I WANT SECURITY

ISSUES WITH THE ENFORCEMENT OF BANKERS' SECURITY

10 June 2004

Michael Quinlan Partner Deputy Leader Corporate Insolvency & Restructuring

Andrew Boxall Partner Corporate Insolvency & Restructuring

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The legendary Otis Redding wrote the song "Security" and the first line of that fantastic song gives

us the title for this paper "I Want Security". In Australia you might be more familiar with the classic

version of that song on Jo Jo Zep and the Falcons' first album, "Don't Waste It". Security is what

this paper is all about.

In this paper we deal with a range of issues which bankers may face when dealing with the

enforcement of their securities and other rights. The issues we deal with are:

1. Should a lender trigger a default relying on the lender's contractual rights?

In this section we will deal with:

(a) Contractual terms

We will focus on some of the contractual terms which are common in lenders'

security documents and some of the issues which they raise and in particular:

• Material adverse changes as an event of default; and

• Combining accounts.

(b) Documentary integrity

We will focus here on the risks which a course of business or representations may

give rise to:

• under the Trade Practices Act 1974 (TPA) and Australian Securities and

Investment Commission Act 2001 (ASIC Act);

• by reason of estoppel; and

• waiver.

(c) Risk management

We will make some suggestions about managing the risk of challenges to the

contract terms/documentation integrity and deal with:

• Documentation of variations;

• Confirmation of discussions;

• Registration of charges; and

• Compliance with the Privacy Act 1988.

2. The Lender's Conundrum: Default versus Managed Workout.

In this section we will deal with:

(a) Indemnity to receivers;

(b) Environmental risk;

(c) Receivers & managers' obligations;

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(d) Retention of staff;

(e) Insolvent trading; and

(f) Validity of charges.

3. Charges and non-assignment provisions

In this section we will look at whether contractual prohibitions on assignment can prevent the giving of a charge or the validity of a charge.

4. The fixed charge as a floating charge

In this section we will deal with recent developments in relation to the law of fixed charges over book debts.

1. Should a lender trigger a default relying on the lender's contractual rights?

(a) Contractual Terms

(i) Material Adverse Change

Many financing documents provide that an event of default occurs if

circumstances arise that, in the financier's opinion, may have a material

adverse effect on the borrower or on such things as the borrower's

business, or the borrower's assets or financial condition, or the borrower's

ability to perform obligations under any transaction document.

Although the case law on material adverse effect clauses is limited, there is

Australian judicial authority confirming the effectiveness of material

adverse change provisions, at least where the event of default is defined

as the occurrence of a material adverse change 'in the opinion' of the

lender or its agent. For example, in Vision Telecommunications Pty Ltd v

Australia & New Zealand Banking Group Ltd,1 the Court held that a lender

could call a default based on a material adverse change clause where it

held the requisite opinion.

However, the issue is obviously not as clear cut as, for example, a

payment default situation and it is important to carefully consider the terms

of the relevant provision.

Some material adverse change clauses, but not all, provide that it is the financier's or bank's opinion which is the relevant opinion.

1 [2001] WASC 139.

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(A) In the financier's opinion

Such a clause imports a subjective test. The lender must have

been aware of the change and have possessed the opinion that

the change may have an adverse impact. At this stage the

authorities are unclear on whether there is a good faith

requirement, that is, whether the opinion must be honestly formed

and reasonable which would import at least a level of objectivity in

what would otherwise be an entirely objective view.

In Vision Telecommunications, it was argued that there was an

implied requirement that the lender form the requisite opinions on

reasonable grounds. Pidgeon AJ considered it unnecessary to

determine whether such a requirement is to be implied as in the

particular circumstances, in that case, his Honour was 'satisfied

that the [bank's] opinion…was formed on reasonable grounds.'2

However, a submission that the lender must make reasonable

inquiries before triggering a default was rejected. Pidgeon AJ held

that, even if:

…there is a requirement for the bank to form a view that is

reasonable, it does not extend as far as that. This submission

would mean that not only must the view be reasonable, but

reasonable steps must be taken to obtain information on which to

base the view. I do not consider that the default clause could be

read so as to require a bank to make inquiries of that type prior to

making a decision within the terms of the default clause. This

requirement is not contained within the terms of the default clause

and I consider there is no basis on which it could be implied.3

Thus if Vision Telecommunications is followed the only

requirement is that the relevant financier held the 'opinion' and that

it was ‘formed on reasonable grounds’. Although there may be no

requirement to make inquiries, it would be prudent for financiers to

do so as it would provide a basis for forming the opinion and hence

allow the financier to argue that the opinion is on reasonable

grounds. A prudent financier would document the basis of the

opinion and gather evidence to support it.

2 [2001] WASC 139 at para 83. 3 [2001] WASC 139 at para 84.

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(B) Circumstances

Most material adverse change clauses identify particular

"circumstances". This term is very broad. However, whether the

clause can be triggered by events wholly out of the control of the

borrower, like a currency crisis, industry downturn or economic

recession, is uncertain. There has been no Australian case which

has considered the validity of a lender termination of contract in

reliance on a material adverse change clause based entirely on

external events. It has been argued that:

[a]n external force like a currency crisis is unlikely to be regarded

as resulting in a material adverse change unless it can be shown

that the crisis directly affects a borrower, as reflected in income

statements, balance sheets, business plans and expense, sales

and revenue projections.4

We agree with that view, however a clause which refers to

"circumstances" which "may" have a particular result does not

require the lender necessarily to wait to see the event reflected in

the borrower’s own internal projections etc if the relevant lender

has formed the view on reasonable grounds that the event will

have such an effect. In each case careful consideration would

need to be given to the particular external event. Such things as:

• the finding of Mad Cow disease leading to a ban on

Australian beef exports;

• the revocation of essential licenses by external licensing

bodies;

are examples of the sort of external events which may be

circumstances which a lender might form the requisite reasonable

opinion about.

(C) Material adverse effect

The question of what is material in a clause which refers to the

financier's or the bank's opinion is subjective. The Courts have said

that 'adverse' means unfavourable, hurtful or injurious. It is

arguable that adversity to the lender requires the lender to believe

that there is a danger that loan obligations will not be met.

4 Gray, R. M., “Does the crisis bring default under MAC clauses?” 17(4) International Financial Law Review (1998) 17 at 19

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In Pan Foods Co Importers & Distributors Pty Ltd v Australia and

New Zealand Banking Group,5 a continued loss of $200,000 per

annum, declining sales, inadequate cash flow and stale stock was

considered a material adverse change such that the bank could

trigger default.

Mere comparison of financial results without further analysis and

evidence would probably not satisfy the material adverse change

clause. In Poignand v NZI Securities Australia Pty Ltd,6 Wilcox J

held that a 210% decline in profits, 89% erosion of current assets

and 572% increase in current liabilities was not enough. A

financier must genuinely form the opinion that circumstances are

likely to materially and adversely affect it. In other words, a

financier needs to provide evidence that it possessed the opinion

that there is a material adverse effect.

A prudent financier would not trigger default on the basis of

material adverse change unless there was strong unambiguous

evidence available that a material adverse change has occurred.

(ii) Combining Accounts

The right to combine accounts is a general law right reflecting the notion

that there is only one banker/customer relationship no matter how many

accounts a customer may have with the bank. It allows a bank or financier

to appropriate a credit balance in one account against a debit balance in

another. This right may arise under contract where it does not arise under

the general law, and all accounts held with a particular bank are capable of

combination unless there is an agreement (express or implied) to the

contrary.

There are a number of issues to be considered when combining accounts

pursuant to a contractual right:

(A) In a liquidation, irrespective of contractual rights to combine

accounts or set-off debts section 553C Corporations Act normally

provides a statutory right of set-off. Where a financier has not

exercised any contractual rights which it might have to combine

accounts until after it knows that the borrower is insolvent the

statutory right of set-off will not be available in relation to the debits

5 (2000) 170 ALR 579. 6 (1994) 12 ACSR 523.

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or credits incurred after the date the financier had that knowledge

because it is excluded in those circumstances by s553C(2).

Exercising set-off could give rise to a voidable preference if made

while the depositor/creditor is insolvent, and within the six months

before the relevant application was made for the winding up of the

depositor/creditor, if the claims would not have been subject to

statutory insolvency set-off in that winding up (see section 2(f)

'Validity of Charges' of this paper for discussion on unfair

preferences). As statutory insolvency set-off is broad in its

application, those circumstances are likely to be few and far

between.

(B) It might be thought that there is a danger that the arrangements

might be held to constitute a charge and therefore be ineffective

against a liquidator or administrator if not registered. Section 9

Corporations Act refers to 'a charge created in any way…'. In

Cinema Plus Ltd (Administrators appointed) v Australia and New

Zealand Banking Group,7 the question of whether a bank's

contractual right to combine a customer's accounts gave rise to a

charge arose. The Court said an essential feature of a charge is a

right to resort to property in order to satisfy a debt or claim. i.e. a

charge is a proprietary interest held by way of security. The right to

combine accounts is a personal right, does not confer a proprietary

interest and therefore is not a charge according to Cinema Plus.

The situation may be less clear when the bank's contractual right to

combine accounts extend not only to a particular customer's

account but to related parties' accounts. In that circumstance

some commentators and authorities have suggested that those

rights are properly characterised as a charge.8 There is however

some authority for the view that such rights are not properly so

characterised.9

(C) An administrator’s lien will prevail over the bank's unexercised right

of combining assets. In Cinema Plus Ltd (Administrators

7 (2000) 49 NSWLR 513. 8 eg D I Everett Multi-Party Set Off Agreement September Journal of Banking and Finance Law and Practice; Derham, Set-Off (1987), Clarendon Press p9; re Tudor Glass Holdings Ltd; Franik Ltd and Thermal Aluminium Ltd (1984) 1 BCC 98,983 CCh D) per Harman J but contra Goode Legal Problems of Credit and Security (2nd ed) 1988, Sweet & Maxwell pp158-160. 9 see eg Goode referred to in 8 and Electro Magnetic(s) Limited (under Judicial Management) v Development Bank of Singapore Limited [1994] 1 SLR 734.

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appointed) v Australia and New Zealand Banking Group,10 the

Court held that when a bank exercises a contractual right to

consolidate the current and loan accounts of a company under

administration, the consolidation takes effect subject to the

administrator's right to indemnity, priority and lien on the

company's property under ss 443D, 443E and 443F of the

Corporations Act. Thus in respect of debts incurred and

remuneration due between the date of the administrator's

appointment and consolidation, the credit in the current account at

the time the right of indemnity arises is available to indemnify the

administrator, and the surplus (if any) when the consolidation takes

effect is available to the banker. It was held that the administrator’s

right to indemnity out of the property of the company, and the lien

over that property, affects all the property of the company at the

time of appointment. That property included the choses in action

allowing withdrawal. The priority and lien took precedence over

the bank’s right to combine accounts, until the bank actually

combined the accounts (that is, presumably, when the bank

actually made the book entries). Therefore the bank should be

aware that if an administrator is appointed, it will need to actively

combine the accounts to defeat the administrator’s right of

indemnity and lien.

(D) It is important that the accounts which are combined are all

accounts of the same customer. Where the customer has more

than one account, a bank must not combine accounts if it has

notice that money in a particular account(s) are trust funds.11 A

bank will have notice that an account contains trust moneys if, for

example, the customer communicates that fact to the bank, or it is

clear from the title to the account that the moneys in the account

are trust moneys. Where this is not the case, according to Clark v

Ulster Bank Limited, a Northern Irish decision which is the only

case we could find dealing with this issue directly:

...the mere fact that the customer's profession or business is such

that it necessarily involves his having moneys belonging to other

people from time to time in his hands, does not affect the banker

10 (2000) 49 NSWLR 513. 11 Clark v Ulster Bank Ltd [1949] NI 132.

