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Chronicles of Insolvency Law: Unreasonable director-related transactions
Substantive Law| What area(s) of law does this episode consider? | Insolvency Law David Armstrong joins us in this episode to talk about unreasonable director-related transaction claims brought by liquidators, and the defences available to company directors. |
| Why is this topic relevant? | The simultaneous demand side and supply side shocks caused by the coronavirus pandemic have placed many Australian small and medium sized businesses under unprecedented financial stress, and for some caused them to become insolvent. Before a company tips over the edge into formal insolvency, it’s not uncommon to see company assets transferred by business owners out of the hands of the company and into the pockets of the company’s directors and their relatives in an effort to preserve some of the assets of the company before they’re divided amongst creditors. This is addressed in the law through the operation of section 5.7B of the Corporations Act 2001, however, what the courts decide constitutes unreasonable director-related transactions and the way they come to these decisions continues to evolve and change. |
| What legislation is considered in this episode? | Corporations Act 2001 (Cth), particularly section 588FDA ‘unreasonable director-related transactions’ |
| What cases are considered in this episode? | Crowe-Maxwell v Frost [2016] NSWCA 46
Vasudevan v Becon Constructions (Australia) Pty Ltd [2014] VSCA 14
Weaver v Harburn [2014] WASCA 227
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| What are the main points? |
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| What are the practical takeaways? |
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| Show notes | NSW State Government’s website for businesses |
| David Turner:
1:00
| Hello and welcome to Hearsay The Legal Podcast, a podcast by, for and about Australian lawyers, my name is David Turner. As always, this podcast is proudly supported by Assured Legal Solutions, a boutique commercial law firm making complex simple. The simultaneous demand side and supply side shocks caused by the coronavirus pandemic have placed many Australian small and medium sized businesses under unprecedented financial stress, and for some caused them to become insolvent. Now shortly before a company tips over the edge into formal insolvency, it’s not uncommon to see company assets transferred by business owners out of the hands of the company and into the pockets of the company’s directors and their relatives, in an effort to preserve some of the assets of the company before they’re divided amongst creditors. These transactions, designed to defeat creditors, are of course voidable, but so too are some transactions, which, in the absence of financial distress, might seem innocuous to many business owners. Our guest today, David Armstrong, has acted for both liquidators and directors in litigation dealing with unreasonable director-related transactions, including a case that recently developed the law in this area. David, thanks so much for joining me today on Hearsay. |
| David Armstrong: | Thank you, David. It’s a pleasure to be here. |
| DT: | Now David, tell us a bit about your background as a lawyer and your experience dealing with unreasonable, director-related transactions. |
| DA: 2:00
| I commenced my career as a paralegal at Norton Rose in the insolvency team, so I had early exposure to the insolvency area and immediately started a graduate program but knew fairly quickly that insolvency was my space. So instead of doing the usual rotations I gravitated naturally towards the insolvency area and particularly was interested in the litigious side of insolvency, particularly acting for liquidators. After working at Norton Rose for a number of years, I joined a boutique insolvency practice within the true meaning of that word, which is bandied around a lot today. And then in 2015 I started my own practice. Armstrong Law Partners, which has been going strong now for five years, I’m the principal of that firm. We cover a lot of areas, but particularly focused on commercial and insolvency. During that time, I’ve had experience acting for liquidators, banks, other secured creditors, and more recently I’ve been focused on acting on the director’s side. |
| DT: 3:00 | Yeah right, I mean, I’ve found certainly moving from a large firm to a boutique practice you do get a bit more of that director side work, and it’s definitely a different dynamic acting for the director. I think you get a better perspective on how some of these transactions and how some of these corporate failures come to pass. I know that certainly acting on the company side and director side I’ve developed a bit more empathy, I think, for defendants in these sorts of cases, |
| DA:
4:00
5:00
| Yeah I agree with that completely. It’s only natural when you’re working with people, rather than documents and transactions like you would be when you’re acting for a liquidator and you haven’t necessarily met the people involved in the company and its transactions, that you do develop that empathy. And you get to learn their stories and oftentimes these transactions that you might be looking at from a liquidator’s point of view as quite obviously voidable or accompanied by a breach of directors’ duties or befouling some other aspect of the Corporations Act. So they may have a more innocent explanation, and often the directors haven’t turned their minds to exactly what they’re doing. And it’s particularly the case with closely held companies and I’m talking about companies where there may be a sole director, secretary, maybe a couple involved, one may be the main income earner in the business, the other partner might be providing administrative or back-office work and they’re not necessarily commercially sophisticated people, and they haven’t obtained advice from accountants or lawyers at the commencement of starting their business. It’s very easy nowadays to log onto certain websites and click a few buttons and all of a sudden, you’re the director of a company and you don’t have to do any learning. And I personally find that that is one of the biggest obstacles when I’m talking to clients is the fact that they are able, you know, with a credit card and $500 to start their own company; but without actually thinking about what they need to put in place in terms of systems and the advice they need, like accountants, applying for tax file numbers, registering for GST, all these little things that you would ordinarily do if you were approaching a business with a proper business plan. |
| DT:
6:00
