Liquidation Surplus - Shareholder Debts To Be Repaid Before Receiving Bite Of Cherry - Insolvency/Bankruptcy

This week's TGIF looks at a decision of the Supreme Court of New South Wales where a liquidator sought to distribute a surplus of $8.7 million despite one of the shareholders who was potentially entitled to a portion of the surplus being bankrupt and a debtor of the company.

Key takeaways

It is important to ensure that appropriate consideration is given to the way that a company's debts and credits are able to be set-off at all times during a liquidation.
The relevant entitlements under a surplus are fixed by the ownership of shares in the company subject to such adjustments as may arise in the company's constitution and are subject to the supervision of the Court.
Before the Court endorses a proposal for the distribution of a surplus, the liquidator must ensure that the proposal sees that any person who is simultaneously a debtor of the company but also entitled to a portion of the surplus effectively repays their debt to the company before they may receive any portion of the surplus.

Background

D & D Corak Investments Pty Ltd (in liquidation) (Company) had been incorporated in the 1940s. However, following the death of Dane Corak in 2015, the Corak family had a number of protracted disputes among family members.

In December 2017, Mr Steven Nicols (Liquidator) was appointed by Black J as liquidator of the Company. Following the winding up of the Company and payment of all creditors' claims, the Liquidator made an application to the Supreme Court of New South Wales under section 488(2) of the Corporations Act 2001 (Cth) (Act) for special leave to distribute a surplus of $8.7 million. The Liquidator also sought orders dispensing with certain formal requirements under the Act to enable the efficient conclusion of the liquidation.

Via his Will, Mr Corak had left his shares in the Company equally to his three daughters, who were each existing shareholders of the Company. In October 2018, one of Mr Corak's daughters, Ms Feeney, became bankrupt and a trustee in bankruptcy was appointed to her estate. Relevantly, Ms Feeney owed over $2 million to the Company under a loan.

Nature of the Liquidator's application

The primary issue in the proceedings was the application under section 488(2) which provides that, 'a liquidator may distribute a surplus only with the Court's special leave'. The purpose of section 488(2) is to ensure that there is actually a surplus, meaning that creditors' claims have been recognised and met in full, and also to make sure that the appropriate relativities amongst contributories have been observed in the proposed distribution of the surplus.

The principal consideration for the Court, with respect to the surplus, was whether the proposed method of distribution was appropriate in all the circumstances. The Liquidator proposed to distribute the monies in the Company's bank account in three rounds, so that monies were distributed according to the Company's shareholdings while taking into account the loan to Ms Feeney. The liquidator's proposed method of distribution was initially opposed by Ms Feeney's trustee in bankruptcy but ultimately the alternative methodology proposed by the trustee in bankruptcy was not pressed.

What did the Court decide?

Rees J noted that the reference to 'special leave' in section 488(2) requires merely that a special application be made to the Court, rather than the matter being dealt with as part and parcel of some other administrative procedure.

Rees J observed that section 485(2) of the Corporations Act 2001 (Cth) required that, after adjustments of the rights of contributories among themselves, any surplus in a company is to be distributed "among the persons entitled to it". As to the proposed distribution of the surplus, her Honour referred to the principle in Cherry v Boultbee (1839) 4 My & Cr 442, which applies where a shareholder is entitled to a share of the surplus but is also a debtor of the company. Her Honour noted, amongst other things, that:

the rule in Cherry v Boultbee is a rule in equity whereby if a person who is entitled to participate in a fund is also bound to contribute to it, that person cannot participate unless and until they have fulfilled the duty to contribute to it;
the rule is an illustration of the fundamental principle that "a person who seeks equity must first do equity"; and
where the shareholder becomes bankrupt after the event precipitating the establishment of the fund, the principle in Cherry v Boultbee prevents a person who was both a debtor and a shareholder at the commencement of the liquidation from receiving a rateable proportion of the surplus without contributing to the company's assets the amount of their debt owed.

Rees J approved the method of distribution proposed by the Liquidator on the basis that it accorded with the rule in Cherry v Boultbee. The method proposed by the Liquidator effectively ensured that Ms Feeney's debt was repaid via the initial rounds of distributions before her trustee was able to be paid monies from the surplus.

Comment

The Court's reasoning in this case demonstrates the fact that any distribution of a surplus following the winding up of a company cannot be made to a party entitled to the surplus (or a portion of it) unless and until that party has repaid any debts that they owe to the company.

The case serves as a useful reminder that any liquidator seeking to make an application under section 488(2) must be able to demonstrate that they have structured the proposed distribution to take into account the appropriate rules of set off relating to the respective debts and credits of the company and its contributories.

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.