Australia holds the line on priorities between successive trustees - Insolvency/Bankruptcy

In this week's TGIF, we consider the Federal Court's recent decision in Fotios (Bankrupt) v Helios Corporation Pty Ltd (No 3) [2023] FCA 251, and earlier decisions in the same proceedings, clarifying the current Australian position as to priorities between creditors of successive trustees.

Key takeaways

The insolvency of personal and corporate trustees continues to raise difficult priority issues despite how commonplace trading trust and family trust structures are in Australia.
The current law in Australia is that a former trustee has priority to a subsequent trustee in a competition between trust creditors asserting subrogation to each trustee's rights of exoneration. It remains to be seen whether Australian appellate courts will adopt the pari passu approach taken recently in a majority Privy Council decision.
In practice, the priority regime that is implemented will often depend not only on legal principles but also on steps taken out of court. Certainty as to those principles, however, is crucial in allowing stakeholders and their advisers to reach a commercial resolution.

Australia's position on competing trustees

Australia is a cautious world-leader in trust law. The Privy Council's recent landmark decision in Equity Trust (Jersey) Ltd v Halabi; ITG Ltd & Ors v Fort Trustees Ltd & Anor [2022] UKPC 36 acknowledged that, in contrast to the UK, trading trusts have been a feature of commercial life in Australia for many years. As a result, certain aspects of trust law have received more judicial attention in Australia.

The Privy Council's decision drew heavily on Australian authorities in reaching unanimous findings under Jersey law (held to be relevantly the same as English law) on questions about the survival of trustees' proprietary interests in trust assets after being replaced as trustee.

There was a 4:3 split, however, on the question of competition between successive trustees. The majority reasons, referred to a lack of authority on the point in England and Jersey, and found that although the 'general default rule' is that first-in-time prevails, a 'pari passu' rule should apply as between competing trustees.¹

Australia has had authority on this point since at least 2007. The point was also squarely addressed in the recent Federal Court case decided by Colvin J in Fotios (Bankrupt) v Helios Corporation Pty Ltd (No 3) [2023] FCA 251. Colvin J's decision, which confirms his Honour's judicial advice given a year ago in the same proceedings based on the first-in-time principle, is the first Australian decision to address the Privy Council's decision.²

What happened in the Fotios case?

The case emerged from the bankruptcy of WA mining industry figure, Mr Michael Fotios. When Mr Fotios became bankrupt, he ceased to be trustee of a family trust (Trust) because of an ipso facto clause in the trust deed. Helios Corporation Pty Ltd (Helios) was subsequently appointed as replacement trustee. Helios later went into voluntary administration without triggering the ipso facto clause.

The Trust's financial position was uncertain. An analysis by Court-appointed experts indicated that a deficiency in assets over liabilities was likely but that there remained a possibility of a return to beneficiaries.

This uncertainty as to the value of the net Trust assets made it necessary to resolve the priorities for competing claims on those assets. This was done over the course of three decisions by Colvin J starting in March 2022.

At the outset of the litigation, the Court made consent orders:

granting leave for Mr Fotios's bankruptcy trustees to commence proceedings against Helios;
appointing Helios' voluntary administrators as receivers of the Trust property; and
prioritising certain costs for the Court-appointed experts and the voluntary administrators'/receivers' costs in preserving the Trust property.

The receivers then applied for judicial advice on priorities.

Priority between successive trustees

The main priority issue was between potential creditor claims of subrogation to:

the rights of Mr Fotios as former trustee, in proceedings brought by the bankruptcy trustees; and
Helios' rights as current trustee.

When the judicial advice was first given a year ago, the Court held that the claims from when Mr Fotios was trustee had priority over those from when Helios was trustee, applying the principle that a former trustee's rights have priority over a new trustee in the absence of some vitiating factor.

When the matter returned to Court this year, Colvin J had to consider the effect of the Privy Council decision. His Honour confirmed the earlier judicial advice that the current state of the law in Australia is to apply general equitable principles (i.e. first-in-time) to prioritise the former trustee. His Honour emphasised, however, that this is not an absolute rule and that:

equity will depart from it where there is inequality in merit; and
the position may be different where the subsequent trustee takes office without any knowledge of the possibility of a prior equity.

