Financial infrastructure development network – Asia Pacific Economic Cooperation
A speech by Gavin McCosker, Chief Operating Officer and Registrar of Personal Property Securities, Australian Financial Security Authority, to the APEC 2016 Asia-Pacific Forum on Financial Inclusion: Financial Inclusion in a Digital Age, held on 7 – 8 April 2016 in Tokyo, Japan.
Thank you—and thanks to the Asia-Pacific Financial Forum for organising this important event.
Today, I bring you some observations on the policy balances required to establish an effective insolvency system.
The starting point for this conversation is to acknowledge that we can’t view an insolvency system in isolation.
An insolvency system has the same central objective as a secured transactions system. Its purpose is to support economic growth by helping to give companies – especially Micro, Small & Medium Enterprises (MSMEs) – access to the finance they need for business expansion.
According to the International Finance Corporation, more than 8 million of our region’s SMEs – and presumably millions more MSMEs – do not currently have sufficient access to finance.
Developing effective credit markets is an important step in closing this finance gap – because equity markets are rarely accessible or attractive to these smaller operators.
To make debt available and affordable for SMEs, we must address the issue of risk attached to a loan. Given a large portion of that risk is around borrower insolvency, one way to dramatically impact on the risk profile is to secure the loan by offering collateral and making sure that security is upheld.
Obviously policy makers can’t directly affect individual risk profiles. But they can improve the overall levels of risk associated with the credit market – by giving lenders confidence that, if a borrower does enter insolvency, the system will handle this process in a fair and predictable manner.
This is what an insolvency system does. It creates confidence in the credit system by ensuring that the rights derived from secured transactions laws are recognised and respected.
So the critical areas to be considered are the points in the business cycle where an insolvency system intersects with a secured transactions system.
That’s the abstract idea – let’s have a look at what it can look like in practice.
In Australia, we have two insolvency systems: the personal system and the corporate system – administered by separate government bodies.
I work for AFSA, the Australian Financial Security Authority, which regulates the personal insolvency system. ASFA plays the role of Official Trustee of last resort for personal insolvencies, which means it can investigate bankrupt estates, sell property and pay returns to creditors.
Importantly, we don’t have a tailored insolvency system for SMEs – they fall into our personal insolvency system where the business operates using a non-corporate structure. According to the information that debtors give our office when presenting bankruptcy applications, about 22% of bankruptcies in our personal insolvency system relate to businesses.
Regardless if an SME in Australia incorporates or establishes as an unincorporated entity such as a partnership or sole trader, when accessing finance, in many circumstances the financier will require a guarantee against the personal assets of the business owner.
This means that, in Australia, if an SME can’t repay its debts, unlike a corporate it doesn’t go into formal administration to be turned around or liquidation. Instead, the individual becomes bankrupt – regardless if the business is wound up.
In this case, the owners or partners are treated in the same way as individual insolvencies – and declared bankrupt for a minimum of three years.
Internationally, this is seen as a fairly harsh approach, perhaps harsh enough to stifle innovation.
To this point, the Australian Government has just announced a plan to amend our insolvency laws – with the aim of encouraging entrepreneurship.
The plan includes:
Reducing the current default bankruptcy period for individuals from three years to one year
Introducing a 'safe harbour' for directors from personal liability for insolvent trading if they appoint a restructuring adviser to develop a turnaround plan for the company and
Making ‘ipso facto’ clauses, which have the purpose of allowing contracts to be terminated solely due to an insolvency event, unenforceable if a company is undertaking a restructure.
These changes, which are expected to be legislated in mid-2017 – are designed to strike a better balance between encouraging entrepreneurship and protecting creditors. Over time, the Government hopes that they will reduce the stigma associated with bankruptcy related business failure in Australia.
Currently, the public narrative and perception around financial failure and insolvency is highly negative. This will need to change if we are to embrace an entrepreneurial and innovative business culture.
The learning here is that, when designing an insolvency system’s bankruptcy rules, policy makers need to find a balance between – on the one hand – the competing public interests of rehabilitating debtors and allowing them a fresh start – and on the other – the need to discourage reckless borrowing and spending.
