What is perfection by control?

Control is a way of stamping or advertising the existence of a security interest over collateral. This is done generally by having the person who administers the collateral note the existence of the security interest, and restricting that person’s right to dispose of the collateral without the consent of the secured party.

Control is not available for all types of collateral – only for collateral that is owned by one party (the grantor) but administered by another party. Control is available as a method of perfection for only six (6) classes of collateral, namely¹:

1. 1. ADI accounts;
   2. investment instruments, which includes many things but the most important are unlisted shares, bonds, derivatives (not defined under the PPSA), interests in managed investment schemes, and financial products that are traded on financial markets;
   3. intermediated securities, which has a complex definition but essentially refers to securities held by an intermediary in a securities account. The definition of securities account was amended prior to the commencement of the PPSA to ensure that ASX-listed shares are treated as intermediated securities for the purposes of the PPSA²;
   4. letters of credit;
   5. negotiable instruments not evidenced by a certificate; and
   6. satellites and space objects.

Why is perfection by control so powerful?

Control is a powerful way of advertising to the world that a secured party has an interest in collateral. A secured party’s control over collateral removes (except for ADI accounts) the collateral from the sphere of control of the grantor. Third parties are then unlikely to misjudge that the grantor owns the collateral free from security interests – the collateral will not be available to further encumber. Put another way, perfection by control, by its nature, squarely addresses the apparent ownership problem in personal property secured transactions (see the discussion at paragraph 15.1.2 of Chapter 15 (Why the PPSA?)).

This helps to explain why security interests perfected by control are accorded such high priority, above other registered security interests including PMSIs. For example, a PMSI could attach to proceeds of sold collateral deposited into an ADI account, but a subsequent perfected security interest held by the account bank over the ADI account will win because the account bank is perfected by control (see paragraph 17.6.9 and below), regardless of the time of perfection, or knowledge of the prior PMSI. The account bank has the inherent power to control an ADI account by blocking transactions on the account, for example, following an event of default, in a way unavailable to other parties.

For security interests over shares in a private company (Company B), one way to perfect by control is to register the secured party as the owner of the shares in the register of members maintained by Company B. This means that others who conduct a company search on Company B will see the secured party registered as a shareholder (pursuant to its security interest over shares in Company B). Given this form of control, a person coming along later and investigating those shares is very unlikely to miss the fact that the grantor clearly has a mere encumbered interest in the shares, and that the shares are not available for further encumbrance, at least not a first-ranking encumbrance. This is because another secured party is registered as the owner of the shares (by virtue of holding a security interest over the shares).

Control can be very effective at advertising security interests to the world, hence its very powerful priority position.

Two or more security interests perfected by control over the same collateral – first to take control wins
If two or more security interests are perfected over the same collateral by control, then the first to take control wins³.

Perfection by control over ADI accounts, investment instruments and intermediated securities is discussed below.

Perfection by control over ADI accounts

Only the account bank can perfect by control

Only an account bank (the bank at which an ADI account is held – say Bank A) can be in control of an ADI account for the purposes of perfecting a security interest over the ADI account⁴. It does not matter that a grantor may retain the right to instruct withdrawals from an ADI account – the account bank is still perfected by control, automatically, by virtue of being the account bank⁵.

ADI accounts as circulating assets

Prior to the commencement of the PPSA in early 2012, bank account control agreements were frequently used to grant effective control over a bank account held with one bank (Bank A), to another person (Party B) who has security over the bank account, so Party B has control over withdrawals from the account. This was often done to ensure that Party B has sufficient control over the account to support a fixed (as opposed to a floating) charge, or simply for practical reasons to control the proceeds in the account, and prevent them being dissipated.

An appropriately registered (the registration must nominate that the ADI has control over the ADI account) security interest over an ADI account held by the account bank (ADI) will not be a circulating security interest, regardless of whether the ADI account is a current account or a term deposit⁶, and regardless of whether the grantor retains the right to operate and make withdrawals from the account⁷. ADI accounts that are current accounts (not term deposits) are, however, circulating assets to all other secured parties other than the ADI unless subject to an adequate bank account control agreement in favour of the secured party⁸. This is significant because circulating security interests are subordinated to employee entitlements and an administrator’s lien upon the insolvency of the grantor.

Thus, the PPSA overrides case law that suggests that a current account would be a floating charge (circulating) asset⁹, but only where the ADI (account bank) is the secured party and holds a registration that nominates control over the ADI account. This appears to be very generous to banks.

