“Subrogation is the substitution of one person by another in respect of a debt or claim, together with any associated rights and duties.”
It sounds simple enough at first. However, its application can be tricky.
Subrogation plays a crucial role in insolvency by protecting the interests of those who pay the debts of others.
Therefore, it is crucial to understand how, or if, subrogation applies if your clients intend to provide financial assistance to a company in this current economic climate, where corporate insolvencies are now above pre-pandemic levels.
It can mean the difference between a secure investment and a total loss for your clients.
In most cases, when a company becomes insolvent, it will not have enough funds or realisable assets to pay all its debts. Suppose a third party, such as a guarantor or a related entity, pays off a debt owed by the insolvent company. In that case, that party may be entitled to “substitute” the original creditor and have the same rights of claim against the company.
In addition, if the original creditor had security over the company, the “substitute” may be entitled to that same security as the original creditor, including its ranking as a secured creditor vis-à-vis other secured creditors.
When Does Subrogation Apply?
There are two situations where subrogation usually applies:
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- Where a guarantor pays all of the debt of the insolvent company which it has guaranteed; and
- Where a party pays off the secured debts of an insolvent company.
Therefore, anyone who is not a guarantor who pays off an unsecured company debt and believes they will be able to claim against the company may be in for a rude shock.
As a general rule, the law will refuse reliance on subrogation if a person makes a payment on behalf of a company without any request by the company for that payment to be made.
Accordingly, to overcome this risk, we always recommend the execution of a written assignment of the debt from the creditor before the debt is paid. However, this does not overcome the general risk of having little chance of recovery in an insolvency scenario.
The doctrine of subrogation is also included in legislation. Section 560 of the Corporations Act 2001 (Act) allows a party who pays employee entitlements owed to subrogate into the priority position of the employees.
This sounds straightforward. However, it needs to be done the right way.
In a recent case, a related party of a company in administration paid wages and other entitlements directly to the company’s employees to the tune of $160,000 without the company’s request. It later submitted a claim to the liquidator to subrogate it into the priority position of the employees’ claims for unpaid wages and entitlements. Employees receive distributions before ordinary unsecured creditors. The liquidator successfully argued that s560 of the Act did not apply.
Why? The section only applies where the company pays the employee-related liabilities itself using the monies lent to it by the donor. The result was that the related party could only claim as an unsecured creditor.
The takeaway is that if you intend to make a payment on behalf of another party, there are several issues and requirements to consider:
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- Funds provided to a company for the payment of entitlements (or any other payment) must be made to the company directly and not to the employees or other creditors;
- The funds provided must be at the specific request of the company, as opposed to a sporadic payment on behalf of the company;
- The company records must specifically account for the purpose of such funds with full particulars.
As you can see, the devil can be in the detail.
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 | ua.mo1739029131c.arj1739029131d@ofn1739029131i1739029131
Did you know?
Phoenixing is another name of business restructure. Read more about business restructures and when this can be an option for you.
