How does s 588FA apply to the granting of a security interest over an unsecured debt?

Introduction

In certain circumstances, an “unfair preference” may be a “voidable transaction” for the purposes of s 588FE of the Corporations Act 2001 (Cth) (the 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”.^[1] In light of this requirement, how does s 588FA apply if a debt changes from unsecured to secured? This question is important to determining whether the grant of a security interest in respect of an existing unsecured debt may constitute an unfair preference.

The view expressed in commentaries and limited case law is that the granting of a security interest over an existing unsecured debt may constitute an unfair preference. This seems instinctively correct since the creditor is obtaining an advantage over other creditors. However, the requirement that a preference be “in respect of an unsecured debt” may present a difficulty. Based on an analysis of the text of s 588FA and the origin and policy of the provision, this article submits that the words “in respect of an unsecured debt” do not prevent the grant of a security interest over an existing unsecured debt from being an unfair preference. However, this result would be clearer if the reference to an “unsecured debt” were removed from s 588FA.

Section 588FA and the dilemma it presents

A security interest may be set aside under various provisions of the Act. For example, it could be set aside as an “uncommercial transaction”^[2] or an “unreasonable director-related transaction”.^[3] It may also be possible to set it aside as an unfair preference.^[4] For an unfair preference to be a voidable transaction under s 588FE, the following requirements must be met:

• The creditor and the debtor company are parties to the transaction.
• The transaction results in the creditor receiving, “in respect of an unsecured debt”, more than the creditor would receive than if the transaction were set aside and the creditor were to prove for the debt in the winding up.
• The transaction occurs within a certain period prior to the “relation-back day”^[5] and while the company is insolvent.^[6] 

This article is only concerned with the requirement of “in respect of an unsecured debt”.^[7] It will assume that all other requirements are fulfilled.

Section 588FA is located in Pt 5.7B of the Act and is one of the primary provisions concerning unfair preferences. Subsections 588FA(1) and 588FA(2) are as follows:

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

(a)      the company and the creditor are parties to the transaction (even if someone else is also a party); and

(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]

Let us consider the situation where a creditor is granted a valid and enforceable security interest and, as a result, will receive more than if the security interest were set aside and the creditor were required to prove in the winding up. The policy underlying the law of unfair preferences, which is discussed further below, suggests that the grant of the security interest should be an unfair preference. However, the words “in respect of an unsecured debt” in s 588FA(1)(b) present a difficulty. Put simply, the creditor has a secured debt so it is arguable that the impugned transaction is not “in respect of an unsecured debt”. This difficulty has been acknowledged by Garry Hamilton in his book, Invalidation of Securities Upon Insolvency, ^[8] which says:

On looking at the provisions of s 588FA(1), one merely sees a reference to a transaction “in respect of an unsecured debt”. In other words, s 588FA arguably does not strike at charges which are preferentially granted by a company.^[9]

The author of this article was able to locate only one decision on point, being the recent decision of Re Ashington Bayswater Pty Ltd (in liq) [2013] NSWSC 1008 (Re Ashington). In that case, Black J found that the grant of a charge over an existing unsecured debt was an unfair preference.^[10] The decision did not analyse whether the requirement of “in respect of an unsecured debt” had been fulfilled. The author was unable to locate any case concluding that s 588FA cannot apply to the grant of a security interest.

Learned commentaries support the view that the granting of a security interest may be an unfair preference, but do not refer to any authority on the point or analyse the words “in respect of an unsecured debt”.^[11]

Whether the requirement of “in respect of an unsecured debt” has been fulfilled is a matter of statutory interpretation. When interpreting a statutory provision, one must consider (i) the provision’s legislative history including relevant extrinsic materials;^[12] (ii) the text of the provision within the context of the statute;^[13] and (iii) the “general purpose and policy of … [the] provision, in particular the mischief it is seeking to remedy”.^[14]

It is submitted that a textual analysis of s 588FA and related provisions is inconclusive as to whether the grant of a security interest may be an unfair preference. However, the legislative history and policy of the provision support the conclusion that it is an unfair preference. These points are expanded upon below.

