The concept of security
A debtor and lender enter into a loan agreement. The lender agrees to provide credit to the debtor in exchange for the debtor’s promise to repay the loan together with interest. If the debtor defaults, the lender has a contractual/personal right to sue the debtor for any loss it has suffered. In the event of the debtor’s insolvency, the lender is an unsecured creditor and may prove for the amount of the outstanding debt.
Because of the risk of insolvency, most prudent lenders will require the provision of ‘security’ by the debtor when advancing credit. A transaction is secured where the debtor agrees to provide the secured party with recourse to its property if the debtor defaults on its obligations. Such a security interest is usually evidenced by a written document signed by the parties.
By this process, the secured party acquires a proprietary interest in the debtor’s collateral. Unlike the personal/contractual right to repayment, the proprietary interest attaches to the collateral itself and is therefore enforceable against third parties including the debtor’s trustee or liquidator.
Summary of the PPSA
The Act introduces fundamental changes to the creation, registration and enforcement of securities in personal property. It deals solely with consensual security agreements. Liens and other interests created by the operation of the general law are expressly excluded from the PPSA.
Under the PPSA, property subject to a security interest is referred to as ‘collateral’. The party giving an interest in its property is the debtor/grantor, while the party taking the interest is known as the secured party/creditor.
First, the Act modifies existing equitable and common law property rules and replaces them with a statutory framework where prime importance is placed upon the concept of ‘perfection’ and the registration of security interests. Perfection of a security occurs when a secured party effectively provides notice to third parties of its security. Perfection is crucial because it enables a secured party to achieve a ‘priority time’ against competing security interests and protection from the consequences of a debtor’s insolvency. Before a security interest may be perfected, it must have first ‘attached’ to the collateral. Subject to exceptions, the Act gives priority to the secured party that is first to perfect its security.
In contrast, there are significant consequences for failing to perfect a security interest. An unperfected security is:
- subordinate to the interests of an execution creditor that has seized the collateral;
- subordinate to a perfected security in the same collateral; and
- subordinate to the a buyer/lessee of the collateral.
Most importantly, an unperfected security interest will vest in the debtor upon insolvency. Perfection is therefore essential to protect a secured party’s interests.
The steps taken to perfect a security will vary depending upon the category of personal property subject to the security (IE tangible, intangible). A security may be perfected in three ways:
- possession – the secured party takes physical possession of the collateral;
- control – the secured party takes all steps necessary to be in a position to sell the collateral without further action by the grantor. Perfection by control is only available for ADI accounts, investment entitlements, investment instruments, uncertificated negotiable instruments and letters of credit; and
- registration – filing a Financing Statement on the Personal Property Securities Register (likely to be themost common form of perfection)
As a general rule, perfection by control has priority over perfection by other means but only applies to certain types of collateral.
In most cases the secured party will elect to perfect their security by registering it on the newly created PPSR. This register is designed to consolidate all existing registers of security interests in personal property – such as the Australian Register of Company Charges (Cth) and the Vehicles Securities Register (Vic).
Registration will be achieved by the filing of an electronic Financing Statement recording prescribed information about the secured party, the debtor/grantor and the collateral. Care must be taken when entering this data because a misdescription may render the security misleading and potentially invalid. Lodgement of the document creating the security is no longer required for registration purposes.
Functional approach to security & title-based securities
Second, the PPSA introduces a ‘functional approach’ to security. This means a security interest in personal property is created whenever the security ‘is provided for by a transaction that in substance secures payment or the performance of an obligation’.
The Act has therefore expanded the concept of security to include title-based securities such as:
- retention of title clauses/romalpa clauses;
- conditional sale/hire-purchase agreements;
- commercial consignments;
- a lease of goods for more than one year or ‘financing lease’ (now called a PPS Lease under the Act).
The Act also recognises that manufacturers and vendors of goods, which predominantly employ title-based securities (known as Inventory Financiers) service a different financial need to General Financiers (which are generally first in time and secure credit against all a debtor’s present and after acquired property).
In effect, Inventory Financiers are seen to increase the financial viability of a debtor by providing additional working stock and inventory. Consequently, the Act gives titled-based securities a special priority over General Financiers, if certain requirements are met. This special priority is known as a ‘purchase money security interest’ (“PMSI”) because the buyer’s obligation to pay the purchase price of the goods is secured by a security interest in those goods in favour of the seller.