7:00 | I find that even something as simple as understanding separate corporate personality is something that’s often missing where someone’s, as you say, gone online found a website that will make the necessary lodgements for them with ASIC and, I remember having a director side client years ago who just didn’t appreciate that a corporation is a separate legal entity, that it had to pay its own taxes and that income that it earned, and it gave to him, had to be paid on some basis. You know these things that we take for granted aren’t common knowledge for every business owner. TIP: Now there’s no course you have to take or exam you have to pass before you can become a company director – so the owners of incorporated small businesses aren’t always aware of their legal obligations before they take them on. Thankfully, there’s a lot of public information available. In NSW, the state government’s website has a section dedicated to helping small business owners learn about business compliance and regulation. This public information covers a range of relevant topic areas such as:
Additionally, the Federal Government’s ‘business.gov.au’ website provides useful information and support to small business owners, including information on how to buy an existing business, valuing businesses, conducting due diligence with regards to the financial records of the target business, business operations and legal documents. Links to both the state and federal government websites will be included in our show notes in case you or someone you know is interested in learning more about those guidelines, or if you think they would be a useful reference for your clients. |
| DA:
8:00
9:00
10:00
11:00 | Yeah, I agree with that. And one of the cases I did want to talk about today was on that very point, a New South Wales Court of Appeal decision which involved a gentleman who was running a childcare centre. TIP: The case David is referring to here is Crowe-Maxwell v Frost [2016] NSWCA 46, a 2016 decision of the New South Wales Court of Appeal where the court provided a useful summary of the elements of an action to recover unreasonable director-related transactions under s 588FDA of the Corporations Act 2001 (Cth). That section says that ‘a transaction of a company is an unreasonable director-related transaction if:’
For now though, let’s head back to David to hear the facts of the case. Now he didn’t understand the difference between the corporate entity and himself. So effectively it was just his alter ego. He ran this childcare centre for a number of years and he used the company bank account as his personal bank account. So the first thing that we often do when we’re acting for liquidators is to look at the money. And when you look at the bank accounts and you see a company’s bank account and there are a large number of transactions, things like spending money at Woolworths, this person in particular had a penchant for having a punt. So there were transactions where he’d been to the TAB and had been putting on bets. But all throughout this time that he was running the childcare centre, he had never actually formally drawn a wage from the company. He just never turned his mind to the fact that the money that was coming into the company may not be his. He didn’t consult with an accountant, so he wasn’t aware that he would have to pay himself in some fashion and then tax will be payable on that. And so he just continued to treat it as if it was his own money. Looking at that from a liquidator’s point of view, it just seems like such an obvious case to bring in terms of unreasonable director-related transactions. You’ve got a director who on the bank statements looks like they’re going in doing their weekly shop, or having a punt, or going to Vintage Sellers and buying a bottle of red wine on Friday night. But in reality, his position was, “I just thought the money was mine because I’d earned it and I was paying my other expenses. And therefore in lieu of taking a wage or salary or rewarding myself in some other way, I would spend the money as I needed it and I tried to ensure that there was money in place to meet my trading expenses.” But apart from that, he never really gave consideration to the fact that the company was a separate entity to him. |
| DT: | And you can see how if those payments had been made regularly to a separate bank account in the form of a wage, completely different outcome. |
| DA: | Yeah, absolutely. |
| DT:
12:00 | The reimbursement of some kind of personal expenses then raises all these other complicated issues, doesn’t it? Because if they’re construed as a wage, then often a liquidator will say, “well, compulsory superannuation should have been contributed on that wage, and that’s not been paid either.” So now there’s a debt owing there as well, and so the issue tends to balloon. Now let’s start with the basics in terms of the legislation. For someone who’s unfamiliar with the Corporations Act, what is an unreasonable director-related transaction? |
| DA:
13:00 | Well, an unreasonable director-related transaction, it’s just one of the many suite of tools available to a liquidator in liquidation under part 5.7B of the Corporations Act, it’s essentially an anti-avoidance provision designed to allow liquidators the power to claw back transactions that have occurred in the period of time prior to liquidation, when the company was still in the hands of the directors. The main goal is aimed at preventing errant directors from stripping benefits out of companies for their own advantage. One of the benefits for a liquidator is that they don’t have to prove insolvency. So when we’re looking at the other voidable transaction provisions in part 5.7B, they all involve the necessity of the liquidator putting on evidence and proving insolvency. And that can be a very expensive exercise for both parties to litigation if that’s an issue that’s in dispute. So it’s quite an attractive provision for a liquidator when they are looking at transactions and they discover that they don’t need to prove that the company was insolvent at the time of the transaction. |
| DT:
14:00
15:00
| It’s also quite attractive because of the length of time that an unreasonable director-related transaction can be clawed back – four years before the relation back day, which as we’ll come onto a bit later, can catch quite a number of transactions long before the financial health of the company was in question. TIP: Part 5.7B of the Corporations Act deals with what are called voidable transactions, of which unreasonable director-related transactions are only one type. There are also unfair preferences (s588FA), uncommercial transactions (s588FB), unfair loans to a company (s588FD) and creditor-defeating disposition (s588FDB), though those other voidable transactions are beyond the scope of today’s episode. Now David’s reference just now to the relation-back day is the date from which an insolvency practitioner counts back to determine the period of time before their appointment in which transactions of the company are voidable. For example, unreasonable director-related transactions are voidable if they occurred at any time during the four years before the relation-back day. Transactions intended to defraud creditors can be clawed back ten years before the relation-back day! Section 91 of the Corporations Act sets out a useful table that tells you what the relation-back day is in relation to an appointment – often, it’s the appointment of a liquidator, but sometimes it’s the appointment of the voluntary administrator that preceded them, or the date on which a winding up application is filed. One of the key elements in succeeding in an action for an unreasonable director transaction is that a reasonable person in the circumstances of the company wouldn’t have entered into the transaction having regard to the benefits and detriments to the company that arise out of it. Now where that transaction is just a gratuitous gift, and I suppose your case earlier of the company placing a bet on someone’s behalf at the TAB, that can seem like an easy element to fulfil; what are some of the situations where that question about the benefit and detriment to a company arising out of a transaction can be more difficult to answer? |
