The Case for Reform

This document sets out the case for reform  when the STR first started.

Click here to download this document in DOC format.

The Secured Transaction Project’s current position can be seen in the April 2016 Draft Policy Paper, January 2017 Discussion Papers, or 2013 Discussion Papers.

Secured Transactions Law: The Case for Reform

Introduction

1. There are serious shortcomings in the current law of England and Wales as it relates to security over personal property even as amended in 2013. For example:

  • The existing law is complex and not readily accessible to non-lawyers or those in other jurisdictions
  • Transactions which have the same purpose and function as security but which take a different form are outside the personal property security registration regime creating a lack of transparency
  • The law relating to the distinction between fixed and floating charges is in an unsatisfactory state. This makes it difficult to give clear advice when structuring transactions, and the cost of credit may be raised because steps have to be taken to avoid potential problems. This would be unnecessary were the law to use a simpler criterion with much the same practical effects.
  • Registration of security at Companies House applies only to English companies and operates independently from specialist asset registers and international registers.
  • The regime applied to unincorporated businesses is restrictive, creating an unnecessary pressure to incorporate for small and medium-sized businesses wishing to access secured credit

This paper addresses the need for reform and puts forward reform proposals for consideration. The proposals do not extend to security interests in land, although they may pave the way for a simplification of the registration requirements for interests in land. The paper deals only with security interests created by businesses. Consumer security interests were a few years ago the subject of a Consultation by the Department of Business, Innovation and Skills and may be re-considered at a later stage.

What business is entitled to expect from the law

2. London is one of the world’s leading financial centres and English law is one of the world’s leading systems of both transactional law and the enforcement of contractual rights through the English courts.   Provision of security for the performance of obligations is a critical part of financial transactions.   It is therefore particularly important that we should have a modern personal property security law which is responsive to the needs of the commercial and financial community. The law should achieve at least the following:

  • Facilitate the public and private market for secured lending to all businesses of any size and whether or not incorporated
  • Enable security to be taken over any suitable asset to secure any obligation
  • Permit security to be taken over future as well as existing assets and to be effective even though the debtor is allowed to dispose of the assets free of the charge in the ordinary course of business
  • Enable all businesses to grant security, whether or not the business is incorporated
  • Make it simple, quick and cheap to make the security effective in the debtor’s insolvency and against other creditors, and to correct any errors or omissions discovered later
  • Ensure that other interested parties can readily find out whether the debtor’s apparent property is subject to a security interest
  • Enable those who take security to secure their priority against possible competitors by simple and easy steps
  • Enable buyers of property that may be subject to a security interest either (where appropriate) to take free of it or to find out about it quickly and simply
  • Provide for effective enforcement of the security, whether inside or outside of insolvency proceedings
  • Ensure that, as far as possible, financial markets are not hindered by rules about security over financial collateral
  • Reduce as far as possible the risk that parties who have taken and have perfected security in good faith and for value find that it is rendered ineffective by insolvency rules
  • Ensure that the provisions on publicity and priority, at least, apply not just to traditional security but also to other transactions that have a similar function and which may not be apparent to third parties
  • Be as clear and as simple as possible
  • Be readily accessible to lawyers in the UK and from other jurisdictions

How does the current law measure up?

3. If we ask how far current English law meets these objectives, the answer is that in some respects it does so very well. For example, with companies, the first two objectives are largely met: companies can employ very flexible forms of security which enable security to be taken over any asset, or indeed the whole of the company’s assets. In many other respects, however, the current law appears to fall short. To give a few examples:

