Insolvency: unreasonable director-related transactions

//Insolvency: unreasonable director-related transactions

The Victorian Court of Appeal recently considered s.588FDA of the Corporations Act (the Act) relating to unreasonable director-related transactions: Vasudevan as Liquidator of Wulguru Retail Investments Pty Ltd (In Liquidation) (Wulguru) v Becon Constructions (Australia) Pty Ltd (Becon) and Anor [2014] VSCA 14. This was the first consideration of s.588FDA at an appellate level after a string of first instance decisions had narrowed the scope of the section. The Court of Appeal distinguished such decisions and did not follow the general proposition as to requirement of a ‘direct benefit’, restoring s.588FDA as an effective remedy for liquidators generally and, in particular, against third parties taking the benefit of the transaction.

Section 588FDA can be a very effective remedy against third parties because it:

  • does not require proof of insolvency;
  • has a 4 years relation-back period; and
  • is not subject to the s.588FG(2) defence of good faith, absence of a reasonable suspicion of insolvency and provision of valuable consideration which is otherwise available to third parties in relation to uncommercial transactions or unfair preferences.

However, where a third party has changed its position in reliance on a transaction so that it would be unfair or unjust to avoid the transaction ab initio, relief may not extend that far. Importantly there was no evidence of such change of position in this case. It can be expected that arguments as to change of position will be made by third parties in other cases.

Wulguru entered into a deed assuming joint liability for a debt owed by a director to a third party and granted a mortgage to secure such debt. At first instance the Liquidator’s application to set aside the Deed was dismissed. The Court of Appeal (Nettle JA., Beach JA and McMillan AJA) unanimously granted the appeal and declared the transaction to be void ab initio. The result was that the proceeds of sale of the relevant land was property of the company in the winding up and the third party could not prove as an unsecured creditor.

In summary, the facts were:

  1. Mr Thompson was the sole director and shareholder of:
    (a) Wulguru;
    (b) Richmond Commercial Pty Ltd (Richmond); and
    (c) Mulgrave Commercial Pty Ltd (Mulgrave)
  2. Mr Thompson provided personal guarantees in respect to liabilities of Richmond and Mulgrave to Becon;
  3. Mulgrave and Richmond defaulted on their obligations and Becon commenced proceedings against Mr Thompson pursuant to the personal guarantee;
  4. Mr Thompson, Wulguru and Richmond then entered into a deed with Becon to guarantee repayment of obligations of Mulgrave and Richmond to Becon (Deed);
  5. Wulguru assumed a joint and several liability to pay Mulgrave’s debt to Becon and provided a mortgage over real property as security in exchange for the release of Mr Thompson’s liabilities (Mortgage);
  6. Prior to the Deed, Wulguru had no obligation or liability to Becon;
  7. Wulguru entered into a contract of sale to sell part of the mortgaged property. The proceeds were held in trust pending determination of Becon and another’s entitlements; and
  8. Liquidators were appointed to Wulguru 13 months after the Deed was executed.

S.588FDA provides as follows:

A transaction of a company is an unreasonable director-related transaction of the company if, and only if:

(a) The transaction is:
(i) a payment made by the company; or
(ii) a conveyance, transfer or other disposition by the company of property of the company; or
(iii) the issue of securities by the company; or
(iv) the incurring by the company of an obligation to make such a payment, disposition or issue; and

(b) the payment, disposition or issue is, or is to be, made to:
(i) a director of the company; or
(ii) a close associate of a director of the company; or
(iii) a person on behalf of, or for the benefit of, a person mentioned in subparagraph (i) or (ii); and

(c) it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction, having regard to:
(i) the benefits (if any) to the company of entering into the transaction; and
(ii) the detriment to the company of entering into the transaction; and
(iii) the respective benefits to other parties to the transaction of entering into it; and
(iv) any other relevant matter.

The obligation referred to in subparagraph (a)(iv) may be a contingent obligation

The definition of ‘on behalf of’ in s.9 of the Act includes ‘on the instructions of’.

The Court of Appeal considered whether the Deed and Mortgage were made on behalf of Mr Thompson within the meaning of s.588FDA(1) given they were executed on Mr Thompson’s instructions, or alternatively, made for his benefit because they relieved him of his obligations to Becon.

Nettle JA stated at [16]:

“…the requirement that a disposition be made “on behalf of’ a director requires something more than that it be effected on the instructions of the director. Arguably, the provenance of the section and the objectives which (according to the Explanatory Memorandum) it was designed to achieve, imply that a disposition to a person ‘on behalf of a director’ connotes a disposition which is of some benefit to the director. At the same time, however, I doubt that Parliament intended to confine the operation of s 588FDA to direct benefits or that the section should be so construed.