| DA: 16:00
17:00
18:00 | The most obvious transactions are those transactions where the company clearly has derived no benefit. But the early case law in relation to this particular provision was unnecessarily narrowed until a case of Vasudeven where a company agreed to assume a joint liability for the obligations owed by a director to a third party and to grant a mortgage securing performance of that liability. The unsecured obligations of the directors became secured obligations of the company and the director received a direct benefit in terms of a covenant not to sue him. That’s the case of Vasudevan 2014. And at that point in time that is when the courts started to open up the types of transactions that could be looked at that weren’t so obvious. So, courts have now looked at things like assignments of debts, forgiving debts, granting mortgages, granting securities, issuing shares, relinquishing rights, granting encumbrances, paying money out of the company, which is an obvious one, and the transfer of real or personal company property. You can imagine, as I’ve been doing director-related work, people can become quite creative in the way that they do things. So it’s an area of the law that is evolving and continues to evolve, particularly because part of the section which grants the court a very wide discretion to look at any other relevant matter in relation to considering whether or not the transaction is unreasonable. TIP: The Victorian Court of Appeal’s 2014 decision in Vasudevan v Becon Constructions (Australia) Pty Ltd [2014] VSCA 14 broadened the power of a liquidator to attack a transaction as an unreasonable director related one, where there are ‘indirect benefits’ to a director or close associate of a director of the company. Prior to Vasudevan, the common law was clear that ‘direct benefits’ to directors or close associates could be construed as an unreasonable director-related transaction, but it was unclear on whether ‘indirect’ benefits would be too. In Vasudevan, Nettle JA considered the meaning of the term ‘for the benefit of’ in s588FDA, saying: “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 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.” So I think we’ll continue to see different types of transactions come up. In my experience, people are becoming more aware of this provision and are turning their minds to how best to avoid it in the event of a liquidation. |
| DT: 19:00
20:00 | I suppose you’ve got almost two categories of cases, one is where with the benefit of expert advice and some financial savvy, there is a concerted effort to structure transactions in a way which might defeat the recovery powers of a liquidator. But then you also have the types of cases we were describing earlier, which are just guileless, which are plain on their face apparently unreasonable director-related transactions but may not be actually unreasonable perhaps at a final hearing when you re-characterise those as remuneration or something else like that. Now, one interesting aspect of director-related transactions, often many director-related transactions involve payments directly to a director or a benefit received directly by a director, but a director-related transaction can also include a transfer of property to a close associate of a director. And a close associate includes spouses, parents, brothers, sisters, children, the director’s in-laws. And those familial relationships, how do they affect litigation about director-related transactions? Because it’s a kind of relationship that you don’t often see in corporate litigation. |
| DA:
21:00 | Yeah, that’s right, it’s not as commonly seen in this space, but I’ve been involved in a case for example, where a couple divorced and the husband was the director of two companies which owned two commercial properties which were quite profitable, both were tenanted properties. He, unbeknownst to the wife she was, I would say, excluded from the business affairs of the family, to put it one way. Unbeknownst to the wife, whilst he had been collecting rent on these commercial properties, he had not been paying the GST to the ATO. So the husband and wife divorced and entered into a binding financial agreement and the husband passed the properties to the wife pursuant to the binding financial agreement from the company directly to the wife. Now the director then put the company into a creditor’s voluntary liquidation, or CVL, and thought he’d be on his merry way. He knew there were outstanding tax liabilities, but he’d received advice from some pre insolvency gurus. |
| DT: | In inverted commas. |
| DA:
22:00
23:00 | Yeah, who had assured him that for a fixed sum a liquidator would perform a voluntary liquidation and these things would be dealt with and it wouldn’t be a problem. But once the liquidator got into the matter and looked under the hood and realised that there were substantial tax liabilities owing to the ATO and that these commercial properties had been transferred to the wife, we had to look at why that had happened in it. As I mentioned before, the binding financial agreement, which is what finalised the divorce, was the catalyst for the transfer of the properties. The unfortunate situation was it appeared to us that the wife wasn’t aware of any of these issues. So, in signing the binding financial agreement it appeared to her that she was getting value and had no reason to believe that anyone would be coming after her. But the properties were transferred for nil consideration under the binding financial agreement, so the situation rapidly deteriorated. And that resulted in us appointing a receiver to the properties in order to preserve the assets and bringing a case against the director for breach of directors’ duties, also under the unreasonable director-related transaction provisions, and also to set aside the binding financial agreement as an instrument to defraud creditors. Ultimately, that matter was resolved, but much to the detriment of the unsuspecting wife. |
| DT:
24:00 | It’s a tricky position, isn’t it? Because on the one hand, parties to family law disputes, especially family law matters about property, are encouraged to resolve those out of court or encouraged to resolve them by binding financial agreement and had that split been made by order of the Family Court, you might have seen a different result there as well, because the family court has such broad and far-reaching powers to make orders about the entitlements of parties with respect to property. But the execution of that binding financial agreement really gave rise to, and the settlement of that family law dispute, really gave rise to this completely separate issue in terms of an unreasonable director-related transaction. |
