Judicial Methods For Ascertaining Nature Of Charges

This article will lead you to understand the following:

1. The meaning of book debts and charges on book debts

2. The registration of charges on book debts pursuant to Companies Act 1965 ("the Act")

3. The traditional approach of English Courts in ascertaining nature of charges: whether fixed charges or floating charges

4. Alteration of the traditional perception and approach

5. The development - Constructionist approach

6. Collected and uncollected book debts

7. Admissibility of consideration on subsequent events

8. Recent development of English Law

9. Position in Singapore and Malaysia

Meaning Of Book Debts And Charge On Book Debts

In general term based on case laws, book debts simply mean all trade debts. As the Act is silent on the definition of book debts, several writers have tried to offer an explanation. D. Cahill states that in considering whether a particular charge debt is a "book debts" or some other type of debt, the courts will consider whether the debt in question is one that the particular type of corporate borrower in question can be expected to incur as a normal trading debt1.

One can charge the book debts as security for any loan or facility. However, for purpose of registration under the Act, it is crucial to determine whether the charge created is a charge on book debts or otherwise. In Re Brian Tucker2, Lynch J held that when the subject matter is not an existing item on the date when charge is created, then it cannot be classified as a "book debt" merely because it might come into existence at some time in the future. The court opined that the refund of insurance premium did not constitute a book debt.

The other pertinent issue is whether a company can charge company deposits lodged in bank to the same bank and whether such charge constitutes charge on book debts. The first question will be answered by extracting the judgment of Lord Hoffman in Re Bank of Credit and Commerce International SA (No. 8) whereby he stated that: "The depositor's right to claim payment of his deposit is a chose in action which the law has always recognized as property. There is no dispute that a charge over such a chose in action can validly be granted to a third party". Although the statement was only an obiter dictum by Lord Hoffman delivering the unanimous judgment of the House of Lords, it clearly suggests an approval by the House of Lords on a charge by a company over its deposits to the bank which holds the same.

Registration Of Charge On Book Debts Pursuant To Companies Act 1965

Section 108(3)(f) clearly states that "charge on book debts of the company" is registrable. Thus, both fixed and floating charges on book debts are registrable under s. 108.

The real controversial part in this subject is the method to ascertain the nature of charges created, whether it is a fixed or floating charge. The significance of this determination is that the company shall have a guideline on how to deal with the charged assets in its ordinary course of business.

Traditional Approach Of English Courts In Ascertaining Nature Of Charges: Whether Fixed Charges Or Floating Charges

For the beginning, let us understand the meaning of floating charges. Palmer explains as follows:

It is evident ... that a floating charge is an equitable charge which does not fasten upon any specific or definite property, but is a charge upon property which may be constantly varying: it will normally be upon the whole of the company's property, including any which is subject to a fixed charge, but it can be restricted to a limited class of property, and the property which is subject to the floating charge can be dealt with by the company without consulting the holder of the charge and may be sold, exchanged or otherwise dealt with in any way that the directors may think fit provided that it is in the ordinary course of business.3

To appreciate the distinction between floating charges and fixed charges, we may want to refer to the famous expression by Lord MacNaghten:

A specific charge, I think, is one that without more fastens on ascertained and definite property or property capable of being ascertained and defined; a floating charge, on the other hand, is ambulatory and shifting in its nature, hovering over and, so to speak, floating with the property which it is intended to affect until some event occurs or some act is done which causes it to settle and fastens on the subject of the charge within its reach and grasp.4

Traditionally, the creation of charge on book debts will give rise to floating charges. This traditional approach has been laid down by Romer LJ in the case of Re Yorkshire Woolcombers Assoc Ltd (Houldsworth v. Yorkshire Woolcombers Association Ltd5 whereby the House of Lords held that attempted assignment of book debts had in law given rise to the creation of floating charge over book debts. The ratio of this case is as follows:

1. Charged debts remained receivable by the company

2. Charged debts at company's disposal for use in ordinary course of business

3. Absence of control on the part of the chargeholder

The essential element which drives the House of Lords to the above decision is the lack of control by the chargee on the charged assets. Romer LJ went further to elucidate the three characteristics of a floating charge thus:

1. It charges assets present or future or both

2. The assets are of a class that may be changing in the ordinary course of business

3. It is contemplated by the charge that, until some future step is taken, the company can carry on business as normal regarding the charged assets.

