you oughta know - allens · senior associate allens arthur robinson ... mcqs s0111441742v1 150520...

You Oughta Know

Topical Insolvency Issues of which BankersShould be Aware

2 December 2004

Michael QuinlanDeputy Group LeaderCorporate Insolvency & RestructuringPartnerAllens Arthur Robinson

Steven FlemingCorporate Insolvency & RestructuringSenior AssociateAllens Arthur Robinson

Michael PopkinCorporate Insolvency & RestructuringSenior Lawyer admitted in New YorkAllens Arthur Robinson

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In this paper we will address a number of issues and recent developments which we think bankersought to know, namely:

• the new reporting obligations which auditors have to ASIC;

• some securities issues: registration of charges and attacks on charges as voidabletransactions;

• whether payment by a third party or under a bank guarantee or letter of credit can ever bean unfair preference;

• an update on unconscionability and the banking industry; and

• when banks assume duties and liabilities as directors of their clients.

1. New reporting obligations of auditors

We just wanted to draw your attention to a new risk which might face some (but hopefully for you –not too many) of your customers and that is the risk of being reported to ASIC by their CLERPauditors because of the revamped version of section 311 of the Corporations Act introduced as partof the CLERP amendments.

Section 311 of the Corporations Act provides that:

(1) An individual auditor conducting an audit contravenes this subsection if:

(a) the auditor is aware of circumstances that:

(i) the auditor has reasonable grounds to suspect amount to a contravention of thisAct; or

(ii) amount to an attempt, in relation to the audit, by any person to unduly influence,coerce, manipulate or mislead a person involved in the conduct of the audit (seesubsection (6)); or

(iii) amount to an attempt, by any person, to otherwise interfere with the proper conductof the audit; and

(b) if subparagraph (a)(i) applies:

(i) the contravention is a significant one; or

(ii) the contravention is not a significant one and the auditor believes that thecontravention has not been or will not be adequately dealt with by commenting on itin the auditor's report or bringing it to the attention of the directors; and

(c) the auditor does not notify ASIC in writing of those circumstances as soon as practicable, and inany case within 28 days, after the auditor becomes aware of those circumstances.

Contravention by audit company

(2) An audit company conducting an audit contravenes this subsection if:

(a) the lead auditor for the audit is aware of circumstances that:

(i) the lead auditor has reasonable grounds to suspect amount to a contravention ofthis Act; or


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(b) if subparagraph (a)(i) applies:


(ii) the contravention is not a significant one and the lead auditor believes that thecontravention has not been or will not be adequately dealt with by commenting on itin the auditor's report or bringing it to the attention of the directors; and

(c) the lead auditor does not notify ASIC in writing of those circumstances as soon as practicable,and in any case within 28 days, after the lead auditor becomes aware of those circumstances.

Contravention by lead auditor

(3) A person contravenes this subsection if:

(a) the person is the lead auditor for an audit; and(b) the person is aware of circumstances that:

(i) the person has reasonable grounds to suspect amount to a contravention of thisAct; or



(c) if subparagraph (b)(i) applies:


(ii) the contravention is not a significant one and the person believes that thecontravention has not been or will not be adequately dealt with by commenting on itin the auditor's report or bringing it to the attention of the directors; and

(d) the person does not notify ASIC in writing of those circumstances as soon as practicable, and inany case within 28 days, after the person becomes aware of those circumstances.

Significant contraventions

(4) In determining for the purposes of this section whether a contravention of this Act is asignificant one, have regard to:

(a) the level of penalty provided for in relation to the contravention; and(b) the effect that the contravention has, or may have, on:

(i) the overall financial position of the company, registered scheme or disclosing entity; or

(ii) the adequacy of the information available about the overall financial position of thecompany, registered scheme or disclosing entity; and

(c) any other relevant matter.

(5) Without limiting paragraph (4)(a), a penalty provided for in relation to a contravention of aprovision of Part 2M.2 or 2M.3 includes a penalty imposed on a director, because of theoperation of section 344, for failing to take reasonable steps to comply with, or to securecompliance with, that provision.

Person involved in an audit

(6) In this section:

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"person involved in the conduct of an audit "means:

(a) the auditor; or(b) the lead auditor for the audit; or(c) the review auditor for the audit; or(d) a professional member of the audit team for the audit; or(e) any other person involved in the conduct of the audit.

These amendments make it much more likely that your customers' auditors will report them toASIC, rather than risk committing a contravention of the Companies Act themselves, if the auditorsuspects that there may have been a contravention of the Corporations Act. For example if theauditor does not know but suspects that the company is unable to pay its debts as and when theyfall due and that it is continuing to incur debts the auditor may feel (and in fact be) compelled toreport the directors of his client company to ASIC for a suspected breach of the insolvent tradingprovisions. Clearly enough this would not endear the auditors to the directors of their audit clientshould that notification become public, and a listed company for example would no doubt have todisclose such a report. The fact of reporting it could itself cause the company to becomeinsolvency as investors and customers may quickly lose confidence.

2. Some securities issues

If you obtain valid security before you advance funds you will not be an unsecured creditor. In thatcircumstance the only way in which you could receive a preference would be if you receivedpayments which exceeded the value of your security. Only the amount over the value of yoursecurity could potentially be a preference as you were effectively an unsecured creditor for thatexcess amount of debt.

2.1 Security in personal property

Security in personal property can be broken up into two broad categories with respect tothe type of asset charged. The first category is physical chattels, which includes movableproperty that takes a physical form, such as an automobile or piece of machinery. Theother category is choses in action, which have no physical existence but are intangiblebundles of legal or equitable proprietary rights, such as company shares or intellectualproperty rights. Both chattels and choses in action can be given as security by a company,but the law which governs these two categories is slightly different. Another distinctionwhich can be made when talking of company charges over its movable property is thedistinction between a fixed and floating charge.

2.2 Fixed charges

Under the general law in Australia, a mortgage of a chattel operates as an assignment ofthe legal interest of the item charged, subject to the chargor’s equity of redemption. Thereis no analogous Torrens style system when it comes to interests in chattels so all legalmortgages of chattels take the form of a conveyance, unlike with land where a mortgage ofTorrens title operates as a charge. Mortgages may also be granted over chattels which areeither potential, after-acquired or future property. These are categories of chattels whichhave yet to come under the ownership or possession of the mortgagor, but upon doing so,

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the title of that property is conveyed to the mortgagee. Instead of mortgaging the chattel atgeneral law, it could be made merely subject to a charge. A charge is not a conveyance,but instead indicates that the chargee can have recourse to the chattel so charged in orderto satisfy the debt.

It is necessary to look at the intention of the parties when the security was created in orderto determine whether it was done by way of mortgage or charge. While there is adistinction at general law between a mortgage and charge, it must be noted that for thepurposes of the Act, both mortgages and charges of chattels are charges that areregistrable with ASIC under the Act (which is different to the position with charges overland, which do not need to be so registered).

With respect to choses in action, although they are intangible, they are often capable ofassignment under statute at law, or in equity. Because they are capable of assignment,they can be assigned or charged for the purpose of security for a loan, subject to the lawsof maintenance and champerty. This latest proviso is important because a chose in actionmay have a right to sue attached to the property or actually be a bare right to sue, and therules against maintenance and champerty are common law restrictions on the extent thatone party can assign another the right to take legal action against a third party. Choses inaction at law include debts, bills of exchange and insurance policies. Equitable choses inaction are items such as shares or an interest in a partnership or deceased estate.Present choses are debts due under a contract, breach of which will give rise to a cause ofaction in contract. Future choses are contingent debts, payable upon the happening ofcertain events.

The most common choses in action offered to financiers as security for the obtaining offinance are rights under a specific contract, such as the right to receive payment of a sumof money, or general business debts. However, a decision of the Privy Council casts doubtover the extent to which a fixed charge may be taken over the book debts of a company1.If the company can use the proceeds from discharging of those debts without reference tothe chargee, it will be held to be a floating charge (see below), regardless of the languageused in the charge agreement.

At law, only a whole chose in action can be assigned, not a part of one, so any legalsecurity over book debts will have to be over the whole debt. The priority of multiplesecurities held by different parties at general law is governed with reference to the time thatnotice was given to the debtor regarding the assignment of the chose. However, withrespect to a company assigning its debts, registration requirements may also affectpriorities which is discussed further on. Another important issue to note is that until thedebtor is notified of the assignment, he or she may satisfy the debt by paying the assignorthe sum owing, meaning that the assignee may only have recourse to recovering from theassignor and not the debtor.

Other choses often taken as security are intellectual property rights, the goodwill of acompany’s business (most often taken along with securing the business’ tangible assets so

1 Agnew v Commissioner of Inland Revenue (2001) 2 AC 710

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the chargee would be able to sell the business as a going concern), and shares which areowned by the company.

