Focus: Insolvency – November 2003
The complications of taking charge
In brief: Can the act of granting a charge breach contractual prohibitions on assignment? Lawyer Nick Bilinsky looks at some recent considerations.
Introduction
When lenders take security over a company's entire assets, those assets usually include contracts. Many contracts contain covenants against assignment. Getting consents to the charge from all counterparties to all contracts may be difficult or impracticable. If the lender does not have a valid security interest over those contracts, then a receiver may not be able to take control of them as part of a company's business, thereby losing control of those contracts and priority over them.
Worse, if the contracts are material, then the lender may not be able to claim a charge over all, or substantially all, of the company's assets, nor may the lender be able to appoint a receiver if an administrator has been appointed or exercise its right to appoint an administrator.
This is on top of the possible concern that, if the charge does breach a contractual prohibition, the counterparty has remedies which may include terminating the contract. Project and construction finance also involves taking security over contracts, but lenders may wish not to have to worry about getting consents from counterparties to minor contracts.
A charge of the normal type arguably should not breach a clause that merely prohibits assignment. However, at best, it depends on the drafting of the prohibition on assignment and the charge. Two Australian cases have unfortunately left the position confused, so that, in evaluating their security, lenders should assume that a prohibition on assignment in the normal form does prevent a valid charge.
Starelec
The latest Australian consideration of the subject has come from the Queensland Supreme Court in Starelec (Qld) Pty Limited & Vangale Pty Limited (in liq) v Kumagai Gumi Co Limited [2002] QSC 137. While this case did not ultimately decide the question of whether an equitable charge constitutes an assignment, it did discuss the rights conferred on a chargee under a charge and left open the possibility that a charge is an assignment.
The facts
Kumagai engaged a contractor for the development of a resort. A written subcontract was subsequently entered into by the head contractor and Starlec, in respect of electrical services.
Starelec gave a fixed and floating charge to Natwest Bank (Natwest) over all of its undertaking and assets, both present and future.
A receiver was subsequently appointed to the head contractor.
Kumagai and Starelec entered into agreement in relation to the completion of the services that were the subject of the subcontract.
Natwest crystallised the floating charge over Starelec's assets, and assigned the contract to Vangale.
Vangale pleaded that, as a result of it being the assignee from Natwest of all Natwest's rights under the charge, all debts and obligations to pay money or damages owed by Kumagai to Starelec became payable by Kumagai to Vangale. As Vangale's claim against Kumagai was as the assignee of Natwest, its rights could not be greater than those which accrued to Natwest. Accordingly, the application raised the issue of whether the charge upon crystallisation conferred rights on Natwest, especially as a prohibition existed upon assignment by Starelec of the benefit of the subcontract.
What was said
Vangale submitted that, on crystallisation, there was an assignment in equity of the charged contractual rights. It relied on the description given by Senior Puisne Judge McPherson in Relwood Pty Ltd v Manning Homes Pty Ltd that, on crystallisation of a floating charge, the chargor becomes trustee of the asset for the benefit of the chargee. Vangale also relied on statements in other authorities, such as National Life Nominees Ltd v National Capital Development Commission, suggesting that there is a completed equitable 'assignment' upon crystallisation.
Kumagai, on the other hand, argued that charges, as hypothecations, do not involve an assignment or transfer of charged property, even on crystallisation.
Regrettably, the conflict apparent in the authorities was not explored in argument. The difficulty is that the word 'assignment' is used loosely and the commercial situations in which an equitable interest in a charge will amount to an assignment have not been authoritatively determined.
In Sheahan v Carrier Air Conditioning Pty Ltd, Chief Justice Brennan comments that the statement that assets are 'assigned' is too imprecise, and that 'the extent of the equitable interest of a creditor in a fund to be applied in payment of his debts depends upon the terms governing the disbursement of the fund that are enforceable by specific performance' (at 422-423).
In Starlec, Justice Mullins remarks:
In any case, the true effect of the charge given by Starlec...must be determined by reference to the provisions of the charge which may assist in determining whether on crystallisation the charge takes effect as a charge only or as an equitable assignment of the charged property.
