Fixed and Floating Charges - Essay Example

Introduction Organizations often require debt in order to run day to day affairs of the firm as well as use it for capital expenditure purposes. In abid to acquire that debt, organizations either procure debt from banks or from capital markets in the form of bond issues or equity issues. Equity issues are largely unsecured whereas debt issues are often secured against any assets of the organization either tangible or intangible. Financiers often insist upon having sufficient security to cover their advances made to the firm in order to reduce the credit risk. (Goode)1. However, on the other hand, companies often tend to offer such collaterals in order to gain relaxations in obtaining debt including reduction in the interest rates as well as margin requirements. Thus providing a security not only has a legal implication but also offer influence to creditors in controlling the future events. However, from the perspective of a firm, the nature and impact of providing assets of the firm as security carry different significance and as such depends largely upon the credit worthiness of the firm. Better a firm has a creditworthiness chances are that the firm will be able to get larger concessions in providing assets as security.2 It is however critical to note that from legal perspectives, the claim or charge of creditors on the assets of the company are created through different charges created over the assets of the firm with relevant regulatory authorities. These charges can be of either floating nature or of fixed nature depending upon the nature of the mutual agreement between both the parties. It is however also important to understand that the significance of floating and fixed charge to both creditors and the firm may be different again depending upon the nature of agreement made between both the parties. This paper will discuss the business and legal nature of the floating and fixed nature and will critically evaluate the nature of these charges from a business perspective. Security and debt There are generally two sources of funds for an organization i.e. equity contribution made by the shareholders of the firm and the funds acquired from external sources such as bank loans and bond issues. Equity issues or equity contribution is the most risky investment because it is clean i.e. shareholders are offered no guarantee or security that their investment will be paid back and as such shareholders have the least claims against the assets of the company in case of its liquidation because all the claims of company’s creditors are settled first and remaining is distributed to the shareholders. On the other hand, debts obtained from various sources such as banks and capital markets are less risky as compared to equity contributions because they are often backed up either tangible or intangible collaterals offered by the borrowing firm. Since creditors have no voting rights and claims over the earnings of the firm therefore in order to secure against any distress/default condition, collaterals are often demanded so that in case borrowing company failed to pay back its creditors, the funds can be realized by selling assets held as collaterals into opening market. However, to be able to sell any particular asset in case of default, creditors have to register their claim over the asset in the shape of particular floating or fixed charge with the relevant authorities of the country i.e. Securities and Exchange Commission The above discussion indicates that the security is one of the most important aspects of debt and therefore must be dealt in accordance with the prevailing legal rules and procedures of the country as well as the overall business implication of providing any such security. Legal aspects of Charges This section will discuss the legal nature of security and various charges created on securities offered: Floating and fixed charges A charge is a floating charge if it is 1. If it is charge on the classes of the assets of the firm both present and future. 2. That class of assets must be changing from time to time under normal course of business. 3. It allows the firm to continue to work as the going concern under norm course of business. Floating charge is one of the most common types of charges created over the assets and enables a firm to mortgage its entire assets to the providers of the finances and yet continue to operate and trade. Legally, the assets given under the floating charge are not attached until the floating charge is crystallizes and force companies to surrender their assets for liquidation. (Bourne).3 Legally, if a company’s assets are charged in normal course of the business, the charge is always considered as the floating charge. A floating charge can be crystallizes under following conditions: (Mokal)4 1. If company is forced into liquidation. 2. If court appoints a receiver or under the terms of the debt appointment of receiver is invoked. 3. If a company cease to exist or continue to trade and business. The legal significance of the same for the floating charge is also important from the perspective of the different rights given under the law. In case solvency proceedings are started, relevant time period available to a connected person i.e. lender is 2 years to invoke the floating charge against the assets held under the mortgage. (Ferran).5 Further in case of legal proceedings it may be difficulr for the creditors to exactly lodge their claims over the assets of the firm because only a class of asset is defined rather than a particular asset, Though floating charge were accepted by the courts since 1800s however, the concept of fixed charge especially over assets which are circular in nature is relatively new. (Yeo)6. The added advantage offered by fixed charge to the creditors is the fact that assets are primarily identified even before creation of charge and as such creditors do not have to rely most on the asset values to rise or fall. (Bhandari and Weiss).7 From the point of view firms, fixed charges may trigger different legal complications due to failure to comply with the related covenants of the debenture or debt issue. Since the nature and amount of security and charge over it largely depend upon the credit worthiness of the borrowing company therefore the relative covenants are also related with this i.e. firms with relatively better credit worthiness tend to get better terms and conditions as compared to firtms which have poor credit ratings. In case of liquidation of the firm, if the firm fails to produce the assets held under the fixed charge than the consequences of default may be more severe as other assets of the firm may be subject to recievership or liquidation and as such