Security, Insolvency and Risk: Who Pays the Price?
| Author | Vanessa Finch |
| Date | 01 September 1999 |
| DOI | http://doi.org/10.1111/1468-2230.00230 |
| Published date | 01 September 1999 |
THE
MODERN LAW REVIEW
Volume 62 No 5September 1999
Security, Insolvency and Risk: Who Pays the Price?
Vanessa Finch*
The present Government favours reducing fears of business failure and making the
business climate more favourable to entrepreneurs.
1
To this end, it proposes to
legislate on a moratorium to protect troubled enterprises from their creditors and to
give them a chance to pull themselves around.
2
The Government also plans to
examine rescue arrangements; review the relative rights of creditors in insolvencies;
3
and consider any insolvency reforms that might be more supportive of enterprise.
4
To encourage risk taking and to assist companies when they are in trouble may,
however, be to pursue some horses after they have been prompted to bolt.5A more
productive approach might be to consider how to maximise the probabilities of
companies staying out of financial trouble; to examine who bears the risks of
corporate failure; to ask whether corporate insolvency law, in its present form,
helps to solve, or contributes to, corporate difficulties; and to suggest reforms
accordingly. This may demand a more fundamental review of creditors’ relative
positions than is evidenced by the Government’s current focus on the Crown’s
preferential status as creditor.
This article contends that the English system of borrowing combines with
corporate insolvency law’s priority regime to discriminate against small
companies. The focus rests on the security/priority system and it is argued that
this tends to load risks disproportionately onto the shoulders of unsecured creditors
who are liable to be small firms; that this loading cannot be justified on grounds of
ßThe Modern Law Review Limited 1999 (MLR 62:5, September). Published by Blackwell Publishers,
108 Cowley Road, Oxford OX4 1JF and 350 Main Street, Malden, MA 02148, USA. 633
*Law Department, London School of Economics & Political Science.
I would like to thank Rob Baldwin, Paul Davies, Judith Freedman, Sarah Worthington and the anonymous
MLR referees for their helpful comments. My thanks also go to STICERD for financial assistance.
1 See the White Paper: DTI, Our Competitive Future: Building the Knowledge Driven Economy (Cm
4176, December 1998) para 2.12.
2 Although not specified in the White Paper (ibid) it is expected that this moratorium will be applied to
Company Voluntary Arrangements: see Insolvency Service, Company Voluntary Arrangements and
Administration Orders Consultative Document (1993); Insolvency Service, Revised Proposals for a
New Company Voluntary Arrangement Procedure (1995).
3 ‘Including the costs and benefits of any changes to the Crown’s preferential status’: Our Competitive
Future, n 1 above, para 2.13.
4 ‘Including whether any of the current restrictions on bankrupts could be eased’: see ibid para 2.13.
(‘Enterprise’ in the White Paper includes those small businesses which have not incorporated and
therefore come under the umbrella of bankruptcy, rather than corporate insolvency).
5 This article, for reasons of space, confines its discussion to corporate insolvency issues and does not
deal with unincorporated businesses and personal bankruptcy law.
either efficiency or fairness;6and that fresh attention to the allocation of risks
should underpin current insolvency reforms.
The article is divided into five parts. The first sets the scene by outlining the
different ways in which credit can be obtained by companies and by indicating the
means by which companies tend to finance their operations. The second looks at
the argument that a system based on security, with priority, is justifiable on
efficiency grounds. The third considers the difficulties with that argument and
reviews a number of reforms that might reduce inefficiencies. The fourth asks
whether security is fair and the final part suggests that it is necessary to move
beyond the ‘lifeline’ philosophy evident in the December 1998 White Paper if we
are really to come to grips with the needs of both healthy and troubled companies.
Raising finance
Credit is important in corporate financing but not all ways of funding corporate
operations involve credit. Companies can also raise money internally or through
the sale of equity shares – a process in which money is put into the company in
return for dividends and a hoped-for increase in share value. Where credit
arrangements are used for financing, credit can be obtained in four main ways: by
offering security; by seeking an unsecured loan; by using a sale as a de facto
security arrangement or by resort to a third party guarantee.
Security taking is the norm in relation to most borrowings, and banks for
instance, will demand security in the majority of commercial loan arrangements.7
Offering security may attract potential lenders because, inter alia, it reduces their
loan risks by giving them privileged claims to repayment in the event of the
borrowing company’s insolvency.8The normal rule in a corporate insolvency is
that all creditors are treated on an equal footing – pari passu – and share in
insolvency assets pro rata according to their pre-insolvency entitlements or the
sums they are owed.9Security avoids the effects of pari passu distribution by
creating rights that have priority over the claims of unsecured creditors.10
6 Other values such as accountability and accessibility are, for reasons of space, left out of account here.
On evaluating corporate insolvency law, see V. Finch, ‘The Measures of Insolvency Law’ (1997) 17
OJLS 227. For an earlier discussion focusing on fairness in security arrangements see R. Goode, ‘Is
the Law too Favourable to Secured Creditors?’ (1983–1984) 8 Can Bus Rev 53.
7 See R. Cranston, Principles of Banking Law (Oxford: OUP, 1997) ch 15; Insolvency Law and
Practice, Report of the Review Committee (Cmnd 8558, 1982) hereafter ‘the Cork Report’, ch 34.
