Readers will be familiar with securities over assets and the need for some of them to be registered in some circumstances. Having said that, we still find instances where creditors do not register securities over company assets with ASIC, and end up with unenforceable charges when they are needed most.
But this article is not about the registration of securities over company assets. It is about properly executed and registered securities over debtors, stock and similar assets being worthless. This arises because section 561 of the Corporations Act says that priority employee entitlements also have priority over the charge holder in respect of floating assets - debtors, stock etc.
Take the instance where a director of a cash strapped company seeks a loan from a relative or friend, or for that matter a main stream lender. The lender being prudent reduces the loan to writing and is granted a fixed and floating charge to secure the loan. The charge is registered with ASIC. But the company has few fixed assets, so the majority of the security is over floating assets. At the time of the loan, there are minimal employee entitlements, but a large number of employees. The company is subsequently wound up.
When it is wound up, the company has significant outstanding employee entitlements. The money from the sale of the floating assets will be used to pay these entitlements and the secured creditor - having done everything right - gets the surplus, if any.
So how does a lender secure his position when there are no other assets that can be used as security?
We have seen three inventive ways, but none of them are perfect.
The first is to separate the priority debt from the floating assets. This may be done by transferring the employees to a subsidiary. The company then enters into a supply agreement with the subsidiary. Theory is to replace the priority debt with a non-priority debt to the subsidiary. But this may not be convenient for a range of reasons. The initial transfer may create tax and other obligations and costs, and the whole scheme may be found to be ineffective if the company is wound up soon afterwards.
If the loan is only meant to be short term, the lender may decide not to lend, but to purchase the company's debtors to an equivalent amount. The 'lender' will be effectively repaid as the debtors are collected. The logistics of having the company collect the money under some form of agency agreement, and keeping the monies separate from their own monies while new debtors are created and the company continues to trade will need to be considered. Unless the lender wishes to act as a debt factorer, this is not a long term solution.
If the company has significant stock, the lender may purchase the stock. The stock would be left with the company on consignment and the monies repaid as the stock is sold. This will have very similar logistical problems as purchasing debtors.
There is no perfect answer and lenders should be aware that any floating charge security is subject to the priorities of employee entitlements that may not have existed when the loan was made. But, with a little thought, a legitimate arrangement may be able to be formed that will better protect that loan. Employees naturally will not be keen to see these arrangements in place, but if the company would fail because it could not obtain the loan funds, it may be an arrangement that saves their jobs.