New Bullas Wrongly Decided!

The controversial Court of Appeal ruling in New Bullas of 1994 has been recently held by the Privy Council in the New Zealand case of Re Brumark Investments Ltd. to have been wrongly decided. Although decisions of the Privy Council are not binding they are of great persuasive authority. The effect of the decision is that an effective fixed charge on future book debts can only be obtained if the chargee bank ensures that the proceeds of such book debts are not at the company’s disposal by eg. requiring the proceeds to be paid into a blocked account.

It is possible for a company to create two kinds of charges over its assets, namely a fixed charge or a floating charge. Fixed charges tend to be created over a company’s fixed or permanent assets, whereas floating charges tend to be created over a company’s circulating assets like stock in trade. A fixed charge gives the chargee an immediate proprietary interest in the assets which are the subject of the charge which binds everyone into whose hands the assets come with notice of the charge. Unless it obtains the consent of the holder of the charge, the company is unable to deal with the assets which are subject to the fixed charge without breaching the terms of the charge. The floating charge was developed to enable the company to give effective security over its entire undertaking and assets from time to time which leaves the company free to deal with its assets and to pay trade credits in the ordinary course of business, unless and until the charge is enforced, eg. by the appointment of a receiver. One of the best descriptions of a floating charge was that given by Romer LJ in the 1903 case of In Re Yorkshire Woolcombers Association Ltd in which he stated the following as being the three characteristics of a floating charge:

Of these three characteristics, the third is the most important and distinguishes a floating charge from a fixed charge. The existence of a fixed charge over all the assets of the company would make it impossible for the company to carry on business in the ordinary way without the consent of the charge holder, so that its ability to do so without the consent of the charge holder is inconsistent with the fixed nature of the charge.

The problem for banks and other lenders with the floating charge is that preferential creditors (such as wages of employees, PAYE and VAT) take priority to the bank’s security under the floating charge. By the 1970s the banks had become disillusioned with the floating charge, because of the growth in the extent and amount of the preferential debts and they therefore sought to extend the scope of their fixed charges. Whilst it had always been possible to take a fixed charge over specified existing debts, it was generally considered that it was not possible to take a fixed charge over a fluctuating class of present and future debts, because it was assumed that a charge over fluctuating assets had to be a floating charge.

In the landmark case of Siebe Gorman & Co Ltd -v- Barclays Bank Ltd of 1979, Mr Justice Slade held that a debenture which purported to give the bank a fixed charge on book debts and a floating charge over other assets created a valid fixed charge on the uncollected book debts and their proceeds. He came to this view, because the company was prohibited from disposing of the uncollected debts and although it was free to collect them it was required to pay the proceeds into an account in its name with the bank. He found that on a proper construction of the debenture, the company was not free to draw on the account without the consent of the bank even when it was in credit. He also found that the critical feature which distinguished a floating charge from a fixed charge was not the fluctuating character of the charged assets, but the company’s ability to deal with them in the ordinary course of business. Interestingly, the debenture in the Siebe Gorman case placed no restriction on the company’s right to draw on the account, which was the company’s ordinary bank account and the Judge’s finding that the company was not free to draw on the account without the consent of the bank is open to doubt.

This decision was followed by the Supreme Court of Ireland in the 1986 case of Re Keenan Bros Ltd. In this case, again the debenture prohibited the company from disposing of the book debts or creating other charges over them without the consent of the bank. It permitted the company to collect the book debts, but required it to pay the proceeds into a designated account with the bank from which the company was not permitted to make any withdrawals without the written consent of the bank. The critical feature which led the Court to characterise the charge on the book debts as a fixed charge was that the proceeds were to be segregated in a blocked account which would be frozen and rendered unusable by the company without the bank’s written consent.

The next landmark decision was the 1987 case of In Re Brightlife Ltd. In this case a company purported to create in favour of its bank a fixed charge over its present and future book debts and a floating charge over other assets. Although the company was not permitted to sell, factor or discount debts without the bank’s prior written consent, it was free to collect the debts and pay them into its ordinary bank account, although it was not required to do so. Mr Justice Hoffman held that although the charge was expressed to be a fixed charge, it should be characterised in law as a floating charge because the company was free to collect its debts and pay the proceeds into its bank account where they would be outside the charge over debts and therefore at the free disposal of the company. Mr Justice Hoffman said "in my judgment a right to deal in this way with the charged assets for its own account is a badge of a floating charge and is inconsistent with a fixed charge". Brightlife was followed by the 1994 New Zealand case of Supercool Refrigeration and Air Conditioning -v- Hoverd Industries Ltd which held that a restriction on charging or assigning the debts was not sufficient by itself to create a fixed charge and that (not following Slade J in Siebe Gorman) a requirement to pay the proceeds into the company’s account with the holder of the charge without any restriction on the company’s power to use the money in the account was insufficient to do so either. Brightlife was also followed by the 1998 case of In Re Cosslett (Contractors) Ltd.

