This is one of a series of articles we at Morton Fraser are producing to guide finance companies through the wholesale change proposed in Scots law in relation to security over goods, intellectual property and shares, on the one hand, and invoice finance or the purchase of receivables, on the other.
For a general introduction to what the Bill covers, see my article, Moveable Transactions (Scotland) Bill (the "Bill") which provides an overview. The Bill is slated to move through the Scottish Parliament this session, so, while detail may change during that passage and statutory instruments will be required before it can become effective law, it is now timely to start preparing for the new regime. This article is concerned with the new Statutory Pledge to be introduced for the first time into Scots law by the Bill.
We probably need to start with this, as the terms used in Scots law to describe different types of property differ from those used in English law and also from everyday speech. And we need to agree on what terms we are going to use in this article.
In Scots law all property is either heritable or moveable. Heritable property is land and buildings or rights over land; moveable property is everything else. Moveable property is then itself divided in two: corporeal moveables, in other words, things; incorporeal moveables or, in other words, rights not related to land which you can't, as it were, touch (but including in certain respects the right to receive rents). So corporeal moveables (called chattels in English law) are goods and equipment. Incorporeal moveables include debts (the right to be paid, aka receivables), company shares, and intellectual property (patents, trade marks etc.). To avoid the clunky term "corporeal moveables", I'll use the term "goods" in this article, though it should be understood that is shorthand. It's hard to avoid "incorporeal moveables" but the term when used will usually be expressly associated with the type of incorporeal moveable in question.
In passing I should also make clear that ships and aircraft are excluded from the ambit of the Bill. Security over such assets is the subject of separate statutory provision in Scots law.
In the Bill the person who grants the Statutory Pledge to the creditor is called the "provider".
The Problem to be Solved
This is explained in detail in the introductory article referred to in the first paragraph above. In brief summary, the issues, which have the effect of limiting the availability of finance in Scotland compared with England and elsewhere, are: it is impossible to take fixed security over moveable property in Scots law (having a first priority ranking on the granter's insolvency) unless:
- in the case of goods, the creditor has possession of the goods (as, for example, a pawnbroker),
- in the case of debts, the debtor is notified of the security,
- in the case of company shares, the creditor or its nominee is entered on the register of members,
- in the case of patents or trade marks, the creditor or its nominee is entered as owner on the patents or trade marks register.
These issues mean that, in effect, a fixed security over Scottish moveables is impossible in relation to lending and borrowing in the ordinary course of business. For companies and LLPs the available alternative security would be the grant of a floating charge, but on the borrower's insolvency, unlike a fixed security, a floating charge ranks after the preferred debts, the prescribed part (the part of the assets reserved as a preference for unsecured creditors), and the administrator's expenses.
Having said that, one existing way round the problem in the case of goods, namely a hire purchase or conditional sale transaction, remains competent and unaffected by the Bill. In some other jurisdictions this is not the case - for example, in the US hire purchase transactions are re-characterised as security transactions and made subject to registration. That is not to be the case in Scotland, though Scotland has some problems of its own in relation to hire purchase - see the introductory article mentioned in the first paragraph above.
The Statutory Pledge
The new form of fixed security over goods, company shares (or other "financial instruments") and intellectual property is a new legal creation in Scots law, the Statutory Pledge. Note: though debts are incorporeal moveables as is the right to receive rents, security over them is dealt with through the register of assignations provided for in the Bill, not via the Statutory Pledge.
Other types of incorporeal moveables may be added later by statutory instrument, but for now the only incorporeal moveables that can be subject to the pledge are financial instruments and intellectual property (including an application for intellectual property, say an application for the grant of a patent, and a licence over intellectual property, for example a software licence).
The creation of a Statutory Pledge could not be simpler: under clause 46 of the Bill four things are required to constitute a Statutory Pledge:
- a constitutive document,
- which is executed (or, in the case of electronic signature, authenticated) by the provider,
- which identifies the property the subject of the pledge, and
- which identifies the secured obligation.
