The recent case of SSET Construction Pty Ltd (in liq), Re; Sims v Khattar (2010) NSWSC 102 has reinforced the duties placed on directors to avoid insolvency. The case also encourages the importance of preserving and updating financial records.

QUICK FACTS:

LIQUIDATOR’S RESPONSE:

The liquidator filed proceedings against the defendants claiming firstly that they had breached the insolvent trading provisions under section 588G of the Corporations Act, 2001 (the Act). This breach had further caused them to accrue a huge debt on behalf of the company.

Secondly, under sections 588G and 588 M (2), the liquidator is empowered to recover such debts from defaulting directors, where the company and its creditors suffer a loss. The liquidator needs to show that:

FINANCIAL RECORDS:

The liquidator further relied on section 588E (4) of the Act. This provision states that a company is required to maintain financial records for a specific period as per section 286 of the  Act, failing which, it can be presumed that the company is insolvent for that period.

COURT’S FINDINGS:

It was held by Austin J that SSET had failed to retain adequate financial records, thus breaching section 286 of the Act. This was applicable for all accounting periods till January 2006. The presumption of insolvency arose only from May 2005 as SSET’s solicitor was in possession of the financial records prior to May 2005 and had refused to return them.

The presumption of insolvency did not stop here. The directors were guilty in manipulating cash payments paid out to creditors from August until November 2005.
Relying on section 588E(3), the company was insolvent from August 2005 until the relation-back day – 30 January 2006. The presumptions of insolvency were strong in this case but were eventually outweighed by the liquidator’s proof of the company’s insolvency on 30 June 2005.

His Honor also found that sections 588G and 588M (2) were violated by the defendants. Consequently, the directors were ordered to pay the outstanding debt to the liquidator.

LESSONS TO BE LEARNED:

Directors, like lawyers, trustees and accountants, owe a stringent duty of care and diligence to the company. In theory, this makes one feel honored. In practice, worringly, quite a few directors fall into the trap of dishonoring their duties.

This decision emphasises directors should keep written financial records that correctly record and reflect the company’s transactions and financial and performance. A failure to do so may lead to the presumption of insolvency arising against the company, for the period of time that adequate records were not maintained, as was the case with SSET.

The New South Wales Supreme Court although relieved to deliver judgment in ASIC v Rich, was not happy about enduring a trial for almost four years, with 232 hearing days and a 3000 page judgment.

Australian Securities and Investments Commission v Rich [2009] NSWSC 1229 (ASIC v Rich) reflected important outcomes:

• Directors’ duty of care and diligence;
• The business judgment rule and;
• ASIC’s case management

 
QUICK FACTS:

• ASIC brought an action against Rich, a director at One.Tel, the collapsed company in this case, under Section 180 of the Corporations Act 2001 (the Act).
• This Section imposes a duty on directors to take reasonable care when executing a business decision.
• ASIC also claimed that Rich had not disclosed vital information from One.Tel's board about its true financial position.

 
FINDINGS:
 
Statutory duty vs Business Judgment

• Justice Austin clarified the application of the duty by distinguishing it from the “business judgment rule” or simple innocent mistakes made by officers when  making decisions.
• Whilst the statutory obligation under Section 180 is crucial, it is not designed to suffocate a legitimate industrial spirit.
• The business judgment rule in section 180(2) is capable of providing a defence for directors whose conduct breaches section 180(1).
• If directors have not intentionally erred in making a legitimate judgment, for a proper purpose, or did not have a personal interest in the matter; and “rationally” believed that the decision was in the best interests of the company, then courts do not consider this to be a breach of their statutory duty.
• However, under Section 180 the concept of “rational belief” does not necessarily lead to the notion of “reasonableness”.
• It is but a balancing act - should a director fail to discharge his basic duties, he cannot claim refuge under this rule.
• On the other hand, where errors are made in judgments relating to planning and budgeting affairs, for instance, directors can seek protection under this rule.

 
ASIC

• Justice Austin was not won over by ASIC’s evidence against the defendants, which the court considered as weak and insufficient.
• The court was also not pleased about the lack of litigation funding for this enormous trial.
• ASIC’s approach and reasoning were also questioned, particularly when it failed to call key witnesses.

LESSONS:
 
The judgment in this case, although victorious for directors, should serve as a prudent lesson in knowing when one can avail of the business judgment rule and when one needs to strictly follow his or her statutory obligations.  

ASIC has agreed to use this decision as a guiding tool in picking its battles carefully in future. It needs to weigh the likelihood of success and serving justice against the value of resources, including the court’s time and the future of a director’s career.

