The New Personal Property Securities Law and Bailment Facilities - An Overview

The new uniform Federal personal property securities law will take effect from 1 May, 2011 under the Personal Property Securities Act 2009 (PPSA). This bulletin examines the effect of the PPSA on bailment or 'floor plan' facilities.

The new law is still in a state of flux and this bulletin is general in nature. Significant amendments to the PPSA as originally enacted are in train in the Personal Property Securities (Corporations and Other Amendments) Bill 2010. This bulletin assumes that the Bill will be enacted in its current form and that the current exposure draft regulations to the PPSA will be prescribed as currently exposed.

The change

Under bailment facilities, goods (usually cars, boats or equipment) are bailed to (put in possession of) a dealer by a financier. The financier owns the goods. When there is an impending sale to a customer, the goods are normally sold by the financier to the dealer just before being on-sold by the dealer to the customer.

Bailment facilities have not normally been regarded as 'securities' in the same way that mortgages and charges are. The financier's interest as bailor has not generally been registered under the various security registers maintained by ASIC or States and Territories. The financier retains legal ownership and the simple mechanism of retention of legal title has provided significant protection to financiers until now.

In a major change, the PPSA can override the legal rule that a person cannot take legal title from someone who does not have it - the nemo dat rule. The PPSA can operate to allow buyers and lessees of goods to take them free of the legal ownership of floor plan financiers. The PPSA can also operate to cause loss of legal title in an insolvency.

To avoid these outcomes, financiers will need to take steps to protect themselves under the new law, principally by registering their interest by lodging a 'financing statement' on the new all-encompassing Federal online PPS register.

Bailment as a 'security interest'- 'PPS leases' and 'commercial consignments'

In this bulletin we'll refer to the bailee as a 'dealer' and the bailor as the 'financier', for the sake of familiarity of expression. In the new PPSA lexicon, however, these parties are the 'grantor' and the 'secured party' respectively. Financiers will need to get used to the idea of a dealer being a 'grantor' even though a bailee has only a right to possession and no ownership interest in the goods to 'grant' to the financier! In PPSA terms, property that is subject to a security interest is also referred to as 'collateral' - another term imported from North America that financiers will need to get used to.

The PPSA defines 'security interest' to include the interest of:

• a bailor under a 'PPS lease'.
• A consignor who delivers goods to a consignee under a 'commercial consignment'

The definition of 'PPS lease' in section 13 is somewhat complex but in summary covers a bailment for an indefinite term or for more than a year. For goods that may or must be described by serial number in a PPSA registration financing statement (motor vehicles, aircraft and watercraft) a bailment for 90 days or more is also included. Option terms are included in calculating whether the 90 day or one year period is exceeded.

The original definition of 'PPS lease' only applied where the 'bailor provides value for the bailment to the bailee'. This is not really a feature of floor plan facilities, under which the dealer pays bailment charges to the financier - not the other way round. It seems the drafter got bailee and bailor mixed up because amending Bill will change the definition to require that the bailee provides value to the bailor. By this change floor plan facilities will be brought clearly within the ambit of PPSA 'security interests' as they will be 'PPS leases'.

Bailment facilities might also be brought within the definition of 'commercial consignment' which is in the following terms:

commercial consignment means a consignment if:

• the consignor retains an interest in goods that the consignor delivers to the consignee; and
• the consignor delivers the goods to the consignee for the purpose of sale, lease or other disposal; and
• the consignor and the consignee both deal in goods of that kind in the ordinary course of business;

but does not include an agreement under which goods are delivered to:

• an auctioneer for the purpose of sale; or
• a consignee for sale, lease or other disposal if the consignee is generally known to the creditors of the consignee to be selling or leasing goods of others.

Under the New Zealand equivalent legislation to the PPSA, floor plan facilities are treated as falling within a similar definition of 'commercial consignment'. It is possible that the Australian definition would not catch typical floor plans but would only apply to agency sales which are more typically regarded as 'consignments'.

In any event it is now clear that the legislature intends floor plan facilities to be treated as 'security interests' for PPSA purposes as 'PPS leases'. The policy rationale (evident throughout the PPSA) is that those who extend credit to dealers need to know that the goods that they appear to own are in fact owned by financiers.