Note that this does not say anything about the document having to expressly state that it is intended to create a Statutory Pledge or that it must call itself a Statutory Pledge. This leads to an interesting question, which I deal with below, namely, can an English chattel mortgage or fixed charge on goods itself be registered directly in the new Register of Statutory Pledges or must a separate Statutory Pledge be taken before such registration can be effected? This is important because the legal position at present is that such a chattel mortgage or fixed charge on goods under English law ceases to be effective if the goods are in Scotland and that can be a problem with goods that are mobile - say a truck or a mobile crane.
When does a Statutory Pledge Become Effective
Assuming the four prerequisites for the pledge's creation are satisfied, it becomes effective on registration of the pledge in the Register of Statutory Pledges - for the details as to the mode of registration, see our separate article on that Register. There is no time limit, as there is in relation to registration of charges at Companies House (see below). It is also necessary that the property so pledged is the provider's property and the property is identifiable as being the subject of the constitutive document. It follows that, if the property in question is not the property of the provider on registration of the charge but subsequently does become his property, then the pledge is effective once the provider has acquired title to it. In other words, it does not matter which comes first, the provider owning the goods or patent or whatever, or the registration; both are required and the pledge is effective once both are satisfied.
This leads to a crucial benefit of the new form of security. Provided the definition is sufficiently clear, the one Statutory Pledge can cover present and future assets of the provider. Thus, the property subject to the pledge could be identified, say, as "all trucks at any time belonging to me which have six axles". Then, provided the pledge is registered, it will be effective in relation to those trucks, present and future, which the provider owns or which he comes to own, in the latter case from the date or dates he comes to own them. (The release of trucks from the pledge is dealt with below.) This benefit in relation to future owned assets is restricted where the provider of the pledge is a consumer - see below.
The issue which raises its head in connection with the efficacy of the pledge over future property, of course, is what happens on the supervening insolvency of the provider? The position is quite clear and not surprising given the two conditions which have to be satisfied for the pledge to become effective, registration and ownership by the provider. The Statutory Pledge does not attach to property which, though identifiable by the description in the pledge, is not acquired by the provider before it becomes insolvent, and insolvency is defined in clause 51 of the Bill quite specifically according to the inception of all the possible different types of insolvency regime.
Registration of the Statutory Pledge at Companies House
The foregoing comments about the creation of a Statutory Pledge need qualified in relation to companies and LLPs by the continuing requirement to register such a pledge as a charge at Companies House. The 21 day period for such registration continues unaffected by the Bill. (According to Scots law principles, such registration should be completely unnecessary but the Scottish Parliament has no jurisdiction to legislate on company law.)
And there is a nonsense lurking here - the same nonsense as already bedevils the registration at Companies House of ship mortgages and aircraft mortgages. It derives from the inability of the English legislators in promulgating the rules for registration of charges under the Companies Acts to understand the different legal effect in Scots law of signing a security document on the one hand and registering it in the required register on the other. So, the Companies House rule will be that a Statutory Pledge has to be registered within 21 days of its date (that being its date of "creation" under the Companies Act provisions, following English law principles) whereas, in Scots law, the date if its creation is actually the date it is registered in the Register of Statutory Pledges, which may be outwith that 21 day period. This anomaly can cause practical problems. Exactly the same issue bedevils the registration at Companies House of Scottish ship or aircraft mortgages which are not "created" in a legal sense in Scots law until registration with the applicable shipping or aircraft registry. The same issue of course does also raise its head in relation to securities over land but in this case, and this case only, the Companies Act provisions specifically cater for the Scots law position that a security over land in Scotland has no effect until registered in the Land Register and the 21 day period for registration at Companies House is calculated from that Land Register registration date.
Is Scots law the relevant jurisdiction?
This is always the first key issue to be established in cross-border lending and the taking of security.
The position with goods is straightforward: the form of security taken has to be valid according to the law of the place where the goods are when the security is taken and where they are when it comes to be enforced or relied upon in the insolvency of the provider. So, an English chattel mortgage or fixed charge on goods is valid if taken when the goods are in England but ceases to have effect under current law in relation to the goods if the goods are in Scotland on enforcement. We'll look at what lenders might do about this in practice in future below.