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with notice that any specific sum paid by the customer are trust

moneys.12

The test established by Clark v Ulster Bank Ltd is whether the

nature, number and magnitude of the transactions passing through

the account are such that a 'reasonably intelligent bank official'

would appreciated that the account was a 'client's money

account.'13 The nature of the transactions must be sufficient to

arose a suspicion or put the bank officials on enquiry.

Where trust and other moneys are paid into one account, the trust

continues and the trust is entitled to a part of the fund equal to the

amount of the trust moneys paid in. The bank may be made to

account to the beneficiary if, prior to the consolidation of the

accounts it has notice of both the existence of a trust in respect of

moneys received and that the use of those moneys by the trustee

to reduce its overdraft debt would be a breach of trust.14

(b) Documentary Integrity

This part of the paper deals with a number of issues for consideration when a borrower

defaults and the lender seeks to enforce its contractual rights to terminate the facility and

demand repayment, including issues under the TPA and the ASIC Act, estoppel and

waiver.

(i) Unconscionable Conduct

The provisions

Section 51AA TPA provides that:

a corporation must not, in trade or commerce, engage in conduct that is

unconscionable within the meaning of the unwritten law….

Section 51AB TPA provides that:

a corporation shall not, in trade or commerce, in connection with the

supply or possible supply of goods or services to a person, engage in

conduct that is, in all the circumstances, unconscionable.

Section 51AC TPA provides that:

[a] corporation must not, in trade or commerce, in connection with the

supply…of goods and services to a person (other than a listed public

12 Clark v Ulster Bank Ltd [1949] NI 132 at 135. 13 Clark v Ulster Bank Ltd [1949] NI 132 at 137. 14 Stephens Travel Service International Pty Ltd (Receivers and Managers appointed) v Qantas Airways Ltd (1988) 13 NSWLR 331.

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company)…engage in conduct that is, in all the circumstances,

unconscionable.

Section 51AC protects 'business' dealings, and applies only if the goods

and services do not exceed $3 million.15

Sections 51AA, 51AB and 51AC of the TPA are similar to ss12CA, 12CB

and 12CC of the ASIC Act and s991A(1) of the Corporations Act. The

main differences between the provisions in the ASIC Act and the TPA are

that the ASIC Act refers to a 'person', rather than a 'corporation' and that

the relevant parts of the ASIC Act only apply to conduct in relation to

'financial services'.16 Section 991A(1) Corporations Act applies to 'a

financial services licensee'. Due to the relatively recent inclusion of

unconscionable conduct provisions in the ASIC Act and Corporations Act,

there is little case law in relation to the unconscionable conduct provisions

in this legislation. However, as the provisions in this legislation are similar

to the TPA provisions, trade practices cases provide a reasonable guide as

to how the provisions will be interpreted.

Post-contractual conduct, such as the enforcement of a contractual right or

the exercise of a contractual discretion, can fall within the sections.17 The

legislation leaves it to the courts to determine on the facts of each

particular case what is and what is not unconscionable behaviour, but the

courts may have regard to several matters, including the relative

bargaining powers of the supplier and business consumer, whether the

business consumer was required to comply with conditions that were not

reasonably necessary for the protection of the legitimate interests of the

supplier, and the extent to which the supplier and business consumer

acted in good faith.18

The test

Traditionally, a lender engages in unconscionable conduct if:

15 Section 51AC(9). 16 This includes financial products: s12BAB. A financial product, in turn, includes a credit facility, although there are a number of exceptions: s12BAA(7). 17 A contractual provision might be substantively unfair, and the exercise of rights under it unconscionable conduct; or a provision may be innocent enough, but the circumstances might make its enforcement unconscionable. For example, a contract may provide that loan repayments will be accelerated on the happening of an event of default, widely defined, unless waived by the lender. If the lender uses a trivial event of default, for example, an inadvertent failure by the borrower to notify a change of address to accelerate the falling due of the entire loan, this might be in all the circumstances unconscionable: The Laws of Australia, 35.9, Chapter 3, Part A, Div 3, Subdiv (ii). 18 Section 51AC(3) Trade Practices Act and s12CC(3) ASIC Act.

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• the borrower is under a 'special disadvantage';

• the lender has knowledge of it; and

• the lender unconscientiously takes advantage of the borrower's

special disadvantage19

The law now recognises that a company can suffer from a special

disadvantage.20

Scope of 'special disadvantage'

French J in Australian Competition and Consumer Commission v CG

Berbatis Holdings Pty Ltd (2000) 96 FCR 491 decided for the first time in

Australian law that “special disadvantage" could be “situational”, arising

from the party’s legal and financial circumstances as well as the

inherent/personal circumstances in the Amadio sense of being drunk,

illiterate etc.21

The facts of this matter involve a landlord tenancy dispute where the

tenants were in a vulnerable position in relation to the landlord because

they needed a new or extended lease to maximise the sale price of their

business and enable them to look after their sick daughter. The landlord

and its agents knew of the daughter’s illness and they made the extension

of the lease conditional on the tenants abandoning genuine claims in

ancilliary legal proceedings. French J held that the landlord acted

unconscionably and contravened s51AA TPA.

On appeal to the High Court,22 the High Court held that striking a hard

bargain does not amount to unconscionable conduct. They approved the

principles in Amadio (see above). The majority held that although the

tenants were in a difficult bargaining position, they were not under a

'special' disadvantage. However, the Court declined the opportunity to

discuss the scope of s51AA at length. Therefore whether unconscionable

19 Commonwealth Bank v Amadio (1983) 151 CLR 447, approved in Australian Competition and Consumer Commission v CG Berbatis Holdings Pty Ltd [2003] HCA 18. 20 Commonwealth Bank of Australia v Ridout Nominees Pty Ltd [2000] WASC 37 (appeal dismissed: see Ridout Nominees Pty Ltd v Commonwealth Bank of Australia [2003] WASCA 158), where Wheeler J accepted that a corporation is not excluded from benefit of the unconscionable dealing doctrine and noted that before the Ridout case, there were two Australian cases (Brooks v Sunlife Properties Pty Ltd , unreported, SCWA, Scott J, 21 February 1996, and NZI Capital Corp Ltd v Fulton, unreported Fed Ct of Aust, Black, Davies, Lehane JJ, 10 June 1998) where it had been assumed that the doctrine of unconscionable conduct could apply in favour of a corporation. 21 Commonwealth Bank v Amadio (1983) 151 CLR 447. 22 Australian Competition and Consumer Commission v CG Berbatis Holdings Pty Ltd [2003] HCA 18.

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conduct may arise out of exploitation by a party of a 'situational

disadvantage' as defined by French J is uncertain.

It should be noted that Berbatis was fought on the basis of s51AA and not

s51AC (which was not operative at the time). It has been argued that

s51AC is wider in scope than the Amadio type of unconscionability and

that it 'clearly extends to “situational disadvantage” arising from the matrix

of commercial and legal circumstances of the parties.'23 Moreover, s51AC

provides that the court may have regard to the extent to which a

corporation acted in good faith when deciding whether it has engaged in

unconscionable conduct.

In Elkofairi v Permanent Trustee Co Ltd,24 a wife and husband gave a

mortgage to a financial institution over their jointly owned home as security

for a loan. Part of the loan was used to discharge an existing mortgage

over their property and the balance was used for the husband's own

business and investment purposes. The borrowers defaulted and sought to

prevent the bank from enforcing its rights under the mortgage.

The wife had no income and this was a large borrowing secured over her

only asset. This was apparent to the bank from the loan application form

and sufficient to put the bank on notice of the wife's lack of capacity to

meet the mortgage repayments. The court found that the wife was in a

position of special disadvantage. The bank was not aware of most of the

circumstances, for example, lack of English skills, but it was aware of her

lack of income which the Court found was itself a special disadvantage.

The court held that the bank had taken unconscientious advantage of its

position by lending a large sum of money to a person with no income,

which was secured over her only asset. The wife was, however, ordered to

pay the bank for the benefit she received from the mortgage, namely half of

the monies used to re-finance the prior mortgage on the property.

In Durkin v Pioneer Permanent Building Society Ltd,25 a claim that the

lender acted unconscionably in refusing to advance further funds on the

ground that certain conditions for the advancement of money were not

satisfied was struck out. Dowsett J held that the borrowers were not in a

23 Unconscionability Breaks New Ground – Avoiding and Litigating Unfair Client Conduct After the ACCC Test Cases and Financial Services Reforms [2002] DLR 4; - (2002) 7 Deakin Law Review 73 24 [2002] NSWCA 413. 25 [2003] FCA 419.

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position of special disadvantage by reason of the fact that they were in

need of financial assistance:

People who seek loans are often in financial difficulty. That factor cannot,

by itself, be sufficient to render the conduct of any other party, in dealing

with such a potential borrower, unconscionable.26

Dowsett J considered that unconscionable conduct meant serious

misconduct or something clearly unfair or unreasonable. It was not

unconscionable conduct for the lender to refuse to advance funds on the

ground that a particular condition precedent to the grant of the loan was not

satisfied, as this conduct involved no bargaining so that no question of

disadvantage or exploitation could have arisen.

Is good faith required?

As mentioned above, the list of factors to which a court may have regard in

determining whether or not conduct is unconscionable in contravention of

s51AC TPA and s12CC ASIC Act includes the extent to which the parties

'acted in good faith'. Whether or not s51AC TPA and s12CC ASIC Act

import a duty of good faith on lenders, so that 'even a broadly expressed

right to demand payment of a loan may be given a more qualified

scope…'27 is as yet unresolved.

The duty of good faith may require the lender to act reasonably when

triggering a default where 'default' is defined to include the situation where

an application is made to wind up the company. In

Renard Constructions (ME) Pty Ltd v Minister for Public Works28 in the

context of a clause in a building contract which allowed the principal to

cancel a contract and take over the work in the event of proceedings to

wind up the contractor company, the Court said that

…it would not be reasonable [for the power to be exercised] because of

the bare fact of the proceedings having been instituted, and nothing

more…29

This does not mean that a principal who learns of the institution of winding

up proceedings against the contractor is obliged to make any detailed

inquiry about the likelihood of success of such proceedings…The

26 [2003] FCA 419 at para 47. 27 Paterson, J M. 'Limits on a Lender's Right to Repayment on Demand: Construction, Implication and Good Faith?' (1998) 26 ABLR 258 at 258. 28 (1992) 26 NSWLR 234. 29 Renard Constructions (ME) Pty Ltd v Minister for Public Works (1992) 26 NSWLR 234 at 260.

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obligation of reasonableness would usually be discharged, for example, by

some inquiry from principal to contractor about the proceedings, and it

would require some very conclusive response from the contractor before it

could be said the principal was not reasonable in then exercising the

power. Nevertheless it would not be reasonable, in my opinion, for the

principal to exercise the power because of the bare fact of the proceedings

having been instituted, and nothing more. More would often be supplied by

knowledge the principal had of the contractor's financial position from

sources independent of the contractor. In many cases the principal would

be quite justified in relying on hearsay information, in some cases perhaps

not…30

Similarly, in Hughes Bros Pty Ltd v Trustee of the Roman Catholic Church

for the Archdiocese of Sydney31, an example was given by Priestley JA

where:

…a vexatious and unfounded proceeding for winding up is taken against a

contractor. In such a case it seems to me that the general expectation of

commercial people would be that the principal should take into account

any knowledge it has of the circumstances concerning the presentation of

the proceedings, give at least some consideration to them before

exercising a power…; depending upon the circumstances, the

consideration might be of the briefest; the principal might recognise that

the contractor might defeat the proceedings but nevertheless the practical

circumstances and the possible consequences would lead the principal to

exercise the power in any event. On the other hand, the contractor might

put material before the principal persuading the principal that a claim was

certain to be struck out by the court the following day so that the principal

postponed action; even in such circumstances there might be matters

relative to the principal's position which would impel the principal

reasonably to proceed to exercise the power.

