Potential benefits of releasing security

Philip Jones explains how those holding security may need to consider the potential advantages of releasing it and how insolvency practitioners need to be aware of the effects of doing so.

If you hold a charge securing obligations owed to you by a borrower or other party your natural inclination would be to retain it at all times. In general that should be the approach taken. However, a recent case has shown that there can be situations in which releasing that security may be of benefit. This applies where a company has given a floating charge and part of the proceeds of the assets to which that charge applies, known as the "prescribed part", has to be set aside and used to pay amounts owing to unsecured creditors.

Taking security

Security over a company may be taken for many reasons. A financial institution lending monies to the company, a receivables financier buying debts from the company or directors making loans to the company may each decide to take security.

Security may take the form of:

• mortgages or charges over land
• a full debenture creating fixed and floating charges over the assets and undertaking of the company
• charges over specific assets such as intellectual property, goodwill or book and other debts.

Such security is intended to give the person taking it a better claim to assets of the company in the case of that company entering into some form of insolvency procedure. As a result, the normal and understandable approach of any person holding such security would be to retain it at all times until they are paid. However a recent High Court case demonstrates that this may not always be the correct approach. The case, referred to as the "PAL case", is called Robert Hunter Kelly and Jonathan Peter Sumpton (Liquidators of PAL SC Realisations 2007 Limited) v Inflexion Fund 2 Limited Partnership, Autocruise Co-Investment Limited Partnership.

Prescribed part

Where a company gives a floating charge as security and then goes into liquidation, administration or receivership, subject to certain limited exceptions, unsecured creditors are entitled to receive the "prescribed part".

The prescribed part refers to an element of the monies obtained from the realisation of assets subject to a floating charge and is calculated as follows:

• 50% of the first £10,000 of net floating charge realisations; and
• 20% of all such realisations thereafter; but
• subject to a cap of £600,000.

The prescribed part is only available to unsecured creditors. In order to qualify to receive any part of it one must therefore be an unsecured creditor.

In the past, cases have decided that if the assets which are subject to a secured creditor’s security are insufficient to realise enough to pay that secured creditor in full it cannot receive any of the prescribed part. In effect this was because such a shortfall was not thought to be an unsecured debt.

Case summary

In the PAL case the holder of the floating charge released its charge before the prescribed part was paid to the unsecured creditors. It did so because it realised that the assets which were the subject of its floating security were not going to realise enough monies for it to receive any part of the proceeds of such assets.

The floating charge ranked behind another floating charge and so the only hope of obtaining any monies was to become an unsecured creditor and to receive a payment from the prescribed part. The court held that this was fine. By releasing the charge before the liquidators distributed the prescribed part to unsecured creditors, the floating charge holder had become an unsecured creditor and therefore entitled to receive a payment from the prescribed part.

Relevance to security holders

The PAL case demonstrates the need for holders of floating charges to look at the commercial value of their security and to decide how to use such security (if at all) to ensure that they obtain the best return possible from the assets of the relevant company. The case made clear that a creditor who receives a distribution under its security cannot later release that security and also participate in the prescribed part for any shortfall.

So for holders of floating security the position is clear. If there is a commercial advantage in participating in the insolvency proceedings as an unsecured creditor in relation to the prescribed part, the decision to do so must be made swiftly, clearly and before the distribution of the prescribed part is made.This is likely to be particularly relevant to parties holding second or lower ranking floating charges.

Relevance to insolvency practitioners

For insolvency practitioners, the case is relevant to the issue of where realisations should be paid in order to satisfy their duties to make distributions in relation to the relevant company. The position in relation to floating charge holders should be carefully considered to ensure that they have not given any indication of releasing their security in order to participate in the prescribed part. If they have and this is not appreciated monies may be distributed incorrectly to other parties leaving the insolvency office holders open to potential challenge.