Crystallisation of a Floating Charge

Peter O'Neill looks at floating charges as a form of security and what lenders need to be aware of if they are relying upon them. The floating charge is traditionally seen as a beneficial instrument for both a lender and a borrower. In particular, it allows a lender to obtain security over the whole of a company's assets and undertaking while at the same time not inhibiting the borrower’s ability to trade. A floating charge will generally provide that it will convert into a fixed charge or “crystallise” upon the occurrence of specified events. These events can generally be divided into two categories:

1. Automatic crystallisation – these are the classic well known crystallisation event such as a winding up (or other business cessation event) or the appointment of a receiver. It is accepted that crystallisation will occur automatically upon the occurrence of these events and this is usually re-iterated in the relevant security document; and
2. Express crystallisation – these events can vary from case to case and are set out in the relevant charging document as a matter of contract. For crystallisation to occur, some action on the part of the charge holder is usually required. Generally this will be the service of a “crystallisation” notice upon the occurrence of specified events.

Where a security document includes an express crystallisation clause, and the charge holder seeks to convert the floating charge into a fixed charge, special care should be taken in drafting the “crystallisation notice”. It is not sufficient that a simple letter referring to the relevant clause in the security document is prepared and sent. Instead, the notice must operate to actually convert the floating charge into a fixed one by restricting the borrowers use of the relevant assets. Any ability of the borrower to continue to use the relevant assets in the carrying of its business is inconsistent with those assets being deemed to be subject to a fixed charge, notwithstanding service of the crystallisation notice. Where circumstances give rise to a crystallisation notice being served on a corporate borrower (and that notice has been properly drafted so as to be effective) and that borrower subsequently enters into liquidation, the charge holder should note that they will not rank alongside other fixed charge holders in the distribution of assets. This is seen in Ireland in the Matter of J.D. Brian Motors Limited & Ors (In Liquidation) [2011] IEHC 113. In that case, Judge Finlay Geoghegan clarified that, where a charge is created as a floating charge, then it will not rank ahead of “Preferential Creditors” (as set out in section 285(2) of the Companies Act 1963 and includes Revenue Commissioners and amounts owed to employees) in the distribution of assets of a corporate borrower.  This remains the case even where the floating charge has crystallised (either automatically or pursuant to a validly served crystallisation notice) prior to the borrower going into liquidation. In deciding this to be the proper application of the law in this matter, Finlay Geoghegan interpreted the words of section 285 of the Companies Act, 1963 in their ordinary and natural sense. That section affords priority to certain preferential debts over the claims of holders of debentures under any floating charge created by a company. The section does not address the effect of serving a notice of crystallisation on the borrower. In Judge Finlay Geoghegan’s view however, this meant that it is necessary to look at the charge when it was created by the borrower and that (in a charge was created as a floating charge) any subsequent crystallisation of a floating charge had no bearing on the priority of that floating charge. The serving of crystallisation notices to improve priority will not therefore achieve the desired result as against preferential creditors. Given that holders of crystallised floating charges will continue to rank behind preferential debts and not alongside the holders of “organic” fixed charges in the distribution of assets on a liquidation, certain lenders may question the  benefit in seeking to secure a floating charge. It should be noted however that the benefits of such security are still substantial as a holder of a floating charge will still rank in priority to unsecured creditors and enjoy the rights of enforcement available to security holders, albeit ranking after preferential creditors in the order of priority of payments. From an enforcement point of view, the law does not make any distinction between fixed and floating security and so a floating charge holder can generally take control of a company's assets the subject of its charge and sell them, either as mortgagee or through a receiver. In practice however, lenders seeking to rely on floating charges are best advised to  take a greater care in monitoring the financial performance of their borrowers through analysing account information regularly and by actively monitoring the level of potentially preferred amounts. In order to do so, lenders should ensure that the relevant covenants requiring the delivery of such information are included in the terms of the loan/facility agreement together covenants requiring borrowers to remain compliant in relation to payments due in respect of potentially preferred amounts. This should grant comfort to the Lender and allow the floating charge to remain a valuable security instrument in protecting its interests.