Thus it has been suggested that:

…the features of the duty of reasonableness…suggest a concern with the

process through which the decision is made. If applied to a loan contract,

the duty might require a lender to show that it had taken steps to establish

the grounds for a decision to demand repayment. The duty might also

easily be extended to requiring the lender's decision to be reasonable on

the basis of the established grounds. In other words, a court may treat a

30 Renard Constructions (ME) Pty Ltd v Minister for Public Works (1992) 26 NSWLR 234 at 259-260. 31 (1993) 31 NSWLR 91.

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duty of reasonableness as inviting a review of the substantive merits of a

lender's decision to demand repayment.32

On the other hand, it could be argued that the clear wording of a demand

clause excludes any such implied duties. In Canberra Advance Bank Ltd v

Benny33 the Full Court of the Federal Court did not accept that a lender

should be prevented from exercising its strict contractual rights following an

event of default where the event relied upon was relatively inconsequential,

in that case the borrower being two days late in providing financial reports

required under the contract.34 The court stated that 'there is strong

authority that constrains a court of law from delving too deeply, in cases

such as this, into the question whether the action of the lender was

reasonable or fair'.35 This was especially so in a commercial lending

transaction. In this case the argument was put on the basis of the common

law and not on the basis of the unconscionability provisions of the TPA or

the ASIC Act, the operations of which cannot be contracted out of. At the

time this decision was delivered s51AA had only just been inserted into the

TPA. Section 51AB was inserted in 1986 and s51AC was not inserted until

1998. In those circumstances the obiter comments made by the Full Court

in Benny may not be of much assistance if the claim relies on the

unconscionability provisions in the TPA or ASIC Act.

More recently, in Vodafone Pacific Ltd v Mobile Innovations Ltd,36 the NSW Court of Appeal held that not all commercial contracts have implied in them a duty to act in good faith. The Court accepted that an obligation of good faith may be implied into a commercial contract only where the obligation was not excluded by express provision or was not inconsistent with the terms of the contract.

The facts of the Vodafone case were that, from 1994, Mobile purchased mobile telecommunications services from Vodafone and resold the services. Subscribers acquired and managed by Mobile were connected to the Vodafone network, but were Mobile’s customers. In October 1998 that arrangement came to an end. Mobile sold its customer base to Vodafone for approximately $20 million. By the ASP Agreement, Vodafone engaged Mobile as agent to acquire by direct marketing new subscribers to the

32 Paterson, J M. 'Limits on a Lender's Right to Repayment on Demand: Construction, Implication and Good Faith?' (1998) 26 ABLR 258 at 268. 33 (1992) 115 ALR 207. 34 (1992) 115 ALR 207 at 220 35 (1992) 115 ALR 207 at 213. 36 [2004] NSWCA 15.

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Vodafone network on a postpaid basis. Clause 18.4 of the ASP Agreement provided that:

Vodafone will have the sole discretion to determine, from time to time, the target level in respect of the number of connections of New Subscribers. The target level will be determined by Vodafone in conjunction with the determination of the Business Plan referred to in Clause 21.

In July 2001, Vodafone notified Mobile that the target level for the December quarter was nil. Mobile commenced proceedings against Vodafone claiming breach of express and implied terms of the ASP Agreement, including that Vodafone failed to act in good faith and reasonably in exercising its powers under the ASP Agreement.

The Court accepted that in some circumstances, an obligation of good faith

and reasonableness in the performance of a contractual obligation or the

exercise of a contractual power may be implied as a matter of law as a

legal incident of a commercial contract.37 However, the cases to date fell

short of treating commercial contracts as a class of contracts carrying the

implied term as a legal incident:

I do not think the law has yet gone so far as to say that commercial contracts are a class of contracts carrying the implied terms as a legal incident, and the width and indeterminancy of the class of contracts would make it a large step.38

In Vodafone's case, the Court was prepared to assume, expressly without deciding, that unless excluded by express provision or because inconsistent with the terms of the contract, Vodafone was under an implied obligation to act in good faith and reasonably in exercising its powers under the ASP Agreement, specifically the power of determining target levels in clause 18.4.39

As the power in clause 18.4 is described as a sole discretion (in contrast to a number of other clauses in the ASP Agreement which required Vodafone or Mobile to act reasonably and/or in good faith), the Court held that the implication of the obligation to act in good faith and reasonably in exercising the power of determining target levels in clause 18.4 was excluded.40 i.e. Vodafone was not obliged by an implied term to act in good faith and reasonably in determining target levels.

37 See Alcatel Australia Ltd v Scarcella (1998) 44 NSWLR 349 and Burger King Corp v Hungry Jack's Pty Ltd [2001] NSWCA 187. 38 Vodafone Pacific Ltd v Mobile Innovations Ltd [2004] NSWCA 15 at para 191. 39 Vodafone Pacific Ltd v Mobile Innovations Ltd [2004] NSWCA 15 at para 191. 40 Vodafone Pacific Ltd v Mobile Innovations Ltd [2004] NSWCA 15 at para195 to 198

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Therefore, although it is unclear whether s51AC TPA and s12CC ASIC Act

impose a statutory duty to act in good faith (i.e. that the lender act

reasonably in enforcing its right to demand payment of the loan), recent

judicial authority in NSW supports the view that not all commercial

contracts have implied in them a duty of good faith as a matter of law, but

that duty may if implied if it is not expressly excluded and is not

inconsistent with the terms of the contract. Financiers should consider

whether it would be 'unconscionable' to rely on 'technical breaches' as a

means of demanding payment. Financiers should avoid the use of undue

pressure and unfair tactics, be willing to negotiate in good faith, and comply

with applicable industry codes of conduct.41

Recent cases

Kranz v NAB

In Kranz & Anor v National Australia Bank Ltd42 the Court considered unconscionable conduct and the application of principles in Garcia v NAB to brothers-in-law in the context of an application to set aside certain mortgages and guarantees.

Mr Kranz guaranteed his brother-in-law's loan. The loan was not repaid. Mr Kranz argued that it would be unconscionable for the bank to enforce the guarantee because he did not read the documents, the risk of the transaction was not explained to him and the borrower (his brother-in-law) had misled him about the nature of the transaction. Mr Kranz claimed that the bank should have been put on notice that a relationship of trust and confidence existed between him and his brother-in-law and adequately explained the transaction to him or had a third party explain it to him. The Victorian Court of Appeal did not agree.

Two brothers (Peter and Tom Lefkovic) were directors of Tompet Nominees Pty Ltd. After the stock market crash of 1987, Tompet owed the National Australia Bank approximately $1 million. This debt was secured by a registered mortgage of four properties, including the family homes of Tom Lefkovic and his parents. In an effort to reduce the debt without selling the two family homes, Tom Lefkovic approached the bank with a speculative proposal for Starbronze (a shelf company from which Tom Lefkovic had just resigned as director) to purchase shares in Phoenix Oil & Gas (Tom Lefkovic was the company secretary of both Phoenix Oil & Gas and Phoenix Fingall Group who were selling the shares) and sell those

41 These were the key issues in ACCC v Simply No-Knead (Franchising) Pty Ltd [2000] FCA 1365, which led the court to find that there was 'unreasonable, unfair, bullying and thuggish behaviour' amounting to unconscionable conduct. 42 [2003] VSCA 92, Victorian Court of Appeal per Winneke P, Charles and Eames JJA, 25 July 2003

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shares at a later date for what was expected to be a substantial profit in payment of Tompet's debt. The profit was expected because of a proposed acquisition of a thermal burner, which would increase the company's profit.

The bank agreed to lend the money, on the basis that additional security was provided. Tom Lefkovic approached his brother-in-law Motek Kranz (the appellant), and his parents-in-law, to provide security in the form of personal guarantees and a mortgage over a property they jointly owned (Mr Kranz through a company called Mansville) in Ballarat, Victoria. Tom Lefkovic misled Mr Kranz about the nature of the transaction and no explanation of the true nature of the transaction was given to him by the bank or anybody else. The loan was not repaid and the bank called up the security.

Mr Kranz contended that, on the basis of the principles in Garcia v National Australia Bank Ltd, it would be unconscionable for the bank to enforce the mortgage and guarantee. It was put on behalf of Mr Kranz that there was a relationship of trust and confidence between him and Tom Lefkovic of which the bank knew or ought to have known.

The Court of Appeal unanimously held that, although the bank had not adequately explained the transaction, which was speculative and extremely risky, to Mr Kranz, the bank was not bound to do so because the relationship between Mr Kranz and Tom Lefkovic was insufficiently intimate to put the bank on notice that the transaction would not be properly explained.

The court noted that Garcia principles are not limited to the most intimate family relationships and could extend to brothers-in-law. However, unless the bank is put on notice that such a relationship existed, they are presumed to have no knowledge of the relationship. On the facts of this case, there was no reason for the bank to have known or assumed that there was a relationship of trust and confidence that would render the guarantee unconscionable.

It was also argued by Mr Kranz that he was in a position of special disadvantage because:

• he could not read or write English;

• he had completed only eight years of schooling in Israel; and

• he had relied on Tom Lefkovic as his accountant and business adviser for 12 years.

However, there was also evidence that Mr Kranz was a successful businessman, a director of numerous companies, and had previously agreed to, and signed, several guarantees and mortgages in the course of his business dealings.

Mr Kranz argued that the bank should have known that he was in a position of special disadvantage and, as the transaction was, to the bank's

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knowledge, speculative, unusual and fraught with risk, he was entitled to an explanation of the transaction by the bank or by an independent third party.

The Court of Appeal accepted that the bank did not know, and a reasonable person would not have suspected, that Mr Kranz was under a special disadvantage and the bank did not take unfair advantage of its position by entering into the transaction. It held that it was not unconscionable for the bank to enforce the mortgage and guarantee.

Accordingly, even where:

• a volunteer enters into a guarantee that they do not understand; and

• the volunteer will make no financial gain from entering into the guarantee; and

• no steps are taken to explain to the volunteer the nature of the guarantee by either the lender or an independent third party,

it will only be unconscionable for that guarantee to be enforced if the lender knows that there is a relationship of trust and confidence between the volunteer and the debtor or that the volunteer is acting under a special disadvantage and the lender takes unfair advantage.

Spira v CBA

Spira v Commonwealth Bank of Australia43 the Court considered unconscionable conduct and whether a term of good faith should be implied.

In this case, the bank was held not liable for an allegedly wrongful refusal to lend. It was held that there was no inequality of bargaining power and that the prospective borrower was under no special disadvantage.

A bank lent money to a group of companies with a facility guaranteed by the group's managing director. The bank later refused to allow the borrower to draw down an amount, because it would be used for working capital. There was no provision in the facility prescribing the way the amount could be used (although there had been in the letter of offer on the term sheet).

