Further advances and subsequent security interests: determining priority under Australian law

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Patrick McDonald

MinterEllison, Melbourne

patrick.mcdonald@minterellison.com

This article provides an overview of Australian law governing the priority afforded to competing secured creditors where a prior-ranking creditor advances funds to a borrower having received notice of a subsequent security interest.

While lawyers and bankers are aware of the risks associated with competing security interests (and the mitigants in loan documentation to address them), over time the origins of those mitigants and the legal rules they seek to displace may be forgotten.

This article discusses the development of the rule against tacking, its modern application in Australia and lessons for lenders looking to protect their priority in the face of competing interests.

The rule against tacking

What is tacking?

‘Tacking’ refers to a situation in which a secured creditor, having advanced funds to a borrower in accordance with its finance documents, subsequently provides additional advances to that borrower, relying on its existing security to secure repayment of those advances. The further advances (which may take the form of instalments, progress payments, facility extensions etc) attach to the secured creditor's existing security in a process known as ‘tacking’.

For the purposes of this article, the term ‘mortgagee’ is used generally to describe any form of secured creditor.

The rule against tacking

The ‘rule against tacking’, established by the House of Lords in the case of Hopkinson v Rolt, provides that a first mortgagee – to whom property is mortgaged for advances already made – can ‘tack’ further advances to its existing security in priority to the interests of subsequent mortgagees, unless the first mortgagee has notice of a subsequent mortgage at the time of making the advance.^[1] If the first mortgagee has notice of a subsequent interest, advances by the first mortgagee after that time will rank in priority behind the subsequent interest.

In West v Williams, an exception to this rule was established allowing a mortgagee to tack further advances, even with notice of subsequent interests, where the mortgage instrument imposes a positive obligation on the mortgagee to make those advances.^[2] However, on the particular facts of that case, this exception was held not to apply, with the court finding that the existence of a subsequent interest released the first mortgagee from its obligations under the mortgage – thereby making the provision of further advances voluntary.

The above propositions have been applied by Australian courts with few departures. However, in Matzner v Clyde Securities a significant exception to West v Williams was developed in circumstances where the further advances enhance the value of the secured property.^[3] The court in Matzer confirmed that the rule against tacking is a principle of equity and rests on considerations of justice and fair dealing between competing mortgagees. It was on this basis – with further advances enhancing the security to the benefit of all mortgagees, rather than prejudicing subsequent mortgagees – that the rule against tacking was held not to apply.

The rule against tacking is not restricted to mortgages (whether registered or unregistered) and applies equally where a subsequent interest arises in favour of a purchaser of land or the assignee of a mortgagor's interest.^[4]

Notice – actual or constructive?

Australian courts have generally accepted that a first mortgagee must have actual notice of a subsequent interest for the rule against tacking to apply, though there remains uncertainty as to whether constructive notice would suffice.^[5] In Central Mortgage Registry of Australia Ltd v Donemore Pty Ltd, the registration of a caveat and existence of a second mortgage, without anything more, was held not to constitute actual notice.^[6] This position has been confirmed by legislation in a number of jurisdictions.^[7]

Clayton's Case and subsequent interests

The decision in Devaynes v Noble (known as Clayton’s Case) is also relevant to the repayment of further advances where the rule against tacking applies.^[8] The effect of the ‘first-in, first-out’ rule of payments in Clayton’s Case means that, in the absence of an election by the mortgagor or the mortgagee, repayments by a mortgagor will be applied in repayment of advances in the order in which they were made. Following notice of a subsequent mortgagee's interest, repayments applied in this way will erode the first mortgagee's priority amount in respect of its debt, leaving any further advances to be repaid only after satisfaction of subsequent secured debts of which the first mortgagee had notice at the time of making those advances.

Further advances and the PPSA

In Australia, the rule against tacking no longer applies to personal property within the scope of the Personal Property Securities Act 2009(Cth) (PPSA). The PPSA broadly defines a ‘future advance’ as any advance secured by a security interest (whether or not made pursuant to an obligation) if the advance is provided after the security agreement was made.^[9]

Provided the underlying security agreement contemplates future advances (and captures repayment of those advances as a secured obligation), the priority rules in Division 2 of Part 2.6 of the PPSA are enlivened and a security interest will be given the same priority in respect of all advances, including future advances.^[10] However, exceptions to this general rule do apply, most relevantly the super priority afforded to perfected ‘purchase money security interests’ under section 62 of the PPSA. This can allow subsequent mortgagees to gain priority in respect of certain personal property acquired with funds advanced by that subsequent mortgagee.

Non-PPSA personal property, though limited in scope, remains subject to the common law rule against tacking.

Further advances and real property

The doctrine of tacking as it applies to land under the Torrens system has been modified by statute in a number of Australian jurisdictions.

In the State of Victoria, section 94(1) of the Property Law Act 1958(Vic) provides that:

‘[A] prior mortgagee shall have a right to make further advances to rank in priority to subsequent mortgages (whether legal or equitable) –

(a) if an arrangement has been made to that effect with the subsequent mortgagees; or

(b) if he had no notice of such subsequent mortgages at the time when the further advance was made by him; or

(c) whether or not he had such notice as aforesaid, where the mortgage imposes an obligation on him to make such further advances.’

