Priority creditors and circulating security interests: what's a liquidator to do?
By Nicholas Poole and Jonathon McRostie
When determining the order of payments to be made under section 561, a liquidator must first make a reasoned assessment as to the adequacy of the general assets of the company to meet Employee Priority Claims.
Chapter: Priority Creditors

The Corporations Act 2001 sets out a regime for the order in which certain debts and claims are to be paid in priority to unsecured creditors.

That's straightforward enough for a liquidator, right?

Unfortunately, matters are not that straightforward. In effect, there are two priority regimes under the Act for the preferential payments of particular creditors, each of which applies to a different "fund", and we've observed this has led to some liquidators being unsure of how to proceed – or even worse, using funds they should not.

Section 556 establishes a priority regime for the order in which certain debts and claims "must be paid in priority to all other unsecured debts and claims". Specified Employee Priority Claims, including wages, superannuation contributions and superannuation guarantee charges, and retrenchment payments are included in the priority waterfall.

Employee Priority Claims, and claims of those that advance funds to enable payment of Employee Priority Claims, are afforded priority over assets the subject of a circulating security interest by section 561. That priority is contingent on there being insufficient unencumbered assets to meet the Employee Priority Claims.

That means the section 556 regime applies to unsecured assets, while the section 561 regime applies (with respect to Employee Priority Claims) to assets the subject of a circulating security interest (where the unencumbered assets are insufficient to meet the Employee Priority Claims).

While section 556 gives liquidators' costs and expenses priority over Employee Priority Claims, the position under section 561 is unclear: what costs does a liquidator have in priority to Employee Priority Claims from property comprised in or subject to a circulating security interest? Is there even a priority for liquidators at all from that fund?

It appears uncontroversial that if a liquidator wishes to recoup the costs, expenses and remuneration incurred in the care, preservation and realisation of property the subject of a circulating security interest (under the principle in Re Universal Distributing Co Ltd (in liq) (1933) 48 CLR 171), then the liquidator may do so out of the proceeds of the realisation of that property.

But what constraints are placed by section 561 on a liquidator deducting general costs and expenses of the winding up, outside those governed by the lien provided by Universal Distributing, from the assets subject to a circulating security interest ahead of Employee Priority Claims, is left relatively unresolved both by the Act and the cases that have considered section 561. 

So what is a liquidator meant to do?

Understanding the section 561 regime and the liquidator's "assessment"

Section 561 of the Act states:

561         Priority of employees' claims over circulating security interests

So far as the property of a company available for payment of creditors other than secured creditors is insufficient to meet payment of:

(a)     any debt referred to in paragraph 556(1)(e), (g) or (h); and

(b)     any amount that pursuant to subsection 558(3) or (4) is a cost of the winding up, being an amount that, if it had been payable on or before the relevant date, would have been a debt referred to in paragraph 556(1)(e), (g) or (h); and

(c)     any amount in respect of which a right of priority is given by section 560;

payment of that debt or amount must be made in priority over the claims of a secured party in relation to a circulating security interest created by the company and may be made accordingly out of any property comprised in or subject to the circulating security interest.

Section 433 expressly imposes on a receiver the obligation to make similar priority payments to employees from proceeds in their hands before applying the funds to the secured creditor's debt.

While there is limited reported authority, several cases in Australia and the UK have considered section 561, or materially similar legislation, and give some guidance on the tension between the operation of section 561 and a liquidator's obligations (if any) to priority creditors in connection with the funds the subject of a circulating security interest. 

The UK Position

In Buchler v Talbot [2004] UKHL 9 , the UK House of Lords considered section 175 of the Insolvency Act 1986 (UK), (Insolvency Act), part of which is materially similar to section 561 of the Act; and section 115 of the Insolvency Act, which is in materially similar terms to that of section 556.

The House of Lords created much angst within the insolvency profession by holding that a liquidator could not pay out the general costs, expenses and remuneration from the assets subject to a floating charge in priority to the holder of the charge.