The three criteria also suggest that the element of control and the capability of the company to utilize the charged assets in doing their business are the salient considerations to determine the nature of charges on book debts.

Alterations Of The Traditional Perception And Approach

One may not be aware that the charge on book debts can also be a subject to a fixed charge rather than a floating charge per se. In Siebe Gorman & Co. Ltd v. Barclays Bank Ltd6, the court has been invited to decide on the nature of the charges, whereby the court held that the charge in this case is a fixed charge based on the following reasons:

1. Under the terms, the company could not deal in the debt while uncollected

2. The company had to pay the proceeds into the company's account with bank

3. The company could only make withdrawals from the account with the bank's permission

Slade J took the view that the description of the charge as a fixed charge was sufficient, although other clauses might support it. Looking carefully at the judgment, we shall observe that the reasons used by the House of Lords in the decision suggest, apart from the description of the charge to be a fixed charge, that the terms and conditions of the charge which impose restrictions on the chargor also spelled out the intention of the parties to render it a fixed charge. The said decision was obediently followed in the case of Re Lakeglen Construction (Kelly v. Ms Mohan Ltd) 7.

The Development - Constructionist Approach

In deciding whether a particular charge is subject to a fixed or floating charge, the courts had developed an approach to be taken judiciously. In the case of Re Keenan Bros8, the UK High Court held that the charge created is a floating charge on the basis that the company was able to access the special restricted account for use in the company's business. Thus, although the terms of the charges impose a restrictive measure on the company whereby the company could not deal in the book debts while uncollected and the proceeds once collected had to be paid into a restricted bank account from which withdrawals could only be made with the permission of the chargeholder, in the absence of total restriction for access to the special account, it indicates that the charge created is a floating one. The approach taken by the UK High Court in this case is the construction of the terms of charges itself to determine its nature.

However, the Supreme Court did not agree with the decision and overturned the same by saying that the charge is a fixed charge. The same constructionist approach was taken, but with a different observation altogether. The UK Supreme Court stated that the charge document intended the charge to be a fixed charge because the terms of the charge provided for the mandatory lodgment of book debts proceeds to a special restricted bank account under the lender bank's control. Such mechanism was intended to deprive the company of the use of the book debts proceeds in the ordinary course of its business. Henchy J had this to say regarding the charged book debts:

... withdrawn from the ordinary trade use, put in the keeping of the debenture holder, and sterilised and made undisposable save at the absolute discretion of the debenture holder.

What therefore distinguishes the fixed charge from the floating charge is the power of the chargor to dispose of the asset free from the charge unless and until some further crystallising event occurs9.

It is germane to note that, although two different courts arrive at a different conclusion, both agreed with the approach to be taken in such a case.

In my opinion, the observation by the High Court is rather contradictory with the purported approach taken. Since the High Court agreed that the correct approach is the construction of the charge document in its entirety, the court should examine the documents thoroughly to infer a conclusion. A mere access to a special restricted account per se, would not give an actual freedom or power to the company to utilize or dispose off the charged assets in its course of business. Thus, it can be said that the approach taken by the High Court is not actually a constructionist approach.

Collected And Uncollected Book Debts

To appreciate the distinction between the uncollected book debts and collected book debts, we have to understand the basic meaning of the terms. The uncollected debt simply means unpaid or unsettled debt whereas the collected debt means the debt which has been paid and converted into proceeds in the form of cash etc.

The charge documents normally prescribed the provision which underline a right and power of the chargor to deal with the book debts while uncollected and after it has been collected and converted into proceeds. In most of the cases, the charge documents itself will expressly describe the charge to be a fixed charge and the book debts once collected must be kept in a special restricted account ("restricted proceeds clause"). The chargor can only deal with the proceeds with the consent of the bank. In this kind of charge, the court holds the view that it is a fixed charge. See the court's observation in Siebe Gorman's case and Re Keenan Bros's case.

In the absence of the terms specifying the creation of a special restricted account and for the collected book debts to be kept in it, the court will have to examine the entire documents to determine the true intention of the parties, and will not simply draw an inference based on the description of the documents. In Re Armagh Shoes Ltd.10 Hutton J opined that the court has to determine the nature of the charge by its substance, not by its label. The mortgage deed in this case provided that:

the Mortgagor ... as beneficial owner hereby charges in favour of the Bank by way of fixed charges all receivable debts plant machinery fixtures fittings and ancillary equipment now or at any time hereafter belonging to the Mortgagor

In the absence of the restricted proceeds clause, the court had distinguished this case with Siebe Gorman's case. The only observation we can draw is that the restricted proceeds clause is a salient term to be expressly provided in the charge document to render it a fixed charge.

