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20 March 2024

Taking Security From Related Entities Of A Borrower – Unreasonable Director-Related Transactions

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Vincent Young

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The recent case of Cooper as Liquidator of Runtong Investment and Development Pty Ltd (In Liq) v CEG Direct Securities Pty Ltd [2024] FCA 6 (Cooper), shed light on when the Court will intervene...
Australia Finance and Banking
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Case note – Cooper as Liquidator of Runtong Investment and Development Pty Ltd (In Liq) v CEG Direct Securities Pty Ltd [2024] FCA 6

The recent case of Cooper as Liquidator of Runtong Investment and Development Pty Ltd (In Liq) v CEG Direct Securities Pty Ltd [2024] FCA 6 (Cooper), shed light on when the Court will intervene to avoid director-related transactions. This case should prompt lenders to exercise caution when relying on cross-securities granted by related entities to a borrower or any guarantor.

Background

Runtong Investment & Development Pty Ltd (Runtong) owned land in Adelaide. That land had an approximate value of $3.5 million in 2014. Runtong had plans to construct residential apartments on the land.

Futong Investment & Development Pty Ltd (Futong) and Datong Investment & Development Pty Ltd (Datong) shared some common directors with Runtong. This made Futong and Datong related entities of Runtong.

In September 2014, Futong and Datong borrowed $15.1 million from CEG Direct Securities Pty Ltd (CEG) to fund Runtong's construction costs of the Adelaide Project. Four of the directors of Runtong (who were also directors of Futong and Datong) personally guaranteed Futong and Datong's repayment of the loan to CEG.

On 12 December 2014, Runtong executed a mortgage over the Land in favour of CEG (CEG Mortgage) to secure further borrowings by Datong and Futong. CEG proceeded to lodge a caveat over the Land to protect its interests and in 2017 registered the CEG Mortgage. There was no evidence that at the time the CEG Mortgage was granted that Runtong received any money from the financiers, however there was evidence that in 2015 to 2017 Runtong received advances in the amount of approximately $10 million from CEG Mortgage (Runtong Advances).

Subsequently, Futong and Datong defaulted on the loan and CEG enforced its security, including the CEG Mortgage. In July 2018, CEG sold the Land for $14 million but received net proceeds of $12.2 million on settlement.

The liquidator of Runtong brought proceedings against CEG alleging that the CEG Mortgage was an 'unreasonable director related transaction' pursuant to ss 588FE and 588FDA of the Corporations Act 2001 (Cth) (Corporations Act). The liquidator sought an order that CEG pay the financial benefit CEG received from the transaction to Runtong under s 588FF(1)(a) of the Corporations Act.

Issue

The issue considered by the Court was whether the grant of the Mortgage from Runtong to CEG constituted an 'unreasonable director-related transaction' within the meaning of s 588FDA of the Corporations Act. Specifically, the Court considered:

  1. whether the CEG Mortgage was made on behalf of or for the benefit of the guarantor directors; and
  2. whether the CEG Mortgage was an unreasonable in all the circumstances.

Summary of argument

At a high level, the liquidator argued that the CEG mortgage was for the benefit of the common directors of Runtong, Futong and Datong who had given personal guarantees to CEG. The liquidator contended that when Runtong granted the mortgage over the Adelaide land to CEG, it had the effect of reducing the directors' contingent liability under their personal guarantees. The reduction in contingent liability was a benefit to the director.

Among other things, CEG argued that Runtong's grant of the Mortgage was not unreasonable given it was common commercial practice for lenders to receive cross-securities from related entities where the security available from the borrower was inadequate. CEG led expert evidence to that effect. In particular, the expert concluded that the transaction was commercial primarily because Runtong, Futong and Datong were undertaking the Adelaide development together as a property development group. The expert opined that, in circumstances where CEG proposed to make further advances and the existing security was inadequate, it was commercial for a related entity who was also a member of the development group to offer additional security.

Law

Section 588FDA of the Corporations Act define what constitutes an unreasonable director-related transaction. That section states:

(1) A transaction of a company is an unreasonable director-related transaction of the company if, and only if:

(a) the transaction is:

  • a payment made by the company; or
  • conveyance, transfer or other disposition by the company of property of the company; or
  • the issue of securities by the company; or
  • the incurring by the company of an obligation to make such a payment, disposition or issue; and

(b) the payment, disposition or issue is, or is to be, made to:

  • a director of the company;
  • a relative of a director of the company; or
  • a relative of a spouse of a director of the company; or
  • a person on behalf of, or for the benefit of, a person of a kind referred to in subparagraph (i), (ii) or (iii); and

(c) it may be expected that a reasonable person in the company's circumstances would not have entered into the transaction, having regard to:

  • the benefits (if any) to the company of entering into the transaction; and
  • the detriment to the company of entering into the transaction; and a relative of a spouse of a director of the company; or
  • the respective benefits to other parties to the transaction of entering into it; and
  • any other relevant matter.