The legislative history of s 588FA

Although the task of statutory interpretation must begin with the text,^[15] the text must be considered in its context, which includes its legislative history and extrinsic materials.^[16]

Section 588FA was introduced into the Corporations Law on 23 June 1993 by the Corporate Law Reform Act 1993 and was then carried on into the Act. Prior to s 588FA, s 565 of the Corporations Law effectively applied the antecedent transaction provisions of the Bankruptcy Act 1966 (Cth) to company liquidation. Immediately prior to the introduction of s 588FA, s 565(1) of the Corporations Law provided as follows:

A settlement, a conveyance or transfer of property, a charge on property, a payment made, or an obligation incurred, by a company that, if it had been made or incurred by a natural person, would, in the event of his or her becoming a bankrupt, be void against the trustee in the bankruptcy, is, in the event of the company being wound up, void as against the liquidator. (underlining added)

Section 565 has not been repealed but confined to transactions occurring prior to 23 June 1993 while Pt 5.7B applies to transactions occurring on or after that date.^[17] One of the provisions of the Bankruptcy Act that is picked up by s 565 is s 122, which deals with preferences in personal insolvency. As at 23 June 1993 and like s 565, s 122 specifically referred to the granting of “a charge on property” as a preference. Also like s 565, s 122 did not require the preference to be “in respect of an unsecured debt”. Hence, it was clear from the wording of ss 565 and 122 that the granting of a security interest could be a preference under those sections. The High Court decision of Burns v Stapleton (1957) 102 CLR 97 supports this view. The decision concerned s 95(1) of the Bankruptcy Act 1924-1955 (Cth) which was materially the same as s 122 of the Bankruptcy Act as that section stood immediately prior to 23 June 1993. Mr Burns was initially owed £232 10s by Mr Fallon on an unsecured basis. Mr Burns then advanced a further £500 to Mr Fallon and sold him several cows on credit while at the same time taking an equitable mortgage from Mr Fallon to secure all amounts owing. The High Court unanimously concluded that the grant of the equitable mortgage was a preference in respect of the £232 10s since it “converted an unsecured debt into one secured”^[18] but not in respect of the other amounts since Mr Burns was not a creditor of Mr Fallon for those amounts prior to the grant of the mortgage.^[19]

Part 5.7B of the Act was introduced because the regime created by s 565 was considered unsatisfactory. During the Second Reading Speech for the Corporations Law Reform Bill 1992 (Bill), which ultimately became the Corporate Law Reform Act 1993, it was specifically said that it was “not good enough” to address unfair preferences by making “obscure and difficult cross references to the Bankruptcy Act” and that the Bill would create “clear provisions adapted specifically for companies”.^[20]

The Bill implemented several recommendations of the Law Reform Commission report commonly known as the “Harmer Report”.^[21] The Harmer Report is relevant to interpreting s 588FA due to s 15AB(2)(b) of the Acts Interpretation Act 1901 (Cth), which allows reference to be made to relevant reports of the Law Reform Commission when interpreting ambiguous provisions, provided the report was laid before Parliament before the enactment of the provision.^[22] The Harmer Report has also been referred to in case law when interpreting s 588FA.^[23] The Harmer Report recommended that the policy underlying the previous antecedent transaction regime be maintained.^[24] Parliament appears to have acted on this recommendation since the Explanatory Memorandum for the Bill states that Pt 5.7B is “as recommended by the Harmer Report”.^[25] The Harmer Report also stated that “converting the creditor from being unsecured to secured” is “the most obvious of ‘preferences’”.^[26]