PARK & ANOR V. LANRAY INDUSTRIES PTY LTD & ORS [2010] QSC 82

QUICK FACTS

• The plaintiffs who were the liquidators of the company in liquidation brought an action in their own name rather than as “the liquidators for the company” against the defendants.
• Their claims were based on unjust enrichment, uncommercial and voidable transactions.
• The defendants challenged the capacity in which the plaintiffs brought the proceedings in their own name and also contended that the amended statement of claim filed by the plaintiffs should be struck out.

KEY ISSUE

The key issue in this case was the capacity under which liquidators can bring an action against the defendants – either in their own name or in the name of the company?

SUBMISSIONS AND FINDINGS

CONCLUSION

The Court gave leave to the plaintiffs to make necessary amendments to the claim to reflect the several capacities in which they could sue the defendants.

LESSON

The Act entitles the liquidator of a company to bring legal actions in the name of and on behalf of a company. Therefore if the liquidators wish to sue on behalf of the company then they have to bring an action in the name of the company, the liquidators as individuals are incompetent to sue on behalf of the company.

In this case, the court offered the plaintiffs an opportunity to rectify the defect. However, it is not clear whether this opportunity will be afforded on all such occasions. Plaintiffs therefore should be careful about bringing claims in the right legal capacity as recognized by the law.

The case of Q.B.I. CORPORATION P/L V PLANTATION RISE P/L [2010] QSC 102 focused on certain issues surrounding a Deed of Company Arrangement (DOCA).


BACKGROUND

• QBI was owed in excess of $300,000 by Plantation Rise and following legal action for recovery, QBI appointed voluntary administrators.
• There was little doubt Plantation Rise was insolvent however it held sufficient assets, in excess of $5million, which would see a full return to all unsecured   creditors.
• As a result, the Company entered into a DOCA.
• The issue that arose in this case was whether the effect of the DOCA was to extinguish the debt owed by Plantation Rise to QBI, such that even if Plantation Rise were wound up, QBI would no longer be a creditor capable of claiming in liquidation.
• Given the DOCA had been effectuated, and QBI’s debt extinguished the issue arose as to whether QBI had standing to bring the application at all.

QUICK FACTS

• Plantation Rise received a DOCA but the administrator advised against this - it would have resulted in a lower return to unsecured creditors than in a winding up action.
• Unsecured creditors stood to gain no return from the DOCA, as contrary to the possibility of a return under insolvency. 
• The creditor who voted against the DOCA, being the applicant in this case, commenced proceedings to set aside the resolution and DOCA, and sought a declaration that the creditors' claims had not been extinguished and applied for an order to wind up the Company. 
  

SUMMARY

The applicant under sec.447A of the Corporations Act 2001 (the Act), applied to the court for the DOCA to be set aside however, sec.600A can also be considered in setting aside a DOCA.


THE DOCA

The Act governs the making, execution, performance, variation and termination of a deed. That said, the Act leaves it to the parties as to what their deed contains and they are mostly free to draft a deed to suit their particular circumstances.

However, this does not suggest that all deeds will be fairly and justly executed to favour all those involved. In the case at hand, the applicant believed the contrary.

HOW IS A DOCA INITIATED?

A DOCA must be accepted by the required majority of the company's creditors at a meeting held during voluntary administration of the company. Agreements not formed under this process are not DOCAs. A DOCA itself will come into force once it has been executed by all of the parties to the deed. This must be done within 21 days after it has been accepted at the meeting.

DECISION

In Wilson J’s view, it was in the best interest of the creditors, for the company to be wound up, as the company was already insolvent. Moreover, the proposal for the Deed showed that creditors would receive a lower return if potential recoveries for voidable transactions and insolvent trading were to be litigated under liquidation.

The court therefore held that the Deed as well as the resolution passing the Deed was to be set aside and the company was to be wound up. 

LESSONS TO BE LEARNED

It is prudent advice for all creditors to carefully review the DOCA before passing a resolution at the creditor’s meeting. If a creditor is unhappy with any aspect of the arrangement, it is important to invoke the protection provided by these sections in a timely and appropriate fashion, such as calling for a casting vote or making sure that you are present at the time of the resolution.

The purpose of entering into a DOCA is that the creditor feels secure knowing it is a better arrangement than the prospect of liquidation. However there are times when commerciality will not be the deciding factor. If a director has been dishonest or caused creditors significant grief, creditors may decide not to accept a proposal.

One of the many roles of a liquidator is to try and recover payments made by creditors to the insolvent company, particularly those which can be considered to be either unfair or voidable.

However, the Corporations Act 2001 may require the creditor to recompense monies or assets in certain circumstances. One such circumstance occurred in Cunningham v Commissioner of Taxation [2010] QDC.

FACTS

This case involved a claim regarding payments of money received by the Commissioner of Taxation, the defendant, totaling $143,173 for a discharge of tax liabilities, on behalf of the company in liquidation.

