When a limited company borrows money from a bank or other financial institution, it is not unusual for the lender to ask for security for the debt.
This helps protect the lender’s position since it means it can seize and sell the company assetsGOV.UK “Forms of Security” given as security if the loan cannot be repaid such as if the business enters liquidation.
The idea of providing security for a loan is a concept most business owners will be familiar with and it also similarly affects homeowners when borrowing for a mortgage. However, the confusion often comes with the two different types of charge, fixed and floating, that are used to give lenders security over the assets of a limited company.
What is a Fixed Charge?
If a debt is subject to a fixed charge, the borrowing will be secured against a substantial and identifiable physical asset such as land, property, vehicles, plant and machinery. If the business is unable to keep to the terms of the finance agreement, the lender as a creditor will take charge of the asset and look to sell it in order to recoup the money it is owed.
What is a Fixed Charge Over Assets?
When a lender has a fixed charge, it effectively has full control over the asset the charge applies to. If the business wants to sell, transfer or dispose of the asset, it will have to get permission from the lender first or pay off the remaining debt.
It’s also important to note that a fixed charge gives the lender a higher position in the queue than a floating charge for the repayment of the debt in the event of the borrower’s insolvency.
A common example of a fixed charge in practice can often be seen in factoring or invoice discounting facilities. In this type of arrangement, the finance provider buys a business’s outstanding invoices and lends money against them. The debtor book is then subject to a fixed charge, which means the business invoices effectively belong to the finance provider and not the company.
What are Examples of Fixed Charges?
Examples of financial arrangements that are commonly subject to a fixed charge – also known as secured – include:
- Bank loans
- Invoice factoring arrangements
What is a Floating Charge?
It gives the business much more freedom than a fixed charge because the business can sell, transfer or dispose of those assets without seeking approval from the lender or having to repay the debt first.
From the lender’s point of view, a floating charge leaves it more exposed than a fixed charge because the value of the assets can and will change over time.
However, it’s not possible to attach a fixed charge to every company asset, which is why floating charges are used.
What is Meant by ‘Crystallisation’ of Floating Charges?
Floating charges essentially ‘float’ above changing assets and only become fixed charges, a process known as ‘crystallisation’, in the following circumstances:
- The company defaults on the repayment and the lender takes action to recover the debt
- The company is about to be wound up
- The company appoints the insolvency practitioner
- The company will cease to exist in the future such as through liquidation.
What is the Difference Between a Fixed and Floating Charge?
- There are a number of major differences to be aware of:
- A fixed charge applies to a specific identifiable asset, while a floating charge is dynamic in nature and generally applies to the whole of the company’s property.
- An asset covered by a fixed charge cannot be sold or transferred unless the charge holder agrees. A floating charge can be sold, transferred or disposed of until a point when it crystallises and becomes fixed.
- A fixed charge is always given preference over a floating charge in insolvency.
What Happens in Insolvency?
If a business enters insolvency, there is a designated order that determines which creditors will be repaid from the sale of company assets first.
When it comes to a liquidation, both fixed charge and floating charge holders are classed as secured lenders. That means they take priority over unsecured creditors who must wait until all other costs and creditors have been paid before they receive any of the money they are owed.
What is Meant by Priority of Fixed and Floating Chargeholders?
Fixed charge holders are first in line for repayment and receive the money they are owed from the sale of the company assets they hold a fixed charge over. Under the Insolvency Act 1986, the hierarchy for repayment in an insolvency situation is:
- The liquidator’s fees and expenses
- Secured creditors with a fixed charge
- Preferential creditors – typically employees with wage arrears
- Secured creditors with a floating charge
- Unsecured creditors.
Floating charge holders must wait until fixed charge holders, preferential creditors such as employees and the insolvency practitioner, acting as liquidator, have received the money they are owed before they are repaid. Although as can happen when a business is wound up and by that point, there may not be enough funds to repay debts in full – this is also why the unsecured creditor may receive nothing at all.
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