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An uncommercial transaction arises under section 588FB(1), Corporations Act when a company enters into a transaction that a reasonable person in the company’s circumstances would not have entered into at a time when the company is insolvent or becomes insolvent as a result of entering into the transaction. The Explanatory Memorandum accompanying the introduction of the section into the Corporations Act in 1992 describes the position in the following terms:
“The provision is specifically aimed at preventing companies disposing of their assets or other resources through transactions which resulted in the recipient receiving a gift or obtaining a bargain of such commercial magnitude that it could not be explained by normal commercial practice.” (Clause 1044).
In this paper the operation of the uncommercial transaction shall be reviewed, with reference to significant case law that has provided insights into the transaction since its introduction into the Corporations Act.
The statutory framework of uncommercial transactions
To set aside a transaction as an uncommercial transaction a liquidator must establish that:
• it was entered into during the two years prior to the relation back day, or after that day but on or before the day when winding up began (section 588FE(3)). Other time periods are involved where a related entity is a party to the transaction (section 588FE(4)) or where the transaction was entered into for the purpose of defeating creditors (section 588FE(5));
• at the time of the transaction the company was insolvent or became so as a result of entering into or giving effect to the transaction (section 588FC);
• it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction, taking into account the benefits for the company, the detriment to the company, the respective benefits to other parties to the transaction, and any other relevant matter (section 588FB).
The objective nature of the liquidator’s enquiry under section 588FB(1)
Section 588FB introduces an objective standard by which to measure a transaction that is challenged on the basis of its uncommerciality. The essential enquiry is whether it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction, having regard to:
• the benefits enjoyed by the company;
• the detriment to the company;
• the respective benefits others received; and
• any other relevant matter.
Reviewing the action taken by a company in objective terms may result in unexpected outcomes. For example, a transaction may be commercial, even though it proved detrimental or unprofitable to the company, provided that a reasonable person in the company’s circumstances might also have entered into the transaction.
Peter Pan Management Pty Ltd (in liq) v Capital Finance Corporation.( (2001) 19 ACLC 1392, SC(Vic)).
Transactions likely to be challenged
Section 588FB refrains from specifying the types of transactions covered by the section, which is understandable given the diversity of dealings that may potentially fall within the scope of the provision.
Notwithstanding, the following cases provide typical examples of uncommercial transactions that have come under scrutiny by the courts:
McDonald v Hanselmann (1998) 28 ACSR 49, SC (NSW) (sale of certain manufacturing equipment together with client base and goodwill to the MD’s son at an undervalue);
Kitay v Strathfield Holdings Pty Ltd (1998) 27 ACSR 716, SC (WA) (disposition of property from wholly owned subsidiary to its parent company at an undervalue);
Demondrille Nominees Pty Ltd v Shirlaw (1997) 25 ACSR 535, Fed C (disposal of property, with part of purchase price payable by purchaser to the company being satisfied by release by the purchaser of personal debt of the directors of the company due to the purchaser);
Re Pacific Hardware Brokers (Qld) Pty Ltd (1998) 16 ACLC 442, SC (Qld) (a diamond ring bought for the sole director’s fiancée, with funds drawn from the company’s bank account);
Re Solfire Pty Ltd (in liq) (1997) 25 ACSR 160, SC (Qld) (at a time when the company was insolvent security was granted to directors in respect of unsecured loans to the company from the directors, the transaction being part of a strategy implemented by the directors to defeat the company’s judgment creditor while ensuring that other creditors of the company were paid from funds advanced to the company by the directors); and
Lewis v Cook (2000) 18 ACLC 490, SC(NSW) (in the circumstances of the company in this case, a reasonable person would not have contemplated forgiving a substantial debt due to it from its parent company for no consideration).
While not dealing exclusively with undervalue, it is apparent from the above list that undervalue is at the heart of the section, that is, if the company received less than what is reasonable value from the transaction, the liquidator may seek to avoid it.
The evidential onus of the liquidator in establishing undervalue
The onus is on the liquidator to produce acceptable evidence from which the court can make a finding as to the value of the benefits to the company of entering into the transaction (if any) as well as the detriments experienced. It is likely that in many cases the liquidator and the courts will be preoccupied with comparing the value of what the company received in exchange for what it gave.