| DA: | Yeah, that’s right, and just on the point about the making of orders by another court, the provision itself turns its mind to that exact scenario. So even where a transaction has occurred because of an order of court, it can still be an unreasonable director-related transaction. TIP: Subsection 3(b) of s 588FDA of the Corporations Act states that a transaction can still be an unreasonable director-related transaction, ‘even if the transaction is given effect to, or is required to be given effect to, because of an order of an Australian court or a direction by a government agency.’ |
| DT:
25:00 | Great point. We were speaking earlier about how unreasonable director-related transactions, unique among voidable transactions, don’t require the company to be insolvent at the time of the transaction and also that unreasonable directly related transactions are voidable if they occur at any time within the four-year period before the relation back day, and as a consequence that time period catches a lot of transactions entered into at a time when the company was probably not financially distressed, when the directors were probably not thinking about the effects of such transactions on the company’s creditors, and I’m talking here about the bad habits that a lot of small businesses indulge in perhaps innocently things like purchasing items for personal use, employing a family member who perhaps doesn’t do as much as a full time salary on the books might suggest, buying or leasing cars as company cars that are really more family cars. Can you tell us about a time when you’ve seen transactions like that get someone into trouble or very nearly get someone into trouble? |
| DA: 26:00
27:00
28:00
29:00 | Yeah, it’s very common to see those sorts of transactions when times are good, when the money’s flowing and there’s not necessarily any real need for a director to turn his or her mind to insolvency issues. So usually they’d be consulting an accountant and their accountant would be telling them something like “yes, you can buy that”, or “you can make that cash transfer”, or whatever the case may be, and, “when it comes to tax time we’ll make the appropriate entries and tell the taxman and move on.” Problems do arise where that second part doesn’t necessarily occur. There’s a case of Weaver which I’ve called “the boat case”. And Mr. Weaver had a company that was quite successful. He decided that he wanted to start winding down his business because he was getting older. And at a time when the company was flush with cash, he used the money of the company to pay for a boat which was purchased in his wife’s name. Now it’s a West Australian decision and at first instance because the court had evidence before it that the company was in a very good financial position, it actually held that the transaction was reasonable. And, presumably, the director would then have to go and fix up the other part of that transaction, which would be how do we deal with it from a tax perspective? Is it a cash payment? Is it a Div 7A loan? How do we characterise it? But that’s a separate question to whether it is an unreasonable director-related transaction. On appeal, the court looked at it and said that as the director had decided that he was winding down his business, he ought to have known that the company may not be in such a great financial position in the future, and because he hadn’t taken care of the tax matters that once a liquidator was eventually appointed, which is what occurred, the liquidator was able to look back at that transaction and claw it back as unreasonable. TIP: David was just describing the Western Australian Supreme Court’s decision in Weaver v Harburn, and we’ll include the medium neutral citation in the show notes if you’re interested. Whilst sole directors and shareholders may often conflate their own identity with that of their company, it’s the duty of all directors under s181 of the Corporations Act to exercise their powers and discharge their duties in good faith in the best interests of the corporation – you don’t get the benefits of separate legal personality without also taking the detriments. Now let’s talk about the Division 7A loan that David referred to before. Division 7A is another anti-avoidance measure designed to prevent private companies from making tax-free distributions of profit in the form of payments, loans or debts that are then forgiven. If a private company makes a loan to a shareholder during an income year and then the loan doesn’t meet the requirements set out in s 109N – which is that it’s recorded in writing, and carrying a minimum interest rate (which at the time of recording is 4.52%) and a maximum term (7 years, unless it’s secured over real property) – then the loan amount is treated as a dividend of the company for tax purposes. |
| DT:
30:00 | Now, that’s an interesting result both at first instance and on appeal, because when we look at the elements of an unreasonable director-related transaction, when we’re looking at the benefits and detriments to the company that a reasonable person would draw from the transaction, one would think that there’s no benefit, irrespective of the company’s financial wellness or ill health, to the company buying a boat for the director’s wife. Where those transactions are held to be reasonable because of the financial health of the company, what is the court determining in terms of the benefits and detriments of the transaction? Is it a determination that the transaction is something like remuneration for the director? Is that the benefit that the court is construing there? |
| DA:
31:00
| I think one of the key things to keep in mind is that we need to consider what the purpose of a company is, particularly at the closely held level of the company. I mean people aren’t going into these enterprises which carry a lot of risk, unless there’s going to be some benefit that they can derive from it. So, of course, they’re going to be turning their minds to how do I turn this enterprise into a profit bearing enterprise that will then allow me to confer benefits on either myself, or a family member, or a close associate within the meaning of the Act. The problem is with the characterisation of those transactions. So if it’s dealt with properly, and when I say properly I mean you have your accountant book it properly and the relevant tax is paid or it’s characterised in a meaningful way, then the court is more likely to look fondly upon that. It’s when directors engage in a transaction without having regard to how they’re going to characterise it and it never sort of gets fixed up in the books and records and it ends up being a loose end, and eventually the liquidator gets appointed and starts looking back at the books and records of the company and yippee! Four years, we can look back and we’ve found something there from a time when the company was in a relatively good financial position. |
| DT:
32:00 | Of course, all companies whether large or small are incorporated for the benefit of their shareholders and, you know, a closely held company you would expect the directors and shareholders to have a co-identity, or at least they would be closely related, perhaps familiarly related, and the payment of a dividend which then is used to buy a boat would be completely innocent, right? |
| DA:
| Absolutely. And when I say characterised properly, and I keep referring to the tax man, it needs to be characterised in a way that is appropriate. So it could be a dividend and as long as the appropriate taxes are paid, then there may be no problem with that transaction at that point in time. |
| DT:
33:00 | It really sounds like in terms of advising a client on prevention rather than the cure, that having a regular set of advisers who are regularly giving the company advice on its tax affairs and also on its accounting affairs, is a good idea. You were telling us a bit earlier about a case involving a director who really didn’t have any advice on those sorts of matters and didn’t have any understanding of those sorts of matters but was found not to have engaged in an unreasonable director-related transaction, notwithstanding a number of personal purchases taking place or being transacted on the company’s bank account. Tell us a bit about how that result came to pass. |
| DA:
34:00
35:00 | That was quite an interesting one and you never know your luck in the big city. The particular gentleman was self-represented, and he didn’t put any evidence before the court. All he did was put on a defence saying, effectively what I’ve said before is that “I didn’t fully appreciate the distinction between the company and myself. I never took a wage, salary or dividend throughout the operation of the life of the company. And so my explanation for these transactions is that in lieu of paying myself in a formal way, I bought groceries when I needed them or I had a punt at the TAB if I felt like it.” And it was quite a curious case because of the amount involved. I believe it was a District Court matter initially. And I think the impression in the courtroom was that there was a big bad liquidator beating up on someone who was running a childcare centre who was relatively unsophisticated but providing a good service to the community. And that allowed that particular man to have a lot of leeway from the court. So he didn’t file any evidence, but he was allowed to rely upon his defence as his evidence, and that was actually admitted as his evidence. He was successful at first instance and the court found that in all of the circumstances, and particularly having regard to my favourite part of the section, “any other relevant matter”, the transactions weren’t unreasonable. And it sort of came with a shock to the liquidator, I think because people just couldn’t believe that you could be spending money like that. It was essentially what looked like a slush fund for the director, but in his mind it was how he was paying himself. The matter went on appeal to the New South Wales Court of Appeal and he was successful again there. So it ended up in a good result for him. |
| DT:
36:00 | I can see the justice in the result though, in the sense that the difference between paying on his behalf $100,000 of grocery and TAB bills and paying him $100,000 salary, is immaterial to the company but it produces the same benefit for the company, which is his continued full-time service in lieu of doing any other paid work. So I can see the justice in the result, although it appears to be a surprising one. |
| DA:
| It is surprising, and I think the liquidator was surprised to lose that on appeal. But another factor I did neglect to mention before was that towards the end of the company, he actually was putting some of his own money back into the company to try and keep it afloat. So it’s an odd section, this one, because if you have the right narrative then you can roll the dice sometimes and come up with a good result. |
| DT: | That narrative might be an “other relevant matter” that wins the day. |
| DA: | Yeah, that’s right. |
| DT: | Do you see, I mean, it is such a broad discretion that the court has to look at any other relevant matter in that section, do you see an outer bound to that discretion? |
| DA: 37:00 | I ran a case before her Hon Justice Gleeson as she then was, which is now cited for other reasons, but there is a particular thread in that case that I think is underdeveloped and this was a case where the directors were running an action paintball business. |
| DT: | Oh, those people who accost you in the shopping centre to give you free passes. |
| DA:
38:00
39:00 | Yeah, that’s right. So they were operating this business from a premise, and just to add context, it’s not easy to set up a paintball site. You can imagine people are running around with their guns, shooting paintballs, it’s loud, it’s noisy, nobody wants that sort of business near them so obtaining a suitable site is quite difficult. You need to get a development application through council, ecological studies, you need to have sound tests, there’s a whole process that you have to go through to secure a premise to run one of these businesses. What was so compelling about a narrative in this particular case was that the directors were being sued by a liquidator for about $500,000 in payments which were made towards a property which had been purchased in the names of the directors, and the company itself had no legal, equitable or other right in this other property. And the directors were using company funds to repay what was effectively a home loan. The reason why they did it was because of the obstacles I mentioned before. And the difficulties that they had been having with their landlord at their existing premises. The landlord had got to the end of their original lease, was giving them short periods of tenure, putting up the price of the lease, refusing to offer them any extensive period of tenure, so you know. |
| DT: | Essentially a month-to-month tenancy. |
| DA:
40:00
41:00 | Close to that, yes, it was year to year and eventually month to month. And the directors decided that they needed to find an alternate premise because the particular landlord, he knew that he had the directors over a barrel. So the directors went about locating another suitable site and I mentioned before that it’s not easy for them to do that. After locating another suitable site, they tried to purchase that site through the business, but because the landlord had been starving the business by increasing the rent exponentially from year to year, the company wasn’t able to procure the finance that it needed to purchase the alternate site. So the directors, who were all relatively unsophisticated, approached their accountant and a mortgage broker about how to solve this problem and the solution that was put to them was “well, if you apply to buy this as a home loan, then we can probably get you finance.” So one of the directors put one of their own homes up as security and the directors effectively entered into a home loan facility with a mortgage over this new site. And the company commenced making the loan repayments. Their accountant had advised them that they should book these loan repayments as rent. And the reason why he said he did that was because it was the intention of the directors in the future to use that site as a premise for running the paintball business. And in order to refinance the facility, the company needed to be able to show that it could afford to make the repayments on the home loans. So even though there was no formal documentation, there was never any board minutes, there were no loan agreements, there was no lease, the directors all had a common intention that at a point in time they would move to the new site once the development application process had been completed. It was quite interesting because the liquidator had looked at it and just seen money leaving the company’s bank account and being paid towards home loans in the names of the four directors of the company. And thought “yippee! This is quite an easy one here. We can go back four years and recoup all of that.” |
