December 2010

One task of a company liquidator is to distribute the company’s assets to its creditors. In general terms, all creditors are entitled to share in the proceeds realised from those assets, with their entitlement being proportional to their respective claims against the company.

Notwithstanding that underlying principle of equality, some creditors are ‘more equal’ than others.

The Corporations Act 2001 (Cth) (“the Corporations Act”) bestows various priorities upon certain classes of creditors, e.g. employees, for public policy reasons. Another class of priority creditors are those who have been granted a security by the company – they may be able to recoup amounts owed to them in priority to almost all other persons.

The most common form of security obtained over a company is a ‘charge’. Charges can be ‘fixed’ or ‘floating’ (or both) in nature, and can be granted over part or all of the assets of a company.

When considering taking a charge over a company, a creditor is well advised to review the operation of a number of sections of the Corporations Act which can have a significant impact on the priority afforded to a charge holder.

‘Relevant Persons’ and Enforcement within 6 Months (s267)

It is fairly commonplace in the SME[1] environment for a director or shareholder, or a person related to one of them, to provide finance to a company. Generally speaking, these funders are as entitled as any third party to be granted a charge over the assets and undertakings of a company securing amounts which are owed to them.

However, s267 of the Corporations Act states that a charge granted in favour of a ‘relevant person’ (defined in s267(7) as a person who is at the time of the creation of the charge, or has been within the six months prior to the creation of the charge, an officer of the company[2], or is a person associated with such a person) is, and is taken to have always been, void if a step is taken in enforcement of the charge within six months of its creation.

The phrase ‘step in enforcement’ is interpreted broadly by the Court, such that essentially any action relying upon the charge that is taken by the charge holder to recover the amount owed to them constitutes a step in enforcement of the charge. Thus, rights which arise as a consequence of the terms of a charge, commonly including the charge holder’s entitlement to take possession of assets or to appoint a receiver to the company, will, if undertaken within the stipulated period, be steps in breach of s267, automatically rendering the charge void.

A secured creditor is entitled to seek leave from the Court to enforce its charge, but must do so before it takes any step in enforcement of its charge[3]. In order to obtain leave, the charge holder must satisfy the Court that the company was solvent immediately after the charge was created and that it is just and equitable for the Court to grant leave.

The Court has confirmed that a limited number of actions by a charge holder do not constitute a step in enforcement for the purposes of s267. Perhaps the most practically relevant of these is the power under s436C of the Corporations Act for a charge holder to appoint a Voluntary Administrator, which has been held not to constitute a step in enforcement[4].

It is important to recognise that not all charge holders will be entitled to make such an appointment, as s436C requires that, in order to appoint a Voluntary Administrator, a charge holder must first be satisfied that the charge:

• is held over all, or substantially the whole, of the company’s property; and
• has become enforceable, and is still enforceable at the time of the appointment[5].

Charges which are void against an Administrator or Liquidator

The Requirement for Registration (s266)

Most charges held over a company’s assets are required to be registered with the Australian Securities and Investments Commission before they can be enforced against a liquidator or administrator of the company. Without such registration, they are effectively rendered useless and the creditor is placed back into the position of an ordinary unsecured creditor. 

The major class of asset which falls outside this requirement for registration is real property. Whilst a charge over real property does not need to be registered under the Corporations Act, it is strongly recommended that any security which is held over real property be registered (both as a charge and in accordance with the requirements of the Real Property Act 1900 (NSW)) in order to ensure that the claim over that asset does not lose priority to any subsequent registered securities.

Whilst s266 requires registration of a charge within a specific time period (usually within 45 days of its creation), non-registration within that time does not automatically invalidate the charge. As long as the charge is registered at least 6 months before the appointment of an external administrator, even if it was registered outside the requisite time for registration, it may still be enforceable as against that external administrator or liquidator.

Floating Charges (s588FJ)

Another common circumstance in the SME environment is where the funds secured by a charge were provided to the company at some time(s) prior to the granting of the charge – this is known as ‘prior consideration’. Whilst this in itself is not enough to affect the validity of the charge, a liquidation of the company can dramatically change that position in circumstances where the granting of such a charge gives the charge holder an advantage over other creditors of the company.

Section 588FJ of the Corporations Act is intended to prevent an unfair advantage being obtained by one creditor at the expenses of others. Pursuant to this section, a charge which secures prior consideration is void as against the liquidator of a company if:

• the company is being wound up pursuant to an order of the Court[6];
• the charge was created within 6 months prior to the commencement of the liquidation; and
• the company was insolvent immediately after the charge is created.

If the charge secures prior consideration as well as amounts that were advanced at the time of the creation of the charge, or after the charge was created (known as present and future consideration), the amounts of any present or future consideration generally remain recoverable under the charge as against the liquidator.  

Section 588FJ also provides that a charge created in circumstances where present or future consideration is advanced to a company in order to:

• pay out an unsecured debt owed to that creditor, or an entity related to it (effectively swapping an unsecured debt with secured debt); or
• pay for property or services supplied to the company which amounts are in excess of the market value of that property or service;

is void (see ss588FJ(4) and (5)).

Voidable Transaction (ss588FA, 588FB and 588FDA)

Even if a charge holder is entitled to maintain its priority in the face of ss266, 267 and 588FJ of the Corporations Act, their charge can still be vulnerable to attack by a liquidator in circumstances where it may be voidable as against the liquidator because it can be characterised as:

• an insolvent transaction in the form of an uncommercial transaction, i.e. the granting of the charge may constitute a bargain of such magnitude that it cannot be explained by normal commercial circumstances[7]; or
• an unreasonable director-related transaction – similar principles apply as regards uncommercial transactions, but there is no requirement to prove that the company was insolvent at the time of the transaction, or became insolvent as a consequence of it.

Conclusion

When considering charges it is recommended that particular care is taken to examine its registration status, the type of consideration secured, the relationships of the parties to it, the solvency of the company at the time of the granting of the charge and whether there is a reasonable commercial basis for it being granted.

As seen above, just because a creditor is granted a charge does not automatically entitle that creditor to a priority claim on the assets of the company in all circumstances. Creditors therefore should carefully consider the actual level of priority which they will obtain by taking a charge over a company lest they end up without any priority, thereby joining the ranks of the ordinary unsecured creditors.

Conversely, external administrators of companies are recommended to carefully consider all of the facts and circumstances associated with the granting of charges to creditors of a company – it may be that a claim for priority under a charge cannot be upheld in the context of the liquidation of the company, significantly affecting the position of other creditors.

O’Neill Partners – Commercial Lawyers has a range of experience and expertise in dealing with the requirements associated with charges over company assets. We can assist you to ensure that any charge is, as far as possible, validly implemented, as well as advising and assessing whether a charge may be void or voidable and how best to enforce, or challenge, such a charge.

This article has been prepared by Colin Brown, a member of our insolvency litigation team, and we invite you to contact either Colin or our Chairman and senior partner, Michael O’Neill, for further information about the matters discussed.

The contents of this article are intended to provide only a general summary on matters of interest and are not comprehensive, nor does this article constitute legal advice.  You should seek legal or other professional advice before acting or relying on any of the content of this article.

© O’Neill Partners – Commercial Lawyers, 2010