McDonald v Hanselman (1998) 28 ACSR 49 SC(NSW).
The significance of this case is the difficulty the parties and the Court experienced in arriving at a proper valuation to determine whether the transaction under scrutiny was uncommercial.
Skouloudis Group Pty Ltd (in liq) v Planet Enterprizes Pty Ltd (2003) NSWCA 31, 17/2/2003.
The case clearly identified difficulties that may be experienced by a liquidator in establishing value, particularly in circumstances where the company’s books and records do not adequately record particulars that relate to the valuation issue.
Notwithstanding such obstacles, liquidators will need to exercise caution when contemplating uncommercial transactions recovery proceedings that are proving to be complex, poorly documented and expensive. In spite of such frustration, the statutory duties of the liquidator require proper investigation into uncommercial transactions, and any neglect in this regard without proper justification, may be viewed by the courts as a serious and significant omission by the liquidator, resulting in the liquidator’s removal by the court under section 503, Corporations Act: City and Suburban Pty Ltd v Smith (as liquidator of Conpac (Aust) Pty Ltd). (1998) 28 ACSR 328, Fed C.
Statutory meaning of “transaction” for purposes of section 588FB
Under section 9, Corporations Act the term “transaction” for the purposes of section 588FB means a transaction to which the body is a party, and includes a conveyance or transfer, a charge created over company property, and a payment made. It is apparent from the definition that the company must be a party to the transaction, a requirement that has, however, received broad interpretation by the courts, particularly in circumstances where the transaction under scrutiny involves individual steps in the course of dealings so as to give one aspect a different characteristic from that which the totality of dealings would suggest.
Kalls Enterprises Pty Ltd (in liq) v Baloglow (2007) 25 ACLC 1094, CA (NSW).
This case provides a useful illustration of the broad meaning of the term “transaction.”
An “insolvent transaction” of the company
The uncommercial transaction is an “insolvent transaction” as defined in section 588FC, necessitating the liquidator to establish the company’s insolvency at the time the transaction was entered into. As with all insolvent transactions under the voidable transactions scheme, the difficulty of the liquidator’s task in establishing insolvency may prove to be the difference between the liquidator succeeding or not.
To some extent the rebuttable presumptions of insolvency available to the liquidator under sub-sections 588E (3), (4), and (8) are designed to alleviate difficulties of proof that may be experienced by the liquidator in recovery proceedings.
However, perhaps the more policy-orientated question is whether uncommercial transactions should in any event be burdened by the need to produce evidence of the company’s insolvency at the time of the transaction.
The debate on this issue may be divided into two competing arguments. First, there is the position that the uncommercial transaction regime is designed to redress corporate conduct that has, within a defined period preceding the company’s winding up, caused the company to its detriment to enter into an uncommercial transaction. Here the suggestion is that, irrespective of the financial position of the company at the time of entering into the transaction, the transaction should be capable of being impugned by the liquidator for the benefit of the company and its creditors, given the detriment that the company has suffered within the defined period preceding liquidation.
Essentially the advocates of this approach have been heavily influenced by insolvency law policy which is accustomed to setting aside uncommercial transactions occurring in prescribed periods, without reflection on the financial status of the transferor at the relevant time. The policy justification in such cases is that the detriment suffered by a company within a defined period preceding winding up as a result of uncommercial transactions should be capable of being redressed by the liquidator, irrespective of the solvency status of the company at the time. This policy approach is also consistent with the Bankruptcy Act 1966 in respect of undervalued transactions occurring within two years before the commencement of bankruptcy.
The opponents of this approach tend to adopt a company law orientated view of the issue. The suggestion is that voidable transactions such as the uncommercial transaction should be confined to insolvent dealings and not encompass solvent dealings of a company. Further, it is suggested that company controllers ought to be permitted to manage a solvent company’s affairs without concern that, in the event the company subsequently proceeds into liquidation within a defined period, the transaction may be avoided if it can be characterised as being uncommercial. Essentially this approach insists that solvent companies and their solvent transactions should not be disturbed by the operation of insolvency law avoidance provisions such as the uncommercial transactions scheme.
Available defences in uncommercial transaction recoveries
On the assumption that the elements of an uncommercial transaction have been satisfied, orders under section 588FF in relation to uncommercial transactions are subject to possible defences available under section 588FG.