8 See A. Diamond, A Review of Security Interests in Property, DTI (London: HMSO, 1989) (hereafter
‘Diamond Report’). Security may also be attractive to creditors because it gives powers of
enforcement (fear of which often leads debtors to give priority of performance to secured creditors); it
allows the secured creditor to prevent seizure of secured assets by other creditors; it may also allow
pursuit where the secured assets are sold to another party: see Diamond Report, 9–10. Note the lack of
rationality in the use of the term ‘security’ in England ie the lack of distinction between the security
agreement which creates the security and the property securing the obligation: see Cranston, n 7
above, 435. On the effect of security in general see the Cork Report, n 7 above, 12 and ch 34.
9Onpari passu see R. Goode, Principles of Corporate Insolvency Law (London: Sweet & Maxwell,
2nd ed, 1997) ch 7; D. Milman, ‘Priority Rights on Corporate Insolvency’ in Clarke (ed), Current
Issues in Insolvency Law (London: Stevens, 1991).
10 See Cork Report, n 7 above, ch 35 paras l49–197; R. Goode, Commercial Law (Harmondsworth:
Penguin, 2nd ed, 1995) Part IV. Security can arise either consensually or through operation of law.
There are four forms of consensual security in English law – the pledge, the contractual lien, the
mortgage and the equitable charge. As for security arising through operation of the law (‘non-
consensual security’) the main forms are the lien, the statutory charge, the non-contractual right of
set-off, the equitable right to trace and procedural securities. See generally I. Snaith, The Law of
Corporate Insolvency (London: Waterlow, 1990); Goode, ibid; D. Milman, ‘Security for Costs:
Principles and Pragmatism in Corporate Litigation’ in B. Rider (ed), The Realm of Company Law
(London: Kluwer, 1998).
The Modern Law Review [Vol. 62
634 ßThe Modern Law Review Limited 1999
A company can seek a loan without offering security but in such an unsecured
arrangement the lender bears the risk that if the debtor company becomes
insolvent, its own debt will be satisfied after the secured creditors have been paid.11
The unsecured creditor, moreover, has no enforceable interest in the debtor’s
property prior to winding up, only a right to sue for money owed and to enforce a
court judgement against the debtor.
Companies can also enter into a number of legal relationships that, on their face,
appear to be sale arrangements but which operate in practice as security devices.12
The main devices are: reservations of title; hire purchase agreements; sale and
lease back deals; sale and repurchase contracts and discounting of receivables.13
The key aspect of these agreements is that the debtor company is able to raise
funds by allowing ownership to rest with the ‘creditor’ rather than offering security
and the ‘creditor’ avoids having to compete for insolvency assets with other
creditors because he or she holds title, or has not passed title, in the assets at issue
to the insolvent company.14
Finally, a loan can be secured through the ‘guarantee’15 of a third party – which
may be an individual director of the debtor company but might also be a parent or
subsidiary company within a group.16 The guarantor is not liable for any amount in
excess of that recoverable from the principal debtor and, if the guarantee is given at
the request of the debtor, the guarantor has an implied contractual right to be
indemnified by the debtor against all liabilities incurred.17
Turning to the patterns of borrowing that tend to be encountered in companies,
these are liable to vary according to a number of factors such as the company’s
needs, size, commercial sector and plans, but bearing this in mind, some
generalisations can be made. In doing so it is helpful to distinguish the practices of
the small or medium enterprise (SME) from those of larger companies.
11 The priority of payment out in corporate liquidation is as follows: secured creditors with fixed
charges; the costs and expenses of liquidation; preferential creditors; secured creditors with floating
charges; unsecured creditors; shareholders (owed sums in their capacity as shareholders such as
dividends); deferred creditors (such as shareholders with claims for the return of their capital;
directors found liable for wrongful or fraudulent trading) who have debts owed to them by the
company which have been deferred by order of the court).
12 See F. Oditah, Legal Aspects of Receivables Financing (London: Sweet & Maxwell, 1991) 11:
Bridge, ‘Form, Substance and Innovation in Personal Property Law’ (1992) JBL l.
13 See Oditah, ibid 33–34, 50–55; Goode, n 10 above,656–657. See also Goode ibid 646, et seq on the
imposition of conditions on the right to withdraw a deposit and contractual set off. On charges over
credit balances see Re BCCI (No 8) [1997] 3 WLR 909; Goode, ‘Charge-Backs and Legal Fictions’,
[1998] 114 LQR 178; G. McCormack, ‘Charge Backs and Commercial Certainty in the House of
Lords’ (1998) CFILR 111.
14 On reservations of title, for instance, see S. Wheeler, Reservation of Title Clauses (Oxford: OUP,
1991); G. McCormack, Retention of Title (London: Sweet & Maxwell, 1990); I. Davis, Effective
Retention of Title (London: Fourmat, 1991); S. Worthington, Proprietary Interests in Commercial
Transactions (Oxford: Clarendon, 1996), ch 2.
15 If A owes B a financial obligation then instead of, or in addition to, taking a charge on A’s property, B
may take a contract with a third party, C, under which C promises to meet A’s obligation to B if A
fails to do so (C being the ‘guarantor’). See further R. Goode, Legal Problems of Credit and Security
(London: Sweet & Maxwell, 2nd ed, 1988).
16 The Government itself may also act as a guarantor and the UK offers a good deal of credit
insurance to exporters through the Export Credits Guarantee Department which, inter alia,
guarantees bills of exchange purchased by banks. Guarantees may relate to specific transactions or
operate on a continuing basis and relate to a flow of transactions: see further Goode, n 10 above, ch
30.
17 In an insurance arrangement, in contrast, the insurer protects the covered party and there is no right of
indemnity against the defaulter: see R. Goode, (1988) JBL 87.
September 1999] Security, Insolvency and Risk
ßThe Modern Law Review Limited 1999 635
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