LAW ON
CORPORATE
FINANCE
BY
Mr. Haranarayan Mahapatra
B.Com, LL.M., PGDCL & IPR
Former Asst. Prof. At Hidayatullah National Law University,
Naya Raipur, Chhattishgarh
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LAW ON
CORPORATE
FINANCE
BY
Mr. Haranarayan Mahapatra
B.Com, LL.M., PGDCL & IPR Former Asst. Prof. At Hidayatullah National Law University, Naya Raipur, Chhattishgarh
Law on Corporate Finance
Unit-1 Chapter-1 (Meaning, Importance & Scope)
Meaning
Financing is a part of the management activity that deals with planning and controlling the
financial resources of a firm. Financial management is responsible for raising funds and using them in an effective manner.
Finance: Finance is the provision of money when and where it is required. Every business whether big or small needs finance to carry out its operations and achieve its goals. Finance can
be divided into: (1) Public Finance (2) Private Finance
(1) Public Finance: Public finance deals with the requirements, receipts and payments of funds in government institutions, central governments, state governments and local self-governments.
(2) Private Finance: Private finance deals with the requirements, receipts and payments of funds in case of individuals, business organizations and non-profit organizations.
Business Finance can be divided into (1) Sole-Propritory Finance (2) Partnership Firms Finance (3) Company or Corporation Finance.
(2) Deciding the capital structure: Capital structure refers to the combination of different types of
securities for raising finance. After deciding the total amount of finance to be raised, it should be
decided that how much finance should be raised from which type of security. An organization
can raise finance both for the long-term and the short-term.
(3) Selecting a source of finance: After deciding the capital structure, an appropriate source of
finance is selected. Different sources from which finance may be raised include equity shares,
preference shares, debentures, bonds, commercial banks, financial institutions, public deposits
etc. If finance is required for the short-term then public deposits, commercial banks and financial
institutions may be suitable. If finance is required for the long-term then equity shares,
preference shares, debentures and bonds may be suitable.
(4) Selecting a pattern of investment: After raising finance, a decision about the investment
pattern is to be taken. Investment pattern is related to the use of funds like how much to spend on
fixed assets and which assets to purchase, how much to invest and on which project. Investment
should not be made on a risky project even if it gives more profit. Techniques like capital
bugdeting and opportunity cost analysis may be used in making decisions about capital
expenditure.
(5) Proper cash management: Cash management is also an important function of a finance
manager. Cash management relates to management of working capital in order to meet the
operating expenses like payment to creditors, payment of wages, administrative expenses and
other day-to-day expenses. Sources of cash can be cash sales, collection from debtors, cash-
credit, bank overdrafts and other short term arrangements with banks and financial institutions.
Cash management should be done in such a way that cash should neither be in shortage nor in
excess.
(6) Implementing financial controls: Efficient financial management requires the implementation
of proper financial control. Financial control can be properly implemented through tools like
budgetary control, cost control, break-even analysis, ratio analysis, cost-benefit analysis and internal audit.
(7) Proper use of surplus: Proper utilization of profit or surplus is very important. Surplus is
required for growth and expansion of the organization as well as the protection of interests of the
shareholders by way of payment of dividends. Decision should be made as to how much of
surplus to retain in the business for growth and expansion and how much to distribute among the
shareholders as dividend.
Unit-1 Chapter-
Capital Needs
Working Capital: -
Working capital is money available to a company for day-to-day operations. The formula for working capital is: Current Assets - Current Liabilities
How it works/Example:
Here is some balance sheet information about XYZ Company:
Figure 1 Balancesheet for Company XYZ Assets In Rupees Liabilities In Rupees Cash Rs 60,000/- Accounts Payble Rs 30,000/- Marketable Securities Rs 10,000/- Accrued Expenses Rs 20,000/- Account Receivable Rs 40,000/- Notes Payble Rs 05,000/- Inventory Rs. 50,000/- Current Portion Long-Term Debt Rs 10,000/- Total Current Assets Rs.1,60,000/- Total Current Liabilities Rs 65,000/-
Using the working capital formula and the information above from Figure 1, we can calculate that XYZ Company's working capital is: Rs.1,60,000 – Rs. 65,000 = Rs. 95,000.
