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Vulnerable Securities: The Frailties of The Floating Charge

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About The Author

Matthew Valentine (Guest Contributor)

Matthew currently works as a paralegal at a full-service regional firm, having graduated from Canterbury Christ Church University with a First-Class degree in Music.

We spend our time searching for security and hate it when we get it.

John Steinbeck

The development of insolvency law has subjected the floating charge – a valuable invention in secured financing transactions – to various statutory rules relating to validity and priority on insolvency.  These consequences greatly reduce the attractiveness of obtaining floating charges to lenders. However, these statutory provisions might be justified by the goals of insolvency policy, for which it was necessary to create a security instrument in this form such that is workable for both lenders and borrowers.

This article therefore examines the floating charge, scrutinising whether there are reasonable justifications for its comparable vulnerability to a fixed charge. It asks whether a practical solution can – and should – be implemented to ameliorate this, either by the lender or the legislature, without compromising the objectives of each party.

Introducing Fixed and Floating Charges

Charges are proprietary interests in property granted by way of security without a transfer of title or possession of that property. Charges provide the lender a right to appropriate an asset in discharge of a liability. A mere contractual right to take or retain possession, without a right of appropriation, does not constitute a charge.

Lord Macnaghten in Illingworth v Houldsworth [1904] AC 355 described fixed charges as an immediate proprietary interest in the secured property which ‘fastens on ascertained and definite property or property capable of being ascertained and defined’. Fixed assets, such as land, building and equipment are therefore ideally suited to this charge.

A fixed charge can, in theory, extend to all of the borrower’s present and future assets. This benefits creditors by effectively guaranteeing that it will sufficiently cover the borrower’s liability. In practice, however, such a charge creates difficulties in relation to disposable assets: these assets – such as circulating assets like stock-in-trade and book debts – require the borrowers to obtain consent from creditors before disposal. This can, in effect, paralyse borrowers with an administrative burden – the securing of creditor authorisation – every time they wish to use the charged asset. For this reason, a fixed charge over such assets would be unsatisfactory for both creditors and borrowers.

The seminal case of Re Panama, New Zealand and Australian Royal Mail Company (1870) 5 Ch App 318 established a different form of charge: the floating charge. This creates a present security interest over a shifting fund of assets which becomes enforceable only when an event has occurred that causes the charge to crystallise. In the meantime, the borrower is free to use the charged assets and remove them from the security.

The occurrence of some future event is known as crystallisation; this can occur upon the cessation of a company’s business, an intervention by the creditor or an express crystallisation clause. At this point the charge ceases to be an interest in a fund of assets and attaches to the specific assets that are then comprised in the fund.

Such a charge enables financiers to advance credit on the security of a company’s inventory and receivables, while leaving the borrower company free to dispose of such assets subject to the charge without consent. Floating charges are most valuable to lenders seeking security over receivables: they will therefore endeavour to have their charge characterised as such.

Disadvantages of Floating Charges upon Insolvency

Prior to the legislative developments relating to charges, there was no reason for the courts to exercise their powers of characterisation. It was the intervention of statute that has required the courts to draw distinctions between fixed and floating charges. There are now four principal reasons why the distinction is significant, which relate to the validity and priority of floating charges on insolvency.

Section 245 of the Insolvency Act 1986

A floating charge created not for new value in the period prior to insolvency is subject to challenge and can be set aside. No equivalent provision exists for fixed charges, which can only be avoided if they are subject to a pre-existing priority. If the purpose of Section 245 of the Insolvency Act 1986 (IA 1986) is to prevent the conferment of an unfair advantage on an existing creditor at a time when liquidation is imminent, it appears arbitrary that obtaining a fixed charge will, subject to the rules on priority, promote the position of the lender ahead of most other creditors.

