Now you're secured, now you're not

In certain circumstances, an 'unfair preference' may be a 'voidable transaction' for the purposes of s 588FE of the Corporations Act 2001 (Cth) (Act). The requirements of an unfair preference are contained in s 588FA. One requirement is that the creditor receives a preference 'in respect of an unsecured debt'.

In light of this requirement, how does s 588FA apply if a partial payment of a debt is made where that debt is secured at the time of the payment, but later becomes unsecured due to a provision of the Act or the Personal Property Securities Act 2009 (Cth) (PPSA)?

Section 588FA is as follows:

(1)   A transaction is an unfair preference given by a company to a creditor of the company if, and only if:

…

(b)   the transaction results in the creditor receiving from the company, in respect of an unsecured debt that the company owes to the creditor, more than the creditor would receive from the company in respect of the debt if the transaction were set aside and the creditor were to prove for the debt in a winding up of the company …

(2)   For the purposes of subsection (1), a secured debt is taken to be unsecured to the extent of so much of it (if any) as is not reflected in the value of the security.

       … [underlining added]

Based on the text of s 588FA(1)(b), it is arguable that the partial payment of a secured debt, which is later rendered unsecured, is not 'in respect of an unsecured debt' because the debt was secured at the time of the payment. Admittedly, the debt became unsecured at a later date but it is unclear whether this makes any difference. This article addresses this uncertainty.

Although there is no case law addressing how s 588FA operates in these circumstances, this article will illustrate that there is a good argument that such payments may be unfair preferences.^[1]

How can a secured debt become unsecured?

A secured debt can become unsecured at the choosing of the creditor by the creditor either proving as an unsecured creditor or voting in respect of their entire debt.^[2] However, this article will focus on a secured debt becoming unsecured against the choosing of the creditor. This can happen in four ways under the Act and PPSA:

1. Section 267 of the PPSA causes certain security interests to 'vest' in the company if unperfected.
2. Section 588FL of the Act causes certain security interests to 'vest' in the company if they are not registered within certain time limits.
3. Section 588FP of the Act may render certain security interests ‘void, and … taken always to have been void’.
4. Section 588FJ may render a circulating security interest ‘void, as against the company’s liquidator’.

Hence, these four legislative provisions affect a security interest in three different ways: the security interest may (i) ‘vest’, (ii) become ‘void, and … taken always to have been void’ or (iii) become ‘void, as against the company’s liquidator’. We must consider how s 588FA operates when a security interest is affected in each of these three ways.

s 588FL of the Act and s 267 of the PPSA: the security interest ‘vests’

The concept of 'vesting' is significant to s 267 of the PPSA and s 588FL of the Act. Case law indicates that the 'practical effect' of a security interest vesting under s 267 is that it is 'extinguished'.^[3] For s 588FL, case law indicates that the vesting of a security interest will result in the secured creditor losing the benefit of their security to creditors generally^[4] and the extinguishment of their property interest.^[5]

In light of these matters, it is submitted that a security interest that 'vests', in the context of ss 267 and 588FL, is extinguished.^[6]

So how does s 588FA operate if a security interest is extinguished? Sub-section 588FA(2) deems a secured debt to be unsecured for the purposes of s 588FA(1) ‘to the extent of so much of it (if any) as is not reflected in the value of the security.’ If a security interest is extinguished, the value of the security is nil and none of the debt is reflected in the value of the security.

In that case, s 588FA(2) deems the debt to be entirely unsecured for the purposes of s 588FA(1) and the requirement that the transaction be ‘in respect of an unsecured debt’ is fulfilled.

This argument assumes that the time for assessing the ‘value of the security’ is the time of the winding up and not the time of the impugned payment.

This assumption has been confirmed by the recent District Court of South Australia decision of Matthews v The Tap Inn Pty Ltd.^[7] Chivell J noted that the time for assessing whether a creditor has received a preference, for the purposes of s 588FA(1), is the time of the winding up.^[8] Since s 588FA(2) is ‘For the purposes of subsection (1)’, his Honour concluded that the time for assessing the ‘value of the security’ for s 588FA(2) should also be the time of the winding up.^[9]

Whether the above argument is correct is a matter of statutory interpretation. There appears to be no case that has considered this argument.^[10] Hence, we should apply the principles of statutory interpretation to determine its cogency.