Why it Matters:
Working capital is a common measure of a company's liquidity, efficiency, and overall health. Because it includes cash, inventory, accounts receivable, accounts payable, the portion of debt due within one year, and other short-term accounts, a company's working capital reflects the results of a host of company activities, including inventory management, debt management, revenue collection, and payments to suppliers.
Positive working capital generally indicates that a company is able to pay off its short-term liabilities almost immediately. Negative working capital generally indicates a company is unable to do so. This is why analysts are sensitive to decreases in working capital; they suggest a company is becoming overleveraged, is struggling to maintain or grow sales, is paying bills too quickly, or is collecting receivables too slowly. Increases in working capital, on the other hand, suggest the opposite. There are several ways to evaluate a company's working capital further, including calculating the inventory-turnover ratio, the receivables ratio, days payable, the current ratio, and the quick ratio.
One of the most significant uses of working capital is inventory. The longer inventory sits on the shelf or in the warehouse, the longer the company's working capital is tied up.
When not managed carefully, businesses can grow themselves out of cash by needing more working capital to fulfill expansion plans than they can generate in their current state. This
Company borrowing
Companies borrow money from a range of sources, including their directors and shareholders, personal contacts, banks, venture capital companies, institutional investors and (PLCs only) through the Stock Exchange.
There are no particular statutory requirements except that charges to secure such borrowing must be registered at Companies House.
Many companies borrow from their directors and shareholders, either formally, perhaps granting them a debenture, or informally, with just book-keeping records, such as a director's loan account. Lending money or assets to the company can be an alternative to putting it in as share capital.
If a private company borrows from its bank, the bank will probably require the directors to give personal guarantees of the debt and, depending on the amount, may want security over the company's assets, or perhaps other property, such as second mortgages on the directors' homes. Security over the company's assets is usually in the form of an 'all-monies' debenture, secured with fixed and floating charges over all the company's assets. Once signed, this will cover all future arrangements the bank makes with the company - overdraft facilities, loans for specific purposes, etc. In most cases, the terms are for repayment on demand, and any default will allow the bank to claim from the directors immediately on default by the company if they have given personal guarantees.
Borrowing from venture capital companies and, sometimes, from other financial institutions, is often part of a larger finance package involving shares and loans.
In most cases of borrowing a debenture is issued. A debenture is the traditional name given to a loan agreement where the borrower is a company.
Unit-1 Chapter-
Objectives Of Corporate Finance
All businesses aim to maximize their profits, minimize their expenses and maximize their market share through corporate finance. Here is a look at each of these goals.
Maximize Profits
A company's most important goal is to make money and keep it. Profit-margin ratios are one way to measure how much money a company squeezes from its total revenue or total sales.
There are three key profit-margin ratios: gross profit margin, operating profit margin and net profit margin.
1. Gross Profit Margin
The gross profit margin tells us the profit a company makes on its cost of sales or cost of goods
sold. In other words, it indicates how efficiently management uses labor and supplies in the
production process. Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales
Suppose that a company has Rs.1 Crore in sales and the cost of its labor and materials amounts to Rs. 600,000/-. Its gross margin rate would be 40% (Rs.1 Crore – Rs. 600,000/Rs. 1 Crore).
The gross profit margin is used to analyze how efficiently a company is using its raw materials,
labor and manufacturing-related fixed assets to generate profits. A higher margin percentage is a
favorable profit indicator.
Gross profit margins can vary drastically from business to business and from industry to
industry. For instance, the airline industry has a gross margin of about 5%, while the software
industry has a gross margin of about 90%.
2. Operating Profit Margin
By comparing earnings before interest and taxes (EBIT) to sales, operating profit margins
show how successful a company's management has been at generating income from the
operation of the business:
Operating Profit Margin = EBIT/Sales
If EBIT amounted to Rs. 200,000 and sales equaled Rs. 1 million (10 lakhs), the operating profit margin would be 20%.
This ratio is a rough measure of the operating leverage a company can achieve in the conduct of
the operational part of its business. It indicates how much EBIT is generated per dollar of sales.