| DT: 42:00 | It’s interesting, it’s something that we were discussing with another guest on Hearsay recently, and you mentioned it earlier in this episode, when you’re acting for the liquidator all of your evidence is in the form of the books and records of the company. You have all of this documentary material, but no context to the documents, and the documents can tell a very different narrative to the narrative that a director who actually has experience of the events that the books and records are recording can give. That the director can contextualise a lot of this information and with that context that can often really change the prospects of a case. |
| DA:
43:00
| You’re absolutely correct, and in this particular case, what was so compelling about the narrative was that when the directors told us their story, it was completely consistent and we believed them. And despite thinking the case law is against us here, there is a discretion under that ‘any other relevant matter’ subsection and it’s just such a compelling story from truthful clients that we need to put this before the court because the documents don’t tell the true story about what was going on. There were some supporting documents, so the directors had, in addition to the common intention that her Honour had found that the directors held, the directors had also applied for a development application for this new site, they had applied for ecological studies and sound studies and all of the other steps that they needed to take in order to prepare this other property for their eventual transition to the new site so they could continue operating their business and get out from underneath this particular landlord. But from the liquidator’s point of view, they just saw directors enriching themselves by buying a rural property and they just couldn’t believe that the directors could honestly be doing this. |
| DT: 44:00 | I suppose that information asymmetry can really be a trap for liquidators in being unaware of that context. And it’s difficult to obtain that context as a liquidator, you know there are theoretically tools, ideally you get a complete RATA and you get the opportunity to conduct public examinations which are supposed to give you some context, but they don’t really, it’s often approached in a very adversarial way that doesn’t elucidate a lot of information, and as a consequence that missing context can really result in what appears like a very strong claim, like the one you’re describing, not being so. |
| DA:
45:00 | Yeah, that’s right. And we had the benefit of having been able to sit with the clients and when you heard them tell their story and just the woes and the challenges they’d faced overtime, we had the feeling that if we put our clients in the witness box that the story would be compelling enough to get us up. I think it’s important when you’re looking at this section that you don’t forget that there is some discretion there and a compelling story may still carry the day. But to get back to your original question, which I think was actually about the outer limits of… |
| DT: | That discretion. |
| DA:
46:00 | That discretion, her Honour in this particular case held that the payments that had been made by the company, even though the company had no benefit conferred on it by these payments other than this ethereal, common intention that the directors all held, that they would eventually move to this other site, her Honour held that the payments were reasonable up until a point. And this particular decision has been cited for other reasons, but I still think there’s a loose thread there because what her Honour did was look at it and say at a point in time, it became apparent that the company was not going to be in a financial position to be able to develop and move to this new site. So, at that point in time the transactions became unreasonable. |
| DT:
47:00 | It’s interesting it almost bears a resemblance to a safe harbour sort of plan, doesn’t it? That you a burdensome lease that’s causing financial distress for the company, there’s a plan to turn things around, to produce a better course of action for the company, and while ever it’s got some prospect of succeeding that is a good safe harbour plan or in this context, a reasonable transaction to enter into, but when that plan is no longer producing a good outcome for the company, or might be expected to produce a good outcome for the company, that’s when those payments became unreasonable. There’s a bit of a parallel there. TIP: The ‘safe harbour’ defence, found in section 588GA of the Corporations Act and the sections that follow it, shields directors and other company officeholders from personal liability for insolvent trading where the directors develop and implement a course of action that is ‘reasonably likely to lead to a better outcome for the company’; that is, likely to lead to a better outcome for the company’s creditors, given the insolvency of the company, with the help of specialist advisors, enhanced reporting, and other tools. |
| DA:
48:00 | Yeah, there is absolutely. And that certainly is what swayed her Honour in that case; is that she found that the directors ought to have realised that at a point in time their future plans were not going to come to fruition, so they needed to abandon them. They failed to do that so it was a half win if I can call it that. So, you know, roughly half of the transactions were found to be reasonable and roughly half of them were unreasonable. |
| DT:
| And a great result to clarify the operation of that provision especially from her Honour Jacqueline Gleeson, who’s now a judge of the High Court. Those first instance decisions of High Court judges always receive a little bit more respect in hindsight, don’t they? |
| DA: | They do, they do, and that’s why I would like to see this particular thread argued more, I think there’s more in it. |
| DT:
49:00 | It’s reasonableness from a far broader lens, isn’t it? Than merely a corporate benefit and detriment perspective. There’s sort of a thread to tug on there in terms of a broader scope of reasonableness. And I think when we’re talking about risky projects. I think in hindsight it’s easy to say, “well, this transaction produced no benefit for the company. Ergo it’s unreasonable” or, “this transaction produced a detriment for the company, ergo it’s unreasonable.” But at the time the transaction was entered into there might have been a prospect that it would have produced a substantial benefit to the company. Like in the action paintball case, producing alternate premises from which to trade that would free them from the burden of a lease. |