The obligation referred to in subparagraph (a)(iv) may be a contingent obligation.

Relevantly for this case, an 'unreasonable director-related transaction' under s 588FDA of the Corporations Act includes a transaction which benefits a director of the company but is also a transaction which a reasonable person in the company's circumstances would not have entered into given the potential detriment on the company.

Held

Was the CEG Mortgage for the benefit of a director?

In considering whether the directors of Runtong who provided personal guarantees benefitted from the CEG Mortgage, the Court construed 'benefit' under s 588FDA broadly. The Court held that 'benefit' captured any legal or financial advantage enjoyed by the directors in question.

The Court reviewed the loan documentation for the transaction, including the Third Loan Agreement. The Third Loan Agreement provided that the Land was mortgaged to CEG as additional security for further advances made to Datong and Futong and exposed Runtong to a potential liability of $15 million. The Court found that the mortgage gave CEG access to another asset to recover part of the loan from. This reduced the amount that the guarantors would potentially need to pay CEG and was a financial benefit to the guarantors.

Given the guarantors were the directors, the Court found that the CEG Mortgage was for the benefit of a director as required by s 588FDA.This is an interesting outcome given there was no suggestion that CEG was itself a related entity of the directors.

Was the CEG Mortgage unreasonable?

When considering whether a transaction is unreasonable, the Court held that the relevant question is whether, at the time of transaction, a reasonable person in Runtong's circumstances would not have granted the mortgage to CEG in all the circumstances. Those circumstances included the financing transaction between CEG and Futong/Datong as a whole and not just the CEG mortgage.

On reviewing the financial transaction documents, the Court found that there was no benefit to Runtong at the time the CEG Mortgage was granted, only detriment. There was no evidence that Runtong received any money at the time of the grant of the CEG Mortgage and Runtong was not named as a primary debtor or borrower under the transaction documents. The Runtong Advances in 2015 to 2017 did not change whether the transaction was objectively reasonable because those advances were not made to Runtong at the time of the grant of the CEG Mortgage.

In addition, the Court rejected the expert evidence that Futong, Datong and Runtong were operating as a property development group. In doing so, the Court rejected any suggestion that Runtong may have indirectly benefited from the granting of the CEG Mortgage. Rather, Runtong had exposed its only asset to a potential sale by CEG if third parties (i.e. Futong and Datong) did not comply with their obligations under the transaction documents.

As a result, the Court concluded there was no benefit to Runtong from granting the CEG Mortgage and no adequate commercial explanation for Runtong granting the CEG Mortgage.

Relief

The Court was therefore satisfied that the liquidator had met the requirements of s 588FDA in respect of the CEG Mortgage and that transaction was voidable under s 588FE(6A) of the Corporations Act.

There was no contractual or other obligation that compelled Runtong to pay interest on the Runtong advances. In those circumstances, the Court ordered CEG pay Runtong $1.9 million, being the difference between the total value of the benefits provided by Runtong to CEG in the Mortgage ($12.2 million) and the Runtong Advances that funded Runtong's construction ($10 million).

There was no evidence that Runtong had requested the advance of any money at the time the CEG Mortgage was granted nor had Runtong been named a primary debtor or borrower in any loan agreement. Although CEG pointed to a handwritten note that suggested the loan funds were to fund Runtong's development, it was not enough to establish a defence that CEG was aware of Runtong's benefit from the loan as at 12 December 2014.

Key takeaway

Cooper shows that lenders must exercise caution when relying on cross-securities granted by related entities of the borrower or a guarantor as they may be deemed void in liquidation. Given that, unlike other voidable transactions, a claim under s 588FDA does not require proof that the company in liquidation was insolvent, this section creates a high bar for directors and lenders.

To safeguard against the possibility of a voidable transaction, lenders must turn their minds to the specific benefits that each security grantor receives from a transaction. Transactions must have a commercial justification that a reasonable person in the company's position would have fairly accepted to protect against later scrutiny.

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.

ARTICLE
20 March 2024

Taking Security From Related Entities Of A Borrower – Unreasonable Director-Related Transactions

Australia Finance and Banking

Contributor

Vincent Young is a true boutique construction, property + projects, employment + workplace relations firm. We are hands on. We manage every matter as if it were our own. We mix and match our lawyers and consultants to seamlessly produce cost effective, high quality work consistent with the client risk profile.
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