High operating profits can mean the company has effective control of costs, or that sales are
increasing faster than operating costs. Positive and negative trends in this ratio are, for the most
part, directly attributable to management decisions.
Because the operating profit margin accounts for not only costs of materials and labor, but also administration and selling costs, it should be a much smaller figure than the gross margin.
3. Net Profit Margin
Net profit margins are those generated from all phases of a business, including taxes. In other
words, this ratio compares net income with sales. It comes as close as possible to summing up in
a single figure how effectively managers run the business:
Minimize Costs
Companies use cost controls to manage and/or reduce their business expenses. By identifying
and evaluating all of the business's expenses, management can determine whether those costs are
reasonable and affordable. Then, if necessary, they can look for ways to reduce costs through
methods such as cutting back, moving to a less expensive plan or changing service providers.
The cost-control process seeks to manage expenses ranging from phone, internet and utility bills
to employee payroll and outside professional services.
To be profitable, companies must not only earn revenues, but also control costs. If costs are too
high, profit margins will be too low, making it difficult for a company to succeed against its
competitors. In the case of a public company, if costs are too high, the company may find that its
share price is depressed and that it is difficult to attract investors.
When examining whether costs are reasonable or unreasonable, it's important to consider industry standards. Many firms examine their costs during the drafting of their annual budgets.
Maximize Market Share
Market share is calculated by taking a company's sales over a given period and dividing it by the
total sales of its industry over the same period. This metric provides a general idea of a
company's size relative to its market and its competitors. Companies are always looking to
expand their share of the market, in addition to trying to grow the size of the total market by
appealing to larger demographics, lowering prices or through advertising. Market share increases
can allow a company to achieve greater scale in its operations and improve profitability.
The size of a market is always in flux, but the rate of change depends on whether the market is
growing or mature. Market share increases and decreases can be a sign of the relative
competitiveness of the company's products or services. As the total market for a product or
service grows, a company that is maintaining its market share is growing revenues at the same
rate as the total market. A company that is growing its market share will be growing its revenues
faster than its competitors. Technology companies often operate in a growth market, while
consumer goods companies generally operate in a mature market.
New companies that are starting from scratch can experience fast gains in market share. Once a
company achieves a large market share, however, it will have a more difficult time growing its
sales because there aren't as many potential customers available.
Unit-
Creaditor’s Protection
Creditor protection is a collective term that is used in two different ways. One common use has to do with the various resources that provide debtors with an equitable amount of protection from creditors in the event that the debtor is unable to pay off an existing obligation according to the terms and conditions related to the transaction. The other application of this term has to do with the protection of creditors, in terms of limiting the loss incurred when a debtor defaults on an outstanding debt.
When creditor protection is used to describe laws, procedures, or regulations that are aimed at protecting the debtor from action by the creditor, the term usually refers to prohibitions that keep the creditor from acquiring all the debtor’s financial assets. The idea is to make sure the debtor does retain control of enough income and assets to live what is considered to be a basic standard of living. This prevents the debtor from becoming dependent on the local government for necessities such as food, clothing, and shelter.
For example, if a debtor should default on a bank loan, the bank has the right to sue for recovery of the outstanding balance. If the creditor is awarded a judgement, then the court will order that funds be withheld from the debtor’s wages in order to settle the debt. Rather than withhold the entire sum of wages each pay period, creditor protection statutes will bind the court to determining the percentage of income that will be withheld and forwarded each pay period to the creditor, until the debt is discharged in full. As a result, the debtor is still left with enough money to cover his or her basic expenses.
In terms of offering protection to creditors, there are also laws and procedures that provide lenders and other types of creditors with courses of action in the event that a debtor cannot or will not honor an outstanding debt. Creditor protection of this type acts to help the creditor maintain his or her business, and not cause any injury to other clients who would be hurt financially if the creditor had to cease operations. At the same time, this type of protection makes sure the creditor is not damaged financially because of the debtor’s default.