Following this, both parties laboured under the mistaken belief that the borrower was in breach of a covenant prescribing the minimum interest cover, as projections showed there would be a breach. As a result, the bank said it was in a position to call in the facility and to demand repayment and questioned the guarantor's credibility, despite conceding that the breaches were not serious. Negotiations followed and additional funds were issued, on condition that a certain amount was repaid to the

43 [2003] NSWCA 180, New South Wales Court of Appeal per Handley, Beazley and Tobias JJA, 1 September 2003

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bank at the end of the year. The borrower defaulted on this obligation and the guarantor was sued by the bank for the amount outstanding.

The guarantor cross-claimed, arguing the bank breached an implied term of good faith; a wider implied term that the bank would not threaten to breach; and an express term by refusing the draw down; and the bank acted unconscionably in contravention of the Trade Practices Act, preventing the enforcement of the renegotiated contract. The trial judge dismissed the cross-claim and the guarantor appealed.

On appeal, the bank succeeded. The appeal was dismissed. The bank breached the contract when it refused the draw-down. However, the borrower could not prove any damage from that breach.

There was no wider implied term not to threaten to exercise powers other than in good faith. Threatening a breach of contract was not a breach, although, in certain circumstances, it may constitute repudiation that may be accepted by the other party.

A threat to commit an unlawful act may have created a tortious act of intimidation, but this was not argued by the guarantor. As a threat can be a tort, there is no reason to imply a term that prevents a party from threatening to breach the contract.

Potential breaches of financial covenants indicated in projections and interim accounts were not a 'potential event of default'.

There was no unconscionable conduct, and both parties were under the misapprehension that there was a breach. The bank was within its rights to demand repayment as a condition for further breaches. It was held that inequality of bargaining power is not a 'special disadvantage' and there was no unconscionability within the meaning of s51AA of the Trade Practices Act 1974.

Boral v Action Makers

In Boral Formwork & Scaffolding Pty Ltd v Action Makers Limited44 the Court considered unconscionable conduct in relation to a letter of credit.

The Supreme Court of New South Wales granted an interim injunction to prevent payment on an unconditional letter of credit where there was a serious question to be tried about whether the demand was unconscionable.

Boral Formwork & Scaffolding Pty Ltd applied for an ex parte injunction that the National Australia Bank be restrained from paying on an unconditional letter of credit, issued to an English company, Action Makers Limited. The letter of credit was designed to secure payment by Boral, within 90 days of invoice, of the price of goods that Boral was to acquire from Action Makers.

44 [2003] NSWSC 557, Supreme Court of New South Wales per Campbell J, 18 June 2003

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It was undisputed that Boral received goods, but it alleged that some of the goods were defective upon receipt. Boral asserted that it had incurred expenditure both in repairing the goods and on other items arising from the goods being defective, and submitted that it was entitled to set off that amount against the purchase price of the goods.

Action Makers Limited had gone into administrative receivership and the receivers proposed to call on the letter of credit, based on the uncontroversial proposition that an essential characteristic of a letter of credit is that it is an autonomous contract and its performance is independent of the underlying contract to which it relates. Boral questioned the receivers' ability to do so, pointing to the defects in the goods and asserting that these defects prevented the beneficiary from being able to certify, as required by the letter of credit, that the total value of the defective goods was due under the agreement to supply the goods.

Justice Campbell found that there was a serious question to be tried about whether the demand for the full invoice value constituted unconscionable conduct.

While his Honour noted that the usual rule applicable to letters of credit is that the person who holds such a document should be paid first (with any fight about whether payment ought to have been made to occur later), his Honour found that the receivership of Action Makers Limited and its likelihood of going into liquidation created an exception to this general rule. The receivers had said that, if payment was received by Action Makers in full, and Boral then brought a claim for damages arising from defects in the goods, Boral would be an unsecured creditor for that claim. The receivers had also stated that, if Action Makers went into liquidation, there would likely be a nil dividend to unsecured creditors. Accordingly, if payment was made on the letter of credit, Boral could suffer a detriment for which any right to claim damages, or right of proof, would be an inadequate remedy.

In these circumstances, and in light of the urgency surrounding the application, Justice Campbell found that the balance of convenience favoured the grant of a short interlocutory injunction for only as long as necessary to enable better informed argument by both parties before the court.

While such allegations are not currently made with the frequency with which misleading and deceptive conduct allegations are made, lenders should be wary of the scope of allegations relating to unconscionable conduct.

(ii) Misleading and Deceptive Conduct

On triggering a default, a lender may be met with a claim that it has

engaged in conduct that is 'misleading or deceptive or is likely to mislead

or deceive' contrary to s52 TPA or s12DA ASIC Act. This section will

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outline two possible types of misleading or deceptive conduct that may be

alleged by a borrower.

(1) The facility agreement and prior communications

It is common practice for a lender to offer a line of credit to a

borrower by way of a Letter of Offer and General Conditions, so

that the facility agreement consists of the Letter and the General

Conditions.

The lender should ensure that the Letter of Offer and any

communications leading up to the Letter of Offer do not amount to

misleading or deceptive conduct in contravention of s52 TPA or

s12DA ASIC Act. In Commonwealth Development Bank of

Australia v Lawton,45 the bank sought to enforce a mortgage (given

by the borrower as guarantor) when the borrower's company failed

to pay interest on a term loan facility. The borrower argued that the

bank's conduct was misleading or deceptive because the letter

sent to the borrower prior to the execution of the mortgage and the

Application for Finance did not state that the borrower would be

required to guarantee the repayment of monies. Ashley J held that

the letter and the Application for Finance was neither misleading or

deceptive.46 The Court had regard to the fact that the borrower was

an experienced businessman who had previously entered into

mortgages, and he had a personal solicitor at the time who was

also the company solicitor.

In Metcalfe v NZI Securities Australia Ltd,47 the trustee of a unit

investment trust applied for a loan. During the course of

negotiations, two facility letters were provided to the trustee by the

lender in which the term of the proposed loan was set out. The

agreement was stated to be conditional upon the preparation,

execution and delivery of formal legal documentation, which was to

incorporate 'substantially' the terms set out in the facility letters.

The letters, however, provided for the extension of the term of the

loan in terms which were different to the formal loan document.

The trustee defaulted and the bank appointed a receiver to the

45 Unreported, Sup Ct, Vic, 19 Feb 1998. 46 Para 9 and 10. 47 Unreported, FC, FCA, no 117/96, 5 March 1996.

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trustee. The trustee brought proceedings claiming breach of s52

TPA. The court awarded damages to the trustee stating that:

the trustee was very misleadingly presented with a document

purporting to be the legal embodiment of the arrangement set out

in the facility letters, while in reality a different and less favourable

arrangement had been substituted'48

One commentator has observed that Metcalfe:

…raises the question of whether or not it would be misleading

and deceptive for a lender to present a facility agreement which

did not accord with a facility letter, without pointing out the

difference, in a case where there was only one facility letter

issued substantially prior to the preparation of the facility

agreement...As always, the question will be "whether in light of all

the relevant circumstances constituted by the acts, omissions,

statements or silence, there has been conduct which is or is likely

to be misleading or deceptive": Demagogue Pty Ltd v Ramensky

(1992) 39 FCR 31 at 41.49

In Durkin v Pioneer Permanent Building Society Ltd,50 the borrower

alleged that certain statements made by the lender as to the

prospects of the borrower obtaining further funds were misleading

and deceptive contrary to s52 TPA. In addition to specifying in a

letter the condition precedent which had to be satisfied before the

lender would advance the funds, the lender also made

representations as to the time within which the lender would settle

the loan contract etc. The court held that the borrowers did not rely

on these representations, the representations were not

inconsistent with the letter and that any representation as to the

availability of funds was subject to the conditions set out in the

letter. In essence, it was not alleged that the lender made

statements which led the borrower to believe that the position was

other than as appeared from the correspondence.

These cases illustrate the significance of prior dealings between

the lender and borrower leading up to the transaction. Letters of

offer and other preceding communications should be carefully

checked by lenders to ensure that they are consistent with what

48 Para 6. 49 Paterson J, Metcalfe v NZI Securities Australia Ltd (1996) 24 ABLR 391. 50 [2003] FCA 419.

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has been agreed between the parties. If the agreement is to be

constituted by a later formal agreement, this should be made clear

to the borrower. Although preliminary documents will often be

insufficiently complete to constitute a binding contract:

Clear statements that the arrangement is subject to formal

contract or disclaiming legal intent are important in avoiding

unintended contractual liability, particularly in a more detailed

preliminary document which could stand alone as a contract…If a

preliminary document is intended merely to provide a flexible

starting place for negotiations, lenders need to be careful to avoid

creating an impression of greater significance through the

wording of the document…51

(2) Explain the terms of the agreement and risks

In order to safeguard against breach of s52 TPA or s12DA ASIC

Act, the lender should ensure that the terms of the agreement are

adequately explained to the borrower, or advise the borrower to

obtain an explanation from a third party, even if the borrower is a

'sophisticated' customer.

In Abram v Bank of New Zealand,52 the borrowers were not

properly informed by the bank's solicitor of the terms of the

mortgage. The bank's solicitor failed to draw attention to the 'all

moneys' and 'on demand' provisions. The borrower claimed that

the bank engaged in misleading and deceptive conduct and acted

unconscionably in contravention of s51AB TPA. This claim was

unsuccessful because:

while the [borrower]…did not have explained to them the material

terms of the memorandum of mortgage…, and while [it was an]

"undesirable"…practice [to have the lender's]…solicitor explaining

mortgage documents to a mortgagor, [the lender's]…conduct was

not unconscionable…. The [borrowers]…were told they could

obtain independent legal advice, and did not avail themselves of

the opportunity.'53

The lender's failure to explain the risks of the facility will not be

misleading or deceptive unless the borrowers accepted the

explanation as including all they needed to know in the way of risk

51 Paterson J, Metcalfe v NZI Securities Australia Ltd (1996) 24 ABLR 391 at 394. 52 (1996) ATPR 41-470. Leave to appeal to the High Court refused: [1997] 15 Leg Rep SL 4b. 53 Para 36.

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before deciding to proceed with the transaction. In Commonwealth

Bank of Australia v Mehta,54 the bank explained the risks of the

foreign currency loan to the borrower, but left out material

particulars, so as to provide the borrower with an inadequate

description of the risk involved. The bank's conduct was held not to

be misleading or deceptive because the explanation given had not

purported to be an explanation of all the borrower should know

before entering the transaction.55

This case illustrates that the bank may face a s52 TPA and/or

s12DA ASIC Act claim even if it explains to the customer the terms

and conditions of the transaction.

(3) Remedies

Where a lender is found to have breached ss51AA, 51AB, 51AC or

s52 TPA or ss12CA, 12CB, 12CC or 12DA ASIC Act, the court

may:

• Order the lender to pay damages,56 and/or

• Make 'other orders', including an order declaring the

contract void, varying the contract, or refusing to enforce

any of the provisions57

(iii) Estoppel

This section is a case study of Socomex v Banque Bruxelles Lambert SA58

and considers the following issues:

• Whether a bank is estopped from withdrawing a facility if it allows a

borrower to exceed the facility limit;

• Whether a bank is required to give reasonable notice when it

exercises its right to demand repayment; and

• Whether a bank is estopped from withdrawing its facility and

demanding repayment where there is an expectation based on the

parties' conduct that the bank would continue to provide the facility.

54 (1991) 23 NSWLR 84. 55 (1991) 23 NSWLR 84 at 105. 56 Section 82 TPA; s12GF ASIC Act. 57 Section 87 TPA; s12GM ASIC Act. 58 [1996] 1 Lloyd's Rep 156.

