What a difference a security interest can make in liquidation.
As we approach the end of financial year, it's time to remind advisors of an important matter which is often overlooked. If remedied, however, it may well avoid that awkward moment when your client asks: "why didn't you tell me that"?
So, what exactly is "that" and why is it important?
Advising your clients to secure loans made to a company (referred to as related party credit loan accounts) is a process easily put in place, usually via a solicitor. If implemented properly, it may provide the secured party with an advantage over unsecured creditors in the event of the company being placed into liquidation.
Related Party credit loan accounts arise under variety of circumstances including advances of monies to assist with working capital or the acquisition by the company of a new business or other assets. Credit loan accounts may also arise from dividends which are declared but remain undrawn, or in the case of a trust, as an unpaid present entitlement (UPE).
Subject to priority claims of employees pursuant to s.561 of the Corporations Act 2001, a liquidator is required to deal with the claims of secured parties ahead of unsecured creditors. From our experience in meeting with directors and shareholders to discuss insolvency appointments, there are many instances in which directors and shareholders were completely unaware that they could have secured their loans and would have done so if they had been advised of that option. No advisor wants to find themselves in the embarrassing situation of being challenged by a client for failing to advise of what could otherwise have been an effective risk mitigation strategy.
Securing monies advanced to a company (or a trustee of a trust) is ideally done ahead of, or contemporaneously, with the advance of the monies. This provides the maximum protection to the secured party as security taken at an appropriate time is difficult to challenge (provided of course the security documents and PPSR registrations are properly perfected).
Even in a situation where funds have been advanced, and security has not been taken, it's still possible to put a security interest in place for the funds previously advanced. However, if the company was insolvent (or likely to have become insolvent) at the time the security was subsequently put in place, the transaction may be challenged by a liquidator. This challenge arises if the security occurred up to four years prior to the company being placed into liquidation, where the secured party is also considered to be a related party.
Similarly, failing to secure monies advanced to a company by a related party may not only impact their ability to recover the loan, but could have potentially adverse consequences. This is when the loan is fully or partially repaid in circumstances where at the time of repayment, the company was insolvent and the related party knew, or ought to have known of that fact.
However, where the credit loan account is secured (and provided the security and registration were properly perfected at a time when the company was solvent), then any reduction of the loan balance will not be considered a preferential payment - because the repayment of a secured loan does not prejudice the interests of unsecured creditors (as a secured creditor ranks ahead of unsecured creditors).
With financial year end now upon us, it's an opportune time to engage with your clients and identify an unsecured related party credit loan accounts. We have no doubt they will, at the very least, value your proactive thought leadership.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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