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01 Nov 2007

Legislation Highlighted - 588FA(2) - Secured Creditors and Preferences

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4 min

Most readers will be familiar with unfair preferences - commonly called preferential payments. Readers will also be aware that there is a general exclusion for payments to secured creditors. This is stated in the Act as:

CORPORATIONS ACT 2001 - SECT 588FA Unfair preferences
(1) A transaction is an unfair preference .. only if:
(b) .., in respect of an unsecured debt that the company owes to the creditor

The reasoning is that a payment to a secured creditor in reduction or discharge of the secured debt reduces or extinguishes the security interest over the secured asset and does not change the company's net asset position. The payment is equal to the increase in the equity in the asset. The company is effectively trading cash for equity. This theory is fine if the value of the asset is more than the amount of the secured debt and the amount of the payment.

Commonly though the asset is worth less than the amount of the secured debt. The general exclusion for secured creditors has its own limitation from the use of the words "an unsecured debt" and through subsection (2).

(2) 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.

There are circumstances when a secured creditor will not be able to rely on their security to provide them with protection from unfair preference claims. The best known limitations are:

1. The granting of the security itself may have been a preferential act under section 588FJ. If the security itself is voided, leaving the debt as unsecured, any payment received by the creditor after taking the security could be preferential.

2. Section 588D provides that a secured debt becomes unsecured to the amount that the creditor proves for the debt as an unsecured creditor. It is a deemed surrender of the security for the purposes of the claims under Part 5.7B of the Act.

3. If the debt to the secured creditor is more than the value of the asset secured, the excess debt is unsecured. A payment to the creditor may be preferential to the extent that the payment exceeds the value of the security. For example - if the creditor is owed $100 and is paid that $100, but the asset secured is only worth $60, the difference of $40 is 'unsecured' and may be preferential. This is a simple example of section 588FA(2).

But things can get complicated.

Say the debt is $400, the value of the asset secured is $200, and the creditor receives a payment of $300. The excess of the payment above the value of the asset (some $100) is unsecured and may be preferential. The $200 - equal to the value of the security - is in theory protected. But the creditor still has a $100 debt and security over the asset.

Does the $200 protected payment extinguish the security leaving the balance of the debt unsecured? Can the creditor double-dip and use the security to protect the first $200 and recover the balance of their debt?

Case law follows the proposition that a payment is not preferential to a secured creditor because the secured creditor gives up a security interest in the asset, and the company gains that amount of equity in the asset. If the creditor could double-dip that proposition would not stand. The creditor could elect to either keep the $200 and give up their security interest, or refund the $200 and keep their security interest. They cannot do both.

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