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In Socomex v Banque Bruxelles Lambert SA, the respondent (BBL)

provided banking facilities for Socomex, a commodity trading company,

over a number of years by making loans or giving facilities for the purpose

of Socomex's operations. By guarantee dated 9 November 1987, the

managing director of Socomex unconditionally guaranteed to pay on

demand all moneys due or payable to BBL from Socomex provided that the

total amount recoverable from him did not exceed US$5m. In 1991, BBL

had advanced moneys to Socomex in excess of $25m. On 12 December

1991, BBL notified Socomex that it was not prepared to advance further

funds. As a result Socomex was forced to close out its futures position and

suffered loss. On 16 April 1992, BBL gave notice to Socomex that the

facilities were no longer available and demanded immediate repayment of

the sums advanced under the facility letter. BBL also demanded payment

from the managing director of all sums due by Socomex.

The managing director argued, amongst other things, that BBL represented

that it would give reasonable notice before withdrawing financial support for

Socomex and that BBL was precluded from seeking to enforce the legal

charge. Socomex argued that, based on the parties' communications and

conduct and against the background of commodity trading and futures

dealing, it was not open to BBL to refuse without a reasonable period of

notice such further credit as might be necessary at any time for Socomex

to pay any margins on futures contracts which it had made. Socomex

asserted that there were conversations and dealings during which BBL

imposed requirements and gave assurances which were inconsistent with

the refusal of further advances announced on 12 December 1991.59 In

response, BBL submitted that the parties' legal relationship was set out in

the facility letter and there was no agreement with or duty to Socomex to

give notice before refusing to advance further moneys, and that there was

an implied term that the facilities were to be immediately terminated and all

outstanding liabilities were to become immediately due and payable in

circumstances falling within cl 7 (dealing with events of default) of the

facility letter.

Mance J recognised that the managing director may have had extensive

relationships of friendship and trust with senior officer(s) at BBL, but said,

however, that 'statements made and support given in circumstances where

trust exists may not apply in a different context. Nor are they necessarily

59 [1996] 1 Lloyd's Rep 156 at 162.

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intended to affect legal relationships.'60 Reliance was placed on the fact

that there were 'informal understandings' that BBL would give Socomex

warning before withdrawing its finance.61 Mance J rejected this and said

that 'the legal relationship was and was understood to be governed by the

strict legal principle of 'on demand' repayment and enforceability enshrined

in the debentures, however hopeful Socomex might be that BBL

would…act on greater notice to and after discussion with Socomex.'62

Mance J found that:

…Socomex relied on BBL's conduct in relation to the operation of the

margin facility. It is true that BBL on occasions allowed, and knew that it

was allowing, the draw-down under the margin facility of sums

substantially in excess of the nominal limit…Further, discrepancies

developed…between current limits as…described in BBL's internal

documentation and the limits ostensibly agreed with Socomex. Neither

BBL's internal conduct nor its conduct in relation to Socomex…in allowing

such sums to be drawn down and to remain outstanding…lead…to a

conclusion that BBL undertook any commitment to allow such drawing

down…of money in the future.63

His Honour concluded that:

[t]here is nothing which can or does substantiate Socomex's case that it in

some way was or became an implied term of the relationship the BBL

would give reasonable notice before withholding further margin

finance…That such notice would be given would no doubt be the ordinary

commercial expectation in normal circumstances where a trusted

customer carrying on an apparently sound business retained the

confidence of its bankers. But it was never a legal obligation…64

Further, it was held that the managing director was not discharged from his

liability as guarantor up to US$5m. A surety is discharged in circumstances

where the creditor acts in bad faith, is guilty of misrepresentation, causes

the default or varies the terms of the contract between the surety and the

principal in a way which could prejudice the interests of the surety.65 This

was not the case here.

60 [1996] 1 Lloyd's Rep 156 at 163-4. 61 [1996] 1 Lloyd's Rep 156 at 177-8. 62 [1996] 1 Lloyd's Rep 156 at 178. 63 [1996] 1 Lloyd's Rep 156 at 170. 64 [1996] 1 Lloyd's Rep 156 at 189. 65 [1996] 1 Lloyd's Rep 156 at 198.

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In summary, three principles emerge from this case. Firstly, a financier is

not required to give notice before withdrawing its facilities, although

normally notice would be given. Secondly, where there is an 'on demand'

clause, the financier will not be estopped from withdrawing its facilities and

demanding repayment, even though it has allowed the borrower to exceed

the limit of the facility. Thirdly, in some circumstances, where a guarantor

has an expectation (due to conduct such as informal communications and

understandings between the guarantor and the bank) that the financier

would continue to support the borrower, it is not unconscionable for the

financier to withdraw support and seek to enforce the guarantee.

In Commonwealth Bank of Australia v Morley,66 Beach J commented that:

a bank which allows a customer to exceed the limit of an overdraft facility

from time to time is not thereby estopped from requiring that the funds

advanced pursuant to the facility be repaid in accordance with the agreed

terms of the facility.67

(iv) Waiver

Most facility agreements contain a "no waiver" clause which says that there

will be no waiver by conduct and that express conduct is required for there

to be a waiver.

Notwithstanding the inclusion of such a clause, the conduct of the lender

may lead to a finding that the requirement for writing has been waived. In

Canberra Advance Bank Ltd v Benny,68 a failure to provide financial

statements amounted to an event of default under the facility documents. It

was argued that the bank's failure to demand production of earlier

statements meant that the bank had waived its rights to receive other

statements. It was held that the lender's silence or failure to enforce its

rights did not amount to a waiver. However the Court recognised that:

there are occasions when, notwithstanding the presence of a provision to

the effect that a waiver must be in writing, the courts have found that

waiver has occurred despite the absence of writing.'69 …a term in a

contract which states that any waiver must be in writing can be the subject

66 Unreported, Vic Sup Ct, 6878 and 6989 of 1993, 19 May 1995). 67 At 13. 68 115 ALR 207. 69 Canberra Advance Bank Ltd v Benny 115 ALR 207 at 220.

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of evidence which would justify a finding that the conduct of a party was

such that the requirement for writing had been waived by that party.70

To avoid this result financiers should ensure that correspondence,

discussions and negotiations are without prejudice to their rights, and

accept any subsequent payments on the same basis. In Oliver Hume

(Southern) Pty Ltd v Apswoude,71 it was held that the acceptance of

payments did not amount to waiver because:

In each of those letters [referring to the payment] it was expressly stated

that the sums tendered were accepted without prejudice to the

respondent's right to recover the balance then due…Waiver was not a

consequence which, by purporting to tender the payments as instalments,

the applicant could force on the respondent; and, in their responses, the

respondent's solicitors were astute to ensure that there was no room for

an inference that this had occurred…72

In Durkin v Pioneer Permanent Building Society Ltd,73 there was an

existing loan from the lender to the borrower. The borrower applied for an

additional advance. The lender specified a certain condition which had to

be satisfied before it would advance further moneys to the borrower. Prior

to the condition being satisfied, the borrower alleged that the lender made

oral assertions that the lender would settle the loan within twenty-one days.

Dowsett J held that it was clear from the lender's written communications

with the borrower that the lender was still insisting on the condition and had

not waived the condition. The lender's willingness to offer assistance in

advance of the condition being satisfied did not amount to a waiver of the

condition.74 Again this case illustrates the benefit to financiers of making

their position clear and in writing.

(c) Risk Management

(i) Documentation of Variations

To minimise the risk of uncertainty and disputation about the terms

applying to any particular contract it is important that any agreed variations

be documented in writing.

(ii) Confirmation of Discussions

70 Canberra Advance Bank Ltd v Benny 115 ALR 207 at 221. 71 Unreported, Sup Ct Vic, 4043 of 1997, 12 March 1997. 72 Unreported, Sup Ct Vic, 4043 of 1997, 12 March 1997 at 7. 73 [2003] FCA 419. 74 [2003] FCA 419 at para 40.

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Similarly, to minimise the risk of assertions being made that agreements

have been varied when they haven't been, or that representations have

been made when they haven't been, it is prudent to confirm the contents of

significant discussion with clients in writing.

(iii) Registration of Charges

Section 263(1) Corporations Act provides that, where a company creates a

charge, it must ensure that a notice of charge is lodged with ASIC within 45

days. Section 266(1) provides that a registrable charge on property of a

company is void as security on that property as against a liquidator or

administrator, unless such notice is lodged.

In National Australia Bank Limited v Davis & Waddell (Vic) Pty Ltd (in

liquidation),75 extension of time was granted to the bank to register the

charge. In that case, a charge was granted to the bank from May 2000. In

August 2000, the bank discovered that security documents had not been

registered and had been lost. Replacement security documentation was

executed in December 2000. Notification of the charge was not lodged with

ASIC until February 2001, 18 business days after the expiration of the 45

day statutory time limit. The company was subsequently wound up.

The bank sought an order under s266(4) Corporations Act, extending the

period for lodging notice of the charge. That section entitles the court to

make such an order if the failure to lodge the notice:

• was accidental or due to inadvertence or some other sufficient

cause; or

• is not of a nature to prejudice the position of creditors or

shareholders.

The Victorian Supreme Court, on appeal from a decision of a Master, held

that the bank's failure to register the charge was accidental, and due to

inadvertence. The fact that the company was in liquidation at the time of

the bank's application was found not to be fatal to an application for

registration out of time, but to a be a factor which must be considered with

all the other relevant factors. In this case, there were exceptional factors

that justified the exercise of the court's discretion to extend time, including

that the company had relied on the bank for financial accommodation

without which the company could not have conducted its business, and the

delay in lodging the notice for registration was relatively short.

75 (2003) 44 ACSR 296.

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In Hewlett Packard Australia Pty Ltd v GE Capital Finances Pty Ltd76 the Court considered the grounds for granting an extension period for lodging notice of charge under section 266(4) Corporations Act and the circumstances in which the discretion to grant extension will be exercised

The Court considered whether the extension can be granted after administrators have been appointed.

The Federal Court upheld the trial judge's decision to grant an extension, taking a broad view of how the judicial discretion should be exercised.

By a facility agreement, GE provided a revolving credit facility to Daisytek Australia, secured by a fixed and floating charge over all Daisytek assets, executed as a deed. Daisytek inadvertently failed to lodge a notice of the charge within the period prescribed by s263 Corporations Act (45 days). The relevant date was 6 January 2003. On 14 March 2003, Daisytek's lawyers became aware of the omission and the form was lodged. On 16 May 2003, an administrator was appointed to Daisytek and informed of the omission. Proceedings were then begun by Daisytek for an extension of the period under s266(4). An order extending the lodgment time was made by the trial judge on certain conditions, despite the objections of Hewlett Packard, an unsecured creditor of Daisytek.

Each of the judges delivered separate judgments on the questions of whether the trial judge had correctly exercised his discretion in ordering a conditional extension, and how the actual provision should be constructed. Justices Allsop and Branson found that the judge acted within the power conveyed by the legislation and correctly exercised his discretion. In the minority, Justice Whitlam found that the primary judge lacked the power to make the extension order.

Justice Allsop engaged in a thorough survey of the law concerning the position of creditors with registered and unregistered charges where insolvency is pending. His Honour concluded that he was bound by prevailing authority to the effect that an order extending the period could be granted after the commencement of winding-up proceedings or the appointment of administrators. Justice Branson was of the same opinion. Both judges were highly critical of this prevailing position, noting that there was nothing in the Corporations Act to empower a court to extend the lodgment period after a winding-up order was made. However, unlike Justice Whitlam, the majority believed that only a High Court decision would be sufficient to reverse 100 years of authority.