This confusion can create difficulties in two ways: the clauses prohibiting assignment could be interpreted widely, so that 'assignment' is given its loosest possible meaning so as to include assignments; or picking up on the dicta quoted by Justice Mullins, a court might construe a charge as being an assignment in the stricter sense.
Macintosh v Turner – charges are assignments
In Macintosh v Turner Corporation Ltd (in liq) & Ors (1995) 13 ACLC 1314, Justice Sackville held that a clause of a contract prohibiting assignment without consent precludes an assignment of a party's right to performance of the contract and also its right to receive benefits accrued under the contract, but does not prevent a dealing with the proceeds. His Honour relied upon the decision of the House of Lords in Linden Gardens Trust Ltd v Lenesta Sludge Disposals Ltd and the principle that an assignment of contractual rights in breach of a contractual prohibition is ineffective.
Unfortunately, both parties regarded the charge as breaching the prohibition on assignment, so the point was not argued. This was understandable in that case because the operative words in the charge were that the chargor 'charges, assigns and transfers' the mortgaged property.
The facts
Turner Corporation Limited (Turner) entered into a building contract with Austotel Pty Limited (Austotel). The contract contained a provision in which the parties agreed not to assign the contract without the other party's consent.
Turner gave a charge to the State Bank of New South Wales, in return for funding. The charge secured Turner's undertaking and assets 'whatsoever and wheresoever both present and future'. No consent was obtained from Austotel.
Turner defaulted under the charge and the bank appointed a receiver. Turner went into provisional liquidation. A dispute arose between Turner and Austotel under the contract. The liquidator settled the dispute, which resulted in Austotel paying Turner A$1.525 million. When Turner came to be wound up, the liquidator applied for directions to see whether it was justified to pay the money to the bank. A creditor of Turner opposed the directions, on the ground that a clause in the contract prohibiting assignment precluded the bank's charge from attaching to the money.
The Federal Court decision
As stated above, Justice Sackville found in favour of the bank. His Honour considered that once Austotel paid Turner an amount under the contract, the money lost its character as an accrued benefit under the contract and simply constituted one of its assets. As a matter of construction, the provision that Turner should not 'assign this agreement' could not prevent Turner effectively charging an asset constituted by moneys received as the result of performance of the contract (at 1316).
In other words, although the charge in question was ineffectual to charge Turner's right to performance of the contract and its right to receive benefits accrued under the contract, once monies were actually paid to Turner they formed part of its general assets, independent of the contract, and were therefore capable of being charged. In the end, the bank was fortunate to win by virtue of the fact that the money had been paid and the asset was not just a benefit that had accrued under the contract.
The significance of the decision
If Macintosh v Turner is followed, in cases where a bank takes security over assets or benefits flowing under an agreement, the existence of a non-assignment provision may invalidate the enforceability of that security (at least where it uses words of assignment) but not over the proceeds.
While Macintosh v Turner has not been overruled, there is considerable authority, both judicial and academic, to suggest that an equitable charge is not an assignment but, rather, a potential right or power exercisable upon default by the chargor. It differs from a mortgage (a form of assignment), where there is a conveyance of an existing proprietary interest (see Tancred v Delagoa Bay & East Africa Railway Co (1889) 23 QBD 239 and Re Earl of Lucan, Hardinge v Cobden at 475:
What is given is not the thing but a charge upon the thing. That is the true effect of the deed.
The position is slightly different where the contract in question is a lease. There is authority that an assignment of a lease which breaches a prohibition on assignment is still valid. However, the breach will often allow the lessor to terminate.
Conclusions
The conflict in the authorities has created inherent uncertainty in the law. For financiers taking charges over debts, the position is particularly problematic.
While the law remains unsettled, and before the question is resolved by an Australian appellate court, financiers must be aware that the law may currently read down the applicability of charges in the face of non-assignment provisions.
In the meantime, while we wait for clearer authority, clients would be well-advised to continue the practice of seeking the consent of the counterparty when securing their interests by way of charge over contractual entitlements which contain prohibitions on assignment.
For further information, please contact:
- Tania CiniPartner,
Melbourne
Ph: +61 3 9613 8574
Tania.Cini@aar.com.au - Geoff RankinPartner,
Brisbane
Ph: +61 7 3334 3235
Geoff.Rankin@aar.com.au