Scots law applies to a security over a company's shares if the shares in question are shares in the capital of a Scottish registered company - the nationality or residence of the provider of the security is not relevant (except in relation to registration of any security granted at the relevant register of companies). This is a notorious problem under current law because any fixed security over such shares is only effective in relation to the shares of a Scottish company if the creditor or its nominee is registered on the company's register of members - and many creditors baulk at that for good reasons. The new Statutory Pledge solves this problem not only in relation to shares but also in relation to any "financial instruments". The rules for execution or authentication of a Statutory Pledge in relation to financial instruments are relaxed to take second place to the facilitative rules under the Financial Collateral Arrangements legislation where that legislation applies to the type of financial instrument in question - see our separate article on the Bill in relation to such arrangements.
The position with intellectual property is even more complicated. There is only one UK patents register and one trade marks register (quite apart from the European and other international ones). Scots law dictates the requirements for a fixed security over such property if it is Scottish. It can be hard to determine if any given patent, trade mark, copyright or whatever is Scottish or English if the creating entity trades in both places - and the English rules for the creation of a fixed security over English intellectual property have always been straightforward, whereas the current Scottish ones require the creditor or its nominee to be registered in effect as owner of the patent or trade mark on the appropriate registry, which can apply unwanted obligations to the relevant registering creditor. The new Statutory Pledge solves this problem but does not answer the question as to whether the, say, patent or trade mark in question is English or Scottish. The prudent practice will be to take both English and Scottish security and register the Scottish security in the Register of Statutory Pledges.
Consumers, partnerships and sole traders
The Bill applies to partnerships as it does to companies and LLPs - in fact, it's even more useful in this context as partnerships don't have the current default option of granting a floating charge to secure their borrowing. And, of course, there's no question of having to register the pledge under the Companies Acts where the provider is a partnership.
The same is true for sole traders but only as respects any assets which are used or are to be used for the purposes of the sole trader's business. For other assets, a sole trader is in the same position as a consumer.
So how does the Bill deal with Statutory Pledges in respect of consumers? Clause 52 of the Bill applies the same rules to consumers as to business borrowers but with some qualifications, namely:
- the consumer can't grant a Statutory Pledge over an asset it does not yet own, unless the acquisition of that asset is financed by credit and the obligation to repay that credit is the secured obligation; and
- where the asset is goods, it must have a monetary value exceeding £1,000 (or another amount prescribed by statutory instrument from time to time).
From a lawyer's point of view this all makes sense. A legal system should make provision for borrowing money on security where the security is restricted to the asset bought with the money - what in other legal systems is called a "purchase money security interest". Simple examples would be a car or an expensive musical instrument. This, however, may be an area where the parliamentarians are uncomfortable - see the reaction in the Westminster Parliament to attempts in English law to reform the outdated Bill of Sale legislation under which consumers in England can give security over goods. There are fears of consumers being prejudiced by simplification there of the law. In my firm view such an attitude would be wholly misguided: consumer protection law is a matter for the Consumer Credit Act and FCA regulation and such regulation would apply to any consumer borrowing by Statutory Pledge. After all, hire purchase is a way a consumer can acquire goods; that agreement is then regulated by the FCA, but the hire purchase facility itself remains available. But we should be aware that if the Scottish Parliament seeks to amend the Bill in any way, this is probably the most likely area where the final Act may differ from the Bill.
Dealings with Encumbered Property
If a purchaser in good faith acquires property which is subject to the Statutory Pledge from the provider, without the secured obligation being repaid, the position can be quite complex. In all cases though the Bill is seeking to ensure fairness and the resulting position is considerably better than the current English law position with a chattel mortgage where the innocent purchaser may be unfairly deprived of the asset he has paid for in good faith.
The resulting situation of the good faith purchaser of goods under the Bill can be summarised as follows.
- If the property is transferred without the consent of the secured creditor the pledge continues to attach to the property. The consent is only valid if specific to the transfer in question and given with 14 days before the transfer, so this timescale will be a crucial trap and needs careful consideration in transactions in future.
