Expect to see further strong penalties against directors seen to ignore insolvent trading provisions. Insolvent trading - the final say?
Expect to see further strong penalties against directors seen to ignore insolvent trading provisions. While the insolvent trading prohibition (section 588G of the Corporations Act (the Act)) has been a key feature in the environment facing company directors, it is surprising that there have been so few high profile cases going to higher courts in relation to this area.
There have been many judgments of courts at first instance dealing with this issue. But it is only in the last 12 months that we have had two major Court of Appeal decisions which have certainly given the clear message that insolvent trading is a fundamental area of our legislation and one in which the courts will take a tough line.
The New South Wales Court of Appeal in Deputy Commission of Taxation v Clarke (2003) 176 FLR 235 witnessed a clear denial by the New South Wales Court of Appeal that "sleeping directors" or wives (or husbands or partners), who do not participate in the affairs of the company for whatever reason - whether it is because of other obligations (home duties or whatever), will not escape potential liability by relying on the fact that they were not involved in the relevant contravention. The message in that case was very clear - the sleeping director is gone forever.
Now, the Victorian Court of Appeal (Chief Justice Warren, Charles JA and O'Bryan AJA) in a resounding judgment has confirmed the analysis by Justice Mandie in the Water Wheel case and dismissed the appeal by John Elliott and his co-directors against the finding that they had been in breach of the insolvent trading provisions.
While the Court of Appeal in Elliott & Anor v ASIC ( VSCA 54) saw the court reduce the disqualification term imposed on one of the directors, in dealing with the critical questions of liability under the section, the unanimous decision made it clear that Mandie J had been correct in his conclusions.
We have discussed the decision of Mandie J in an earlier edition of Law Reporter.
It is appropriate to discuss the relevant facts and to paint some of the background to the quite important judgment of the Court of Appeal because of its very careful enunciation of the factors that the "prosecution" had to establish in order to obtain a finding of breach.
Elliott and Plymin were non-executive director and managing director respectively of the Water Wheel companies (namely, Water Wheel Mills and its parent company, Water Wheel Holdings).
The companies were found to be insolvent from 14 September 1999 onwards by Mandie J at trial. On that date, the bank informed the company that it had decided to end their relationship, and that its facilities were repayable on demand.
Considering that, prior to this date, auditors' reports had revealed rapid increases in trading losses, creditors were not being paid in accordance with normal trading terms, and directors had resigned after questioning the solvency of the company, Mandie J found that there were reasonable grounds for Elliott and Plymin to have suspected insolvency. Neither had taken any steps to prevent the company from continuing to trade.
In effect Mandie J found that both directors had breached their duty under s 588G of the Act to prevent the companies from trading while insolvent.
At trial, Elliott and Plymin both denied that Water Wheel was insolvent during the relevant period and further denied that they were in breach of their duty as directors to prevent insolvent trading. These arguments proved unsuccessful, and Elliott was ordered to pay compensation to both companies under s 588J(1) of the Act, was prohibited from managing a corporation for a period of four years, and ordered to pay a penalty of $15,000 under s 1317EA(3)(a) of the same legislation. Plymin was also ordered to pay compensation to both companies, was prohibited from managing a company for 10 years, and was ordered to pay a pecuniary penalty of $25,000. Both defendants appealed the judgment.
In essence, counsel for the directors argued that Mandie J had been incorrect in analysing the relevant section and its application. In effect, he argued that Mandie J had erred:
- in finding that Elliott had contravened s 588G without first identifying the steps that Elliott should have taken to prevent the debt from being incurred, and satisfying himself that the steps, if taken, would have been effective in preventing the debt
- in finding that a director with a requisite degree of awareness of insolvency would contravene s 588G(2) if that person failed to take steps or make an attempt to prevent trading considering that no steps had been identified or proven to have been effective if taken
- by treating an individual director with the requisite degree of awareness of insolvency as having failed to prevent the company from incurring a debt unless the director satisfied the onus of proving one or more of the defences in s 588H.
Instead, according to Elliot's counsel, Mandie J should have held that it was necessary for ASIC to prove that each time the relevant debt was incurred, Elliott was aware that there were grounds for suspecting insolvency. Therefore, he argued Mandie J should have then stated what steps Elliott should have taken to prevent the debt being incurred, and determined whether those steps would have been effective.
Presumably, this would have involved ASIC proving that Elliott had the power to intervene in the management of Water Wheel, or to instruct Plymin or other directors not to incur further debt or appoint an administrator. Judd concluded by arguing that evidence already before the court showed that Elliott would have been outvoted at a board meeting in any event.
