Trustee insolvency - the High Court has cleared up the confusion, or at least some of it - where are we now?

In brief 14 min read

A recent High Court case has brought very welcome clarity to questions that have long bedevilled the insolvency of corporate trustees. We explain the decision and its ramifications.

Key takeaways

• In the insolvency of a trustee, it is now clear:
  • the statutory order of priority applies to trust assets, so trust employees get preference;
  • trust assets are generally only to be distributed among trust creditors, not other creditors; and
  • liquidators can pay trust-related fees and expenses out of trust assets.
• But there is a question as to whether other unsecured trust creditors rank equally in relation to trust assets.
• More generally, (whether or not the grantor is a trustee) secured creditors may have a harder time 'fixing' their security over certain assets so as not to lose priority to employees etc.

The findings in a nutshell

The case, Carter Holt Harvey Woodproducts Australia Pty Ltd v Commonwealth,¹ was the final stage in the Re Amerind² appeal process concerning the receivership of a trustee.

The Commonwealth claimed that trust employees (and therefore the Commonwealth, which had paid them) had priority in the distribution of trust assets. (See our Insight on the Victorian Court of Appeal decision.)

The High Court settled two controversies by holding:

• that the statutory order of priority applied to the distribution of trust assets in paying trust creditors (so trust employees get preference); and
• that in the trustee's liquidation trust assets could be applied only in paying trust creditors, not other creditors of the trustee (except to the extent trust assets are used to reimburse the trustee personally for trust expenses paid out of its own pocket).

It said that security interests granted by trustees over circulating trust assets could be circulating security interests and, to that extent, rank after statutory preferred creditors. And it confirmed, obiter, that liquidators could pay their remuneration in relation to a trust out of trust assets

However, one judgment (by three judges) expressly left open an issue as to how unsecured non-preferred trust creditors rank among themselves. Case law and recent commentary have favoured the view they rank equally.

How does it affect you?

For trustees – more clarity but generally business as usual

Trustees continue to have rights of indemnity out of trust assets. They comprise:

• a right of reimbursement, to apply trust assets to reimburse the trustee for trust expenditure personally paid by it out of its own pocket; and
• a right of exoneration, to apply trust assets to pay liabilities properly incurred by the trustee. It was this right that was the subject of the decision.

The interest of beneficiaries in the assets continues to be subject to those rights, so the beneficiaries receive assets only after the trustee's rights have been satisfied.

For insolvency practitioners – clarity, up to a point

Insolvency practitioners will welcome the clarity. In particular:

• Liquidators of trustees can now clearly use trust assets to pay their fees and expenses in relation to the trust. When the relevant company is trustee of multiple trusts, some issues need to be worked out as to allocation between trust funds.
• Liquidators of trustees must pay preferred employee entitlements out of trust assets in preference to other unsecured trust creditors (but this only applies to employees engaged by the trustee as trustee, not its corporate employees or its employees as trustees of other trusts).
• Generally, receivers must do the same out of trust assets subject to a circulating security interest (though a question whether this is limited to security for 'debentures' was not raised or mentioned in the litigation).
• In a liquidation of a trustee, trust assets are only available to pay trust creditors, not other creditors (except to the extent the trust assets are applied to reimburse the trustee for expenses and liabilities that it paid out of its own pocket).

They may not be delighted by the potential uncertainty in the ranking of other unsecured creditors, but it remains to be seen whether this has any effect.

For employees of trading trusts – clear preferential payment

In general, their position as preferential creditors in relation to trust assets has been cemented. So, too, has the position of anyone (like the Commonwealth) who funds payments to them.

For other unsecured trust creditors – a mixed bag

Their position is mixed. In relation to trust assets, they rank after preferential creditors (eg in the case at hand they will get nothing). But where the trustee had non-trust creditors or creditors as trustee of another trust, the trust creditors do not have to share proceeds of trust assets with them (except amounts received by the trustee as reimbursement).

More generally, the position of unsecured creditors of trustees continues to be less than ideal (as discussed next).

For banks and others lending unsecured to trustees – more clarity in credit assessments but no nirvana

They can more confidently make a credit assessment looking at the trust on its own as a separate economic entity, based on the trust assets and liabilities, and not other liabilities of the trustee.

However, the express leaving open of the ranking among unsecured creditors may affect legal certainty and legal opinions.