There are different forms of protection to creditors. In some cases, life insurance creditor protection provides the creditor with coverage that can be used in the event a debtor should die before the total debt is repaid. This type of insurance creditor protection actually serves the interests of both the creditor and the heirs of the deceased, in that the outstanding debt is settled in full by the insurance provider and does not touch the assets of the debtor.
When Creaditor’s finance farms, they typically obtain certain rights or powers that are generally protected through the enforcement of regulations and laws. Some of these rights include disclosure and accounting rules, which provide investors with the information they need to exercise other rights. Protected shareholder rights include those to receive dividends on pro- rata terms, to vote for directors, to participate in shareholders' meetings, to subscribe to new issues of securities on the same terms as the insiders, to sue directors or the majority for suspected expropriation, to call extraordinary shareholders' meetings, etc. Laws protecting creditors largely deal with bankruptcy and reorganization procedures, and include measures that enable creditors to repossess collateral, to protect their seniority, and to make it harder for "rms to seek court protection in reorganization.
mens rea, it should not be held criminally liable. Another major defence used against holding
corporations criminally liable is, a corporation is a separate legal personality and limited liability
of its shareholders. Courts in India and several other jurisdiction have therefore, rightly assumed
the power to identify certain compelling circumstances, when it can pierce the veil and disregard
corporate form to impose criminal liability on the promoters, directors, members, or employees
of the company. Although, we observe a greater tendency of the courts to adhere to the limited
liability principle in general, the courts have never been reluctant to pierce the veil whenever a
company is found to be involved in any form of criminal or illicit activities.
As regards the element of mens rea , courts have widely used the „identification doctrine‟ to fasten the liability on corporations. The doctrine is a legal fiction in which courts try to identify
“the actions of the "directing mind" of the corporation and merges individual and corporate
persons in order to assign criminal liability to the latter.” With the most recent cases of Vodafone
International Holdings and Ram Saroop Gupta v. Major Sp Marwah, the principle still holds the ground to find the true identity of the company.
LEGAL STANDARDS FOR PIERCING THE CORPORATE VEIL UNDER ALTER
EGO DOCTRINE
The present standards for piercing the corporate veil, is still in its formative stage. Courts in India have, therefore, rightly given it the appellation of „changing concept, expanding its horizon‟.
One key attribute of these standards is that they have always been very fact-specific. The fixing of liability differs only in degree, but not in kind. Therefore, it becomes very difficult to make sweeping generalizations about the standards courts can use to fix criminal liability on corporates. Despite that, judges have used their wide discretion in this regard to apply certain well accepted legal principles to impose criminal liability on corporates.
Conventionally, most piercing cases in the past relied upon the alter ego theory. The origin of
this theory can be traced back to the Texas Supreme Court‟s description of veil piercing in the
following words - “under the alter ego theory, courts disregard the corporate entity when there
exists such unity between the corporation and individual that the corporation ceases to be
separate and when holding only the corporation liable would promote injustice.” What the courts
exactly look into in such cases is, the actual dealings and close nexus between the shareholder
and the corporation. The other indicator often used by the courts is “Sham to Perpetrate a Fraud.”
One of the earliest cases which recognised this as a ground for piercing the corporate veil was
Castleberry v. Branscum. The Court had observed that the veil can be pierced if “recognizing the
separate corporate existence would bring about an inequitable result.” In such cases, what the
courts actually look into is constructive fraud. Another important principle is the single business
enterprise theory which, allows a claimant to trace the assets of one or more affiliates of a
company, to satisfy the liability of the corporation on the basis that, the corporation and its
affiliates “integrated their assets to achieve a common business purpose.” Here, the prime
consideration is, whether or not two corporations in question operated as a single business
enterprise to commit the default.
To sum up, the veil can be pierced in all cases depending upon factors like, relevant statutory or other provisions, object sought to be achieved, impugned conduct, involvement of public
interest, and the interest of the affected parties.
