Owen Hodge Lawyers takes a look at a recent case history as an example of how business clients can keep trading profitably with their customers even if their customers are running the risk of insolvency.
Our client is a successful supplier of sports shoes. It had been doing business with its major customer for over four years but the customer had a recent change of management for the worse and it fell into arrears with its tax debts.
The management at our client’s customer decided to break all the rules and start up a new company with the same name. It redirected all its own customers to the new company – leaving all the accumulated debt (including all the accumulated tax debts) in the old company. The old company ceased trading shortly afterwards and a liquidator was soon appointed.
The process of starting up a new company leaving the debts in the old company is called “Phoenix Trading” and is highly unlawful. Directors can run the risk of being pursued by the liquidator of the old company for breach of up to five sections of the Corporations Act (ss 180, 181, 182, 183 and 184). Phoenix trading can also put the company’s own legal advisors at risk. See ASIC v Somerville  NSWSC 934, where a solicitor who helped clients strip assets from their company before liquidating it, was banned from being a company director for six years.
Nevertheless despite these issues, the new company wanted to re-commence buying from its favourite supplier (our client) and our client soon began to supply its sports shoes to the new company. There is nothing wrong or unlawful with that.
But what would happen if the new company also failed? Its liquidators could quite possibly pursue our client for receiving unfair preferences (s 588FA Corporations Act) and this could result in our client having to refund to the liquidator all the moneys it had legitimately received from the new company for payment of sports shoes previously sold to the new company within 6 months of the commencement of the winding up – section 588FE(2)(b)(i) Corporations Act 2001.
The issue put to us was: what securities or other arrangements could be put in place to legitimately prevent the operation of the unfair preference provisions? How could our client be protected from its own customer’s liquidation?
There were a number of things that could be done and here they are:
1. Firstly, the resupply of the sports shoes continued only after changing the terms and conditions of sale to ensure that a Romalpa (ie. Retention of Title) clause was in place. Personal property security registrations were also effected. This ensured that if our client’s customer fell into liquidation, our client could recover the actual sports shoes that were in the possession of their insolvent customer, but unsold.
2. Secondly, the terms were also changed to ensure that sale of the sports shoes by our client’s customer through a chain of sales to any number of sub-distributors (or resellers) was not authorised by the terms and that the security interest in the sports shoes therefore remained intact – see s 32 of the Personal Property Securities Act and Warehouse Sales Pty Ltd v LG Electronics Australia Pty Ltd  VSC 644. Only sales of the sports shoes to an end-user (ie. a retail ‘mum and dad’ customer) for value without notice of our client’s security interest were authorised.
This meant that the sports shoes could be recovered from distributors and sub-distributors (if any) in the event that our client’s customer went into liquidation.
It is generally a lot easier to recover the actual sports shoes than recover their proceeds of sale. Recovering the proceeds of sale can be a protracted and difficult process, despite the fact that a properly drafted personal property securities registration should ensure that the security interest continues into the proceeds of sale of the goods in question.
3. Thirdly, we further changed the terms of sale to ensure that our client’s customer was bound to direct its own end-users to pay the money due to it not into our client’s customer’s trading account (which could be frozen upon the appointment of a liquidator) but into a separate bank account over which our client was the sole signatory.
By ensuring that the terms complied with s341 of the Personal Property Securities Act, our client was able to “control” that account and thereby have the highest priority available to any security holder under the Personal Property Securities Act.
Of course the bank with which the trading account was opened arguably had a higher priority by virtue of s 25 of the Personal Property Securities Act and so an Account Bank Deed was required to ensure that our client’s priority was higher than that of the bank. See Dura (Australia) Constructions Pty Limited (in Liquidation) (Receivers and Managers Appointed) –v- Hue Boutique Living Pty Limited  VSCA 326, and s 57 of the Personal Property Securities Act 2009.
4. Fourthly, what would happen if end-users ignored these directions and paid our client’s customer’s account instead of the third party bank account? An ‘allpap’ general security deed giving our client a security interest over our client’s customer’s ‘all present and after acquired property’ was also put in place to cover this exigency. It also covered all circulating assets as defined in s 340 of the Personal Property Securities Act.
5. Fifthly, we suggested to our client that its customer’s directors should give personal guarantees. Of course, the problem with guarantees is that any litigation can take up to 18 months to litigate – giving guarantors ample time to divest themselves of assets. Whilst this activity is a breach of s 121 of the Bankruptcy Act, it is not uncommon because it places stumbling blocks in front of creditors, should litigation become necessary or be pursued.
6. However, we updated our guarantees long ago to include a provision granting a security interest in the guarantor’s own personal property, and so upon breach a receiver can be immediately appointed. This reduces the risk of costly litigation and lengthy delays. In addition, our new charging clause can prevent any attempt by the guarantor to transfer their real estate to third parties.
How did our client go? They went really well, but then its own customer began to run short of cash and wanted to put in place an invoice financing facility. The factoring company wanted to rely on s 64 of the Personal Property Securities Act and assert its recovery rights ahead of our client’s securities.
The factoring company
Section 64 of the Personal Property Securities Act is to the effect that when accounts are sold, the purchaser of the accounts has a security interest in them which ranks ahead of any general security agreement.
Our client did not oppose the demand of the factoring company, as our client’s customer had previously agreed (as mentioned in point 3 above) to ensure its own end-users paid for the goods by paying the proceeds of sale into the separate bank account. This would arguably therefore by-pass the factoring company’s security interest as our client’s customer’s accounts did not extend to the separate bank account which had been previously set up.
The factoring company was not impressed with this arrangement (for obvious reasons) but nevertheless, we negotiated a position by which the factoring only applied to such invoices of our client’s customer as did not include the sports shoes supplied by our client.
This made it clear (i.e. beyond any argument) that the interest of the factoring company did not extend into the separate bank account that had been previously set up. This meant that our client’s security in the separate bank account was not affected by the invoice financing facility.
Our client has continued to trade profitable in the knowledge that its security documents and terms of trade protect it to the maximum extent permitted by law.