What to Consider When Seeking a Mortgage from a Debtor

Estimated reading time: 10 minutes Other

When you lend money, or offer goods or services on credit, how do you protect your interest in the case of non-payment of the debt? In this article, we consider how you might secure this debt with an interest in land. Key mechanisms for doing this are via a ‘charging clause’ in a director’s personal guarantee, and/or via registration of a mortgage.

What to Consider When Seeking a Mortgage from a Debtor

In this article we explain: 

What Does It Mean to Secure a Debt?

Being a creditor of a debtor company means managing the risk that the debtor company will not pay what it owes. Given the expectation that there will be company insolvencies it pays to think about protection in advance. Unless there is a specific mechanism put in place protecting your interest, you will be an ‘unsecured’ creditor, with no ability to recover funds in the case of non-payment in a liquidation of the debtor (due to a statutory limit). Importantly, being a creditor does not in itself give you an interest in land owned by a debtor or related parties to the debtor (such as directors). Specifically, a trading debt does not give you a right to place a caveat on the debtor’s land (or that of the debtor company’s directors), preventing dealings (such as the sale) of that land. In order to secure an interest in the land, there must be an agreement for security over land entered into at the time that the debt is created.  

The main reason to protect your interest with a security is to give yourself priority in the case of debtor insolvency. In many cases, the reason that a debtor company will not be paying your debt is because it has a general inability to pay its debts as they fall due. A situation of insolvency means that the company is likely to be liquidated, and returns on liquidations in Australia for unsecured creditors are very poor. By having a security in place, you will have priority in the case of liquidation and this is your best chance of being paid a debt.

How Can a Debt Be Secured?

One way of securing your debt could be to secure an interest in the non-land assets of the debtor company. However, there is always a risk that this will be insufficient assets to secure a debt. Australia’s economy is driven by small-to-medium-sized enterprises (‘SMEs’) which have limited assets – particularly at the point where they get into financial difficulty and are unable to pay their debts. SMEs in Australia don’t have much by way of assets anymore as they usually are leased (such as plant and equipment) or secured by financiers (through General Security Agreements).

A common way around this is through a director’s personal guarantee. This ‘pierces the corporate veil’ and means that the director will be personally liable for the debt in the event of non-payment. How might a personal guarantee secure an interest in land? It may do so via a ‘charging clause’: That is, wording which secures the creditor’s interest in the director’s land (such as any commercial or residential properties they happen to own). 

Note, that in order for a personal guarantee and charging clause to be effective a signed written contract is required. Otherwise a deed must be ‘signed, sealed and delivered,’ in lieu of the consideration in that contract. It is worth emphasising that this personal guarantee cannot be obtained after the date of the debt being incurred through a standard credit application form.

It should also be noted that there is currently a delay for creditors in attempting to enforce payment of a debt through the usual mechanisms. The first step to prompt payment of a debt (and eventually enforcing that debt) is to issue a ‘statutory demand for the payment of debt’. Currently, as a result of COVID-19, creditors now have six months (rather than the prior 21 days) to respond to a statutory demand for the payment of debt. In addition, the minimum amount owing must be $20,000 (as opposed to the prior minimum of $2000).  

How Do Charging Clauses Work? 

As discussed, a common way of securing a debt through an interest in land is through a charging clause in a personal guarantee. This set of words in an agreement or contract permits a creditor a ‘charge’ in the debtor’s assets. The charging clause might be:

  • Of general application. In this case, for example, it might have wording to the effect of “I charge all of my property held now or in the future, wherever located, for the payment of any moneys that I may owe at any time to [insert creditor’s name]; 
  • Related specifically to land. In this case it may have wording to the effect of “I charge all of my right, title, and interest in land held now or in the future wherever located…” It is common in charging clauses of this form to also contain wording stating “[debtor’s name] agrees that, upon request by [creditor’s name], [debtor’s name] will immediately execute a registrable mortgage in favour of [creditor’] name”. Through the latter wording, the creditor becomes an ‘equitable mortgagee’. 

There is no particular wording required by law, and the particular wording that is appropriate will depend on the specifics of the case at hand. 

A key consequence of a charging clause is that it gives a creditor a ‘caveatable’ interest in that land that is secured. That is, a caveat can be lodged. A caveat is an instrument that prohibits all dealings in the land. Note that the caveat does not in itself allow you to gain possession of the land, but is intended to give notice of the interest in the land. 

The caveat is lodged with the land title system of the state or territory in question (e.g., Land Use Victoria or NSW Land Registry Services). Once recorded on that system, a ‘caveat note’ will appear on the title of the property giving anyone with an interest in the property notification that you claim rights in the property, and that those rights need to be resolved. Caveats can also be withdrawn by the caveator. 

Note that when lodging the caveat, it is important to provide in supporting documentation information describing the caveatable interest. 