The 1982 Cork Committee Report’s justification for making floating charges more vulnerable provides a logical reasoning for this distinction, stating:

It is quite another matter to permit a creditor, concerned for the solvency of his borrower, to take security which will allows the borrower to trade and acquire further assets on credit with which to swell the security at the expense of the unpaid vendors

But the limited scope of Section 245 of the IA 1986 is difficult to reconcile with this. The Committee appear to be suggesting that it is acceptable to prioritise floating charges over existing unsecured vendors who have not received payment, but not against future unpaid, unsecured vendors. The extra protection that future unsecured, unpaid vendors receive seems excessive given that they are in a better position to discover – via the registration system – the existence of a floating charge and mitigate against this.

A further argument can also be put forward against the provision. The very nature of a floating charge allows a business to continue trading. Therefore, granting a floating charge instead of a fixed charge leaves the assets available to the borrower to utilise to continue the company as a going concern. It also benefits future vendors to the extent that they get paid before insolvency. In granting a fixed charge for no new value in the period before insolvency, the company receives no new finance, but has a portion of its assets ring-fenced. If these assets are vital to the survival of the company, this may perpetuate the company’s financial instability and the increase the prospect of insolvency. The granting of a fixed charge in these circumstances seemingly defeats the aim of insolvency policy.

The Rights of Preferential and Unsecured Creditors

The rights of preferential creditors to receive payment on insolvency in priority to floating (but not fixed) charges were established in the 19th century. However, since the Enterprise Act 2002 (EA 2002) abolished Crown preference, preferential claims are now largely restricted to claims of the company’s employees. This abolition was accompanied by an arrangement by which unsecured creditors gained limited rights of priority over floating, but not fixed, charges. Consequently, a prescribed percentage of floating charge assets up to a maximum amount must be set aside for unsecured creditors.

Preferential Creditors

It is possible to give a floating charge over all of the assets of a company. Such a charge would cover assets that derive their value from the work of employees. It would be unfair for the claims of employees not to be given priority when their labours had added value to the floating charge. In this context, it would be equitable to provide employees with a claim out of floating charge assets, and not those normally subject to fixed charges.

In theory, the justification for the subordination of floating charges to preferential creditors achieves the aim of insuring employees. However, in practice, it appears that there are more beneficial means available to these preferential creditors. Under the insolvency legislation, employees obtain a priority for unpaid wage claims up to a maximum of £800 per person. This sum is relatively small and does not provide substantial insurance. However, employees also have entitlements under the Employment Rights Act 1996 (ERA 1996) to a maximum £2,320 per employee out of the National Insurance Fund in respect of unpaid wages where their employer has entered insolvency proceedings. These claims are subrogated to employees’ preferential claims in their employers’ insolvency where they are paid under the ERA 1996.

If it were the legislature’s intent for the State to provide a larger insurance claim for unpaid employees on insolvency, it raises the question why floating charge holders should be subordinated at all. The effectiveness of the employee’s claims against the National Insurance Fund shows that, in order for employees to receive the insurance-related benefits which are claimed to be provided by their preferential status, it is not necessary to engage in redistribution between the creditors in insolvency.

Unsecured Creditors

Prior to the EA 2002, unsecured creditors’ only protection against a floating charge was the requirement that floating charges were registered. This allowed them to discover the existence of a charge which would have priority over them on insolvency before providing credit to the company. This remedy was more theoretical than real and provided no protection to involuntary creditors such as tort victims. The justification for the statutory ‘carve-out’ provision, which ring-fences a ‘prescribed part’ for unsecured creditors, appears to be based on rectifying the vulnerable position unsecured creditors were previously in. If the political agenda is as such, then the ‘prescribed part’ must be procured from a form of security. The issue is whether floating charges should be burdened with this issue.

The justification for subordinating floating charges to unsecured creditors as opposed to fixed charges is based on two characteristics of floating charges. Firstly, floating charges allows the borrowers to continue to deal with the company assets. Secondly, floating charges can be obtained over companies’ entire assets. In this situation, borrowers can accumulate credit from unsecured creditors such as trade creditors who supply goods on credit. Floating charges could subsequently crystallise which would fix on the assets provided by the trade creditors, but leave them unpaid. As these characteristics are not inherent in fixed charges, the fixed/floating distinction seems to be necessary.