Counsel raised a number of other points which related to technical issues which do not need to be discussed in this note.
The Court of Appeal rejected the interpretation placed by counsel for Elliot (and Plymin in effect endorsed all of Elliott's counsel's arguments).
In that context, ASIC argued that in this case the evidence showed that no steps had been taken by relevant director to curtail trading by Water Wheel because the directors thought that the directors were solvent and they had no reason to suspect insolvency. In these circumstances, there would have been no occasion for the directors to have taken any steps to stop insolvent trading.
Furthermore, ASIC argued that the interpretation of the section should not be changed as a result of the fact that there had been legislative developments - the section had to be read together with section 588H (which enables the directors to establish particular defences). The onus of proof, once ASIC has established its case, is on the director to show that "all reasonable steps" were taken to prevent the company from incurring the debt.
In reaching its conclusion, the Victorian Court of Appeal which in this case delivered a joint judgment, agreed that the previous versions of section 588G (ie section 556 in the Companies Code of the various states and section 592 of the Corporations Law of 1991) had established "sudden death liability" for directors.
The court disagreed with counsel's argument that the new section introduced in 1992 created a "new beginning". In its view the new provision did not require a new formulation and by reviewing some of the older cases (which it is unnecessary for us to refer to) it confirmed that the formulation of liability, notwithstanding the fact that it had been reworded, supported the view that the legislature intended to achieve at least the same level of responsibility for directors in insolvent trading as had been imposed by the courts in earlier decisions.
There had been no contemplation of placing any onus on the regulator (in this case ASIC) to prove each particular breach or failure on the part of directors to prevent insolvent trading.
The Court of Appeal placed particular emphasis on statements in the Harmer Report (which led to the introduction of the current version of the section) to the effect that:
This formulation of a director's duty removes attention from the incurring of a particular debt or debts and directs attention to the director's responsibility for the overall financial management of the company. (at para 107 of VSCA)
In conclusion, their Honours decided the questions before the Court in interpreting the relevant section in the following manner:
- s 588G(2) does not require proof that an individual director failed in his or her duty to take a step which would have been effective to prevent the company incurring the debt
- ASIC, in order to establish liability against Elliott, was not required to prove that he was under a duty to take a particular step that would have been effective to prevent the company from incurring a debt, and he did not take such a step
- Mandie J was not required to consider what duty Elliott had to prevent the company incurring each particular debt for which a contravention was alleged
- the judge properly considered Elliott's defences, including the availability of a defence under s 588H(5)
In considering the orders that the court could make in these circumstances, reliance was placed on the judgment of Santow J in Re HIH Insurance Pty Ltd (the Adler case) [Law Reporter, April 2002]. A number of propositions were put forward which summarised the approach that the court in earlier cases had taken into consideration of disqualification of directors. As this is an issue that is relevant in another note that we publish in this month's Law Reporter (ie the Rich and Silbermann case), we set then out for your consideration and to remind you of the issues that are relevant:
(a) disqualification orders are designed to protect the public
(b) the banning orders is designed to protect the public by seeking to safeguard the public interest in the transparency and accountability of companies and in the suitability of directors to hold office
(c) protection of the public includes protection of individuals that deal with companies, including consumers, creditors, shareholders and investors
(d) the banning order is protective against present and future misuse of the corporate structure
(e) the order has a motive of personal deterrence, though it is not punitive
(f) the objects of general deterrence are also sought to be achieved
(g) in assessing the fitness of an individual to manage a company, it is necessary that they have an understanding of the proper role of the company director and the duty of due diligence that is owed to the company
(h) longer periods of disqualification are reserved for cases where contraventions have been of a serious nature such as those involving dishonesty
(i) in assessing an appropriate length of prohibition, consideration has been given to the degree of seriousness of the contraventions, the propensity that the defendant may indulge in similar conduct in the future and the likely harm that may be caused to the public
(j) it is necessary to balance the personal hardship to the defendant against the public interest and the need for protection of the public from any repeat of the conduct
(k) a mitigating factor in considering a period of disqualification is the likelihood of the defendant reforming
(l) the following criteria need to be assessed:
- Character of the offender
- Nature of the breaches
- Structure of the companies and the nature of their businesses
- Interests of shareholders, creditors and employees
Risks to others from the continuation of offenders as company directors
- Honesty and competence of offenders
Hardship to offenders and their personal and commercial interests
- Offenders' appreciation that future breaches could result in future proceedings
A number of other criteria dealing with the relevance of the length of disqualification were also discussed but these are not particular relevant in these circumstances.