In the liquidator’s attempt to recover the above sum, he relied on:

·         section 588FF of the Act claiming an unfair preference and;

·         section 588FE claiming voidable transaction

THE LAW

What is an unfair preference?

According to section 588FF an unfair preference occurs when a creditor has received more from a debtor before liquidation than that creditor would otherwise have received during the process of winding up.

Section 588FE considers such transactions as voidable when the company is insolvent.

What happens next?

The liquidator, also the plaintiff of the company in liquidation, will request the court to unwind the transaction in such cases, even if it includes the Commissioner of Taxation. In turn, the Commissioner may demand an indemnity from the directors of the company in respect of loss and damages it will suffer, should the liquidator’s claim succeed. The underlying principle for unwinding a preference is to uphold the equality of distribution among creditors. This is the classic ‘pari passu’ principle.

ORDERS THAT CAN BE GRANTED

Under section 588FF the courts may grant certain orders if satisfied that a transaction is voidable because of section 588FE. It can direct the amount to be paid back to the company, either in its entirety or partially. This also applies to company property that has been transferred under such transactions.

WHAT TO LOOK OUT FOR

In this case, although the defendant denied that the transaction was voidable and an unfair preference, he did not extend any defense under the Act. The liquidator was able to prove that the company was insolvent at the time the payments were made to the defendant.

The court, based on the facts, decided to grant an order for the return of the entire sum.

The Act sets out defenses that are available to creditors who have received an unfair preference. In order to rely on the defense, a creditor must prove that valuable consideration was given; he acted in good faith and; there was no reason to suspect insolvency. If creditors cannot prove any one of these, then the defense fails. The burden of proving these defenses lie with the creditor but the liquidator has the right to challenge any defense.

Often when a company is in financial distress, creditors and other third parties get a chance to exercise their legal rights by becoming the shadow directors of the company. If a company acts according to the wishes of a lender or a third party then such a person may be considered as a shadow director of the company.

A recent decision in Buzzle Operations Pty Ltd (In Liquidation) v Apple Computer Australia Pty Ltd2010] NSWSC 233 provides useful guidance to lenders as well as third parties on liabilities arising whilst acting as a shadow director of a financially distressed company.

This case assures creditors that by being closely associated with the distressed company, does not necessarily mean that they are acting in the capacity of a shadow director of the company.

WHAT IS A SHADOW DIRECTOR?

When a company or its director is used to acting according to the terms or wishes of a third party then such a third party may be called a ‘shadow director’.

This case involved six Apple resellers who merged their business to form a new entity named Buzzle. Eventually the merged entity failed and Buzzle was placed into liquidation.

Buzzle and its directors brought an action against Apple alleging that Apple had played a major role in directing the merger and in decisions taken at Buzzle’s board - thus acting as “shadow director” of Buzzle and subsequently becoming involved in the insolvent trading.

The liquidator also argued that Apple had its own reason for permitting the merger to advance, including the prospects of recovering the debts that were due to it by the resellers before the merger proceeded.

The liquidator also claimed the charge to be void as Apple’s involvement had made them an “officer” of Buzzle or “a person associated.

FINDINGS

The Court found that though majority of business decisions were taken in the presence of Apple and although Apple had supported Buzzle financially this did not clearly deem that Apple was the “officer” of Buzzle.

There was no evidence to prove that Apple was working as an “associate” with the director’s of Buzzle. Also, Apple was not involved in the company’s corporate decision making. It merely put conditions on its commercial dealings with Buzzle. Apple acted as an observer and attended meetings conducted by Buzzle.

In dismissing the claim it was found by the Court that Apple was not the shadow director of the Buzzle.

SUMMARY

This case throws light on the involvement of creditors with a debtor company. It demonstrates the importance of the liability of the creditor when getting involved with the distressed company. The case also suggests that a written statement that the creditors were not involved in the company’s corporate decision making would assist the creditors in proving that they had no intent to act as the shadow director of the company.

An entity or a person cannot be a shadow director just because they are present in all the board meetings or impose conditions on dealing with the company. An external company cannot be termed as a shadow director unless the directors are accustomed to act according to the wishes and conditions of such an external company and cannot exercise their own decision as to the corporate governance of the company.

Statutory demand is considered to be one of the strongest weapons for debt collection. And why not - it avoids bankruptcy petitions.

What is a statutory demand first of all? This is a document that is served by a creditor to a company for a debt which exceeds $2,000 and which has to be paid by the company to the creditor. This is defined under the Corporations Act.

Forza Finance v Vergepoint Facts

·         In Forza Finance Pty Ltd v Vergepoint Sales and Mangement Pty Ltd [2010] QSC 46, a statutory demand which was issued by the creditor stated that for the purpose of service of any application was the business address of the creditor's solicitor but it did not mention anything about the fax details of the creditor in the body of the demand.