2.3 Floating charges

A financier may wish to take an assignment or charge over all the book debts as opposedto a single debt. This will normally take the form of a floating charge, as the debtors owingon the books of a business, especially large corporations, will be changing all the time. Afloating charge will allow the company charging its debts to deal with and discharge debtsas the case arises, without needing to first gain the consent of the chargee. Upon defaultof the loan by the chargor corporation, the floating charge crystallises and the chargee canthen give notice to the debtors existing at that time and proceed to collect from them in duecourse. This will most often be done by way of appointment of a receiver, the terms ofwhich will usually be set out in the security agreement.

In general, floating charges are an attractive form of security for a company to give over itsassets because the terms of the security allow it to deal with the assets charged withoutfirst consulting the chargee. Only upon the happening of certain events, such as default,will the charge crystallize and that freedom be restricted. These events are either definedwithin the terms of the security instrument or implied by law. While the charge remainsfloating, the company retains the right to unilaterally grant fixed charges over the assetswhich are subject to the floating charge, except if there is a specific provision in the floatingcharge agreement prohibiting this. In reality, most floating charge agreements do prohibitthese types of subsequent dealings. If the company does grant a subsequent charge overan asset contrary to the provisions of the floating charge interest, it is arguable that theparty taking the subsequent charge takes the property subsequent to an equity whichattaches to that asset, but only if that party has notice of that equity. Similarly, if thesubsequent party takes the charge when it has notice of the restriction in the floatingcharge instrument, then that subsequent charge will be postponed to the original floatingcharge.

A floating charge created within six months prior to the filing of an application for a windingup order in insolvency is void, unless it secured the giving of a new benefit to the companyor the company was solvent when the charge was created.

2.4 Types of business debts which are typically secured by personal property

A company is likely to give a fixed charge in respect of smaller loans, where it would beinappropriate to grant a fixed and floating charge over the entire assets when consideringthe amount of money involved. Often when buying a new asset, the company may give acharge over that asset in order to finance the purchase. A floating charge is appropriate fora company which must be able to deal with its assets on an everyday basis without firstconsulting the chargeholder. This will be the case where a large proportion of a company’sassets are stock in trade or book debts.

2.5 Documents which evidence the transaction

Security over the personal property of a company is usually taken in the form of a deed ofcharge or a specific mortgage security, both in addition to the traditional loan contract.

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Further protection is often taken by the lender by retaining key documents of title. Specialnotice must also be taken of the requirements listed under any statute dealing with specifickinds of chattels which has been taken as security. There is such legislation governingmotor vehicles, liquor licences, various intellectual property rights, and crops, stock andwool, among others.

Before execution of a security agreement with a company, it is prudent for the chargee toobtain a statutory declaration from an authorised officer of the company, confirming that thesecurity arrangement was entered into by the company in accordance with the proceduresset out for such a transaction in its constitution, that the company is not insolvent, and thatthis transaction is of benefit to the company. This is in part an attempt to provide someprotection for the chargee against a claim from any liquidator or administrator laterappointed that the charge was not properly executed, or not given for a proper purpose andis thus invalid. The existence of those provisions in the security agreement will notnecessarily afford the chargee that protection. For example, if the chargee knows that thechargor is in fact insolvent at the time the charge is given, such a representation in thesecurity document from the chargor may not be sufficient to establish that the chargee infact believed the chargor to be solvent.

The security documents generally set out the following information:

(a) description of the monies secured including all monies owing by the borrower alongwith all expenses and fees which may be charged by a financier;

(b) a covenant to repay by the borrower, either on demand or by a fixed date, includingboth principal and interest (this covenant is necessary in case realisation of theasset secured falls short of what is owing);

(c) warranties that the company has power to enter into and perform its obligationsunder the document and has undertaken the necessary corporate action inaccordance with its constitution to properly execute the documents;

(d) undertakings or covenants such as prohibitions against creating another securityover the same asset to be mortgaged or charged, selling the asset (unless it issubject to as floating charge) and to insure the property in question for its fullamount, among other things;

(e) listing what occurrences will be events of default under the agreement upon whichthe lender can commence to enforce the security; and

(f) the power of the lender to appoint a receiver and what that receiver is entitled todo.

2.6 Registration of Charges

Charges against the property of a company, which is not land, incorporated within Australiamust be registered with ASIC. If the charge is not registered within 45 days of its creation,as required by the Act, there are two potential consequences. The first is that if thecompany was to become insolvent or be placed into voluntary administration (VA), then thecharge would not be valid against the liquidator or administrator. Second, the chargewould not be valid against a later chargee who took security over the same property and

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registered it prior to the registration of the first charge. Section 262 of the Act lists thetypes of charges that must be registered.

Section 263(1) Corporations Act provides that, where a company creates a charge, it mustensure that a notice of charge is lodged with ASIC within 45 days. Section 266(1) providesthat a registrable charge on property of a company is void as security on that property asagainst a liquidator or administrator, unless such notice is lodged.

In a recent decision, National Australia Bank Limited v Davis & Waddell (Vic) Pty Ltd (inliquidation),2 extension of time was granted to the bank to register the charge. In that case,a charge was granted to the bank from May 2000. In August 2000, the bank discoveredthat security documents had not been registered and had been lost. Replacement securitydocumentation was executed in December 2000. Notification of the charge was not lodgedwith ASIC until February 2001, 18 business days after the expiration of the 45 day statutorytime limit. The company was subsequently wound up.

The bank sought an order under s266(4) Corporations Act, extending the period for lodgingnotice of the charge. That section entitles the court to make such an order if the failure tolodge the notice:

• was accidental or due to inadvertence or some other sufficient cause; or

• is not of a nature to prejudice the position of creditors or shareholders.

The Victorian Supreme Court, on appeal from a decision of a Master, held that the bank'sfailure to register the charge was accidental, and due to inadvertence. The fact that thecompany was in liquidation at the time of the bank's application was found not to be fatal toan application for registration out of time, but to a be a factor which must be consideredwith all the other relevant factors. In this case, there were exceptional factors that justifiedthe exercise of the court's discretion to extend time, including that the company had reliedon the bank for financial accommodation without which the company could not haveconducted its business, and the delay in lodging the notice for registration was relativelyshort.

The bank should ensure that staff are aware of the consequences of a failure to lodge anotice of charge within 45 days of its creation. Even though the bank may apply to the courtfor an extension, it appears that there must be exceptional circumstances before theextension will be granted.

In order for a charge to be registrable at ASIC the stamp duty payable at the relevant officeof state revenue must be paid. The amount to be paid is determined as a percentage ofthe amount secured. Timely payment of stamp duty is advisable in order to avoid the build-up of interest and other penalty charges which may apply, and to facilitate registration ofthe charge with ASIC.

It is important though for the bank not to fall into the trap of believing that it has anenforceable charge and a fully secured debt simply because it has successfully managedto get its charge executed and stamped properly and registered with ASIC in time.

2 (2003) 44 ACSR 296.

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2.7 Validity of Charges – attack as voidable transactions

Workouts often involve revisions to facilities and securities. The negotiated position mustbe able to withstand the scrutiny of a liquidator should the borrower be wound up. Section588FE Corporations Act provides that different types of transactions will be voidable indifferent time frames prior to the relation-back day.3 In the case of an unfair loan to thecompany, the liquidator may avoid the unfair loan made at any time before the day whenthe winding up began. The liquidator must first establish the insolvency of the borrower atthe time of the transaction.

A 'transaction' is broadly defined and includes:

• a conveyance, transfer or other disposition of property;

• a charge created by a body over its property;

• a guarantee given by a body;

• a payment made by a body;

• an obligation incurred by a body;

• a release or waiver by a body; and

• a loan to the body

Section 588FE(2) provides that the liquidator may avoid an insolvent transaction of thecompany that was entered into during the six months before or after the relation-back day.An insolvent transaction is a transaction entered into by the company where:

• at the time of entering the transaction the company is insolvent, or the companybecomes insolvent by entering into the transaction, and

• the transaction is an unfair preference or an uncommercial transaction.

A transaction is an unfair preference if it results in a creditor of the company receiving fromthe company in respect of an unsecured debt more than the creditor otherwise would if thetransaction were set aside and the creditor were to prove for the debt in the winding up ofthe company.4 Examples of unfair preferences include taking further security for existingadvances, and payment to the bank beyond the level of its security.

