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Using fixed and floating charges over assets as loan security—Part 5

2018-09-16 13:43:16

By Paul Kibuuka

Normally, when a company doing business in Tanzania takes out a loan, it will use its assets as security for the loan, and as such, creates a ‘charge’ over certain assets to ensure that the lending bank has a higher position in the ‘pecking order’ for the net proceeds of the assets in the event of the company’s insolvency. There are two types of charges; fixed, and floating.

Fixed charges are created over specific tangible or intangible assets; and the company is not free to deal with the assets without the prior approval of the bank or until the company repays the principal and interest of the loan.

On the other hand, floating charges are created over current and future assets; and the company may deal with the assets in the ordinary course of its business until when the charge ‘crystalizes’ into a fixed charge, usually when the company defaults on the loan and the bank has taken recovery action.

The distinction between fixed and floating charges has become very germane. From a conjectural viewpoint, the difference hinges on the debtor company’s freedom to deal with the charged assets and the bank’s level of control over those assets.

To illustrate the above point, consider this: If the debenture contains a prohibition on the disposal of charged assets, then it is fixed. But if the debenture allows the company to dispose of the assets until a crystallizing event occurs, and therefore, until the bank intervenes, then the charge is floating.

The practical problems of this conjectural viewpoint however become evident when a debenture, without imposing a total embargo, restricts the manner in which a company may dispose of the charged assets pre-crystallization.

Every charge is either fixed or floating. If we examine the distinction between these two types of charges over book debts, we see a mix of law and fact. A debenture may characterize a charge over book debts as ‘fixed’, but the court may disagree—depending on how much control is indeed exercised by the bank over the book debts proceeds; for instance, does the bank require the proceeds to be paid into a blocked account?

Therefore, care is needed to strike a delicate balance between the freedom of a company to dispose of charged assets and the control wielded by a bank over those assets. Or else, a fixed charge created over book debts could be at risk of being voided by a liquidator, thereby defeating the object and purpose of taking security.

A restriction in the form of a negative pledge provision in a floating charge debenture will not convert the charge into a fixed one. Equally, a company that is allowed limited freedom over charged assets will not downgrade a fixed charge into a floating one. To clarify this, think of a fixed charge over real property which has the benefit of a lease. Okay, the bank has a fixed charge; but, the company remains entitled to the rental payment until the bank enforces the charge.

Drawing a clear fixed/floating charge distinction is of utmost importance in the banking and financial sector, because floating charge holders have weaker priority over fixed charge holders and also preferential creditors rank higher than floating charge holders in insolvency situations.

Priority depends on order of registration under the requirements of Section 96 of the Tanzanian Companies Act, 2002. Non-registration renders the charge void as against the receiver, liquidator and creditor in consequence of which the loan secured becomes immediately payable. Moreover, an unstamped debenture is inadmissible in court, and therefore, evidentially impoverished. 

Fixed charges provide the best position to a bank. Floating charges offer unmatched flexibility: a company is free to dispose of charged assets and the bank is able to secure all assets in a class even though asset value may diminish over time. Banks in Tanzania favour an ‘all-asset debenture’ creating a fixed and floating charge over all the debtor company’s assets; in addition, to other security devices. Another possibility is the composite security deed containing a fixed charge, and a floating charge over all assets not secured by a fixed charge.

Paul Kibuuka is the managing partner of Isidora & Company Advocates, a corporate, commercial and financial law firm. This article was published in The Citizen on Saturday, 15 September 2018

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