With respect to the section 588FG defences it should be recognised that a distinction exists between defences available to a non-party to the transaction (sub-section(1)) as opposed to a party to the transaction (sub-section(2)). This distinction will have particular relevance to an uncommercial transaction where a non-party is the actual beneficiary or recipient of company property or funds, the subject of the company’s uncommercial dealings.
Re Pacific Hardware Brokers (Qld) Pty Ltd (1998) 16 ACLC 442 SC(Qld).
The principal statutory remedy available to the liquidator with respect to an uncommercial transaction is to seek court orders under section 588FF.
In this regard, the most appropriate course is for the court to make a declaration to the effect that the transaction, being uncommercial within the terms of section 588FB, is a voidable transaction under sub-sections 588FE(2), (3), coupled with an order under section 588FF which authorises the court to settle on one or more of the remedies listed in section 588FF(1).
In the alternative, general law remedies may be sought by the liquidator, for example, an account of profits or the remedial constructive trust. The latter remedy will be of particular relevance in cases where the liquidator can establish an uncommercial disposition of company property involving a breach of directors’ duties known to the recipient of the property, thereby enabling the court to invoke the remedial constructive trust or another appropriate equitable remedy against the recipient of the property: Kalls Enterprises Pty Ltd (in liq) v Balgolow (2007) 25 ACLC 1094, CA(NSW).
Relationship between uncommercial transactions and other recovery proceedings
Because the uncommercial transaction is an insolvent transaction under the voidable transactions regime, directors who cause their insolvent company to enter into an uncommercial transaction may also be exposed to personal liability for failing to prevent the company from incurring debt at a time when it was insolvent. This is made possible by section 588G(1A) which extends the definition of incurring “a debt” for the purposes of the insolvent trading provisions to include a company entering into an uncommercial transaction. As a consequence, a liquidator confronted with the possibility of an uncommercial transaction recovery may also investigate the insolvent trading liability of the directors.
In other cases the circumstances giving rise to the uncommercial transaction may also constitute a breach of directors’ duties at general law or under the Corporations Act. Again this provides the liquidator with an alternative recovery proceeding, particularly where the principal objective of the liquidator in the potential proceeding is to obtain compensation orders against the directors involved.
In the context of recoveries against directors a significant nexus exists between uncommercial transactions and unreasonable director-related transactions (UDRT’s) falling under section 588FDA. UDRT’s were introduced in 2003 with a view to the recovery of unreasonable directors’ bonuses, but were in fact extended generally to payments made, dispositions of property, and the issue of securities by the company (section 588FDA(1)(a)).
For the transaction to be caught under this provision it is to be made to a director, a close associate of a director, or a person on behalf of those persons. “Close associate” includes a relative or de facto spouse of the director (section 9, Corporations Act). Moreover, the transaction must have been entered into during the relation back period set under section 588FE(6A).
For a transaction to be unreasonable under this provision it must be established that a reasonable person in the company’s circumstances would not have entered into the transaction, having regard to the benefits and detriments to the company in doing so (section 588FDA(1)(c)). It is apparent that this wording is similar to the description of uncommercial transactions contained in section 588FB.
However, it is an important aspect of UDRT’s that they do not come within the operation of the insolvent transactions provision, section 588FC. As a consequence there is no requirement that the company was insolvent at the time of entering into the transaction. Moreover the defence under section 588FG(2), although an available statutory defence in respect of uncommercial transactions, is not available to a party to a UDRT.
Thus while there is common criteria between uncommercial transactions and UDRT’s, uncommercial transactions are only voidable if they are also an insolvent transaction. In contrast, UDRT’s are much less onerous in their evidential content. In particular, it is not necessary to prove that the company was insolvent when the transaction was made, and the transaction may occur up to 4 years before an application is made to wind up the company.
Finally, as is to be expected, it is common for a transaction to fall within both the uncommercial transaction provisions and the UDRT’s provisions, thereby providing the liquidator with alternative pleadings.
Universal Financial Group v Mortgage Elimination Services (2006) NSWSC 1132, 31/10/2006.
DISCLAIMER: this newsletter is not intended as legal advice; no reliance is to be placed hereon.