The court found that the primary judge was not incorrect in finding that there were 'exceptional circumstances' to exercise the discretion to permit the extension of time in which to lodge the charge, notwithstanding the impending insolvency of Daisytek.

76 [2003] FCAFC, Federal Court of Australia per Branson and Allsop JJ, Whitlam J dissenting, 21 November 2003

mcqs S0111337063v3 150520 1.8.2006 Page 32

However, a court is more likely to grant an extension under s266 where the financial position of the company over whose property the charge operates is apparently secure. Where liquidation or insolvency seems imminent, the risk of prejudicing unsecured creditor's interests may be too high for the court to exercise its discretion and order the extension. Consideration will thus be given to the financial position of the company before the court exercises its discretion to make an order.

Until the High Court intervenes, s266 will continue to be interpreted liberally. Judges will have a wide discretion to order an extension of the time period in which to register a charge. At present, a charge might still be registered after the 'critical day' where an administrator is appointed, as was the case here.

(iv) Privacy Act 1988

The Privacy Act 1988 establishes a national scheme to regulate private

sector organisations by providing a minimum standard for handling

personal information. The National Privacy Principles (NPP) are ten

principles which set the minimum standard for the way in which

organisations must handle personal information.

The Privacy Act 1988 applies to organisations which are linked to Australia.

Organisations include an individual, body corporate, a partnership, trust

and an unincorporated association. An organisation will be linked to

Australia if it is incorporated or established in Australia. However,

extra-territorial provisions in the Privacy Act mean that the Privacy Act will

apply to foreign companies in certain circumstances. For example, if the

bank sent personal information about a customer to a related company

overseas, it will be bound by the Privacy Act in the way it handles this

information.

Personal information means information or opinion about an individual,

whether true or not and whether recorded in a material form or not.

Examples include a person's name, address, telephone number, date of

birth, resume or personal file. It does not matter that the information is not

true or does not refer to the person by name.

Related bodies corporate may share personal information if that

information is used for the same purpose for which it was initially collected.

It can only be used for other purposes where that use would be reasonably

anticipated by the individual or the individual consents to the other use.

Both organisation must comply with the NPPs, even if the information is

transferred outside Australia.

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The NPPs cover collection, use and disclosure, data quality, data security,

openness, access and correction, unique identifiers, anonymity,

transborder data flows and sensitive information. For example, under NPP

1, a bank must only collect personal information that is necessary for one

or more if its legitimate functions or activities. A bank must only collect

information by lawful and fair means and not in an unreasonably intrusive

way, and at the time of collection as soon as practicable afterwards, must

take reasonable steps to ensure that the individual is aware of certain

things, including the identity of the collector and why the information is

collected. Under NPP 2, a bank should only use or disclose personal

information for the primary purpose for which it was collected. A bank can

use the information for another purpose if the individual consents. In

addition, a bank must take reasonable steps to ensure that the personal

information that it collects and uses is accurate, complete and up to date

(NPP3) and to protect the information from misuse, loss or unauthorised

access (NPP 4).

In addition, Part IIIA of the Privacy Act regulates the collection, use and

disclosure by credit providers (which includes banks and their agents, to

the extent that the agents are performing some function in relation to

assessing a loan application or managing a loan) of information relating to

a person's credit worthiness, credit standing, credit history or credit

capacity. There are a number of circumstances in which a credit provider

needs the customer's consent before it obtains or discloses credit

information about the customer, for example, when a bank assesses an

application for consumer credit or commercial credit, assesses the credit

worthiness of a guarantor in connection with another individual's

application for credit; collect overdue payments in respect of commercial

credit, and exchanges references with other credit provides about an

individual's credit worthiness.

2. A Lender's Conundrum: Default Versus Managed Workout

(a) Indemnity to Receivers

Before agreeing to accept appointment as a receiver or as a receiver and

manager, any insolvency practitioner will require a comprehensive indemnity from

the appointor. The giving of such an indemnity means that the appointor is

intimately concerned with the expenses of the receiver and with any liability which

the receiver might incur which is subject to the indemnity.

mcqs S0111337063v3 150520 1.8.2006 Page 34

(b) Environmental Risks

Like other officers of a company, receivers may become liable for a range of

expenses under various environmental legislation. Where the assets or company

over which the financier has security may have environmental exposure, it will be

important for the financier to carefully consider those risks before moving to

appoint a receiver.

(c) Receivers' & Managers' Obligations

In enforcing a charge, the financier or its receiver is bound by s420A Corporations

Act. Section 420A requires a 'controller', in exercising a power of sale in respect of

property of a corporation, to take all reasonable care to sell the property for:

(a) not less than that market value; or

(b) the best price that is reasonably obtainable, having regard to the

circumstances existing when the property is sold.

A controller is a receiver or receiver and manager of the property of a company, or

anyone else who is in possession, or has control of the company's property for the

purpose of enforcing a charge.

(i) Application of s420A

In Jeogla v ANZ Banking Corporation Limited,77 Einstein J held that the

receiver had failed to take reasonable care to sell the property in question,

a cattle station, and, more particularly, the breeding of cattle on it. The

receiver subsequently sought leave to appeal from Einstein J's decision,

but leave was refused.78 In the course of his decision, Spigelman CJ

disagreed with some of Einstein J's reasoning. Although Spigelman CJ's

comments were obiter, they may be highly persuasive to a trial judge

considering this issue in the future.

Einstein J held that s420A contained two price standards which a receiver

may have to seek to attain. The first was the market value contained in

s420A(1)(a). The second was the best price standard contained in

s420A(1)(b). The best price standard only applied if the property in

question did not have a market value. On appeal, the Chief Justice though

this was incorrect. There is nothing in s420A to support an overwhelmingly

dominant role for the market value standard.

77 (1999) 150 FLR 359. 78 See Skinner v Jeogla Pty Ltd (2001) 37 ACSR 106.

mcqs S0111337063v3 150520 1.8.2006 Page 35

Einstein J's approach makes the question of whether or not a property has

market value pivotal. Einstein J adopted a definition of market value as

the value of the property concerned as if it were disposed of to an

unrelated purchaser bidding in a market on an ordinary commercial basis

for a property of the kind disposed of, without any sort of discount or

incentive for purchase being offered.

The problem with this definition is that it does not indicate when an item of

property will not have a market value. Indeed, it is possible that there is no

item of property without a market value. If so, the best price standard would

never apply.

Spigelman CJ, on the other hand, thought that 'market value' in s420A

should be interpreted to mean either 'definite value' (a value which is

clearly and obviously established as a market price, for example, shares in

a company listed on the stock exchange) or 'determinable value' (property

has a determinable value if the number and nature of comparable sales is

such that a market value can be readily ascertained). If the Chief Justice's

view is followed, this means that it is more likely that a receiver will only be

expected to obtain the best price achievable in the circumstances of the

sale. In the mean time, however, until his views are actually applied in a

case, receivers should proceed on the basis that Einstein J's approach

represents the law.

(ii) How can financiers best ensure that their obligations under s420A are

discharged?

In exercising a power of sale, financiers should take note of the following:

• The financier if it is in possession or more likely its receiver can be

and is, arguably, required to enlist the assistance of experts in

determining the market value of assets and the best way to market

those assets so as to ensure that their market value is obtained

upon their sale. However, it is the financier if it is in possession or

more likely its receiver which remains ultimately responsible for

ensuring that, at the minimum, the market price is obtained.

• As to which 'market' the financier if it is in possession or more likely

its receiver is required to realise the asset's market value, it is in

that market which reflects the true value of the particular asset by

reference to its particular characteristics.

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The following is a series of steps which should be followed by financiers or

their receivers when exercising a power of sale to ensure that the

obligations and standards imposed by s420A are satisfied:

• Consciously develop a thorough understanding of the nature of the

asset being sold and identify the markets in which the property

could be sold. From there, with expert assistance, select the most

appropriate market for the asset to be marketed and sold to so as

to ensure that the ‘correct’ market value is realised.

• Not blindly follow its ‘general commercial experience’, which

presumably is gleaned from a range of asset sales in a range of

industries, none of which may provide the bank with the in-depth

knowledge required for the particular asset and industry which it is

faced with.

• Enlist the support of experts who have a proven record in relation

to both the assets and the industry being dealt with ie engage

competent selling agents and valuers.

• Ensure that marketing/selling agents actually complete the tasks

the financier has agreed they are to complete.

• Plan a sale which is designed to test the market by public auction

where an auction sale would be usual for the type of property

concerned. In fact, as a rule of thumb, property should be sold by

auction wherever possible.

• Ensure that the sale is properly advertised with full information

about the features of the property likely to attract buyers.

• Allow adequate time for the advertisement to have effect (i.e. time

to enable the prospective market to digest the relevant

information).

• Respond to all enquiries and expressions of interest before selling

the business.79

• Where faced with difficult or contentious circumstances (whether it

be, for example, due to the unusual nature of the asset or state of

the relevant market) don’t hesitate consulting the parties most

likely to complain (and later launch a s420A challenge) in respect

of the preferred sale strategy. Such consultation is not an

79 Kyuss Express Pty Ltd v Sellers (2001) 37 ACSR 62.

mcqs S0111337063v3 150520 1.8.2006 Page 37

acknowledgement of any right of potentially aggrieved parties to

dictate the sale process, but is simply a prudent step which will

result in the financier being aware of all potential issues which may

be lurking.

• Generally adopt a much more “hands on” approach to the

marketing and sale of assets.

• Refrain from informing (or even speculating) potential purchasers a

reserve price at auction80 and details of the amount due to the

mortgagee.81

(d) Retention of Staff

It is obvious that, in most circumstances, staff are going to be less enthusiastic

about working for a company which they know is in financial trouble or which is

subject to external administration than they are going to be about working for a

viable company with a secure financial future.

There are likely to be difficulties in keeping staff if the company goes into a form of

formal administration and the employees believe the company is not going to last

long. Where retaining staff is critical to the viability of the company – for example

where it is in the services sector – the impact on staff of a formal appointment will

need to be carefully considered.

(e) Insolvent Trading

Section 588G of the Corporations Act imposes personal liability on a director of a

company which incurs a debt whilst the company is insolvent if, at the time that the

relevant debt was incurred, the director had reasonable grounds to suspect that the

company was insolvent, or would become insolvent by incurring that debt. A

director will become liable if at the time the relevant debt was incurred he was

actually aware of the existence of reasonable grounds for suspecting insolvency or

a reasonable person in a similar position within a similar company would have

been aware.

(i) Can a financier be a director?

As well as people formally appointed as a director for Corporations Act

purposes the term 'director' includes persons who are not formally

appointed as a director but act in that position or persons whose

instructions or wishes the directors of the corporation are accustomed to

80 Barns v Queensland National Bank Ltd (1906) 3 CLR 925. 81 Mike Gaffikin Pty Ltd v Princes Street Marina Pty Ltd (1995) 17 ACSR 495.

mcqs S0111337063v3 150520 1.8.2006 Page 38

act in accordance with. i.e. shadow director. The definition of 'director' in s9

refers to a 'person'. However, a body corporate can clearly be a director,

including a shadow director, of a company despite the fact that it cannot be

validly appointed as such.

The definition of director is designed to encompass all those who have a

decision-making role within the company. It is not intended to cover those

who merely offer advice or suggestions on particular issues. Thus, if the

directors or board members are accustomed to act on advice given by the

a person in his or her professional capacity or as a result of a business

relationship with the directors or board members, the shadow director

principle will not apply.

