Mechanisms of Business - Contractual and Legislative Options
The following post is taken in part from an assessment taken during my time at the University of York, as part of the Law, Commerce and Finance module. This piece focuses on the mechanisms used in business transactions, both in contracts and in pieces of legislation, in order to protect assets and ensure trust between the parties involved. I would like to make it clear that this article is an explanation and analysis piece, aimed at more advanced readers who either have an established interest in the workings of business transactions, or who have a general grasp of legal terminology. For other members of the public, other articles are available and will continue to be added to, with explanations which are easier to follow.
Re Panama, New Zealand, and Australian Royal Mail Company[1] established a mechanism known as the floating charge. The purpose of which is to provide a security interest over shifting assets, with the charge becoming enforceable following a relevant event: cessation of the business, insolvency or the enactment of a crystallisation clause being examples of relevant events. Here, crystallisation references the circumstances which are required in order for the charge to be activated. For this reason, such a mechanism is often favoured when banks lend money to businesses which often have a quick turn around with stock, for example cafes and hairdressers. For instance, I may obtain a loan from a bank for £5,000 with the intention being to use that money for stock for my business. The bank may well have a floating charge clause in the agreement, which I would not feel the effects of day to day, as I am free to use the stock how I please. However, should a particular event occur, say I miss some repayments, then the bank would enact the crystallisation clause in order to protect their interest and would thereby gain possession over the stock. However, there are a number of circumstances which can render a floating charge invalid, meaning it often isn’t as effect as intended. Namely, s245 of the Insolvency Act 1986[2] which shows that the validity of the floating charge often revolves around the time in which it was created. Here, we see that only when a charge is created in excess of two years prior to the borrowing companies’ liquidation (this is the time period for directors, with banks and other lending services being twelve months), can it be valid. And even then, only money granted at the time of, and after, the creation of the floating charge, but within the previous time period, can be deemed valid. The ‘Cork Report’[3] was thoroughly confusing and ambiguous in its attempt to clarify its reasoning for making floating charges a more vulnerable type of charge than a fixed charge by stating: “It is quite another matter to permit a creditor, concerned for the solvency of his borrower, to take security which will allow the borrower to trade and acquire further assets on credit with which to swell the security at the expense of the unpaid vendor.”[4]
Whilst this magnifies the advantages to the floating charge – namely the decreased likelihood of insolvency by giving the borrower the ability to utilise the security to increase business profit – it also shines a light on the chasm of difficulties with such a charge, as exemplified by s.176ZA[5] and s. 175(2)[6] of the Insolvency Act 1986. These sections show that assets subject to a floating charge may be used to pay liquidation fees as well as preferential debts (such as fixed charges), in cases where the companies funds are insufficient. If the company the creditor is lending to is strong financially, or the floating charge is only for a short-term loan, then this can be an effective mechanism to use. However, because of the wide-ranging difficulties one can encounter here, as well as the probability that the recipient will try to use the abundant laws and exceptions to try to render the charge invalid in a case of insolvency.
Whilst floating charges are often used in financial transactions between businesses and lenders, another more immediate and certain way of protecting one’s interest is the use of the fixed charge. In the way that floating charges are more practical for revolving assets such as stock, fixed charges are useful when the asset in question is fixed, such as land, a property or certain machinery and equipment. Lord Macnaghten described the fixed charge as such: “[A fixed charge] is one that without more fastens on ascertained and definite property or property capable of being ascertained and defined.”[7] This type of charge provides extra security by extending itself to all current and future assets, thereby guaranteeing the lender their money back. Additionally, fixed charges have priority in cases of liquidation and prohibit the protected asset(s) from being used to pay fees and other liquidation costs.[8] Due to the vast array of advantages and privileges granted by fixed charges - such as the debtor not being able to deal with the charged assets or offload or make amendments to them without the clear, written permission of the creditor - creditors are sometimes anxious to offer a floating charge to a debtor unless the assets in question call for this (it would be inappropriate to place a fixed charge on a Greengrocers stock, for example). For this reason, a fixed charge is known to be a much more effective way of protecting one’s interest in commercial and financial transactions.
Often, businesses will sell and buy parts, materials, bulk purchase etc. between each other knowing that the buyer has to sell on the purchased items or make something out of the raw materials in order to be able to pay for their purchase. For this reason, Retention of Title (RoT) clauses are often used in these types of transactions. This mechanism enables the seller to protect themselves by working around s16-18 of the Sales of Goods Act 1979[9], which states that unless otherwise agreed between the parties, the property title will change hands when the property itself does. Blue Monkey Gaming v Hudson & Others[10] established the requirement that, in case of insolvency, it is the responsibility of the seller of the goods, and not the administrator of the insolvent company, to identify any goods they claim ownership of. In this case, the RoT claim was dismissed as Blue Monkey Gaming (BMG) had taken no steps, post administration, to identify their goods and had provided inaccurate information to the administrator. In their judgment, it was explained that expecting an administrator to pick apart and sort out property owned by a number of third companies would be ‘totally unrealistic’ and ‘practically unworkable’, and would place an unfair burden upon the administrator.
