Court approves liquidators breach of trust claim against director and associated company - Insolvency/Bankruptcy

This week's TGIF considers a recent case where a liquidator obtained judicial advice to commence proceedings against a director and related company concerning the unlawful receipt and use of trust money.

Key takeaways

Liquidators play an integral role in protecting creditors' rights and entitlements in the winding up of a company, particularly in cases where the directors of the company are alleged to have been involved in unlawful conduct.
In complex liquidations, liquidators can seek judicial advice from a court as to a proposed course of action. Provided all material facts are disclosed, the judicial advice will protect the liquidator from personal liability for breach of duty.
It may be particularly prudent for a liquidator to obtain judicial advice where the winding of a company involves one or more trusts and the liquidator proposes to take action for the benefit of particular creditors. Where litigation is involved, it may also be prudent for a liquidator to seek advice as to how any such litigation is to be funded.

In a recent decision of the Federal Court of Australia (Re CannHarvest (in liq) [2022] FCA 1473), Justice McElwaine ordered that a liquidator would be justified in commencing proceedings related to the unlawful receipt and use of trust money.

The case provides insight into the role of a liquidator in investigating a company's affairs, particularly where there has been dishonest and potentially unlawful behaviour. It also reiterates the importance of seeking judicial advice in complex liquidations.

Background

On 19 March 2019, administrators were appointed to CannHarvest Ltd (CannHarvest). The company subsequently went into liquidation on 3 May 2019.

During the course of the administration, the Liquidator became aware that approximately 70 investors had paid money to CannHarvest with the expectation they would be issued shares.

According to CannHarvest's records, no prospectus had been provided for the issue of the shares. The Liquidator also spoke with Mr Langman, a director of CannHarvest, who indicated there was no prospectus. A document purporting to be a prospectus was subsequently identified (Prospectus), however, Mr Langman denied any knowledge of it.

The Liquidator's investigations also revealed that, in total, $809,997.84 had been paid to the company under this fundraising process. However, shares had not been issued to 11 of the prospective share applicants who had paid $10,000 each. Instead of these monies being held in a designated trust account, the money was receipted into CannHarvest's general account (the Share Account) of which Mr Langman was the sole signatory. The funds were used for expenditure and, further, a total of $101,750 had been paid to another company (the Recipient Company) of which Mr Langman was the sole director, secretary and shareholder.

The Liquidator concluded that there were insufficient trust funds in the liquidation to account to the prospective share applicants. As such, the Liquidator decided to seek judicial advice on how to treat the remaining trust funds held by the company and in relation to the commencement of proceedings against those involved in the alleged breaches of trust.

The application

The Liquidator sought judicial advice pursuant to section 90-15 of the Insolvency Practice Schedule (Corporations) that she would be justified in (among other things):

treating money received into the Share Account as money held on trust for the prospective share applicants who were not issued shares;
commencing proceedings against Mr Langman and the Recipient Company; and
using CannHarvest's funds to commence and prosecute the proceedings on behalf of the prospective share applicants.

Applicable law

Justice McElwaine noted that shares are a financial product under the Corporations Act 2001 (Cth) (the Act) and that money received in respect of a prospective share issue must be held in a designated trust account. CannHarvest's failure to do this alone constituted a prima facie breach of trust.

In addressing the alleged accessorial liability of Mr Langman in CannHarvest's alleged breaches of trust, his Honour referred to the test for establishing 'knowing assistance in a breach of fiduciary duty'. In summary, his Honour cited authority which said a person may be liable on a knowing assistance claim where they assist in the execution of a dishonest and fraudulent design with knowledge of the circumstances indicating that dishonesty.

Justice McElwaine also noted that, as a director of CannHarvest, Mr Langman owed fiduciary duties in relation to CannHarvest. The duties were owed in addition to the statutory obligations placed on Mr Langman by sections 180-182 of the Act, which respectively required him to exercise care and diligence, act in good faith and not improperly use his position.

What did the Court decide?

Justice McElwaine concluded that the Liquidator had adduced sufficient evidence to establish a proper and reasonable basis for a claim to be pursued against Mr Langman and also the Recipient Company. His Honour gave the judicial advice sought by the Liquidator that she was justified in commencing proceedings against these parties on behalf of the prospective share applicants.

While his Honour was also prepared to give further advice sought by the Liquidator that she was justified in using trust money to fund the litigation, his Honour was not prepared to give advice that the Liquidator could use general company funds in the event there was a shortfall in the trust monies or if the litigation failed and she was ordered to pay costs.

His Honour did not rule out the possibility that such advice might be given the future but concluded that further consideration was required, particularly in relation to the principles that govern when a liquidator is permitted to have their costs and expenses paid from trust and non-trust assets.

Comment

This case reiterates the important role a liquidator plays in the winding up of a company, particularly where a company or its directors have been involved in potentially dishonest behaviour.

Investigations by liquidators can be crucial to uncovering misconduct, which can lead to the recovery of amounts for creditors affected by that misconduct.

Often, any proposed proceedings by a liquidator will be complex and this is particularly so where the liquidator must consider his or her ability to fund any litigation from the available assets of the company. In such cases, it may be prudent for a liquidator to seek judicial advice from a court approving any proposed course of action. Provided all material facts are disclosed on the application, the advice will protect the liquidator from personal liability for any alleged breach of duty.

Where trusts are involved, careful consideration will need to be given to a liquidator's ability to have recourse to trust assets to fund any proposed proceeding concerning the trust and a liquidator may wish to seek judicial advice as to how any litigation is to be funded.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.