Peas Of Mind: Court Of Appeal Gives Green Light To Director Loan Repayments

In Changela v Dracoma, the New South Wales Court of Appeal clarified the scope of the prohibition against payments made by a solvent company, which later becomes insolvent, to its directors or their associates.

Key takeaways

• Where a company is solvent and has no other creditors, the repayment of anon-demand loan received from directors will not, by itself, be an "unreasonable director-related transaction" under section 588FDA.
  
• Liquidators must identify a real commercial detriment when seeking to void director-related transactions. A transaction will not be 'unreasonable' merely because it reduces cash reserves that might have later been used to prevent insolvency.
  
• Thereasonableness of a director-related transaction must be assessed objectively, based on the company's circumstances at the time of the payment, and without the benefit of hindsight.

Background

Changela Exports Pty Ltd (the Company) was a small, short-lived business which traded in the export of Australian chickpeas to India. The Company had no formal governance structures and maintained its accounting records on an ad hoc basis. While Sweta Changela was a director of the Company, it was in all practical senses governed by Prashant Changela and Dr Pandya through his company Vijay Pandya Pty Ltd, both of whom admitted at trial to being shadow directors (together, the Appellants).

In September 2016, the Company purchased a crop of chickpeas from Dracoma Pty Ltd (Dracoma), a company owned in full by Mr Alex Wheeler that harvested chickpeas on several farms in New South Wales. The purchase price of around $1.5 million was paid in full by April 2017.

In July 2017, the Company was advanced two separate loans of $250,000 by the Appellants (the Changela family and Dr Pandya). By 20 September 2017, both loans were repaid in full (the Impugned Payments).

In October 2017, the Company entered discussions with Dracoma regarding the potential purchase of its 2017 crop of chickpeas (2017 Crop), which was to be on-sold to a third-party company based in India. The Company agreed to purchase the entire crop in December 2017. However, the introduction of hefty import tariffs by the Indian Government led to the Company suffering significant losses. The Company ceased trading in early 2018 and was ultimately wound up in December 2020.

At the time of winding up, the Company had not paid Dracoma in full for the 2017 Crop, with around $1.2 million outstanding. During the liquidation, Dracoma was assigned the right to commence actions against the Company's past or present directors by the liquidators of the Company.

Dracoma then brought proceedings in the NSW Supreme Court seeking recovery of around $2.25 million for various director-related transactions made between 2016 and 2020. Dracoma alleged that these payments were unreasonable and voidable under sections 588FDA and 588FE of the Corporations Act 2001 (Cth)(the Act).

The meaning of unreasonable director-related transactions

The primary judge found the Impugned Payments to be unreasonable director-related transactions under section 588FDA of the Act.

Section 588FDA states that a payment made by a company will be an unreasonable director-related transaction if:

• it ismade to a director of the company or one of their close associates; and
  
• it would beexpected that a reasonable person in the company's circumstances would not have entered into the transaction.

If both conditions are satisfied, and the transaction is found to be voidable under section 588FE, a court may make an order directing the beneficiaries of the director-related transaction to repay some or all of its value.

Following recent authorities on the point, the primary judge considered that the test for 'reasonableness' under section 588FDA was an objective one. In other words, an assessment of a director-related transaction should consider the business relationship between the parties, and the beneficial or detrimental effect of the transaction on the Company and its creditors.

The Appeal

The Court of Appeal overturned the decision of the primary judge, finding that the Impugned Payments were not unreasonable director-related transactions.

In reaching its decision, the Court of Appeal considered the following factors to be relevant to the 'reasonableness' of the Impugned Payments:

• the Company was solvent at the time the Impugned Payments were made, and it was not made insolvent as a result of those repayments;
  
• the Company had no trade creditors at the time of the Impugned Payments;
  
• there was no agreement or contractual commitment to purchase chickpeas from Dracoma in 2017 until at least two months after the Impugned Payments were made;
  
• the payment did not impact the Company's balance sheet as it did no more than extinguish a corresponding liability;
  
• the Impugned Payments were not made in preference to any other creditors of the Company and did not obviously expose the Company to the risk of litigation; and
  
• the Appellants previously were, and were expected to be, the Company's primary source of capital to finance each trading season.

The Court of Appeal did not consider the Impugned Payments to be unreasonable. As part of their reasoning, their Honours compared the circumstances of the Impugned Payments with other director-related payments that had previously been found to be unreasonable, including:

• a transfer of property worth $550,000 for $1;
  
• the transfer of a business for nil consideration, denying the company the opportunity to "market and sell its business"; and
  
• payments of around $420,000 to one creditor which left the relevant company unable to fully repay other creditors.

For the Court of Appeal, the circumstances surrounding the Impugned Payments provided the perfect example of when itwouldbe reasonable for a company to repay a director loan.

Crucially, if the Impugned Payments were found to be unreasonable, their Honours observed that "a rational director who hoped to be repaid might hesitate to fund the operations of solvent companies".

Comment

Director-related transactions remain under close scrutiny to ensure that the terms of such transactions are fair and provide a clear commercial benefit to the impacted company.

An assessment of the 'reasonableness' of a director-related transaction should consider the ordinary trading habits of the impacted company, and the actual commercial benefit or detriment of that transaction. Hindsight will not assist an objective assessment of a director-related transaction.

Directors should still ensure that all related-party transactions are properly documented and commercially justified. However, the decision in Changela v Dracoma confirms that fair, arm's length repayments of genuine loans will generally be permissible where the payments will not affect the solvency of the paying company, and where no other creditors are prejudiced by those payments.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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