And, in any event, there are a number of other issues that need to be taken into account when dealing unsecured with trustees that may affect the credit quality. Some of those issues reflect the position described below – that unsecured creditors have no direct access to trust assets, and they depend for indirect access entirely on the trustee's rights of exoneration, which are fragile. The position of unsecured creditors is not ideal.

For secured creditors (of trustees and more generally) – review your security arrangements

To the extent the security is a circulating security interest, generally the secured creditor loses priority to statutory preferred creditors. That is nothing new. But there was a question mark concerning trust assets. It is now clear that this applies to security granted by trustees where the relevant circulating assets are trust assets, and the preferred creditors are trust creditors.

Secured creditors try to 'fix' security over assets like trade receivables, bank accounts and inventory proceeds so they are not regarded as circulating assets and are not subject to preferential claims. The Court of Appeal judgment effectively limited their ability to do this. This was not appealed or questioned in the High Court.

So, in many cases the pool of assets that are circulating assets and available to preferential creditors is enlarged. Secured creditors need to review their arrangements to see if they can restrict it. But doing so is harder than some may have thought. This applies whether or not the grantor is a trustee.

Controversies in trustee insolvency existing before the Amerind litigation

As discussed above, if a trustee properly incurs liabilities as trustee it has a right to discharge those liabilities by paying the relevant creditors out of trust assets.

Unless they hold security, those creditors do not have direct access to trust assets. They only have indirect access, by being subrogated to the trustee's right of exoneration.

There is no special insolvency regime applicable to trusts and trustees. If a company that is a trustee becomes insolvent, it may be placed in liquidation, administration or receivership. In that case, the relevant insolvency provisions of the Corporations Act 2001 (Cth) apply.

But trust law also applies. How do trust law and corporate insolvency law intersect? Should trust assets be dealt with under those provisions? Does corporate insolvency law apply to assets held on trust? Are they regarded as assets of the company for that purpose? If so, to what extent?

There have been two questions about which courts have come to conflicting views:

• Should trust assets available to pay creditors under the right of exoneration be distributed only among trust creditors, or should they also be distributed among all other creditors of the company?

There has been a longstanding divide. In re Enhill,³ a Victorian appellate court said trust assets are available for all creditors. In Suco Gold,⁴ a South Australian appellate court said trust assets were only available for trust creditors, and most commentators agreed.

• Should such trust assets be treated as assets of the company and be distributed among creditors in the statutory order of priority (giving preference to employees), or should they be treated as outside the statutory order and distributed equally among all trust creditors without any preference?

Courts and commentators had come to conflicting views.

In addition, it had not been definitively settled that liquidators of a trustee could use trust assets to pay their fees and expenses in relation to the trust.

Background

The dispute

A company, Amerind Pty Ltd, was the trustee of a trading trust and carried on business solely in that regard, so it held only trust assets and trust liabilities. As trustee, it owed money to a secured creditor, to employees, and to various unsecured creditors. Like all trustees, it had a right of exoneration to pay those trust liabilities out of trust assets.

The secured creditor, a bank, held a registered PPSA security interest over all assets, including ADI accounts, funds paid under a factoring arrangement, and tax refunds and other miscellaneous receivables.

Amerind suffered financial difficulties, and the bank appointed receivers. The Commonwealth paid Amerind's employees their entitlements under the Fair Entitlements Guarantee Scheme.

The receivers had realised most of the assets. They paid the bank debt in full out of the proceeds of fixed assets of the trust and were in a position to retire. A dispute arose in relation to competing claims to the receivership surplus:

• The Commonwealth claimed that it and employees should be paid in preference to the other creditors, under the statutory priority regime in ss433 and 556 of the Corporations Act.
• The other unsecured creditors claimed that the statutory priority regime did not apply, because the surplus was not property of the company, but trust property, and, in any event, the relevant asset was not a circulating asset.

The receivers sought directions from the court. The trial judge found for the other unsecured creditors, saying trust assets were not assets of the company. The Commonwealth appealed. The Court of Appeal upheld the appeal and an unsecured creditor appealed to the High Court.

The relevant Corporations Act provisions

Section 433 provides that where a receiver takes possession of 'property of the company' subject to a 'circulating security interest' securing debentures, the receiver must pay certain entitlements to employees in preference to other unsecured creditors, in accordance with the s556 statutory priority regime.

Section 560 provides that, if the company pays employees as a result of a third party advancing money for the purposes of making that payment, then the third party (here, the Commonwealth) has the same right of priority as the employees who received the payment

A curious omission – were there 'debentures'?