“Chargebacks” are permitted under the PPSA

Chargebacks were controversial for a long time because a bank account is essentially a debt which a bank owes to a customer. Many courts and commentators saw conceptual difficulty with a bank taking a charge over a debt that it itself owes.

The PPSA removes all doubt and expressly confirms that charge-backs are possible, over both bank accounts and all obligations in general. This means that the person to whom a debt or other obligation is owed, can grant security over it to the person who actually owes them the obligation¹⁰.

Implications for taking security over Australian bank accounts

If an account bank takes security over an ADI account to defeat other existing security interests over the account not perfected by control, both the grantor (owner of the bank account) and the secured party (account bank) would need to be very careful of negative pledge restrictive covenants in existing loan or security agreements to which the grantor may be subject from other financiers prohibiting the grant of further security. Restrictive covenants that prohibit the grant of further security may not void any further security granted¹¹, but the breach of covenant would likely be an event of default, which may precipitate enforcement by other financiers. The account bank would also need to be careful of the tort of inducing a breach of contract by asking or inducing the grantor to grant further security in breach of restrictive covenants.

Further, security granted just prior to the onset of insolvency carries the risk of being set aside as a preference or other voidable transaction¹².

One practical solution for account banks could be to take a security interest over the account in account opening forms, which does not become enforceable unless an event of default listed in the account opening forms occurs. This may avoid any argument about an account bank taking security later, in breach of restrictive covenants granted in favour of other financiers which prohibit the grant of further security over ADI accounts.

Second, and for the reasons stated above, bank lenders (say Bank X) are likely to require significant cash or proceeds accounts in structured, project or other large financings to be held with them so that they have control over these ADI accounts for the purposes of perfecting security interests held over the ADI accounts. This will prevent other banks at which ADI accounts may be held (say Bank Y) from taking a security interest over the bank accounts to defeat prior registered security interests over the accounts held by others. In other words, “split banking”, where a borrower holds transaction accounts at one bank, and then borrows from another bank, is likely to become less common in Australia.

Control over intermediated securities

A secured party must obtain the power to direct an intermediary in order to perfect a security interest by control over an intermediated security. This can be done by either¹³:

1. 1. entering into a tri-partite agreement between the grantor/owner of the securities, the secured party and the intermediary; or
   2. having the grantor and the intermediary enter into a bilateral agreement; or
   3. entering into a bilateral agreement between the grantor/owner and the secured party, which is then notified to the intermediary.

ASX-listed shares are treated as intermediated securities under the PPSA¹⁴. Prior to the commencement of the PPSA, a secured party would normally take security over ASX-listed shares by entering into a sponsorship agreement with the broker who is the sponsor of the shareholding in the CHESS system. The sponsorship agreement would provide that the broker must not sell or otherwise deal with the shares without the consent of the secured party, to ensure that the secured party has control over the shares. Such a sponsorship agreement will be sufficient to perfect a security interest over ASX-listed shares (intermediated securities) by control under the PPSA¹⁵.

Control over investment instruments

Perfection by control over shares in an unlisted company

To perfect a security interest by control over shares in an unlisted company, the secured party can have the company (the issuer of the shares) register the secured party as owner of the shares¹⁶.

For example, assume Party A owns shares in a unlisted company, Company B. Party A could give a secured party control over those shares for the purposes of perfecting a security interest over the shares by procuring that the issuer of the shares (Company B) register the secured party as owner (by virtue of having a security interest in the shares) of the shares in the register of members held by Company B. Perfection by control over shares in an unlisted company in this way is, therefore, very similar to taking a legal mortgage of shares prior to the commencement of the PPSA.

Alternatively, given that shares in an unlisted Australian company will normally be evidenced by certificate, control can be taken by taking possession of the share certificates and taking authority from the grantor in the security agreement to transfer the share certificates (for example, upon an event of default occurring)¹⁷. This has been the standard practice pre-PPSA for taking security over shares in an unlisted company, and this practice/method will be effective under the PPSA to perfect a security interest over shares in an unlisted company by control.

Investment instruments listed on a prescribed financial market

Where investment instruments are listed on a prescribed financial market (often this will be a stock exchange or similar), control can be taken by a secured party by:

Section 27 of the PPSA also includes other ways to take control over an investment instrument.

Rules for taking control over letters of credit and negotiable instruments