the rights of other creditors may be impaired if creditors having fixed charge are senior to other creditors. (Harwood).8 Business aspects of charges As discussed in the previous section that security and various charges created over it have both legal as well as business implications for an organization. This section will discuss some of the business implications of creating floating and fixed charges over the assets of the firm. Fixed Charges The legal definition of fixed charges indicates that the assets given under fixed charge cannot be changed or replaced without the prior approval of the creditors therefore a firm might have to hold the assets till the period the debts are fully adjusted by the firm. This is more critical from the firm’s perspective because a firm may have to hold an unproductive asset for too long in a bid to comply with the legal covenants of the agreement made between the firm and the creditor. (Marsh and Soulsby)9 Since every transaction between the creditors and the firm are legally enforceable and in most of the cases firm have to comply with certain negative and affirmative covenants therefore such restrictions may lead the company to continue holding assets which may not be economically productive and shall be replaced with the more productive assets. The implications therefore are not only the loss of economic value but also forgoing of better cash flows that may have been generated through new assets. Though in most of the cases, creditors allow the replacement of assets held under fixed charge however, this not only increases the overall cost for the firm but also force them to encumber more productive assets in place of old and non-productive thus reducing the overall leverage capacity of the firm. From business perspectives this is critical as organizations often tend to revalue their assets periodically in order to improve their leverage capability so that they can borrow more in case of any need without giving new assets as collaterals. From a firm’s perspective, the reporting of assets held under fixed charges are more easier because once assets are identified it is than easier not only to value them but also report them to creditors who may require periodical reports of the firm’s assets in order to monitor for any loss of asset value. Since creditors often require some margin over the principal amount of debt i.e. the value of securities offered by the firm is often greater than the total borrowing because creditors require a cushion against the downslide in the value of assets due to any reason. However, it is also important to note that since assets held under fixed charge cannot be changed therefore organizations does not have to make good any shortfall in the value of security due to any reason over the normal course of business. Floating Charge The nature of floating charge is significantly different from that of the fixed charges and organization enjoys relatively more flexibility while dealing with the floating charges. Since under assets under floating charge can be disposed off and added therefore firms have the liberty to make more efficient decisions in terms of managing their asset base. Assets held under floating charge can be disposed off if firm believe that the future expected economic value to be driven from the assets will be nil or decline. Similarly, new assets can be added to the asset base of the firm in order to make more productive use of company’s asset base. (Worthington)10 What is also significant to understand that assets held under a floating charge may be difficult to maintain and any shortfall in the value of security will have to be top up by the firm. Since, creditors require a certain margin to be maintained over the actual principal amount borrowed therefore in order to manage that threshold level of margins, firm have to continue to pile up assets in certain quantity and value. This therefore may also result into piling up of assets specially inventories in much larger quantities thus reducing the overall inventory and receivable turnover for the firm. Other financial ratios such as current ratio as well as quick ratio may show adverse changes due to maintaining of certain threshold levels of assets. Floating charge is more beneficial for the firms because even though a firm may not possess a particular asset but it can borrow against because floating charges are often created against the present and future assets of the company. (Sealy and Worthington)11. It allow it to leverage or take benefits of its future assets even without first purchasing them thus the overall availability of funds may increase under floating charges as the charge is created against the present and future assets of the firm. Conclusion In order to secure the debt, creditors often require the securities in order to further reduce the credit risk they run by lending to different firms. Such securities can be in different forms and shapes and different legal implications for both the firms as well as the lenders. Fixed and floating are two types of charges which are created against the assets of the firm and as such have different significance for both the firm and its creditors. A floating charge is considered as more practical because it allow both the lender as well as the firm to secure their interests in more optimum manners. However, fixed charges over the assets of the firm may have slightly more harsher implications for the firm because of the level of rigidity involved in it. On the other hand, fixed charge may seem more favorable to lender because assets are identified even before lending as such lenders can monitor such assets more closely and issue timely warnings to the borrowing firm to correct the situation. Works Cited 1. Bhandari, Jagdeep S. and Lawrence Alan Weiss. Corporate bankruptcy. Cambridge: Cambridge University Press, 1996. 2. Bourne, Nicholas. Principles of company law. London: Routledge, 1998. 3. Ferran, Eilis. "Priorities and Floating Charges." The Cambridge Law Journal 46 (1986): 31-33. 4. Goode, Royston Miles. Legal problems of credit and security. New York: Sweet & Maxwell, 2003. 5. Harwood, Stephenson. Shipping Finance. London: Euromoney Books, 1998. 6. Marsh, Stanley Bryan and J. Soulsby. Business law. London: Nelson Thornes, 2002. 7. Mokal, Riz. "The Floating Charge - An Elegy." 2003. SSRN. 3 August 2009 . 8. Sealy, L. S. and Sarah Worthington. Cases and Materials in Company Law. 8. Oxford: Oxford University Press, 2007. 9. Worthington, Sarah. Proprietary interests in commercial transactions. Oxford: Oxford University Press, 1996. 10. Yeo, Victor C.S. "Is the Fixed Charge over Book Debts a Viable Security Arrangement?" Singapore Academy of Law Journal 14 (2002): 69. Read More