Section 588FDA: indirect benefits to directors risk voiding a mortgage transaction

Written by Pravin Aathreya (Partner) and Lauren Connolly (Associate)

Cooper as liquidator of Runtong Investment and Development Pty Ltd (in liq) v CEG Direct Securities Pty Ltd [2024] FCA 6

In this decision, the Federal Court held that the pre-liquidation grant of a mortgage by a company to the defendant company was an unreasonable director-related transaction under section 588FDA of the Corporations Act 2001 (Cth) (Corporations Act). The case highlights the vulnerability to attack of such related-party transactions, insofar that they confer an indirect benefit to the company’s directors via reduced liability under personal guarantees without any reciprocal benefit to the company.

Background

The plaintiff liquidator of Runtong Investment and Development Pty Ltd (Runtong) brought proceedings against CEG Direct Securities Pty Ltd (CEG).

Runtong was the owner of land located in South Australia. As part of acquisition of the land in October 2012, Runtong granted a mortgage to NAB. Two years later on 12 December 2014, Runtong executed a mortgage over the land in favour of CEG, who registered the mortgage (CEG Mortgage).

The CEG Mortgage transaction was part of a series of securities provided to CEG to secure borrowings by two other companies, Australian Datong Investment & Development Pty Ltd (Datong) and Futong Investment and Development Pty Ltd (Futong). Runtong, Datong and Futong shared two common directors, and each of the three companies also had other directors. The borrowings by Datong and Futong totalled over $15 million. The two common directors had also previously given personal guarantees guaranteeing the repayment of the borrowings by Datong and Futong to CEG (Prior Guarantee).

The company’s liquidator contended that the transaction was voidable as an unreasonable director-related transaction within the meaning of s 588FDA of the Corporations Act. The plaintiff argued that the CEG Mortgage was made to CEG for the benefit of the common directors by reducing their contingent liability under the Prior Guarantee.

CEG called an insolvency practitioner, Ms Robyn Karam, as an expert witness in its defence. CEG argued (in reliance on that expert evidence) that Runtong’s granting of the CEG Mortgage was not unreasonable given the taking of cross-securities is common in the commercial world in circumstances where the security available from the borrower is inadequate.

Issues

The key issue before the Court was whether a reasonable person in Runtong’s circumstances would have entered into the transaction. The Court also had to address whether the CEG Mortgage transaction was made to a person on behalf of, or for the benefit of, a director of Runtong within the meaning of s 588FDA(1)(b).

Findings

Justice O’Sullivan held that the grant of the CEG Mortgage was an unreasonable director-related transaction.

The Court found that given the directors were personally liable under the Prior Guarantee, any reduction in their personal liability occasioned by the realisation of any security had to be to their benefit. The transaction conferred an indirect benefit upon the directors, meeting the requirements of s 588FDA(1)(b). Justice O’Sullivan also noted that the fact that CEG benefited from the CEG Mortgage did not mean that the directors did not also benefit. 

In determining the question of whether a reasonable person in Runtong’s circumstances would have entered into the transaction, Justice O’Sullivan held there was no evidence that revealed any adequate commercial explanation for the transaction or any benefit to Runtong (including the existence of any apparent need by Runtong to borrow money). The Court did not accept Ms Karam’s opinion that it was reasonable for Runtong to enter into the CEG Mortgage in the circumstances existing at the time of the transaction.

The Court emphasised the lack of available evidence, such as the absence of Runtong’s financial records, which resulted in CEG failing to prove a central assumption upon which Ms Karam’s expert evidence was based (namely, the relationship between Datong, Futon and Runtong as being part of a “property development group”). The evidentiary deficiencies were also partly attributable to the death of a director involved in the transactions. In addition, CEG did not call any evidence from either of the common directors or any other of Runtong’s directors.

However, the Court finally found that although the total value of the benefits provided by Runtong to CEG through the transaction was approximately $12.1 million, CEG was entitled to a set-off of approximately $10 million to reflect funds advanced by CEG for development of the land which resulted in an appreciation of the land’s value.