This is in contrast to the judgment in Aluminium Industrie Vaassen BV v Romalpa Aluminium[11], in which the claimant agreed to sell quantities of aluminium foil to the defendant on the understanding that title over the aluminium, as well as over any products made with that aluminium, remained the property of the claimant until all payments were made for the foil. This clause was included to act as an extra layer of security, whilst still enabling the defendants to sell their products as they normally would. In the judgment by Mocatta J., it was agreed that the claimants had the right to trace the sums from the sub-sales and that such a clause created a fiduciary duty that the defendant had to account for these sub-sales. Whilst RoT claims can be difficult to resolve, especially if the products you sell are difficult to trace and account for, it is a fairly simple way to acquire surety to protect your interest. In this sense, the mechanism is quite effective and fit for purpose, despite the stringent nature of being able to account for your own products post selling them.
International transactions often require a mechanism which is much more substantial in order to make sure that all parties involved comply with their part of the transaction. For this, Letters of Credit (LOC) - and their associated counterparts, such as Bills of Lading - are utilised. Often, especially when transactions involve multiple jurisdictions, there’s no certainty that the seller is going to get paid, and the buyer receive their goods. However, LOC’s aim to remedy this by evolving the use of another mechanism: Bills of Exchange. A Bill of Exchange, as defined in s3 of its Act[12] is simply; “an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time a sum certain in money to or to the order of a specified person, or to bearer.”
Whilst Bills of Exchange are still used, for example in the form of cheques, the need for autonomy of mechanisms and documents in transactions, whilst still protecting each parties’ interests, has produced the LOC. In its most simple form, a transaction involving a LOC will entail at least eight stages and four key relationships, which are as follows:
Relationships
1. Seller and Buyer
2. Buyer and Issuing Bank
3. Issuing Bank and Advising bank (possibly also act as the nominated and confirming bank)
4. Advising Bank and Seller
Stages
1. The seller and buyer enter into a contract, agreeing to a sale and purchase.
2. The buyer will then go to a local bank in their jurisdiction to apply for a letter of credit.
3. If granted by the bank, this issuing bank will then forward the letter of credit acceptance documents on to the Advising Bank, this being the bank in the seller’s jurisdiction.
4. This Advising Bank will then forward this notification of acceptance for the LOC on to the seller.
5. The seller will then check over the LOC Terms to make sure they are as agreed, and if satisfied will ship the goods.
a. When the goods are shipped, a ‘Bill of Lading’ (BL) will be given to the seller if the goods are accepted onboard the ship. The Captain will be trained to make sure whichever type of good being shipped, it is up to a good level of quality. Hopefully, a clean bill of lading will then be presented.
6. The seller will then present this BL to the advising bank in order to ask for payment.
7. The advising bank forwards these documents on to the issuing bank in the buyer’s jurisdiction to ask for payment.
8. Providing the documents meet the standards set out in the agreement (for example, payment may not be made if the BL is not clean), the Issuing bank will debit the buyers account and will then give the documents to the buyer.
There are quite a number of benefits to using this mechanism. Firstly, if the BL is in your name as the seller, you have title to those goods until the buyer receives this Bill. This, of course, helps in cases of insolvency as the goods will be protected regardless. Additionally, LOC are often negotiable, meaning that they can be transferred to someone else (for example, if you find a more suitable buyer), and can also be used as an insurance guarantee in case one of the parties does not perform. However, banks can charge a lot for this service and often buyers will pay extra to make sure the LOC is a revocable one, meaning that the issuing bank can revoke the goods and call off the deal if they are not deemed to be in the condition expected. This can also create headaches for the seller, if their goods are half way around the world before finding out the buyer won’t take them and you won’t get your money for the transaction. Despite this, LOC are seen as being very secure and effective, hence the heavy reliance on them in modern day International commercial and financial transactions. As they are more complex, and have more security than the old Bills of Exchange, and are easier to apply to International law than a single RoT clause (which is often formed in a way more suited and appropriate to domestic laws instead), LOC’s are generally favoured, even with the ability to revoke at the buyers end, as the seller can stipulate “for the credit to be issued by a particular bank in such circumstances where it is to be inferred that the seller looks to a particular banker to the exclusion of the buyer.” [13], thereby mitigating their liability in the event that the buyers bank collapses.
[1] [1870] L.R. 5 Ch. App. 318 [2] http://www.legislation.gov.uk/ukpga/1986/45/section/245 [3] Report of the Review Committee on Insolvency Law and Practice (1982) Cmnd 8558 [4] Ibid [5] http://www.legislation.gov.uk/ukpga/1986/45/section/176ZA [6] http://www.legislation.gov.uk/ukpga/1986/45/section/175 [7] Illingworth v Houldsworth and Another [1904] A.C. 355 [8] Company Law Concentrate: Law Revision and Study Guide (5th edn), by Lee Roach, Oxford University Press 2018, CH 7, 131 [9] http://www.legislation.gov.uk/ukpga/1979/54 [10] [2014] EWHC (Ch) [11] [1976] 1 W.L.R. 676 [12] Bills of Exchange Act 1882, s 3 [13]W J Alan & Co Ltd v El Nasr Export and Import Co [1972] 2 QB 189 (CA)