8 legal steps to protect your business against debtor insolvency
When agreeing the terms of a contract with a contracting company (‘the debtor’) for the supply of goods, services and/or finance, there are a number of protective measures that creditors should seek to negotiate with the debtor to protect themselves in the event the latter becomes insolvent.
The underlying number of company insolvencies in the UK increased year-on-year by 12.6 per cent between April and June, demonstrating the challenges posed by debtor insolvency currently.
What is a creditor?
A creditor is a person or a business that has provided some form of credit to a debtor. In law there are various classes of creditor, but here we will deal with the two principal classes: secured and unsecured creditors.
Most suppliers, customers and contractors dealing with businesses are unsecured creditors, which in essence means they are one of the last groups to be paid in the event of an insolvency.
It is often the case that unsecured creditors will receive little-to-no money from the distribution of assets once all other creditor groups have been paid. Accordingly, it is in the interests of unsecured creditors to look to jump up the priority ladder and take what is known as a security interest, which will allow the creditor to take assets without competing against other unsecured creditors in the final distribution process.
What type of security measures can creditors take?
When agreeing contracts, there a number of pre-emptive security and/or quasi-security measures that can be put in place to assist the creditor in the event the debtor becomes insolvent.
Here, we take a look at eight of the most common:
1. Fixed Charge
A creditor that holds a fixed charge over the debtor’s assets is entitled to the proceeds of the realisation of that asset in satisfaction of the liability due. The holder of a valid charge will suffer no deductions in the insolvency process. Title and possession will normally remain with the debtor, however the debtor will be restricted from disposing of the asset without the creditor’s permission. The fixed charge is the best security interest available as it will provide the creditor with a proprietary interest in the asset.
2. Floating Charge
Floating charges are normally taken over a debtor’s fluctuating assets, for example the goodwill, cash in hand and at the bank, book debts and work in progress. The advantage of a floating charge is that it allows the charged assets to be purchased, transferred and disposed of during the course of the debtor’s business without the charge holder’s consent. The floating charge only crystallises if there is a default or similar event as stipulated in the charging instrument. At that stage, the floating charge is converted to a fixed charge in relation to all of the assets over which it had previously “floated”.
3. Parent company guarantees
A parent company guarantee is given by the debtor company’s ultimate or holding company in favour of the creditor. Therefore, if the debtor company becomes insolvent, the creditor will reserve its rights to enforce the contractual obligations against the parent company. Parental company guarantees are a quasi-security measure as they will not protect the creditor in the event the entire group or the parent become insolvent.
4. Performance bond
Bonds of this nature are normally specific to the construction industry, however the general principle still remains. A performance bond is a form of security which is provided by a third party (normally an insurance company) that will not be tied to the debtor’s financial difficulties. The disadvantage to bonds of this nature is that they are not called “on demand”, hence the claim on the bond is after the event, for incurred losses.
5. Retention of title clause
if a creditor is supplying an asset to a debtor, a clause can be inserted into the contract which will restrict the passing of title in the goods supplied under the contract until the debtor has paid the full purchase price. This is also frequently referred to as a “Romalpa clause” following the Court of Appeal decision in Aluminium Industrie Vassen BV v Romalpa Aluminium Limited  1 WLR 676.
Where the circumstances are such that the requisite elements necessary for the creation of the trust can be held to exist, monies which would otherwise have appeared to form part of the general asset pool may be held to form part of a specially constituted trust held for the benefit of specific individuals. For the purposes of an express trust, the debtor company will frequently establish a separate fund for the purpose of guaranteeing repayment to an identified group of investors.
Another example of a trust, which is only applicable to financial transactions, is where a creditor has lent money for a specific purpose but the advance has not been used for that purpose by the insolvency date. This is commonly referred to as a “Quistclose trust” which takes its name from the case: Barclays Bank Ltd v Quistclose Investments Ltd  UKHL 4. Unlike express trusts, Quistclose trusts are imposed by the courts during insolvency, therefore they should not be relied upon as a sole means of security.
7. Contractual lien
In this context, a lien is the right to retain possession of the debtor’s property until the debt is settled. Liens commonly arise automatically in certain types of commercial transactions, such as a client’s relationship with its solicitors or bankers. Liens should not be used in financial transaction and creditors should look to take security by way of a charge or a pledge. However, contractual liens can be very useful commercial transactions, as the creditor will be able to retain possession of the debtor’s property until the debt is repaid.
A pledge is a means of creating a security by delivering an asset to a creditor to hold until an obligation is performed (for example a debt is repaid). The creditor takes possession of the asset whilst the debtor/the company retains ownership. The creditor will be entitled to sell the pledged asset if the obligation is not performed.
This article has been provided in collaboration with Alston Asquith, a corporate/commercial law firm in Central London which acts for businesses, wealth owners and dealmakers, offering the practical support necessary to populate, grow and protect their respective assets.
Should you have any other queries about seeking security or protecting your assets, please contact Hilton-Baird on 0800 9774848 or by emailing firstname.lastname@example.org and we’ll be happy to help.