As the old saying goes, forewarned is forearmed. ROT suppliers need to be aware of the limitations associated with their ROT rights under the PPSA and factor these in when preparing their ROT clauses and when determining whether to continue to offer their goods on an ROT basis to particular customers.
ROTs under the PPSA
First, a quick recap:
Under the PPSA an ROT supplier's ownership rights in the goods it supplies to a customer are treated as a security interest in those goods. Unless those rights are registered they will lose priority to another registered security interest, such as a general security interest registered by a bank against a customer’s assets or be unenforceable as against a liquidator, if the customer goes insolvent.
If an ROT interest is properly registered, provided the goods supplied are not used mainly for domestic, personal or household use, it has a special priority status. Under the PPSA, ROTs are known as “purchase money security interests” or “PMSIs”. Registered PMSIs would trump pretty much all other types of security interests in the same goods, even if the other security interests are registered before the PMSI.
In most instances, a PMSI over the goods supplied would extend to, and give the registered ROT supplier priority over, any proceeds generated from any dealing with those goods.
Exception to the power of a PMSI
Whilst the supplied goods remain in the hands of the customer a registered ROT supplier's rights in those goods will remain paramount. Issues arise, however, once the customer disposes of those goods and an ROT owner's rights in those goods are converted into rights over any debt owing to the customer in respect of those goods (ie. outstanding tax invoices) or rights in the proceeds earned from the sale of those goods.
There are 2 situation where a third party's rights are able to trump the super priority of the PMSI held by a registered ROT supplier:
First, a debt factoring financier that has taken an assignment of the debt owing to the customer of the ROT supplier in respect of the ROT goods that customer has sold may have priority over the ROT supplier in respect of the assigned debt; and
Second, a bank that is financing the customer of an ROT supplier will have priority over the ROT supplier in respect of any cash proceeds derived from the sale of the ROT goods which are sitting in the customer's account with that bank.
Rights of a debt factoring financier
Under section 64 of the PPSA a registered non-PMSI security interest granted to a debt factoring financier for new value in an account in respect of sold inventory would have priority over a registered ROT in respect of an invoice arising from the sale of that inventory where:
the financier's interest is registered prior to the ROT interest; or
the financier's interest is registered after the ROT interest and the financier gives a notice (compliant with section 64(2)) to the registered ROT interest holder at least 15 business days before the earlier of registration or attachment of the financier's interest in the debt.
The above carve out for a debt factoring financier's rights exposes an ROT supplier to a greater risk of not being able to recoup the full amount owing in respect of the goods supplied in circumstances where those goods have been sold. This is because the ROT supplier's super priority would no longer extend to any debts assigned to a financier that has either notified the ROT supplier of its interest or registered prior to the ROT registration.
The following example illustrates how section 64 could work to undermine a registered ROT supplier's rights.
Customer A purchases widgets from Supplier B on ROT terms, which Customer A on-sells on 90 day credit terms. Supplier B registers its ROT interest in the widgets on the PPS Register. To help finance its business and assist with its cash flow requirements Customer A obtains a loan from Financier C and in return assigns its outstanding invoices in respect of all sold widgets to Financier C. 15 business days prior to registering its interest in the accounts, Financier C gives Supplier B written notice of its intention to start taking assignments of debts from Customer A. Shortly thereafter, Customer A goes into liquidation. At the time of liquidation Customer A has purchased $100,000 worth of widgets from Supplier B on an ROT basis, all of which it has on sold. Only half of the debts in respect of the sold widgets have been paid, with the proceeds sitting in Customer A's bank account with Bank D.
In the absence of a section 64 notice from Financier C, Supplier B would be entitled to claim amounts owing under all outstanding debts as well as cash proceeds sitting in Customer A's account with Bank D, to the extent necessary to pay the purchase price of the widgets.
Let's change the above scenario, so that Financier C has given a valid section 64 notice 15 business days prior to taking assignments of any debts from Customer A. Whilst Supplier B would still have priority over Financier C in relation to the cash proceeds sitting in Customer A's bank account with Bank D, the effect of Financier C's notice is to give Financier C the right to claim the amounts owing on all unpaid debts in priority to Supplier B. So, until such time as the accounts are actually paid, Supplier B's ROT rights are subordinated to Financer C's rights in respect of those unpaid debts.
Rights of a financing ADI
The second situation where a registered ROT supplier's rights may be trumped is where cash proceeds are held in a bank account of a financing bank.
