Unreasonable director-related transactions

A recent Victorian case has worrying implications for financiers and creditors.

A decision of the Victorian Court of Appeal in Vasudevan v Becon Constructions (Australia) Pty Ltd [2014] VSCA 14 has the potential to significantly broaden the power of a liquidator to attack a company transaction under section 588FDA of the Corporations Act 2001 (Act) where there are ‘indirect benefits’ to a director or close associate of a director of the company.

Although the decision will be welcomed by liquidators, it has worrying implications for financiers or creditors. Even a third party arm’s-length creditor could be caught.

For creditors, the type of transaction most at risk will be where a company has provided a guarantee or security for a debt of a third party.

Background

If a transaction is an unreasonable director-related transaction, there is a four year relation back period and the liquidator does not have to prove insolvency at the time of the transaction or that the company became insolvent as a result of the transaction. This is an advantage to the liquidator.

Examples of a transaction by a company include a payment, transferring or mortgaging an asset, the giving of a guarantee, release or waiver or the incurring of an obligation.

The court has a wide discretion regarding the range of orders that can be made in relation to a voidable transaction, including declaring the transaction void.

In Vasudevan, the company in liquidation had entered into a deed and given a third party mortgage, assuming liabilities to secure the existing debt of another company. No money was advanced to the company in liquidation.

The sole director of the company in liquidation was also a sole director and shareholder of the other company that owed the existing debt. The director was not a director or shareholder of the third party creditor.

The Court held that the deed and mortgage were void.

Section 588FDA: Why all the fuss?

Broadly, the purpose of the section is to enable a liquidator to avoid unreasonable transactions entered into by a company where, for example, there has been a payment, transfer or disposition made or right granted to:

• a director of the company or his or her close associate; or
• a third party on behalf of, or for the benefit, of a director or close associate.

A transaction will be an unreasonable director-related transaction of the company, if:

• the transaction is a payment made by the company; a sale, transfer or disposition of company property; the issue of security by the company; or the incurring by the company of an obligation to make such a payment, disposition or issue;
• the payment, disposition or issue is, or is to be, made to:

1. a director of the company;
2. a close associate of a director of the company; or
3. a person on behalf of, or for the benefit of, a director of the company or a close associate of a director of the company; and

• it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction having regard to:

1. the benefits (if any) and detriment to the company of entering into the transaction;
2. the respective benefits to the other parties to the transaction of entering into it; and
3. any other relevant matter.

Main issues in Vasudevan

The main issues in Vasudevan were:

• whether the deed and mortgage were for the ‘benefit of’ the director because the deed and mortgage were executed by the company in liquidation on the director’s instructions; and
• whether the words ‘for the benefit of’ in respect of a director or a close associate of a director mean only a direct benefit or whether indirect financial benefits were also caught.

If indirect benefits are caught, then section 588FDA is capable of being applied by a liquidator to a wider range of company transactions.

Starting with the earlier decision of Ziade Investments

In Ziade Investments Pty Limited v Welcome Homes Real Estate Pty Limited [2006] NSWSC 457 the company in liquidation granted mortgages to companies to secure past loans that had been made to the company in liquidation.

Under the mortgages there was no forbearance to sue for recovery of the existing debts and the mortgages were not granted in consideration of future advances.

Mr Ziade was a director of the company in liquidation and he and his wife were the shareholders of the companies that received the mortgages.

In Ziade Investments, Gzell J held that the mortgages were an insolvent and uncommercial transaction under a different section of the Act.

It was not necessary for his Honour to decide whether the mortgages were an unreasonable director‑related transaction. However he expressed the view that, although Mr and Mrs Ziade were shareholders of the companies that received the mortgage, they did not receive a direct benefit from receiving the mortgage.

The reasoning was that the legal identity of a company is different from its shareholders. The companies that received the mortgages gained the benefit of the mortgage in their own right and not for the benefit of their shareholders.

Gzell J expressed the view that, in relation to benefits, it was not the intention of the legislator to include derivative interests (indirect interests) constituted by any increase in the value of the shares or of any trust benefited by the transaction.

His Honour said that, to be caught under section 588FDA, a transaction must be for the direct benefit of a director or close associate of the director. An indirect benefit is not sufficient. The financial interest of a shareholder is an indirect benefit.

The reasoning of Gzell J in Ziade Investments has been applied in the cases of Re Lawrence Waterhouse Pty Ltd (in liq), Shaw v Minsden Pty Ltd [2011] NSWSC 964, Verge v Stenson [2011] WASC 158 and Re Great Wall Resources Pty Ltd (in liq) [2013] NSWSC 354.

The decision in Vasudevan

Mr Thompson was the sole director and shareholder of Wulguru (the company in liquidation) and of two debtor companies, Richmond and Mulgrave.

The creditor Becon had instituted legal proceedings against Mr Thompson as guarantor to recover money owing by Richmond and Mulgrave. At that time Wulguru had no liability to Becon.

Mr Thompson was not a director or shareholder of Becon and he had no financial interest in Beacon, a third party arm’s-length creditor.

Wulguru entered into a deed with Becon to restructure the debts of Richmond and Mulgrave, where:

• the recitals to the deed recorded that it was accepted by Mr Thompson;
• Wulguru assumed a joint and several liability to pay Mulgrave’s debt to Becon;
• Wulguru agreed to provide a mortgage to Becon to secure the performance of Wulguru’s obligations under the deed; and
• upon execution of the mortgage by the company in liquidation, Becon agreed to discontinue its proceedings against Mr Thompson and release him from various liabilities.

As Mr Thompson was the sole director of Wulguru, the deed could only have been entered into by Wulguru on his instructions.