The liquidator's position in Buchler relied particularly on section 175(2)(a), which expressed the expenses of the winding up as a priority within the same section as that which granted the priority creditors a priority over the floating charge holder. Lord Nicholls explained that its wording – that the expenses of the winding up are to rank ahead of the preferential debts – was "only to confirm their priority over the preferential debts when these are being paid in the winding up" out of the uncharged assets of the company. Notably, the Insolvency Act was then amended by section 176ZA to give a liquidator's general expenses priority over the priority creditors to the extent the general assets are insufficient.

It is possible that a similar argument could be proffered in Australia. Meaningfully, section 561 of the Act does not contain a similar provision to that of section 175(2)(a) or, meaningfully, the later amendment to the Insolvency Act, so it would seem even less clear how section 561 contemplates a liquidator's priority to costs outside of Universal Distributing.

The Australian approach

Justice McKerracher in Re Saker [2014] FCA 771 had the opportunity to clarify section 561 in practice.

Both the liquidators and the employees laid claim to a sum of money transferred to the liquidators by the receivers, who had since retired. That sum could not meet both the liquidators' and employees' claims, so the issue of which party had priority under section 561 was critical. Here, the court said, the secured party had already been paid out in full, and had no remaining claim over the proceeds of the secured assets, so "subject to satisfying themselves that section 561… has been complied with," the liquidators could use the funds in order of the priorities in section 556.

This reasoning suggests that a liquidator may have recourse to assets the subject of a circulating security interest for the purpose of applying those funds pursuant to the priority in section 556, including in payment of the liquidator's costs and expenses, but that is contingent on the liquidator being satisfied of the compliance with section 561.

The priority afforded to employee claims in section 561 is only available "so far as the property of a company available for the payment of creditors other than secured creditors is insufficient to meet payment" of those claims. It is an approach that presumably informed the liquidators' concession in Kirman v RWE Robinson & Sons Pty Ltd (in liq) [2019] FCA 372 that there was no basis on which remuneration and expenses not falling within Universal Distributing can be paid out of property subject to a circulating security interest (this however did not form part of the ratio of the Court's decision).

So, an assessment must be made as to the sufficiency of the unencumbered assets of the company to meet the claims of priority creditors, before payments either to the holder of the circulating security or the Employee Priority Claims. But when must the liquidator make this assessment, and what factors are relevant for the liquidator to satisfy themselves of compliance with section 561?

Justice Finkelstein considered this question in Cook v Italiano Family Fruit Company Pty Ltd [2010] FCA 1355, stating:

"In my view, there is to be only one assessment of the sufficiency of a company's assets and that is to be when enough is known about the company's affairs. The assessment must take into account all actual and potential realisations… at the very least, the assessment cannot take place until the value of the priority debts payable under s 561 is known, as well as the value of those priority debts which, under s 556, have precedence over debts payable under s 561..."

In some windings up, it may become obvious at an early stage that there will be a deficiency in the company's free assets. In other windings up, it may take much longer. In those cases the controller of the floating charge assets must make adequate provision for the payment of the priority debts before making any payment to the secured creditor."

“ A liquidator must assess the sufficiency of the unencumbered assets of the company to meet the claims of priority creditors, before payments  to either the holder of the circulating security or the Employee Priority Claims – but when?

So, what should a liquidator do?

What is important for these purposes is that when determining the value of the priority debts payable under section 561, a liquidator must first make a reasoned assessment as to the adequacy of the general assets of the company available to meet the Employee Priority Claims and the priority debts under section 556 that rank ahead of those claims. The timing of this assessment will depend largely on the circumstances of the particular liquidation, but any prudent liquidator seeking recourse to circulating assets for his or her remuneration should, at a minimum:

  • consider the assessment of the sufficiency of the "free assets" for the purposes of section 561 (which a liquidator is bound to do by the Act);
  • make one assessment only, and ensure when making that assessment it can stand up to scrutiny; and
  • take detailed records of the decision-making process and reasons and basis for making the relevant assessment, in particular why it is that sufficient information was considered to be available at that time and specifically what that information is.

If the liquidator and/or receiver does not specifically make an assessment, or does it too early in the winding up, he or she might then be exposed to claims by priority creditors or secured creditors (or parties advancing funds and taking the priority under section 560) as persons aggrieved under the Act.