Insolvency Law Update - Vic Court of Appeal denies liquidators approval of proposed settlement agreement

Commercial Law
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Recently the Victorian Court of Appeal upheld a decision to deny liquidators approval of a proposed settlement in McDermott and Potts as liquidators of Lonnex Pty Ltd (in liquidation) [2019] VSCA 23. The creditors had been opposed to the settlement.

Background

The liquidators of Lonnex (Ross McDermott and John Potts) had commenced proceedings pursuing claims which arose from a striking series of transactions. Lonnex and a related company Millennium Management Pty Ltd each operated two medical practices at different locations in Melbourne. The day after establishing a tax consolidated group with related entities, Lonnex and Millennium both sold their assets – their 4 clinics – to Lonnex & Millennium Management Holdings Pty Ltd (LMMH) for $22m and $18m respectively. These amounts were payable at LMMH’s option by way of intercompany loans.

On the same day, Lonnex and Millennium forgave those loans.

Under the transactions LMMH acquired some of their liabilities. However others, principally those owing to the Commissioners of Taxation and State Revenue, were left with Lonnex and Millennium. The owner of the shares in LMMH, Dr Geoffrey Edelsten, subsequently onsold them.  (See [4]-[6])

The liquidators of Lonnex claimed inter alia that the release of the debts given by Lonnex to LMMH was an uncommercial transaction under s 588FB of the Corporations Act 2001 (Cth), and an unreasonable director-related transaction under s 588FDA, and sought judgment in the sum of $22m. The liquidator of Millennium (Andrew Yeo) subsequently issued a corresponding proceeding.   LMMH’s defence included arguments that the forgiveness of the loans was part of a larger composite transaction under which benefits flowed to Lonnex and Millennium, such that the impugned transactions were neither uncommercial nor unreasonable. (See [8])

Lonnex’s creditors were recorded in the judgment as including the Commissioner ($7.7m), the State Revenue Office ($264K), “perhaps” Dr Edelston ($3.6m) and minor creditors including Medicare. (See [10])

The Commissioner had funded Lonnex’s liquidators to conduct the Lonnex proceedings up to mediation. Agreement had not been reached on funding beyond that. (See [11])

Following mediation, Lonnex’s liquidators made applications under s 477(2B) and the then s 511 of the Corporations Act for orders directing that they were justified in compromising the proceeding and approving their entry into terms of settlement accordingly. An associate judge refused that application. The liquidators sought leave to appeal. The Commissioner of Taxation, being the largest creditor, appeared in opposition to the liquidators’ application. (See [2]) Indeed the proposed settlement was opposed by the Commissioner, the State Revenue Office, and the trustee in bankruptcy. (See [10])

Broadly, the liquidators argued that the proposed settlement was a reasonable commercial outcome and that they had not been put in funds to contest the proceeding further. The Commissioner disputed the wisdom of accepting the settlement and wanted a different liquidator appointed to pursue Lonnex’s litigation. (See [2]) Senior Counsel for the Commissioner informed the Court of Appeal that if Millennium’s liquidator Mr Yeo were to take over as liquidator of Lonnex, the Commissioner would be prepared to enter into a funding arrangement with him, and that Mr Yeo had consented to act as liquidator of Lonnex.

On the appeal, the liquidators submitted that the associate judge’s discretion had miscarried on several grounds. There was argument on the following issues –

  1. the significance of the fact that funding of the liquidation and the liquidators’ past and future expenses and liabilities had not been secured,
  2. the significance of the creditors’ opposition to the proposed settlement,
  3. the relevance and content of the legal opinion, and
  4. whether the proposed settlement was in the interests of creditors. (See [41])

Another proposed ground of appeal was the liquidators’ contention that the associate judge erred, or his discretion miscarried, in failing to give reasons or adequate reasons, for refusing leave under s 477(2B). (See [40]) The associate judge had stated that the s 477(2B) application was refused for the same reasons as the s 511 application. (See [62])

The Provisions

After the filing of the application, s 511 of the Corporations Act was repealed and replaced by the Insolvency Law Reform Act 2016 (Cth). The liquidators submitted that the principles which formerly covered s 511 applications applied equally to the replacement provisions contained in the Insolvency Practice Schedule (Corporations), namely ss 90-15 and 90-20. The case therefore proceeded as an application under s 511.

To pause here – for any practitioners looking to bring an application now under s 90-15 – I note that on an application for directions in Walley, In the matter of Poles & Underground Pty Ltd (Admin Apptd) [2017] FCA 486 at [41], Gleeson J observed that the question of whether to exercise the power in s 90-15 was “to be answered by reference to the principles applied to the exercise of the discretions previously contained in s 479(3) and s 511 of the Act”. This has since been approved in El-Saafin v Franek (No 2) [2018] VSC 683 at [110] (application by administrators for directions), in Re Hawden Property Group Pty Ltd (in liq) [2018] NSWSC 481; (2018) 125 ACSR 355 at [8] (application for directions), in Krejci (liquidator), re Community Work Pty Ltd (in liq) [2018] FCA 425 at [46] (application for directions and for s 477(2B) approval), in GDK Projects Pty Ltd re Umberto Pty Ltd (in liq) [2018] FCA 541 at [33] (application for the appointment of special purpose liquidators) and in an unreported decision in which I appeared last year for the liquidator Re Cameron Lane Pty Ltd (in liquidation) Playaround Pty Ltd v Peter Robert Vince, Supreme Court of Victoria, 14 August 2018 (appeal from the rejection of a proof of debt) .  