Under section 14, the interest of bailment financier is also the special kind of security interest known as a 'purchase money security interest' ('PMSI'). This can give additional protection to the financier - more about that below.

The PPSA provides a basic principle that security agreements will take effect according to their terms. The legal form of security agreements currently in use generally won't need to change (although many will need fine-tuning). So bailment financiers will, for example, continue to have legal ownership of bailed goods.

However, the PPSA does set out requirements for security interests to be effective, and it also sets out rules about their priority and what happens on insolvency and enforcement. Even though the PPSA may not itself change the basic nature of various security agreements that are entered into, or the basic nature of the rights that financiers are granted, there are rules about validity, priority, insolvency and enforcement that can enhance, negate or affect the value of those rights.

Attachment

The first requirement for an effective security interest under PPSA is 'attachment'. Attachment occurs when:

• The dealer has rights or the power to transfer rights in the goods. Of course a dealer bailee has no legal rights in terms of title to the goods. Accordingly, section 19 deems that these rights arise when the dealer obtains possession of the goods from the financier; and
• The financier gives value for the security interest or the dealer does an act by which the security interest arises. Usually this act will be the execution of security agreement - typically the bailment agreement.

At this point the legal ownership of the bailment financier becomes a 'security interest' attaching to the goods which are owned by the financier. This security interest is notionally 'granted' by the grantor dealer.

Enforcement against a third party

Under section 20, for the financier's attached security interest to be enforceable against a third party the financier must have possession, control or a security agreement in writing.

For bailment agreements, a written security agreement will therefore be essential. It is important to note that section 20 contains specific requirements for written agreements.

Perfection

The final key element for a security interest is 'perfection'. The basic philosophy of perfection is that it is something by which the fact of the security interest becomes visible to those who might otherwise deal with the dealer and have a false impression of its asset position.

Perfection provides important protection against third parties who might otherwise take an interest in the goods and also protects against loss of the security in an insolvency of the dealer.

Perfection can be obtained by registering the security interest.

Perfection can also be obtained by the financier taking possession, although not by seizure or repossession. Perfection by possession is in any event not practicable given the nature of a bailment is to put the dealer in possession of the goods.

It can therefore be expected that registration in the manner contemplated by section 21 will be the main way in which PPS security interests arising from bailment can be perfected.

Third parties can obtain interests in bailed goods

A radical effect of the PPSA is to allow third parties to take title or other rights to goods legally owned by a financier but free of the financier's interest. There are some existing laws that have this effect but the PPSA extends the range of situations and should provide more certainty and consistency to those who understand the law's operation.

Third parties can take free of a security interest in a number of situations which we deal with below. Sometimes there is a requirement that the taker give 'value' or sometimes 'new value', the latter requiring fresh value that the dealer gets, and which the financier could have rights against, as a result of losing its rights in the collateral.

The provisions generally refer to the taker being a buyer or lessee, and this is to be distinguished from another financier who is granted a competing 'security interest' in the same goods. In that case, detailed priority rules apply - which are touched on below.

Unperfected security interests

Section 43 states the general rule in relation to third parties who take collateral (e.g. bailed goods) subject to security interests. The Act provides that such third parties who buy or lease for value take free of unperfected security interests. This fundamental rule drives home the importance of perfection of security interests.

Sales or leases to third parties in the ordinary course of business

Under section 46, a buyer or lessee also takes free of the security interest where the sale or lease is in the ordinary course of the seller's or lessor's business. This is a necessary rule to protect customers of dealers.

This outcome will not apply where buyers or lessees hold the goods as inventory - e.g other dealers.

Serially numbered property - aircraft, motor vehicles and watercraft

The PPSA can treat security interests differently according to whether or not the goods concerned may or must be described by reference to a serial number in the PPS registration process.

This distinction is of particular significance to bailment financiers as aircraft, motor vehicles and watercraft are affected. The regulations propose that aircraft, motor vehicles and watercraft must be described by serial number if they are 'consumer property'. If they are 'commercial property' then they may be so described - it is not mandatory. Aircraft, motor vehicles and watercraft will be commercial property if used in the course of an ABN registered business. Otherwise they will be consumer property.

