Unreasonable director-related transaction – liquidator successfully challenges the grant of a mortgage as cross-security

Lenders caught up in unreasonable director-related transaction 5 min read

In a recent Federal Court decision¹, a liquidator was successful in having a mortgage declared an unreasonable director-related transaction under section 588FDA of the Corporations Act 2001 (Cth) (the Act). This demonstrates that liquidators can rely on the section as an extra 'tool' to claw back assets arising from potentially voidable transactions, and serves as a reminder to lenders to be wary when taking securities from related entities. In this Insight, we examine these and other important lessons from the case.

Key takeaways

• Liquidators may rely on s588FDA as an additional 'tool' in their kit to claw back assets arising from potentially voidable transactions, including the grant of securities to lenders.
• It may be easier to prove an unreasonable director-related transaction than other types of voidable transactions, as liquidators do not need to establish the company is insolvent or prove that the directors acted with impropriety.
• Cooper is a reminder to lenders to be cautious when taking securities from related entities, and to consider the commercial benefit that the grantor of the security has obtained – whether the directors are receiving a commercial benefit may also be relevant. The decision shows that the court will adopt a logical, 'follow the money' approach in determining these issues.

Overview

Runtong Investment and Development Pty Ltd (Runtong) was a company involved in property development, which granted a mortgage to CEG Direct Securities (CEG) as cross-security for loan advances that CEG provided to two entities related to Runtong. The loan advances were for approximately $15 million and personally guaranteed by two of Runtong's directors.

CEG subsequently sold the land for $12 million, the effect of which reduced the contingent liability of Runtong's directors to CEG under the various loan agreements.

In determining whether the grant of the mortgage was an unreasonable director-related transaction, the court considered the following key questions:

• Was there a benefit provided to the directors of Runtong?
• Was there a commercial benefit to Runtong or, alternatively, did Runtong suffer a detriment?
• Would a reasonable person in Runtong's circumstances have entered into such a transaction?

The court largely found in favour of the liquidator of Runtong, in that there was no benefit provided to Runtong as part of the transaction, and it was not a reasonable transaction into which it should have entered. In fact, the detriment – in offering up Runtong's only asset for sale by CEG in the event of defaults by the related entities – was 'obvious and substantial'. The liquidator was successful in obtaining orders for CEG to pay $1.9 million to Runtong under s588FF.

The facts

Runtong was the proprietor of a large parcel of land in Adelaide, South Australia. It had two related entities known as Datong Investment and Development Pty Ltd (Datong) and Futong Investment and Development Pty Ltd (Futong). All three entities were involved in property investment and development, and shared two directors.

In 2014, Datong and Futong entered into various loan agreements with the lender, CEG, to develop land owned by Futong (the loan agreements). The amounts payable to CEG by Datong and Futong under the loan agreements totalled $15 million. The loan agreements were secured by way of personal guarantees by four individual guarantors, including the two common directors.

In December 2014, Runtong executed a mortgage over the land in favour of CEG, as part of a series of securities provided to CEG to secure borrowings by Datong and Futong.

The related entities, Datong and Futong, later defaulted on the loan agreement, and CEG enforced the cross-security Runtong had provided.

In June 2018, Runtong's creditors resolved to wind it up. In July, CEG sold the land for $12 million. The liquidator challenged the mortgage granted to CEG.

Loan arrangements between Runtong, related entities Futong and Datong, and CEG

'Unreasonable director-related transaction' under s588FDA

Section 588FDA sets out a three-stage test to determine whether a transaction is an unreasonable director-related transaction. It requires:

• a transaction;
• that the transaction be made either to a director or on behalf/for the benefit of a director (or relative of a director, or spouse); and
• a reasonable person in the company's circumstances not to have entered into the transaction.

It is an objective assessment. Notably, this provision does not require that the company be insolvent. The requisite 'transaction' here was the grant of the mortgage.

Did the transaction benefit the director?

The court considered that 'benefit' captured 'both direct and indirect benefits', and included any legal and financial advantages to the director in question.

The liquidator argued that the benefit to the two director guarantors was the reduction of the contingent liability of 'the Directors … by whatever net sum CEG received from realising its security over the Land'.

CEG argued there was no benefit to Runtong's directors and said that since further funds were advanced upon the grant of the mortgage, the directors' contingent liability actually increased. It also argued that the liquidator's case ignored Runtong’s liability for interest and costs under the mortgage and other loan and guarantee documents.

The court ultimately agreed with the liquidator and held that any reduction in the directors' personal liability was to their advantage.Although CEG also benefited from the mortgage, that did not mean the directors did not also benefit.

Was the transaction reasonable in the circumstances?

Section 588FDA outlines four factors to be assessed in determining reasonableness:

• the benefit to the company;
• the detriment to the company;
• the respective benefit to other parties to the transaction; and
• any other relevant matter.

This test focuses on the reasonableness of the company's conduct, and not that of its individual directors, and considers the circumstances as they existed at the time of the transaction. It is not necessary for the court to find the directors breached their duties or acted with impropriety in entering into the transaction.

The court held that the transaction was not reasonable in circumstances where Runtong had no commercial justification to grant the mortgage. This was because:

• Runtong had not requested any advance of money.
• No money was actually advanced to Runtong until nearly a year after the grant of the mortgage.
• Runtong was not contemplating development of the land.
• Runtong was not a primary debtor or named in another loan agreement.

Rather, Runtong suffered detriment by exposing its only asset to sale by CEG if loans by other parties were not repaid. CEG was the only party who benefited from the transaction.

Renee Zou and Harriet Walker also contributed to this article.