A company has bank funding under a GSA (General Security Agreement) but is strapped for cash. The shareholders come to the party by purchasing a big slice of the company’s inventory which they allow the company to keep and continue to sell to its usual customers, buying it back from the shareholders as needed.
If the company goes into receivership or liquidation, who has the best claim to that inventory? The shareholders as owner or the bank under its GSA?
A common practice
We’ve seen versions of this scenario many times recently in PPSA litigation.1
To date, the cases have turned on whether the sales were in the ordinary course of business, in which case the goods are transferred from seller to buyer free and clear of any security interest, such as the bank’s GSA.2
We have been surprised by some of the courts’ decisions, particularly when the sales appear, commercially, to be more in the nature of a financial arrangement than in the ordinary course of business.
A tougher response from the court
The High Court decision in Carey v Smith3 is tougher in its approach and should give comfort to those who take orthodox security interests, such as banks. It found not only that the sale was outside the ordinary course of the company’s business, but that it was in effect a financial transaction and therefore, a security interest under the PPSA.
The shareholders entered into a sale and buy-back arrangement to help the company, which was not at that stage in financial difficulty, but needed working capital to harvest and stockpile an unusually large peat crop.
The court found that the sale was not in the ordinary course of business because:
- the purchasers under the sale and buy-back agreement were not usual customers of the company, and indeed were related to it
- the sale was a one-off, in that inventory was not usually sold in such a quantity and in an unprocessed state
- exclusive possession remained with the company until two years after the sale, during which time the company was able to sell the inventory to its usual customers
- at the end of the two year period, the purchasers had the option to “put” the remaining inventory to the company, which was then obliged to purchase it (this factor was particularly significant for the Judge)
- there was no evidence that the sale or buy-back price matched market value
- the purpose of the transaction was to meet a particular cash flow need. The transaction was initiated and negotiated by the company’s chairman, not a manager or sales representative
- there was no advertising, and
- the acknowledged intention of the sale was to provide security to the purchasers. Their honesty in this regard was perhaps disarming. They were described in the agreement as “investors”. In evidence, one said:
“I thought that by buying [the inventory] I would have something to sell if the put option was not exercised”.
The new normal?
While some of the other judgments approached the ordinary course of business question in a similar way, this is the first judgment to take up the suggestion, in at least one academic article,4 that such transactions are, in reality, financing transactions and not sales.
In the Carey case, the Court found that the substantive purpose of the transaction was to provide funding. It was therefore, in substance, a security interest. The High Court here is protecting and upholding the power of a GSA. Financing transactions will not in the future be so easily described as sales, so as to remove assets from the reach of the GSA creditor.
Get expert advice
Perhaps the lesson of the case to would-be providers of extra funding is best summed up by comments in the judgment itself:
“Unfortunately [the director], who thought of the idea of the sale and buy-back agreement, was not legally qualified, and he said in evidence that he was not familiar with securities like the bank’s GSA.
It seems that neither [the director], nor [the shareholders] recognised the need for caution and, in particular, for sound legal advice before they proceeded to implement the idea”.5