Motor vehicles are probably the most common goods found on floor plans. The draft Regulations define a motor vehicle as personal property that:

• is built to be propelled on land by motor;
• is capable of a speed of at least 10 kph, or has one or more motors with a combined power greater than 200 W;
• does not run on rails, tram lines or other fixed path; and
• has a vehicle identification number, chassis number or manufacturer's number.

The term is not limited to vehicles that need to be registered for road use. A 'motor vehicle' will also include trailers or other pieces of machinery or equipment that are designed to be towed behind a motor vehicle, if they weigh at least 200 kg and are capable of being towed at a speed greater than 10 kph.

Serial number not shown or incorrectly shown on the PPS Register

For goods that may or must be described by a serial number, section 44 provides that a buyer or lessee can also take free of the security interest if a search, by serial number only, would not disclose a registration that perfected the security interest. The Explanatory Memorandum to the PPSA gives this example:

PersonA owns a number of collectable motor vehicles in the course of running a business of hiring out vehicles for special events. PersonA secures a loan from BankA against the motor vehicles. BankA perfects its security interest in the vehicles by registering against all of PersonA's motor vehicles, but does not register each motor vehicle individually by their serial numbers. PersonB buys one of the motor vehicles from PersonA. A search of the PPS Register by reference to the motor vehicle's serial number would not disclose that BankA has a security interest. PersonB would take her interest in the motor vehicle free of BankA's security interest in the motor vehicle.

However this rule does not apply (amongst other exceptions) if the buyer or lessee holds the property as inventory. The taker also won't take free if the security interest was created or provided by a transaction to which the buyer or lessee was a party. Originally, actual knowledge of a breach of the security agreement would have prevented taking free - but this requirement is being dropped under the amending Bill.

Special rules for motor vehicles

Section 45 has two special rules for motor vehicles.

The first rule is that a buyer or lessee of a motor vehicle can take free of a financier's security interest if they give new value, obtain their interest from the grantor of the security interest (i.e. the dealer) and:

• the vehicle is of a kind that may or must be described by a serial number; and
• at a time between the day before the sale or lease and the time the sale or lea e took place a search by serial number would not disclose a perfected security interest.

Note that if the registered interest was not shown on the register on the day of the transaction or even the previous day the buyer or lessee still gets the goods free of the security interest. This is similar to a 'day and a half' rule in some current State legislation.  Again this rule doesn't apply (amongst other exceptions) if the buyer or lessee holds the vehicle as inventory, or has actual or constructive knowledge of a breach of the security agreement.

The second rule particular to motor vehicles is that a buyer or lessee for new value can take free of a security interest if the seller or lessor is a person prescribed by regulations. The draft regulations provide that dealers covered by the State or Territory motor vehicle dealer licensing schemes are to be prescribed persons.

The purpose of this provision is to allow a person to buy or lease a motor vehicle from a motor vehicle dealer, free of a security interest, without the need to search the PPS Register prior to acquiring their interest. The following example is from the PPSA Bill Explanatory Memorandum:

GrantA is a motor vehicle dealer. GrantA has cars in stock financed under a floor plan arrangement with bailment company FinanceA. Under the floor plan arrangement FinanceA purchases the vehicles from ManufacturerA and allows GrantA to retain them on its premises for sale. FinanceA registers its security interest in each vehicle. BuyA wants to purchase a car from GrantA with finance provided by BankB. Neither BuyA nor BankB need to search the PPS Register as the transferor (GrantA) is a motor vehicle dealer. BuyA acquires its interest in the car free of FinanceA's security interest.

However the rule won't apply if (amongst other exceptions) the buyer or lessee holds the vehicle as inventory or has actual or constructive knowledge that the seller or lessor has breached the security agreement. In relation to the degree of knowledge the Explanatory Memorandum to the PPSA contains the following:

Many buyers or lessees of motor vehicles from motor vehicle dealers would be aware that motor vehicles held by dealers as inventory are subject to a security interest but this knowledge alone would not disqualify buyers and lessees.