- There is then an anti-avoidance provision whereby if a creditor acquiesces generally in such transfers, the effect is to extinguish the Statutory Pledge altogether. This is to prevent the fixed charge created by the Statutory Pledge being administered in effect by the creditor as a floating charge. Again, there is scope for chaos here where creditors act loosely without prior legal advice as to how they must administer the Statutory Pledge and unwittingly give such acquiescence.
- The above is subject to a crucial derogation because a purchaser of goods in good faith, where the creditor has not consented to the sale and purchase, obtains good title if the person from whom he acquired the goods acted in the ordinary course of business in making the sale. The business in question must relate to the goods though - the example given by the Scottish Law Commission is that a motor dealer selling its office furniture is not selling the furniture in the ordinary course of its business. The fact of the pledge being registered does not prejudice the purchaser's good faith. Note: this important qualification to the above general rule only applies to goods, whereas the general rule requiring creditor consent applies to intellectual property and financial instruments as well as goods.
- There is a further derogation in relation to property acquired by the purchaser in good faith for personal, domestic or household purposes. There are various particularities around this: the purchaser must be paying a fair price; the value of what is acquired does not exceed an amount prescribed by statutory instrument; the property is not a motor vehicle (because the next bullet point explains the specific rules applicable to motor vehicles).
- There is a derogation in respect of motor vehicles which mirrors for Statutory Pledges the rules which already apply to the position of a purchaser who innocently buys a vehicle which is owned by a finance company which has hired it out on a hire purchase agreement. The protection does not apply if the purchaser is in the motor trade but it does extend to anyone who then in turn buys the vehicle from that previous purchaser in the motor trade.
- There are separate rules for acquiring a financial instrument in the ordinary course of trading. Again, as you would expect, the purchaser is protected provided he was in good faith and the acquisition is made in accordance with the rules of the relevant market.
Assignation and Discharge of Statutory Pledge
A Statutory Pledge can be assigned and, if the pledge is already registered, the assignation document must by executed or authenticated by the assignor. The assignation carries with it the benefit of any enforcement procedure already instigated by the assignor. Note also clause 100 of the Bill which allows the assignee to require the Keeper of the Register to amend the details of the pledge in the register. The assignation is not rendered invalid by failing to do this; so, it's a voluntary procedure but compliance with it will obviously make the task simpler for anyone wanting to deal with the holder of the pledge.
A Statutory Pledge can be restricted (so as to limit the property which is subject to it) or discharged by a written statement by the secured creditor. The statement must be evidenced in writing which can be electronic.
Insolvency, Ranking, the Effect of Diligence and Enforcement of Pledge
The main issue on insolvency is of course that the Statutory Pledge ranks as a fixed security and, therefore, is not subject to the problems affecting a floating charge on the insolvency of the provider (where the holder of the floating charge ranks behind the preferred debts, the prescribed part held back for unsecured creditors, and the administrator's expenses).
The other novelty which the introduction of the Statutory Pledge brings about is that it is now possible for more than one creditor to hold such a pledge over the same property and for the multiple pledge-holders thus to be ranked in relation to each other. They rank by priority according to their date of registration, but the creditors can vary this by written agreement, as is the case currently with other forms of security. The agreement is not registrable and only takes effect between or among the parties to it.
How then does the pledge-holder rank in competition with a creditor exercising diligence against, inter alia, the property which is the subject of the pledge? Clause 66 of the Bill explains that the pledge takes priority over diligence executed after the pledge is created. But that priority is restricted to:
- Sums advanced before the execution of the diligence, plus
- Sums required to be advanced after the execution of the diligence by the terms of the contract setting out the terms of the secured obligation.
This is an arrangement familiar in the world of the statutory provisions applicable to standard securities.
The enforcement of a Statutory Pledge is dealt with in a separate article in this series.
