There are mainly two kinds of charges that a company may allow for the creation of its assets. Floating charge and Fixed-charge.
Introduction
A single section i.e. Section 71 is used by the legislature to cover all the topics related to debentures in the Companies Act, 2013. Companies are required to borrow a huge amount of money very frequently. Pursuant to this reason, the requirement of loan by the company might not be fulfilled by a single money lender. Several units have to come together to provide a huge amount of loan to the company. Borrowing money by the method of issuing debentures, thus, becomes one of those ways that are very convenient for the company.
For instance, if a company is willing to borrow a sum of Rs. One lakhs. It can divide this huge amount into one thousand units, where each unit may amount to a sum of rupees hundred only and it is upon the discretion of the lender to buy as much as units as he is willing to lend to the company.
The company will be then certifying the number of units held by the lender and this process of lending and certification is known as debentures. Henceforth, a debenture is nothing but a certificate of loan that is provided by the company. It is a form of security.[1]
It is not an essential element for the debentures to lead to the creation of charge on the assets of the company but it is a very common feature of the debentures.
There are mainly two kinds of charges that a company may allow for the creation of its assets. They are as follows:
- Floating charge
- Fixed charge
FLOATING CHARGE
In normal situations, the mortgage is subject to creation on some asset which is either specific or definite. This kind of mortgage is always deemed fit for those types of properties which are more or less fixed. But the impracticable question arises over the charging of the assets that is to of be either circulating or liquid in nature.
These assets are of ever-changing nature and there has to be the creation of a fresh charge every time whenever they get turned over in the due course of business. Such creation will be responsible for creating a hindrance in the business. Henceforth, it was realized that there should be some kind of charge that is capable of leading the smooth functioning of the company and not paralysing the business of the company.
In addition to it, such a charge should be able to provide a sense of safety and security to the lenders who have given their money to the company.
This can be understood in the words of Gower i.e. the unusual security has evolved due to the ingenuity showed by the equity practitioners. But such security is of highly beneficial nature and is termed as a floating charge.[2]
This can be understood with the help of a simple illustration, which is as follows. A company has used its stock in trade as security to borrow money. Even though the immediate and present charge is created, yet it will not be get fixed on the stock. Instead of getting fixed, it will be in a floating nature over the changing stock in the trade. And when the lender will be in a mood to get his security enforced, he has the option of doing so by the way of seizing whatever stock is then possessed by the hands of the company. Whenever such a seizure takes place, the floating charge gets either crystallised or fixed.
The extent of validity of such a charge was recognized clearly in the matter of Panama New Zealand & Australia Royal Mail Co., re[3]: a steamship company that has the power of doing so issued went for issuing mortgage debentures, charging entire sum of money that gets arisen from therefrom and the undertakings, with paying back the money that was borrowed at the specified time slots along with the total interest that was accrued in the meantime.
The company went into the process of winding up even before the debentures got due. The debenture- holders were of the intention to get their securities enforced.
The creditors that were unsecured rose questions over the validity of the charges on a fluid thing like the undertakings of the company. However, the court had held that the word undertaking covers all the undertakings of the company under it and not only those that were existing at that time when the debentures were being issued by the company and were subject to be the property of the company someday later. Henceforth, debenture holder has a charge upon all kinds of property of the company, past, present as well as future.
Thus, floating charge is a kind of charge that is ambulatory in nature, which keeps floating with the property it is intending to cover. It gets attached to the subject charged in the conditions that vary from time to time.[4] Further, Gower said that it is a charge that floats just like the cloud over the whole assets from time to time and it falls within a very generic description.[5]
The floating charge does not get attached to any of the properties that are specific in nature until and unless it gets crystallised. Further, in the meantime, the company has the option of using the assets that are charged in the ordinary course of its business.
CHARACTERISTICS OF FLOATING CHARGES
Romer J had explained the difference between a fixed charge and a floating charge by giving an explanation of the chief characteristics that are possessed by the floating charge with remarkable clarity in the matter of Yorkshire Woolcombers’ Assn Ltd re:[6]
Any charge or mortgage by a company that contains the main three characteristics can be termed as a floating charge. These characteristics are as follows:
- There should be a creation of charge over the prescribed class of assets both present and future.
