Ch 18 Financing the company – debt or equity capital

Exercise 18.6 – How lenders secure loans

Identify the types of creditors that Retrofit Pty Ltd now has and their priorities in the
event that the company cannot pay.

There are three broad categories of creditor:

 Secured creditors — This means that they have security for funds or property that
they have loaned or sold to the company. Note that students should understand
from the definitions in the Personal Property Securities Act the difference between
non-circulating security interests and circulating security interests. For example,
for non-circulating assets: land and buildings, plant and equipment, office
furniture and motor vehicles. Would goodwill qualify? For circulating assets:
cash, debtors or accounts receivables and inventories. What are the benefits of
having non-current assets as security for the lender as well as Retrofit Pty Ltd?
What are the benefits for having current assets as security for the lender as well as
Retrofit Pty Ltd? We need to consider the importance of the Personal Property
Securities Register and the difference between security over circulating and non-
circulating assets.
 Preferential creditors — These are certain unsecured creditors that will have
the right to be paid after the secured creditors, but before the unsecured creditors.
Examples are staff wages, the liquidator’s fees and the costs to liquidate the
company. These types of creditors will be discussed later under the topic of
insolvency (chapter 13).
 Unsecured creditors — These will include a range of creditors, typically
customers/suppliers. This will include the professional services firm that employs
the student, utility suppliers, office suppliers, service providers and other suppliers
of goods used by Retrofit Pty Ltd. Students should discuss and mention what
types of providers these could be in relation to the case study.

From the financial information provided you will note that there are 5 categories of
creditors.

 The mortgage to ANZ is a fixed security interest — real estate mortgages are
generally paramount, and are not part of the Personal Property Securities
Register.
 The debenture is secured, as it is trade debtors, would be circulating security
interest. Its priority depends on whether the security interest has been
perfected by registration on the Personal Property Securities Register.
 The trade creditors — ordinary unsecured debt, no priority as such.
  Bank overdraft (Westpac; a different overdraft to ANZ) appears to be
unsecured, no priority as such.
 Unpaid super is technically unsecured, but claims by employees are given
priority in a winding up situation. Also, directors can be made personally
liable for the company’s unpaid super contributions under Australian tax
legislation.

Tiger Lily Investments Pty Ltd has only contributed the first tranche of $300 000. As
the remaining two tranches are invested, this will be used to reduce the debenture by
$600 000.

The balance sheet is important to advisers to understand where the financial pressure
may come from for the company and what they can do to assist the company.

Looking at the numbers, the assets exceed liabilities, so the company is still solvent.
For example, the directors can pay a dividend to the preference shareholders (5.5% of
the $300 000 = $16 500) without breaching the solvency test.

Other issues to consider are:

 The role of Samantha as a nominee director (see chapter 7 on directors’

obligations and duties and to whom they are owed, especially with regards to a
nominee director).
 The nature of the preference shares being non-cumulative and the fact they
need to be repaid (the accountants will need to assist the company and ensure that
it has the capacity and has budgeted to be able to repay or refinance the preference
shares).
 The payment of the bonus to directors of $150 000 each. The issue of director
remuneration is a matter to be decided by the board — see clause 77 of Retrofit’s
constitution (see chapter 7). It is unlikely that for a proprietary company
shareholder approval is required.

From the above, if $300 000 is paid out in bonus payments to directors, there will be
insufficient accounting profits to pay a dividend of $16 500 to the preference
shareholders. What will happen? What can the preference shareholders do?

What can Samantha do?

If Retrofit Pty Ltd is unable to pay its debts when demanded then the company could
be regarded as insolvent. See s 95A. As a result, if the company is wound up (placed
in liquidation) then there is an order in which the creditors are paid out. The first
creditors to be paid out are the secured creditors. If the security is non-circulating
assets then they are paid first.

The second creditors are the secured creditors with a security interest over circulating
assets. However, in the event that there are insufficient funds to pay employees then
the employees will take priority over the secured creditors who have circulating
security interest as security.

Secured creditors need to ensure that the assets they take as security are not
jeopardised by any actions of Retrofit Pty Ltd.

To protect the interest of the lenders, security over personal property (all assets other
than land and buildings) should be registered with the Personal Properties Securities
Registrar. The benefit of registration of these securities for the lender is that if those
securities in the event of a default by Retrofit Pty Ltd are realised, the proceeds will
be given to that lender in preference to any other secured creditor against those assets.

This raises the issue of negative pledge clauses. Remember that the assets are owned
by the company Retrofit Pty Ltd but that it has given them as security to the creditor.
What is to stop the company offering the same security to another lender as security
for a loan? It is legitimate for a lender to insist on a clause in the loan document to
prevent the company from securing its assets to another lender.

Exercise 18.7 – Alex and Paco and their plans to seek $2m in capital via a
share issue

APPLIED PROBLEMS
18.7 Alex and Paco recently purchased a block of land in Surfers
Paradise for $1 million. They want to develop the land by building an
apartment block and selling the apartments at a profit. Unfortunately,
Alex and Paco don’t have the money to proceed with the development.
Alex and Paco come up with a plan to develop the land whereby they
will register a company called Bug Out Ltd. Alex, Paco and their friend
Greta will be the directors of Bug Out Ltd. They plan to get investors to
buy shares in Bug Out Ltd for $2 million.
With the proceeds of the share issuance, they will have Bug Out Ltd buy
the land from them for $1.5 million. With the remaining $500,000 they
plan to build the apartment building.
If Alex and Paco proceed with their plan and register Bug Out Ltd, would
they be required to comply with the disclosure requirements in Ch 6D of
the Corporations Act in connection with the fundraising they propose?
Exercise 18.7

As a company grows its business, opportunities for expansion will arise.

Management will need to consider its options for financing an expansion of
the business should that be deemed desirable. Conversely, in difficult
financial times management may need to consider the options for ensuring
sufficient cash flow to help a business survive.

The two main forms of corporate financing generally considered by

management are:
 equity, and
 debt.

In issuing shares or debentures, a major factor is whether disclosure in the

form of a prospectus to potential investors is required. Under Ch 6D,
disclosure is required if the shares are to be offered to the public. Pty Ltd
companies cannot do this. But note Bug Out ltd is a public co, and so it can
offer. Whether disclosure is required will depend on who they are offering to -
what the target investor audience is and how many investors the offer is made
to. For example, to be exempt the offer must be put to no more than 20
investors and be no more than $2,00,000.

Exercise 18.8 – Larissa’s options for finance

What are the implications under Ch 6D of the Corporations Act of the

two fundraising options Larissa is considering – offer to institutional
investors (companies that invest as part of their business), or, list on
the ASX?
If the business is floated on the ASX the Corporations Act Ch 6D will apply
and disclosure will be required. An offer to institutional investors would be
an offer to professional investors and this would not require Ch 6D
disclosure.

If a decision is made to carry out a float, what type of disclosure

document will be required and what type of information must it contain?
In accordance with Corporations Act section 705 there are five types of
disclosure documents, in chapter 10 we have only briefly mentioned a
prospectus in relation to a float.

Can Larissa advertise the fact she is raising funds?

Advertising can only be conducted when and as how provided in Corporations
Act section 734.