Trustee insolvency - the Full Federal Court weighs in to the debate

In brief

We recently examined the implications of a Victorian Court of Appeal decision on trustee insolvency in the Amerind Appeal¹. As we foreshadowed, the Full Federal Court has just released its decision on similar issues.² It came to a similar position to the Victorian court in deciding that trust assets should be applied first in paying employees and other statutory preferred creditors (though for varied reasons). But it came to the opposite position in holding that trust assets could only go to trust creditors, not non-trust creditors. That finding will cheer lenders and others dealing with trusts, but leaves a confused landscape. Partner Philip Blaxill , Senior Finance Counsel Diccon Loxton and Associate Lucas Tan report.

The factual background

Killarnee was the trustee of a trading trust and carried on business solely in that capacity. All its assets were held on the terms of the trust and all its claims and liabilities were entered into or incurred in furtherance of the objects and purposes of the trust.

The trustee company encountered financial difficulties, and went into administration.

Subsequently, a liquidator was appointed. On the appointment, the trust automatically terminated, leaving the company holding the trust assets as bare trustee. The liquidator realised the remaining trust assets, and also recovered from the Australian Taxation Office an amount paid as an unfair preference.

The liquidator applied to the court for directions and declarations regarding the proper approach to take in relation to the distribution of the proceeds.

A number of the issues involved judicial controversies where courts of different jurisdictions had come to different views over several decades. So, in an attempt to settle the issues, the Federal Court convened the Full Court of the Federal Court to hear the liquidator's application as first instance.

The legal controversies

It is well accepted that a trustee has a right of exoneration against liabilities properly incurred by it as trustee, to hold and apply trust assets to pay those liabilities. That right is a proprietary right in the trust assets.

But a number of questions have arisen where the trustee is a company in liquidation (or receivership⁴). To what extent does that proprietary right of exoneration mean the trust assets or that proprietary right and its proceeds are 'property of the company'? That in turn bears on:

• whether liquidators can use their statutory powers to realise those assets when the trustee has no trust power to do so;
• whether those proceeds are to be applied among trust creditors in the statutory order of priority under the Corporations Act; and
• whether those assets are to be applied in paying non-trust creditors.

Different courts had come to different conclusions on each of those issues. On either side of the third question were decisions of two appellate courts — in Victoria Re Enhill⁵ decided trust assets were available for non-trust creditors; in South Australia Re Suco Gold⁶ decided they were not. (On the second question, both decisions said the statutory order applied).

The Amerind Appeal decided they were property of the company, and answered yes to the last two questions. It didn't consider the first.

The Amerind Appeal decision was issued just before release of the FCFC judgement, and the FCFC judges amended their judgments to take account of it.

The decision of the FCFC

Issues for the FCFC to consider included the following:

Can liquidators use their statutory power to realise property of the company to realise the trust assets, where the company as bare trustee does not have that power?

The court unanimously held no. The trust assets were not 'property of the company' though the right of exoneration was. The liquidator needed a court order (eg to appoint him receiver over the trust assets. But the court said, in this case, there was no reason why a court would not retrospectively bless the sale.

Should the liquidator apply the proceeds of the unfair preference claim against the ATO in accordance with the statutory priority regime under the Corporations Act?⁷

The parties had agreed that he should. The court accepted that position, but in the absence of argument on the issue declined to express any view itself.

Where there are trust assets available under the trustee's right of exoneration should they be applied among trust creditors in accordance with the statutory priority regime under the Corporations Act?⁸

The broad answer is yes.

Allsop CJ and Farrell J were of the view that the assets should be so applied (though each priority step will need to be considered separately).

Allsop CJ thought the right of exoneration was 'property of the company' and the statutory order applied. However, the right retained its inherent equitable character and that will not be altered in an insolvency scenario. Under this approach, each provision in s556 of the Corporations Act must be examined for its meaning. He said that even if the statutory order did not apply, then, as Farrell J suggested (see below), distribution would be in accordance with equitable principle, and equity would follow the statute by providing for the priority of employees.

It appears Farrell J amended her judgment following the Amerind Appeal. She regarded herself as bound by it on this issue as the FCFC decision was a first instance decision. Therefore the statutory order applied though it may not apply to all claims – not all claims were covered by the right of exoneration and each provision needs to be examined separately. For example, the right (and the distribution) may not cover the liquidator's expenses in connection with the appointment over the company. It appears that but for the Amerind Appeal, her preferred approach was to say that the assets should be distributed in accordance with equitable principle. A court of equity should authorise the distribution of trust assets consistently with the order in paying the liquidator's relevant trust-related remuneration and employee-related expenses.