A transaction is uncommercial if it may be expected that a reasonable person in thecompany's circumstances would not have entered into the transaction.5 Examples ofuncommercial transactions include where:

• a related company of a borrower provides a guarantee or security or makes

payment in respect of the past indebtedness of the borrower and the related

company derives no benefit from it, or

3 The relation-back day is determined according to the manner in which the company goes into liquidation, as set out in s9of the Corporations Act 2001. For example, if liquidation occurs through a resolution of a creditor's meeting to appoint aliquidator, the relation back-day is the date on which the liquidator is appointed.4 Section 588FA(1) Corporations Act 2001.5 Section 588FB(1) Corporations Act 2001.

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• onerous terms are agreed by the borrower as a condition of continuing facilities.

The transaction will be reviewed from the perspective of a reasonable person in theborrower's circumstances, taking into account the company's financial position andpredicament, whether the benefits of entering into the transaction outweigh the detriment,and the benefits to the bank.

Where the transaction is voidable, the court has wide powers to make orders to avoid thetransaction, including orders directing payment of money to the company equivalent to theamount paid by the company under the transaction, and orders declaring the transaction tobe unenforceable.6

2.8 Defences to voidable transaction

Section 588FG provides two sets of defences to an action by a liquidator to have a

voidable transaction set aside, depending on whether the person against whom the

liquidator has brought the claim was a party to the voidable transaction. If the person is a

party to the transaction and the transaction is not an unfair loan to the company, the person

must prove that:

• they became a party to the transaction in good faith;

• they had no reasonable grounds for suspecting the company was insolvent or

would become insolvent at the time they entered into the transaction;

• a reasonable person in those circumstances would not so suspect; and

• they provided valuable consideration for, or changed their position in reliance on,

the transaction.

• If the person against whom the liquidator is proceeding was not a party to the

voidable transaction, and did not receive a benefit as a result of the transaction,

this is of itself a defence. Where the third party did receive a benefit, then they

must prove:

• they received the benefit in good faith;

• they had no reasonable grounds for suspecting the company was insolvent or

would become insolvent at the time they received the benefit; and

• a reasonable person in those circumstances would not so suspect.

6 Section 588FF(1)Corporations Act 2001.

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3. Can payment by a third party or under a bank guarantee or letter ofcredit ever be a preference

A favoured means by which creditors have sought to avoid receiving preference payments in thepast was to be paid by a third party or by obtaining a bank guarantee or letter of credit. This shouldwork fine however as mentioned in 3 above there is a very wide definition of transaction whichapplies to unfair preferences and other voidable transactions. It is clear for example that if A owesB money and B owes C money and B directs A to by pass B and pay C directly that C couldreceive a preference from B.7

Letters of credit have generally been considered safe until the decision in New Cap ReinsuranceCorp Ltd & Anor v Somerset Marine & Ors [2003] NSWSC 540 in July last year.

In that case New Cap Re and its liquidator sought recovery of monies paid to the defendantreinsurance companies on the basis that they were unfair preferences within the meaning ofsection 588FA(1) of the Corporations Act. By interlocutory process, the defendants sought orderssetting aside the originating process, arguing that the letter of credit agreement under which theyindirectly received money from New Cap Re was not an agreement to which they were a party, andso the legislation did not apply to the transaction in question. The court took the view that, in thecontext of the entire transaction, there was an arguable case that New Cap Re's discharge of itsindebtedness to the defendants via its bank constituted a transaction for the Corporations Act'spurposes. Accordingly, the defendants' application was dismissed on the basis that New Cap Reand its liquidator should not be denied the opportunity to have a court finally determine the matter.

Somerset was an insurance agent that underwrote reinsurance business as agent for a pool ofreinsurance companies (collectively, the defendants). New Cap Re reinsured the pool byreinsurance treaties entered into by Somerset on the reinsurance companies' behalf. Because ofloss events, New Cap Re became liable to the defendants under the reinsurance treaties. Onbehalf of the pool, Somerset requested the establishment of letters of credit in specific amounts infavour of the respective pool members.

New Cap Re entered into a letter of credit agreement with an issuing bank and administrative agent(Chase Manhattan, Sydney) and a collateral agent (Bank of Bermuda, New York), whereby thebanks agreed to issue letters of credit for the Somerset account, up to individual commitment limits.Provision was made for reimbursement from New Cap Re of any monies paid by ChaseManhattan. New Cap Re's obligations were also secured by a collateral agreement between it,Chase Manhattan and the Bank of Bermuda.

A call was made by the defendants under the reinsurance treaties and New Cap Re requestedChase Manhattan to issue letters of credit. Payment was made and New Cap Re was requested toreimburse the amount.

The defendants argued that they were not a party to any transaction with New Cap Re that led topayment to them under the letters of credit and that they received nothing from New Cap Re. Inother words, they argued that they were not caught by the terms of s588FA(1). The defendantsargued that the only transaction to which they and New Cap Re were parties were the reinsurancetreaties. They were not parties to the letter of credit agreement or the collateral agreement. They

7 Macks and Emanuel (No 14) Pty Ltd v Blacklaw & Shadforth Pty Ltd (1997) 15 ACLC 1099 (Emanuel)

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did not receive payment from New Cap Re or otherwise pursuant to any chose in actionenforceable against New Cap Re.

New Cap Re submitted that the transaction was one where, under the defendants' request, NewCap Re arranged for the letters of credit in favour of the defendants and Chase Manhattan receivedreimbursement from New Cap Re. New Cap Re argued that the banks were instruments by whichthe defendants received payment from it. Looking at the overall transaction, New Cap Re's fundswere depleted and, pro tanto, the debts due to the defendants were discharged. It was submittedthat it would be a curious result if payment by cheque or cash might be challenged as an unfairpreference, while payment by letter of credit could not.

Both sides relied on divergent authority to support their contentions. Importantly, New Cap Rerelied upon Emanuel and the proposition that, for the purpose of characterising any impugnedtransaction and its effect for the purpose of the preference provisions, the court should look at the 'ultimate effect' of the ' entire transaction' . Justice Gzell was of the view that the decision ofEmanuel and its criticism of cases relied on by Somerset had force. While noting that the issue hadnot been authoritatively determined by a court, Justice Gzell saw no reason why New Cap Reshould be denied the chance to place the case before the court for final determination.

In the court's view, concentration on the issue of the bank's right to reimbursement and right ofrecourse under its security ignored the fact that New Cap Re's funds were depleted in advance ofpayment on the letters of credit. There was a serious issue to be tried as to whether the defendantshad been unfairly preferred and it was not appropriate to dismiss New Cap Re's claim summarily.

The case was appealed unsuccessfully to the New South Wales Court of Appeal. This case andEmanuel make it difficult to be confident that payments from third parties can never be challengedas a preference unless the third party is a volunteer or has not been party to any transaction in thevery broad sense defined by section 9 of the Act (set out in 3 above) which also involves the debtorand creditor.

4. An Update on Unconscionability and the Banking Industry.

This section of the paper sets out, in overview form, an update on the law of unconscionability as itaffects the banking and financial services industry. The acknowledgements section of this paperdoubles as a reading list for those readers interested in better understanding this area of the law.

This is very much a developing area of the law and as such the objective of this section of thepaper is to make the reader aware of the framework within which an unconscionability cause ofaction might be raised and trends in the law

This section of the paper is divided into 5 main areas:…

4.1 An overview of unconscionability: how might it impact on the banking and financial servicesindustry?

4.2 The broader context of unconscionability: one aspect of a mushrooming area ofprotectionism in the law;

4.3 The law of unconscionability: what is the bottom line?;

4.4 A review of what the courts are saying about unconscionability;

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4.5 A practical perspective: safeguards which a financial institution might consider implementing in orderto reduce its risk profile.

4.1 An overview of unconscionability and how it impacts on the banking and financialservices industry;

One of the more interesting judicial developments of the past 20 or so years, has been thedevelopment of the law of unconscionable conduct both by Australian courts, and Stateand Federal parliaments.

These developments have created a new and powerful tool for aggrieved customers ofbanks and financial institutions to hold those institutions liable for conduct, which conductmay or may not be outside the strict contractual relationship between the bank and itscustomer.

This encroachment of the law into the traditionally private business relationship of bankerand customer, has equipped courts to "do equity" as between the parties, which, critically,may mean voiding or rewriting the bank's facility or security documents. The next sectionof this paper will track some of the philosophical undercurrents of the development of thislaw.

As it relates to the banking industry, the law has evolved out of disputes between the bankand the bank's retail customers. However, there is no reason, at least at the jurisprudentiallevel, why commercial customers of the bank cannot utilise this developing area of law.The limited use of this cause of action under the Trade Practices Act 1974 (TPA) to dateprobably has more to do with the $3 million cap of any relief, prescribed under the TPA. Anumber of distinguished commentators consider it possible that section 51AA and 51AC of

the TPA8 may become as prolific a plaintiff's exocet as is section 52 of the TPA.