When interpreting a statutory provision, one must consider the text of the provision within the context of the statute,^[11] the provision’s legislative history including relevant extrinsic materials^[12] and the 'general purpose and policy of … [the] provision, in particular the mischief it is seeking to remedy'.^[13] The text of s 588FA has been considered above, so let’s now turn to its legislative history and purpose.

Two aspects of the legislative history of s 588FA are worth noting; first, the provisions that preceded s 588FA. Prior to s 588FA, s 565 of the Corporations Law applied the antecedent transaction provisions of the Bankruptcy Act 1966 (Cth) to company liquidation. One of these provisions was s 122, which dealt with preferences in personal insolvency. Neither s 565 of the Act nor s 122 of the Bankrutpcy Act required a preference to be 'in respect of an unsecured debt'.

For this reason, neither ss 565 or 122 would prevent a partial payment in respect of a secured debt, which later becomes unsecured, from being an unfair preference. This raises the question of whether s 588FA was intended to alter the substance of the previous regime or simply embody it in one piece of legislation so that references do not have to be made between the Act and the Bankruptcy Act.

Several cases have indicated that s 588FA was not intended to significantly depart from the previous regime.^[14] Although none of these decisions dealt with the present scenario, the fact they say that s 588FA was not intended to significantly depart from what constituted an unfair preference under the previous regime suggests that a partial payment of a secured debt, which later becomes unsecured, may be an unfair preference.

The second aspect of the legislative history of s 588FA that is worth noting is its passage through Parliament. Section 588FA was introduced into Parliament by the Corporations Law Reform Bill 1992 (Bill). The version of s 588FA, as contained in the Bill that was first introduced into Parliament, was different to the version that currently exists in the Act.

The original version in the Bill made no reference to secured or unsecured debts and did not contain s 588FA(2). The potentially problematic words, ‘in respect of an unsecured debt’, instead read ‘in respect of a debt’. For this reason, the original version would not have prevented the partial payment of a secured debt, which later becomes unsecured, from being an unfair preference.

The words 'in respect of an unsecured debt' were substituted into s 588FA(1)(b) by the Senate as 'minor technical amendments'.^[15] The Senate added what would become s 588FA(2) for the same reasons. The fact that the introduction of the phrase ‘in respect of an unsecured debt’ was merely ‘technical’ and 'minor' suggests that it was not intended to substantially change the version of s 588FA that was originally introduced into Parliament.

Let’s now turn to the purpose of s 588FA. The purpose of s 588FA is to prevent a creditor obtaining an advantage over other creditors and hence upsetting the principal of equal distribution. This purpose can be discerned from three sources.

First, the text of s 588FA(1)(b) specifically targets transactions that result in a creditor receiving more than if the transaction were set aside and the creditor were made to prove for their debt in the winding up.

Secondly, the explanatory memorandum for the Bill states that the purpose of the provisions concerning voidable transactions is to ‘ensure that unsecured creditors are not prejudiced by the disposition of assets or the incurring of liabilities … which would have the effect of favouring certain creditors or other persons’.^[16] The explanatory memorandum also states that an 'unfair preference means a transaction that gives a company's creditor an advantage over the company's other creditors.'^[17]

Thirdly, case law has acknowledged the purpose of the unfair preference provisions. In G & M Aldridge Pty Ltd v Walsh,^[18] the High Court said that a 'primary objective' of the preference provisions is 'securing equality of distribution amongst creditors of the same class.'^[19]

It is consistent with the purpose of s 588FA for a payment in respect of a secured debt, which later becomes unsecured, to be set aside as an unfair preference. Once a secured creditor loses their security, they are in the 'same class'^[20] as unsecured creditors. Then allowing the creditor to retain a payment, which another creditor of the 'same class' could not retain, is granting them an advantage. For this reason, the policy of s 588FA supports the payment being treated as an unfair preference.