Some Thoughts on Interaction with Foreign Laws
It will of course frequently be the case in business lending that the borrower owns property in more than one jurisdiction and creates a purportedly fixed security under another law over all its relevant property which happens to include goods, intellectual property or financial instruments in Scotland or to the transfer of which for some reason Scots law may apply. Is that security effective over the Scottish assets and what will creditors do and what will the Keeper of the Register of Statutory Pledges accept?
There is no doubt that where Scots law is the relevant jurisdiction (see the section explaining this above), registration of the security in the Register of Statutory Pledges will be required. Therefore, the initial stance of the creditor is likely to be to consider taking a pledge over the Scottish property in question. But what if they don't do this and seek to register the foreign security in the Register? And what if the property consists of mobile goods, so there's a chance that at the point of the provider's insolvency the goods are in Scotland, whereas they weren't when that foreign security was taken? And what does the creditor do about existing charges over mobile goods where it already has a charge elsewhere and which could now be the subject of an effective fixed security under Scots law should the goods be in Scotland at that point of insolvency?
While these issues could arise in relation to any jurisdiction, the commonest jurisdiction where they will arise is of course English law. English law recognises two types of fixed security over goods: a fixed charge and a chattel mortgage. The former is simply a type of security; the theory regarding the latter is more complex in that, while in general terms it's simply treated as a security, the legal fiction is that it is a transfer of a property right subject to the borrower having a right to redeem it. So, will creditors now seek to register fixed charges or chattel mortgages in respect of mobile goods in the Scottish Register when taking these as new securities, and will they seek to register such existing securities over mobile goods in the Scottish Register now they can (once the Bill is law and in effect)? Will the Keeper accept them for registration or will the Keeper insist only that a Statutory Pledge calling itself such will be registered?
This is a difficult question and only an answer based on personal analysis can be given - no one knows what the Keeper will do nor whether this will be litigated. The crux of the matter is, as explained above, that the requirements for the creation of a Statutory Pledge are simple. Nowhere does it say you have to call it, or have words which indicate that it is, a Statutory Pledge; all that is required is a "constitutive document". The resulting pledge is a fixed security. My conclusion is that a security created under a foreign law which purports to create a fixed security in the nearest equivalent language of that jurisdiction should be registrable in relation to Scottish property and create a Statutory Pledge on registration provided there is a constitutive document which is executed or authenticated, which identifies the property which is to be the encumbered property and which identifies the secured obligation. Returning to the English law situation then, it is my view that an English fixed charge on goods in Scotland or on mobile goods, which might end up in Scotland, should be registrable. But I'm less certain about chattel mortgages because, though they operate as fixed securities, in English legal theory they're a slightly different type of beast and that, pending judicial clarification, the better counsel will be to take a specific Statutory Pledge over the relevant assets. Of course, for new chattel mortgages, it might be a straightforward matter to include wording that it also creates a Statutory Pledge over goods in Scotland. That though does not help a creditor contemplating registering an existing chattel mortgage in Scotland over mobile goods.
Creditor to Assist Enquiries
Finally, one issue which may irritate creditors - clause 110 of the Bill. An "entitled person" has the right to ask the pledge-holder (as shown in the Register) to provide:
- if the creditor still holds the pledge, a written statement describing the secured obligation and whether or not the property the entitled person asks about is encumbered by the pledge, or
- if the creditor has assigned the pledge, the details of the assignee (or that the creditor has never been the secured creditor).
The creditor has 21 days to comply with the request but may recover costs reasonably incurred in doing so. The creditor is excused from doing so if the requester is not an entitled person, if it's manifest that the pledge is inapplicable, or if the creditor has already responded to a similar request from the same person within the past three months.
One can easily foresee circumstances where a large creditor gets this request to a remote branch and has trouble therefore complying with the timescale.
An "entitled person" is a person who has right to the property specified in the request, or who has or will have the right to do diligence against the property, or who is of a type to be prescribed by statutory instrument and has the consent of the provider to make a request.
If a creditor mistakenly responds that the property is not encumbered by the pledge when in fact it is, the creditor's right to the pledge is extinguished if the entitled person acquires right to the property within three months of the response to the request.
For further information and detailed advice on any of the issues discussed in this article please contact Bruce Wood.
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