4.2 Broader context of unconscionability

The law of unconscionability is one of a number of areas of increasing regulation ofcontracts between banks and its customers. Before discussing the details of the law ofunconscionability, it is useful to stand back from the nitty gritty of the law to consider thephilosophy behind this developing law.

There has been, since the industrial revolution, a marked change in the jurisprudenceunderpinning the law of contract, or more particularly the level of state and judicialintervention in the regulation of commercial relations between contracting parties.

Professor Brian Harrigan, a consultant to AAR, summarised this development in four neatphases/phrases:

1. Contract is King: "people can effectively sign their life away – just make sure theysign, so that all the rights in play are locked in tight in the contract".

2. Buyer Beware: "the banking contract will hold up, unless the customer signed itwhile ill, drunk, mad, blind or illiterate".

8 Together with other statutory provisions which are referred to later in this paper.

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3. Rise of Consumer Protection: "The law won't interfere with the banking contractjust because the bank has struck a hard bargain, but make sure you have evidencethat the customer is signing voluntarily and understands what they are signing"

4. Brother's Keeper: "The contract and the surrounding contract both made legally,but banks with unequal bargaining power can no longer simply sit on theircontractual rights and their own commercial self-interest" .

The law is presently somewhere between phase 3 and 4: we are approaching the point intime when the High Court must answer the question whether or not Banks are or should betheir brother's keeper. Certainly, the expansion of the law of unconscionability indicatesthat Banks may well be their brother's keeper, although there has been a cautionary notefrom the High Court in the case of Berbatis to which I shall refer in depth.

At the moment, Australia is experiencing a new mushrooming form of common law andstatutory regulation of what has historically been considered the private business ofcontracting parties. It is based on wishy washy concepts such as "fairness" and"unconscionability". Or, to put it another way, Courts will step in to protect what it sees asdeserving victims of a harsh contract.

One thing is for sure, banks can no longer simply rest on their contractual rights and theircommercial self interest. Nor can a bank rely completely on the customer looking out forhis or her own interest.

In conclusion, the rise of protectionism in the law, in the form of the law of unconscionabilitygives disgruntled customers of a bank another argument to raise to avoid contractualobligations/liability.

4.3 The law of unconscionability: the bottom line

If one were to hazard a guess as to which case has had the most significant impact on theretail banking sector in the last 20 years, then the odds on favourite would have to be theHigh Court decision in Commercial Bank of Australia Limited v Amadio9. This was thelandmark case on unconscionability at Australian law.

In the case of Amadio, the respondents were an elderly Italian couple and their son wasthe principal shareholder and managing director of a building business. He asked them toprovide a guarantee mortgage over their land. The bank was aware that the companywhich the parents were providing a guarantee was in financial difficulty. Ultimately, theCourt held that the Bank's conduct of sitting back in these circumstances and relying onsuch a guarantee was unconscionable. The parents were released from liability under theguarantee.

At its simplest, Amadio established that equity may intervene into a contractual relationshipwhere one party to a contract is at a serious disadvantage and the other party hasexploited this disadvantage to obtain an oppressive contract.

Mason J stated that to make out a case for unconscionable conduct one needs to showthat the will of the weaker party is not independent and voluntary and this is the result of

9 (1983) 151 CLR 447

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the disadvantageous position in which the person is placed and of the other partyunconscientiously taking advantage of that position i.e. it is a:

"[c]lass of case in which a party makes unconscientious use of his superior positionor bargaining power to the detriment of a party who suffers from some specialdisability or is placed in some special situation of disadvantage eg a catchingbargain with an expected heir or an unfair contract made by taking advantage of aperson who is seriously affected by intoxicating drinks."

Since Amadio, there has been a proliferation of cases, including a number featuringAustralia and New Zealand Banking Group. This paper will consider some of the moreimportant of these cases later.

Parliament has also intervened, to amend the Trade Practices Act, 1974 (TPA)10 (and, atthe state level, the respective Fair Trading Acts), and to enact the Australian Securities AndInvestments Commission Act (ASAIC)11, which provisions deal expressly with theunconscionable supply of financial services. To date, there have been few authorities onthe unconscionability provisions of the TPA and the ASAIC, although the ACCC is trying tochange this by commencing a number of test cases. Accordingly, whilst there areconsiderable academic writings on these provisions and whether or not (or the extent towhich) these provisions add to, or detract from, the common law, the law is uncertain.

Professor Horrigan notes a number of developments of the law of unconscionability, mostmaterially:

1 The "house-wife" defence, has been expanded to include other (domestic andcommercial) relationships of trust and confidence;

2 The Amadio inspired notion of "special disadvantage" has been expanded frompersonal characteristics and circumstances (i.e. illiteracy, age etc) to includesituational disadvantage which may arise from a party's legal and financialcircumstances;

3 Potential use of doctrines of duress, undue influence and unconscionability bycorporations to avoid contractual obligations;

4 Potential widening of the law of unconscionability by Sections 51AA and 51AC ofthe Trade Practices Act;

5 Growth of ACCC test cases in the retailing, franchising, banking and medicalindustries;

6 Expansion of "good faith" jurisprudence in the commercial context, including inSection 51AC of the Trade Practices Act;

7 Expansion of liability of legal/financial advisors who wrongly advise the bank'scustomers;

10 Trade Practices Act 1974 – Sect 51AA and 51AC11 Section 12CA and 12CC

mcqs S0111441742v1 150520 7.12.2004

This paper will now look at some banking cases to see the application of the law ofunconscionability in the banking sector, both under the common law, and the High Courtcase of Berbatis (which is a High Court authority on Section 51AA of the TPA)

4.4 Overview of some important precedents on the law of unconscionability as it appliesto the Banking industry

There have been a number of significant and interesting decisions post Amadio. It isbeyond this paper to consider such cases. However, the following cases have beenselected because of their impact on the Banking industry and because they illustrate thecourt's attempt to grapple with the limits of unconscionability (both at common law and asdefined in relevant statutes).

Garcia v NAB12

In this case there were a number of interlocking guarantees and an all monies mortgageover the family home. The wife secured the husband's business debts. The wife was fromtime to time made director/shareholder of the business but the husband completelycontrolled the business.

The evidence before the court was that the wife misunderstood the effect of theguarantee/mortgage. She thought that it was for a limited overdraft purpose. The bankprovided little or no explanation to the wife and she received no independent advice.

Result:

The wife won.

The recent case of ANZ Banking Group Limited v Alirezai13 considered the extension ofthe Garcia "wives' equity" beyond the husband wife relationship. In this case, McMurdo Pof the Queensland Court of Appeal stated:

"I do not understand Garcia to necessarily limit appropriate equitable relief tomarriage or marriage like relationships … special relationships of sufficient trustand confidence in which one party could abuse the trust and confidence so as toinvoke equitable relief for transactions entered into by the other are not a closedcategory, they could, for example, arise in some parent-child relationships orperhaps in a relationship between a disabled person and carer, many otherpotential examples can be envisaged."

In this case the relationship was between Mr Alirezai and a friend of his Mr Sarlak. Theevidence was that Mr Alirezai received considerable support and advice from Mr Sarlak, afellow Iranian. The Queensland Court of Appeal observed that:

"A close friendship between borrowers and surety based on shared cultural andreligious values does not in itself require a banker to do more than what was donehere, namely, ensure the surety obtains independent legal advice on thetransaction."

12 (1998) 194 CLR 39513 [2004] QCA 6 (6 February 2004); BC 2 00400178

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So, whilst the Queensland Court of Appeal has indicated that Garcia may be extendedbeyond narrow family relationships, the weaker party still needs to be able to demonstratethat by reason of this relationship there exists some form of special disadvantage. Thatwas not evident in this relationship.

ACCC Banking Test Case – ACCC v NAB14

In this case, a wife executed a guarantee for herself and her husband using a power ofattorney. Her husband was incapacitated. The guarantee secured loans to the husband'sbusiness. The guarantee was required by the bank as additional security, the bank alreadyhaving a mortgage over the family home.

The wife was neither a director or shareholder of the business and the bank did not explainthe transaction to the wife nor suggested that she obtain legal independent advice. Thebank were aware that the company was in financial difficulties but did not inform the wife ofthese difficulties. That result: ACCC obtained a court order and made a media releaseagainst NAB.

Spira v CBA – Corporate Finance15

The bank provided finance to a corporate group, with the prospect of floating on the ASX.The facility was guaranteed by the managing director. The offer letter (but not theexecuted documents) limited how amounts could be used. The bank refused to draw downfor work in capital. The company required urgent funds.

Both parties mistakenly believed that the borrower was in actual breach of facilityagreements as distinct from foreshadowed breaches. The actual breach would allow thebank to refuse finance. The bank said it was entitled to appoint a receiver. The group,because of the threat of the appointment of a receiver, agreed to an amended financearrangement. Both the group and the manager sued under the facility agreements and theguarantees claiming there was an implied good faith term in the contracts, and on that theconduct of the bank was unconscionable.