The version of s 588FA, as contained in the Bill that was first introduced into Parliament, made no reference to secured or unsecured debts. Instead, the phrase “in respect of an unsecured debt” read “in respect of a debt”. Further, s 588FA(2) was not in that version of the Bill. The words “in respect of an unsecured debt” were substituted into s 588FA(1)(b) by the Senate as “minor technical amendments” and were purportedly made “for the reasons set out in the supplementary explanatory memorandum”.^[27] The Senate added what would become s 588FA(2) for the same reasons. The supplementary Explanatory Memorandum said that these amendments were made to “make it clear that a liquidator may not pursue as a preference a transaction in respect of a secured debt, except to the extent that the security is inadequate to support the transaction”.^[28] This explanation of the Senate’s amendments seems consistent with the policy of preventing a creditor from obtaining an advantage over other creditors. If the value of the secured property only covers part of the creditor’s debt, a payment to the creditor that exceeds the value of the property will be partly preferential while a payment that does not exceed the value will not be. The supplementary Explanatory Memorandum appears to make this point. The supplementary memorandum may appear to suggest that the grant of a security interest itself can never be an unfair preference, because it says that “a liquidator may not pursue as a preference a transaction in respect of a secured debt”. However, it is submitted that this should be read as meaning that a transaction in respect of an already secured debt may not be pursued. It should not be read as preventing a liquidator from pursuing a transaction that converts an unsecured debt into a secured debt. This reading is not only clear from the text but is consistent with the Senate making “minor technical amendments” amendments to the Bill rather than substantive amendments.

The Explanatory Memorandum for the Bill discussed several sections relevant to s 588FA. In relation to the definition of “transaction” that was inserted into s 9, it said the definition adds to the transactions covered by s 122 of the Bankruptcy Act.^[29] As already noted, as at 23 June 1993, s 122 specifically referred to the granting of a charge.

What can we draw from the above legislative history? First, the Harmer Report did not recommend the alteration of the policy behind the previous antecedent transaction regime and considered the conversion of an unsecured debt to a secured debt to be an obvious example of a preference. Parliament appears to have acted upon this recommendation in the Harmer Report. Secondly, the previous unfair preference regime clearly extended to the granting of a charge. Thirdly, the statement in the Explanatory Memorandum regarding the definition of “transaction” suggests that s 588FA was intended to apply to the granting of a charge. Finally, the supplementary explanatory memorandum indicates that the phrase “in respect of an unsecured debt” was not intended to alter the substance of the version of s 588FA that was introduced to Parliament; for example, by excluding the grant of a security interest from the reach of the section.

As noted, the previous unfair preference regime clearly applied to the granting of a charge, and the Explanatory Memorandum indicates that the Bill did not intend to change the policy of the previous regime. However, the excerpts of the Second Reading Speech noted above suggest that the current regime was intended to make a clean break from its predecessor. This creates some tension. Fortunately, guidance can be drawn from cases which address the relevance of the previous regime to the current regime. We will now turn to these cases.

In the Victorian Court of Appeal decision of V R Dye & Co v Peninsula Hotels Pty Ltd (in liq) [1999] 3 VR 201 (V R Dye & Co),^[30] Ormiston JA said:

The provisions of the Corporations Law now relevant, introduced by the Corporate Law Reform Act 1992 (Cth), are differently expressed from those previously incorporated from the Bankruptcy Act. However, so far as one can gather, they were not intended to make any significantly different provision for identifying what is an unfair preference, except in a few minor respects and except in so far as the sections now appear in the Corporations Law itself.^[31] [emphasis added]

His Honour then said more definitively:

it is clear that no change was intended to be made to the nature of a preference under the new legislation, whatever other alterations were made to the law.^[32]

Several cases have approved the remarks of Ormiston JA, including Re Ashington.^[33] Similar views have also been expressed in other decisions.^[34] Although none of these decisions dealt with the question of whether the grant of a security interest constitutes an unfair preference, the fact they say s 588FA was not intended to significantly depart from what constituted an unfair preference under the previous regime suggests that the granting of a security interest should still amount to an unfair preference under s 588FA.

