Circulating security interests and competing priorities

by DLA Piper
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The recent Federal Court decision (on 1 March 2017) in Langdon, in the matter of Forge Group Limited (Receivers and Managers Appointed) (in Liq) [2017] FCA 170 considered the situation where a sizeable, unexpected tax refund (of circa $53 million) was paid to the company by the ATO and the question was to where these funds should be applied - towards reducing the company's outstanding (and substantial) secured debt in excess of $171 million or to repay outstanding employee entitlements in priority to any claims by the secured creditors.

The focus of this article is on the following key questions considered by this case:

  • When does a 'circulating security interest' attach to property created or acquired following the appointment of receivers for the purposes of section 433 of the Corporations Act?
  • When will an asset constitute a “circulating asset” under the Personal Property Securities Act 2009(Cth)(PPSA) and whether it can be deemed a ‘circulating security interest’ for the purposes of section 433 of the Corporations Act?

Key Findings

  • Property the subject of a circulating security interest that has not been identified, or did not exist, at the relevant date of the receivership is not required to be paid to statutorily preferred creditors, such as employee entitlements under section 433 of the Corporations Act 2001(Cth)(Corporations Act).
  • Following the appointment of receivers and managers, trading profits and payments made to a company will not be considered property generated in the ordinary course of business.

Key facts of the case

On 11 February 2014, voluntary administrators were appointed to Forge Group Limited and its subsidiaries (Forge) pursuant to section 436A of the Corporations Act. On the same date, the security trustee appointed receivers.

Forge was an Australian income tax consolidated group for the purpose of Part 3-90 of the Income Tax Assessment Act 1997(Cth)(ITAA97). Prior to the appointment of voluntary administrators, entities within Forge had entered into long term contracts to perform a range of civil procurement, design and construction works and paid income tax on the basis of estimated income. However upon the appointment of administrators, a variety of these contracts were terminated and the income tax that was paid in effect turned out to be substantially inaccurate and ultimately resulted in Forge receiving a refund of approximately $53 million from the ATO.

The Receivers sought direction from the Federal Court as to whether the refund monies must be paid to (a) satisfy the preferential employee entitlements or (b) to the security trustee to reduce the secured debt. The Australian Government Department of Employment was invited to act as contradictor which argued that the refund fell within the circulating security interest and should be applied towards the employee entitlements.

Sections 433 of the Corporations Act and 340 under the PPSA

Under section 433 of the Corporations Act, a receiver is required to pay from any property subject to a circulating security interest coming into its hands at the date of appointment of external administrators (Relevant Date), priority creditor claims (ie employee entitlements) in priority to secured party claims. While preceding case law confirmed that priority creditor claims were fixed at the Relevant Date, uncertainty remained over the date of fixing for property subject to a floating charge.

Pursuant to section 51 of the Corporations Act, property is subject to a ‘circulating security interest’ if a PPSA security interest attaches to a ‘circulating asset’. An asset is deemed a ‘circulating asset’ in accordance with section 340 of the PPSA if it is a current asset, or asset which the secured party has given the grantor express or implied authority to transfer, in the ordinary course of the grantor’s business, free from security interests. Examples include inventory and credit card receivables.

Key questions being asked of the court

The directions sought by the receivers concerned two key issues:

  • The ATO refund (ie the secured property) did not exist or come into the hands of the receivers on the Relevant Date, but approximately one year after. The court considered whether “property” pursuant to section 9 of the Corporations Act is caught by the operation of section 433 of the Corporations Act if the property (a) is future property; (b) is the subject of a floating charge and (c) did not exist nor is identifiable on the Relevant Date.
  • The court considered whether the ATO refund fell under the definition of a ‘circulating asset’ pursuant to section 340 of the PPSA and could subsequently be deemed a ‘circulating security interest’ for the purposes of section 433 of the Corporations Act.

The judgment

Fixing Date

The court held a temporal limitation is in fact imposed on section 433 of the Corporations Act. Gilmour J applied the decision in Re CMI Industrial (In Liq) [2015] QSC 96, reinforcing that “property” the subject of a floating charge, which may have been future property at the time the floating charge was granted, must exist and be identifiable on the Relevant Date to be caught by the operation of section 433 and be available to priority creditor claims (ie employee entitlements).

The Australian Government Department of Employment attempted to differentiate the circumstances in Re CMI Industrial to the present case, arguing the secured property in Re CMI Industrial was trading profits arising after the Relevant Date and the refund was an overpayment attributable, in part, to an income year earlier than the date of the secured creditor's security interest. This argument was rejected on the basis that, as the ATO refund did not exist nor was identifiable on the Relevant Date, it cannot be caught by section 433, meaning there was no statutory obligation for employee entitlements to be given priority over secured parties.

Circulating Assets

All parties accepted that the ATO refund came within the scope of the security interest accepted by the general security granted in favour of the secured lenders however the parties disagreed on the question as to whether the refund fell under the definition of a ‘circulating asset’ under section 340 of the PPSA and therefore could be deemed a ‘circulating security interest’ for the purposes of section 433.

Justice Gilmore assessed whether the refund was an asset in which the secured party had given the grantor express or implied authority to transfer, in the ordinary course of the grantor’s business, free of security interests. Ultimately, the decision came down to assessing the terms stipulated in the general security deed and other relevant finance documents and it was found that the refund did not constitute a 'circulating asset' in accordance with section 340 of the PPSA because:

  • The refund was the result of the insolvency, and would never have come into existence in the ordinary course of Forge’s business.
  • None of the provisions in the relevant documents gave rise to an express or implied authorisation by the secured party to allow Forge, in the ordinary course of its business, to deal with the refund free of security interests.

A Positive Outcome for Secured Lenders

The decision provides valuable guidance (and key parameters) in determining whether assets (which are recovered following the appointment of external administrators) may be applied towards reducing outstanding secured debt or to priority claims such as outstanding employee entitlements. In particular the case confirms:

  • Property the subject of a circulating security interest that has not been identified, or did not exist, at the relevant date of the receivership is not required to be paid to statutorily preferred creditors, such as employee entitlements under section 433 of the Corporations Act. The decision confirmed that this will include ATO rebates recovered by a receiver, even where that rebate related to a tax period before the relevant date of the receivership.
  • Following the appointment of receivers and managers, trading profits and payments made to a company will not be considered property generated in the ordinary course of business.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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