Result:

The bank won. Whilst it was held that the bank had breached the contract by refusing thedraw down, no damages flowed from this breach. The guarantor was not under a specialdisadvantage and the bank's conduct surrounding the amended finance arrangements wasnot unconscionable.

ACCC –v- CG Berbatis16

Berbatis is an important case because the High Court considered the issue of whether ornot TPA (and implicitly ASAIC) unconscionability is broader than the common law. If so, a

14 unreported Federal Court 200115 (2003) ATPR (Digest) 46-23716 [2003] HCA 18

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plaintiff's exocet of the magnitude of section 52 of the TPA would indeed have beenlaunched.

Berbatis Holdings Pty Limited was the landlord of a retail shopping centre. There was adispute between the landlord and a number of tenants, which resulted in litigation. Duringthe course of the litigation, the lease of one of the tenants (the Roberts) was due to expire.The Roberts had arranged for their business to be sold but such sale was contingent uponthem obtaining a renewal of the lease. The Roberts were under considerable financial andemotional stress, particularly because of a family illness. Berbatis knew these facts.

Berbatis agreed to renew the lease however upon the condition that the Robertsdiscontinue the litigation. The Roberts agreed to this. However, the ACCC broughtproceedings on behalf of the Roberts alleging that the conduct of Berbatis wasunconscionable in accordance with section 51AA of the TPA. At first instance, the Courtheld that Berbatis had unfairly exploited the specific vulnerability of the Roberts and hadthereby acted unconscionably. The Full Federal Court overturned this decision and theHigh Court agreed with the Full Court of the Federal Court. Significantly, the majority of theHigh Court gave a narrow interpretation of the term "unconscionability".

The reasoning of the majority of the High Court focused on the difference between thenotions of "special disability" and a "hard bargain". In this case, the Court found that whilstthe Roberts were at a distinct disadvantage in their negotiations with Berbatis there wasnothing "special" about this disadvantage and therefore they considered the transactionwas an example of a difficult commercial decision. The majority noted that to sustain acomplaint of unconscionable conduct under section 51AA, it was necessary for theApplicant to establish that the special disadvantage resulted in the loss of the weakerparty's capacity to make a judgment about their best interests.

The decision of the High Court in Berbatis sends a negative signal to small business andconsumers about the utility of TPA unconscionability. The ACCC expresseddisappointment at the judgment of the High Court. However, all is not lost for smallbusiness and consumers, section 51AC of the TPA gives the notion of unconscionability apotentially wider meaning than section 51AA. Having said this, the reasoning of the Courtin Berbatis in applying section 51AA would seem equally applicable to section 51AC.

In short, it appears that for the moment at least, statutory unconscionability is no more orless broad than the common law inspired unconscionability.

4.5 How can the bank protect itself from unconscionability proceedings?

The first and most important step that a bank can take in protecting itself from an allegationthat it has acted unconscionably is to ensure that the bank's customers receivesindependent legal advice about the facility and security document. Some cases raise thespectrum that a prudent bank should also consider ensuring that customers receiveindependent financial advice, especially in circumstances where the Bank doubts thefinancial stability of the customer. If independent legal and financial advice is obtainedthen another stratum of comfort is added to the equation.

Normally a court will not second guess an independent certificate unless it is clear that:

• the solicitor/accountant wasn't really "independent";

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• there was no time for adequate advice;

• solicitor/accountant did not have any relevant financial information and legaldocuments;

• something in the certificate is patently wrong; and

• security provided a signing under influence or duress.

In summary, obtaining independent advice remains the best safeguard for a bank but it willnot guarantee completely a successful defence to an unconscionable cause of action. Forexample, that:

• the bank does not have adequate evidence of the certificate/declaration;

• the bank knows something crucial which the guarantor and the solicitor/accountantdoes not know;

• the bank knows or should know that the guarantor is being pressured, badgered,mislead etc or displays a lack of understanding to bank officers, whatever the solicitor'scertificate says;

• the bank's own conduct is at fault, above and beyond whether the guarantorunderstands what is going on; and

• financial advisor is needed and only legal advice is recommended/obtained.

If one proceeds upon the premise that an independent legal/financial certificate does notprovide an absolute shield to an unconscionable cause of action, it is important for banks todo internal stocktakes of practices, documents and guidelines, at least for the most highrisk operations i.e. unsophisticated customers, or where the Bank knows that the customer(or guarantor) is at a special disadvantage in their negotiations with the Bank such that thecustomer is not acting in an independent or voluntary way.

It is important to note that weaker parties is not limited to Mums and Dads, commercialcounterparties may seek to establish unconscionable conduct: see for example the Boral

Formwork case17 in which Boral sought to establish that a demand under a standby letterof credit was unconscionable. The Spira case is another example (albeit unsuccessful) ofthe attempted application of unconscionability in the business sector.

The risk of a facility or security document being voided or rewritten by a Court cannot beavoided through careful drafting of such documentation. Accordingly a compliance systemneeds to be robust to ensure that when processing loan applications, signing loans/securitydocuments, servicing/re-documenting, prudent practices are followed by the bank officersand that these practices are monitored at each of these stages. Monitoring should alsohave regard to legal developments such as the ACCC and ASIC actions and test cases.

17 Boral Formwork Scaffolding Pty Ltd –v- Action Makers Ltd (in Administrative Receivership) [2003] NSWSC 713 (5 August2003)

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5. Corporate Benefit: When Banks assume duties and liabilities asdirectors of their clients

"the third party calls the tune and the directors dance in their capacity as

directors"per Wells J in Harris v Standard (1976) 2 ACLR at 64

A bank may exercise control over the management and financial affairs of the borrowercompany. This control will be exercised in circumstances where the borrower companyapproaches insolvency. In these circumstances, a borrower company may by inaction oracquiescence, allow a bank to effectively make strategic decisions on behalf of it and it,effectively, simply rubber stamps those decisions. Pursuant to the definition of "director" inthe Corporations Act, the bank may then become, even though not formally appointed, ade facto or shadow director of the borrower company with all the potential liabilitiesassociated with the holding of such a position.

In a litigation context, the identification of directors of companies becomes relevant when,for example:

• a plaintiff endeavours to establish loss caused by breach of directors'duties;

• or where either a liquidator (or, in limited circumstances, creditors) of aninsolvent company brings an action against the directors of the companyfor insolvent trading within the meaning of Part 5.7B of the Act.

The risk of this is increased when one considers the attractiveness for a creditor of aninsolvent , or fast approaching insolvent, company to be able to treat a bank as a directorand therefore seek to have their debt or claim extinguished by the bank.

As will be discussed, what needs to be analysed to see whether a third party is a defacto orshadow director is the degree of control.

5.1 Brief description of director's duties

(a) Fiduciary

In broad terms, fiduciary duties can be categorised as matters of “good faith”. Essentiallythey prevent directors putting their own interests before those of the company or ignoringmatters which the courts believe a prudent director would have regard for.

The four main fiduciary duties are listed below with the main being that of the duty of goodfaith. That is, each of the other duties listed amounts to a breach of the duty of good faith.It therefore appears that a director must breach his/her duty of good faith to breach his/herfiduciary duty. Directors must:

• act in good faith

• exercise their powers for the purpose for which they are conferred and notfor any collateral or improper purpose

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• not fetter the future exercise of their powers; and

• avoid being placed in a position of conflict of interest.

The duty of good faith is owed by each director individually and, broadly speaking, is owedto the company itself rather than to individual shareholders (Percival v Wright (1902) 2 Ch421).

(b) Director's duties pursuant to the Corporations Act 2001

In addition to the fiduciary duties discussed, there are duties of directors which are derivedfrom common law and statute, specifically under Part 2D.1.

It is not proposed that this presentation explore in detail the consequences, risks,obligations and duties of directors generally. Of particular note, however, are director'sduties in relation to insolvency.

