On the Case: Issue 12

Unfair Preferences in a liquidation – When is a Corporate Debt Unsecured?

In this edition of On the Case Adjunct Professor Philip Stern, who taught Insolvency Law at The University of Notre Dame Australia, School of Law, Sydney, last year, discusses a recent decision which has significant ramifications for secured creditors¹.

In Brief

This case concerned the question of when a debt is an unsecured debt for unfair preference purposes. At first instance, the Court concluded that the time for assessing the value of the security is the date of the winding up of the debtor company. On appeal, the Full Court found that the trial judge was wrong to have considered this legal question without first determining the relevant facts. The first instance decision was set aside and the matter remitted to the Supreme Court for determination. If and when a judicial resolution of this important question is made this will be the subject of a new On The Case. In the meantime these decisions are the latest word on this topic.

Background

Section 588FA (1) Corporations Act, 2001 (Cth)² defines an unfair preference, being a transaction which is potentially voidable upon a company going into liquidation. Relevantly, the transaction will be an unfair preference if that transaction is between the company and a creditor, it occurs when the company is insolvent during a period (for an unrelated creditor) of 6 months before a formal insolvency event, and it results in the creditor receiving from the company, in respect of an unsecured debt that the company owes it, more than it would have received as a dividend in the winding-up of the company if the transaction were set aside.

There has been little judicial attention given to the question of when a debt is an unsecured debt for the purposes of the section. Section 588FA(2) elaborates as follows:

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.

At first instance, the South Australian District Court endeavoured to determine when a debt is unsecured³. In that case the parties agreed to have the court determine, as a preliminary question, whether the time for assessing the value of a security in an unfair preference action was:

1. at the date the security was created or
2. the date when each payment to the creditor was made or
3. the date of the winding up or some alternative date.

The Facts

In summary the facts were that the defendant had a second-ranking security (behind a bank) over all assets of the company now in liquidation. At the time of taking that security the company was solvent but it was insolvent at the time of making payments, within the statutory 6 month period, before it went into a formal insolvency administration (here a voluntary administration). At the time of winding up the defendant’s security was worthless.

The Decision at first instance

Chivell DCJ construed the text of s 588FA(2). He found that the words “For the purpose of section 588FA(1)” limit the application of s588FA(2), so that it has no application elsewhere within the Act⁴. The phrase “a secured debt is taken to be unsecured” creates a statutory fiction whereby, even though a debt is secured in that it is covered by a valid security, it is to be treated as unsecured in the specified circumstance⁵. The prerequisite circumstance creating that fiction is that the debt is deemed “unsecured to the extent of so much of it (if any) as is not reflected in the value of the security”; which means that the debt will be deemed unsecured to the extent of so much of it (if any) as constitutes a shortfall between the value of the security and the debt⁶.

The Court considered s588FA(2) might reinforce the pari passu principle, i.e. the principle of equality between unsecured creditors⁷. It applied the Victorian appellate decision in Walsh v Natra Pty Ltd⁸ which held that, in construing s588FA(1), the date for determining whether a creditor was preferred was not on a hypothetical winding-up date, being the dates of payments, but the actual liquidation date. Chivell DCJ followed this authority in construing s588FA(2) because that subsection is stated to be ‘For the purposes of subsection (1)⁹.” He rejected the defendant’s argument that the defendant had full security for its loan because, at the time the security was created, it was intended by the creditor that the value of the assets provided full security for the loan which avoided application of s588FA(2). He also rejected, inter alia, a policy argument that if creditors’ securities were to be at risk of competing with unsecured creditors, secured creditors would be likely to lend less and to call in their securities earlier. He thus concluded that for the purposes of s588FA(2), the time for assessing the value of the security is the date of the winding up of the debtor company¹⁰.

The Decision on appeal

The defendant appealed the decision¹¹. The Full Court recounted disputed pleaded facts and rebuttals of much greater complexity than those stated by the trial judge in his judgment¹². The Full Court determined that it was appropriate that the complex factual dispute be resolved before construing and applying the statutory provisions¹³. In the Full Court’s view the trial judgment was based on hypothetical facts and could not assist the efficient administration of justice when the facts determinative of the legal dispute remained open¹⁴. The Full Court was not prepared to entertain the appeal, the decision was set aside and the case was remitted to the Supreme Court for determination¹⁵.

Implications of this Case

As a result of the Full Court’s decision, the very important issue of determining whether a debt, which was originally fully secured, is secured in an unfair preference context in a corporate liquidation, remains an open question. If and when a clarifying judgment is delivered we will issue a further On The Case.

This article was originally published by Woodgate & Co, Level 8, 6-10 O’Connell Street, Sydney and their willingness to permit its republication is gratefully acknowledged.

¹ The Tap Inn Pty Ltd v Matthews [2015] SASFC 188 (Tap Inn)
² Note that all references to sections in this On The Case are to sections in this Act
³ Matthews v The Tap Inn Pty Ltd [2015] SADC 108 (Matthews)
⁴ Matthews [18]
⁵ Matthews [20]
⁶ Matthews [23],[26]
⁷ Matthews [33]
⁸ [2000] VSCA 60
⁹ Matthews [40]-[41]
¹⁰ Matthews [60]
¹¹ Tap Inn
¹² These facts had been set out in an earlier judgment refusing mediation. ¹³Tap Inn [11]-[12]
¹⁴ Tap Inn [19]
¹⁵ Tap Inn [20]