Another action Australia has taken in an attempt to close the finance gap for SMEs is to broaden the possible collateral classes that businesses can offer lenders to secure finance.
According to the IFC, about three-quarters of the collateral taken by traditional financial institutions is based on land or real estate holdings. Yet land and real estate accounts for less than a quarter of a company’s assets. A much greater share of assets is taken up by what the IFC calls ‘movable property’: accounts receivable, inventory, IP, agricultural equipment and products, vehicles and durable consumer goods.
To address this inequity, in 2012, Australia established the Personal Property Securities Register – of which I am the Registrar. The Register makes it easier for non-corporates to offer business assets like stock in trade as collateral, so they don’t always have to put their own home on the line to access finance at a secured rate. It’s a single, national online database of security interests in personal property.
The Register can also protect SMEs from risk when buying second-hand goods. Business owners simply need to do a quick search to find out if there is an existing security interest on the item, which might mean they could be repossessed.
The Register also protects businesses that hire, rent or lease equipment – or sell on terms, such as retention of title or consignment. Businesses can register their interest in goods they have yet to receive payment for, helping them to recover the debt and lessen the risk of losing the goods if the customer doesn’t pay or becomes insolvent.
When it comes to the different types of assets that can be registered for collateral, the Register separates the collateral classes under four broad categories: Tangible property, General property, Intangible property and Financial property. It means SMEs can use almost any property you can think of – including ‘motor vehicles’, ‘watercraft’, ‘agriculture’ and ‘other goods’ – to secure their loans.
The only major exemption is land, which is still kept on State and Territory asset-based registers – largely for historical reasons.
Since it went live in 2012, the Register has become one of the largest centralised secured transactions registers in the world, supporting an estimated $500 billion capital flows into our economy each year.
Today, we are starting to see green shoots of new types of lenders emerging whose business model is heavily based on taking security over collateral on the Register. The original peer-to-peer lenders were offering unsecured loans. Now, the scope of the Register means these FinTech startups can offer secured loans based on a much broader range of collateral – further opening up the credit market for SMEs.
An important step in gaining the lending market’s confidence in the Register has been to demonstrate that the system recognises and enforces creditors’ security rights.
The key to this lies in our default priority rules, which legally define the priority of security interests. Under Australia’s Personal Property Securities Act, registration is a form of ‘perfection’. According to the rules, perfection of a security interest gives it priority over unperfected security interests in the same collateral.
Since the PPS Act was enacted cases in Australia and in other jurisdictions with similar laws have confirmed that registering an interest in securities provides the best means of being given priority over unsecured parties in the event of an insolvency.
This demonstrates the importance of making sure the information on the Register is accurate and reliable.
As Registrar, I have the power to remove and correct data on the Register. I can also restore information once it’s been removed, including restoring an entire registration.
When deciding what should and what shouldn’t be on the register I have to carefully balance the needs of secured parties with those searching for information and making financial decisions based on what they discover in the register.
At times this means the interests of third parties may take precedence over those requesting action to correct an error. For example, if a third party has relied on the Register after the relevant data was removed, I may decide that information should not be restored.
I also take into account the length of time that has elapsed since the data was removed. If I do decide that an entire registration should be restored, a later search of the Register will not reveal that the data was ever removed.
Most importantly, at all times I’m trying to balance the need to fix a short-term issue with the priority to maintain users’ long-term confidence in the register.
As you can see, there are plenty of policy balances to be struck in the insolvency rules that impact on the way various parties are treated when a borrower can no longer service their debts.
But whatever the details of the policy settings are, if we agree the end game is supporting and growing businesses, the insolvency and secured transactions regimes need to be carefully designed to work in concert with one other. Ideally in an increasingly technology enabled world, this would occur in a manner where technology supports highly usable policy outcomes, rather than technology being the servant of policy.
Both insolvency and secured transactions systems need to pull in the same direction to promote transparency and predictability. This will improve the confidence of both the lenders and the borrowers in the systems themselves.
And, if the systems are designed to be flexible enough to allow market participants to develop innovative business lending approaches – such as Fintech to further increase access to finance for SMEs – then so much the better.