How your clients can effectively and securely fund employee entitlements

A role for advisors in the “fog of solvency mistrust”.

“Fog of solvency mistrust engulfing the residential and commercial building industry” so screamed our Robert Gottliebsen, respected veteran journalist in The Australian in early August. For any doubters out there, they just need to take a look at the daily insolvency notices that show record numbers of builders going broke, and not to mention the trail of suppliers and subcontractors that invariably follow in the wake.

Gottliebsen reports:

“Builders are now falling over on a regular basis. And each time one collapses subcontractors are hit. Subcontractors will demand payment in advance before undertaking any work. But on the other side, builders are petrified about making advanced payments because big losses are also accumulating among many subcontractors”.

So as an advisor, is there anything you can do to assist your clients—be it the builders, developers or downstream suppliers and subcontractor?

Besides the obvious things like recommending your client take out credit insurance if they don’t have any (and if available at an affordable price) you could suggest your clients prepare more reliable cash-flow forecasts etc. But the reality is that such steps won’t fix the problem where the builder (your client, or your clients’ customer) has entered into fixed-price contracts at prices one could only dream of these days, resulting in many building contracts being unprofitable. And then there is the banks’ unknown and fluid position—to support their customers or cut their losses. Updated cash flows and the like will of course be useful to determine if your client is heading towards insolvency, but it will be too little too late in some cases. For those clients who are solvent but face the inherent risk now prevailing, advisors can recommend the following steps to mitigate risk:

• Leveraging section 560 loans (of the Corporations Act 2001).

• Securing the unsecured director/shareholder loans.

Leveraging section 560 loans

Section 560 of the Corporations Act provides that a person who advances funds to a debtor company, for the purpose of enabling that company to pay wages, leave, or retrenchment pay to its employees, has a priority creditor claim for those amounts advanced.

The result here is the payer obtains rights to be subrogated to the priority position enjoyed by employees and receives priority over ordinary unsecured and in some cases secured creditors. However, this priority is limited to the fixed amount that the employees have priority for[1] in a company winding up.

Traditionally, when a director/shareholder advances funds to a company, advances are made either on an unsecured basis or in far fewer cases (in my experience) on a properly secured basis. Then in the event of the debtor company’s liquidation, the director/shareholder would prove as an unsecured or secured creditor as the case may be.

However, where advances are properly made under section 560 of the Corporations Act, the director/shareholder proves as a priority creditor.

In so far as the cascading provisions of section 556 of the Corporations Act are concerned, employees rank ahead of not only unsecured creditors (which should come as no surprise) but also ahead of secured creditors where dividends are derived from circulating assets recovered by the liquidator, namely stock, debtors and cash.

The paradigm shift that section 560 of the Corporations Act brings is that rather than the director/shareholder advancing funds to assist with working capital funding e.g. to repay creditors, the advances are used instead to pay employee wages, and vice versa. The benefits of what otherwise may have been a standard unsecured or even secured loan made by the director/shareholder compared with a loan having the same ranking as employees in a liquidation can be profound.

But to have a valid claim under section 560 of the Corporations Act, the onus of evidentiary proof is high. The making of the loan and the trail of cash payments in and out of the debtor company must be fully traceable, and for this reason legal advice is imperative as to the contractual and evidentiary aspects required to satisfy a liquidator who adjudicates on all claims made. For example, it may be the case that a dedicated new company bank account be opened to identify the funds from the director/shareholder and from which the wage payments are made. For example, it is likely to be problematic if the funds were deposited directly into the company’s existing bank account and applied towards wages in the normal course.

Securing the unsecured director/ shareholder loans

It is not possible to convert a secured or unsecured loan to a section 560 loan. It is however possible to convert an unsecured loan to a secured loan by registering security over the loan even after the loan had been made. Of course, engaging a lawyer to do this is highly recommended.

The risk however, is that the taking of security will be overturned by a liquidator where it could shown that at the time the security was taken, the company was insolvent. In such case the taking of the security may be regarded a preference and has a four-year claw-back period for related persons such as directors/shareholders. But is not inconceivable that a company that is solvent one day can become insolvent the next e.g. as a result of a large bad debt or cancellation of a contract. So, securing a loan when the company is solvent is an important aspect of asset protection.

Ideally of course, a charge should be registered contemporaneously when the funds are advanced so the risk of a preference claim cannot arise. It concerns me greatly that many directors/ shareholders are blissfully ignorant in understanding they are fully entitled to secure their own loans against their company. Some still naively think “security” is only in the domain of the banks. Even where the banks have the first ranking charge, a second ranking charge is still preferable to being unsecured.

One final point to stress is the need to advise clients to secure their loans even where they have not directly loaned money to their company but have provided a guarantee, for example to the bank.

Where a bank has loaned monies to a company on an unsecured basis but taken a guarantee from the director/shareholder supported by a mortgage over the home, then in the event of liquidation, the home may have to be sold to discharge the company’s debt to the bank. Where the bank loan is unsecured, the director in repaying the company’s debt to the bank, subrogates to the position (of the bank) as an unsecured creditor. However, if the director/shareholder held a security interest over the company (to secure their contingent liability to the bank), then at the time of repaying the bank from personal funds, they would subrogate to that of a secured creditor. That could make a world of difference to your client!

[1] Excluded Employees: Excluded employees can only receive $2,000 in relation to wages and $1,500 in relation to leave entitlements in priority to non-employee creditors. They will not receive a priority dividend for other entitlements.

Non-excluded employee: No Limit. Non-excluded employees (not related to the directors) can receive their full entitlements.