Section 588G of the Corporations Act 2001 entitled "Director's duty to prevent insolventtrading by company" imposes civil liability on persons who were directors when thecompany incurred a debt in circumstances amounting to insolvent trading. Liability arises ifthe company was insolvent at that time or became insolvent as a result of the debt, and thedirector was aware that there were reasonable grounds for suspecting that the companywas insolvent or would become insolvent as a result of the debt. The section imposes anobjective standard by providing for liability if a reasonable person in the position of adirector of a company in the circumstances of that company would have been aware thatsuch grounds existed:

(1) This section applies if:

(a) a person is a director of a company at the time when the company incurs a debt;and;

(b) the company is insolvent at that time, or becomes insolvent by incurring that debt,or by incurring at that time debts including that debt; and

(c) at that time, there are reasonable grounds for suspecting that the company isinsolvent, or would so become insolvent, as the case may be; and

(d) that time is at or after the commencement of this Act.

and s588M deals with recovery of compensation for loss resulting from insolvent tradingimposes civil liability of a director through an action by ASIC:

(1) This section applies where:

(a) a person (in this section called the director) has contravened subsection 588G(2) or(3) in relation to the incurring of a debt by a company; and

(b) the person (in this section called the creditor) to whom the debt is owed hassuffered loss or damage in relation to the debt because of the company'sinsolvency; and

(c) the debt was wholly or partly unsecured when the loss or damage was suffered;and

(d) the company is being wound up;

whether or not:

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(e) the director has been convicted of an offence in relation to the contravention; or

(f) a civil penalty order has been made against the director in relation to thecontravention.

(2) The company's liquidator may recover from the director, as a debt due to thecompany, an amount equal to the amount of the loss or damage.

(3) The creditor may, as provided in Subdivision B but not otherwise, recover from thedirector, as a debt due to the creditor, an amount equal to the amount of the loss ordamage.

(4) Proceedings under this section may only be begun within 6 years after thebeginning of the winding up.

Potential shadow or defacto directors should also note ss588FA and 588FJ, under whichthe liquidator may seek, by court order, to avoid certain transactions preceding winding upand recover assets for the benefit of creditors.

Another provision of potential concern is s180(1) of the Corporations Act 2001 whichprovides civil penalty liabilities against directors who do not act with reasonable care in thecompany's circumstances in attending to the affairs of the company. Section 180(1) states:

(1) A director or other officer of a corporation must exercise their powers and dischargetheir duties with the degree of care and diligence that a reasonable person wouldexercise if they:

(a) were a director or officer of a corporation in the corporation's circumstances; and

(b) occupied the office held by, and had the same responsibilities within the corporationas, the director or officer.

5.2 Definition of "director" in Corporations Act

The definition of "director" is encapsulated in s9, being the Definition section, of theCorporations Act 2001. Section 9 reads as follows:

"Director" of a company or other body means:

(a) a person who:

(i) is appointed to the position of a director; or

(ii) is appointed to the position of an alternate director that is acting in thatcapacity,

regardless of the name that is given to their position; and

(b) unless the contrary intention appears, a person who is not validly appointed is adirector if:

(i) they act in the position of a director; or

(ii) the directors of the company or body are accustomed to act in accordancewith the persons instructions or wishes.

Subparagraph (b)(ii) does not apply merely because the directors act on advice given by theperson in the proper performance and functions attaching to the person's professionalcapacity, or the person's business relationship with the directors or the company or body.

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5.3 Difference between a shadow and de-facto director

• Defacto director (s9(b)(i)): although not validly appointed as a director anyperson who acts in the position of director will (unless the contrary intentionappears) be a "director" of the company or body.

• Shadow director (s9(b)(ii)): although not validly appointed as a director,any person with whose instructions or wishes the directors of the companyor body are accustomed to act, will (unless the contrary intention appears)be a "director" of the company or body.

6. When does this issue arise in a commercial context?

"Control" by a lender over a borrower company should not be a problem or legal issuewhen, in normal circumstances, the payments and conditions of the loan or facility arebeing promptly met by the borrower company. The problem largely arises or could arise, inthe case of the defaulting or struggling borrower company. In this case, the lender haseffectively 3 main choices.

6.1 Defaulting or struggling borrower company

• the bank may act on its security and appoint a receiver, alternatively anadministrator may be appointed:

the problem in this scenario is that the bank may lose money in a "liquidation type"sale of the borrower company's business as well as possible professional costs(including legal and accounting) and possible loss of value of business in a "firesale";

• the bank may extend or continue the credit facility and, provided that"control" is not linked to the extension of the facility and the bank remainsat arms length, does not pose, in theory, a problem with regard to banksbeing defined as defacto or shadow directors.

The advantage of this choice is that the lender again remains at arm's length andhas strictly limited involvement. The downside is the lender may even furtherfinancially expose itself, and therefore incur greater losses; OR FINALLY (andmost relevant for our purposes)

• the bank may attempt to guide the borrower company in a "work out": thebank may extend or continue the credit facility, and as an express orimplied condition, it may attempt to guide a borrower company. It couldeven instruct and closely support an adviser appointed to rehabilitate afailing or struggling borrower company. This is where a problem may ariseas this interaction may amount, in certain circumstances, to undue control.

The line between what is acceptable to properly protect the interests of the bank and whatis improper control is difficult to determine. Is the bank or the bank's representative,perhaps agent, merely monitoring the borrower company in its best interests? or is the

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borrower company being controlled by the bank – is the bank giving orders rather thensuggestions? Here, lies the problem and the possible liability.

7. Test

The question to be asked is whether from time to time the bank represents the directingmind and will of the borrower company and thereby controls the borrower company. If thisis the case then the bank could incur liability as a so called "shadow" or "de facto" director.The directing mind in control of a borrower company is in all cases a question of fact and/ordegree. The basic test is whether the bank has been entrusted with the exercise of thepowers of the borrower company. As stated by Owen J in Bank of Western AustraliaLimited v Ocean Trawlers Pty Limited:

"The directors may, outside the articles in the general meeting, by habit or customary courseof business entrust to a person outside the board, wide powers and authorities that couldconstitute control or direction in the relevant sense."

and as clarified by Deputy Commissioner of Taxation v Austin (1998) 16 ACLC 1,555(which will be discussed in a moment), a necessary condition to be acting as a director isthat one must exercise "top level management functions".

It is suggested that for there to be "control" over the financial affairs and management of aborrower company, the control must extend to the central management of the affairs of thecompany, as opposed to the management of particular activities of a company's day-to-dayroutine and trading or administrative affairs. For example in the case of Austin (which willbe discussed) the example was given of a large supermarket business; while the generalmanager of a store may possess qualities that a director may have (eg signing chequesand/or hiring and firing staff), the general manager, in these circumstances, would not bedeemed to be a defacto or shadow director without more. This is due to the fact that theGeneral Manager's control does not extend to central management. Alternatively, in asmall business, these characteristics could indeed be indicative of a director.

This illustrates that each case will have a different threshold test depending upon,predominantly, the character of the borrower customer's business. It also has the effectthat an all encompassing list of factors to fulfil this test does not exist.

8. Case law

In Australia, there are no reported decisions holding a lender (with no significant shareholding in itsborrower) directly liable as a shadow director of its borrower company, however the potential riskstill exists due to the existence of s9 and the manner in which s9 has been applied. The cases ofAntico and Austin are 2 examples of the most persuasive authority in Australia to date and havecontinued to be considered and applied. This is evident in the more recent cases of Natcomp andMuriwai.

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8.1 Standard Chartered Bank of Australia Ltd v Antico (1995) 38 NSWLR 290 ("Antico")

Supreme Court of NSW: Hodgson J

The issue of the potential liability of a lender as a shadow director was considered in thedecision in the Supreme Court of New South Wales in Antico.

In this case, the bank provided A$30 million facility to a listed public company namedGiant. Subsequently the financial position of Giant declined. During this period, Pioneer(another listed public company) held 42% of the shares in Giant, had 3 nominees on theBoard and provided funding to Giant on an increasing basis. The 3 nominee directors werealso directors of Pioneer. Additionally, the bank extended the facility but was not advisedof the security provided to Pioneer by Giant and was only given minor information aboutthe funding by Pioneer.

Later, Giant indicated to the Bank that it could not meet its obligations under the Facility,and the Bank agreed to provide extended financial accommodation to Giant. Winding upproceedings commenced in relation to Giant and the Bank, at this stage, had only receivedsome of the interest that was due to them and a $3.4 million reduction of the principal.

The Bank sued Pioneer and its 3 nominee directors for insolvent trading. In order to findPioneer in breach of the insolvent trading provisions of the then Corporations Law, theCourt had to decide whether Pioneer was a director of Giant.

Hodgson J decided that Pioneer was never appointed a director of Giant but, nevertheless,was occupying or acting in the position of director, or as a company in accordance withwhose directions or instructions the directors of Giant were accustomed to act. Pioneerhad shown, by its conduct, control over the management and financial affairs of Giant.

It is arguable that this case can be distinguished as Pioneer was a major shareholder inGiant and there were no other significant shareholders in Giant. However, the case shouldbe noted and viewed as a warning but not an "all-out" assault on the security of banks withregard to liability as a "director".

8.2 Deputy Commissioner of Taxation v Austin (1998) 28 ACSR 565

Federal Court of Australia: Madgwick J

In this case, Talljade entered into liquidation and the liquidator commenced proceedingsagainst the Deputy Commissioner of Taxation ("DCT") for the recovery of payments ofgroup tax and penalties as unfair preferences within the meaning of s588FA and thusvoidable under s588FE.