Although V R Dye & Co has been referred to approvingly by several decisions, it has not entirely escaped criticism. In McKern v Minister Administering the Mining Act 1978 (WA) (2010) 28 VR 1, Nettle JA did not overturn V R Dye & Co^[35] but did not find all of its reasoning “completely convincing”.^[36] His Honour noted that V R Dye & Co did “not deal squarely with the apparently plain and ordinary meaning of” s 588FA.^[37] Further, s 588FA(1) declares itself a comprehensive statement of what constitutes an unfair preference by commencing with the words, “A transaction is an unfair preference … if, and only if”.

It has been observed that if Parliament wished the preference provisions of the Bankruptcy Act to still apply, it could simply have reproduced those provisions in the Act.^[38] However, the prevailing view expressed in decided cases is that the previous regime is still relevant to the interpretation of the current regime. None the less, it is submitted that the previous regime should not usurp the clear words of s 588FA if those words happen to prevent the grant of a security interest being an unfair preference. In this regard, the Full Federal Court in Re Emanuel (No 14) Pty Ltd (in liq); Macks v Blacklaw & Shadforth Pty Ltd (1997) 147 ALR 281 said that we should be careful to ensure that proper account is taken of the “significant textual differences” between the current regime and its predecessor.^[39] With this in mind, we now turn to the text of s 588FA.

The text of s 588FA and related sections

It has been said that “the task of statutory interpretation begins, and ends, with the words which Parliament has used”.^[40] For this reason, it is important to carefully consider the words used in s 588FA and associated sections.

It is convenient to start with the sections associated with s 588FA, rather than s 588FA itself.^[41] The definition of “transaction” in s 9 specifically lists the granting of a security interest as an example of a “transaction” to which Pt 5.7B applies. Further, s 588FF(1)(e) lists an order releasing or discharging a “security” as an order which the court may make in relation to an unfair preference.^[42] These provisions would have no utility in relation to s 588FA unless the granting of a security interest could amount to an unfair preference. In this regard, it is “a basic principle of statutory interpretation that words in a statute are not ordinarily to be construed as superfluous or insignificant”.^[43] However, the definition of “transaction” and s 588FF(1)(e) apply to all antecedent transaction provisions in Pt 5.7B; for example, “uncommercial transactions” under s 588FB. Also, the definition of “transaction” in s 9 is subject to a contrary intention. Arguably, s 588FA evinces a contrary intention by referring to an “unsecured debt”. If the definition of “transaction” and s 588FF(1)(e) were expressly limited to transactions under s 588FA, there may be a strong textual indication that s 588FA applies to the granting of a security interest, but that is not the case. Based purely on the text, it is plausible that s 588FE(1)(e) and the reference to the granting of a security in the definition of “transaction” do not apply to s 588FA, but rather to other antecedent transactions, such as “uncommercial transactions”.

Let us now turn to s 588FA(1)(b). When confronted with the phrase “in respect of an unsecured debt” in s 588FA(1)(b), the obvious question is what is “in respect of” an unsecured debt? Section 588FA(1)(b) says as follows:

the transaction results in the creditor receiving from the company, in respect of an unsecured debt …, more than the creditor would receive from the company in respect of the debt if the transaction were set aside.

This phrase could be interpreted as meaning (i) the “transaction” must be in respect of an unsecured debt, (ii) the “receiving from the company” by the creditor must be in respect of an unsecured debt, or (iii) either option (i) or (ii). In a typical unfair preference claim, (i) and (ii) will be the same. For example, consider a creditor receiving a preferential payment for a debt which was at all times unsecured. The “transaction” is the payment to the creditor which is also the receiving of property by the creditor from the company. Both the transaction and the receipt are “in respect of an unsecured debt”. However, in the present situation, (i) and (ii) are different. The impugned “transaction” is the granting of a security interest in respect of a hitherto unsecured debt while the receipt will be the payment resulting from realising the security. Hence, the “transaction” will be “in respect of an unsecured debt” while the receipt by the creditor will be in respect of a secured debt.

So, which of options (i)-(iii) is correct? In support of option (ii), the proximity of the phrase “in respect of an unsecured debt” to “receiving from the company”, rather than the word “transaction”, suggests that option (ii) is correct. Section 588FA(1)(b) does not read “the transaction, in respect of an unsecured debt, results in the creditor receiving more from the company than if the transaction were set aside”.

