Liquidation of trustee companies: Court provides important guidelines to liquidators regarding distribution of trust assets to trust creditors

Importance of the case

Apart from aspects of proportionality of remuneration, this case will be of particular importance and interest to insolvency practitioners as the Court has provided has much needed clarification as to how trust assets are to be distributed to trust creditors.

In this regard the Court recognised that whilst authorities had been virtually universal in rejecting the applicability of section 556 of the Corporations Act 2001 (Cth) (Act), they had otherwise been unclear as to what was the correct position to be adopted in distributing trust assets to trust creditors. The Court clarified that distribution should occur on a pari passu basis (as set out in 5 to 6 below).

Executive summary of the Court’s findings

The Court’s findings in relation to the distribution of trust assets to trust creditors can be summarised as follows:

1. The Court confirmed that a trustee is entitled to apply trust assets to discharge liabilities incurred from authorised conduct in relation to a trust, which is secured by an equitable lien over the trust assets that:
   1. vests in the liquidator upon the trustee Company going into liquidation; and
   2. trust creditors have a right of subrogation in relation to;
2. When considering whether a particular liability/expense can be indemnified from the trust assets pursuant to the trustee’s lien (i.e. whether a creditor is a ‘trust creditor’) the Court must consider whether it was “properly” or “reasonably” incurred (that is, not “improperly incurred”) by the Company in its trustee capacity;
3. When considering whether a liability was “properly” or “reasonably” incurred by the Company in its trustee capacity the Court will consider whether the liability was an unavoidable incident of the Company performing its authorised functions as trustee;
4. The expanded definition of “employee” in the Superannuation Guarantee (Administration) Act 1992 (Cth) (SGAA) does not apply for the purpose of the Act (and in particular, section 556 of the Act)
5. Section 556 of the Act has no application in the distribution of trust assets to trust creditors, as section 556 applies only to assets that the Company beneficially owns (i.e. that it owns purely in its personal capacity); and
6. When distributing trust assets to trust creditors, those trust assets are to be applied on a pari passu basis.

Key facts/background

The material facts and background of this case can be summarised as follows:

• The Company was the trustee of the Trust, and the Company’s only activities were to act as trustee of the Trust;
• The Company in effect ran a real estate agency business in which real estate agents were effectively contractors who became beneficiaries of the Trust, and through trust distributions received their commission/remuneration;
• In previous proceedings before the Court the liquidators sought to argue that the Trust was a sham. The Court disagreed and upheld the validity of the Trust;
• The Company had a number of creditors and the total value of the creditors’ claims against the Company, after deducting the liquidators’ remuneration and disbursements, exceeded the value of the realised assets of the Company; and
• One of the more significant debts owing by the Company was a superannuation guarantee charge (SGC) liability (SGC Liability) to the Australian Taxation Office (ATO).

Key issues considered by the Court in relation to the distribution of trust assets

The Court considered the following matters:

• The test to be applied in considering whether trust assets can be distributed to creditors of a trustee company in liquidation, that is, when a creditor of the Company will be a ‘trust creditor’;
• Whether the expanded definition of “employee” in the SGAA applies to the Act;
• Whether the statutory priorities in section 556 of the Act apply when distributing trust assets to trust creditors; and
• In what manner trust assets are to be distributed to multiple trust creditors.

Distribution of the trust assets

The principles concerning a trustee’s indemnity from trust assets in liquidation

In considering the distribution of trust assets, the Court noted that the following well-established propositions applied:

1. “A trustee is entitled to resort to and apply trust assets for the discharge of liabilities incurred in the authorised conduct of the trust”;
2. “Such right of indemnity is secured by an equitable lien over the trust assets which arises by operation of law and confers a proprietary interest, in the nature of a security interest, in the trust property, and has priority over the claims of beneficiaries”;
3. “Upon the bankruptcy or liquidation of a trustee, its right of indemnity and lien vests in its trustee in bankruptcy or liquidator”; and
4. “A trust creditor is entitled to be subrogated to the trustee’s right and lien”.

