The Australian Law Reform Commission in 1988 in its General Insolvency Inquiry set out the range of purposes for insolvency law in Australia which largely revolved around the efficiency and administrative process rather than the possible rehabilitation, restructuring and turnaround possibilities.
This focus has highlighted the stark reality that the Australian insolvency system is ‘creditor’ focused rather than ‘debtor’ focused like our friends in the United States.
Understanding this perspective is particularly useful when we examine the business to business supply relationships that exist across many SMEs.
Many, if not all SMEs, find themselves as either creditors or debtors. It is a fundamental part of the supply and demand capitalist structure. However, many SMEs and their advisors do not play close enough attention to what type of creditor they are. This can have serious, domino style effects on a business.
There are two primary types of creditors: secured and unsecured.
A secured creditor has an enforceable security interest against the property of the debtor.
An unsecured creditor is a creditor who does not have an enforceable security interest and is therefore simply ‘owed’ the money or consideration.
The impact of whether you as a creditor have a secured or unsecured arrangement is significant as explored below.
Case Study
Take for example, a Distributor of Excavation Machinery.
The Distributor signs an exclusive Asia Pacific distribution deal with the manufacturer. As part of the deal, the Distributor agrees to an initial stock order of 5 pieces of machinery being 5 excavators at a total cost of $1,500,000.
The Distributor has never borrowed money before and has a clean balance sheet. The Directors of the Distributors decide to inject the capital themselves rather than seek external funding due to the speed at which the funds are needed.
The Directors inject those funds by way of a Director loan account. At this point, they are unsecured creditors.
If the Distributor was to find itself in trouble, the funds injected by the Directors are not protected, they would simply be unsecured creditors and would not have priority over any other creditors.
If the Directors entered into a loan agreement and a perfected security agreement under the Personal Property Securities Act, their interest would convert from an unsecured creditor into a secured creditor thereby protecting their interests in the event that the Company found itself in an ‘insolvency event’.
When using the PPSA to register a security interest and become a secured creditor, it is crucial that the following are clear:
- Is there a security?
- Has the security interest been perfected?
- What collateral is the security over?
- Are there multiple secured creditors?
- If so, what is the priority?
Key Takeaway
Being an unsecured creditor when you can be secured creditor is like refusing an upgrade to business class. You will regret it.
Don’t settle for economy when you can fly business.
If you would like us to review whether you can become a secured creditor or review the security interests that attach to your client’s business or your business then please email James Frank on jfrank@franklaw.com.au or call (02) 9688 6023.
This is not legal advice.
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