Nettle JA delivered the reasons for judgment in the Court of Appeal. He held that:

• It is not enough that the deed and mortgage were executed on the instructions of the director. That did not make the transaction ‘on behalf of’ the director.
• Mr Thompson received a direct benefit from Wulguru entering into the deed in the form of Becon’s covenant not to sue him and the possibility of him being discharged from liability if Wulguru provided the mortgage.

The deed and mortgage were declared void, despite Beacon being a third party arm’s-length creditor.

Nettle JA said that the direct benefit that Mr Thompson actually received stood in contrast to the kinds of indirect shareholder benefits in issue in Ziade Investments and Great Wall, and, to that extent, the observations in Ziade Investments and Great Wall were distinguishable.

Is section 588FDA limited to a direct benefit?

Nettle JA was of the view:

• the words ‘for the benefit of’ should be given their natural and ordinary meaning;
• the natural and ordinary meaning of a requirement that something be ‘for the benefit of’ a person is that it be ‘for the advantage, profit or good of the person’;
• the section is not limited to a situation where the director or close associate of a director receives an equitable interest or equity in relation to the property;
• the section is not restricted to direct benefits and extends to indirect benefits received by a director or a close associate of a director;
• mere financial interests or mere contractual rights are not excluded;
• 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; and
• the very point of the section is to catch director-related transactions of the kind not otherwise liable to avoidance as an unfair preference, uncommercial transaction or unfair loan.

Implications for liquidators

We suggest the courts will apply the decision in Vasudevan and, as a result, it has significantly extended the operation of section 588FDA to capture indirect benefits received by a director or by a close associate of a director.

Liquidators will increasingly rely on section 588FDA to attack a transaction where a director or close associate of a director had a financial interest in the outcome of the transaction.

Potentially the financial interest may be as a shareholder, as a beneficiary of a trust or where the director or close associate of the director had a security interest. An example of the director or close associate of the director receiving a benefit under a security interest is where they have a security interest over assets of a recipient company that receives a mortgage or transfer of assets from the company in liquidation.

In some cases a liquidator may be able to attack the transaction on the basis that it is a preference (where a six month relation back period applies) or it is an insolvent and uncommercial transaction (where a two year relation back period applies where a related party is not a party to the transaction). For a preference or uncommercial transaction the company must be insolvent at the time of the transaction or become insolvent as a result of the transaction.

However, where there is an unreasonable director-related transaction, the liquidator has a four year relation back period and it is not necessary for the liquidator to prove insolvency at the time of the transaction or that the company became insolvent as a result of the transaction.

Not having to establish insolvency in relation to unreasonable director-related transactions, and the four year relation back period, potentially puts more transactions within the liquidator’s reach.

Exclusion of section 588FG defences

Where you are a party to an unfair preference or uncommercial transaction there is the defence under section 588FG of the Act where, generally speaking, you acted in good faith, gave valuable consideration or changed your position and where you had no reasonable grounds for suspecting insolvency and a reasonable person would not have so suspected. Under section 588FG there is a separate defence for third parties who were not a party to the transaction.

However the defences under section 588FG do not apply to an unreasonable director-related transaction, giving liquidators a further advantage.

Section 588FF(4) limitation on court’s powers

The court has a wide discretion as to the orders that can be made under section 588FF(1) of the Act in relation to voidable transactions, subject to section 588FF(4).

If the transaction is voidable solely because it is an unreasonable director-related transaction, the court can only make orders under section 588FF(1) for the purpose of recovering for the benefit of the creditors of the company the difference between:

• the total value of the benefits provided by the company under the transaction; and
• the value (if any) that it may be expected that a reasonable person in the company’s circumstances would have provided having regard to matters referred to in paragraph 588FDA(1)(c), which are:

1. the benefits (if any) and detriment to the company of entering into the transaction;
2. the respective benefits to the other parties to the transaction of entering into it; and
3. any other relevant matter.

The limitation on the court’s powers in section 588FF(4) only applies where the transaction is voidable solely as an unreasonable director-related transaction. If it is also voidable, for example, because it is a preference or uncommercial transaction, then the limitation will not apply.

In Vasudevan, Nettle JA said that:

• section 588FF(4) confers a broad discretion on the court to do what is just and equitable in the particular circumstances of each case and so as to avoid the possibility of capricious and unfair consequences for innocent third parties; and
• whether or not a transaction should be declared void in a given case will depend on a range of considerations, including, in particular, the interests of parties and third parties who might have acted in good faith in respect to the transaction.

In this case it was not suggested that the third party creditor Beacon had changed its position in reliance on the transaction, that it would be unfair or unjust to avoid the transaction ab initio or that any third party would be prejudiced by an order avoiding the transaction.

There was no observation made that the third party creditor had not acted in good faith.

We suggest that in future cases there will be legal argument as to what will come within the ambit of ‘all relevant matters’ and what will constitute a relevant change of position.

Implications for financiers and creditors

From a financier’s or creditor’s perspective there is a real risk that a liquidator, many years after the event, may challenge a transaction where there were unreasonable ‘indirect benefits’ to a director or close associate of a director of the company.

Examples of the type of transactions that are most at risk of being challenged by a liquidator include:

• the taking of a guarantee or security from a company to secure the existing indebtedness of another person; and
• the giving of a guarantee or security in relation to a loan transaction where the borrower is another person.

The level of risk will increase if the third party borrower is in financial difficulties or the existing loan is under special management.

We suggest that the lender will not be able to simply rely upon the position that the company has legal power to enter into the transaction and that the lender need not consider the benefits (if any) and detriment to the company of entering into the transaction.

Depending upon the circumstances of the transaction a lender may not be protected by declarations obtained from directors that the proposed transaction is for the benefit of the company.

If you would like more information about these issues, please contact Graham Roberts on 61 7 3231 2404 or Kate Whalan on 61 7 3231 2909.