When taking all of these matters into consideration, the court held that the orders made by Mandie J against Elliott to be "moderate rather than severe" (2004) VSCA at para 138. They regarded Elliott's contraventions as being "inexcusable and showing continuing disregard for the position of creditors" (2004 VSCA at para 140).
Regardless of the fact that Elliott was a non-executive director, he had "stubbornly and tenaciously" allowed the company to trade. Nevertheless, in the case of Plymin, the court found that the disqualification period was excessive and reduced it from 10 years to seven years. The pecuniary penalties were not in any way tampered with by the Court of Appeal.
The decision is a clear message to company directors that our courts will take the insolvent trading provision very seriously and will, in the appropriate case, impose significant penalty orders against directors.
John Elliott has decided not to appeal his decision and this is so despite the quite important decision of the High Court of Australia in Rich and Silbermann v ASIC discussed in a separate note this month. In that case, although we do not yet know the published reasons for the High Court decision (which was a majority one) it ruled that the evaluation of the penalty regime made by the New South Wales Court of Appeal in the Rich and Silbermann case, (in a similar analysis we have set out above in relation to the Elliott decision) suggests that the regime was punitive rather than protective. It may well be that ASIC will find it more difficult to pursue these cases in the future in order to obtain large penalties for breaches of the provisions that carry only a civil liability.
Bad sports with money
Courts get tough on anti-competitive purposes
in trade practices cases
When the Australian Competition and Consumer Commission failed to persuade the Dawson Committee to include an effects test into section 46 of the Trade Practices Act (to prohibit the misuse of market power), no one thought that this decision would result in much significant change.
Indeed, the Senate Economic References Committee in reviewing section 46 agreed with Dawson that an effects test should not be introduced. Now, however, the Federal Court in a rather interesting and quite extraordinary decision in ACCC v FILA Sport Oceania Pty Ltd (2004) FCA 376 has shown why it will be unnecessary to worry about the inclusion of an effects test. The word purpose has been given a very vigorous interpretation by the court in this case.
The case is interesting from other perspectives. FILA is one of the leading international sportswear companies which supports football clubs, cricket clubs and other organisations in this country. In this case FILA was involved in licensing Australian Football League (AFL clubs) to supply certain apparel to their members. This arrangement existed with about four or five major AFL clubs.
AFL has two types of licence apparel - "on field" apparel which is identical to that worn by players of the various AFL clubs (such as football jumpers or jerseys). Then there were so called "team spirit" apparel which features the relevant team colours and designs and logo which is not worn by the AFL players.
A large number of companies have been granted licences to provide "team spirit" apparel. In 1999 the AFL restructured its licence system. Apparently FILA decided to introduce a selective distribution policy under which FILA would not supply retailers with either "on field" or "team spirit" apparel if the relevant retailer stocked "team spirit" apparel manufactured by another licensee. The ACCC alleged that FILA had misused its market power and engaged in an anti-competitive distribution system in breach of section 47.
To show there is a breach of section 47 of the Act the ACCC (or a civil litigant) has to show that the particular agreement (for example that company A will supply company B on the basis that company B will not supply other manufacturers' products) will only be breached if the relevant conduct or agreement has either the purpose or effect of substantially lessening competition.
To breach section 46 (the misuse of market power provision) you have to show that the "guilty" person is using it for a purpose of preventing competition or damaging competitors. It has been thought by experts that it is likely to be more difficult to establish an anti-competitive purpose in relation to section 47 than under section 46.
Yet despite this differentiation, and despite the fact that FILA for various reasons decided not to contest the case in Australia (and actually decided to exit its main business activities in this country), Justice Heerey held that the purpose behind the FILA arrangement was in fact anti-competitive.
In doing so he relied on an internal memorandum which had been sent by FILA to its staff instructing them to refuse to supply "on field" apparel to any company which did not agree not to stock "team spirit" apparel because this would, in FILA's view, diminish the value of the "on field' wear. Further, the judge did not obtain any evidence as to the impact that this arrangement had in the market and this is what appears to be necessary in a case under section 47. He simply relied on the relevant memorandum as indicating that there was an anti-competitive purpose of the kind prohibited by the legislation.
Another interesting observation about Justice Heerey's decision was that he treated the relevant markets as the market for each single AFL club. So he would argue Richmond and Collingwood each operated in a separate market as did the Essendon club in the context of their apparel.
This apparent reliance on narrow market definitions together with a vigorous interpretation of the word purpose, led Justice Heerey to find that FILA was in breach of the Act in that its conduct in this case represented "a serious and blatant contravention of the Act extending over a substantial period of time". A penalty of $3 million was imposed on the company. however, he refused to impose a harsher penalty because FILA was a subsidiary of an international company.