Observation Of The Court In Re Brightlife

In Re Brightlife11, the UK High Court made an observation that book debts is an indivisible asset. The court held that the charge created is a floating charge because the charge on its construction attached to the book debts while uncollected but did not extend to them once converted into proceeds. As the proceeds were at the disposal of the company once paid into the account, the charge could not be a fixed charge.

In my opinion, the court arrived to the said decision mainly because the charge did not provide a restricted proceeds clause, or the said clause is not restrictive enough in its operation to deprive the chargor of its right to deal with the collected debts. In such a case, the main characteristic of a fixed charge is absent.

It is also my view that the said observation is misconstrued. The book debts cannot be said to be indivisible mainly because of the following reason namely:

The weight carried by uncollected debts is clearly different from that of the collected debts in the sense that, the uncollected debts only confer an equitable right to the chargee to collect the debts upon default by the chargor whereas the collected debts confer beneficial right on the actual money. The chargee still has to bear a risk that the uncollected debt may not be fully satisfied by the debtor, but in the case of collected debts, it is fully satisfied.

According to D. Cahill, there are two possible interpretations derived from the said decision:

1. The terms of the charge was confined to attaching to the book debts only while they remained uncollected. Once the debts were collected, the charge's terms did not secure the proceeds, and so, those proceeds fall outside the charge.

2. Authority for the proposition that the ordinary use of the book debts proceeds must be restricted as, otherwise any purported charge over book debts is only capable of being at most a floating charge.12

In my humble opinion, the better interpretation of the principle is the second interpretation. However, the idea that book debts is an indivisible asset is rather self-defeating because the charge should be in a flexible form so that the chargor can utilize the charged assets to conduct its business and at the same time the chargee can be assured of its right to recover its money upon default by the chargor.

Observations In Re Holidair13

In the above case, the Supreme Court seems to agree with the principle laid down in Re Brightlife on the book debts being an indivisible asset. Because of the absence of restriction on withdrawals from the special account created with the chargee, the court held that the assets (the proceeds) were available to the company in the normal course of its business, and thus, does not qualify to become a fixed charge even though there is a restriction to deal with the book debts while uncollected.

Admissibility Of Consideration On Subsequent Events

There are cases where the parties did not actually carry out the provisions of the charge documents on grounds of practicality or change of circumstances. The courts in Ireland refused to admit the subsequent event to determine the nature of charges. In the case of Re Wogan14, the charge documents gives a power to the chargee to designate a special account into which the proceeds will be lodged. However, the evidence shows that the said account was never designated by the chargee. The court of the first instance relied on such evidence and held that the charge is a floating charge. However, the Irish Supreme Court overturned the decision based on the following reasons:

1. Intention of the parties must be determined from the terms of the documents which created the charge

2. Consideration of subsequent events, such as whether a special restricted account was ever actually designated or not, was not admissible for this purpose.

3. Terms of the debenture which inter alia provide for a special account to be designated was indicative of a fixed charge.

The effect of the decision is rather extensive and can lead to exploitation by the industry's players. In my humble opinion, it is totally misconstrued when the court refuses to take into account subsequent actual events. It is a cardinal principle that the conduct of the parties is relevant in determining the true intention of parties creating a legal obligation. In the light of the principles of estoppel, the chargee in the above case can be said to have been estopped from claiming that it has imposed a restriction on the payment of proceeds, as the case may be, when in actual fact the chargee has waived his right to designate a special account.

Recent Developments Of English Law

The recent approach taken by English Courts is that the charge documents did not necessarily constitute a fixed or floating charge, but can be both based on the construction of the documents and the intention of the parties. This has been founded in the case of Re New Bullas Trading15. The terms of the debenture in this particular case are as follows:

1. The company was to deal in the uncollected debts only as directed by the chargeholder. If no directions were given, all the company was permitted to do was to collect the debts and pay the collected proceeds either into the company's own account with the bank, or into a separate account to be designated by the chargeholder.