RELEVANT CASES WHEN THE VEIL WAS PIERCED TO IMPOSE CRIMINAL
LIABILITY ON CORPORATES
Applying the principles mentioned above, courts in the past have pierced the corporate veil to tax underlying assets of a company in cases of fraud, sham, tax avoidance, etc. Earlier this year, the
Vodafone International Holdings v. Union of India , presented a case of misuse of the corporate structure to evade taxes. The apex court in this case observed that – “Once the transaction is shown to be fraudulent, sham, circuitous or a device designed to defeat the interests of the shareholders, investors, parties to the contract and also for tax evasion, the Court can always lift the corporate veil and examine the substance of the transaction.” The Court, in this case, accordingly held that the Income Tax Office was entitled to pierce the corporate veil in India to see whether or not a company was a resident of Mauritius and if it was paying income tax in Mauritius or not. Commissioner of Income Tax v. Sri Meenakshi Mills Ltd., Madurai , is another case in which the Court observed that the veil can be lifted to look into the economic realities behind the legal facade. Similarly, in Life Insurance Corporation of India v. Escorts Limited and Others , the Court pointed out four key instances when the veil can be pierced – (a) where a statute itself contemplates lifting of the veil;
(b) where there is a fraud or improper conduct intended to be prevented;
(c) where a taxing statute or a beneficial statute is sought to be evaded, or
(d) where associated companies are inextricably as to be, in reality part of one concern.
In India, Section 542 of The Companies Act, 1960 presents viable scope for piercing the veil to
impose criminal liability for any kind of fraudulent conduct of business making the defaulter
personally liable for the wrong, without any limitation of liability. The Court in one of the oldest
cases, Shri Ambica Mills Ltd., Re, pointed out that in cases of criminal acts of fraud by officers of
a company, the court can pierce the veil to reach the substance of the matter. Another important
case which came up this year is VTB Capital v. Nutritek in which dispute arose out of a
fraudulently obtained loan. The Court of Appeal, in this case made two important observations.
First, it said - “lifting the corporate veil” does not ignore the existence of the company, but
allows the court to provide a remedy that would otherwise be available only against the company
(as opposed to the controller or vice versa). Secondly, it said that there is no requirement that the
corporate veil can be lifted only when there is no other remedy available.
(ii) Liability Arising From Agency: -
The law of agency is an area of commercial law dealing with a set of contractual, quasi-contractual and non- contractual fiduciary relationships that involve a person, called the agent , that is authorized to act on behalf of another (called the principal ) to create legal relations with a third party. Succinctly, it may be referred to as the equal relationship between a principal and an agent whereby the principal, expressly or implicitly, authorizes
Implied actual authority, also called "usual authority", is authority an agent has by virtue of being reasonably
necessary to carry out his express authority. As such, it can be inferred by virtue of a position held by an agent.
For example, partners have authority to bind the other partners in the firm, their liability being joint and
several, and in a corporation, all executives and senior employees with decision-making authority by virtue of
their position have authority to bind the corporation.( Hely-Hutchinson v Brayhead Ltd [1968] 1 QB 549)
Apparent authority
Apparent authority (also called "ostensible authority") exists where the principal's words or conduct would
lead a reasonable person in the third party's position to believe that the agent was authorized to act, even if the
principal and the purported agent had never discussed such a relationship. For example, where one person
appoints a person to a position which carries with it agency-like powers, those who know of the appointment
are entitled to assume that there is apparent authority to do the things ordinarily entrusted to one occupying
such a position. If a principal creates the impression that an agent is authorized but there is no actual authority,
third parties are protected so long as they have acted reasonably. This is sometimes termed "agency by
estoppel " or the "doctrine of holding out", where the principal will be estopped from denying the grant of
authority if third parties have changed their positions to their detriment in reliance on the representations made.
In Rama Corporation Ltd v Proved Tin and General Investments Ltd [1952] 2 QB 147, said Slade J,
"Ostensible or apparent authority... is merely a form of estoppel, indeed, it has been termed agency by estoppel
and you cannot call in aid an estoppel unless you have three ingredients: (i) a representation, (ii) reliance on
the representation, and (iii) an alteration of your position resulting from such reliance."
Another case: Freeman & Lockyer v Buckhurst Park Properties (Mangal) Ltd [1964] 2 QB 480
Liability
Liability of agent to third party
If the agent has actual or apparent authority, the agent will not be liable for acts performed within the scope of
such authority, so long as the relationship of the agency and the identity of the principal have been disclosed.