| DA:
50:00 | I think that’s true of any enterprise. I mean when we’re talking just purely in terms of the solvency of a company, any new enterprise is a risky venture and often they’re insolvent from the get-go if we’re looking at the proper definition in 95A of the Corporations Act. I think it’s very important to focus at the point in time when that transaction occurred, and that’s what the case law reflects in any event. That consideration of the reasonableness or otherwise of the transaction needs to occur at the time of the transaction, not looking rearwards with perfect hindsight. |
| DT:
51:00 | Which, as we’ve said, can be difficult to do when you’re only using the books and records to make that analysis. You mentioned earlier when discussing Weaver or ‘the boat case’ as you described it, that the reasonableness of a transaction has to have regard to the winding down of a business if the business is expected to cease trading in the near future. On that topic, unreasonable director-related transactions are sometimes alleged in connection with prepack style arrangements where the distressed company’s business is transferred to a person, maybe it’s the director, maybe it’s a relative of the director, maybe it’s an entity associated with the director, although for market value which has been arrived at either as a result of valuation or some other basis, what are some of the risks from a voidable transaction perspective, specifically from an unreasonable director-related transaction perspective, associated with this prepack approach and how do you get it right? |
| DA:
52:00
53:00 | I think the most obvious starting point, and the most simple answer to the question is get a genuine valuation done and pay market value. So probably one of the most risky types of prepack are the ones where a valuation is, let’s call it ‘on the nose.’ It’s not quite market value, or some tricks have been used to revalue assets, or certain assets may have been transferred away from the business, particularly things like IP, and that affects the valuation, which is usually a valuation which is director friendly, I’ll call it. And there’s inherent risk in that because a liquidator will look at that and often obtain their own valuation which leads to competing valuations obviously, and that is where the risk is – if a liquidator believes that the business has been transferred for under market value. But there’s nothing inherently wrong with transferring a business which is insolvent to another corporate entity. There’s nothing in the Corporations Act which prevents it. It’s just that you have to make sure that you do the right things. And the courts have said that in the case of the transfer of a business to a close associate, a family member, for example, that they will look more closely at the valuation evidence. And are more likely, in my experience, to overturn a transaction where the valuation evidence is in contest and the court may prefer the liquidator’s valuation evidence if we’re talking about a transaction involving a close family member. TIP: Now we’ve referred to the term ‘close associate’ a few times in this episode, but what does that really mean? Well, section 9 of the Corporations Act defines a close associate of a director as being (a) a relative of the director; or (b) a relative of a spouse of the director. What’s a relative? Well again section 9 further defines a ‘relative’ as meaning a spouse, parent or remoter lineal ancestor, child or remoter issue, or brother or sister. Now this definition is intentionally broad to capture a range of familial relations including step-family members, in-laws, de-facto partners and great great grandparents. |
| DT: 54:00 | I suppose even where you have a valuation prepared by an independent valuer as you say, courts are going to be especially scrutinising of a transaction that involves the transfer of a distressed business to a close associate. Are there other steps you can take once you have that independent valuation to further protect the transaction from criticism? |
| DA:
| As you say, the obvious first step is to get an expert valuation from an independent and reputable valuer. But the next thing I’d suggest is consider potential purchases and bids, and that may involve putting the business on the market. One of the things the courts don’t like when a business is transferred to a close associate is the absence of the business being put to market, because that’s a way to measure the market value. |
| DT: | Nothing verifies valuation better than a public process. |
| DA: 55:00 | Precisely. Thirdly, have a proper sale of business contract in place or an asset sale agreement. You’ll often see cases where people transfer a business and the documents just aren’t in place properly at the time of the transaction. And then finally, seek advice. There are people, they can be lawyers, or they can be liquidators who can help through this process. As I say there’s nothing illegal or untoward about selling an insolvent business so long as it is for market value. And in fact, there’s advantages of doing so; it ensures the continuation of the business, preserves the goodwill of the business and its suppliers and customers, maximises the value of the company, business and assets, and it may lower costs and eventuate in a higher return for creditors of the corporate entity which is going to end up in liquidation eventually. |
| DT: 56:00
57:00
58:00 | We’ve spoken on this show before about how in the UK, for example, there’s a very different attitude towards prepacks, a much more prepack friendly insolvency culture because of all of the benefits that you’ve described – that it really is the best way to achieve a sale of the assets that involves the continuation of the business for the benefit of trade, creditors, employees, even customers. We often forget about the benefit to the people who use the service that the company provides. But that achieves a sale price unaffected by fire sale value, unaffected by that discount for it being sold by a liquidator. TIP: I’ve just used the term ‘prepack’, but if you’re not familiar with insolvency law, you might not have heard it before. Prepacks, or pre-pack insolvency arrangements, are a type of informal business rescue strategy used to rescue an insolvent business through a legally binding transaction, before the company is placed into a formal insolvency process. Here’s how the UK Association of Business Recovery Professionals describes it: “an arrangement under which the sale of all or part of a company’s business or assets is negotiated with a purchaser prior to the appointment of an administrator, and the administrator effects the sale immediately on, or shortly after, his appointment.” Now this procedure differs from a standard external administration where the external administrator negotiates the terms of the sale and effects it themselves after