2. The company was to pay out of the lodged proceeds as directed by the chargeholder from time to time. If no directions were given regarding the proceeds or, if no demand had been made by the chargeholder for repayment from the proceeds, then the proceeds were to be released from the fixed charge and become subject to a floating charge

The evidence of the case showed as follows:

1. No demand for repayment was made

2. No direction was given regarding the proceeds

3. No special account was actually designated by the chargeholder

4. The company continued to collect the debts, lodged the proceeds into its own bank account, and used the monies in the ordinary course of its business.

The English Court of first instance held that the debenture is a floating charge simply because the chargor was free to collect its debts, free to pay the proceeds into its own bank account and free to deal with the proceeds in the ordinary course of its business. Furthermore, none of the potential restrictions possible under the debenture had been put into effect.

However, the English Court of Appeal had a contradictory view and held that:

1. At the time of the creation of the charge, a fixed charge should attach to the debts before collection; and

2. The proceeds once collected would be released from the fixed charge and become subject to a floating charge

and the ratio of the case relate to the following:

1. Intention of the parties

2. The law allows the parties to make agreement to that effect.

3. Just as it is open to contracting parties to provide for a fixed charge on future book debts, so it is open to them to provide that they shall be subject to a fixed charge while they are uncollected and floating charge on realisation.

It is to be noted that the court had adopted the constructionist approach and was reluctant to consider whether subsequent actual events had occurred as between the parties. Moreover, the court upheld the freedom of contract between the parties and hesitated to rewrite the contract for the parties, in line of the cardinal principle of the law of contract. The court had also refused to follow the notion that the book debt is an indivisible asset.

The decision in Re New Bullas, as I see it, has opened a broad perspective of interpretation of the nature of charges created to closely meet the intention of parties. This decision is most welcome to overcome the confusion and subtle distinction between fixed and floating charges over book debts.

Position In Singapore And Malaysia

It is not clear on what is the approach taken by the courts in Singapore and Malaysia as to the method for ascertaining the nature of charges. However, the bottom line is that the court in Singapore and Malaysia will look into the intention of the parties and uphold the contract entered into by the parties.

The court in Singapore had a chance to consider the issue regarding the letter of hypothecation16in the case of Re Lin Securities17. In this case the Singapore High Court held that the letter of hypothecation issued by the company is a floating charge. The court had scrutinized the letter of hypothecation and also evaluated the conduct of the parties with regards to the pledged assets to determine the nature of the charges. Chao Hick Tin J had this to say:

The transaction must be viewed in the commercial context in which the LOH (Letter of Hypothecation) was given. Only when this is done can the court objectively determine the "aim" of the transaction. I ought to state that at the time when each relevant LOH was created, there was nothing to suggest that the company was in financial difficulties - a point which seemed to have had considerable bearing in the decision of the appeal court in Re Keenan Bros Ltd [1908] 1 Ch 152. Not without some significance, the LOH did not expressly state that it created a fixed charge. The bank must have realized that it was impractical to create a fixed charge over the stock-in-trade of a stockbroking company.

Although there are some restrictive clauses in the LOH, the court held that:

The existence of restrictive clauses in an instrument does not ipso facto render an instrument a fixed charge as stated by Porter J in Mercantile Bank of India v. Chartered Bank of India, Australia & China and Strauss & Co Ltd [1937] 1 All ER 231 at p 240.

In the case of Re City Securities18, the same issue has been discussed and the court held that the Letter of Hypothecation is a floating charge. The same judge stated that:

In my judgment, on a true construction, each of the security instruments created no more than a floating charge. This is notwithstanding that some of the express provisions therein may appear to indicate to the contrary. Undoubtedly the actions taken by all the defendant banks were as if they were enforcing a fixed charge. Yet they were unable to identify the specific share certificates upon which the fixed charge attached. And for all the reasons given hereinbefore, they have not brought about crystallization. The security instruments are therefore void against the liquidators.

Thus, it can be said that the courts in Singapore had taken a holistic approach in determining the nature of charges ie, by determining the true intention of the parties based on the construction of the documents as well as the conduct of the parties.

Although the letter of hypothecation is different from a book debts, which is the subject of this paper, the approach taken by the court in such cases can be adopted in the case of charge on book debts. It also shows the attitude and judicial inclination of the courts towards the same subject.