Returning to the present case, section 511 of the Corporations Act relevantly provided –

(1) The liquidator, or any contributory or creditor, may apply to the Court:

(a) to determine any question arising in the winding up of a company; or

(b) to exercise all or any of the powers that the Court might exercise if the company were being wound up by the Court.

(2) The Court, if satisfied that the determination of the question or the exercise of power will be just and beneficial, may accede wholly or partially to any such application on such terms and conditions as it thinks fit or may make such other order on the application as it thinks just.

Section 477(2B) of the Corporations Act provides –

Except with the approval of the Court, of the committee of inspection or of a resolution of the creditors, a liquidator of a company must not enter into an agreement on the company’s behalf (for example, but without limitation, a lease or an agreement under which a security interest arises or is created) if:

(a) without limiting paragraph (b), the term of the agreement may end; or

(b) the obligations of a party to the agreement may, according to the terms of the agreement, be discharged by performance;

more than 3 months after the agreement is entered into, even if the term may end, or the obligations may be discharged, within those 3 months.

I pause here to draw attention to the fact – sometimes overlooked – that s 477(2B) is framed as a prohibition. However, if a liquidator has entered into such an agreement without prior creditor or court approval, it can in some cases be possible to obtain retrospective approval from the court (nunc pro tunc). Such an application is often made together with an application under s 1322(4)(a) and (d). By way of example, two cases in which I appeared for the liquidators in obtaining such approval are –

Principles

The Court of Appeal reviewed the key authorities at [63]-[91]. The passages cited by their Honours  focussed upon several issues, including notably the importance of the views of the creditors. For instance at [66] their Honours cited this passage from the judgment of Lindley LJ in Re English, Scottish & Australian Chartered Bank [1893] 3 Ch 385, 409 –

If the creditors are acting on sufficient information and with time to consider what they are about, and are acting honestly, they are, I apprehend, much better judges of what is to their commercial advantage than the Court can be

At [72] the Court repeated the oft-cited observation of Giles J considering an earlier provision (s 377 of the NSW Companies Code prior to 1992 – authorisation to compromise) in Re Spedley Securities Ltd (in liq) (1992) 9 ACSR 83, 85-6 –

In any application pursuant to s 377(1) the court pays regard to the commercial judgment of the liquidator… That is not to say that it rubber stamps whatever is put forward by the liquidator but … the court is necessarily confined in attempting to second guess the liquidator in the exercise of his power, and generally will not interfere unless there can be seen to be some lack of good faith, some error in law or principle, or real and substantial grounds for doubting the prudence of the liquidator’s conduct. The same restraint must apply when the question is whether the liquidator should be authorised to enter into a particular transaction the benefits and burdens of which require assessment on a commercial basis. Of course, the compromise of claims will involve assessment on a legal basis, and a liquidator will be expected…to obtain advice and, as a prudent person would in the conduct of his own affairs, advice from practitioners appropriate to the nature and value of the claims. But in all but the simplest case, and demonstrably in the present case, commercial considerations play a significant part in whether a compromise will be for the benefit of creditors.

The Court observed that, significantly, Giles J went on to say that it is for these reasons that the attitudes of creditors are ‘important’ in these applications. (See [73])

Following their review of the authorities, their Honours then distilled the following principles at [92] –

  1. The nature of the inquiry undertaken by the court when approval is sought under s 477(2B) in relation to a proposed compromise of litigation is different from the nature of inquiry the court undertakes under s 511 when a liquidator seeks directions in relation to such a compromise.
  2. On a directions application the court must be positively persuaded that the liquidator’s decision to enter into the compromise is, in all the circumstances, a proper one. This necessarily involves a broad consideration of all the relevant circumstances. A direction will exonerate the liquidator.
  3. In contrast, the discrete consideration of an application under s 477(2B) involves a more circumscribed inquiry. The court reviews the liquidator’s proposal, satisfying itself that there is no error of law or ground for suspecting bad faith or impropriety, and weighing up whether there is any good reason to intervene. An order under s 477(2B) does not constitute an endorsement of the proposed compromise. An approval will not exonerate the liquidator.
  4. Given that the nature of the inquiry undertaken in relation to the directions application is broader than that under s 477(2B), it would usually be convenient to deal with with directions application first, and often that consideration would substantially overtake any discrete consideration of the application under s 477(2B).
  5. The court always pays due regard to the commercial judgment of the liquidator, and, on both applications, the attitudes of creditors are also important.
  6. On both applications, but particularly the application for directions, it would ordinarily be expected that a liquidator would have obtained appropriate legal advice in relation to the proposed compromise, and the nature and content of that advice is a relevant consideration.
  7. While the focus of s 477(2B) is delay, the inquiry under s 477(2B) still requires consideration of the substance of the proposed compromise. If a related application for directions reveals either that the directions should, or should not, be given, discrete consideration of the application under s 477(2B) may be superfluous.