In light of the above matters, the text, legislative history and purpose behind s 588FA support the argument that a partial payment of a secured debt, which later becomes unsecured due to s 588FL or s 267, may be an unfair preference.

s 588FP: the security interest is always taken to have been void

Section 588FP may render a security interest to have always been void. Hence, regardless of when the partial payment occurred, the security interest must have been void and the transaction was accordingly ‘in respect of an unsecured debt’. For this reason, a partial payment of a secured debt, which is later rendered unsecured by s 588FP, may be an unfair preference.

s 588FJ: the security interest is void against the liquidator

Section 588FJ may render a circulating security interest void as against the liquidator. The Queensland Court of Appeal considered a similarly-worded provision to s 588FJ in the case of Bradnam's Windows and Doors Pty Ltd v Offermans (Bradnam).^[21] In Bradnam, a secured creditor received several payments prior to the winding up commencing. The creditor's charge then became void against the liquidator under the now-repealed s 266 of the Act as it had not been registered.

The creditor sought to defend a preference claim in respect of the payments on several grounds, including that it was a secured creditor. The District Court of Queensland struck out the creditor's defence on the basis that the charge was void against the liquidator and hence the creditor was unsecured. The Court of Appeal allowed an appeal by the creditor.

Muir JA noted that s 266(1) does not purport to render an unregistered charge void as against the company; rather, it renders it 'void … as against the liquidator'.^[22] His Honour noted that the charge is otherwise implicitly still valid.^[23]

Since ss 588FJ and 266 of the Act both render a security interest void as against the liquidator, Bradnam supports the argument that a payment in respect of a secured debt, which later becomes unsecured due to s 588FJ, may not be an unfair preference because the requirement that it be ‘in respect of an unsecured debt’ has not been fulfilled.

It should be noted that the Court of Appeal in Bradnam considered whether the defence pleaded by the creditor, namely that it was a secured creditor, should be struck out as not disclosing a reasonable defence.^[24]  It did not conclude that the creditor was secured for the purposes of s 588FA and even noted that there were arguments supporting the conclusion it was not secured.^[25]

However, the relevance of Bradnam to s 588FJ may be academic due to s 588FJ(6), which creates a special regime for the recovery of payments made in relation to debts secured by security interests that fall within s 588FJ.

It seems unlikely that a liquidator would choose to pursue a preference claim under s 588FA ahead of s 588FJ(6) since the latter section has several advantages for a liquidator, namely, s 588FJ(6) does not require the liquidator to prove the company was insolvent at the time of the payment and the defence under s 588FG, which applies to a preference claim based on s 588FA, does not apply.

Closing thoughts

A partial payment of a secured debt, which later becomes unsecured due to ss 588FL or 588FP of the Act or s 267 of the PPSA, may be an unfair preference. If the security interest is rendered void against the liquidator due to s 588FJ of the Act, a payment may not be an unfair preference under s 588FA due to the decision of Bradnam. However, the regime established by s 588FJ(6) for setting aside such payments, may still apply.

It is also worth noting one final point. This article has only considered a partial payment of a secured debt and not the complete discharge of the debt. If a secured debt is completely discharged and the security interest comes to an end prior to the time when it would have vested under s 588FL of the Act or s 267 PPSA, had it still been in existence, the debt will have always been secured.

In that case, it appears the requirement that the transaction be ‘in respect of an unsecured debt’ will be unfulfilled. This issue does not arise for ss 588FJ or 588FP. For s 588FJ, the regime created by s 588FJ(6) does not require the payment to be 'in respect of an unsecured debt'.

For s 588FP, that section only renders a security interest void if the secured party purports to take a step to enforce it within a certain timeframe. It is difficult to conceive of a situation where a secured creditor would seek to enforce a security interest if their debt has already been entirely discharged.

This article was originally published in (2015) 27(3) Australian Insolvency Journal 36.  The copyright has been assigned to ARITA.