- The class of assets that are charged must be the one that gets changed when the company performs the ordinary course of business.[7]
- The charge should be contemplated in a way that unless the mortgagee is ready to take any step, the company shall be provided with the right to use the assets that are comprised in the charge in the ordinary course of business.
In the matter of Indus Film Corpn Ltd, re,[8] a film company had taken a loan of s sum of money and went on to the declaration of lien on all of its assets, which included machinery etc., that was lying at that time or that may be bought hereafter until repayment. This was held by the court that such a charge is floating in nature as it is covering all the assets, present or future, of extremely fluctuating nature and had imposed no conditions on the use of such assets.
FIXED CHARGE
Any particular kind of expense that do occur on a regular basis or on a recurring basis can be understood as a fixed charge. The element of the volume of the business is not taken into consideration for such a type of charge. Most of the times, fixed charges are inclusive of the loan i.e. principal as well as the interest and the payments of lease, but the scope of the definition of the fixed charges can be widened in order to include utilities, insurance as well as the taxes in order to fulfil the objective of drawing up the loan covenants by those who had lent their money to the company.
Before setting up any kind of business, it is necessary for the business to list all the ongoing expenditures as well as the important upfront. The expenditures are normally divided under two heads. One is known as a variable while the other is called fixed. The reason for calling one of the expense as variable as it is dependent on the volume of the business.
For instance, the commission of the salesperson can be determined by looking at the sale done by the companies i.e. by determining how much services or products got sold by the company.
On the other hand, there is always the existence of the fixed charge and it does not depend on the volume of the business. When the company shows its concerns towards those who had lent the money, the fixed charge can be further divided into two parts. One is known as lease payment while the other is known as loan payments. The lender has the option to capture all the other fixed expenses such as taxes, utilities and insurance but most of the times, the lease payment as well as the loan payments are being focused by the covenants of loan for fixed charge coverage ratio.
The above mentioned fixed charge coverage ratio is counted as one of the necessary elements in order to measure the capacity of the borrower to repay the loan taken by him. The higher the coverage ratio is, the better the capacity of the company is.
The reason for this connection is due to the usage of the earnings of the company before the payment of any of the taxes or the interests as the fixed charges and numerator as the denominator. An aspect of this coverage ratio is earnings before the amortization, depreciation, taxes and interest over the fixed charges.
A company that is under the liability of a lot of fixed charges and do not have any volume of business in order to cover those expenses that are fixed in nature, while the variable charges alone, can be in trouble with those creditors, who are in possession of the collateral on the assets of the business and in some particular cases, personal assets also.
REGISTRATION OF CHARGES
Whenever there is a creation of any charge, it needs to be registered with the Registrar of Companies. The upper limit of time fixed by the legislature is 30 days from the date on which the charge is created. The registration of charge is nothing but similar to the notice served to the public in relation to the interests possessed by the creditors in those charged property/ assets.
This is done so that no one else can interfere with those properties or assets again. If these registrations become subject to any sort of delay, then they have to pay additional fees in order to get it registered as per the amount specified under the provisions of the Companies Act (Registration offices and fees) Rules of 2014.
[1] A company has the option of issuing debentures that can be converted into shares either partly (PCDs) or fully (FCDs). In order to refer to the rules and regulation with respect to the debentures, see, Section F of SEBI Guidelines for disclosure and investor protection on the issue of convertible and non- convertible debentures.
[2] 3rd edn., the principles of modern company’s law, 1969; See also, Robert R Perrington, The Genesis of Floating Charge, (1960) 23 Mod LR 630
[3] (1870) LR 5 Ch App 318: 22 LT 424
[4] Lord Macnaghten in Govt Stock and other securitised investment co ltd v manila railway co ltd., 1897 AC 81, 86: 75 LT 533 (HL).
[5] 3rd edn., Gower, the principles of modern company’s law, 1969, 78
[6] (1903) 2 Ch 284: 88 LT 811 (CA)
[7] Hi-Fi Equipment (Cabinets) Ltd, re, 1988 BCLC 65 (Ch D). See also, Cosslett (Contractors) Ltd re, (1996) 1 BCLC 407 (Ch D).
[8] AIR 1939 Sind 100: 181 IC 681