Their Honours then added this at [93] –

It can be seen that the authorities present a tension in the circumstances of the applications the subject of the present case. The liquidator is ordinarily best placed to determine what course the liquidation should take, in the interests of creditors, any contributors and the proper recovery of the costs and expenses of the liquidation. the court will generally not enter into the merits of that determination, confining itself to the question whether the proposed course is a proper one for the liquidator to take. At the same time, the interests and wishes of creditors are highly influential and the creditors are, if properly informed, in the best position to evaluate what is in their own interests. As such, the views of the creditors as to the merits of the present proposal are a highly material consideration.

Principles from Newtronics – s 477(2B)

I pause here to note that the principles here distilled by the Court of Appeal are somewhat informed by the circumstances of this case, and partly focussed upon the different functions served by each of s 477(2B) and s 511. On s 477(2B) applications, the Courts often cite and apply the principles as distilled by her Honour Justice Gordon in Stewart, in the matter of Newtronics Pty Ltd [2007] FCA 1375. It may be useful to repeat them here –

  1. The Court does not simply “rubber stamp” whatever is put forward by a liquidator. (The passage by Giles J in Re Spedley Securities, reproduced above, is often quoted in full together with this principle. Note that its final sentence makes clear that the key consideration is whether the proposal is for the benefit of creditors.)
  2. A Court will not approve an agreement if its terms are unclear.
  3. The role of the Court is to grant or deny approval to the liquidator’s proposal. Its role is not to develop some alternative proposal which might seem preferable.
  4. In reviewing the liquidator’s proposal, the task of the Court is – “[not] to reconsider all of the issues which have been weighed up by the liquidator in developing the proposal, and to substitute its determination for his in…a hearing de novo [but]…simply to review the liquidator’s proposal, paying due regard to his or her commercial judgment and knowledge of all of the circumstances of the liquidator, satisfying itself that there is no error of law or ground for suspecting bad faith or impropriety, and weighing up whether there is any good reason to intervene in terms of the ‘expeditious and beneficial administration’ of the winding up.
  5. Further, in judging whether or not a liquidator should be given permission to enter into a funding agreement (whether retrospective or not), it is important to ensure, inter alia, that the entity or person providing the funding is not given a benefit disproportionate to the risk undertaken in light of the funding that is promised or a “grossly excessive profit”,
  6. Generally, the Court grants approval under s 477(2B) only where the transaction is the proper realisation of the assets of the company or otherwise assists in the winding up of the company.

(See Newtronics at [26] and the authorities there cited.)

Application 

The Court of Appeal – in the unanimous judgment of Whelan AP and McLeish and Hargrave JJA – held that the associate judge had not erred.

Their Honours found that the associate judge was correct to regard the wishes of creditors as a “very important consideration”. Indeed they noted that “he would have erred not to have done so” (see [98]). It was clear, however, that the associate judge did not consider himself bound to act in accordance with the creditors’ wishes, taking account of other matters including the funding position, the legal opinion tendered, the relevance of the Millennium proceeding and the possibility that Mr Yeo might be placed in funds to conduct the Lonnex proceeding. Their Honours noted that the fact that the source of those funds would be the principal creditor served to highlight the importance, in this case, of the attitude of creditors to the proposed compromise of the Lonnex proceeding. (See [95] & [98])

The Commissioner had also submitted that there would be adverse consequences for the Millennium proceeding if the Lonnex proceeding were to be settled, which the Court accepted had considerable force. (See [99])

The Court found the absence of funding for the Lonnex liquidators to continue the liquidation was not an “overriding factor” in this particular case. Here there were alternative options, including that the liquidators could resign so that Mr Yeo could be appointed. (See [95]-[96]) Notably, however, the Court observed that in a different case where no compromise has been achieved, it might be proper for a liquidator to discontinue litigation if funds to continue to conduct it are unavailable. (See [97])

Takeaway

This case serves as a warning to liquidators to take heed of the attitude of creditors to a proposed settlement of a claim, particularly majority, unrelated creditors. Certainly it is a reminder that the Courts will treat the creditors’ judgment of what is in their own commercial interests as of importance, in considering an application for approval to enter into a settlement deed and for directions.

Having said that, this was a somewhat unusual case. Each case will turn on its own facts. It will not always be the case when it comes to settling a proceeding that there is another proceeding arising out of the same transaction/s running in parallel, which may be adversely impacted by the settlement. Moreover, where liquidators are without the funds or a creditor willing to fund litigation, there will not always be an alternative convenient option waiting in the wings, of another liquidator who has consented to act with a creditor willing to fund him (and the majority creditor at that).

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Carrie is a commercial law barrister practising primarily in the areas of insolvency and corporations law, equity and trusts, bankruptcy, restitution, and banking and finance.

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