In considering whether an indemnity applies to a particular liability of a Company, the Court noted that the test was whether the “expenses … [were] “properly” or “reasonably” incurred in their capacity as trustee, which has been held to mean “not improperly incurred””.

Court’s assessment of whether the indemnity extended to the SGC liability

The central liability considered by the Court was the SGC Liability.

After the Court discussed the nature of the SGC Liability and how it arose in the particular circumstances of this case, the Court found that: (a) the SGC Liability arose from payments by the Company to contractors (Payments); (b) the Payments were plainly an authorised function of the Company; (c) the SGC Liability were incurred by the Company by making the Payments; and (d) the SGC Liability arose as an “unavoidable incident of … [the Company’s] performance of its authorised functions as trustee”.

Accordingly, the Court found that the indemnity did extend to the SGC Liability concluding that the “right of indemnity extends to taxes payable as an inevitable incident of the operation of the trust”.

Court’s assessment of whether the statutory priorities applied

The next issue was whether the ATO was entitled to a statutory priority in the distribution of the trust assets, and if not, how the liabilities were to rank.

This was important because the Court noted that the Company did not carry on any activity except as trustee of the Trust, and as such “all its liabilities were prima facie incurred in its trustee capacity, and as such trustee it was entitled to be indemnities out of the trust assets in respect of them” (emphasis added).

The relevant statutory priority the Court was asked to consider was the priority contained in section 556(1)(e) which provides that, among other things, superannuation guarantee charges and the liability to pay those amounts “in respect of services rendered to the company by employees” (emphasis added).

The Court noted that there were 2 issues to be considered: (1) whether the SGC Liability fell within section 556(1)(e); and (2) whether section 556(1)(e) applied in the distribution of trust assets.

Did the SGC liability fall within Section 556(1)(e): Definition of Employee

When considering whether the SGC Liability fell within section 556(1)(e) of the Act the Court was primarily concerned with whether the expanded definition of “employee” in the SGAA applied, as contended by the liquidator.

The Court noted that the definition of employee in the SGAA was specifically identified as being only applicable for the purpose of the SGAA, and that it would be “anomalous” to use the expanded definition of employee for an SGC but not other liabilities referred to in section 556(1)(e) (such as wages).

Accordingly, based on the Court’s previous findings, the Court found that the relevant contractors did not fall within the definition of “employee” as set out in the Act and therefore section 556(1)(e) had no application.

Applicability of Section 556(1)(e) to trust distributions

In any event, the Court went on to consider whether section 556 applied. The Court noted that there has only been one case, being a South Australian Full Court decision (SA Decision), that suggested the statutory priorities applied. However the Court observed that the SA Decision had been “virtually universally accepted to be incorrect”.

The Court concluded by confirming that section 556 was “concerned only with the distribution of assets beneficially owned by a company and available for division between its general creditors”, and as such had no application to the distribution of trust assets.

How trust assets are to be distributed

The Court noted that the authorities had been unclear as to what was the correct position as to how trust assets were to be distributed to creditors who fell within the trustee’s indemnity.

The Court noted the two alternatives were:

1. “Where the equities are equal, the trust creditors have priority according to the order in which the claims arose, on the basis that as each claim arose it brought with it an interest, via subrogation, in the trustee’s lien over the trust assets”; or
2. “The trust creditors’ claims rank pari passu”.

The Court indicated that the better view was that the creditors ranked pari passu. This was based on the fact that:

• The trustee’s lien was in the nature of a floating charge over the trust assets rather than a specific security over any specific asset or for any specific liability;  and
• The creditors of a trust do not acquire any direct interest or security in the trust assets, but rather only have a derivative right to be subrogated to the trustee’s right of indemnity, and that derivative right is shared by all trust creditors.

Conclusion

Liquidators will need to consider the matters discussed above in circumstances where they have been appointed to a Company that has acted in its trustee capacity, to ensure that trust assets are appropriately distributed to trust creditors.

This article has been prepared by Grant, Whatley and Matthew Youssef, Associate.