Administrators’ Ability to Dispose of Assets Subject to Floating Charges

An administrator can dispose of assets subject to a floating charge without the leave of the court. For property subject to a fixed charge, leave of the court is required. The effect of this provision is that the administrator can make use of the funds subject to a floating charge to continue to run the business. The administrator may well trade at a loss, leaving the value of the floating charge asset to diminish rapidly.

The EA 2002 exacerbates this disadvantage, as many companies which would previously have gone into administrative receivership will now go into administration. Administrators owe duties to their creditors as a whole, not any one in particular. Further, recent legislative developments have reversed the decision in Buchler v Talbot [2004] which stated that liquidators were also not entitled to assets subject to a floating charge.

If, after the decision in Re Spectrum Plus [2005], it is not possible to achieve a fixed charge over receivables, the need for the administrator to make use of the floating charge assets is a practical one. Prior to administration, the borrower has the right to use the assets subject to a floating charge in the ordinary course of business. It follows that, if administrators’ aim is to resume the company as a going concern, they will generally need the proceeds of receivables to achieve that. Depriving the borrower of the use of receivables effectively paralyses the company, so it would have the same effect on administration. Furthermore, if administrators do try to resume the company as a going concern, it is not usually possible if there is no finance available to fund a rescue-oriented administration. As financiers will only lend to an administration if there are available assets to lend against, if virtually all valuable assets are subject to fixed charges then the effect would leave the administrator with no viable financing options.

Rectifying the Vulnerability?

One of the primary objectives for lenders is to obtain a security interest that sufficiently mitigates against the risk of borrowers’ default. Due to statutory intervention, the floating charge is a form of security that does not fully provide this. Therefore, the justification for the vulnerability and subordination of floating charges requires further consideration; indeed, it is apparent that the majority of subordinations a floating charge is subject to are either unjust or impractical. However, it may be possible for either the lender or legislature to remedy the vulnerability of the floating charge.

Options for the Lender

The disadvantages of floating charges increase the attractiveness in taking fixed charges. The decision in Re Spectrum Plus [2005] has cut back on the availability of floating charges over receivables. Re Spectrum Plus [2005] established that it is only possible to achieve a fixed charge over receivables such as book debts if the proceeds are paid into a ‘blocked account’. The issue for lenders is that their Lordships provided limited guidance on what amounts to a blocked account. Such ambiguity may lead lenders into pursuing alternative methods for securing receivables.

‘Blocked Account’

Simply restricting access to receivables such as book debts for the benefit of lenders’ security impinges borrowers’ ability to maintain cashflow and working capital. This would be the equivalent of building societies insisting that homeowners use all their earnings to pay off the mortgage. The House of Lords in Re Spectrum Plus [2005] outlined an alternative method for achieving a fixed charge over book debts. Lenders could prevent all dealings with debts other than collection and require the proceeds when collected to be paid into a blocked account, either with the lender bank or with a third party bank. Blocking the account ensures that the book debts are not at the free disposal of the borrower, to be dissipated at will, but instead preserved for the chargee’s security. A borrower would still be reluctant to submit to such a restriction on their ability to handle the proceeds of book debts. However, the requirement established in Re Spectrum Plus [2005] does not prevent lenders explore techniques which theoretically exercise the necessary control but in practice provide borrowers with access to book debts.

It is not clear whether the ‘two-account structure’ established in Re Keenan Bros [1986] BCLC 242 would pass the Re Spectrum Plus [2005] test. The Re Spectrum Plus [2005] litigation did not provide a conclusive answer whether the proceeds paid into a blocked account, but transferred periodically into a second account from which the borrower could draw withdraw, would be effective. However, the consent of the lender to withdrawals from the second account would have to constitute independent acts of will: a blanket consent will not suffice and would lead to the charge being recharacterised as a floating charge.