  • Unincorporated businesses are prevented from charging future goods or creating a floating charge, thus creating a “pressure to incorporate” that is quite unnecessary
  • The scheme for registering company security and for correcting errors or omissions is wasteful and costly, while the scheme for unincorporated businesses is so technical that it is very risky to use
  • Registration is only a perfection requirement, and not necessarily conclusive as to priority with competing security interests, so that a creditor who makes a search, finds nothing on the register and registers his security interest may find that his security ranks behind an earlier creditor who still has time to register within the 21 days allowed
  • The rules of priority as between competing secured creditors and other financiers are unnecessarily complex, partly because of the many different forms of security each of which has its own set of priority rules. The differences bear little relation to the practical situation and in respect of trade receivables can be almost unworkable in practice without incurring substantial expense. As a result the practical outcome is frequently uncertain. This often makes it necessary for the parties to enter into a priority agreement which would not be needed under a clearer system which emphasizes function over form
  • The rules on tacking of future advances are unclear and unsatisfactory
  • The rules of priority as between the holder of a fixed charge and an innocent buyer or lessee of the charged property are wholly unclear
  • The rules on enforcement also vary from one kind of security to another, often making it necessary to insert express provisions into the security agreement to ensure the secured party can enforce the security effectively
  • The register provides no information about rights that other parties may have over the debtor’s property which are in practical terms fulfilling the same or similar functions as traditional forms of security, such as title-retention devices and outright sales of receivables (we refer to these collectively as “quasi-security”)
  • The rules of priority and enforcement of quasi-security and accountability for surplus are different again, often for conceptual rather than practical reasons
  • The law relating to the distinction between fixed and floating charges is unacceptably unclear
  • The law is a mixture of case law and a series of statutes, making it hard to access or to understand. This makes it, despite its substantial merits, almost useless as a model for other jurisdictions or international bodies to follow
  • The use of clauses prohibiting assignment in some contracts causes problems for certain types of receivables financing
  • Important aspects of the law relating to financial collateral lack clarity, such as the meaning of ‘possession or control’ and the position regarding priority between competing interests over financial collateral
  • The implementation of the Financial Collateral Directive by the Financial Collateral Arrangements (No 2) Regulations (FCARs) is too wide in that the protection applies to some charges for which it seems inappropriate, while the protection does not apply to other security interests for which it seems to be appropriate
  • The protection given by the FCARs is imperfectly aligned with the protection given by other statutes relating to market contracts

Time for major change

4. Despite important but relatively narrow changes made in 2013 to the system of registration, it is time to give detailed consideration to a radical overhaul of the law of security over personal property as a whole. Reform must ensure that the weaknesses mentioned above (and others) are addressed without either reducing the strengths of the current law or producing or perpetuating an unacceptable level of uncertainty.

The PPSA model [1]

5. Fortunately, it is not necessary to devise a radical alternative from scratch. Many other common law jurisdictions have developed a relatively simple but more comprehensive scheme which has now been in operation for many years. It originated with Article 9 of the US Uniform Commercial Code, which was extensively revised in 2002. With slight variations the scheme is now in force throughout Canada, where it is known as the Personal Property Security Act (PPSA) regime. [2] Legislation based on the PPSA regime is now in place in New Zealand and Australia, and is being introduced in Jersey.

6. A key feature of the PPSA regime is the integration of the treatment of all transactions fulfilling a security function and the replacement of a wide range of security devices with a single concept, the security interest. All such devices, ranging from mortgages, charges and pledges to (where fulfilling the economic equivalent of security) hire-purchase agreements and equipment leases, are subject to the same rules of registration, priority and, in most cases, enforcement, whereas under English law each device is subject to different rules.   Where distinctions are drawn in a PPSA regime, this is based not on the location of legal title, but on the nature of the collateral (for example, inventory, equipment, receivables) and the nature of the secured obligation (for example, purchase-money security interests are treated differently).

7. Under the PPSA regime a security interest can be made effective against third parties (‘perfected’) by registration, by the taking of possession or, in the case of financial collateral, the taking of control.   Registration can be done in advance of the security being created, so that the register is then a warning that a security has been or may be taken.   This is known as notice filing.   Since filing can be done in advance, only one filing is required for all transactions between the same parties involving the same kind of collateral.

8. The PPSA regime includes a set of priority rules designed to produce a commercially reasonable outcome for typical disputes.       Filing is a priority point, in that priority between security interests generally depends on the date of perfection. Security over an asset for which the secured party provided the acquisition finance would have priority over previously-registered security interests which also apply to the asset (as the result of an after-acquired property clause).   Purchasers take free of certain security interests in some circumstances, as mentioned below.

9. Whatever form it takes, under the PPSA regime, the creditor’s interest in the collateral is limited to a security interest, so that if a conditional seller sells goods on the debtor’s default any surplus is payable to the debtor in the same way as it would have been under a mortgage or charge.   The rules regarding enforcement apply to all security interests, although many of them can be varied by agreement.