Section 94(1) applies irrespective of whether the mortgage explicitly secures further advances, and other than as provided in that section, the right to tack in respect of competing real property mortgages in Victoria has been abolished. Section 82 of the Property Law Act 1974(Qld) makes similar provision for further advances secured by real property in Queensland.

Section 94(1)(a) codifies the existing law that mortgagees may enter into priority arrangements to determine or postpone priorities in respect of common security, while section 94(1)(b) confirms the continued effect of the rule in Hopkinson v Rolt. Section 94(1)(c) arguably seeks to reverse the decision in West v Williams by allowing a first mortgagee to tack future advances, with or without notice of a subsequent mortgage, if the mortgage imposes an obligation to make those advances.

In the absence of statutory abolition, the common law rule against tacking continues to apply to real property under Australia's Torrens system.^[11] This is most notably the case in the state of New South Wales.

Lessons for mortgagees

Preventing subsequent security interests

As a guiding principle, mortgagees should endeavour to prevent subsequent security interests arising in respect of secured property. The ‘negative pledge’, an almost-universal feature of finance documents, will restrict a security provider from creating, or permitting to exist, a security interest over secured property other than certain interests expressly permitted by the finance documents. A breach of the negative pledge will generally constitute both a draw-stop (preventing the mortgagor from requesting further advances) and an event of default (allowing the mortgagee to accelerate repayment and enforce its security).

Where a subsequent interest arises (either by operation of law or with the mortgagee's consent), the finance documents should impose a positive obligation on the mortgagor to procure entry into priority arrangements, thereby allowing competing mortgagees to make their own arrangements governing the priority of payments and recourse to secured property.

Priority arrangements matter

Whether common law or statutory rules of tacking apply, it is always open to mortgagees to agree priorities between themselves by entering into priority arrangements. Where subsequent security interests are created, competing mortgagees should enter into these arrangements to regulate the order in which they are paid for amounts secured by their common security.

Priority or intercreditor arrangements will often be in the best interests of all competing mortgagees and in Australia, market practice has developed such that competing mortgagees will regularly enter into priority arrangements as a matter of course. For a first mortgagee, these arrangements may allow it to tack further advances to its first-ranking security and have priority for all financial accommodation it has provided. For subsequent mortgagees, priority discussions will give the first mortgagee notice of the subsequent interest, thereby enlivening the rule against tacking. It may also assist the subsequent mortgagee to better understand the commercial value of its security in negotiations with the mortgagor. Whether the rule against tacking is maintained ultimately relies on the commercial agreement between the parties.

Where the statutory rules of tacking in Victoria and Queensland apply, a priority arrangement confirming or postponing priorities is only relevant where Sections 94(1)(b) and (1)(c) (and the Queensland equivalents) do not apply.

Mortgage should impose an obligation

If priority arrangements cannot be agreed, a mortgagee proposing to make further advances should ensure its mortgage instrument expressly contemplates those advances. The making of further advances, the priority they are afforded, and a covenant binding the mortgagee to make them should each be documented in the mortgage to ensure the first mortgagee has priority for the amounts it advances on or after receiving notice of a subsequent mortgage.

Arguably, an obligation imposed in another instrument which the mortgage secures will satisfy the requirement that the mortgage imposes the obligation to make further advances. This will usually be contained in a facility agreement or similar document, and be secured by the mortgage through a broad definition of secured money extending to present and future advances.

However, the law on this issue is unclear. To the limited extent the common law allows tacking of further advances after notice of a subsequent security interest, it would seem that an express obligation to provide the further advances must be included in the mortgage instrument itself. Until this uncertainty is resolved, it is prudent for mortgagees to include the obligation in the mortgage instrument, notwithstanding it may be contained elsewhere. That said, given the practice by mortgagees to enter into priority arrangements, it would be unusual in Australia for a mortgage to also impose funding obligations.

Ruling off accounts

Following notice of a subsequent security interest, a mortgagee should open a new account in its books in the mortgagor's name, credit or debit (as relevant) to that new account all payments made by the mortgagor, as well as all advances from the mortgagee to the mortgagor. From the date on which the new account is opened, repayments by the mortgagor should be applied first in reduction of any debit balance in the new account, and second in reduction of any other secured money.

By adopting this practice, the mortgagee rules off the existing account, ensuring its priority ranking in respect of amounts advanced after notice of a subsequent interest is not eroded by appropriating payments in the order prescribed in Clayton’s Case. In requiring further advances be repaid in priority to the balance of the secured money, the mortgagee rebuts the presumption in Clayton’s Case and ensures those further advances do not rank in priority behind subsequent mortgages.

Indeed, this has been a common practice among lenders since Clayton’s Case was decided, and Australian facility and security documents will, as a matter of course, contain provisions to this effect.

Conclusion

The rule against tacking illustrates why competing security interests must be taken seriously. When in doubt, the prudent course for all parties is to enter into priority arrangements to rebut the common law rules, where their application would otherwise have unintended consequences.

Though largely restricted in its operation due to statutory developments in Australia, most notably the introduction of the PPSA, the rule against tacking remains relevant where secured creditors hold competing interests in real property. First mortgagees should not assume they will always rank in priority to subsequent security holders, and first on the register may not always mean first in priority where disputes over the priority of repayments arise.

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