The free assets of the company and when they are free to take: equitable subrogation and the secured creditor.

• Jurisdiction: Australia
• Author: Wangmann, Katherine
• Date: 01 August 2015

CONTENTS I Introduction II Background to 'Free' Company Assets and ss 433 and 561 A The 'Free' Assets B Fixed Charges and Floating Charges C Section 433 D Section 561 E Consideration of ss 433 and 561 F Equitable Subrogation III The Secured Creditor's Right to Equitable Subrogation A Section 561 and Equitable Subrogation 1 Cook v Italiano 2 Damilock 3 Dalma No 1 4 Saker 5 Leon Plant Hire B Section 433, Recoupment and Equitable Subrogation 1 Cook v Italiano 2 ExDVD C Reconciliation of the Authorities IV Determining the Rights of Secured Creditors A Recovery of Specific Property and Money B Should We Recognise a Right of Subrogation? C Does Subrogation Require a Breach of Trust? D Whether Subrogation Should Be Statutory or Equitable V Conclusion I INTRODUCTION

A longstanding principle in insolvency law is that the proceeds from preference recoveries (1) are available for distribution in accordance with the statutory priorities set out in s 556 of the Corporations Act 2001 (Cth) ('Corporations Act'). Assets distributed under s 556 of the Corporations Act are sometimes called the 'free' assets of the company because they are not subject to any security interest.

The first priority for payment from the free assets is the payment of the various expenses of the winding up. After those expenses are paid, ss 556(1)(e)-(h) of the Corporations Act provide for the payment of employees' wages, superannuation contributions, workers' compensation, leave entitlements and retrenchment payments. When all priority debts have been paid, any remaining assets may be distributed to the unsecured creditors in accordance with the pari passu principle enshrined in s 555.

However, in some circumstances, priority debts may also be paid from the secured assets of the company. Sections 433 and 561 of the Corporations Act provide for the payment of debts including the debts set out in ss 556(e), 556(g) and 556(h) from circulating (or floating charge) assets. Conversely, courts have recognised an equitable right of subrogation by which a secured creditor may sometimes be entitled to payment of a secured debt from the free assets of the company.

This article considers the application of ss 433 and 561 of the Corporations Act and the effect of recent case law regarding secured creditors and equitable subrogation. Consideration is given to whether secured creditors should be entitled to the free assets of the company, including the proceeds of preference recoveries, and whether a right of subrogation should be recognised. This article also considers whether the right of secured creditors to share in the free assets of the company should depend on whether those assets are moneys or specific property. Finally, this article reflects on the kind of right of subrogation that might be recognised and whether a right of subrogation should be enshrined in legislation.

In this article, those debts under ss 556(e), 556(g) and 556(h) are referred to as the 'employee debts' because they generally comprise employee wages, superannuation, workers' compensation, leave entitlements and retrenchment payments. The people owed those debts are referred to as the 'employee creditors'.

II BACKGROUND TO 'FREE' COMPANY ASSETS AND SS 433 AND 561

A The 'Free' Assets

The principle that the proceeds of preference recoveries belong to the unsecured creditors of the company has existed for over several hundred years in English law. (2) In the decision of N A Kratzmann Pty Ltd (in liq) v Tucker [No 2] ('Kratzmann'), (3) the High Court considered whether the proceeds of a preference recovery were subject to a charge in favour of the secured creditor. The High Court held that a conveyance of land or transfer of specific property could be subject to a charge in favour of a secured creditor. (4) On the other hand, a transfer of money was not available to secured creditors. The rationale for this view was that, although a money transfer may have been subject to a charge at the time of the transfer, the money recovered by court order is not the same money. (5)

The finding in Kratzmann was in line with English authority at the time and in particular the decision in Re Yagerphone Ltd ('Yagerphone') where Bennett J found that the proceeds of a preference recovery did not become part of the general assets of the company but was a sum of money received by the liquidators and available for distribution to the unsecured creditors. (6) However, the English case law did not make a distinction between the transfer of land or specific property and the transfer of money.

