In a landmark UK Court of Appeal ruling on May 26, banks gained some ground in their bitter three-year battle against preferential creditors over who has the repayment priority claim on book debt receivables in an insolvency. Joanna Hickey reports.
Amid a barrage of controversy, the Court of Appeal overturned a High Court decision in the case of NatWest versus Re Spectrum Plus Ltd’s preferential creditors, ruling that the book debt was a fixed charge, rather than a floating charge, asset. The case will now pass to the House of Lords for a definitive decision, the outcome of which will strongly influence the classification of all future book debt in the UK.
Book debt comprises the receivables and monies due to a company for goods or services provided. Fixed charge assets are tangible assets such as buildings that the borrowing company cannot sell or change without the consent of the bank lender, which has the first charge on these assets. Floating charge assets concern more fluid assets such as raw materials, invoices or a supermarket’s stock, which are unsuited to a fixed charge. These assets can be controlled by the borrower in the normal course of business, without recourse to the lender.
However, in a default situation, it is the preferential creditors, not the banks, which have the first claim on floating assets. Although in September last year, Crown debt (including Inland Revenue tax and VAT) was demoted from preferential creditor status, a substantial band of preferential creditors remain, including employee claims for remuneration and pensions. By ruling that Spectrum’s book debt was a fixed charge, the Court of Appeal gave NatWest the priority claim on receivables over the preferential creditors.
The Spectrum case is the culmination of an acrimonious three-year dispute. Historically, until 2001, banks assumed book debt was a fixed charge and so they had priority over preferential creditors. This assumption was based on the ground-breaking Siebe Gorman case in 1979, where a High Court judge ruled book debt a fixed charge, giving Barclays the first claim.
However, in 2001 the Brumark-Barclays case blew this assumption apart. The Brumark judge ruled that Barclays did not, in fact, have a fixed charge on book debt and that book debt was a floating charge asset.
The reverberations of this contradiction of the Siebe Gorman ruling have been far-reaching, plunging banks and preferential creditors into war over ensuing UK insolvencies. Soon after Brumark, most UK liquidators froze payments of book debt to either party pending a clear, enduring decision from the UK law courts. Thus, although insolvency distributions that took place before 2001 will not be affected, there are currently millions of pounds from several thousand insolvencies with purported fixed charges over book debts sitting in limbo in liquidators’ accounts, waiting to be distributed.
Small LBO financings impacted
Given the sums involved, the House of Lords Spectrum decision has major ramifications and an expeditious hearing in the coming months is expected.
Many lawyers are privately predicting the House of Lords will reverse the Court of Appeal’s decision. However, if this happens, the funds tied up with insolvency practitioners are not the only thing at stake. The outcome will also affect the way in which banks lend in future.
Although the greatest impact will be felt in commercial lending, LBO financings are also affected. As LBO lending is cash flow based, losing the first charge over an incoming cash flow like book debt represents a blow for banks. “The whole way in which businesses are financed is currently under review. The House of Lords decision will be crucial in the way LBO financings are structured going forward,” says Chris Ashurst, partner at Mazars international accountants and business advisers.
Small buyouts, deals in the £5m to £50m range, in particular are affected, as banks rely more on security in smaller deals, perceiving them to be more risky. “The lending supporting smaller buyouts will be more affected than the bigger ones. Smaller buyouts have a higher rate of default and less stable cash flows, so security over assets such as book debt plays a bigger part in bank lending decisions. Thus for smaller buyouts, if banks no longer have a priority claim over these receivables, the impact on the financing will be greater,” says Ralph O’Beirne, partner at Chantrey Vellacott.
As banks have had to address the fact that book debt could be classified as a floating charge asset since 2001, the structure of small LBO financings has already started to change. “If book debt is ruled to be a floating charge, lending to LBOs will become far riskier for banks. They are therefore devising new financing structures to allow them increased yield and security if the Spectrum appeal is not upheld,” says Ashurst.
These new structures include equity-type instruments that sit alongside senior debt and mezzanine, which boost banks’ overall returns. “For smaller deals for existing clients, banks are creating integrated finance packages with an element of high coupon shares. This effectively makes banks minority equity investors, which can increase their potential upside substantially,” says Debbie Clarke, director at Mazars.
More worryingly for the individuals running small buyout firms, banks are also seeking personal guarantees from company management. “For new clients, banks are now looking for personal guarantees from the MBO team and MBI candidates,” says Clarke.
Big deals unaffected
However, although banks have also treated book debt as a floating charge on bigger LBO financings since 2001, there has been little impact on the structure or pricing of these deals. Similarly, even if the House of Lords pronounces Spectrum’s book debt a floating charge, banks are not expected to alter their big buyout lending strategies. “If book debts are conclusively held to be subject to a floating charge, banks will take it on the chin, it is just another part of the risk of this business. It will not have much impact on the bigger LBO financing market, for deals over £100m. Banks will not change the amount, pricing or structure of their senior debt financings because of this, at least not unless, over some years, it transpires that their recovery rates are falling as a result,” says Robin Harvey, partner at Allen & Overy.
This is due partly to the perception that bigger buyouts are less likely to default, but also to the intense level of competition for high-end LBO financings. “The likelihood that charges over book debts may be classed as floating has not affected the way in which banks finance big LBOs. The mid to large-cap LBO financing market is competitive. Banks have made a pragmatic decision; they want to do LBO deals whether they get a fixed charge on the book debts or not,” says Gabrielle Samuels, professional support lawyer at Ashurst.
In addition, banks do still have some security on book debt, as well as other forms of security. “Even with a floating charge characterisation, banks are still secured on the book debts, albeit at a lower level. The book debts are only one secured asset class. If we were going to see a significant change in lending practices, it would have happened post Brumark,” says Jane Fissenden, partner at Ashurst.
Also, even with book debt classed as a floating charge asset, banks’ security position in a UK LBO still far surpasses that in other European countries, where banks are just as eager to lend. “An English security package including a floating charge over book debts is still far better than the security package that banks typically get in jurisdictions such as France. Yet there is no pricing or structural differential between French and UK LBO financings driven by this substantial disparity in security,” says Harvey. n