Clarity at last! Important decision on classifying circulating and non-circulating assets

This article was written by Tim Klineberg and Gavin Rakoczy.

The issue

The priority of secured creditors to receive distributions out of secured assets is heavily entrenched in the Australian insolvency regime. Specifically, under s561 of the Corporations Act 2001 (Cth) (Act) priority employee claims were required to be paid from assets subject to floating charges ahead of the competing claims of secured creditors.

Following the introduction of the Personal Property Securities Act 2009 (Cth) (PPSA), the floating charge terminology in s561 was adjusted to reference circulating assets and a complex supporting definition of 'circulating asset' was introduced by s340 of the PPSA. While the practice remained to use what had previously been 'floating' assets to make distributions to employees ahead of other creditors including those with security, there was a lacuna in the legislation relating to the classification of assets as circulating or non-circulating, which the case law has been slowly addressing over the last decade.

RCR Tomlinson

Before the appointment of partners of McGrathNicol as administrators on 21 November 2018, the RCR Tomlinson group (RCR Group) employed more than 3,800 people and comprised 41 companies. It conducted several different construction-related businesses under the RCR Tomlinson banner including Solar, Rail, Property Services and Laser.

From a relatively early stage of the administration it was clear that there would be no DOCA proposal. The administrators were able to conclude a number of business sales saving many of the employees' jobs with many employee entitlements being assumed by purchasers. However, a number of non-viable business operations were required to be shut down, including the significant Solar business. Creditors resolved to wind up all companies in the RCR Group at the second creditors' meeting held on 29 March 2019, with the administrators appointed as liquidators.

Several million dollars of employee entitlements were paid by the Commonwealth Government (Commonwealth) under the Fair Entitlements Guarantee scheme, making the Commonwealth a significant priority creditor. The RCR Group also had substantial secured debts owed to a group of lenders including the Commonwealth Bank of Australia (Secured Lenders). There were insufficient assets within the RCR Group to pay both the Commonwealth and Secured Lenders in full.

Key issue

The liquidators required clarity on the principles to apply in characterising certain of the RCR Group's assets as circulating or non-circulating. Given the shortfalls to Secured Lenders and the Commonwealth this was an important issue which impacted their returns.

Prior to the decision summarised below, there was a lack of authority on how to characterise certain types of assets in a construction liquidation, in particular certain types of 'work in progress' and proceeds generated from bonds and similar instruments. The different types of assets are explained in detail below.

Why is the decision important?

In In re RCR Tomlinson Ltd (admin apptd) & Ors [2020] NSWSC 735, Justice Black provided important guidance on the proper characterisation of these assets as circulating or non-circulating and on the proceeds which are therefore available to pay priority employee claims pursuant to s561 of the Act. This has important implications for insolvency practitioners, secured creditors and employees of insolvent corporate groups. Similar issues had arisen in previous post-PPSA liquidations of major construction businesses, but had not been considered and determined by courts. We and the liquidators were determined to try to clarify the applicable legal principles to assist in this and future administrations and liquidations.

The case also provides a useful example of how parties working together collaboratively can use agreed facts to avoid extensive discovery and evidence in a highly complex and factually dense dispute. This approach can greatly improve efficiencies in the administration and liquidation of complex estates, and limits the costs and time required to resolve potentially complex disputes. The Commonwealth was advised by Clayton Utz and the Secured Lenders were advised by Herbert Smith Freehills.

What directions were sought?

The administrators (subsequently liquidators) of the RCR Group, sought directions from the Supreme Court of NSW concerning whether certain assets were properly classified as circulating assets and therefore available to pay priority employee claims pursuant to s561 of the Act.

Specifically, the following directions were sought:

Snapshot Date issue: at what date is the character of assets as circulating or non-circulating to be assessed for the purposes of determining the assets available to pay employees under s561?
Surplus Proceeds issue: if post appointment date, a counterparty of an insolvent company calls on a bond or similar instrument for losses suffered and remits any surplus proceeds to the insolvent company, will those proceeds comprise circulating assets?
Subcontractor Proceeds issue: if pre-appointment date a subcontractor defaults under a contract but the insolvent company only calls on the supporting bond or similar instrument post appointment date, will those proceeds comprise circulating assets?
WIP issue: which of the following types of work-in-progress (WIP) comprise circulating assets?
1. WIP Permutation 1: goods or services under a contract are completed pre-appointment date, but payment is subject to issuance of an invoice, which occurs post appointment as does payment of the invoice;
2. WIP Permutation 2: goods or services under a contract are completed pre-appointment date, but payment is subject to certification and issuance of an invoice, both of which occur post appointment as does payment of the invoice;
3. WIP Permutation 3: goods or services under a contract are only partly performed pre-appointment date, then post-appointment date the goods or services are completed following which an invoice is issued and then paid;
4. WIP Permutation 4: a contract for goods or services is executed pre-appointment date, but the goods or services are all provided post appointment date, at which time an invoice is issued and paid;
5. WIP Permutation 5: an umbrella agreement is in place pre-appointment date, but the order for the goods or services is only placed post appointment date, at which time the goods or services are provided and an invoice then issued and paid.

What did Justice Black decide?

Justice Black heard the case on 17 April 2020 and 8 May 2020. Remarkably, given the complexity and novelty of the issues involved, his Honour delivered judgment on 11 June 2020.

