01 Feb 2013

Secured creditor receives proceeds of preference actions after outdoor furniture retailer collapses

by Paul James, Nick Poole, David Fagan

The position now seems to be tilted in favour of secured creditors but only where there has been (and to the extent of) a prior payment of employee entitlements from floating charge assets.

A recent decision by Justice Mansfield of the Federal Court reaffirms an earlier decision of Justice Finkelstein which held that a secured creditor was entitled to receive the proceeds of preference actions brought by a liquidator (Re Damilock Pty Ltd (in Liquidation) [2012] FCA 1445).

Damilock Pty Ltd operated “Casual Living”, a South Australian business specialising in the sale of indoor and outdoor furniture. After an unsuccessful expansion into NSW and Victoria, Damilock went into administration and subsequently liquidation.

ANZ was the primary secured creditor to Damilock, holding a fixed and floating charge over Damilock’s assets. After realising claims against guarantors of the debt, there was a shortfall to ANZ of $1.154 million. With the consent of ANZ, employee entitlements in the order of $612,000 were paid out by the liquidators. Unfortunately, Justice Mansfield did not elaborate on the significance of such consent.

After pursuing unfair preference claims against creditors from the period leading up to Damilock’s insolvency, realising available company assets and paying necessary legal fees, the liquidators held a further sum of $342,000. Unsecured creditors were owed approximately $17 million, and the liquidators estimated that unsecured creditors could receive at best a dividend up to two cents in the dollar.

The liquidators sought directions from the Court pursuant to section 511 of the Corporations Act 2001 (Cth) on whether to give unsecured creditors that small dividend or otherwise give the amount raised to ANZ as secured creditor. Justice Mansfield found that the facts were “on all fours” with those in Cook v Italiano Family Fruit Company Pty Ltd (in Liquidation) (2010) 276 ALR 349 (Cook).

In an almost identical scenario but for the fact that the liquidators of Italiano Family Fruit Company Pty Ltd (in Liquidation) (Italiano) did not seek the consent of the secured creditor prior to paying out employee entitlements, Justice Finkelstein in Cook held that the bank, as primary secured creditor, had a claim for breach of trust against liquidators.

This was because section 561 of the Act only allows employee claims to be paid where the company’s property ‘is insufficient to meet payment of’ employee claims. The result of the preference claims was that Italiano’s property was in fact sufficient to pay the employee claims.

Justice Finkelstein decided that meant a statutory precondition to the employees’ payment had not been met, and as a result the liquidators had misapplied the property which they held on trust for the bank.

Drawing on this reasoning, Justice Mansfield in the Damilock case ordered that the funds should be applied to ANZ as primary secured creditor. Curiously, Justice Mansfield did not consider it necessary to differentiate between Italiano and the Damilock case and rationalise how the breach of trust argument applied to the Damilock case in circumstances where ANZ provided its consent to the payment.

One can assume Justice Mansfield relied upon Justice Finkelstein’s reasoning that, inter alia, a secured creditor that gives its informed consent to the liquidator (so that employee entitlements can be paid) can be later subrogated to the claims of the employees if sufficient funds are realised from preference claims or other realisations.

Prior to these two decisions the position was far from clear. As noted by Justice Finkelstein in Cook:

"it has been accepted that money recovered in preference actions that can only be brought by a liquidator are not caught by a charge over the company’s current and future assets. The basis for this seems to be that because the chargee cannot sue to recover the preference it is not entitled to benefit from the liquidator’s ability to get in the property. Whether this acceptance is warranted requires investigation."

Thus, conventional wisdom, particularly from a practical perspective, was to treat any recoveries from preference claims as an asset that was not subject to a secured creditors’ charge. Such property, therefore, was available to be distributed to all creditors. For right or for wrong, the position now seems to be tilted in favour of secured creditors but only where there has been (and to the extent of) a prior payment of employee entitlements from floating charge assets.

What is not clear, however, is whether or not the prior consent of a secured creditor (as was the case in Damilock) will be required in order for secured creditors to obtain the benefit of preference actions or whether or not the breach of trust argument (as per Justice Finkelstein in Italiano) is the better view. Further, are liquidators required to withhold payments that would otherwise be made pursuant to section 561 of the Act until all possible realisations are known? Whatever the case, understandably, this creates significant practical difficulties for liquidators.

On the whole, the position is still not settled and it is impractical for liquidators to seek directions every time. What is required, for greater certainty, is legislative intervention clarifying the position so that parties may adjust their expectations accordingly.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.