In support of option (i), the supplementary Explanatory Memorandum for the Bill states that the words “unsecured debt” were introduced to s 588FA(1)(b) by the Senate to “make it clear that a liquidator may not pursue as a preference a transaction in respect of a secured debt, except to the extent that the security is inadequate to support the transaction”.^[44] This statement suggests Parliament intended the “transaction” to be “in respect of an unsecured debt”.

In support of option (iii), linking the words “in respect of an unsecured debt” to either the “transaction” or the receipt is perhaps giving s 588FA(1)(b) an unduly narrow and strict interpretation that will limit its application and is inconsistent with its purpose. Further, it is arguable that no significance should be attached to the location of the phrase, “in respect of an unsecured debt”, within s 588FA(1)(b) for two reasons. First, the phrase is so proximate to both the words “transaction” and “the creditor receiving from the company” that it should apply to either. Secondly, Parliament appears to have had no intention of linking the phrase to either a “transaction” or a receipt. When the Bill was presented to the Senate, s 588FA(1)(b) read “the transaction results in the creditor receiving from the company, in respect of a debt”. The Senate then amended it as follows: “the transaction results in the creditor receiving from the company, in respect of an unsecured debt”. The location of the words “an unsecured debt” appears to have been dictated by the form of the Bill presented to the Senate rather than any deliberate decision by the Senate to associate the unsecured debt with the “transaction” or receipt. This is consistent with the Senate’s amendments being merely technical.

Overall, it is submitted that option (iii) is preferable for the reasons identified above. However, even if option (ii) were correct, it may not present an obstacle to the grant of a security interest being an unfair preference. It has been noted above that a secured creditor will receive payment when they realise their security. This type of receipt occurs while the creditor is secured and is hence not “in respect of an unsecured debt”. However, there is arguably an earlier receipt, being the receipt of a proprietary interest in the secured property, which occurs when the security interest is created. The debt is unsecured when the security interest is first created and hence the receipt of the proprietary interest is arguably “in respect of an unsecured debt”. In the case of a possessory security interest, such as a lien or pledge, the proprietary interest will be possession of the secured property. In the case of a fixed equitable charge, the chargee will receive an equitable interest in the charged property.^[45] There is debate as to whether a floating charge grants the chargee an equitable interest in the charged property immediately upon the creation of the floating charge or only upon its crystallisation.^[46] Hence, this argument may not assist in relation to a floating charge. However, this is less significant due to the Personal Property Securities Act 2009 (Cth) (PPSA), which does away with floating charges in relation to “personal property”. A “security interest” under the PPSA gives the secured party an interest in personal property upon its creation.

Based on a purely textual analysis, it is submitted that it is unclear whether s 588FA extends to the granting of a security interest. Section 588FE(1)(e) and the definition of “transaction” in s 9 are equivocal while s 588FA itself is open to different interpretations. Still, the text does not prevent s 588FA applying to the grant of a security interest. Overall, the textual interpretation is perhaps unhelpful as it leads to fine and somewhat artificial distinctions being drawn which are a distraction from the purpose and policy of s 588FA. It is this policy to which we will now turn.

The general purpose and policy of s 588FA

It is submitted that the primary purpose of s 588FA and the primary “mischief” it aims to prevent is a creditor obtaining an advantage over other creditors and hence upsetting the principal of equal distribution. The principal of equal distribution, known as the pari passu principle, “has long been regarded as a fundamental principle of insolvency law”.^[47]

The purpose of s 588FA can be discerned from four sources. First, the text of s 588FA(1)(b) specifically refers to a transaction resulting 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 the purpose of the provisions concerning voidable transactions is as follows.