A refinement of the blocked account structure could involve the proceeds of book debts instead paid into a partially blocked account where the use of proceeds is limited, or a monetary limit is placed on the amount which may be withdrawn, such as payment waterfalls. Worthington proposes that where a borrower is left to apply the proceeds of book debts in a predetermined manner, the case will be viewed as within the ambit of Re Spectrum Plus [2005]. Any arrangement to create a fixed charge that is ignored in practice will likely be treated by the courts as a sham. However, the non-discretionary nature of a pre-arranged control mechanism could be viewed as a restriction on the borrower, rather than a sophisticated articulation of the expectation of what usually occurs in the ordinary course of business.


If banks will not lend solely against floating charges and cannot take fixed charges due to the necessary exercise of control, companies may instead enter into asset-based finance arrangements in relation to receivables such as factoring.  These arrangements involve companies agreeing to assign the receivables such as book debts to the financiers by way of outright sale for immediate working capital and are therefore not subject to statutory redistribution. Moreover, the risk of financiers constituting as shadow directors is avoided as withdrawals are linked to the ultimate value realised from the receivables which have been sold, as opposed to the wisdom of the companies’ spending.

The typical arrangement is as follows: the company borrow money from the secured lender, who takes a fixed charge over assets where a fixed security is viable and a floating charge over anything else the company presently or will own. The company’s book debts are assigned to the secured lender.

If companies do adopt these techniques, this does not imply that banks will cease their involvement in receivables financing. Indeed, most clearing banks have asset finance division which offer factoring products. Banks will simply seek to structure as ‘sales’, what in reality may be better characterised as loans against the security of receivables, and that these will in due course be challenged as being in substance a floating charge. This suggests that Re Spectrum Plus [2005] may not be the conclusive chapter in litigation concerning the floating charge.

Upon insolvency, such an arrangement entitles the lender to the book debts owed under the debt factor, and any outstanding debt is secured by the fixed charge. This effectively renders the purpose of claiming a floating charge obsolete. Thus, where lenders are paid in full under the factoring agreement or fixed charge, they do not bring a claim under a floating charge and as a result, leave little available for unsecured creditors and administrators. Moreover, the assignment of book debts is seen as an absolute assignment rather than an assignment by way of security, therefore no registration is required. Thus, unsecured creditors will have no notice of such an agreement.

The disadvantage with the encouragement the EA 2002 gives to the adoption of this technique is that it militates against the purpose of statutory redistribution: its policy is therefore effectively self-defeating.

Options for the Legislature

The disadvantages concerning floating charges are now evident, but a satisfactory resolution is less so. The disadvantages of floating charges derive from insolvency policy. It is therefore within the ambit of the legislature to intervene and provide a resolution whereby the policy aims are achieved without discriminating against floating charges. In February 2014, the City of London Law Society (CLLS) issued a Discussion Paper, identifying the distinction between fixed and floating charges as an area of law that warranted review. It proposed three options which could be taken to ameliorate the issues surrounding fixed and floating charges.

Option 1

The first option would address the obfuscation between fixed and floating charges by clarifying the existing law on whether charges will be fixed or floating. This would alleviate the uncertainty in characterising charges, providing clarity on whether, for example, fixed charges with payment waterfalls constitute floating charges. However, it does not deal with the fundamental issue of the weak position of floating charges. By merely clarifying the existing distinction, it may compound the availability of floating charges over receivables.

The Financial Law Committee (FLC) of the CLLS proposed an alternative method by issuing a Discussion Draft of a Secured Transaction Code. The drafted Code takes the existing law as a framework and then attempts to simplify it by creating a single security interest based on the charge. The draft Code abolishes security assignments which would remove lenders’ ability to claim receivables under a factoring arrangement and bypass the insolvency legislation.

In creating a single security interest, the Code removes the distinction between fixed and floating charges. This removes any uncertainty in characterisation and ensures that charges over assets typically subject to floating charges, such as receivables, are not subject to statutory redistribution.

