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Australia – Step-In Rights In IT Contracts May Be A Security Interest.

18 September, 2013

 

Legal News & Analysis – Asia Pacific – Australia – TMT

 

WHAT YOU NEED TO KNOW

 
  • A recent New Zealand case has confirmed that construction contract step-in rights can constitute a security interest under the New Zealand Personal Property Securities Act 1999 (NZ) (NZ PPSA). A similar conclusion is likely to follow under the Australian Personal Property Securities Act 2009 (Cth) (PPSA).
  • This means that depending on their terms, technology outsourcing contract step-in rights may create security interests under the PPSA as well, in which case they will only be effective if they have been properly perfected. Even if a principal does perfect its step-in rights, it may not be able to exercise those rights effectively if the contractor has granted security to someone else.

 

WHAT YOU NEED TO DO

 
  • Principals should treat step-in rights which give rise to an interest in a contractor’s property as a security interest under the PPSA, and perfect them by registration on the Personal Property Securities Register.
  • Principals should register their interests at the time the contract is entered into, and not wait until they actually need to step in.
  • Even if it is not clear that a step-in right gives rises to a security interest, principals should consider registering the right in any event to best achieve protection.

 

A recent decision of the High Court of New Zealand, McCloy v Manukau Institute of Technology [2013] NZHC 936, concerned a dispute between the receivers of a construction supplier (Mainzeal) and a customer of Mainzeal (Hobson Gardens) regarding equipment that Mainzeal had been using to complete some construction works for Hobson Gardens on Hobson Gardens’ property.


The construction contract between Mainzeal and Hobson Gardens was based on the standard New Zealand Institute of Architects’ contract terms. It provided that if Mainzeal went into receivership and the receiver did not take over the construction work, Hobson Gardens could terminate the contract. The contract said, if Hobson Gardens so terminated the contract, that Hobson Gardens would be deemed to be in possession of the contract works, and that Mainzeal’s interest in the equipment would be transferred to Hobson Gardens. Hobson Gardens would then be entitled to use the equipment to complete the works, and to sell Mainzeal’s interest in the equipment and use the sale proceeds to pay money that Mainzeal owed to it.


Mainzeal went into receivership and its receiver, appointed by the Bank of New Zealand (BNZ), declined to take over the construction works. Hobson Gardens then terminated the contract and asserted that it was now in possession of the works. The receiver claimed that it was entitled to the equipment under BNZ’s securities. Hobson Gardens resisted this.

 

Were the step-in rights a security interest?

 

The receivers argued that Hobson Gardens’ step-in rights were a security interest for the purposes of the NZ PPSA, and that BNZ’s security interest had priority. Hobson Gardens argued that its step-in rights were not a security interest, so that the priority rules in the NZ PPSA did not apply.


The Court held that the purpose and wording of the step-in rights amounted to an in-substance security interest: a “transaction that in substance secured payment or performance of an obligation”. This conclusion was supported by the following indicators:

 

  • the step-in clause was clearly intended to give Hobson Gardens a form of security over Mainzeal’s interest in the equipment; and

 

  • the step-in rights were designed to enable Hobson Gardens to complete the contract works and sell the equipment to cover any liability of Mainzeal to Hobson Gardens resulting from Mainzeal’s failure to complete the works.

 

Whose security interest had priority?

 

Where there are two competing security interests, the NZ PPSA provides that a perfected security interest prevails over an unperfected security interest. BNZ had perfected its security interest by registration, but Hobson Gardens had not, so BNZ’s security interest prevailed over Hobson Gardens’.


It is worth noting that Hobson Gardens did not perfect its security interest over the equipment by possession, even though it had taken possession. While it is possible under the NZ PPSA to perfect a security interest by taking possession of the collateral, possession will not perfect a security interest if the possession results from seizure or repossession (section 41(b)(ii) of the NZ PPSA). This meant that taking possession as part of exercising its step-in rights did not serve to perfect Hobson Gardens’ security interest as well.