When the agency is undisclosed or partially disclosed, however, both the agent and the principal are liable.
Where the principal is not bound because the agent has no actual or apparent authority, the purported agent is
liable to the third party for breach of the implied warranty of authority.
Liability of agent to principal
If the agent has acted without actual authority, but the principal is nevertheless bound because the agent had apparent authority, the agent is liable to indemnify the principal for any resulting loss or damage.
Liability of principal to agent
If the agent has acted within the scope of the actual authority given, the principal must indemnify the agent for
payments made during the course of the relationship whether the expenditure was expressly authorized or
merely necessary in promoting the principal's business.
(iii) Liability predicted under Tort theory: -
When a creditor provides specific assistance to a debtor or assumes control over a debtor's operations, whether directly or by suggesting a third person, and a debtor relies on the creditor, the creditor may risk being held liable for failing to perform such assumed duties with reasonable care. However, a number of questions arise. What is the scope of the duty? Recognizing the social efficacy of bona fide creditor efforts to assist a struggling business, will the courts adopt an exception to the rule or attempt to maintain an incentive for creditors to provide such assistance by adopting a gross negligence or recklessness test? Should courts do so? How will performance of the duty be measured? Presumably, under the doctrine of contributory negligence, the debtor will be required to object to or not carry out actions which he believes are improper. Will courts stretch the concept of foreseeability to third parties such as other creditors? These and a multitude of other questions are raised by application of the assumption of duty rule in these types of cases. Such questions have traditionally posed a problem in this area of the law. As Professor Prosser noted, "just when the duty is undertaken, when it ends and what conduct is required, are nowhere clearly defined, and perhaps cannot be.”
The use of tort law theories to expand the liabilities of lenders who choose to exercise substantial control over their debtors was demonstrated by the recent jury verdict in State National Bank of El Paso v. Farah Manufacturing Co. In Farah the plaintiff-debtor alleged that its lenders used a change in the management control clause in their loan agreement with Farah to engage in fraud and duress and to improperly interfere with Farah's business. A variety of improper and selfish interests were ascribed to the lenders. Following a jury trial, a verdict in excess of eighteen million dollars was awarded to Farah. Given the possibility of extensive liability for negligently assisting in a debtor's business, creditors would be well advised to carefully consider taking any such proposed action, or proffering others such as consultants.'
(iv) Liabilities imposed under the Securities Law (Security and Exchange Act) of the Nation: -
While the number of cases that have considered the specific issue of creditor liability as a controlling person under the Securities Acts are relatively few in number, one again sees the potential for liability when creditors become involved in the day-to-day affairs of a borrower in order to protect their loans. Although the courts appeared to appreciate the dilemma confronting the lenders, it refused to dismiss the complaint, thus ensuring substantial costs to defend the litigation at least through discovery and perhaps through trial. The cases provide one easy answer
- simply lending money is insufficient to result in liability as a controlling person. The tough question - how far can a creditor go in taking action to protect its debt remains un-answered. Analogizing to the instrumentality and agency cases, exercising modest veto power over limited financial debtor actions, obtaining necessary financial information, and making limited suggestions about business practices would not render a creditor a control person. If such were
right to have the assets reconveyed (referred to as being a "clog" on the equity of redemption); although the
position has become more relaxed in recent years in relation to sophisticated financial transactions.
References to "true" legal mortgages mean mortgages by the traditional common law method of transfer
subject to a proviso in this manner, and references are usually made in contradistinction to either equitable
mortgages or statutory mortgages. True legal mortgages are relatively rare in modern commerce, outside of
occasionally with respect to shares in companies.
Equitable mortgage
An equitable mortgage can arise in two different ways – either as a legal mortgage which was never perfected
by conveying the underlying assets, or by specifically creating a mortgage as an equitable mortgage. A
mortgage over equitable rights (such as a beneficiary's interests under a trust) will necessarily exist in equity
only in any event.
Under the laws of some jurisdictions, a mere deposit of title documents can give rise to an equitable mortgage. [19] (^) With respect to land this has now been abolished in England, although in many jurisdictions company
shares can still be mortgaged by deposit of share certificates in this manner.