There have been no cases where a financial institution has been held to be

a shadow director to date. However, if, for example, a financier becomes

actively involved in the internal affairs of a corporate client facing

insolvency in an effort to assist its financial recovery, and the degree of this

involvement is to the extent that the financier is making decisions for the

corporate client, there is a risk that the financier will be considered to be a

shadow director.

For example, on default of a loan, a financier may agree not to call in the

loan provided that certain restrictions are implemented. The financier may

require that it be allowed to send in an accountant to inspect the premises

of the borrower's business, ascertain the assets and liabilities and prepare

a report, attend monthly board meetings, request that the borrower's

accountant prepare a weekly list of required payments which would be

furnished to the financier, restrict the borrower from disposing of any major

assets without the financier's approval, and prevent the borrower from

entering into any financial transactions that require security without the

financier's approval. The financier may also provide a further loan to the

company to allow the company to continue trading. If the company then

goes into liquidation a liquidator might consider bringing an insolvent

trading claim against the financier as a 'director'. Clearly, the financier has

imposed stringent financial reporting requirements on the company and

has management and financial control.82 It is arguable that the financier

may have overstepped its role as a mere lender to the company and that

82 See Standard Chartered Bank of Australia v Antico & Ors (1995) 38 NSWLR 290, where it was held that the imposition of financial reporting requirements and management and financial control were important considerations in holding that one company was a shadow director of another.

mcqs S0111337063v3 150520 1.8.2006 Page 39

the directors had little choice but to accept the conditions imposed by the

bank to ensure that the bank does not call upon the loan.

Although courts accept that it is not uncommon for lenders to impose

conditions on loans, including conditions as to the application of funds and

disclosure of the borrower's affairs, the bank could be considered to be a

shadow director of the borrower/company if:

the conditions imposed…show a willingness and ability to exercise control,

and an actuality of control, over the management and financial affairs of

[the borrower]'.83

There are two exceptions where the extended definition of 'director' in the

Corporations Act to include persons whose instructions or wishes the

directors of the company or body are accustomed to act will not apply.

Those exceptions are where the directors act on advice given by a person

in:

(a) the proper performance of functions attaching to the person's

professional capacity; or

(b) the person’s business relationship with the directors or the

company.

It is doubtful whether a financier that plays an active role with corporate

clients in financial difficulties, in offering advice, is acting in its 'professional

capacity'. In our view this exception is likely to be restricted to recognised

professions. A stronger argument for a financier would be that the advice

was provided on the basis that the financier has a 'business relationship'

with the borrower, such that the financier is not considered a shadow

director.

If a lender is found to be a shadow director of a company, it may be liable

in accordance with s588G for insolvent trading.

(ii) Defences

Section 588H outlines a number of defences to a contravention of s588G,

including:

• the director had reasonable grounds to expect, and did expect, that

the company was solvent at the time the debt was incurred and

would remain solvent even if it incurred the debt;

83 Standard Chartered Bank of Australia v Antico & Ors (1995) 38 NSWLR 290 at 327-8.

mcqs S0111337063v3 150520 1.8.2006 Page 40

• the director had reasonable grounds to believe, and did believe,

that a confident and reliable person was responsible for providing

to him adequate information in relation to solvency and that person

was fulfilling that responsibility;

• because of illness or some other good reason, the director did not

take part in the management of the company at the time the debt

was incurred; or

• the director took all reasonable steps to prevent the company from

incurring the debt.

The first three defences may be unavailable to a financier which enters into

a business workout situation with the company/borrower. In relation to the

first defence, the very fact that the business workout situation has been

implemented may indicate that the company is in financial difficulty and

may be (or become) insolvent. Where the scope of the financier's control

and involvement with the customer is such that it is at risk of being

considered to be a director the financier should make further inquiries

before allowing further debts to be incurred. The financier may also be

unable to rely on the second defence in a workout situation as it may be

well aware of the company's financial difficulties. Similarly, if a financier

becomes a shadow director of the company, it may be difficult to argue that

the financier did not take part in the management of the company at the

relevant time. Thus assuming that the financier was found to be a director

and the exceptions referred to in (i)(a) and (b) above were held not to apply

the most likely defence that a bank may be able to rely on would be the

fourth defence outlined above. To satisfy this defence though where the

financier had power to do so it should have prevented the financier from

being incurred – if the debt has in fact been incurred then this defence may

be difficult to make out.

(iii) Conclusion

As it seems that the statutory defences to insolvent trading may not be

applicable to a financier in the event that the financier is found to be a

shadow director of an insolvent company, it is important to ensure that the

financier is not deemed to be a shadow director.

It is imperative that, where a financier is concerned about the recoverability

of a loan, caution is exercised in its level of involvement in the operations

of the company. While legitimate restrictions can be placed on the

company relating to the loan itself, or the assets secured directly by the

mcqs S0111337063v3 150520 1.8.2006 Page 41

loan, care should be taken when communicating with the company in

relation to its future. Financiers should not be seen to be involved in

transactions of the company or other managerial decisions of the company.

In particular, banks should avoid seeking ultimate veto rights in relation to

payments and other transactions of the company. This could be seen to be

a decisive factor when considering the financier's legitimate involvement in

an insolvent company.

If a financier is involved in a business workout, it should encourage the

board to seek independent financial and legal advice, and to undertake due

deliberation. Financiers should consider and clearly document the reasons

why they may consider the borrower/company to be solvent at the time so

that such documentation can be relied upon if the need arises.

Documentation could also be drafted to clarify whether what is involved in

a particular transaction is, in fact, a new debt or simply a rollover of an

existing one.

(f) Validity of Charges – attack as voidable transactions

Workouts often involve revisions to facilities and securities. The negotiated position

must be able to withstand the scrutiny of a liquidator should the borrower be wound

up. Section 588FE Corporations Act provides that different types of transactions

will be voidable in different time frames prior to the relation-back day.84 In the case

of an unfair loan to the company, the liquidator may avoid the unfair loan made at

any time before the day when the winding up began. The liquidator must first

establish the insolvency of the borrower at the time of the transaction.

A 'transaction' is broadly defined and includes:

• a conveyance, transfer or other disposition of property;

• a charge created by a body over its property;

• a guarantee given by a body;

• a payment made by a body;

• an obligation incurred by a body;

• a release or waiver by a body; and

• a loan to the body

84 The relation-back day is determined according to the manner in which the company goes into liquidation, as set out in s9 of the Corporations Act 2001. For example, if liquidation occurs through a resolution of a creditor's meeting to appoint a liquidator, the relation back-day is the date on which the liquidator is appointed.

mcqs S0111337063v3 150520 1.8.2006 Page 42

Section 588FE(2) provides that the liquidator may avoid an insolvent transaction of

the company that was entered into during the six months before or after the

relation-back day. An insolvent transaction is a transaction entered into by the

company where:

• at the time of entering the transaction the company is insolvent, or the

company becomes insolvent by entering into the transaction, and

• the transaction is an unfair preference or an uncommercial transaction.

A transaction is an unfair preference if it results in a creditor of the company

receiving from the company in respect of an unsecured debt more than the creditor

otherwise would if the transaction were set aside and the creditor were to prove for

the debt in the winding up of the company.85 Examples of unfair preferences

include taking further security for existing advances, and payment to a secured

lender beyond the level of its security.

A transaction is uncommercial if it may be expected that a reasonable person in

the company's circumstances would not have entered into the transaction.86

Examples of uncommercial transactions include where:

• a related company of a borrower provides a guarantee or security or

makes payment in respect of the past indebtedness of the borrower and

the related company derives no benefit from it, or

• onerous terms are agreed by the borrower as a condition of continuing

facilities.

The transaction will be reviewed from the perspective of a reasonable person in the

borrower's circumstances, taking into account the company's financial position and

predicament, whether the benefits of entering into the transaction outweigh the

detriment, and the benefits to the bank.

Where the transaction is voidable, the court has wide powers to make orders to

avoid the transaction, including orders directing payment of money to the company

equivalent to the amount paid by the company under the transaction, and orders

declaring the transaction to be unenforceable.87

Defences to voidable transaction

Section 588FG provides two sets of defences to an action by a liquidator to have a

voidable transaction set aside, depending on whether the person against whom the

85 Section 588FA(1) Corporations Act 2001. 86 Section 588FB(1) Corporations Act 2001.

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liquidator has brought the claim was a party to the voidable transaction. If the

person is a party to the transaction and the transaction is not an unfair loan to the

company, the person must prove that:

• they became a party to the transaction in good faith;

• they had no reasonable grounds for suspecting the company was insolvent

or would become insolvent at the time they entered into the transaction;

• a reasonable person in those circumstances would not so suspect; and

• they provided valuable consideration for, or changed their position in

reliance on, the transaction.

If the person against whom the liquidator is proceeding was not a party to the

voidable transaction, and did not receive a benefit as a result of the transaction,

this is of itself a defence. Where the third party did receive a benefit, then they

must prove:

• they received the benefit in good faith;

• they had no reasonable grounds for suspecting the company was insolvent

or would become insolvent at the time they received the benefit; and

a reasonable person in those circumstances would not so suspect.

3. Charges and Non-assignment Provisions

Where a provision of a commercial contract prohibits an assignment of the contract, it is

important to know whether a charge will contravene the non-assignment provision. For

example, in a project finance context, where a financier provides construction finance to a

developer and obtains security by way of a fixed and floating charge over the builder's

assets, and the builder's contracts with third parties prohibits assignment without consent,

is the charge enforceable? Or is the charge an "assignment" and hence unenforceable as it

contravenes the non-assignment provision?

The question whether an equitable charge constitutes an assignment is unresolved. There

are conflicting authorities, both judicial and academic, as to the nature of a charge.

(a) Is a charge an assignment?

There is authority to suggest that an equitable charge is not an assignment. In

Trancred v Delagoa Bay and East Africa Railway Co88 Denman J stated that:

87 Section 588FF(1)Corporations Act 2001. 88 (1889) 23 QBD 239 at 242

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A document given 'by way of charge' is not one which absolutely transfers the

property with a condition for conveyance, but is a document which only gives a right

to payment out of a particular fund or particular property, without transferring that

fund or property.

Note that His Honour was only interpreting section 25(6) of the Judicature Act 1873

which applied to assignees under absolute assignments, but not assignments

purporting to be by way of charge only.

A charge may be considered a potential right or power exercisable upon default by

the chargor.89 Thus, according to Professor Goode, a floating charge may be

described as an 'incomplete assignment' because the 'vesting of an equitable

proprietary interest in the chargee is deferred until crystallisation and completed

only at that point'. A number of cases support the view that a floating charge is not

an assignment until crystallisation occurs.90

In Macintosh v Turner Corporation Ltd (in liq) and Others,91 Sackville J held that a

charge constitutes an assignment and that a clause of a contract which prohibits

assignment without consent precludes a charge from charging a party's right to

performance of the contract, and also its right to receive benefits accrued under the

contract. His Honour relied upon the decision of the House of Lords in Linden

Gardens Trust Ltd v Lenesta Sludge Disposals Ltd92 and the principle that an

assignment of contractual rights in breach of a contractual prohibition is ineffective.

In that case, Turner Corporation Ltd entered into a building contract with Austotel

Pty Ltd. The contract contained a provision in which the parties agreed not to

assign the contract without the other party's consent.

Turner gave a charge to the State Bank of New South Wales in return for funding.

The charge secured Turner's undertaking and assets 'whatsoever and

wheresoever both present and future'. No consent was obtained.