The decision in Kratzmann has been approved and followed by Australian courts (7) until the recent decision of Finkelstein J in Cook v Italiano Family Fruit Co Pty Ltd (in liq) ('Cook v Italiano') which challenged the findings in Kratzmann. (8)

B Fixed Charges and Floating Charges

Prior to the Personal Property Securities Act 2009 (Cth) ('PPSA'), a secured creditor usually held either a fixed or floating charge over a company's assets. A fixed charge was generally held over specific assets of the company while the other assets of a company, such as stock, inventory and receivables, were subject to a floating charge. (9)

Whether a secured creditor's charge was a fixed charge or a floating charge usually depended on the level of autonomy that the company had in relation to the particular asset. (10) If the company could not deal with the asset except by reference to the secured creditor, the charge over that asset was likely to be characterised as a fixed charge.

On the other hand, if the company was permitted to deal with the asset in the ordinary course of business, a charge over that asset was likely to be characterised as a floating charge. (11) For example, receivables have generally been characterised as floating charge assets because a company is usually free to collect the receivables and deal with the proceeds in the ordinary course of its business without reference to the charge holder. Similarly, a charge over future (or not yet acquired) property was usually considered a floating charge. (12) The floating charge only attaches to the particular assets on crystallisation --usually on the appointment of receivers and managers or administrators, or on the default of the company. (13)

Under the PPSA, the terminology of 'fixed charge' and 'floating charge' has been replaced by the concept of the security interest in circulating or non-circulating assets. (14) Section 51A of the Corporations Act defines a 'security interest' as a PPSA security interest or a charge, lien or pledge. Section 51C(b) of the Corporations Act confirms that a circulating security interest includes a security interest that is a floating charge. Collateral that is the subject of a circulating security interest is a circulating asset. Correspondingly, collateral that is the subject of a non-circulating security interest is a non-circulating asset.

Similar to the distinction between fixed and floating charge assets, a security interest is a circulating security interest if the company has the authority to deal with the relevant assets in the ordinary course of business. (15) Under the PPSA, some kinds of assets such as receivables and inventory are deemed circulating assets unless the secured party meets certain PPSA registration and control requirements. (16)

C Section 433

Sections 433(2)-(3) of the Corporations Act preserve the circulating assets of a company or their proceeds for the benefit of the employee creditors in circumstances where the secured creditor has exercised its rights under the security agreement and where the winding up of the company has not commenced. Section 433 is the successor to s 331 of the various Companies Acts passed in 1981 ('Companies Code') and s 196 of the uniform Companies Acts of the early 1960s ('Uniform Companies Acts'). (17)

Section 433 is a remedial provision designed to favour employee creditors by giving them a statutory entitlement to assets that would not otherwise have been available to them. (18) The section allows certain employee debts to have priority to the claims of other creditors. In Korda v Silkchime Pty Ltd, Le Miere J explains that:

The purpose and effect of s 433 and its statutory predecessors is to protect the position of preferential creditors by giving preferential claims priority over the claims of floating chargees who would have otherwise "scooped the pool" of the chargor's assets. (19) Two criteria must be met for s 433 to apply. First, there must be a receiver appointed or a person must have taken possession of or assumed control of the circulating assets. (20) This may occur where the secured creditor has appointed a receiver. Alternatively, there may be an administrator, liquidator or agent of the secured creditor who has taken possession of or assumed control of the circulating assets.

The employee debts must be paid from the circulating assets or their proceeds before the possessor can use those assets to pay out the secured creditor. The obligation extends only to circulating assets in the possessor's possession or control. In Cook v Italiano, Finkelstein J describes the obligation as follows:

the section relevantly requires the receiver or agent to pay out of property coming into his/her hands certain debts in priority to any claim for principal or interest by the debenture holder. The priority debts include most of the priority debts payable out of floating charge assets under s 561 and in particular the employee entitlements. (21) There is authority that, if the secured creditor takes possession of the circulating assets, he or she has an obligation to comply with s 433. (22)

Secondly, the receiver's appointment or the taking possession or control of the assets must occur prior to the winding up of the company. Section 433 does not apply where the winding up of the company has commenced. (23)

Section 433 will still apply if the company is in voluntary...