Siopsis J's views on the general priority issue were consistent with Farrell J's but he declined to give the requisite directions in this particular case.

He said that the proceeds held by the liquidator from the previous sale of the trust assets were the product of an unauthorised sale and therefore the statutory priority regime had no application to them. On application, the court would have retrospectively appointed the liquidator as a receiver to make the prior sales. If that were done, it would be open for a court in exercising equitable jurisdiction to direct the receivers to give priority to employee trust creditors. But no application had been made.

Siopsis J said that the right was not capable of constituting 'property of the company' under the priority regime for various reasons.

The upshot is that all three judges are of the view that a court would generally apply equitable principles to order prior distribution to the liquidator's expenses relating to the trust, and to trust employees. Equity would follow the law. Two judges, Allsop CJ and (following the Amerind Appeal) Farrell J, also thought the statutory order would directly apply.

Should the proceeds of the right of exoneration be applied among non-trust creditors as well as trust creditors?

The court's answer was no.

Allsop CJ and Farrell J both answered no. As there were no non-trust creditors, the court did not need to address this issue. It might therefore be thought that any discussion of the issue would be obiter and non-binding. But Allsop CJ said it was part of the reasoning for the decision. 

Allsop CJ favoured the Suco Gold approach to the Re Enhill approach.

He said that there was no reason for an insolvency scenario to change the inherently equitable character and nature of the right of exoneration and the proceeds of its exercise. This should be maintained under the statutory priority regime, albeit with any necessary qualifications in respect of payment of costs. Here, the insolvent trustee is obliged by fiduciary duty to use its right of exoneration from trust assets only to pay trust creditors. The right is only for that purpose, and is in the nature of an equitable lien or charge.

Under this approach, the liquidator's costs should be payable out of the trustee's right of indemnity by reference to the obligations of the trustee company arising out of the carrying on of the business authorised by the trusts. If there is more than one trust, the liquidator will be able to make an estimate of the work and expense involved in the liquidation so far as it relates to each trust. Where no apportionment is possible, the maxim that equality is equity should provide the solution to the problem of apportionment.

Farrell J also preferred Re Suco Gold over Re Enhill, having regard to the intrinsic nature of a trustee's right of indemnity, as well as practical considerations in more complex situations of a trustee of multiple funds or where the trustee also conducts business in its own rights.

Siopsis J did not address the question, but the consequence of his views would be trust assets are not subject to statutory distribution, to any creditor, whether trust or non-trust.

Where to from here?

On application of trust assets first to preferred creditors.

There are now two appellate authorities (Suco Gold and the Amerind Appeal) that say the statutory order applies, and binds liquidators. 

On application of trust assets to pay non-trust creditors.

As foreshadowed in our earlier Focus: Statutory priority of secured creditors and trustee insolvency: implications of Re Amerind appeal decision, until this issue is resolved by the High Court, there will now be different positions in different forums. Liquidators and receivers may want to select their forum with care when seeking directions from the court.

Insolvency practitioners should exercise caution in applying any proceeds realised from trust assets in exoneration of trust liabilities and obtain legal advice and directions from the court where appropriate.

Parties assessing the credit risk of trusts when the trustee has other activities (ie it is not a single purpose trustee) may want to factor in the risk of the Amerind Appeal/Re Enhill approach applying.

In Victorian state courts, if the liquidator of the trustee realises any trust assets to apply in payment of trust liabilities, then the proceeds to the extent of those liabilities must be distributed among all its creditors in statutory order, and not just among its trust creditors (see the example in our earlier Focus: Statutory priority of secured creditors and trustee insolvency: implications of Re Amerind appeal decision).

In federal courts, the position is that trust assets available under that right should be applied only among trust creditors.

In South Australia, the decision in Re Suco Gold is binding and now consistent with the position in the federal courts.

In all other states, the position remains less clear, but in our view it is more likely that the decisions in Re Suco Gold and Killarnee will be followed.

In light of the above, this area of law in relation to the 'insolvency' of trusts is in need of High Court intervention and ideally, some statutory reform to provide some certainty in relation to a generalised priority regime.