10. Fixed and floating charges are replaced by a single security interest, under which the normal position is that the debtor can pay out cash and can dispose of inventory free of the security interest, and may be given contractual powers to dispose of other assets.   The priority rule of first to file applies, therefore, to both types of charges.

11. Article 9 has been operative for many decades in the US and the PPSA regime has operated throughout Canada and New Zealand for many years. It therefore can be described as “tried and tested”.   In New Zealand, which adopted a PPSA regime in 1999, surveys conducted by Professor Mike Gedye showed that 97% of respondents preferred the Personal Property Security Act to the prior law. Several other experts have expressed the view that the PPSA is a great improvement on prior law. Australia, which has also recently brought in reforming legislation, did so after conducting a wide-ranging review and an economic impact assessment which demonstrated a clear need for reform. It therefore makes sense to start by reviewing the PPSA regime.

Transnational reform initiatives

12. The PPSA regime has also been used as a model for recent reform initiatives by UNCITRAL and UNIDROIT. The UNCITRAL Legislative Guide to Secured Transactions, which was adopted in 2008 to assist States to modernize their secured transaction law uses the concept of a single security interest, and recommends a notice filing system with priority by date of filing.  UNICITRAL is now engaged in drafting a Model Law based on the Legislative Guide.   The Cape Town Convention on International Interests in Mobile Equipment 2001, which has been ratified by 58 countries, and which is likely to ratified by the UK in the near future, is based on a similar system. [3]

A model for Europe

13. We would add that the European Commission has on several occasions indicated that the law of security over moveable property may need to be harmonized, as many Member States have laws that make it hard to take security, or to move property subject to a security interest from one jurisdiction to another without risking invalidating the security. A recent study as part of the Draft Common Frame of Reference prepared for the European Commission suggests that the basic PPSA regime could well form the basis of a European model also. [4] In any negotiations in Europe it would be advantageous if we could provide a fully worked-up model which might then be adopted as the European model also.

Previous recommendations for reform in England and Wales

14. In the UK, no fewer than three reports going back over a period of nearly 40 years have recommended that the law should be reformed in a fundamental way. [5] The first was the Crowther Report in 1971, which recommended the adoption of essentially an Article 9/PPSA scheme. Its recommendations were considered and amplified by the Diamond Report in 1989. More recently, at the suggestion of the Company Law Review Steering Group, [6] the question of fundamental reform was referred to the Law Commission.

15. The Law Commission published a consultation paper, [7] which was followed in 2004 by a consultative report on security interests granted by companies. [8] This set out a very full scheme, taking into account the PPSA and Article 9, including the amendments made by Revised Article 9. The Law Commission’s final Report [9] was more limited: for example, it did not recommend the full scheme because it recognized that in some areas more work was needed, and it recommended retaining the distinction between fixed and floating charges until such time as the insolvency legislation (which had just been amended extensively by the Enterprise Act 2002) was reviewed again. But in most respects its recommendations on registration of company charges and also sales of trade receivables followed the PPSA scheme closely. In the end, however, even these recommendations did not reach the statute book, despite support for many of the proposals. The need to meet the timetable for the introduction of the Companies Bill, a major measure which ultimately became a statute of 1300 sections, imposed severe constraints on the legislative process. The result was that there was insufficient time to engage with the professions and industry and commerce to the extent that the Law Commission would have liked, and there was a feeling on the part of consultees that they had not had adequate time to consider the proposals. It therefore makes sense to look again at the scheme proposed by the Law Commission; and to start with the more fundamental proposals contained in the Consultative Report of 2004. (“the full Law Commission scheme”).

The Secured Transactions Law Reform Project

16. This project brings together judges, practitioners, academics and those who work in various branches of the secured lending industry – banks, financiers and borrowers.   A number of working groups are reviewing the problems with the current law and considering whether the full Law Commission scheme is best way forward.   It is not necessarily envisaged that the project will adopt any version of the scheme in full or without amendment.  For example, there are some respects in which we believe that even the full Law Commission scheme and the most recent versions of the PPSA do not make use of the most recent developments, particularly developments in IT which can significantly reduce certain risks; conversely, in some respects the scheme may go further than we think is necessary or appropriate for our purposes.

