Dangers of irrevocable authorities and breaches of fiduciary duty

Potential liability of third parties – accountants and solicitors

When a debtor owes money to a creditor, it is not uncommon for the debtor to propose that the creditor be paid from the proceeds of a sale or other transaction where the debtor is to receive a payment. It could, for example, be a sale of land or shares or proceeds from an insurance claim.

Where, for example, an accountant or solicitor is acting on behalf of the debtor in relation to the other transaction, the debtor may give a direction to the accountant or solicitor, as the debtor’s agent, directing them to pay the creditor from the proceeds of the transaction.

It is an obscure but potent principle of agency law that, in certain circumstances, the agent of the debtor can be personally liable to pay the creditor if payment is not made in accordance with the debtor’s direction. For the agent to be liable the direction does not need to be expressed to be irrevocable. The agent of the principal can be personally liable even if the principal purports to withdraw the authority.

In FTV Holdings Cairns Pty Ltd v Smith [2014] QCA 217, the Court of Appeal of the Supreme Court of Queensland considered the law relating to what are commonly called ‘irrevocable authorities’ and the liability of third parties under the rule in Barnes v Addy.

The facts in FTV Holdings

The borrowers owed money to an unsecured lender. The borrowers proposed a payment arrangement where the borrowers would sign an irrevocable authority directing that the debt of $200,000 plus interest be paid to the lender out of the proceeds of an anticipated sale of the borrowers’ house.

The borrowers’ solicitors sent the irrevocable authority to the lender’s solicitors as instructed by the borrowers.

It took over a year for the house to be sold.

The borrowers instructed their solicitors to act on the sale of the house but later told their solicitors that they were not going to pay the lender from the settlement proceeds. The borrowers’ solicitors were instructed to pay the net proceeds to a bank account in the borrowers’ names.

The borrowers’ solicitors gave the settlement cheque directions to the buyer. At settlement a cheque was given to the registered mortgagee to discharge the existing mortgage. The balance purchase price (after payment of the borrowers’ solicitors’ costs) were paid by cheque to the borrowers and deposited to the borrowers’ bank account.

Following settlement the borrowers’ solicitor directed the selling agent to pay the balance deposit to the borrowers.

The lender did not get paid and the borrowers went bankrupt. The lender sued the borrowers’ solicitors for approximately $215,000, being the amount that should have been paid to the lender from the sale proceeds.

Irrevocable authority

The specific wording of the irrevocable authority was examined by the Court.

The borrowers did not merely promise that they would repay the lender’s debt from the proceeds of sale. By the irrevocable authority they agreed to appropriate the proceeds of sale to the lender to the extent necessary to discharge the debt.

The wording of the irrevocable authority did not oblige the borrowers to ensure that their solicitor would receive or hold the relevant part of the sale proceeds, but it did require the borrowers to ensure that they, or an agent acting on their behalf, would ‘forward’ or pay the lender’s solicitor ‘from’ the proceeds of settlement ‘at’ settlement.

The Court of Appeal said that the lender had provided consideration for the authority that was not capable of being revoked by the borrowers.

In those circumstances, the Court of Appeal found that the irrevocable authority created a valid equitable charge over the balance sale proceeds in favour of the lender.

The Court of Appeal said that the borrowers had committed at least three breaches of their fiduciary duties owed to the lender:

• Before settlement, the borrowers had instructed their solicitors not to pay any of the sale proceeds to the lender but instead to pay the balance proceeds to the borrowers after discharge of the mortgage. This was a breach of fiduciary duty by the borrowers because it was designed to produce a breach of the borrowers’ prospective duty as trustees to pay the relevant part of the proceeds to the lender.
• At settlement the borrowers received the whole of the balance sale proceeds without accounting to the lender for their debt.
• After settlement the borrowers retained the resulting credit balance in their account and did not pay the lender.

Was the irrevocable authority enforceable against the borrowers’ solicitor?

The actual communications between the borrowers’ solicitor and the lender’s solicitor were scrutinised by the Court.

In the communications the borrowers’ solicitor did not say or do anything that could fairly be construed as a personal promise to the lender. The borrowers’ solicitor only acted and professed to act on behalf of the borrowers as their solicitor.

No express or implied promise was made by the borrowers’ solicitor to the lender that he would pay the balance sale proceeds to the lender.

The Court of Appeal said the solicitor was not liable under the irrevocable authority for money had and received because there was no overt or positive acknowledgment by the solicitor. While such an acknowledgment can be implied from acts or words that do not amount to an express promise or engagement, they cannot be implied from silence alone.

The Court also said the claim for money had and received failed because the solicitor did not receive or hold the money at any time. The lender did not prove that the solicitor ever held or controlled the bank cheque for the balance sale proceeds.

However that was not the end of the matter.

Liability under Barnes v Addy

The lender argued that the borrowers had breached their fiduciary duties to the lender and that the solicitors, in complying with the borrowers’ instructions, knowingly assisted the borrowers in the breach of their fiduciary duty.

This claim against the solicitor ultimately failed because it was raised for the first time on the appeal (i.e. after the trial), at which time the solicitor was no longer able to present evidence that might have answered the claim.

However, the Court of Appeal did make some obiter remarks about the circumstances in which a professional adviser might become liable for carrying out their client’s instructions that would breach a fiduciary duty of the client.

It is established that the rule in Barnes v Addy extends to breaches of fiduciary duty in addition to breaches of trust.