Justice Black held that the Snapshot Date was the "relevant date", being the date on which the winding-up is taken to have begun under Part 5.6 of the Act. Relevantly, this was the date of appointment of administrators to the RCR Group. It followed that it was at this date that McGrathNicol were required to assess whether the RCR Group's assets were circulating or non-circulating for the purposes of s561 of the Act. Helpfully, this finding is consistent with the approach the courts have taken previously in decisions concerning s433 of the Act (which governs the payment of priority employee claims by receivers).

In relation to the balance of the issues, his Honour considered that the classification of the assets as circulating or non-circulating relevantly turned on whether each was an 'account' under s340(5) of the PPSA. In this respect, his Honour made overarching comments to the following effect:

The initial inquiry in each case is to ascertain whether the relevant asset comprised 'property' for the purposes of the PPSA. For example, if the relevant 'asset' is so contingent that it is a mere expectancy, it will not comprise an existing contractual right and will therefore not be 'property'.
Next, in order to for the asset to be an 'account', the asset must be grounded in an existing legal obligation to pay an identifiable monetary sum on some ascertainable future date arising from the disposal of property.

Separately, the Court did not accept, "as a matter of ordinary usage", the Commonwealth's contention that intangible WIP could comprise 'inventory' for the purposes of s340(5)(e) of the PPSA and therefore be a circulating asset.

With regards the specific matters the subject of the application, Justice Black held as follows:

Issue	Circulating?	Reasoning
Surplus Proceeds	No	The Court found that Surplus Proceeds were not 'property' because any right to the Surplus Proceeds was so contingent that it was nothing but an expectancy. This uncertainty was derived from two elements: whether the RCR entity would perform its obligations under the contract with the principal; and if not, whether the principal would call on the bond. Further, the Court held that even if the Surplus Proceeds were 'property', they did not comprise an 'account': while the Surplus Proceeds were of a monetary nature, they lacked the character of an 'obligation' as understood in general usage; it would be "an extraordinary result" if employee priorities under s561 extended to any amount that might be recovered if a contingency occurred, without regard to whether it occurred before or after the appointment date; his Honour considered that he should give weight to the analysis in the New Zealand decision of Strategic Finance[1] regarding the concepts of 'accounts receivable' and 'monetary obligation'; the definition of 'account' in s10 of the PPSA had a common core meaning with 'accounts receivable' in s16 of the Personal Property Securities Act 1999 (NZ), and the Surplus Proceeds were so contingent in character that they could not properly fall within that concept; the terminology "whether or not that obligation has been earned by performance" in s10 of the PPSA did not render the Surplus Proceeds an account, since the RCR company's right to the Surplus Proceeds depended not only upon the future performance of the RCR company, but also on whether the principal would call the bond; and Forge 2[2] was not of direct relevance, since the bonds in the present case were called after the appointment date, whereas in Forge 2 the wrongful call on the securities was made prior to the appointment date.
Subcontractor Proceeds	No	The Court held that: an unexercised right to require payment of money is not the same as the right to receive payment of money; the obligation to pay under the relevant bonds could not arise before the relevant bond was called and in the case of the Subcontractor Proceeds that may never occur; it would be a perverse result if monies which may never be received could be taken into account in determining employees' preferential entitlements under s561; while of a monetary character, the Subcontractor Proceeds did not satisfy the requirements identified in Strategic Finance for a monetary obligation since they were not an existing legal obligation at the appointment date to pay an identifiable monetary sum to the RCR company; and the bonds did not qualify as a negotiable instrument under s340(5)(f) of the PPSA because they were payable up to a specified maximum rather than a certain sum, nor were they negotiable.
WIP Permutation 1	Circulating	Justice Black found that: the extension of the definition of 'account' under s10 of the PPSA to amounts 'whether or not earned by performance' included amounts earned by performance, but which had yet to be invoiced; and applying Forge 1,[3] any disputes as to the amounts to be invoiced could be determined by the relevant pre-appointment date contracts.
WIP Permutation 2	Circulating	Applying the reasoning from WIP Permutation 1, the Court held that because any dispute as to the certification or amount owed could be determined under the terms of the relevant contract, this category of WIP comprised an account and was therefore a circulating asset.
WIP Permutation 3	Not circulating	For the following reasons, the Court held that this category of WIP did not comprise a circulating asset: in circumstances where there was no contractual basis for apportioning payment between pre and post appointment goods and services, there could be no monetary obligation and therefore no account with respect to incomplete pre-appointment date goods or services; as at the appointment date, there was only a mere possibility that a monetary obligation might arise if, and only if, the relevant works (goods or services) were completed; and any work performed after the appointment date was not in the ordinary course of business (having been conducted by an administrator or liquidator) and did not fall within the meaning of 'account' consistent with the decision in Langdon.[4]
WIP Permutations 4 & 5	No orders made, but likely not circulating	Justice Black formed the view that there was no controversy between the parties on these points. However, applying his Honour's judgment it is tolerably clear that these categories of WIP would not give rise to 'monetary obligations' and would therefore not comprise circulating assets.

[1] Strategic Finance Ltd (in liq) v Bridgman [2013] NZCA 357.

[2] Hamersley Iron Pty Ltd v Forge Group Power Pty Ltd (in liq) (recs and mgrs apptd) [2018] WASCA 163.

[3] Hamersley Iron Pty Ltd v Forge Group Power Pty Ltd (in liq) (recs and mgrs apptd) [2017] WASC 152; (2017) 52 WAR 90.

[4] Re Langdon; Forge Group Ltd (recs and mngrs apptd) (in liq) [2017] FCA 170; (2017) 118 ACSR 434.