Example

GrantA is a motor vehicle dealer. BankA has perfected a security interest in all of the vehicles at GrantA's showroom, by registering each vehicle against its serial number. The security agreement obliges GrantA to sell the vehicles for an amount determined in accordance with a formula agreed to by GrantA and BankA, with a minimum price of $X for any vehicle. BuyA is an associate of GrantA, though not a motor vehicle dealer, and is aware that GrantA is obliged to sell the vehicles for at least $X. GrantA sells a motor vehicle to BuyA for an amount significantly less than $X. BuyA would not acquire the motor vehicle free of BankA's security interest.

Low value domestic and household property

For personal property bought or leased by someone who intends to use it for personal domestic or household use, and that has a value not more than $5,000 there is another special rule. This kind of property may also be taken free of a financier's security interest.

However this doesn't apply if the personal property is of a kind that may or must be described by a serial number. It also doesn't apply if the buyer or lessee has actual knowledge of breach of the security agreement. The Explanatory Memorandum gives an example:

MsX buys a chainsaw at a garage sale for $2,000 with the intention to use it in her hobby workshop. MsX is not aware of any security interest in the chainsaw. The market value of the chainsaw is less than $5,000. MsX would take the chainsaw free of the security interest.

Priority and insolvency rules

The PPSA contains very complex priority rules, an examination of which is beyond the scope of this bulletin.

Bailments will enjoy additional protections accorded PMSIs. A PMSI that is perfected by registration in the required way and is over inventory has priority over a perfected security interest of another kind.

For PMSIs over floor plan inventory it will be important for financiers to register by the time possession of the goods is given to the dealer to ensure that the security interest has the additional priority protection accorded to PMSIs.

Under section 267 upon insolvency an unperfected security interest can vest in the grantor (dealer). In effect this can defeat the security interest. This is a radical outcome as it applies in effect to negate the legal ownership of the goods. Previously floor plan financiers were entitled to retrieve their owned goods from an insolvency, although their rights might be delayed by an insolvency administration.

However certain short term PPS leases of up to a year are excluded from this rule, if they are of goods that may or must be described by a serial number.

The transition to PPSA

The transitional rules are complex and a full treatment of these is beyond the scope of this bulletin.

The PPSA will apply to security interests from the scheduled commencement date of 1 May, 2011.

Security interests registered on registers under existing law (eg. REVS or the ASIC charges register) before that time will be automatically 'migrated' to the PPSA register under co-operative government arrangements. So financiers should not need to take steps to register those.

However the PPSA aims to effect a complete transition to the new registration regime within 24 months and for this to occur the PPSA has to deal with existing security interests, including bailment facilities not previously registrable under any of the old Federal or State and Territory laws. As these are largely invisible, migration won't be possible as they are not found on any current register for the government bodies to migrate them to the PPS register.

The PPSA addresses this by allowing a 24 month period for these 'non-migrated' transitional security interests to be registered by their financiers. If this is done the security interests will:

• be taken to have attached immediately prior to the start of PPSA.
• be deemed to be temporarily perfected during that 24 months.

As noted above the outcomes for bailment facilities that are not perfected by their financiers before the 24 months expires could include loss of ownership and loss of priority.

Security interests that arise after the PPSA commencement time but pursuant to a security agreements entered into before then are also 'transitional security interests' with temporary perfection. This should cover, for example, bailments made from time to time under a pre-existing pre-PPSA bailment agreement. The new 'security interests' that arise each time a new batch of goods is bailed pursuant to the agreement will still be transitional security interests even though they arise whilst the PPSA is in force.

It will be critical for bailment financiers to take the opportunity to register their transitional security interests within the 24 months allowed to avoid loss of priority or defeat of the security interest on insolvency.

What do bailment financiers need to do?

Bailment financiers need to:

• familiarise themselves with the operation of the new law
• above all, ensure that existing bailments are registered before the end of the transitional 24 month period.
• ensure facility documents meet the requirements for written security agreements
• consider their procedures for due diligence when establishing bailments, and when refinancing other financiers
• develop procedures for registration to ensure that PMSI 'super-priority' is achieved.
• consider whether changes are needed to existing documents, particularly in relation to enforcement matters and waiver of rights that would otherwise be available to grantors under the PPSA.

Author: Oliver Shtein