The Reintroduction of Crown Preference: What Does this Mean for Secured Lending?

Introduction

The Finance Bill 2020 received Royal Assent on 22 July 2020 and became the Finance Act 2020, reintroducing the heavily contested measure of restoring HM Revenue and Customs (HMRC) as a secondary preferential creditor on insolvency (Crown Preference). Crown Preference will therefore be reintroduced from 1 December 2020. Its reintroduction will affect recoveries under both new and existing floating charges.

Priority

The reintroduction of Crown Preference will give HMRC a preferential right to be paid, ahead of floating charge holders and unsecured creditors, payments due in respect of VAT, PAYE (including student loan repayments) and employee national insurance contributions (taxes that a company collects on HMRC's behalf). The tax debts specified above will be preferential if the insolvency is commenced after 1 December 2020. HMRC will remain an unsecured creditor for taxes that it collects directly, including corporation tax and employer national insurance contributions.

Secured Lending Market

The news is a blow for the secured lending market, particularly when combined with the issues for lenders presented by the COVID-19 pandemic, the introduction of the Corporate Insolvency & Governance Act 2020 and the recent increase in the prescribed part to £800,000. Lenders will need to adjust to the new climate by reanalysing their credit portfolios and altering their approaches to loan origination or refinance. Consequently, we may see a reduction in the amount of funds that lenders are prepared to advance to a business, with lenders taking into account potential dilutions in realisations following insolvency. Where secured lending deals continue to be originated or refinanced, we expect to see more onerous terms placed on the borrowers in terms of more robust security packages and further requirements of additional information and restrictive covenants in the finance documentation.

Asset Based Lenders

We expect Crown Preference to have a significant impact on asset-based lenders (ABLs) who are fundamental to providing working capital for various businesses. ABLs will need to consider the valuations provided to them by third-party valuers and (i) assess how these valuations affect the amounts they are prepared to lend against assets that are typically secured by way of floating charge (inventory and plant and machinery (P&M)) or (ii) merely the value they attach to such floating charge assets that represent their boot collateral.

Adaptation/Solutions 

• In relation to lending against P&M, we have always recommended that ABLs seek to take fixed charge security, reinforced by covenants restricting the borrower's dealing with P&M. Although, we have noted in recent insolvency proceedings that both liquidators and administrators have mounted increasingly aggressive attacks on fixed charges, seeking to argue that such charges are merely floating charges. Therefore, we recommend that certain enhancements to the P&M security package should be considered:
  1. Ideally, the security should be taken in the form of a chattels mortgage (in a separate document or included within the debenture). A chattels mortgage involves the transfer of legal title of the chattel to the lender (mortgagee), on the express or implied condition that title will be transferred back to the security provider (mortgagor) on repayment of the debt.
  2. It is essential that the P&M that is subject to a mortgage is identifiable and title and ownership are ascertainable. Lenders should schedule P&M within the charge document (in many cases, the company’s fixed asset register can be repurposed to provide the schedule) and obtain an undertaking from the security provider in the security document to update the list of mortgaged P&M at regular intervals – somewhat like a borrowing base certificate for P&M. Updated lists do not require registration at Companies House, but are simply signed by the company and held by the lender on file.
  3. We continue to hold the view that plating of P&M should not be necessary in order to perfect a fixed charge. Nevertheless, as some liquidators and administrators use the absence of plating or other forms of actual notice (in contrast to registration) as a ground for attacking fixed charges, we feel bound to advise that plating of at least major items would be advisable from the outset. This does present practical and cost issues, and in some cases it may not be feasible. However, where plating can be done with relative ease, we advise lenders that they should do so.
• In relation to inventory, field warehousing may be practical where goods are held in third party warehouses such as those operated by logistics providers. In such cases, it may be possible to make arrangements with the warehouse keeper to act on the instructions of the lender in permitting goods to leave the warehouse. This element of third party control should not only buttress a fixed charge but may also permit the creation of a traditional pledge. There is no English jurisprudence to suggest that a pledge can ever be anything other than fixed.
• In relation to purchased receivables, to the extent these (and all associated / related rights) vest absolutely in the lender (or, in respect of non-vesting debts, are secured by way of fixed charge), it is unlikely the proceeds of such debts could be subject to any Crown Preference liability.
• Lenders may consider obliging borrowers to make certain disclosures as to the tax position of the borrower on drawdowns, give repeating representations during the duration of the loan, and allow the lender access to the relevant company records to support the representations to allow the lenders to regularly review and check the tax exposure of the borrower and the likely amount of an HMRC preferential claim.
• Lenders may require borrowers to hold tax reserves in a ring-fenced account to deal with preferential liabilities to HMRC which would otherwise dilute realisations of the lender. However, whether this will be practical is doubtful as it will impact a business's cash for working capital purposes.
• Lenders will need to consider the pricing of their loans as they are likely to incur additional time managing the loan, making regular enquiries or reviewing the tax position of the borrower or taking proactive action if the borrower's tax liabilities begin to increase resulting in a risk of larger than forecast reduction in the lenders realisations.