they’re appointed. The benefits of a prepack arrangement include reduced external administrators’ fees – they don’t have to manage the business or sell it – and a sale price which is unaffected by the stigma of insolvency, meaning creditors can theoretically get higher returns. It also means the business can continue to trade unaffected by the spectre of insolvency – and for this reason, prepacks are often used to sell the business to a new entity related to the business owners, so it’s important that an independent valuation of the business assets is obtained before the sale happens, to confirm that the transaction isn’t an unreasonable director-related transaction and is being conducted on arm’s-length terms. Prepack arrangements are common in the US, the UK and Canada, but they’re not common yet here in Australia – there’s still a bit of debate about their appropriateness here at home. But we do have a kind of prepack unfriendly culture in Australia which is a shame given those benefits. It would be good to see a greater support for that approach to business rescue in Australia. I think. |
| DA: | I agree. I agree. |
| DT:
59:00 | I think we expect a bit too much from our insolvency processes. I think that there’s a more of a creditor friendly approach to insolvency in Australia and that involves investigating wrongdoing by directors, reporting tax offences to the ATO, preparing reports, chairing meetings, very expensive and formal processes that perhaps isn’t the best way to rescue a business and all of those goals kind of compete with one another, don’t they? If I can add a gloss to one of your one of your points in terms of seeking advice, I’d say, because you mentioned, this earlier, seek advice from the right people because there are pre-insolvency gurus as we described earlier who will purport to give some great advice on how to do a prepack, or how to more likely phoenix the company that can get you into far more trouble than you’re in to start with. |
| DA:
| Yeah, that’s right. And maybe that is a distinguishing factor between the Australian market and the English market. I don’t know, is it the pre insolvency gurus that have unfortunately tarnished what would otherwise be a legitimate process which ensures a better outcome for all stakeholders? |
| DT:
1:00:00 | David, we’ve spoken today about unreasonable director-related transactions and litigation about them, both from the perspective of the liquidators pursuing that litigation and the directors defending it. And of course, we’ve discussed how you have experienced on both sides of that fence; if you were to leave our listeners acting for liquidators with one tip from today’s episode and you were to leave our listeners acting for directors with one tip from this episode, what would those be? |
| DA: | I think for the listeners who are acting for liquidators, be careful when you’re reviewing documents to not immediately jump to conclusions about how to characterise a particular transaction. And I refer back, of course, to that case we discussed earlier where it looked on the bank statements like a director who had been treating his company’s bank account as a slush fund. There was a more complex narrative behind that story, and similarly, in the action paintball case that we ran, the liquidators in that case in fact ran examinations before running the proceedings. So they knew the narrative, but were still… |
| DT: | Unconvinced by it. |
| DA: 1:01:00
1:02:00 | Yeah, completely unable to believe that a court would find that directors using company funds to repay home loans could be reasonable. And they completely disregarded the narrative that surrounded that case, which is what ultimately helped us at least partially win the case on the day. When it comes to acting for directors, I think it’s important again to get the full picture from them and try and understand what they were doing at the time that they entered into a particular transaction. You will have clients of course that come to you and have entered into a transaction which is just blindingly obvious and it’s occurred not long before the company has gone into liquidation. And a liquidator will often turn to this particular provision because the liquidator doesn’t need to prove insolvency. So my main tip for solicitors acting for directors is to get a full understanding of the background picture because the court does have a discretion in this particular section. And the court needs to consider whether the transaction was reasonable at the time that the company entered into the transaction. So what you need to do is ask your clients about the factual matrix at the time of the transaction, rather than putting on the lens that you might put on when you’re acting for a liquidator and looking backwards and thinking immediately, “well, this looks unreasonable because there’s no normal commercial explanation for it. It’s not what I would have advised the client to do at the time, therefore, it’s unreasonable.” I think you need to pause at that point and have a think about that. |
| DT: | An imperfect transaction doesn’t necessarily become an unreasonable one. |
| DA: | Absolutely. |
| DT: | David, thanks so much for joining us today on Hearsay. |
| DA: | It’s been a pleasure, thank you, David. |
| DT: 1:03:00
1:04:00 | As always, you’ve been listening to Hearsay The Legal Podcast. I’d like to thank my guest today David Armstrong, from Armstrong Law Partners, for coming on the show. Now you probably know that we’ve got plenty of other insolvency law content, if that’s your thing. Our interview last year with Professor Jason Harris and Mark Wellard about the small business restructuring process, or our episode featuring Jason Porter from SV Partners and Vince Pirina and Andy McEvoy from Aston Chace about public examinations, are just two examples. If you’re an Australian legal practitioner, you can claim 1 CPD point for listening to this episode. Now whether an activity entitles you to claim a continuing professional development point is, as you know, self-assessed, but we suggest that this episode constitutes a substantive law point. If you’ve claimed CPD 5 points for audio content already this CPD year, then you might need to access our multimedia content on our website to claim further points from listening to Hearsay. More information on claiming and tracking your points through Hearsay can be found on our website. The Hearsay team is Kirti Kumar, Araceli Robledo, Zahra Wilson, Sadhir Shiraj and me, David Turner. Nicola Cosgrove is our executive producer and keeps Hearsay on its feet. Hearsay is proudly supported by Assured Legal Solutions, a boutique commercial law firm, making complex simple. You can find all of our episodes, as well as summary papers, transcripts, quizzes and more on our website. And if you’re a subscriber, we’ll let you know by email whenever we release a new episode. And by the way, our free trial episodes are now available on Apple Podcasts and on Spotify, so if you like us, give us a rating on your preferred platform and maybe tell a friend to listen to an episode too. Thanks for listening and I’ll see you next time. |
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