17. In particular, the issue of recharacterisation was addressed by the Law Commission who concluded that, although outright assignments of receivables were to be within the regime for the purposes of registration and priorities, they were not to be recharacterised as security interests as a matter of law: this is also the position under the PPSA regime. However, the Law Commission concluded that sales of goods on retention of title terms, and equipment finance transactions based on retention of title (such as hire purchases, conditional sales and finance leases) could be recharacterised as security interests. There is a division of opinion, even among those who are in favour of including such retention of title devices in the scheme for the purposes of registration and priority, as to whether they should be recharacterised as a matter of law. This point is open for debate and further discussion.

Advantages and disadvantages of a new regime

18. Any reform proposal must be accompanied by an evaluation of the benefits that the proposed reforms would bring and also of any costs they would impose. On the positive side, [10] in relation to security created by companies, there seem to be major advantages in terms of:

  • cost reduction
  • speed
  • enhanced flexibility
  • transparency and accessibility of the legal rules
  • simplicity and modernity

To this should be added the advantages that would accrue to both unincorporated businesses and creditors were the highly technical and complex Bills of Sale Acts to be repealed and security created by unincorporated borrowers brought within the scheme outlined.

19. On the negative side, we will need to evaluate all the costs that would be involved. Some costs would inevitably be incurred because new methods and documents might need to be developed, new equipment to be installed and staff to be trained. However, all changes to law involve initial start-up costs which need to be set against the benefits of the new system. Other costs might arise if the new scheme were to have any weaknesses compared to the current law.

20. It would be a particular concern if the new law were to limit the freedom of contract traditionally enjoyed by parties under English law, or if the new law would be significantly less certain. The regime provisionally proposed by the Law Commission was attacked on both grounds. The criticisms made will need to be evaluated. Some of them appeared to be based on misunderstandings of the proposals. For example, there is nothing to indicate that the scheme of remedies available to a chargee on the chargor’s default which was proposed would limit the freedom of contract any more than does current English law on mortgages. However, the questions will need re-examining to check that any restrictions are necessary and acceptable.

21. Obviously there would be a period of uncertainty. No legislative scheme can produce absolute certainty on every point. What is important is that the scheme should simplify and modernise the law and produce outcomes that are commercially sensible in the typical case. A careful analysis will have to be made of each point to ensure that this will be the case.

22. Any change in law necessarily means that there will be situations in which someone loses compared with the position under the present law. But against this must be set the significant benefits that could be expected to be derived overall if the experience of other jurisdictions is anything to go by.

23. In weighing the costs and benefits of the new scheme we should take into account the fact that it has now been adopted in many jurisdictions, most of which have had it in place for many decades and all but two of which are common law jurisdictions whose rules were previously much the same as those of English law. It will therefore be a matter for consideration as to whether English security law and practice are so distinctive as to make it unnecessary to follow the same approach.

24. We have laid out in this paper the case for reform of English personal property security law. We are aware that there are those who think reform is largely unnecessary. We invite them to make their case by joining us in vigorous reasoned debate and to participate in the project. Ways to participate are set out in the Project website.

Notes

[1] A fuller description of a “typical” PPSA scheme can be found in H Beale, M Bridge, L Gullifer and E Lomnicka, Law of Personal Property Security (2nd edn, 2012), chapter 23.

[2] For reasons that will appear in the outline given in para 14, the schemes are also referred to as “notice-filing” schemes.

[3] See R. Goode, Convention on International Interests in Mobile Equipment and Protocol Thereto on Matters Specific to Aircraft Equipment: Official Commentary, 3rd edn (Rome: UNIDROIT, 2013).

[4] DCFR Book IX, which adopts something close to an Article9/PPSA scheme. See Study Group on a European Civil Code and Research Group on EC Private Law (Acquis Group), Principles, Definitions and Model Rules of European Private Law, Outline Edition (Sellier, 2009).

[5] The Cork Report in 1982 was concerned primarily with insolvency but also made some proposals for far-reaching changes to security, including expressing broad support for the scheme proposed by the Crowther Committee.

[6] Modern Company Law for a Competitive Economy: Final Report URN 01/942, ch 12.

[7] CP 164, 2002.

[8] Company Security Interests: A Consultative Report (Law Com Consultation Paper No 176, 2004).

[9] Company Security Interests: Final Report (Law Com No 296, 2005).

[10] When the Law Commission provisionally proposed a full PPSA-type regime, it provided an extensive list of the benefits it believed the scheme would bring. See Law Com Consultation Paper No 176, pp xviii-xx.