Generally speaking, an equitable mortgage has the same effect as a perfected legal mortgage except in two
respects. Firstly, being an equitable right, it will be extinguished by a bona fide purchaser for value who did
not have notice of the mortgage. Secondly, because the legal title to the mortgaged property is not actually
vested in the secured party, it means that a necessary additional step is imposed in relation to the exercise of
remedies such as foreclosure.
Statutory mortgage
Many jurisdictions permit specific assets to be mortgaged without transferring title to the assets to the
mortgagee. Principally, statutory mortgages relate to land, registered aircraft and registered ships. Generally
speaking, the mortgagee will have the same rights as they would have had under a traditional true legal
mortgage, but the manner of enforcement is usually regulated by the statute.
Equitable charge
A fixed equitable charge confers a right on the secured party to look to (or appropriate) a particular asset in the
event of the debtor's default, which is enforceable by either power of sale or appointment of a receiver. It is
probably the most common form of security taken over assets. Technically, a charge (or a "mere" charge)
cannot include the power to enforce without judicial intervention, as it does not include the transfer of a
property proprietary interest in the charged asset. If a charge includes this right (such as private sale by a
receiver), it is really an equitable mortgage (sometimes called charge by way of mortgage). Since little turns on
this distinction, the term "charge" is often used to include an equitable mortgage.
An equitable charge is also a non-possessory form of security, and the beneficiary of the charge (the chargee) does not need to retain possession of the charged property.
Where security equivalent to a charge is given by a natural person (as opposed to a corporate entity) it is
usually expressed to be a bill of sale, and is regulated under applicable bills of sale legislation. Difficulties with
the Bills of Sale Acts in Ireland, England and Wales have made it virtually impossible for individuals to create
floating charges.
Floating charge
Floating charges are similar in effect to fixed equitable charges once they crystallise (usually upon the
commencement of liquidation proceedings against the chargor), but prior to that they "float" and do not attach
to any of the chargor's assets, and the chargor remains free to deal with or dispose of them. The U.S. equivalent
is the floating lien, which unlike the floating charge, can be given by any kind of debtor, not just corporate
entities.
Pledge
A pledge (also sometimes called a pawn) is a form of possessory security, and accordingly, the assets which
are being pledged need to be physically delivered to the beneficiary of the pledge (the pledgee). Pledges are in
commercial contexts used in trading companies (especially, physically, commodity trading), and are still used
by pawnbrokers, which, contrary to their old world image, remain a regulated credit industry.
The pledgee has a common law power of sale in the event of a default on the secured obligations which arises
if the secured obligations are not satisfied by the agreed time (or, in default of agreement, within a reasonable
period of time). If the power of sale is exercised, then the holder of the pledge must account to the pledgor for
any surplus after payment of the secured obligations.
A pledge does not confer a right to appoint a receiver or foreclose. If the holder of pledge sells or disposes of the pledged assets when not entitled to do so, they may be liable in conversion to the pledgor.
The major flaw with the pledge is that it requires physical possession by the pledgee, which traps a business
pledgor in a paradox. Unless the pledgee literally occupies the same premises as the pledger, the collateral
once transferred is unavailable for the pledgor to operate its business and generate income to repay the
pledgee. Lawyers in many jurisdictions tried to get around this problem with creative devices like conditional
sales and trust receipts (see below) with varying results.
Legal lien
A legal lien, in many common law systems, includes a right to retain physical possession of tangible assets as
security for the underlying obligations. In some jurisdictions it is a form of possessory security, and possession
of the assets must be transferred to (and maintained by) the secured party. In the case of a possessory lien, the
right is purely passive. In the case of a possessory lien, the secured party (the lienor) has no right to sell the
assets - merely a right to refuse to return them until paid. In the United States, a lien can be a non-possessory
security interest.
Many legal liens arise as a matter of law (by common law or by statute). It is possible, however, to create a
legal lien by contract. The courts have confirmed that it is also possible to give the secured party a power of
sale in such a contract, but case law on such a power is limited and it is difficult to know what limitations and
duties would be imposed on the exercise of such a power.