A Scottish quirk in relation to administration: what is a prior floating charge holder?

The study of the law of administration in the LLM classes on the law relating to debt and insolvency and company law has thrown up an interesting – surely unintended – quirk in relation to the Scottish floating charge holder.

Among other things the Enterprise Act 2002 was intended to see the expansion of the use of administration.  Partially removing the power to make a decision as to whether or not a company should go into administration from the court and into the hands of floating charge holder – the new approach mirrors (to some extent) that in existence prior to the 2002 Act under the receivership regime and empowers the floating charge holder both within and outwith court processes relating to the appointment of the administrator.  The control of the floating charge holder is enshrined in various measures in Schedule B1 to the Insolvency Act 1986. 

The charge holder has the power to apply to the court under paras 10 – 13 of Schedule B1 – and unlike other applicants does not require to prove that the company is unable to pay its debts (see para 11 (a) when read with para 35).  The charge holder can intervene in another's application to court and have its own appointee made administrator (see para 36). 

Outwith a court process the charge holder can appoint an administrator under para 14, when the floating charge becomes enforceable (ie when it is breached (para 16)).  The informal process generally empowers the floating charge holder – but is subject to a caveat where there is more than one floating charge.  In such a situation paragraph 15 (1) applies.

This states,

"A person may not appoint an administrator under paragraph 14 unless –

(a) he has given at least two business days' written notice to the holder of any prior floating charge which satisfies paragraph 14 (2), or

(b) the holder of any prior floating charge which satisfies paragraph 14 (2) has consented in writing to the making of any appointment."

So far, so what?  The ranking of floating charges will determine who has priority in appointing the administrator outwith the formal judicial processes.  And the ranking of floating charges is fairly straightforward.

But, rather than relying on the general principles of ranking (wherever they are found) paragraph 15 goes on to specify for the purposes of paragraph 15 when a floating charge is a "prior floating charge".  We must turn to paragraph 15 (2).  And that sub-paragraph is simple enough.  It states,

"One floating charge is prior to another for the purposes of this paragraph if –

(a) it was created first, or

(b) it is to be treated as having priority in accordance with an agreement to which the holder of each floating charge was party."

So, this seems to be an application of the general principle prior tempore potior jure subject to a caveat that a ranking agreement will apply. But, the Scottish ranking fo floating charges is a mite more complex than that.  The date of creation of a floating charge is – under s 410 of the Companies Act 1985 (the provisions are still in force) – the date of execution of the floating charge. But, for certain purposes floating charges do not rank in accordance with the date of execution.  Section 464 (4) of the Companies Act 1985 provides a set of ranking rules for competing floating charges.

Section 464 (4) provides,

"Subject to the provisions of this section –

(b) floating charges rank with one another according to the time of registration in accordance with Chapter II of Part XII;"

It must be with this in mind then that paragraph 15 (2) of Schedule B1 to the 1986 Act is amended.  Paragraph 15 (3) provides,

"Sub-paragraph (2) shall have effect in relation to Scotland as if the following were substituted for paragraph (a) –

"(a) it has priority of ranking in accordance with section 464 (4)(b) of the Companies Act 1985 (c. 6)"."

So, for Scotland the amended paragraph 15 of Schedule B1 reads as follows:

"One floating charge is prior to another for the purposes of this paragraph if –

(a) it has priority of ranking in accordance with section 464 (4)(b) of the Companies Act 1985 (c. 6), or

(b) it is to be treated as having priority in accordance with an agreement to which the holder of each floating charge was party."

This then seems to address the problem.  If there is a ranking agreement to determine priority that will apply, if not then s 464 (4)(b) is applicable and for the purposes of paragraph 15 of Schedule B1 the priority of floating charges is determined in accordance with the order of registration of the floating charges.  However, the draftsman seems to have missed one key point. Section 464 (4) is a default rule that is not merely disapplied when there is a ranking agreement between the floating charge holders.  It can be disapplied in other cases too.

To examine this we must turn back to s 464 of the Companies Act 1985.  Section 464 (4) begins by stating that it is

"Subject to the provisions of this section"

Well, what can that mean?

Examination of the previous subsection gives the answer. Section 464 (3) of the 1985 Act provides,

"The order of ranking of the floating charge with any other subsisting or future floating charges … over all or any part of the company's property is determined in accordance with the provisions of subsections (4) and (5) except where it is determined in accordance with any provision such as is mentioned in paragraph (a) or (b) of subsection (1)." (emphasis added)

And section 464 (1) deals with negative pledge clauses – ranking clauses which are put in a floating charge in order to regulate ranking with subsequent securities.  It is virtually unheard of in modern Scottish practice for a floating charge not to contain a negative pledge clause – and such a clause is an agreement between the debtor company and the specific floating charge holder.  A third party floating charge holder need not be a party to it.  Indeed, section 464 (1)(b) only envisages the third party floating charge holder as being a party where the floating charge attempts to regulate ranking as against a subsisting floating charge.  Where there is no subsisting floating charge then section 464 (1)(a) can apply.  This provides,

"… the instrument creating a floating charge over all or any part of the company's property under section 462 may contain –

(a) provisions prohibiting or restricting the creation of … any other floating charge having priority over, or ranking pari passu with, the floating charge".

which under s 464 (1A) means

"the floating charge shall rank over any … floating charge created after the date of the instrument."

And for the purposes of s 464 (1A) the date of creation is the date of execution of the floating charge under s 410 of the Companies Act 1985 – see AIB Finance Ltd v Bank of Scotland 1993 SC 588.

Thus, if Alf Ardman Ltd grants a floating charge to Alpha Bank on day 1, and that charge contains a negative pledge clause; and on day 2 Alf Ardman Ltd grants a floating charge in favour of Beta Bank which also contains a negative pledge clause then irrespective of the order of registration Alpha Bank's floating charge will rank above that of Beta Bank. This is purely as a result of the application of s 464 (1) and (1A) meaning that ranking in accordance with s 464 (4) does not arise. However, as Beta Bank and Alpha Bank have not – in this case – reached a ranking agreement then for the purposes of paragraph 15 of Schedule B1 to the 1986 Act which bank would have the prior floating charge.  If relying solely on s 464 (4)(b) because there is no ranking agreement this could be viewed as meaning that if Beta Bank registered first, Beta Bank is the prior floating charge – but for the purposes of paragraph 15 only.  This cannot be what was intended, given that Alpha Bank – for every other purposes – would have the prior floating charge. 

This then illustrates one of the dangers of legislative drafting.  Being over-precise can create problems that are not present in the reliance on general principles.  The expression prior floating charge – if limited to a prior ranking floating charge – would have plugged in to the various ranking provisions without the risk that over-specification might actually invert the policy the legislation is designed to implement.

Additionally this quirk illustrates that the criticism made of the drafting of the Enterprise Act 2002 (and its amendments to the Insolvency Act 1986) by Professor Sir Roy Goode and others (see Goode, Principles of Corporate Insolvency law (3rd edn, 2005) Preface is – at least to me – well justified.

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