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Book debts and the need for careful drafting of security documents

calculator, £20 and £10 notes with a black pen with the lid off Print publication

08/03/2018

The issue

The question of what is or isn’t a book debt often raises its head when lenders are looking to enforce their security. A typical debenture will purport to create a fixed charge over a company’s “book debts”. That expression is usually taken to mean any sums due and owing to the company for goods and services supplied or work carried out in the ordinary course of business.

Since the House of Lords decision in Re Spectrum Plus Ltd [2005] 2 AC 680, a fixed charge is only capable of being created over book debts if the money received is paid into a blocked designated account over which the lender has control (both on paper and in practice). If all the elements of control are not met then the charge will only be a floating charge irrespective of the designation of the charge purported by the debenture.

The significance of this distinction is that, on an insolvency, the proceeds of a floating charge are payable to the secured creditor only after payment out of those proceeds of preferential creditors’ claims, the “prescribed part” set aside as a matter of statute to be paid to unsecured creditors and the costs of administration and/or liquidation. These elements can substantially dilute what is ultimately available to repay the secured creditor from those proceeds, in many cases down to zero.

The question of taking security over book debts was looked at again recently in Plant and another v Vision Games 1 Ltd and others [2018] EWHC 108 (Ch). The case touches on what constitutes a book debt and serves as a reminder that security documents must be drafted as to be compatible with the transactional documents to which they relate. Attempting to rely upon generic security documents, or provisions for security arrangements which are not actually put into practice, can lead to results which are unwelcome or at least not what was intended.

Background to the case

This case involved the insolvency of Relentless Software Ltd, a developer of video games. In order to fund the development of its games, the company obtained finance from Vision Games 1 Ltd (the Funder). The terms on which the finance was provided were set out in three development and sales agreements (DSAs), each one of which related to a different game.

Under the terms of the DSAs, the actual development of the games was to be carried out by a subsidiary of the company called Relentless Vision 1 Ltd (RVL). The company would provide the employees and expertise which RVL required, while the Funder would advance money into a ‘production account’ held by RVL on each occasion that pre-defined ‘milestones’ were reached. RVL would then apply this money towards costs of the development. Importantly, any money received by the company by way of tax credits were also to be paid into the production account. By contrast, receipts from the exploitation of the games were to be paid into an ‘exploitation account’, also held by RVL.

To provide the Funder with security for its finance, the company entered into a ‘deed of charge’, by which it granted to the Funder a fixed charge over all of its ‘book debts’, which were defined as ‘all present and future book and other debts and monetary claims due or owing to [the company] in respect of the [games]’. Further, the company undertook to pay the proceeds of all such book debts into a ‘designated account’ and, until it did so, to hold that money on trust for the Funder.

In practice, the terms of the documentation were not adhered to. It was the company, rather than RVL, that developed the games. RVL was left as a subsidiary of the Funder, rather than the company, as intended. No ‘designated account’ was ever put in place, and it is not clear whether the Funder paid the finance for the production of the games into the production account, or directly to the company.

The company got into financial difficulty and administrators were appointed. A dispute arose between the administrators and the Funder as to whether or not the Funder had any security rights over certain tax credits amounting to some £190,000 which had been paid to the company as a consequence of its development of the games under the DSAs.

The Funder argued that the tax credits were ‘book debts’ as defined by the deed of charge, and that, accordingly, they either fell within the scope of its fixed charge, or, in the alternative, were held on trust pending their payment into a ‘designated account’.

What did the court decide?

The court accepted that the tax credits could be capable of falling within the definition of book debts because they were monetary claims payable to the company. However on a proper construction of the deed of charge they are excluded from the definition in this case. This is because the deed of charge had to be construed together with the DSAs and the DSAs provided that the tax credits were to be paid into the production account (which was an account of RVL) whereas the deed of charge provided that the book debts must be paid into a designated account which was an account of the company.

There was a clear incompatibility between the literal provisions of the DSAs and the deed of charge insofar as they related to tax credits received by the company. This incompatibility had to be resolved by reading the general wording of the deed of charge (which only referred to ‘book debts’ as a broad category) as subject to the DSA provisions dealing specifically with the application of any tax credits received. Because the DSAs required the company to deal with the tax credits in a manner which was inconsistent with either the fixed charge or trust applied to ‘book debts’ under the deed of charge, the tax credits had to fall outside the scope of that defined term.

The court also touched on the question of whether the charge on the book debts amounted to a fixed charge in the light of the fact that the Funder had the right at any time to designate a blocked account into which the book debts were to be paid but in the event never did so. Although the judge referred to the Spectrum Plus case, he refrained from expressing any views as to whether a fixed charge had been created.

Summary

In conclusion, it is clear that security documents must be drafted so that they dovetail with the transactional documents so that ambiguities are not created allowing assets to slip through the security net. Tax credits and other payments such as VAT rebates or loss reliefs can be classed as book debts if they relate to the business of the company and these can be secured by a fixed charge if the security holder has sufficient control over the account into which they are paid.

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