The need for a requirement that the company should pay the proceeds of its book debts into a bank account which the company maintained with the holder of the charge was not inconvenient either to the banks or their customers as this was what the company would in any event do. However, the banks did not want to monitor the bank account and be required to give their consent whenever the company wished to make a withdrawal. As Lord Millett said in Brumark "they wanted the best of both worlds. They wanted to have a fixed charge on book debts while allowing the company the same freedom to use the proceeds that it would have if a charge were a floating charge". There was a particular problem where the holder of the charge was not the chargor’s principal bankers, because in the normal course the proceeds of book debts would not be received by the charge holder, but by the chargor’s principal bankers.

To overcome this problem, the draftsman of the charge in the 1994 case of New Bullas Trading Limited set out deliberately to distinguish between the book debts and their proceeds by the debenture purporting to create two distinct charges, namely a fixed charge on the book debts while they remained uncollected and a floating charge on their proceeds. The proceeds of the book debts were not released from the fixed charge until they were actually paid into the company’s bank account. The intended effect of the New Bullas debenture was that until the charge holder intervened, the company would continue to collect the debts, though not to assign or factor them, and the debts, once collected, would cease to exist. The proceeds which then took their place would be a different asset which had never been subject to the fixed charge and would, from the outset, be subject to the floating charge.

The debenture in the Brumark case contained similar provisions to the New Bullas debenture.

The question which needed to be decided in New Bullas as in the Brumark case, was whether the book debts which were uncollected when the receivers were appointed were subject to a fixed charge or a floating charge. At first instance Knox J, following Brightlife, held that the book debts were subject to a floating charge, although his decision was reversed by the Court of Appeal where Nourse LJ gave the only judgment.

The main theme of the New Bullas judgment was that the parties were free to make whatever agreement they liked and the question was therefore simply a matter of construction.

In the Brumark case, their Lordships considered this approach to be fundamentally mistaken and that, whilst the Court would seek to gather the intentions of the parties from the language they have used, it is for the Court to decide upon the categorisation of the charge to see whether it in fact created a fixed or a floating charge.

Whilst their Lordships accepted that a debt and its proceeds are two separate assets, the latter were merely the traceable proceeds of the former and represented its entire value. The issue, however, for their Lordships was whether the debenture was so drafted that the company was at liberty to turn the uncollected book debts to account by its own act. They held that under the Brumark debenture, the company was left in control of the process by which the charged assets were extinguished and replaced by different assets which were not the subject of a fixed charge and were at the free disposal of the company. This their Lordships regarded to be inconsistent with the nature of a fixed charge and held that New Bullas was wrongly decided.

Their Lordships stated "to constitute a charge on book debts a fixed charge, it is sufficient to prohibit the company from realising the debts itself, whether by assignment or collection. If the company seeks permission to do so in respect of a particular debt, the charge holder can refuse permission or grant permission on terms, and can thus direct the application of the proceeds, but it is not necessary to go this far. As their Lordships have already noted, it is not inconsistent with the fixed nature of a charge on book debts for the holder of the charge to appoint the company its agent to collect the debts for its account on its behalf. Siebe Gorman and Re Keenan merely introduced an alternative mechanism for appropriating the proceeds to the security. The proceeds of debts collected by the company were no longer to be trust monies, but were required to be paid into a blocked account with the charge holder. The commercial effect was the same: the proceeds were not at the company’s disposal. Such an arrangement is inconsistent with the charge being a floating charge, since the debts are not available to the company as a source of its cashflow, but their Lordships would wish to make it clear that it is not enough to provide in the debenture that the account is a blocked account if it is not operated as one in fact".

Conclusion

Although the Brumark case is a Privy Council decision and is only persuasive rather than binding, it effectively lays to rest the New Bullas decision which has been heavily criticised by most academics. In future, the only way to obtain an effective charge over book debts will be to ensure that the proceeds of those book debts are not at the chargor company’s disposal. For a chargee bank it will not be sufficient merely to direct that the proceeds of the book debts are paid into a current account or deposit account held at that bank. Instead, the chargee bank will need to put in place a blocked account mechanism to ensure that the chargor company does not have access to the proceeds of the charged book debts without the bank’s consent. For a chargee bank, it will be very difficult to obtain an effective charge over future book debts where the proceeds of such debts are collected by a third party bank unless the charge expressly extends to balances held at other banks and contains a restriction on dealing with such proceeds which is agreed to and enforced by the third party bank. However, such an arrangement is likely to be commercially unacceptable to the chargor company as well as the third party bank.

Banks will need to consider amending their standard forms of debenture and procedures to ensure that the requisite control procedures concerning the proceeds of book debts are in place. They will also need to consider taking supplemental charges over book debts from existing customers where their current documentation or procedures are defective.

Another interesting possibility is that a preferential creditor (such as the Inland Revenue) might wish to fund a liquidator to bring an action for recovery of money paid under a mistake of law up to 6 years prior to the date of the Brumark judgment (per the 1998 case of Kleinwort Benson Ltd -v- Lincoln City Council) in relation to book debts collected by the receiver as agent of the chargor company and paid over to the chargee bank in the mistaken belief that the chargee bank had a fixed as opposed to a floating charge over such book debts.