The Court distinguished  Ziade Investments Pty Ltd v Welcome Homes Real Estate Pty Ltd & Anor [2006] NSWSC 457 (2006) 57 ACSR 693 (Gzell J) and Re Great Wall Resources Pty Ltd (in liq) [2013] NSWSC 354 (Brereton J) . Re Great Wall Resources Pty Ltd (In Liquidation) [2013] NSWSC 354, where it was held that provision of benefit to a company of which the director was a shareholder was an indirect benefit not caught by s.588FDA. Brereton J. saying:

“…only a direct benefit will suffice and that a benefit to a company of which the director is a shareholder, even the sole shareholder, will not”

The reasoning in Ziade Investments was also followed in Verge v Stinson [2011] WASC 158 and Lawrence Waterhouse Pty Ltd (in liq), Re Shaw v Minsden Pty Ltd [2011] NSWSC 964 which are not cited in this decision.

In this case the Court of Appeal found that there was a direct benefit to the director, being Becon’s covenant not to sue and the contingency of ultimately being relieved of his obligations as surety to Becon. Nettle JA, however, went further than distinguishing the preceding cases and rejected an argument that the concept of benefit was restricted to actual equitable interests or equities and did not extend to mere financial interests or contractual rights [22-24]:

“I reject that argument for three reasons. First, if Becon’s contention were correct, the words ‘for the benefit of’ in s 588FDA(1)(b)(iii) would add nothing to the preceding expression of ‘on behalf of’. In that connection, I do not accept Becon‘s suggestion that ‘on behalf of’ is intended to capture cases in which the director in question derives an equitable interest in the disponed property and that ‘for the benefit of’ is directed at cases in which the director in question derives a mere equity in the disponed property (as where the disposition is in favour of a trustee of a discretionary trust of which the director is an object). Although the objects of a discretionary trust may not have an interest as such in the assets of the trust, it is commonplace to refer to assets of that kind as being held on behalf of the objects of the trust, and there is no reason in the context of this legislation to suppose that Parliament would do otherwise.

Secondly, the natural and ordinary meaning of a requirement that something be for ‘for the benefit of’ a person is that it be ‘for the advantage, profit or good’ of the person.[13] So, in this context, just as moneys paid by A to B to discharge C’s indebtedness to B would ordinarily be conceived of as paid to B for the benefit of C, so too the incurrence by A of obligations to B in order pro tanto to relieve C of his obligations to B would naturally and ordinarily be conceived of as being for the benefit of C.

Thirdly, the natural and ordinary meaning of ‘for the benefit of’ accords to the objective of the section of preventing directors stripping benefits out of companies to their own advantage. Conversely, given the ease with which an errant director might channel benefits from a company under his charge to another company in which he is financially although not legally or equitably interested, there is every reason to suppose that Parliament intended not to confine the meaning of the expression to something in the nature of an equitable interest.”

The reasoning in Ziade and Great Wall depended in part upon the definition of ‘close associate’ in the Act; it was thought that if Parliament intended to catch transactions benefitting companies of which a director was a shareholder then the definition of ‘close associate’ could have been expanded to include such companies. The Court of Appeal disagreed [26]:

“With respect, however, I disagree. As I see it, the close associate provisions are designed to catch a benefit flowing to a close associate whether or not the benefit has the effect of legally or financially advantaging the director in question. In contrast, the natural and ordinary meaning of ‘for the benefit of’ in s 588FDA is calculated to catch a benefit which legally or financially advantages the director in question regardless of whether it is paid or directed to a close associate of the director. Since the two regimes are aimed at different albeit potentially intersecting sets of possibilities, it would run counter to the evident intention of the legislation to read down either to the point of mutual exclusion.”

Although the defence in s.588FG(2) does not apply to s.588FDA there is a limiting discretion in the Court in s.588F(4) which [30]:

“provides that, where a transaction is liable to avoidance solely because it is an unreasonable director-related transaction, the court is to make an order only for the purpose of recovering the difference between the value if any provided by the company and the value that it may be expected that a reasonable person in a company’s circumstance would have provided having regard to the benefits and detriment to the company of entering into the transaction, the benefits and detriments to other parties to the transaction, and any other relevant matter. In effect, that confers a broad degree of discretion on the court to do what is just and equitable in the particular circumstances of each case and so thereby to avoid the possibility of capricious and unfair consequences for innocent third parties. That and the limited number of cases in which the unreasonable director-related provisions have featured since their introduction are a relatively sound indication that the potential application of this legislation is not nearly as broad as Becon says it fears.”

The outcome of this case suggests that the courts will adopt a broader interpretation of the words “for the benefit of”, in the application of s.588FDA of the Act. This decision is likely to lead to liquidators paying closer attention to transactions made for the benefit of a director, holding such directors accountable. It may well be that there will be more cases featuring this provision in the future.

For further information, or if you have any queries relating to this area, please contact Andrew Cox of our office on 03 9614 7707.

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2014-04-03T00:16:00+00:00April 3rd, 2014|Categories: Insolvency|