Turner defaulted under the charge and the bank appointed a receiver. Turner went

into provisional liquidation. A dispute between Turner and Austotel arose under the

contract. The liquidator settled the dispute and Austotel paid Turner over $1.5

million. When the Court ordered the winding up of Turner, the liquidator applied for

directions as to whether it was justified to pay the money to the bank. A creditor of

89 A charge differs from a mortgage, which is a form of assignment as there is a transfer of an existing proprietary interest. See for example Burlinson v Hall (1884) 12 QBD 347 per Day J. 90 See for example Ferrier v Bottomer (1972) 126 CLR 597 at 607 and National Mutual Life Nominees Ltd v National Capital Development Commission (1975) 37 FLR 404 at 409-10. 91 (1995) 13 ACLC 1314 92 [1994] 1 AC 85

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Turner opposed the directions on the ground that the clause in the contract

prohibiting assignment precluded the bank's charge from attaching to the money.

Sackville J found in favour of the bank. His Honour considered that, once Austotel

paid Turner an amount under the contract, the money lost its character as an

accrued benefit under the contract and simply constituted one of its assets. As a

matter of construction, the provision that Turner should not 'assign this agreement'

could not prevent Turner effectively charging an asset constituted by moneys

received as the result of performance of the contract.93

In other words, although the charge in question was ineffectual to charge Turner's

right to performance of the contract and its right to receive benefits accrued under

the contract, once moneys were actually paid to Turner, they formed part of its

general assets independent of the contract and were therefore capable of being

charged. It was fortunate for the bank that the money had been paid and asset

was not just a benefit which had accrued under the contract.

The Queensland case of Starelec (Qld) Pty Ltd & Vangale Pty Ltd (in liq) v

Kumagai Gumi Co Ltd94 is the latest Australian pronouncement on the subject of

whether an equitable charge can amount to an assignment. While it ultimately did

not decide the question, it did discuss the rights conferred on a chargee under a

charge.

In describing a chargee's interest under a floating charge, Mullins J quoted WJ

Gough:95

Under a floating charge, the chargee acquires an equitable proprietary interest in

the charged assets only at the time of crystallisation. Prior to crystallisation, the

floating chargee obtains a personal equity, or 'mere equity', against the chargor

arising under the floating charge contract.

and:

An equitable proprietary interest vests in the chargee at crystallisation because final

and irrevocable appropriation of the charged assets to the charge contract occurs

at crystallisation…For this reason, the floating charge is described as a present

security and also as an incomplete assignment.

The respondent in Starelec submitted that on crystallisation there was an

assignment in equity of the charged contractual rights. The respondent relied on

the description given by McPherson SPJ in Relwood Pty Ltd v Manning Homes Pty

93 ibid at 1316 94 [2002] QSC 137 95 Company Charges 2nd Ed, (1996) at pp 332-333

mcqs S0111337063v3 150520 1.8.2006 Page 46

Ltd (No 2)96 that on crystallisation of a floating charge, the chargor becomes

trustee of the asset for the benefit of the chargee. Other authorities relied on by the

respondent which suggest that there is a completed equitable assignment upon

crystallisation include Biggerstaff v Rowatt's Wharf Ltd,97 and Business Computers

Ltd v Anglo-African Leasing Ltd.98

The applicant, on the other hand, stressed the view that charges, as

hypothecations (i.e. encumbrance), do not involve an assignment or transfer of

charged property, even on crystallisation.

Regrettably, the conflict apparent in the authorities was not explored in argument.

Still unresolved is the issue of whether a charge confers simply a right in

personam/a right to realisation of the debt owed at the point of both execution and

enforcement/crystallisation of the charge,99 or whether a charge operates to assign

a proprietary right upon enforcement by the chargee.

Charges over debts are especially problematic. The creation of a charge over a

debt essentially places the chargee in the same position as if he were an assignee

in equity. The remedies of the chargee effectively make him such, as the most

efficient recourse available is to sue the debtor in equity for the amount in question.

In such circumstances, it may be possible for a party to create a charge, which is

prima facie not an assignment, but which is intended to operate as an assignment

at the time of, or just before, the debt comes to be enforced.

The question will depend on the terms of the charge. In Sheahan v Carrier Air

Conditioning Pty Ltd,100 Brennan CJ suggested that it is too imprecise to talk of

charged assets being assigned, and that 'the extent of the equitable interest of a

creditor in a fund to be applied in payment of his debts depends upon the terms

governing the disbursement of the fund that are enforceable by specific

performance". The term 'assignment' has been used loosely in certain contexts,

and the strict definition of 'assignment'101 has not been used in a categorical sense

in relation to charges. Mullins J in Starelec also remarked:

In any case, the true effect of the charge given by Starelec…must be determined

by reference to the provisions of the charge which may assist in determining

96 [1992] 2 QdR 197 at 201 97 [1896] 2 Ch 93 at 106 98 [1977] 1 WLR 578 at 582 99 See Swiss Bank Corporation v Lloyds Bank Ltd [1982] AC 584 per Buckley LJ. 100 (1997) 189 CLR 407 at 422-423 101 In Norman v Federal Commissioner of Taxation (1963) 109 CLR 9 at 26 Windeyer J describes an assignment as the "immediate transfer of an existing proprietary right, vested or contingent, from the assignor to the assignee".

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whether on crystallisation the charge takes effect as a charge only or as an

equitable assignment of the charged property.

Conclusion

It appears that it is possible that in certain commercial situations the equitable

interest in a charge may amount to an assignment, although when those situations

arise has not been authoritatively determined. Whether creation of an interest by

way of a charge constitutes an assignment will depend on the provisions of the

charge and the prohibiting clause itself, in which the term 'assignment' is used.

While the law is unsettled, it is important that banks do not secure their interests by

way of charge without the consent of the counterparty.

4. Fixed charge as a floating charge

Re Spectrum Plus Ltd unreported102 considered what controls or limitations must be placed by a chargee on the use of the proceeds of book debts by the chargor in order to establish a fixed charge over the book debts.

Following the decision of the Privy Council in Agnew v Commissioner of Inland Revenue (Brumark), the English High Court of Justice has cast a significant shadow over the longstanding form of fixed charges over book debts which was upheld in Siebe Gorman & Co Ltd v Barclays Bank Ltd.

(a) Siebe Gorman & Co Ltd v Barclays Bank Ltd103 (Siebe Gorman)

Although criticised in recent times, the judgment of Slade J in Siebe Gorman has long stood for the proposition that a charge over book debts and proceeds of book debts could be a fixed charge if the chargor is sufficiently restricted in its dealings with them. Slade J stated that a charge on book debts would be a floating charge if the intention of the parties was that the chargor would be free to dispose of the proceeds of the book debts without restriction.

In Siebe Gorman, a charge over book debts which purported to be fixed provided that the chargor must:

• pay the proceeds of book debts into an account with the Bank (the account was an ordinary trading account of the company); and

• not assign or charge the book debts to any other person without the consent of the Bank.

Slade J concluded that the parties intended to create a fixed charge and the chargor was sufficiently restricted in its ability to dispose of unencumbered title to the book debts without consent. Accordingly, the document created a fixed charge notwithstanding that there were some forms of dealing which were not specifically prohibited.

102 [2004] EWHC 9 (Ch), High Court of Justice of England and Wales, per the Vice-Chancellor, 19 January 2004 103 [1979] 2 Lloyd’s Rep 142

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(b) Brumark

Since Slade J decided Siebe Gorman, the “Siebe Gorman form” of charge has become the standard form for creating a fixed charge over book debts. However, in 2001, on appeal from New Zealand, the Privy Council reviewed the law in relation to fixed charges over book debts.

In Brumark, the Privy Council considered whether a charge over uncollected book debts which left the company free to collect them and use the proceeds in the ordinary course of business was a fixed or floating charge.

The Privy Council described the approach to deciding whether a charge is fixed or floating: first ascertain the intent of the parties; secondly, characterise the parties intentions as a matter of law. The key difference in approach between the Privy Council and Slade J was that the Privy Council ascertained the intention of the parties by examining the nature of rights and obligations which the parties intended to grant each other rather than looking at the label the parties used to describe the charge. The relevant intention is whether the chargor should be free to deal with the charged assets and withdraw them from the security without the consent of the holder of the charge. In Brumark, the Privy Council found that this was the case and accordingly concluded that the charge was not properly construed as a fixed charge.

(c) Re Spectrum Plus

This case concerned a charge securing all moneys due to a bank in relation to a facility made available to Spectrum Plus for the purpose of providing working capital. The security purported to include a specific (fixed) charge over all present and future book debts of the company. The charging provisions were drafted in substantially the same form as those in Siebe Gorman.

The High Court of Justice considered the decision in Siebe Gorman and subsequent application of that case before applying the test described in Brumark. Accordingly, the High Court of Justice examined the rights and obligations the parties intended to grant each other in respect of the book debts:

… the account is an ordinary current account with a clearing bank and there is no express restriction on the operation of the bank account within the limits of the facility … The facility is liable to be withdrawn or reduced on notice and is repayable on demand but unless and until either of those events occur the company is free to draw cheques in favour of suppliers or creditors in the ordinary course of business as it sees fit.

From these rights and obligations, the High Court of Justice concluded the intention of the parties was that Spectrum Plus was free to deal with the book debts and withdraw them from the security without consent as the book debts were under the control of and available for use by the company in the ordinary course of business. It was acknowledged that the charge contained some restrictions similar to those in Siebe Gorman (no factoring, no block discounting and the proceeds must be collected in an account of the bank) however, those restrictions still

mcqs S0111337063v3 150520 1.8.2006 Page 49

allowed collection and free use of the proceeds and accordingly were inconsistent with the nature of a fixed charge.

Notwithstanding that the charge purported to be a fixed charge, this was insufficient to change the nature of the floating charge which was evidenced by the intentions of the parties. Accordingly, the High Court of Justice reached the conclusion that the decision in Siebe Gorman is incorrect and the charge is inconsistent with a fixed charge and is therefore a floating charge.

Since 1979, the decision in Siebe Gorman has been followed and applied by English lenders and insolvency practitioners. The English Crown gave notice in 2002 that it intended to challenge the decision in Siebe Gorman although it would not disturb distributions made prior to the Privy Council’s Brumark decision. Spectrum Plus clearly represents the Crown’s challenge to the Siebe Gorman decision and it is expected that this case will eventually be decided by the House of Lords. What it means is that:

• Fixed charges over book debts will in fact be floating charges if the chargee can in effect exercise complete control over:

• the collection of the book debts and the proceeds; or

• the proceeds of the book debts.

• The status of fixed charges over book debts is now more uncertain than it has been for nearly a quarter of a century

5. Conclusion

In short the message for lenders is not to be shy in proclaiming "I Want Security" and when you get it "Don't Waste It".

NOTE: This document is intended only to provide a general review on matters of concern or interest to readers. The text of this document should not be relied upon as legal advice. Matters differ according to their facts. The law changes. You should seek legal advice on specific fact situations as they arise. Parts of this paper have been extracted from the Allens Arthur Robinson Annual Reviews of Insolvency and Restructuring Law 2002 and 2003. We would like to thank Annie Tan for her invaluable help in putting this paper together and, most particularly, in updating it.

mcqs S0111337063v3 150520 1.8.2006 Page 50

Visit our website, www.aar.com.au, for:

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• The 1999, 2000, 2001, 2002 and 2003 Annual Reviews of Insolvency & Restructuring Law; and

• The 1999, 2000, 2001, 2002 and 2003 Annual Reviews of Insurance & Reinsurance Law.