Funding the payment of employee entitlements: subrogation rights under section 560 Corporations Act strictly construed

11 December 2013

In this issue:

• The operation and objectives of section 560 Corporations Act discussed
• The need for certainty as to when the section 560 priority arises
• The strict, literal approach adopted by Australian courts when applying section 560

Introduction

Pursuant to section 560 Corporations Act where a person has advanced funds to a company to make payments in relation to employee entitlements (in particular, to wages, superannuation contributions, leave and termination of employment entitlements) then, in the event that the company proceeds into winding up, the person making the advance is given the same priority rights in the winding up that the employees would have enjoyed had the advances not been made.

This is a desirable provision for it encourages lenders to advance funds to a company experiencing financial difficulties in the knowledge that if employee entitlements have been paid from the funds advanced, the lender will acquire a priority ranking in the event that the company borrower subsequently fails and proceeds into winding up. Moreover, in confining its operation to employee entitlements, the section recognises the vulnerability of employees in having their entitlements satisfied, and encourages the payment of their claims.

The significance of section 560 becomes apparent when the Commonwealth advances funds to meet eligible employee entitlements under the Fair Entitlements Guarantee (FEG) scheme administered by the Department of Employment. In respect of employee entitlements paid under the scheme the Commonwealth acquires the benefit of section 560, and is subrogated into the position of employees who have had their entitlements paid. It is apparent that section 560 is critical for the operation of the FEG scheme.

The section 560 priority must be unambiguous in its operation

Whenever a priority entitlement such as that contained in section 560 is introduced into the winding up process it is imperative that confusion over priority eligibility is avoided. Moreover, case law that applies the section will need to provide consistent and effective commentary on the manner in which the priority provision is to operate.

Since its introduction into corporate insolvency law section 560 has undergone close analysis by Australian courts as they have sought to describe and implement the priority entitlement that the section bestows.

It is imperative that persons contemplating taking advantage of the section 560 priority become fully conversant with decisions in this area.

The following discussion of leading cases on section 560 will assist in acquiring this understanding.

A payment under section 560 has been “made by [the] company”

In the recent case in the matter of Dalma No1 Pty Ltd (in liquidation) (2013) NSWSC 1335, 17/9/2013 the court had occasion to reflect on the requirement of section 560(a) that “a payment has been made by [the] company.”

Prior to the winding up of Dalma No1 Pty Ltd, Dalma Constructions Pty Ltd, a related entity, had made a number of direct payments in reduction or satisfaction of employee entitlements owed by Dalma No1 to its employees. In ultimately deciding that Dalma Constructions was not entitled to priority under section 560, the court stated:

“The fundamental difficulty in the present case is that none of the payments in question were made “by [the] company,” in terms of section 560(a): Dalma Constructions paid the relevant liabilities directly. Section 560 only applies where the company (i.e. the company being wound up) pays the employee-related liabilities itself….”

In adopting a strict, literal approach to the section, the court acknowledged that it sought to interpret section 560 “without doing violence to its wording.”

The payment was made by the company “as a result of an advance of money”

The question has arisen as to whether the reference in section 560(b) to an “advance” of money requires a loan to the company which creates a debtor-creditor relationship, as distinct from other forms of contributions such as a gift or transfer to the company on trust. This issue arose for consideration in Lombe v Wagga Leagues Club Ltd (2006) NSWSC 3, 31/1/2006.

In that case, with respect to a company under a deed of company arrangement, an entity contributed to the fund established under the deed for the purpose of meeting employee entitlements. The terms of the deed expressly stated that the contribution did not entitle the contributor to participate as a creditor in the deed fund.

When subsequently the deed failed and the company proceeded into winding up the contributor invoked section 560 with respect to contributions previously paid into the deed fund.

In deciding that the section 560 priority was not available the court reasoned that under the trust deed the contributor did not “advance” anything. “It made a once and for all payment without right or expectation of repayment.” Essentially, the court equated “advances” with a “loan” such that section 560 only applies when the person who “advances” funds becomes a creditor of the company in liquidation.

In the context of section 560 the debtor-creditor requirement would appear to detract from the purpose of the section which is to encourage a contribution towards meeting employee entitlements, whether or not the contribution generates a debtor-creditor relationship between contributor and company. Moreover the approach is contrary to a number of overseas decisions relating to provisions comparable to section 560 which accept that money can be advanced without being lent, and that to advance money is to furnish money for a specified purpose, without the need to establish a debtor-creditor relationship.

The advance must be “for the purpose of making the payment”

A fundamental requirement of section 560 is that advances were made “for the purpose of making the payment” of the kind specified in the section.

This issue, amongst others, arose for consideration in Capt’n Snooze Management Pty Ltd v McLellan (2002) VSC 432, 18/10/2002. Counsel for the liquidators sought to establish that although the terms of a loan agreement with the company had expressly adopted section 560 purposes, the payments advanced under the agreement were in substance intended to assist with the company’s cash flow; “and, in particular, to see trade creditors paid, and to safeguard the company’s ability to continue to trade.”

Taking into account the express terms of the loan agreement, and the nexus between moneys advanced and the amount of employee entitlements, the court concluded that, at least in this aspect of the case, the lender had established that the advance was made for section 560 purposes.

[Note: the lender was unsuccessful in obtaining the section 560 priority on other grounds that are no longer relevant in view of subsequent amendments to the section.]

Concluding comments

Unlike a number of overseas jurisdictions where provisions comparable to section 560 have been “interpreted liberally” and given “a benevolent construction” Australian courts have, in pursuit of certainty, adopted a strict, literal approach to the priority bestowed under section 560. As the court in Dalma No1 Pty Ltd (in liquidation) (see above) observed:

“When invoking section 560, conformity with the ‘actual language and internal structure’ of the provision is paramount, and if the apparent object of the provision (subrogation of the benefactor) cannot be achieved without doing violence to its wording, the provision is not engaged….”

For those attempting to take advantage of the section 560 priority the message is clear – in seeking to fund the payment of employee entitlements you will need to establish and implement processes that comply with the “internal structure” of section 560 to the letter.