In Malaysia, the issue regarding the charge on book debts has not been particularly discussed by the courts. However, we can see the approach taken by the court in the case of A M Arumugam v. Standard Chartered Bank19 whereby the court adopted the same approach laid down in Re Lin Securities. The Court of Appeal had this to say:

The learned judge's finding finds support in the case of Re Lin Securities (Pte) [1988] 2 MLJ 137. In that case, the plaintiffs were the liquidators of Lin Securities (Pte) Ltd. ("the company"). Prior to the appointment of the liquidators, the company received credit facilities from 21 banks, ie, the 21 defendants. The company in return gave various letters of hypothecation ("LOH") whereby the assets of the company were purportedly charged to the 21 banks. The main issue there was whether each LOH created a charge and if so, whether the charge was a fixed or floating charge. There the court held that one should not determine the effect of the LOH wholly within the four corners of the document. It must be viewed in the context of the surrounding circumstances of the transaction. The transaction must be viewed in the commercial context in which the LOH was given.

It is now clear that the courts in Malaysia also had adopted a holistic approach by looking at the construction of the documents and evaluating the evidence on the conduct of the parties before ascertaining the nature of charges created.

It is also important to note that in the above three cases, the documents ie, the letter of hypothecation did not specifically mention its nature as being fixed or floating charge. Thus, the approach taken by the courts may be differed in the case where the charge documents specifically mention that it is a fixed charge. Again, the court will uphold the freedom of parties to contract and at the same time evaluate the conduct of the parties. Therefore, the law in England, Singapore and Malaysia in this particular area can be said to have evolved to a very flexible nature.

Conclusion

I must agree with Prof Dr. Samsar Kamar that the law on charges over book debts is extremely complex20. It becomes more complex when the issue has not been largely considered by case laws especially in Malaysia. Be that as it may, I would conclude by underlining certain guidelines, in the hope that the same would to considered by legal practitioners or at the very least by students studying the subject on how to ascertain the nature of charges on book debts, as follows:

1. The charge document must be read as a whole to determine the intention of the parties. If the charge provided a restricted proceeds clause, it is most likely that the charge created is a fixed charge;

2. Even if the parties had labeled the charge documents to be a fixed or floating charge, a careful scrutiny on the terms and conditions of the documents must be done to determine the actual intention of the parties;

3. In the case where the intention of the parties is not clear upon a construction of the documents, then reference can be made to the conduct of the parties; and

4. If the conduct of the parties is contrary to the terms and provisions of the charge documents, the equitable principle of estoppel may be taken into consideration.

Lastly, I would note that the extremely careful drafting and bona fide conduct of parties will, in most of the cases, be of assistance to secure the party's right and interest.

Endnotes:

* Advocate & Solicitor, High Court Malaya

1. Corporate Finance Law at p. 336.

2. Re Brian Tucker: Farrell v. Equity Bank [1990] 2 IR 549.

3. Palmer on Company Law (23rd Ed.) at paras 44-05.

4. Illingworth v. Houldsworth [1904] AC 355 at p 358.

5. [1903] 2 Ch. 284 Court of Appeal (a.k.a. Illingsworth v. Houldsworth [1904] AC 355 in the House of Lords, where Court of Appeal was affirmed).

6. [1977] 2 Lloyd's Reps 142.

7. [1980] IR 347.

8. [1985] IR 401.

9. Article by Prof. Dr. Samsar Kamar bin Haji Abdul Latif on "Priority in Corporate Receivership".

10. [1984] BCLC 405.

11. [1987] 2 WLR 197.

12. Corporate Finance Law at p. 347

13. [1994] IR 481.

14. Re Wogan's Drogheda Ltd (Jenkins v. Hill Samuel (Ireland) Ltd) [1993] 1 IR 154.

15. [1994] vol. I BCLC 485.

16. Holden on Securities for Bankers' Advances (5th Ed.) refers to it as (at p. 268) "a legal transaction whereby goods may be made available as security for a debt without transferring either the property or the possession to the lender"

Hart on Law of Banking (4th Ed.) Vol. II at p. 906 defines it as: "Where property is charged with the amount of a debt, but neither ownership nor possession is passed to the creditor, it is said to be hypothecated."

17. [1988] 1 LNS 159.

18. [1990] 1 LNS 18.

19. [2006] 1 CLJ 357.

20. Article by Prof. Dr. Samsar Kamar bin Haji Abdul Latif on "Priority in Corporate Receivership".

THIS ARTICLE HAS BEEN PUBLISHED IN CURRENT LAW JOURNAL

CITATION: [2009] 1 CLJ(A) li