The issue with the Code is that it provides no guidance on how such a change would affect existing rules on insolvency. If insolvency policy seeks to provide assets available to preferential and unsecured creditors, and administrators, the issue as to whose assets should be made available to them remains. Further, the Code has provided no guidance on how Section 245 of the IA 1986 would operate.

Option 2

The second option proposed by CLLS is to replace the necessity to distinguish between fixed and floating charges on insolvency, and replace it with a requirement for priority claims to be paid out of an identifiable list of assets. The Discussion Paper highlights the New Zealand legal model for priority claims as an alternative statutory trigger. Since the implementation of the Personal Properties Security Act 1999, the concept of the floating charge in New Zealand was abolished and an alternative trigger was implemented. The amendments to New Zealand law reformulated the priority of claims based on the class of asset, as opposed to the type of charge. A security interest over ‘a company’s accounts receivable’ or ‘inventory’ shall all be subordinated to priority claims. These assets include book debts and stock-in-trade.

It could be argued that such asset class distinctions provide relatively clear conceptual certainty. Case law suggests that despite the perceived conceptual certainty, in practice parties are still determined to argue that their transactions fall outside of the statutory definition in order to avoid insolvency consequences. The term ‘accounts receivable’ has already been subject to litigation in New Zealand since its introduction. Such litigation reinforces my belief that adopting such a statutory trigger would effectively replace one uncertain distinction with another, which could effectively widen the current pool of assets available to preferential and unsecured creditors and administrators.

Furthermore, a distinction between the rights of a chargee over one type of asset should take priority over another requires further consideration. Following the decision in Re Spectrum Plus [2005], most charges over receivables are likely to be characterised as floating.  Thus, the suggested trigger will cover the same assets that would presently fall under most floating charges. It follows that the justification for prioritising the rights a chargee over one type of an asset over another are the same as those analysed under floating charges.

The alternative statutory trigger leaves lenders seeking to secure receivables in a familiar position under the current floating/fixed distinction. The application of insolvency rules to certain asset classes does provide assets priority claims, yet subjecting receivables to statutory redistribution exposes lenders taking charges over receivables to the same subordination as if they were to obtain floating charges. Moreover, the practical uncertainties encountered in New Zealand may encourage lenders and their lawyers to attempt to draft agreements that escape the asset class triggers. Thus, the conflicting concerns of lenders and the insolvency policy perpetuates.

Option 3

The third approach put forth by the CLLS would be to remove the requirement of characterisation in insolvency, and pay a levy as a small percentage of all charged assets up to a cap. A 1 percent or 5 percent levy might provide an adequate fund for the protection of priority claims. If this approach were adopted, the scope of these provisions would need to be considered. For example, the amount of funds available for the administrator’s expenses and the extent to which he can use creditors’ assets to cover those expenses.

The comparable advantages of this option to the others proposed by the CLLS are relatively clear. This approach would deliver the policy objectives of providing assets for preferential and unsecured creditors and administrators, eliminate unnecessary legal analysis, and crucially, apply equally to all charge holders. The wholesale changes to the current insolvency system would require a great deal of consideration, however, and it is likely that implementing such an approach would be time-consuming. Further, the principles of such an approach may provide certainty, though when applied in practice may lead to arbitrary results which limit the rights of both secured lenders and insolvency practitioners.


This article, after identifying the disadvantages for lenders in obtaining a floating charge, outlines methods which lenders may utilise to avoid their security interest being characterised as such. These methods indicate that the uncertainty will not prevent financing; rather lawyers will find ways round the problem thus defeating the purpose of statutory redistribution. In order to resolve this, the legislature ought to provide a framework which clarifies uncertainty and achieves insolvency policy without prejudicing lenders. The three options proposed by the CLLS provide a helpful starting point for discussion, but competing interests are evidently tricky to balance and it is at the point of insolvency where the issue becomes inescapable.

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Tagged: Banking & Finance, Company Law, Legal Business, Property Law

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