Evolution of security interests in C19th UK John Armour

Case study ‘Floating charge’ – General security interest – Emerged in UK in late C19th Yields insights into relationship btw legal institutions and financial innovation – Courts’ gap-filling role – Creation of new property rights – Legislative curtailment of innovation

Context Mid to late C19th – Industrial firms seeking investment capital beyond founders and family members – Poor-quality information available about financial status and prospects – Arms’ length investors prefer to supply debt finance based on collateral

The investment problem Creditor – Wishes to have assured rights to seize assets should debtor fail to repay Debtor – Wishes to put assets to use in business

The contract Collateral remains in debtor’s possession, debtor entitled to use in ordinary course of business If debtor defaults, creditor may seize collateral “State-contingent” entitlements to the collateral [How is this different from a “simple” debt contract?]

Potential problems What if debtor promises same asset as collateral to two different creditors? What if debtor sells asset? What if debtor had borrowed from an unsecured creditor first? – What if, in addition, debtor had promised the unsecured creditor not to promise the collateral as security to anyone else?

“Proprietary rights” vs “Contractual rights” Proprietary rights – Capable of affecting position of persons who are not party to an agreement regarding them – Asset “belongs” to C => others cannot claim it Contractual rights – Do not affect position of persons who are not party to agreement

How it makes a difference: ProblemContractual rightsProprietary rights What if D promises same asset to two creditors as collateral? Neither has priority if D goes bankrupt First creditor may seize collateral What if D sells collateral?Creditor has no priority to proceeds of sale and no recourse against purchaser Creditor has priority to proceeds and may be able to seize collateral from purchaser What if D had previously borrowed from unsecured creditors? Earlier and later creditors rank equally if D goes bankrupt Secured creditor may seize collateral, even if subsequent in time

The problem of third parties Creditors prefer to have proprietary rights rather than purely contractual rights But these impose search costs on third parties (purchasers, unsecured creditors, etc) Legal systems control these costs using 3 basic strategies

Controlling search costs 1.‘Numerus clausus’ (Rudden, 1987; Merrill and Smith, 2001) (civilian systems, common law) 2.Selective enforcement (Armour and Whincop, 2001) (equity) 3.Registration (Hansmann and Kraakman, 2002) (centralised systems)

C19th lending contracts Evolution in breadth of collateral – Specific assets (“the loom in X Ltd’s factory at the end of Mill Lane”) – Specific classes of asset (“all looms owned by X Ltd, present and future”) (rejected in civilian systems) – All classes of asset (“all assets and undertaking of X Ltd”)? (ultimately rejected in US)

The genesis of the floating charge Statutory precedent: – Companies Clauses Consolidation Act 1845 – Used by railway companies – Contained provision for grant of mortgages over ‘undertakings’ Precedent manuals used by practitioners transplant wording (Nolan, 2004) Court decisions create implied terms

The courts’ response Sales of inventory – Will purchasers be subject to claims from secured creditors? Contractual solution – Secured creditor gives borrower express power to use collateral in “ordinary course of business” Courts’ response 1.No express term -> no power (Re Marine Mansions, 1867) 2.Express term enforced (Re General South American Co, 1876) 3.‘Floating charge’ -> implied term (Re Florence Land, 1878)

When was it used? Royal Exchange Shipping Corp Ltd advert (The Times, 4 March 1880) “[S]uch a charge is now very familiar to commercial lawyers, and has been upheld by the Courts, including the Court of Appeal, on several occasions. The effect of it, as well settled by these decisions, is that all the property of the company, both present and future, is liable for payment of the debentureholders...” (The Times, 6 March 1880)

When was it used? Source: Armour (2006)

Statutory subordination Lack of transparency Salient ex post hardship to certain groups of creditors (employees, taxes, church tithes, etc) Preferential Payments in Bankruptcy Act 1897 – Certain classes of unsecured creditor entitled to repayment in priority to floating charge creditor – Employees, certain taxes, church tithes, etc

Statute and the floating charge: A brief historical digression Source: Armour (2006) Preferential Payments in Bankruptcy Act 1897

Lessons for legal evolution 1.Incremental development of gap-filling function of law by courts through precedents on interpretation of types of contract 2.Importance of choice of strategy for minimising third party search costs in relation to proprietary rights 3.Impact of legislative curtailment: ex post redistribution on ex ante transaction structure