Transfers of collateral jeopardise security interests
When collateral is transferred (sold or leased) by the grantor it raises various issues about the position of secured parties holding security interests in the collateral.
The threshold question is whether the transfer extinguishes security interests. There are ten (10) extinguishment rules under the PPSA, which extinguish security interests for the benefit of purchasers or lessees in certain circumstances when collateral is sold or leased. The extinguishment rules are discussed in detail in the next chapter, Chapter 21 (The Extinguishment Rules).
Transfers by way of sale of collateral are tricky because they mean that the owner of collateral changes from
the original grantor to a new party, the buyer. This is so even if the terms of a security agreement that governs a security interest over the transferred collateral prohibit the grantor from selling collateral without the consent of the secured party. Grantors can validly transfer (or grant further security interests over) collateral despite restrictive covenants in security agreements that prohibit grantors from transferring or further encumbering collateral, which are sometimes called negative pledge clauses1. The PPSA validates unauthorised transfers or grants of security to promote certainty and protect buyers and incoming secured parties. The position of existing secured parties is then determined according to the extinguishment rules and other priority rules.
Unauthorised transfers or grants of security can, of course, still trigger defaults or events of default under security agreements, depending on the terms of applicable security agreements. The validation of transfers and grants of security does not preclude defaults.
Transfers, at least by way of sale, mean that existing security interests granted by the seller are potentially no longer validly perfected because the identity of the owner of the collateral, and therefore the grantor under those security interests, has changed. Without more this would invalidate the registrations of security interests attached to the transferred collateral. Perfection by registration under the PPSA is primarily registration against the grantor, and the grantor potentially changes when collateral is sold. Registration can be also be against the serial number of serial numbered property that must be registered by serial number, which is consumer serial numbered property and commercial aircraft only.
The PPSA forms a compromise, using temporary perfection, to protect secured parties when collateral is transferred, as explained below.
Transfers of collateral raise five (5) key issues for secured parties
Transfers of collateral raise at least the following five (5) key issues for secured parties:
(a) first, does the transfer (sale or lease) extinguish security interests in the collateral for the benefit of the buyer or lessee?
There are ten (10) extinguishment rules under the PPSA. These are discussed in Chapter 21 (The Extinguishment Rules).
If a security interest is extinguished, then that is the end of the game against the transferred collateral. The buyer or lessee takes free and clear of the security interest. If the extinguishment
is by lease, when the lease term expires and the collateral is returned to the grantor the extinguished security interests can re-enliven – see the discussion commencing at paragraph 20.1.8 below, and at paragraph 21.15.1 and below of Chapter 21 (The Extinguishment Rules);
(b) second, assuming a security interest is not extinguished upon a transfer of collateral, does the security interest continue in the collateral in the hands of a buyer or lessee?
The answer is yes, provided that proceeds are generated by the transfer or disposal of the collateral2. The general rule is that where secured parties have not expressly or impliedly consented to the release of their security upon a transfer of collateral, security interests in collateral granted by sellers or lessors:
(i) continue to attach to collateral in the hands of a buyer or lessee provided that proceeds are generated by the transfer3; and
(ii) are temporarily perfected for up to 24 months against the collateral in the hands of the buyer or lessee, if perfected against the seller or lessor before the transfer4.
There are special rules to deal with priority contests that arise between secured parties of a seller and a buyer of collateral where collateral is sold without extinguishment of the security interest held by the seller. These situations may arise where a buyer of collateral has itself granted either existing all-assets security interests that attach to after-acquired property and attach to the collateral in question once acquired by the buyer, or the buyer grants new security interests over the collateral once acquired. See paragraph 18.16.1 and below of Chapter 18 (Priority) for discussion5;
(c) third, do security interests attach to the proceeds generated when collateral has been transferred, such as sale proceeds or rental income?
Again, yes. Security interests automatically attach to all proceeds of collateral, in addition to the security interest continuing in the collateral transferred into the hands of a buyer or lessee unless extinguished6. Secured parties must also ensure their security interests are perfected against proceeds. Perfection against proceeds will be most common by registration. Perfection is automatic (even without registration) for proceeds that are currency, cash in ADI accounts, cheques and insurance proceeds for damage to collateral7 provided a registration covered the original collateral before disposal. See paragraph 17.8.2 of Chapter 17 (Perfection) for further discussion on how to perfect against proceeds;
(d) fourth, can a secured party assert or enforce its security interest against both the original collateral in the hands of a buyer or lessee (if the security interest is not extinguished upon transfer of collateral), and in addition against proceeds generated from the transfer?
Again, yes. Secured parties can assert rights against both the original collateral (if the security interest is not extinguished upon transfer) and proceeds generated from the transfer such as sale proceeds or rental income, but limited to the value of the collateral when transferred8.
A secured party has two sources of recovery where security interests are not extinguished upon transfers of collateral - the original collateral and the proceeds - but collectively is limited to the value of the collateral when it was transferred. This gives secured parties and receivers or controllers appointed by them two potential pools of assets from which to recoup the moneys or obligations owed to them, and is likely to maximise recoveries for secured parties; and
(e) fifth, if a security interest is extinguished upon a transfer of collateral, can the secured party subrogate to any rights of the grantor to receive proceeds such as an unpaid purchase price or future rent due under a lease of the collateral?
Yes. An extinguished secured party may subrogate to any “rights in relation to the collateral” which the grantor receives from the disposal, such as the right to receive an unpaid purchase price, or the right to receive rent under a lease. See paragraph 21.16.1 and below of Chapter 21 (The Extinguishment Rules) for discussion of these subrogation rights.
Re-attachment of (extinguished) security interests to goods when the lease term expires or a sale of goods is rescinded
Leases are by definition for a limited period. Upon expiry of leases the collateral reverts to the lessor free of the lease. For goods only, upon the expiry of a lease, security interests that were extinguished by the lease re-attach to the collateral9.
Provided that a registration of the extinguished security interest remains effective when the lease expires and the goods return to the lessor, perfection of the extinguished security interest re-enlivens and priority is determined as if the goods were never leased and the security interest never extinguished10.
A similar result applies where goods are sold and the sale extinguishes a security interest, yet the sale is later rescinded or avoided and the goods are returned to the grantor (seller).
There is, accordingly, a powerful incentive for secured parties not to release or amend their registrations when collateral is leased or sold, even if their security interests are extinguished. Instead, secured parties should (if possible) maintain registrations in case goods are returned to the grantor, to ensure that their security interests re- perfect.
The return of goods upon the expiry of leases or the rescission of sales that extinguished security interests over collateral is discussed further at paragraph 21.15.1 of Chapter 21 (The Extinguishment Rules).
Notes:
1 PPSA section 79 (1)
2 PPSA section 32(1)
3 PPSA section 32(1)
4 PPSA section 34(1)
5 The PPSA is clear (section 66(1)(c)) that this applies to both existing future property security interests such as general security interests (fixed and floating charges), which will attach to after-acquired property, as well as security interests newly granted by a buyer of collateral after acquisition of the collateral.
6 PPSA section 32
7 PPSA section 33(1)(c)
8 PPSA section 32(2)
9 PPSA section 37(1)
10 PPSA section 37