·         The cover letter of the demand had the fax details of the creditor’s solicitor, via which the debtor faxed his reply for setting aside the statutory demand.

·         The debtor also posted a copy to the business address of the creditor's solicitor, which reached the solicitor but after the deadline.

·         The creditor disputed the debtor’s application and method of correspondence via fax.

Summary

The Supreme Court of Queensland whilst recognizing the importance of timely service rejected the creditor’s objections.

The Court held that the mode of service used by the debtor was appropriate to set aside the statutory demand - it did not matter that it was not synonymous with the mode of service as specified in the demand since the documents were sent to the address for service.

Implications

The pragmatic approach of the Court reflects the flexibility afforded with rapid technological means of communicating. To have decided to the contrary would have stifled the ‘instantaneous’ means of conducting business and resolving debt collection cases.

Every shareholder deal has the potential to end in dispute and as a result, the winding up of the company. Contracting parties sometimes believe that as long as the parties agree on significant matters, minor disagreements generally resolve themselves.

It is not always that simple when it comes to allegations of oppression under section 232 of the Corporations Act 2001 (‘the Act’).

The case of Tomanovic v Argyle HQ Pty Ltd; Tomanovic v Global Mortgage Equity Corporation Pty Ltd NSWSC 152 (5 March 2010) is illustrative.  

Quick Facts

Tomanovic invoked the protection under several sections of the Act, alleging oppression:

• He sought a winding up order under section 233 of the Act alleging oppression;
• Alternatively, a buy out order under section 233 of the Act.

 Points of law

 The key points of law in this case involved identifying oppression. Some of the relevant principles highlighted by Justice Austin are listed below:

• The plaintiff seeking an order of oppression is under an onus to demonstrate the absence or lack of good faith – mere inconvenience is not to be regarded as oppression;
• Fairness and reasonableness are other principles to be taken into account;
• The conduct of the minority shareholders will also be considered;
• Winding up of a company and the court’s intervention should only be used as a last resort in such matters.
  

 Findings

• The Court found that there was no deadlock between the defendant and plaintiff – the business had carried on despite the strained relationship between the parties;
• Moreover, the plaintiff had become a dormant participant in the Company over the years;
• There was no oppression and no obligation for the defendant to buy the plaintiff’s shares.

 Resolution

The Court did not issue a winding up order. It resolved that the inability to dispose of shares or a difficult relationship does not amount to oppression. Moreover, where the commercial viability of the business is not frustrated, a winding up order on grounds of oppression would be inequitable.

The simplest and most proactive way to attempt to resolve or avoid potential shareholder conflicts is to not only to have a shareholder agreement in place but to have one covering all eventualities, such as terminations, buy-outs and exit strategies for instance.

Agreements involving indemnity clauses must be drafted carefully and must clearly state the intention of the parties with regard to the liabilities arising from the breach of the indemnified party. This might appear obvious but a recent case suggests otherwise.

Quick Facts

In Westina Corporation Pty Ltd v. BGC Contracting Pty Ltd [2009] WASCA 213, Westina and BGC entered into a hire agreement. The plaintiff’s side of the deal involved providing a road train and three trailers and a qualified operator for transporting ore and other materials, for BGC.

The plaintiff company was to indemnify and hold the defendants harmless for any injury, death or any other loss arising out of the use of the above equipment. These terms were a part of the hire agreement.

What happened next?

One of the employee’s from the plaintiff company who was driving the hired equipment for the defendant died when the road train owned by the defendants collided with another train. It so happened that the train Westina’s employee collided with was owned by BGC and driven by it’s a BGC employee.

At trial it was held that the accident was due to the negligence of the defendant’s employee.

Post accident

The defendant tried to claim shelter under the indemnity provisions, saying it was drafted to cover any and all loss arising from the hiring of the plant, regardless of the defendant employee’s negligence.

However, at appeal, it was unanimously held that the indemnity must be viewed contextually –‘the surrounding circumstances known to the parties, and the apparent purpose and object of the transaction’ were to be considered carefully.

The Court of Appeal also found other uncertainties in the wording of this clause, which cast uncertainty over when indemnity would arise, to what extent and what responsibility the two parties were to endure when the indemnified party caused a breach under the agreement.

In hindsight

• The Court of Appeal concluded that when faced with such an ambiguous clause, clarity must be found in favour of the indemnifier.

• Needless to say that an indemnity clause must be precisely and vigilantly drafted – the parties’ intention must be transparent and clear.

• The pitfall of making assumptions must be avoided, especially where one party has insured itself against indemnity risks, should not indicate that this party will naturally suffer all ensuing risks.