Orders were made in favour of Talljade.

Subsequently, the DCT, as cross-claimant, sought to be indemnified by Mr Austin as adefacto director under s588FG. Section 588FG provides that, when such a preferencepayment is made and the court makes an order against the DCT, then the directors of thecompany (with presently immaterial exceptions) are liable to indemnify the DCT.

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(a) Mr Austin's involvement

Talljade was a small company of two family run restaurants. Originally, Mr Austin wasappointed a director but retired, however, by an oversight on behalf of Talljade'saccountant, the ASIC form (then the ASC) was never lodged.

Regardless of Mr Austin's resignation, Mr Austin:

• signed agreements with the DCT and had the authority to do so by thecompany;

• counter signed cheques and authorised stop notices; and

• continued to negotiate on behalf of the company.

The issue was therefore, was Mr Austin a director?

(b) Judgment

Mr Austin was deemed to be a director.

• Top level management: The Court held (at 569):

"Thus it seems to be a necessary condition of acting as a director, whether properlyappointed or not, that one exercises what might be called the actual (and statutorilyextended) top level of management functions. However, that is not necessarily asufficient condition for such a conclusion, nor is it the same as saying that one mustdo things which only a director can do."

• Small companies: With specific regard to small companies the Courtstated (at 570):

"If, in the case of a small company, a person has, with full discretion, “acted as thecompany” in relation to matters of great importance to the company, and other thanas an arms' length expert engaged for a limited purpose, the conclusion that thatperson has acted in the capacity of a director may well be justified. The extent towhich and the circumstances in which the person has so acted will nevertheless beof importance."

This means that in relation to a small company, if a third party has acted:

• with full discretion; and

• other then at arm's length

The third party may be a director, subject to the circumstances.

• With specific regard to a large company, the Court discussed theconsiderations relevant to criminal liability of corporations and specificallyreferred to Tesco Supermarkets Ltd v Nattrass [1972] AC 153 which wasconcerned with the breaching of consumer protection law. Madgwick Jstated (at 570):

"In a large and diversified company, great discretion to deal with very importantmatters must be reposed in employees. In the case of a supermarket chain, as inTesco, it would hardly occur to anyone to suggest that a managerial employee heldto have “acted as the company” in breaking a consumer protection law at aparticular store was acting as a director of the vast company concerned. As

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suggested above, in the case of a single person making decisions for a companythe business of which was confined to the operation of a corner store, a differentview might be taken."

Madgwick J used this example to illuminate that while certain authority may besufficient to deem an individual a director in a small company it will not necessarilybe sufficient to do so in a large and diversified company. This reiterates the pointthat there is not an all-encompassing list of factors or a single test to be applied,rather each company and facts must be analysed individually.

• The perception of others: The Court also held that another relevant factormay be how the person who is claimed to have acted as a director wasreasonably perceived by outsiders who deal with the company. This mayaid a conclusion that the supposed director has held himself or herself outas such (at 570).

Generally, while the Court deemed that the variety of commercial and corporate life is suchthat it is unprofitable to attempt a general statement as to what is meant by "acting as adirector", whether a person does so act will often be a question of degree, and requires aconsideration of the particular company concerned (at 570).

8.3 Natcomp Technology Australia Pty Ltd v Graiche [2001] NSWCA 120 ("NatcompCase")

NSW Court of Appeal: Spigelman CJ, Stein and Heydon JJ

One of the more recent cases that has considered de facto and shadow directors in asuperior court in Australia is the Natcomp Case.

Natcomp had supplied computer equipment to Amtech which was a small company andwas operated by only 2 people. Amtech subsequently entered into liquidation in late 1996and Natcomp sought to recover the price of the computer equipment that it had delivered toAmtech from the directors of Amtech.

Dr Graiche was a medical practitioner and had an association with Amtech as follows:

• Graiche accompanied the directors of Amtech and the Managing Directorof Natcomp to a trade fair in Taiwan in June 1996, during which Graichemade frequent use of the term "we at Amtech".

• During the fair, Graiche had distributed a business card carrying the logo ofAmtech, which described him as the "CEO" of the Company, which in theview of the Court was intended to mean the Chief Executive Officer.Graiche subsequently claimed that the reason he used these cards was inorder to deal with the exhibitors at the trade fair for his own purposes, andobtain technical information.

• Evidence was produced by a number of third parties that they had hadconversations with Graiche in which he had said that "he was the personwho made the decisions at Amtech".

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• On at least one instance Graiche had paid for computer equipment orderedby Amtech and paid for it in cash. At the time Graiche had said that he hada financial interest in Amtech.

• At a meeting between the directors of Amtech, Graiche and an advertisingagency, Graiche was introduced as the Company's business advisor, hehad contributed financially to the company. At a later meeting, Graichewas introduced as "the brains behind Amtech".

• Graiche had lent $18,000 to Amtech for a short period.

• The trial judge held that Graiche was not a director for the purposes of theCorporations Act 2001. Natcomp appealed.

The leading judgment in the case was delivered by Stein J. The Court applied Austin anddecided that:

• indications that a person may be a "director" despite the absence of formalappointment require a consideration of the duties performed by that personin the context of the operations and circumstances of the particularcompany concerned (Natcomp Case at 13; Austin at 569);

• in a large and diversified company, great discretion to deal with importantmatters must be reposed in employees. So, for example, a manager of alarge supermarket would not be considered a director of the companywhere the supermarket is but one of many operated by the company(Natcomp Case at 13; Austin at 569);

• a relevant issue may be the reasonable perception of the person who isclaimed to have acted as a director by outsiders who dealt with thecompany (Natcomp Case at 13; Austin at 570). To that extent, the fact thatthe person holds himself or herself out as a director is relevant to a findingas to the person's status as director or otherwise (Natcomp Case at 13)

It was found that Graiche's involvement with Amtech was apparently limited to an interestin the development and marketing of possible new products and this was insufficient tobring Graiche within the definition of "director". Accordingly the appeal was dismissed.

The result is surprising as the facts indicate that Graiche wielded real authority in Amtechand had permitted third parties to perceive him in that capacity. Unfortunately, inconfirming the decision of the trial judge, the Court did not explain why Graiche did notcome within the definition of defacto director. However this case does do two things:

• it reaffirms the principles espoused in Austin; and

• it indicates that the threshold to be considered a defacto or shadow directoris high and therefore provides some security for lenders.

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8.4 Deputy Cmr of Taxation v Muriwai; Deputy Cmr of Taxation v Solomon [2003]NSWCA 62 (Unreported, 24 April 2003)

NSW Court of Appeal, Handley, Sheller JJA, Gzell J

The Natcomp Case, as well as Austin has been considered and applied in Deputy Cmr ofTaxation v Muriwai; Deputy Cmr of Taxation v Solomon [2003] NSWCA 62 (Unreported,NSW Court of Appeal, 24 April 2003 Handley JA, Sheller JA, Gzell J) ("Muriwai").

In this case, two related companies failed to remit to the Commissioner of Taxation PAYEdeductions. Pursuant to s222AOB(3) (which relates to such payments):

"If this section is not complied with on or before the due date, the persons who are directorsof the company from time to time after the due date continue to be under the obligationimposed [to make such payments]"

Dr Solomon was a re-appointed director of both of the relevant companies butsubsequently resigned. However, Dr Solomon continued to act in the interests of thecompanies. The evidence was that he:

• had daily contact with directors;

• had the right of approval of the sale of the Singapore operations;

• attempted to generate revenue from stock sales;

• had an active involvement in the preparation of projected cash flows;

• had an active involvement in an arrangement with the ATO to receive areduction of the group's taxation liabilities; and

• had an active involvement with the employees of the companies.

Mr Muriwai was a director who subsequently resigned but he remained on with thecompanies as an employee "to try to manage a way out of the [companies' financialdifficulties] but not as a director" (at para 22). Mr Muriwai also:

• had conversations with Dr Solomon about the running of the companies;

• had involvement in the preparation of projected cash flows;

• entered into negotiations with various directors and third parties for theobtainment of funds to be injected into the companies to avoid liquidation;

• was attempting to convince the directors of the companies to place theminto liquidation or administration;

• had involvement with the employees of the companies and instructions tothe employees which the employees treated as superior to the instructionsgiven by the directors of the company;

• was seeking financial advice and legal advice on behalf of the companies

Various issues were raised in Muriwai but the relevant issue for our purposes was whetherDr Solomon and/or Mr Muriwai were defacto or shadow directors at the relevant time andthereby liable for the debt to the Commissioner of Taxation?

