When a company borrows money, the lender / bank usually takes some security for that debt. This is designed to protect the lenders’ position and also to try and get the lenders’ money back if the borrower fails. These types of security are termed fixed and floating charges.
What is a Fixed Charge?
The bank or lender may have provided money to acquire specific asset(s) like property, printing press, car, etc. The company cannot sell this without the lenders permission. The debt must be repaid as per the loan agreement or facility letter.
Examples of a Fixed Charge
- A Mortgage you borrow money to buy a house and you cannot own the house outright until the debt is repaid, nor can you sell it without the lenders permission. The mortgage is a form of fixed charge, thus you become a fixed charge holder.
- Assignment of a company’s debtor book through factoring or invoice discounting. This means the bank buys the outstanding invoices and lends money against them. The debtor book is then subject to a FIXED charge. In effect, the book debts belong to the bank or factoring company, NOT the company. The factoring or discounting charge is the most common fixed charge, other than property.
- Goodwill payment in administration. For example, if the business fixed assets, sold by an administrator, are worth £20,000, but the buyer pays £100,000 for the business, the databases, the customers and so forth, then £80,000 is a goodwill payment. This is usually paid to the bank or lender.
What is Floating Charge?
A floating charge (sometimes called a floating lien) is held over assets that can change over time in the normal course of business. Although the assets may be physical, the number of them, or the value, condition, or other properties can change. So fixtures and fittings can be subject to a floating charge as they are difficult to quantify. A debtor book is constantly changing. It would not be practical to stick a fixed charge over every item of stock or desks and chairs, would it? So, the floating charge allows the lender to recover some money if the assets are sold.
So, a floating charge can be held over the following:
- Stock, finished or raw material
- Work in progress
- Unfactored debtors
- Fixtures and fittings
- Vehicles or assets not subject to fixed charges
But the lender does rank behind some other creditors like wages, and the “prescribed part creditors”. This is where it gets complicated! As of December 2020 HMRC now rank ahead of the floating charge holders. A factored debt is subject to a fixed charge as the debt is assigned to the factor and as such does not change.
What is a Debenture?
This is the document that sets out the FIXED and FLOATING charges and the attached terms and conditions. When signed by the company, the lender sends a form to Companies House to register that charge. This prevents other people getting security against the assets in question, unless a Deed of Priority is created (see below).
What happens if a company becomes insolvent?
This is where things get a bit more complex so we explain here by a simple example:
Suppose a software company has a debtor book of £400,000 against which the Royal Bank has provided factoring facility of £300,000 and an overdraft of £20,000. The company has £50,000 of fixed assets and 15 people. It owes £100,000 to trade creditors and £50,000 to HMRC. It loses a big client and enters liquidation. The debtor book would be collected (usually by lender and directors who have provided personal guarantees). BUT debtors don’t always get recovered in full, of course!
After insolvency costs, a total of £250,000 is collected in from debtors. The business is sold to a buyer for £30,000 goodwill and £25,000 for the assets like work in progress, PCs, equipment etc but not debtors. So a total of £305,000 is available.
The bank, as a FIXED and FLOATING charge holder would be paid out as follows; debtor proceeds of £250,000 go to pay the fixed charge off. The Goodwill element is also a fixed charge “collection” and is paid to the bank as well. Thus, the bank has a shortfall of £15,000 on the fixed charge.
There are arrears of staff salaries and holiday pay of £20,000. That is paid next, to the ex-staff from the £25,000 received for the assets and the tax man is owed £50,000 as preferential. That leaves nothing available for the bank under the floating charge collection. It is still owed £15,000 under the fixed charge and also the overdraft of £20,000 remains.
In this very simple example the bank would lose c.£35,000. The preferential (staff and HMRC) creditors are paid in full and unsecured creditors get nothing.
Insolvency ranking – prefer to see a picture flowchart (click here)?
What is a Deed of Priority?
If there are a number of lenders and loans, a pecking (ranking) order is drawn up and the Deed lays out the order of priority if a default occurs. In essence, it specifies who the preferential creditors are, so the most highly ranked are paid first.
What is a Deed of Postponement?
Often a director will introduce money to a company and the bank will require his loans to be frozen until their debt is serviced and or paid.
So, I hope this little guide helps your understanding, suffice to say in practice is much more difficult.
When a bank sees a shortfall looming, it will want a practical solution that ensures the best recovery of its debt obviously, but with asset values falling many banks will see losses ahead.
If you want to ask questions about fixed and floating charges please email us or call Iain Campbell on 08009700539.
If you are interested in creating a fixed charge over assets or want to make a loan to a company then you may be interested in some standard templates of letters and agreements. We are experts in business rescue, corporate rescue and company rescue and can help sole traders, partners and directors.