Strictly, s433 only applies in relation to security for 'debentures'.

No one at any level seems to have taken the point or observed that the relevant secured bank debt was not a 'debenture' as defined in s9 of the Corporations Act (which excludes most bank debt) and therefore s433 did not apply.

This may have been because, even if s433 did not apply, s561 would apply, as liquidators had been appointed. That applies in a liquidation and provides for broadly the same priority regime with respect to circulating security interests, whether or not they secure debentures. The High Court in various obiter remarks confirmed that its broad analysis applicable under s433 also would apply to liquidators under s561. And other cases have held s561 applies to receivers in a liquidation as well as to the liquidators.

The High Court decision

Grounds of appeal

The unsecured creditor relied on two grounds of appeal for saying that s433 did not apply.

1. the relevant property, being trust property, was not 'property of the company' for the purposes of s433; and
2. in any event, the relevant property of the company was its right of exoneration, and that was not a circulating asset as defined in the PPSA, and therefore there was no circulating security interest.

The decision

The High Court unanimously rejected the appeal. There were three separate judgments, with only subtle differences in approach between them.

Ground 1

The Commonwealth made two alternate submissions.

Under each, it said that trust property available for exoneration was property of the company.

• Under the first, said the trust property was therefore available for all creditors, not just trust creditors (along the lines of the Victorian decision, Re Enhill).
• Under the second, it said that the trust property was only available for paying trust creditors (along the lines of the South Australian decision, Suco Gold, and a recent full Federal Court decision).⁵

The High Court rejected the first submission and adopted the second. All judgments emphatically rejected the re Enhill approach.

To the extent of the right of exoneration (and its right of reimbursement), the trust assets were assets of the company. The trustee had a beneficial or proprietary interest in the trust property (variously described) to apply them in paying trust liabilities (and to reimburse itself). The beneficiaries only had rights subject to that interest: ie they were only entitled to what remained after the liabilities were satisfied and expenses reimbursed.

In relation to the right of exoneration, that interest was still subject to a limit – the assets could only be applied in paying trust creditors. They were not available to pay other creditors.

In relation to the right of reimbursement, where the company was reimbursing itself out of trust assets for trust expenses personally paid by it, the amounts received by it were its own personally, and available for all creditors.

Ground 2

The High Court held that s433 did apply. The section's relevant requirements were satisfied.

The Court of Appeal had held that the relevant assets (of various types) were circulating assets. This was not appealed, and the High Court did not re-examine this. Where it did discuss circulating assets, it only discussed inventory and its proceeds.

The High Court said the relevant inventory and proceeds were assets that came into the hands of the receiver. So too were the proceeds of the inventory received after the receiver's appointment. They were property of the company. They were subject to the security interest. It was those assets that may be examined as to whether they were circulating assets. It was meaningless, or irrelevant, to say that the right or power of indemnity was not a circulating asset.

While the case strictly concerned receivers, the Court said the principles were also applicable to liquidators.

Some remaining questions

Trustee insolvency, trust creditors

Trading and investment trusts are extremely common in Australia. Routinely, trustees of such trusts are companies. One might hope that there would be a clear and recognised regime where they are insolvent, and as to the rights of creditors. But there is not. And the position of trust creditors is not ideal

This decision is a significant advance in some areas and has provided some much-needed clarity to some important issues, but other issues and difficulties remain.

Judgments in the High Court themselves noted that questions may arise in the following areas.

• What is the correct order of priority between trust creditors after payment of the priority debts?
• While commentators have recognised some uncertainty, the market has operated on the assumption that they would rank equally. This view has been fortified by case law and has considerable merit on principle and policy. It remains to be seen whether this will be disturbed by the express reservation of the issue by three High Court judges.
• What occurs when the trustee is trustee of more than one trust — how are expenses etc apportioned between funds?
• There is some discussion of the principles that might be applied.

Secured creditors generally (whether or not regarding trusts)

As we noted in our Insight on the Court of Appeal decision, that court took an expansive view of which assets are circulating assets. And in relation to tax refunds, the rationale on which they did so is not clear.

Some queries may remain when a receiver is appointed under a circulating security interest that secures bank debt that is not a 'debenture' as defined. Section 433 might not apply to require the receiver to pay preferential creditors. If a liquidator is appointed, s561 applies to give the preferential creditors priority, but what happens if a liquidator is not appointed?

Next steps

If you'd like to discuss these questions further, please contact any of the people below.