Subrogation to the rights of a creditor when a third party pays debts

An important doctrine to ensure your client’s entitlements are protected.

Subrogation is the substitution of one party for another, especially the transfer of the right to receive payment of a debt to someone other than the original creditor. It usually arises when a company is in financial distress and a third party pays debts the company owes, often due to insolvency or to maintain a working relationship with financiers or suppliers.  

So, why is the doctrine important or even relevant? 

Recent insolvency statistics suggest that insolvencies, particularly corporate insolvencies, are on the rise. Business collapses reportedly hit a three-and-a-half-year high, to jump back above pre-pandemic levels for the first time, as rising interest rates and a cooling economy impacted corporate Australia. This makes it vitally important that directors, guarantors, related parties (or for that matter, any third party) understand subrogation, so their financial position isn’t impaired if they provide financial assistance to a business in financial distress. 

The first aspect to understand, is that if a guarantor pays a debt of a primary debtor (such as a related company), the guarantor can usually make a subrogated claim for the amount paid under the guarantee. The operative effect of the subrogation is that it puts the payor in the creditor’s shoes, so that they can seek reimbursement from the debtor who is primarily liable for that debt. 

While this happens automatically by operation of law and therefore doesn’t need a separate agreement that says subrogation is permitted, we often find situations where a non-guarantor third party pays a debt on behalf of another, assuming they’ll be entitled to claim against the original debtor. Unfortunately, the true position is that without a suitable agreement, the payment by a non-guarantor third party gives no automatic right of subrogation. Documenting assignment of the debt to the non-guarantor prior to payment being made, is key to establish their right to claim against the original debtor (including the right to prove their debt in a subsequent liquidation or bankruptcy). 

Obtaining the benefits of subrogation are perhaps even more relevant where the debt paid out has an entitlement to security, as the payor may have an entitlement to benefit from the security in the place of the secured creditor they paid out. This played out in a recent liquidation that involved the following circumstances: 

• A major bank held a security interest registered against the company on the PPSR[1],

• The bank confirmed it received full payment of its outstanding debt from two sources:

  1. $798,311 from sale proceeds of the company’s business.

  2. $105,000 from the director’s spouse, from an account held jointly with the director.

• The director and his spouse had jointly and severally guaranteed the loan to the major bank. 

In that matter, legal advice established that the director's spouse paid out the bank on the basis that her claim would be subrogated to the rights of the bank as secured creditor. The advice was based on the following:

• A presumption arises that the director's spouse, a joint guarantor, has paid off the debt, unless the contrary appears, and intended for the security to be kept alive for her own benefit. The presumption works as if the security had been assigned from the secured creditor to the third party.

• The director’s spouse’s actual or presumed intention as joint guarantor is an important criterion of subrogation. A payer may have intended to lend the money to the debtor on an unsecured basis to pay the secured creditor, or, on the other hand, the payer may have intended to advance the monies to pay out the secured debt on the basis that the payer would step into the secured creditor’s shoes and be entitled to the same security upon payment. 

In the case above, it was clear the joint guarantor paid out the secured debt on the basis that her claim would be subrogated to the secured creditor’s rights. When that payment was made to the secured creditor, the company was in liquidation, so it was unlikely she would have intended to give the company an unsecured loan. Accordingly, the relevant intention was proven and the right of subrogation was conferred on the director’s spouse as if the bank had assigned the rights of security. 

There are several key takeaways. 

Firstly, subrogation cannot be assumed if the debt is not paid by the guarantor or where a valid assignment of the debt to the payor was made before the payment. 

Secondly, if someone intends to make a payment on behalf of another party—particularly if it is, or may soon be, in administration or liquidation—it’s important to consider whether security, subrogation, or assignment is available to maintain rights for making such payment. For the avoidance of uncertainty, it may require the debtor requesting for a person/entity to make such payment, or for security or assignment documentation to be prepared and signed before making any payment.

[1] Personal Property Securities Register (PPSA): https://www.ppsr.gov.au/