Margin Lender Insolvencies

Insolvent Trading Implications for Margin Lender Insolvencies

By Leigh Adams

“Financial Fallout”, Lexis Nexis Butterworths, December 2008, Page 52

Introduction

With the world’s worst financial crisis in 75 years still unfolding, it is timely to look at the markets trading debt instruments and to see whether there are any potential implications for directors of the failed institutions under the insolvent trading provisions of the Corporations Act (s588G etc).

A suitable backdrop for such an examination is the factual matrix behind the Opes Prime collapse. The Opes Prime litigation was one of the first reported cases in this area – but it is certainly not the last.

The Opes Prime Debacle

The Opes Prime group of companies was established in 2003. Opes Prime was involved in financial services, asset management, stockbroking and Islamic finance.

There is currently a plethora of litigation in relation to the collapse of Opes Prime together with several class actions and many individual court cases. One of the earliest of these cases was Beconwood Securities Pty Ltd –v- ANZ Banking Group (2008) 66 ACSR 116 in which Justice Finkelstein explored the rights of investors in the Opes Prime securities lending arrangements.

The Beconwood Securities Case

This case is instructive as it explains the legal structure of the margin lending facilities that were sold by Opes Prime. Only with an understanding of this legal structure can the potential application of the insolvent trading provisions of the Corporations Act be explored.

Without analysing Justice Finkelstein’s judgment exhaustively, it is instructive to note that his Honour concluded that Beconwood Securities Pty Ltd (“Beconwood”) had borrowed approximately $1.3 million from Opes Prime and it had also transferred to a subsidiary of Opes Prime approximately 13 million shares (worth about $7 million) which it held in third party listed companies. Those shares were then transferred to a subsidiary of ANZ. ANZ provided the funding to Opes Prime. These funds enabled Opes Prime to operate its margin lending services.

The effect of the arrangement was that in consideration of ANZ lending the money to Opes Prime (which then lent it to Beconwood to acquire the securities), Beconwood traded its legal title over the shares to Opes Prime which subsequently transferred the legal title to ANZ. Beconwood also received a contractual right to receive equivalent securities to those which it had transferred to Opes Prime once the loan funds were repaid.

Beconwood contended that it had intended that the agreement act like a mortgage but his Honour dispelled this notion in noting that absolute title in the shares was transferred to Opes Prime and that there was no obligation to return the shares in specie even when the loan funds were repaid.

Insolvent trading generally

Whilst not all the facts are available at the time of writing, one would imagine that once the current worldwide share market turmoil began to unravel from November 2007, few if any margin lending facilities would have been written and accordingly an initial view might be that s588G in such circumstances would be unlikely to apply.

It is anticipated that litigation alleging misleading and deceptive conduct may well arise out of the Opes Prime and other margin lending collapses. Moreover, the Australian Newspaper on 24 October 2008 (page 20) has indicated that the liquidators may seek up to $270 million from ANZ over an allegedly uncommercial transaction involving ANZ being given improved security on loans made to Opes Prime a week before the “stockbroker imploded”. This is important as it has implications for insolvent trading which we will now explore.

The Insolvent trading provisions

By virtue of s588G of the Corporations Act, a director has a duty to prevent insolvent trading by a company. Simplified, the section applies if:

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

(2) the company is insolvent at that time or becomes insolvent by incurring that debt; and

(3) at that time there are reasonable grounds for suspecting that the company is insolvent or would become insolvent on incurring that debt.

Other than proving that a particular individual was a director at the time when the company incurred the debt in question, the other threshold test is that the company was insolvent at that time.

Corporate insolvency is defined in s95A as a company being unable to pay all of its debts as and when they become due and payable.

Insolvent trading – the usual trading debts

Any claim against the Opes Prime directors in relation to losses sustained from margin lending facilities put in place prior to November 2007 is likely, in my view, to be speculative. The reason for this is that to succeed under the section, the plaintiff must establish that the company was insolvent at the time the debt was incurred. In a rising share market, it is unlikely that a liquidator will be able to establish that there were reasonable grounds for suspecting that the company was insolvent when the rising share prices (i.e. the underlying security) were able to more than cover day-to-day indebtedness.