For example, in the above scenario let's assume that Bank D entered into a loan agreement with Customer A under which Bank D agreed to provide Customer A with a loan in return for Customer A giving a charge over, amongst other things, any bank account Customer A had with Bank D. When Customer A went into liquidation, the cash proceeds received in relation to the sold widgets were sitting in an account opened with Bank D. Under the PPSA, Bank D is deemed to have “control” over the account Customer A has with Bank D. Under the PPSA "control” is the strongest form of security. So, in a competition between Supplier B and Bank D, Bank D's rights over the account would take priority over Supplier B's rights as a PMSI holder.
As with the case of a debt factoring financier, Bank D's priority over the proceeds in the account limits the ROT supplier's ability to trace the cash proceeds of the sale of its widgets to recoup the outstanding amount of the purchase price owing to it, and thus exposes the ROT supplier to a greater risk of non-payment.
Practical tips for ROT suppliers
So, if you are a registered ROT supplier and receive a section 64 notice, what should you do?
There are a couple of things that we would recommend:
- Check that the notice complies with section 64(2), that is, it contains a description of the inventory to which it relates and sets out the effect of the notice as detailed in section 64(1). If it is defective it may not be enforceable. If you find it to be defective the issue becomes whether you notify the sender and alert it to the defect, thus giving it the opportunity to correct the defect, or remain silent and risk subsequently being estopped from denying the effectiveness of the notice.
- Check what is described as inventory in the notice. Keep in mind that the notice only gives priority to debts relating to the sale of inventory. However, your ROT registration may cover both inventory and non-inventory. Accordingly, if the notice refers to your entire registration it would be broader than what section 64 contemplates. To avoid a future argument as to what debts a financier would have priority over and the possible risk of being estopped from denying a financier's rights to debts over non-inventory (due to remaining silent on this point at the time the notice was issued), we would recommend that an ROT supplier promptly write back to the financier and clarify which property is inventory and confirm that only accounts in relation to that property are the subject of the notice.
- In practice, when determining to whom a section 64 notice should be issued it is likely that debt factoring financiers will search the register to identify all registrations against their customer which have the "inventory" box ticked, and only issue notices in respect of those registrations. With this in mind, if you are proposing to register a security interest that covers both inventory and non-inventory, in circumstances where the non-inventory property is of a substantial nature, consider registering 2 separate financing statements: one for inventory (where you would tick the inventory box) and the other for non-inventory where the box is not ticked. By doing this, it is much more likely that a section 64 notice would only be given by the financier in respect of the inventory, thus avoiding the situation identified in point 2 above.
- Be careful when determining whether or not the collateral the subject of your registration is inventory or not. If the collateral may include inventory you should tick the box, otherwise, there is a risk that an inventory financier may attempt to challenge your registration as defective or possibly attempt to bring a claim of misleading and deceptive conduct on the basis that a failure to properly identify a registration as covering inventory caused that financier not issue a notice under section 64, which it would otherwise have done.
- Finally, if you do receive a section 64 notice, remember you will have 15 business days to alter your position. If you believe the notice would have a significant impact on your security position you can alter your supply arrangements in respect of future inventory sales to require upfront payment or a larger upfront deposit or insist on a negotiated priority position with the inventory financier.
As far as the "control" issue is concerned, one option is to draft your ROT clause to require your customer to deposit all proceeds of sale of ROT goods into a bank account with a non-financing bank. Alternatively, you could enter into a priority agreement with the financing bank. However, in reality, neither of these options may be very practical except in a few exceptional cases where the amounts in question are substantial enough to warrant one of these unique arrangements.
ROT suppliers need to remember that registering their interests as a PMSI will not guarantee priority over all other claims. This article focuses on 2 ways in which the effectiveness of a PMSI can be limited.Make sure that you obtain proper legal advice as to the full implications of the PPSA on ROT supplies to ensure that you understand your rights and how to protect and preserve them under the new PPSA regime, in order to avoid any unexpected surprises.
Written by Beata Berman, Special Counsel and Stephen Kerr, Partner.
For further information please contact:
Partner | Melbourne
P +61 3 8644 3624
Special Counsel | Melbourne
P +61 3 8644 3627
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Important disclaimer: The material contained in this publication is of a general nature only. It is not, nor is intended to be, legal advice. If you wish to take any action based on the content of this publication we recommend that you seek professional advice.