In Barnes v Addy there are two separate grounds or ‘limbs’ under which a third party can be liable.

The first limb

The first limb, known as ‘knowing receipt’, involves a person knowingly receiving property in breach of a trust or fiduciary duty.
Applying earlier authorities, the Court of Appeal said in relation to the first limb:

• Decisions have distinguished receipt by an agent acting only as a mere depository or channel from receipt by an agent for the agent’s own benefit or in the agent’s own right.
• ‘Receipt’ is taken to mean receipt in the recipient’s own name or for the recipient’s own benefit.
• The receipt by the third party needs to be for his or her own benefit or in his or her own right in the sense of setting up a title of his or her own to the property so received.

The Court of Appeal observed that the registered mortgagee presumably authorised someone to act as its agent at settlement to receive the bank cheque in exchange for the release of the mortgage, but that if the solicitor instead took delivery of the bank cheque in favour of the borrowers’ bank for the credit of the borrowers he probably acted ‘merely as a channel’ to deliver it to the bank.

The Court did not need to express a conclusion upon that issue because the lender did not prove that the borrowers’ solicitor ever had possession of the bank cheque or of any of the proceeds of sale (other than the small amount of the solicitor’s fees, which were not in issue). Accordingly the first limb in Barnes v Addy did not apply.

The second limb

The second limb, known as ‘knowing assistance’, involves a person knowingly assisting the trustee or fiduciary to carry out a ‘dishonest and fraudulent design’.

In order to be liable under the second limb the third party must have assisted in the breach of trust or fiduciary obligation with the knowledge of a ‘dishonest and fraudulent design’ on the part of the trustee or fiduciary.

Not all breaches of fiduciary duty necessarily involve dishonesty and fraud. The requirement of ‘dishonest and fraudulent design’ refers to conduct that is ‘morally reprehensible’. The terms are not used in the same way as in a criminal law context or in actual fraud in a common law sense.

The dishonest and fraudulent design must be carried out by the trustee or fiduciary.

The third party does not need to be dishonest or profit from the transaction. In FTV Holdings the solicitors had not acted dishonestly or profited from the transaction. The solicitors acted in accordance with their clients’ instructions.

The third party does need to have knowledge of, and participate in, the dishonest and fraudulent design.

Knowledge in any of the following four categories is sufficient for ‘knowing participation’:

• actual knowledge;
• wilfully shutting one’s eyes to the obvious;
• wilfully and recklessly failing to make such enquiries as an honest and reasonable person would make; or
• knowledge of circumstances that would indicate the facts to an honest and reasonable person.

Mere knowledge of facts that would have put a reasonable person on inquiry will not attract liability.

Pleading a breach of Barnes v Addy

An allegation that the third party assisted in the breach of trust or fiduciary obligation with the knowledge of a ‘dishonest and fraudulent design’ on the part of the trustee or fiduciary must be properly pleaded so the allegation is put in issue at trial. As noted above, this did not occur in FTV Holdings.

As a result, the lender’s case at trial did not include the necessary allegations about the state of mind of the borrowers and of the borrowers’ solicitor. No evidence was called at trial regarding the relevant matters or to rebut such a case at trial because the relevant allegations were not pleaded by the lender.

Because of this, the Court of Appeal said that it did not make any adverse finding on the issue as to the states of mind of the borrowers and of the borrowers’ solicitor.

However, the Court of Appeal did suggest that a future similar case might have a different outcome if the claimant was able to plead and establish that:

• the solicitor knew that the lender had compromised its claim against the borrowers in exchange for the borrowers’ irrevocable authority and direction to the solicitor to pay the lender’s debt from the proceeds of the sale at settlement;
• the solicitor was instructed to act in a manner that a reasonable person in the solicitor’s position would have considered contrary to the terms of the irrevocable authority; and
• the solicitor complied with those instructions by organising settlement of the sale as instructed and giving no notice to the lender of the change in the borrowers’ instructions.

Implications

Courts will scrutinise the wording of an irrevocable authority to identify the terms of any obligations.

Third parties, such as accountants, need to be aware of the requirements of an irrevocable authority and, if necessary, obtain legal advice.

Third parties need to be very careful to ensure that they do not give any promise or acknowledgment that they will act in accordance with an irrevocable authority.

We suggest that they should expressly inform creditors that they do not make any promise or give any acknowledgement that they will act in accordance with an irrevocable authority.

However they will still need to have appropriate systems in place to ensure the requirements of an irrevocable authority are not overlooked or contravened.

Even if you have not given an express promise or acknowledgment that you will act in accordance with the direction of an irrevocable authority, you still need to be particularly aware of the potential liability under the second limb of Barnes v Addy.

Particularly worrying is that a delinquent trustee or fiduciary does not need to be sued in the legal proceedings. It does not matter if they are bankrupt or in liquidation.

The potential for liability under Barnes v Addy is likely to increase as more cases are considered by courts.

For example, Barnes v Addy can apply to certain breaches of fiduciary duty by a director of a company.

We suggest that liquidators may also, in appropriate cases, seek to make a third party liable under Barnes v Addy in addition to relying upon claims under the Corporations Act 2001. For example, in the Bell litigation, securities were granted to the banks about 18 months before liquidation. The transactions were outside the preference period however the liquidator sought to have the securities set aside relying upon both limbs of Barnes v Addy.

If you would like more information about these issues, please contact Graham Roberts on +61 7 3231 2404 or in relation to insurance enquiries Kevin Bartlett on +61 7 3231 2496.