If a caveat is improperly registered, the owner may apply to the court to have it removed or issue a lapsing notice (if based in NSW). If the court finds that there was no basis for the caveat, it will be removed and it is likely you will need to pay the costs of the other party. Note also, that you could be liable for any losses suffered by other parties as a result of that inappropriate caveat. 

The validity of charging clauses was upheld recently in Re Carter Holt Harvey Woodproducts (Australia) Pty Ltd (No 1) [2017] VSC 499. In that decision of the Supreme Court of Victoria, a broad charging clause was held to secure an interest in a director’s land. The court re-iterated the general law relating to charging clauses and confirmed that no particular wording was required in order to create an enforceable charging clause.  

It is worth emphasising one important limitation of a charging clause: There could still be other secured creditors who will have priority over you. This is particularly common in the case of a director’s residential properties, where there is usually a mortgage in existence. This will mean that the bank with a mortgage will be able to take control in a default scenario and get the first payment out of sale proceeds.

Possible Challenges to Charging Clauses

In what ways could a charging clause be challenged by another party? While this is by no means an exhaustive list, some of the options available include:

  • Issuing a ‘lapsing notice’. The owner of the property might use a lapsing notice to challenge the caveat. This means that the secured creditor needs to start court proceedings to protect the interest or lose it through automatic lapsing. The caveat may lapse if there was something deficient in the documentation supporting the caveat: For a recent example, see the decision of the NSW Court of Appeal in Ta Lee Investment Pty Ltd v Antonios [2019] NSWCA 24
  • Alleging non-compliance with the National Credit Code. The code does not apply to all credit contracts, but (with some exceptions) applies to those who are in the business of providing credit and where the credit is for personal, domestic or household purposes, or in order to purchase, renovate or improve residential property for investment purposes, or to refinance credit previously provided for this purpose. It provides for various protections to the debtor including disclosure obligations for the creditor. For more information, see guidance from the Australian Securities & Investments Commission (ASIC).
  • Bringing action for ‘unfair contract terms’. Under the Australian Consumer Law (ACL), individuals and small businesses are protected from ‘unfair contract terms’.  In the case of small businesses, this applies to contracts from 12 November 2016. Note, there are restrictions on the application of this law. For example, for small businesses, it only relates to terms contained in ‘standard form contracts’, and where the contract was for the sale or grant of an interest in land or the supply of goods or services;
  • Bringing action under the Contracts Review Act 1980 (NSW). This allows for contracts in NSW to be reviewed by the court for “undue influence, unfair pressure or unfair tactics”. 

Key (though not the only) questions to ask when framing a charging clause are: 

  • Was independent advice offered?
  • Was there inequality of bargaining power?
  • Was there undue pressure?
  • Is the principal agreement enforceable? 

What to Consider When Registering a Mortgage 

As part of the charging clause, or independently of it, it will often be advantageous to register a mortgage in relation to the credit contract, i.e. transform the ‘equitable mortgage’ into a ‘legal mortgage’. This means that in the case of default, the lender is able to exercise various powers including the power to sell the property.

  • Note that there are duties that apply to a mortgagee in this situation. For example, in NSW, reasonable care needs to be taken to ensure that the property is sold at fair market value (See s 111A(1)(a) Real Property Act 1900 (NSW));
  • If there is a first ranking mortgage, consent of the first mortgagee is required and therefore a caveat may be the only available method of quasi-security. 

What to Consider When Taking Security in Personal Property

As part of the charging clause, or in addition to it, you may seek to secure your debt through a ‘personal property’ security: Essentially, a mortgage on the personal property of the debtor, rather than land. This includes such property as plant and equipment or inventory, or financial assets.

In order to secure such an interest, it must be registered under the Personal Property Securities Act 2009 (PPSA). This law regulates security interests in personal property. This security can relate to: 

  • General assets of the grantor/debtor;
  • Specific assets. 

An important form of security available under the PPSA is a Purchase Money Security Interest (‘PMSI’). This means that the grantor/debtor will be obligated to pay the purchase price of collateral. This can be used: 

  • By suppliers to retain title in their goods; 
  • To protect the interests of lessors with a “PPS Lease”. 

One important advantage of a PMSI is that it gives a creditor ‘super-priority’ with respect to the collateral. That means that you have priority over other securities in that property, in some cases, even where that interest was registered before yours. 

Conclusion 

When lending, or offering goods or services on credit, it is important to consider what you will do in the case of non-payment. In order to protect your interests, it is worth considering whether you can secure a mortgage from a debtor. One common way of doing this is through the addition of a ‘charging clause’ to a company director’s personal guarantee. Before executing such a clause, however, consider carefully the requirements in order for such a clause to be legally binding, and to prevent possible challenges from other parties. It is also worth considering whether your interest might be secured by a personal property security instead of, or in addition to, a mortgage.  

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