The purpose of the provisions in this proposed Division [2 of Pt 5.7B] is to ensure that unsecured creditors are not prejudiced by the disposition of assets or the incurring of liabilities by a company in a period shortly before the winding up which would have the effect of favouring certain creditors or other persons, and especially related entities.^[48] [underlining added]

The Explanatory Memorandum also states that “unfair preference means a transaction that gives a company’s creditor an advantage over the company’s other creditors”.^[49]

Thirdly, case law has acknowledged the purpose of the unfair preference provisions. In G & M Aldridge Pty Ltd v Walsh (2001) 203 CLR 662, the High Court said that a “primary objective” of the preference provisions is “securing equality of distribution amongst creditors of the same class”.^[50] In V R Dye & Co, Ormiston JA said the objective of legislation concerning unfair preference is “to prevent existing creditors from being disadvantaged”.^[51]

Fourthly, learned commentators have noted that the law of unfair preferences is motivated, at least in part, by the policy of equal distribution.^[52] Professor Keay noted that this policy has been viewed as the “fundamental justification for avoidance provisions, and particularly those setting aside preferences”.^[53]

The aim of equal distribution has a related objective, which is to discourage the “race to the courthouse”^[54] by creditors to “dismember the debtor”.^[55] Professor Keay has acknowledged that preventing this dismemberment is a further objective of unfair preference provisions.^[56] Another objective noted by Professor Keay is “collectivism” which dictates that individual creditors must surrender the right to pursue their debt and instead take part in a collective process with other creditors.^[57] A “race to the court house” does not encourage cooperation amongst creditors nor between creditors and the debtor. It may also hinder the debtor in overcoming their financial difficulties.^[58] It is submitted that a race to obtain security interests over the property of the debtor may cause similar problems to a “race to the courthouse”. A debtor could face demands for security from several creditors, which may be accompanied by an ultimatum of court proceedings or the withholding of further finance or supplies. This could result in an “unsavoury scramble by creditors for the assets of the insolvent”.^[59] Further, if a security interest is enforced shortly after it is obtained, which is likely if it is granted during the relation-back period, the grant of the interest may be little more than a precursor to “dismembering” the debtor.

It is submitted that allowing the grant of a security interest to be set aside as an unfair preference is consistent with the purpose and policy of s 588FA, since the granting of a security has the potential to advantage one creditor over others. This purpose could have been more clearly encapsulated in s 588FA if it had been enacted in the form that it was originally introduced to Parliament. The original version would have worked perfectly well. In this regard, s 122 of the Bankruptcy Act, as it existed at the time of the Bill and at the time of writing, makes no distinction between secured and unsecured debts. The UK equivalent to s 588FA also draws no distinction.^[60] The addition of the word “unsecured” in s 588FA(1)(b) simply gives rise to difficulties because the word must be given meaning due to the principle that “all words in a statute must prima facie be given some meaning and effect”.^[61] It is submitted that s 588FA would be clearer and equally effective if the word “unsecured” were removed from s 588FA(1) and s 588FA(2) were deleted in its entirety.

Conclusion

In light of the above matters, it is submitted that the historical context and policy behind s 588FA support the grant of a security interest being an unfair preference, while the text of the section and related provisions are equivocal but do not stand in the way. It is submitted that when the text of the section permits an interpretation that is consistent with its policy, that interpretation should be adopted instead of an alternative interpretation which is inconsistent with that policy. This is consistent with High Court authority, which has said that “the context, the general purpose and policy of a provision and its consistency and fairness are surer guides to its meaning that the logic with which it is construed”.^[62] It is also consistent with s 15AA of the Acts Interpretation Act 1901 (Cth) which states that “the interpretation that would best achieve the purpose or object of the Act … is to be preferred to each other interpretation”. It is submitted that focussing solely on the text of s 588FA is unhelpful as it results in fine and somewhat artificial distinctions which are a distraction from the policy of the provision. So much is clear from the analysis of the text earlier in the article.

The limited case law is consistent with this view. In Re Ashington, which appears to be the only case directly on point, Black J found that s 588FA can apply to the grant of a security interest.

Overall, it is submitted that s 588FA would be clearer and equally effective if the word “unsecured” was deleted from s 588FA(1)(b) and s 588FA(2) was deleted in its entirety.