Banks Take Security - So Should Business Owners
Updated: Feb 8, 2021
In this month’s case study, we examine the effect of security interests in an insolvency scenario. All too often we see where directors or related parties have loaned significant funds to a company but have failed to register a security interest, as is their right. This can leave related parties at a serious and unnecessary disadvantage in a liquidation situation. Why would a director or related party do this when a bank would not! Our clients, Barry and Michelle, operated a small building company. To establish the business the company borrowed money from Barry’s mother, Ann, and obtained lease finance and an overdraft from a major bank. Unfortunately, things do not always go according to plan and ultimately the business failed. At that time, the company’s financial position looked like this:
Assets Trade debtors $250,000 P&E - under finance $120,000 P&E - no direct finance $200,000 Total assets $570,000 Liabilities Bank Overdraft $80,000 Bank lease finance $120,000 Loan (related party Ann) $350,000 Trade creditors $250,000 ATO $300,000 Employee entitlements $50,000 Total liabilities $1,150,000
Now, in this case the major bank had registered an AllPAAP (All Present and After Acquired Property) charge over the company and numerous PMSIs (Purchase Money Security Interests) charges over the specific assets subject to lease finance. Ann had not registered a security interest at all, even though she was owed more money than the bank. Unfortunately, this is a very common occurrence and one that can have serious implications in a liquidation scenario as you will see below. Let’s have a look at the security interests that were registered against the company (in this case, a PMSI and an AllPAAP) and understand what they really mean in an insolvency situation. A PMSI:
Has a “super priority” over other creditors in relation to the specific asset subject to the charge.
Sales proceeds from the sale of an asset subject to a PMSI go to the secured lender up to the amount they are owed in relation to that security interest.
If the sale price exceeds the secured interest, the surplus funds should be banked into the company’s account.
Is a charge over the “fixed” and “circulating” assets of the business.
An example of a fixed asset is equipment – something physical.
An example of a circulating asset is trade debtors.
After PMSIs have been satisfied, the AllPAAP has priority for the proceeds of sale of fixed assets.
For circulating assets, employee entitlements have priority over the AllPAAP, and once these are satisfied, the security holder takes priority over other unsecured creditors.
So, why is ensuring related party debt is secured important? Let’s have a look at two scenarios in a business exit and liquidation. One where Ann’s loan is unsecured, and then the position if Ann did have a valid security interest over the company – an AllPAAP. First the assets are realised:
The company sells the assets under finance, with the bank’s consent.
The company then sells the equipment not subject to finance and banks the proceeds into the company’s account.
Debtors are all collected and the proceeds banked into the company’s account.
When all assets have been sold and debtors collected, the company will have $570,000 available for creditors, being $320,000 from the sale of fixed assets and $250,000 from debtor collections. Now let’s examine the distribution which is quite different in either scenario. If Ann was Unsecured (No AllPAAP)
Funds available to company $570,000 Less: 1st Bank Lease Finance (PMSI) $120,000 Less: 2nd Bank Overdraft (AllPAAP) $80,000 Less: 3rd Employee entitlements $50,000 Sub-total $320,000 Less assumed liquidator’s fee $30,000 Available to unsecured creditors $290,000
In this scenario, the balance of funds would be distributed on a pro rata basis as shown below:
Funds dispersed: Ann $113,000 Trade creditors $81,000 ATO $96,000 Total $290,000
Now, what would happen if Ann was, in fact, secured by way of an AllPAAP:
Funds available to the company $570,000
Less: 1st Bank lease finance (PMSI) $120,000 2nd Bank overdraft (AllPAAP) $80,000 3rd Ann – Fixed assets (AllPAAP) $120,000 4th Employee entitlements $50,000 5th Ann – Circulating assets (AllPAAP) $200,000 Total $570,000
The cost of securing this loan with the correct documentation and AllPAAP registrations would have been circa $1,500 and the outcome: $ 113,000 Return to Ann if Unsecured $ 320,000 Return to Ann if Secured A massive difference for a very small investment. A related party who holds a security interest gets a “seat at the table” in liquidation, rather than just being an ordinary unsecured creditor. This can open up a range of strategic options and greatly improve the outcome for the related party. WHAT’S THE TAKE HOME Whenever you see related party debt on a company balance sheet, we recommend that you explore the options available in taking an appropriate security interest to protect the lender’s interests and please call us immediately. Registering an AllPAAP needs to be completed within a certain period for it to be immediately effective, however, there are things that can be done to secure past debts in certain circumstances. For past consideration, like a loan the company was granted some time ago, a minimum period of six months needs to elapse before the charge is not automatically voidable in an insolvency situation. Due to the restrictions on enforcing certain actions during COVID-19, this current unique period offers an opportunity for business owners to review their position and consider what options might be available to secure related party loans.
Should you have clients or associates that you know are struggling with financial issues or need assistance in reviewing their business affairs in preparation for what’s around the corner, our team of Strategists would be pleased to discuss options that are available on how to best design and implement insolvency strategies.
Contact us now on p. 1300 765 080 | firstname.lastname@example.org