Insolvent Trading   - additional ANZ Security

Section s588G(1A) deals with the issue of the timing of incurring a debt and it is instructive to note that if a company enters into an uncommercial transaction within the meaning of s588FB, then a debt is taken to be incurred when that transaction is entered into. Accordingly, any improved security given to ANZ could not only result in the relevant transaction being declared void as an uncommercial transaction, but also could result in the directors of Opes Prime being pursued for the value of the loss sustained by the company in giving ANZ the additional security.

Insolvent trading – company taxes

No doubt the liquidator of Opes Prime will look very closely at the issue as to whether taxes of any description have all been paid when due since November 2007. The issue of whether taxes, levies, employee entitlements and penalties for late payment of taxes and levies are debts incurred was raised in Powell and Duncan –v- Fryer Tonkin and Perry (2000) 18 ACLC 480.

On appeal, the Full Court confirmed the view of Prior J at first instance concerning the width of the term “incurred a debt” in s588G and stated:

“Moreover… a debt is taken to have been incurred when, by its conduct or operations, a company has necessarily subjected itself to a conditional, but unavoidable, obligation to pay a sum of money at a future time.”

Accordingly group tax, income tax, employee entitlements and (as per the Court of Appeal in FAI Traders Insurance Co Ltd –v- Ferrara (1996) 41 NSWLR 91), accruing workers compensation premiums are debts which are incurred for the purpose of s588G, when they become due for payment.

Defences

There are specific defences which include the fact that (i) the director in question had reasonable grounds to expect and did expect that the company was solvent, and also (ii) the fact that there was no participation by the director in the management of the company at the time the debt was incurred by reason of illness or for some other good reason or (iii)  that the director took all reasonable steps to prevent the company from incurring the debt.

Expectation

As to how and when this defence might be used, only time will tell. I think that a director may have a tough time in convincing a court that he or she expected the share market to recover at any time since November 2007, particularly as the global financial news has by and large deteriorated in a fairly linear fashion since that time, and shows no sign of improving at any time soon.

No participation in Management

The prospects of any director relying on the defence that the director did not take part in management because of illness or for some other good reason (s588H(4)) is now considered remote having regard to the Court of Appeal decision in Deputy Commissioner of Taxation –v- Clark [2003] NSWCA 91 where it was stated that what may be a “good reason” for not participating in the management of a company was to be illuminated by the requirements of standards of care and skill by directors.

  The Court of Appeal stated that one aspect of a director’s duty of care and diligence was a core irreducible requirement of participation in the management of the company. A string of cases in the late 1990’s, culminating in the above Court of Appeal decision,  has made it very clear that the “I wasn’t there, I didn’t know” application of the section is now long gone. It is now considered good law that the section operates on the assumption that every director will be involved in the management of the company unless “illness or other good reason” excuses involvement. The cases indicate that the words “good reason” must be written down so that they do not conflict with the obligation of directors generally to participate in the management of the company.

All reasonable steps

Despite being more than 16 years old, this defence still awaits judicial interpretation.

The Civil Liability of the Director

By virtue of s588J an application may be made for a civil penalty order against a director who breaches his or her duty to prevent insolvent trading. Where the relevant debt is wholly or partly unsecured, and the creditor has suffered loss or damage in relation to the debt as a result of the company’s insolvency, then the court can order that the director pay to the company compensation equal to the amount of that loss or damage.

As to whether a director will be entitled to rely on s1318 which empowers a court to relieve a director from liability for contravening provisions of the Corporations Act if the director has acted honestly and having regard to all the circumstances of the case ought fairly to be excused, only time will tell.

Conclusion

The insolvent trading provisions of the Corporations Act undertook their second major rewrite in June 1993. They have been subsequently tightened and clarified from time to time. Their capacity to apply to margin lending insolvencies is not in doubt and we look forward to reviewing reported cases as time goes by.