Because the case had not been defended it is unclear whether Justice Heerey would have reached the same conclusion had evidence been lead by FILA on various matters. But, as noted above, what is clear is that the judge has adopted a very different approach to the definition of purpose in a section where it has to be linked to impact on market. If this type of reasoning is translated across into section 46 cases it will not be very difficult to establish anti-competitive purposes at all. Exclusive dealing arrangements of this kind will need to be reassessed by companies and specialist advice taken to ensure that the potential for breaching the Act is not exacerbated.
The High Court
strikes a blow
A critical decision on civil penalty regime
Ever since the Australian governments cooperated to have included in the Corporations Law (now the Corporations Act) a civil penalty regime in the 1990s to make it easier for the regulator (then the Australian Securities Commission, now known as the Australian Securities and Investments Commission to prosecute the breaches of the legislation, there has been a constant debate and tension on whether the civil penalty regime was truly a civil penalty regime.
In other words, did the regulator (ASIC) have to establish guilt in cases involving a breach of the statute on the civil burden of proof rule - ie balance of probabilities? or did it still have to rely on the criminal test - beyond a reasonable doubt? Furthermore, what were the rules of evidence that applied in relation to the establishment of a case under the civil penalty regime - were they civil or criminal standards?
In that context, one of the most important questions was whether there would be double jeopardy? If ASIC successfully "prosecuted" a person for breaches of the civil penalty regime, could ASIC later mount a criminal case relying on basically the same set of facts.
That is one of the critical questions that Rodney Adler and others are facing in relation to the HIH collapse. It is also central to the arguments that have been raised by Rich and Silbermann of One.Tel in their battle with ASIC in relation to the disclosure of certain information which ASIC has sought from them in order to pursue its investigation of the collapse of that company.
In ASIC v Rich at first instance, Austin J held that the information being sought by ASIC in relation to the discovery claims were truly in the context of a civil penalty regime, and that therefore the directors could not refuse to supply this information to ASIC on the grounds that it might incriminate them. In last month's Law Reporter we commented on the New South Wales Court of Appeal decision in this case. By a majority it was held that the information was being sought by ASIC under a civil penalty regime and that the directors could not refuse to supply the information on the basis that it might amount to self?incrimination. Justice McColl wrote a strong dissenting judgment and leave to appeal to the High Court was granted.
That case has now been heard by the High Court of Australia (on 22 April 2004) and in an extraordinary set of events, the High Court has given judgment in the case on the same day, but has indicated that its reasons will be provided later. (Rich & Silbermann v ASIC  HCA Trans 121)
In essence, the High Court held that the appeal by Rich and Silbermann should be upheld (together with costs) and that the orders made by the earlier court should be set aside - in other words, there is no requirement on the part of Rich and Silbermann to provide ASIC with the information that is being sought.
The High Court has indicated that its decision was reached by a majority of the seven judges sitting (Gleeson CJ, McHugh, Gummow, Kirby, Hayne, Callinan and Heydon JJ) - we do not yet know who is in the majority.
We will await with a great deal of interest the reasons for the majority decision. But Brett Walker SC, counsel for the applicants, was able to persuade the court that the penalty regime being administered under the Corporations Act was in effect not protective but punitive. In other words, the court appears to have accepted the conclusions reached by Justice McColl in the New South Wales Court of Appeal decision.
The implications of such a finding might be quite significant. If the High Court limits its reasons to the specific matters before the court - ie the question of whether the information being sought could amount to self-incrimination - the matter may not create such significant problems. If, on the other hand, the High Court questions the very essence of the civil penalty regime and how it operates, then we may have another crisis following us in the corporate law regime. When the High Court ruled in Re Wakim in 1999 that the Commonwealth's agreement with the States to regulate this area was unconstitutional, it brought about a commercial and constitutional crisis, the likes of which have rarely been seen. One hopes that we will not see a repetition of that situation, on a different basis, on this occasion. We will find out in due course. In the meantime, however, ASIC's powers to obtain information in relation to penalty cases that is being run by it, could be significantly limited by the recognition by the High Court of Australia of the right of directors (and others) not to incriminate themselves by providing information to the regulator.
Depending on the nature of the High Court's reasoning, this could also impact on the final makeup of the CLERP9 legislation. If the Opposition senators in Canberra believe that the decision in Rich and Silbermann might well have watered down the impact of our corporate law in dealing with allegedly delinquent directors, they may require even more amendments to be introduced into the CLERP9 legislation. The potential for significant further changes to the statute in this area becomes significantly heightened as a result of this quite interesting and potentially far-reaching decision.
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