 

Implications for outsourcing contracts in Australia

 

Technology outsourcing contracts will typically contain a step-in clause. Under this clause, where a specified trigger event occurs (often where the contractor has materially breached its obligations or is likely to do so), the principal under the outsourcing contract may “step in” to take back responsibility for the services provided by the contractor. There is no standard form of step-in clause for a services contract, and the clause can take a variety of forms, such as:

 

  • a bare contractual right to access the contractor’s systems to conduct the operations;
  • a contractual right to access and modify the contractor’s systems, including a right to modify source code;
  • transfer of title to the contractor’s systems to enable the principal to conduct operations, with a right to sell to cover costs; and
  • a contractual right to access the contractor’s systems, and to hold a lien over the systems until all of the principal’s costs are recovered.

 

Even before the McCloy decision, many Australian practitioners were of the view that certain types of step-in rights (such as those in McCloy) were likely to give rise to a security interest under the PPSA. The decision in McCloy has confirmed that view.
Whether a particular step-in clause gives rise to a security interest will turn in particular on whether the clause gives the principal an interest in the contractor’s property. On this basis, the first two examples listed above are unlikely to be security interests (as they give the principal only bare contractual rights). The third and fourth examples, however, are likely to be security interests, and will need to be properly perfected if the principal wants to be able to rely on them.

 

Consequences for Australian principals

 

If a principal’s step-in rights do give rise to a security interest, then the step-in rights are at risk of being of little practical value if they are not perfected. Similar to New Zealand, the only option open to principals to perfect the security interest is by registration on the Personal Property Securities Register. The PPSA does also allow a secured party to perfect its security interest by taking possession, but like the NZ PPSA, the PPSA provides that possession will not perfect a security interest if it results from seizure or repossession (section 21(2)(b) of the PPSA).


If a principal does not protect the security interest under its step-in rights by registration as early as possible, it exposes itself to a number of risks:

 

  • if the security interest is not perfected, the principal’s rights under the step-in clause to use and then sell the materials and equipment will be ineffective upon the insolvency of the contractor (section 267 of the PPSA);
  • if the security interest is not perfected within 20 business days of the contract coming into force and the contractor is an Australian company, the principal’s rights will be ineffective, even if the security interest is perfected outside that timeframe, if the contractor becomes insolvent within six months after it is so perfected (section 588FL of the Corporations Act 2001); and
  • even if the contractor is not insolvent, the principal’s rights under the step-in clause to use and then sell the materials and equipment will be defeated by any perfected security interests over them (section 55(3) of the PPSA).

 

Even if the principal does perfect its security interest as soon as possible, it needs to be aware that its rights under the step-in clause to use and then sell the materials and equipment will be defeated by any other perfected security interest that has an earlier priority time (section 55(4) of the PPSA).

 

What you need to do

 

The McCloy decision suggests that a principal under an IT services contract with step-in rights should proceed on the basis that the step-in rights are a security interest for the purposes of the PPSA, if the step-in rights give it an interest in the contractor’s property.

 

If the step-in rights are a security interest

 

  • If the step-in rights do give rise to a security interest, the principal should perfect its security interest by registration as early as possible, and in any event within 20 business days of signing the contract.
  • The principal might also want to search the Personal Property Securities Register before signing the contract, to see whether any other secured parties have a security interest that could defeat the principal’s ability to use its step-in rights.
  • If there are, the principal should consider requiring the contractor to persuade those other secured parties to agree that the principal’s interest will take priority over them, despite the fact that they are registered first. This may or may not be commercially practicable.

 

If the step-in rights might be a security interest

 

  • If it is not clear that a step-in clause gives rise to a security interest, it may be nonetheless prudent for a principal to register a financing statement on the Personal Property Securities Register, in case a court later holds that it is a security interest.
  • If a principal is considering this, however, it needs to be mindful of section 151(1) of the PPSA, which provides that a person is subject to a civil penalty for breach of the PPSA if they apply to register a financing statement but do not believe on reasonable grounds that they have (or will have) a security interest.

 

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For further information, please contact:

 

Tim Brookes, Partner, Ashurst
tim.brookes@ashurst.com


Bruce Whittaker, Partner, Ashurst
bruce.whittaker@ashurst.com


Tanvi Mehta, Ashurst
tanvi.mehta@ashurst.com

 

Ashurst TMT Practice Profile in Australia

 

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