A charge holder may not share in the prescribed part

Overview
Two recent cases have confirmed that neither a fixed nor a floating charge holder may share in the prescribed part available for unsecured creditors in the circumstances where the security holder suffers a shortfall following realisation of its security.

The prescribed part
Section 176A of the Insolvency Act 1986 (the "Act") came into force on 15 September 2003, at the same time as the new administration regime contained in Schedule B1 of the Act was introduced. Subsection (2) provides that:

20th February 2008

Overview
Two recent cases have confirmed that neither a fixed nor a floating charge holder may share in the prescribed part available for unsecured creditors in the circumstances where the security holder suffers a shortfall following realisation of its security.

The prescribed part
Section 176A of the Insolvency Act 1986 (the "Act") came into force on 15 September 2003, at the same time as the new administration regime contained in Schedule B1 of the Act was introduced. Subsection (2) provides that:

 "The liquidator, administrator or receiver -

  • (a) shall make a prescribed part of the company's net property available for the satisfaction of unsecured debts; and
  • (b) shall not distribute that part to the proprietor of a floating charge except in so far as it exceeds the amount required of the satisfaction of unsecured debts."

Section 176A only applies to floating charges created on or after 15 September 2003. The prescribed part payable to unsecured creditors is 50% of the first £10,000 of the net realisations subject to any floating charge, plus 20% of the net realisations exceeding £10,000, to a maximum of £600,000.

The Permacell case
The first court judgment on this matter arises from an application for directions made by the liquidators (the "Permacell Liquidators") of Permacell Finesse Limited (in liquidation) ("Permacell"). The judgment is limited to a consideration of the position of the floating charge holder.

Synseal Holdings Limited ("Synseal") held a floating charge over the assets of Permacell. Permacell entered into administration and then into liquidation. During the course of the administration, the administrators realised all of Permacell's assets. However, the realisation was insufficient to allow payment in full of the debt due to Synseal.

As the floating charge was created in 2005, the prescribed part was payable pursuant to section 176A of the Act. The Permacell Liquidators applied to the Court for directions whether Synseal was entitled to a share of the prescribed part in respect of the shortfall due to them.

The Permacell arguments
Given the terms of section 176A(2)(b), it seems clear that a floating charge holder may only receive a portion of the prescribed part if there is an excess remaining after all unsecured creditors have been paid in full from the prescribed part available. However, the judge noted that, in the normal course, a secured creditor is entitled to claim any shortfall he suffers after realisation of his security, as an unsecured creditor of the company. Further, on the face of it, the principle that available assets should be distributed equally amongst any given class of creditors (the pari passu principle) supported Synseal being entitled to share in the prescribed part.

However, the judge found that the matter fell to be dealt with in accordance with the specific provisions of section 176A, which had been formulated specifically to deal with the circumstances in hand. The purpose of section 176A was to create a fund to which unsecured creditors alone had access. It was foreseeable that, if a floating charge holder were permitted to share in the prescribed part, the debt due to them could easily swamp the debt due to the unsecured creditors, thereby diluting the return that they would otherwise enjoy.

Furthermore, the judge noted that, if a floating charge holder were entitled to share in the prescribed part, the exception set out in section 176A(2)(b) could never apply if the company was insolvent.

The Airbase case
The second court judgment on this topic is in the matter of Airbase (UK) Limited [2008] EWHC 124(Ch). This judgment is wider than that of Permacell in that it considers the position of both fixed and floating charge holders.

The facts are similar to those considered in Permacell. Airbase (UK) Limited ("Airbase") was in administration. Again, the administrators realised the assets of Airbase during the course of the administration. The assets realised comprised assets that were the subject of both fixed and floating charges held by Harris N.A. ("Harris"). Realisation of the Airbase assets resulted in a deficit to Harris under both its fixed and floating security. The question therefore arose whether Harris was entitled to share in the prescribed part in respect of the shortfall.

The Airbase arguments
For similar reasons set out in respect of the Permacell case, the judge came to the conclusion that Harris was not entitled to share in the prescribed part in respect of the deficit it suffered following realisation of the assets subject to its floating charge. However, the judge also found that Harris was not entitled to share in the prescribed part to the extent of its deficit following the sale of the assets subject to its fixed security. This was notwithstanding that the restriction contained in section 176A(2)(b) discussed above relates specifically to the proprietor of a floating charge.

In reaching his decision, the judge referred to section 248 of the Act. Section 248 contains a definition of "secured creditor" and of "security", which reads as follows:

  • "(a) "secured creditor", in relation to a company, means a creditor of the company who holds in respect of his debt a security over property of the company, and "unsecured creditor" is to be read accordingly; and
  • (b) "security" means –
    • (i) in relation to England and Wales, any mortgage, charge, lien or other security, and
    • (ii) in relation to Scotland, any security (whether heritable or moveable), any floating charge and any right of lien or preference and any right of retention (other than a right of compensation or set off)."

The judge noted that the terms of section 176A contemplated a distribution to "unsecured creditors". On an application of section 248, this would not include the holder of either a floating or a fixed security. Harris was therefore not entitled to share in the prescribed part in respect of the shortfall suffered under either its floating or its fixed security.

The outcome
This judgment is not surprising in respect of the position of a floating charge holder. The Airbase decision is perhaps unsurprising also, given that, had the judge enabled Harris to share in the prescribed part in respect of its fixed charge shortfall, this would in essence have negated any benefit that the unsecured creditors would have enjoyed from any restriction on Harris from sharing in the prescribed part in respect of its floating charge shortfall. The decision therefore in the circumstances of this case avoids driving what would otherwise be a coach and horses through section 176A but arguably does so in a way which incorrectly extends its intended effect.

In England and Wales, the secured creditor will often hold a debenture over the assets of the company, comprising a full suite of fixed and floating charges. The position is somewhat different in Scotland however, given the security rights that operate north of the border. In particular, it is foreseeable that there could be one secured creditor holding fixed charges or standard securities over various assets of a company, with an entirely different secured creditor enjoying the benefit of a floating charge. The result of the Airbase case would be that, if on an insolvency the fixed charge holder suffers a deficit following realisation of the assets subject to his security, he is unable to share in the prescribed part in respect of that deficit, notwithstanding that he has no floating charge to fall back on for the purposes of additional recoveries. The fixed charge holder is therefore left in the position that he will only receive a further payment in respect of the debt due to him once the prescribed part has been paid to the other unsecured creditors, and the floating charge holder has been paid in full. This is despite the fact that the fixed charge holder is, provided certain requirements are met, entitled to treat the deficit due to him as unsecured debt for various other purposes in the context of the insolvency, including for the purposes of voting at creditors' meetings and proving as an unsecured creditor.

Additionally, if the secured creditor/unsecured creditor distinction based on section 248 is taken to its logical conclusion, it could be used to disqualify other creditors from sharing in the prescribed part pot. The definition of "security" does not extend only to those holding a fixed or a floating charge, but includes a creditor holding a lien or any other kind of security (save for a right of retention and compensation in Scotland). Does this mean that creditors holding any type of security will be unable to share in the prescribed part in respect of any part of the debt due to them?
Section 176A applies equally in Scotland as it does in England and, while these decisions are not binding in Scotland, there is no immediate reason to think that the Scottish courts would depart from them. It is however foreseeable that these decisions could be distinguished both north and south of the border at a later date by fixed charge holders who are not floating charge holders, or by the holder of any other type of security. These cases also give renewed emphasis to the need to ensure that fixed charges rank ahead of floating charges and are not affected by negative pledge provisions of the same.