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When a debtor is made bankrupt or liquidated, their assets will be paid to creditors on a priority basis. Therefore, it is important that you, as a creditor, understand the different classifications that determine the priority for payment. Additionally, you should assess whether a person or company is insolvent, prior to taking legal action. This article will explain who is a creditor, the tests of insolvency and the presumptions of insolvency at law concerning company and individual debtors.

Who is a Creditor? 

A creditor is a person or company who is owed money. Therefore, if you provide goods or services and you are not paid for those goods or services, you are a creditor. An employee who is awaiting payment of wages or superannuation is also a creditor.  

There are different classifications of creditors that will determine what priority you will be paid after your debtor is made bankrupt or liquidated.

Secured Creditors

A secured creditor is a creditor who has the benefit of a security interest over some or all of a debtor’s assets. A security interest can take a number of forms:

Type of Security Interest
Explanation
Personal Property Securities Act 2009 (Cth) (PPSA) security interest

A security interest will arise from a transaction that provides an interest in personal property, and in substance, secures payment or the performance of an obligation. Personal property includes any property other than real estate. 


Further, registering the security interest in the Personal Property Securities Register (PPSR) will ‘perfect’ the interest, creating a priority interest enforceable against third parties, including a liquidator or trustee. 

Purchase Money Security Interest (PMSI)

A person or entity who lends money to a person or entity for the purchase of any personal property may take a security interest in that particular asset. Once registered, the PMSI will take priority over other creditors. 


Note, people or entities commonly register PMSI in relation to motor vehicles purchased on finance.   

Mortgage

A mortgage is a contractual arrangement where one party (the mortgagor/borrower) provides their property as security for a loan advanced by the other party (mortgagee/lender). Additionally, a mortgagee is the most classic example of a secured creditor. 

Charge

A charge is a form of security created by agreement. A person or entity may charge their personal or real property to secure their payment obligations. A chargor also retains ownership of their property. However, the chargor, being the secured creditor, has the right to utilise the collateral property if the debt is not paid.

Lien

A lien is the right to hold another person’s property as security for the performance of a payment obligation. Further, a ‘particular lien’ is exercised over specific goods in your possession where you are owed money in respect of those goods. 


However, a ‘general lien’ may be exercised over any goods in your possession for amounts owed to you for both past and present services. Therefore, the courts tend to approach general liens more cautiously, given their broad nature.  

Unsecured Creditors 

An unsecured creditor is a person or entity that does not hold a security interest over its debtor’s assets. Whether you are a secured or unsecured creditor determines what priority you get paid when your debtor is either liquidated or made bankrupt.

Tests of Insolvency 

The process of assessing whether a person or company is insolvent can be complex. There are two main tests that generally determine solvency (or insolvency):

1. Cash Flow Test

Under the cash flow test, a person or company will generally be regarded as insolvent when they are unable to pay their debts as and when they become due and payable. Indeed, the inability to pay means there is insufficient cash or other realisable assets available to pay creditors upon demand.

2. Balance Sheet Test

Under the balance sheet test, a person or company will generally be insolvent if their total liabilities exceed the value of their assets. Therefore, this means there are insufficient assets to discharge the liabilities.  

Presumptions of Insolvency at Law

There are presumptions of insolvency at law in relation to both company and individual debtors.  

For Companies

A creditor who a company owes money can rely on the statutory presumptions of insolvency to wind up their debtor. A company is insolvent if, during or after the three months ending on the day a winding up application is made to the court, it fails to comply with a creditor’s statutory demand. However, other less commonly relied on presumptions include where:

  • an execution process issued against the company on a judgment is returned wholly or partially unsatisfied; 
  • a receiver is appointed to the company; or
  • creditors enforce security interests.  

For Individuals

Before a creditor can commence bankruptcy proceedings against a debtor, an act of bankruptcy must occur within the six months preceding the presentation of a creditor’s petition to the court. An act of bankruptcy indicates that a debtor cannot pay their debts and is therefore insolvent.  

There are a number of acts of bankruptcy that a creditor can rely on. However, the most common is the failure of a debtor to comply with a bankruptcy notice. The non-compliance of a bankruptcy notice is a fundamental element that must take place within the six months before a creditor petitions the court to make their debtor bankrupt.  

Rebutting the Presumption

In both cases, a debtor may challenge these presumptions by illustrating their solvency to the court with adequate evidence. A court will also determine the solvency of a debtor company at the date of the hearing. However, they will take into account future events where relevant. Indeed, rebutting the presumption of insolvency can be an onerous and costly task for a debtor. The debtor must present the court with evidence of its financial position. Further, they must do so by taking into account both the cash flow insolvency test and balance sheet insolvency test.

Key Takeaways

In summary, a creditor is a person or company that a debtor owes money to. However, remember that your creditor classification and the security interest you hold will determine your priority status for payment after your debtor becomes bankrupt or liquidated. There are also specific tests that you can use to assess whether a company or individual are insolvent. You should consider these tests and the presumptions of insolvency before deciding to commence bankruptcy or winding up proceedings. If you need assistance with a debtor who may be insolvent, contact LegalVision’s dispute and litigation lawyers on 1300 544 755 or fill out the form on this page.

Frequently Asked Questions 

What is a secured creditor?

A secured creditor is a creditor who has the benefit of a security interest over some or all of a debtor’s assets. For example, their security interest could be in the form of a mortgage, lien or PMSI. 

What is an unsecured creditor? 

An unsecured creditor is a person or entity that does not hold a security interest over its debtor’s assets. Therefore, they have a lesser priority interest.

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