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The Court considered Austin and the Natcomp Case and held that Dr Solomon and MrMuriwai were directors of the companies pursuant to s9 of the Corporations Act 2001 (atapara 47):

In Deputy Commissioner of Austin (1998) 28 ACSR 565 Madgwick J identified performanceof top level management functions, acting as the company in matters of great importanceand the reasonable perception by outsiders that a person was a director of the company asfactors in determining whether the extended definition in s60 of the Corporations Lawapplied. Those observations were endorsed by this court in Natcomp Technology AustraliaPty Ltd v Graiche (2001) 19 ACLC 117."

With regard to Dr Solomon, it was argued that the facts indicated a similar situation to DrGraiche in the Natcomp Case. However this submission was not successful as the Courtdistinguished the facts in this case on the basis that Dr Graiche was not involved in thecompany's main activity of retail sale of computer packages, his involvement being limitedto the development and marketing of new products. By contrast, the Court found,Dr Solomon was involved in the main activity of the companies.

The significance of this case is two-fold:

• firstly it reaffirms the authority of Austin and the Natcomp Case; however

• by distinguishing the Natcomp Case on the basis that a defacto or shadowdirector must be involved in the "main activity" of the company.

8.5 Summary of factors

The cases indicate that the individual characteristics of the borrower-company andborrower-lender relationship will determine whether a bank, in a specific situation, is ashadow or de-facto director. There is therefore no well-defined set of elements that mustbe proved before liability is imposed on a lender as a de facto director. Instead, an open-ended list of factors for cumulative consideration has developed18: These factors can notbe considered in isolation and many of them would not, without more, result in a lenderbeing considered a defacto or shadow director, nonetheless they have been considered bythe Court to be indications of the requisite "control". The factors can be categorised into"factors indicating control" and "factors related to an equitable interest". As you will note,many of the factors are common to many agreements that are entered into by lenders.These are indicated in bold text.

(a) Factors indicating the control of the lender

• the lender has effective control through major (not necessarily majority)shareholdings in the borrower company;

• the lender effectively controls a selection of the borrower company's Board ofDirectors;

• decisions of the borrower company are being influenced by the "bestinterests" of the lender;

18 As listed in Mark Stoney LLB, LLM.; Borrower Companies Approaching Insolvency – The Potential Liability of the Lenderas a De Facto Director.; (2000) 8 Insolvency Law Journal 192 (however the list has been added to pursuant to recent cases)

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• the lender directs the directors of the borrower company how to act and thedirectors act as directed;

• the borrower company invites the lender to take over or fails to object whencontrol measures are imposed by the lender;

• the lender controls the borrower company's disbursements and decides whichbills to pay;

• the lender is able to control the borrower company's income or sales;

• the lender places its own employees or its agents in the borrower company'sbusiness;

• the lender participates in the daily operations of the borrower company'sbusiness;

• the lender controls (whether through a management change clause inthe security documentation or otherwise) the selection of the borrowercompany's management;

• the lender has the right to, or actually exercises, veto power over the borrowercompany;

• the lender controls the borrower company's stock;

• the lender insists that the borrower company accept some third party to act asthe borrower company's "consultant" or "adviser" to assist in the "recovery" ofthe borrower company;

• the lender negotiates an informal moratorium with the borrower company'strade creditors;

• the lender negotiates with regulators on the borrower company's behalf;

• the lender initiates or implements a scheme designed to minimise theborrower company's liability for income tax;

• the lender conducts or assists in negotiations for the takeover of the borrowercompany;

• the lender orders or purchases goods and services for the borrower companyand is involved in the sale of the borrower company's products or services;

• the lender is involved in, or consulted with (or has some form of power ofveto), with respect to the hiring and firing of staff and advising on labour forcetransfers;

• major strategic decisions concerning the borrower company (such asthe acquisition or abandonment of acquisition, or sale or disposal, ofmajor assets) are made by, negotiated by, investigated by, delayed by orsubstantially influenced by, the lender rather than the borrowercompany;

• the lender is involved in the main activity of the company;

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(b) Factors indicating the dependence of the borrower company

• the borrower company is totally dependent on the lender for its finances;

• the lender is attempting to act in good faith for the mutual benefit of theborrower company, the borrower company's other creditors and itself ratherthan for its own benefit alone;

• for the most part, the directors abandon their decision-making role and regardthe lender (or a consultant appointed by the lender) as a shadow, or even themanaging director.

(c) Factors related to an equitable interest

• the lender has a security interest in most or all of the borrowercompany's assets;

• the lender imposes various restraints on the borrower company, such asrequiring the lender's approval before making capital improvements orencumbering assets or making new financial commitments;

• the lender becomes a signatory on the borrower company's bankaccount and thereby controls its bank account through the bankmandate;

• decisions to fund the borrower company, on the basis of appropriate securityprovided by the borrower company, are effectively made by the lender andsimply accepted by the borrower company;

(d) Factors related to supervision of the borrower company

• the lender imposes the requirement for financial reporting and financialdata by the borrower company;

• the lender conducts regular checks, audits, or visits to the borrowercompany's business;

• the lender monitors the borrower company's trading on a regular basis;

• the lender requires the borrower company to liaise with the lender with respectto the daily management of the company;

Taken in isolation, none of the factors outlined above would necessarily evidence theinference that a lender was a de facto or shadow director of its borrower company.However, the factors must be taken together. As Vinelott J stated in Re Tasbian Ltd (No 3)which is an English case in which an agent who was appointed by a bank was held to be adefacto director:

"The dividing line between the position of a watchdog or adviser imposed by an outsideinvestor and a de facto or shadow director is difficult to draw..."

9. Recommended course of action

The issue of the liability of a bank as a shadow or de facto director and thereby being subject to theduties of a properly appointed director at law remains both difficult and uncertain and it is

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suggested that appropriate risk management, through the maintenance of an arm's lengthrelationship, is the most prudent course. For example:

• when dealing with parties always express, preferably in writing, that the agent or bank isnot a director of the borrower company;

• always deal at "arm's length" and a "hands off" is the most prudent course however iflender feels necessary to get involved - it should be limited involvement and assistancepreferably with prior legal advice (advice and suggestion may be given but not a direction).A justifiable business interest does not grant an absolute right to unduly interfere with theaffairs of a borrower company

• if an external consultant (or adviser) is appointed - ensure that the borrower company itselfappoints the consultant and the consultant is not directed or instructed by the lender.Additionally, the lender must not require the borrower company and/or the consultant tofollow strategies devised by the lender;

• consultant's terms of appointment (and all subsequent dealings with the borrower) clearlyshow that advice rather then directions or instructions are being offered.

• if a bank is to cause the borrower company to engage a consultant chosen by the bank(which is not recommended), the lender should once again avoid express directives orinstructions to the consultant to minimise any suggestion of agency and to minimise anysuggestion that the decisions emanate from the lender company itself.

10. Conclusion on when Banks assume duties and liabilities as directorsof their clients

In the event that a court did determine that a lender had crossed the indistinct dividing line and hadbecome a defacto director of its borrower company, then a host of statutory and common lawobligations and duties come into play with potential legal consequences and risks to the lender. Itis clear that a defacto and shadow director is subject to the same liabilities and penalties as is adirector who is properly appointed in law. However banks can take some security in the recentcase law which reflects the hesitancy of the Court in deeming a third party a defacto or shadowdirector, however, the interplay of the definition of "director" in s9 and the liabilities of directorsresults in a risk that should be managed. It may be simply a matter of time before a cause of actionbased upon a bank as a defacto or shadow director is brought.

11. Conclusion

This paper has looked at a range of topical insolvency issues of which we think banks should beaware. It has examined each of:

• the new reporting obligations which auditors have to ASIC;

• some securities issues: registration of charges and attacks on charges as voidabletransactions;

• whether payment by a third party or under a bank guarantee or letter of credit can ever bean unfair preference;

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• an update on unconscionability and the banking industry; and

• when banks assume duties and liabilities as directors of their clients.

NOTE: This document is intended only to provide a general review on matters of concern orinterest to readers. The text of this document should not be relied upon as legal advice. Mattersdiffer according to their facts. The law changes. You should seek legal advice on specific factsituations as they arise. Parts of this paper have been extracted from the Allens Arthur RobinsonAnnual Reviews of Insolvency and Restructuring Law 2002 and 2003.

Visit our website, www.aar.com.au, for:

• An electronic, fully-searchable version of this paper;

• Past papers presented at Allens Arthur Robinson Corporate Insolvency & RestructuringForums and Insurance Forums;

• The 1999, 2000, 2001, 2002 and 2003 Annual Reviews of Insolvency & Restructuring Law; and

• The 1999, 2000, 2001, 2002 and 2003 Annual Reviews of Insurance & Reinsurance Law.