December 8, 2016

Bankruptcy: 'secured creditor' found wanting

There are two ways in which Bankrupt Trustees (“Trustees”) may gain access to a Bankrupt’s property in order to distribute it amongst creditors.  Firstly, property owned by the bankrupt at the commencement of the bankruptcy will vest automatically in the Trustee pursuant to Section 58 of the Bankruptcy Act (“the Act”).  Secondly, property formerly owned by the bankrupt but transferred prior to the commencement of bankruptcy will be recoverable if the transactions were made in circumstances that would allow the court to declare the transfer void against the Trustee.  The scenario below relates to the latter and Section 120 of the Act.

We were recently appointed as Trustees over an individual’s affairs where the estate’s main asset consisted of a residential property (“the Property”) which had three respective registered mortgages attached to the Property.  During the course of our investigations we identified that two of the three registered mortgages were provided by the Bankrupt to “secured creditors” for no consideration thereby having the effect of disadvantaging the estate’s creditors pursuant to Section 120 of the Act.

The purpose of Section 120 of the Act is to prevent properties from being put into the hands of relatives (or other parties) to the disadvantage of creditors.  In order to invalidate a transaction under Section 120 of the Act, the Trustees have the onus of proving that no consideration or consideration that was not equivalent to the market value of the property was provided.

If the transfer took place within five years of the commencement of bankruptcy, and the Bankrupt was insolvent at the time, the transaction will be voidable.  If, however, the transfer took place within two years or four years (to a related party) and at the time the transferor (i.e. the Bankrupt) was solvent then the transaction will not be void.  There are other exemptions but that is not the focus of this article.

Scenario: The Bankrupt’s main asset, the Property had a value of approximately $600k.  Prior to entering bankruptcy, the Bankrupt was the sole Director of a printing business.  Attached to the Property were the following three registered mortgages:

  1. Secured Creditor A, owed $450k;
  2. Secured Creditor B, owed $100k; and
  3. Secured Creditor C, owed $150k.

If the three registered mortgages were valid, there would have been insufficient funds to repay Secured Creditor C in full and certainly no funds would be available to the estate’s unsecured creditors.

Secured Creditor A was a major banking institution which provided the funding for the purchase of the Property and had a first ranking registered mortgage.  There were no issues with this registered mortgage.

However, Secured Creditor B and Secured Creditor C provided a different story.

Secured Creditor B and Secured Creditor C had a history of transactions with the Bankrupt and the Bankrupt’s former business.  These transactions included a business loan of $250k from Secured Creditor B ($150k) and Secured Creditor C ($100k) to the Bankrupt’s company (before the Company was placed in liquidation).  The business loan was received in June 2014 and in return Secured Creditor B and Secured Creditor C were provided a General Security Agreement (“GSA”) against the company as collateral.

A year later, i.e. June 2015, the Bankrupt provided the granting of a registered mortgage over the bankrupt’s residential property, for no consideration, in addition to the above GSA.  Six months thereafter (i.e. January 2016), the company was placed in liquidation and the sole Director entered bankruptcy soon after.

We successfully argued that the effect of providing a registered mortgage over the Property to Secured Creditor B and Secured Creditor C caused an unfair and uncommercial change to their respective priority positions in the bankruptcy’s estate, i.e. affording them a greater dividend return compared to the estate’s unsecured creditors.  As a result, Secured Creditor B and Secured Creditor C fortified their respective “secured positions”, and would now rank on a parri passu (equal) basis with the estate’s unsecured creditors.  The “undoing” of these mortgages will now provide a return to the estate’s creditors which is a great outcome given there would have been no dividend return should the second and third mortgages be upheld.

Section 120 of the Act had been breached in that:

  • The granting of the registered mortgage was made in circumstances where both Secured Creditor B and Secured Creditor C knew or ought to have known that the company’s director was insolvent and could not meet his debts as and when they fell due;
  • No consideration was given in relation to the granting of the registered mortgage, or if any consideration was provided it would be deemed as post-consideration; and
  • The Deed of Loan did not attach the Director as guarantor of the loan or address what would occur to the Director (financially) if the Company failed to meet its obligations under the Deed of Loan.

Clearly there are provisions in the Act which allow Trustees to claw back certain transactions which would otherwise disadvantage creditors as evidence above.  “Secured creditors” in similar situations should review their positions otherwise they could find themselves forfeiting their registered mortgages and ranking on an equal basis with unsecured creditors.

If any of your clients have received a bankruptcy notice and would like to discuss the options please contact one of SV Partners insolvency experts on 1800 246 801.

Article written by Frank O’Neill, Senior Manager, Queensland

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