification of a fixed charge over the asset was wrongly decided)

Facts: Supported the proposition that book debts could be the subject matter of a valid fixed charge. Chargee was entitled to have the debts assigned to it if required and to direct the company on how to deal with its book debts. The proceeds of the debts were to be paid into a bank account designated by the chargee and only if the chargee failed to give any directions as to how the moneys paid in should be dealt with would the company then be free to deal with the moneys as it wished.

Administrative receiver asked court to characterise the charge as it seemed to be an attempt at a hybrid - fixed charge over book debts whilst uncollected but floating charge over the proceeds of such debts once they had been paid into the designated bank account

Why was it considered to be bad law?

CA upheld the primacy of freedom of contract by keeping it as a fixed charge since the debts did not cease to be subject to a fixed charge solely at the will of the debtor -company, but ONLY PURSUANT to an express agreement of the parties that, once the proceeds of the debt were paid into a designated account, the debt would be released from the fixed charge.

BAD LAW - These conditions are similar to a rat’s cheese in a controlled environment and defeat the distinction between them. How is it possible for a fixed charge to exist over book debts if the company can deal with them in the ordinary course of business once express permission is first obtained and only in specific circumstances? In the absence of instructions from the debenture-holder, no party would know the exact nature of the charge.

4. Re Brumark - Considered that Re Bullas Trading was fundamentally mistaken

Most important - dicta from Millet LJ on book debts

Facts: Similar to Re Bullas Trading - company gave bank fixed charge over uncollected book debts but floating over proceeds once they had been collected and received by the company in its company’s account - would it be floating unless called upon, in which case it would be fixed?

Key Principle: 2 Stage Test + Examination of Control (Substance over Form) + Lord Millet dicta on what kind of charge exists over book debts

How did Lord Millet clear the confusion between debts and proceeds?