In this case, there were no such vitiating factors. Helios was connected to Mr Fotios and was appointed during his bankruptcy. As a first instance decision, it was also not the place to introduce a new rule of equity rather than allow the receivers to carry through a resolution of competing claims formulated based on the earlier judicial advice.

Related priority issues

In addition to the main priority issue between the competing trustees, several related priority issues were dealt with within the same framework:

Unpaid beneficiaries treated as creditors of relevant trustee

There were potentially around A$8.4 million in claims against the trust assets by beneficiaries for alleged "unpaid present entitlements" (including in the name of Mr Fotios).

The Court found that these should be treated as creditors of the relevant trustee and that it was unlikely any tracing claim was available. Since the characterisation was not without doubt, the relevant beneficiaries were given liberty to apply.
Right of recoupment not given special priority

There was a claim for recoupment by Ms Renee Fotios of around A$270,000 for having paid out, as guarantor, certain bank debt that had been borrowed by Mr Fotios as former trustee of the Trust.

The Court rejected the argument that recoupment rights should trump the trustees' rights of exoneration. In the absence of authorities on the point, the Court ordered that the receivers were justified in treating the claim as one of the claims to be subrogated to the rights of Mr Fotios as former trustee.
Security from the successor trustee did not confer priority as against the former trustee's creditors

There was also a claim by Ms Fotios as a secured creditor under an alleged loan deed entered into with Helios around 9 August 2021 (shortly before the appointment of voluntary administrators on 19 August 2021).

The Court found that this security ranked behind Mr Fotios as former trustee and was only exercisable against Helios as subsequent trustee.

Outcome

Ultimately, the priority regime to be implemented was based on a series of out-of-court steps taken by the parties following last year's judicial advice. These steps included:

A deed of company arrangement (DOCA)

Helios' creditors approved a DOCA proposal in June 2022.

The report to Helios' creditors explained that a fund would be established under the DOCA, against which claims could be made, with priorities being broadly costs and expenses first, followed by the right of recoupment claim, then liabilities incurred by Mr Fotios as trustee (per Bankruptcy Act 1966 (Cth) priorities), then liabilities incurred by Helios as trustee (per Corporations Act 2001 (Cth) priorities).
Bankruptcy composition

The DOCA dovetailed with a composition proposed by Mr Fotios and approved at a meeting of his creditors in August 2022.
Implementation documents

There were several instruments providing for resolution of competing claims, including a settlement deed in October 2022, using some (but not all) of the Trust assets and the contribution of assets from outside the Trust.

The Court's decision last month approved the receivers' use of the Trust assets to implement the proposed compromise under the DOCA and bankruptcy composition.

Comments

This case confirms the current law in Australia and the risk that creditors of successor trustees (even with security) will rank behind a former trustee.

It remains to be seen what influence the Privy Council's decision in Equity Trust (Jersey) v Halabi will have on the development of Australian trust law and practice. Until it is addressed by the High Court, it may focus retiring trustees on taking some of the precautionary measures outlined by the Privy Council (e.g. seeking indemnities or security).

In 'insolvent' situations, it may give out-of-the-money creditors of successor trustees an argument to use in extracting value from out-of-court settlements – at least where the stakes are high enough to indicate a willingness to take the issue on appeal.

This case also highlights two practical points. The first is that priorities are often not just a function of legal principle but also of out-of-court agreements between the parties and court orders tailored to the commercial realities at hand.

In this case, the Court acknowledged the role of the DOCA and bankruptcy composition in allowing creditors to make an informed choice. This approach also adjusted the strict legal position in prioritising certain recoupment rights.

The second is that an out-of-court agreement is easier to reach if there is certainty as to the underlying legal principles. This has been notoriously difficult when it comes to trusts, even before the Privy Council's decision.

The potential for legislative guidance in this area continues to gather pace, following the Treasury's 2021 consultation paper 'Clarifying the treatment of trusts under insolvency law' and the current inquiry into corporate insolvency laws, which covers "trusts with corporate trustees" in its terms of reference.

Footnotes

¹ Halabi at [239] per Lord Briggs with whom Lord Reed and Lady Rose agreed. Lady Ardern concurred in the result, separately finding that the first-in-time rule was inconsistent with equitable principle when it comes to successive trustees: Halabi at [279].

² With the exception of the High Court's passing reference in Metal Manufactures Pty Limited v Morton [2023] HCA 1 at [71] fn 95.

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