A recent Federal Court ruling underscores the potential dangers for directors who sign off on unwise related party transactions, writes Professor Pamela Hanrahan.

    The Federal Court decision in Australian Securities and Investments Commission v Daly [2023] FCA 290 has again highlighted the risks faced by directors who commit their companies to unauthorised and imprudent transactions with related parties. 

    ASIC’s successful civil penalty action against four officers of Endeavour Securities (Australia) Ltd (Endeavour) had its genesis back in 2015. Endeavour was part of a group of companies that included Linchpin Capital Group Ltd (Linchpin). Linchpin operated an unregistered investment vehicle known as the Investport Income Opportunity Fund (IIOF). Endeavour established a registered managed investment scheme with the same name and raised over $17m from 131 investors throughout 2015–16 under a series of product disclosure statements (PDSs). About 95 per cent of those funds were then transferred from the registered scheme to Linchpin’s IIOF. 

    Soon after, ASIC began an investigation of the Linchpin group. In August 2018, receivers were appointed and in March 2019, Endeavour and Linchpin settled ASIC enforcement proceedings and were placed into liquidation. In the 2019 proceedings, Endeavour was found to have contravened the Corporations Act 2001 (Cth) on multiple occasions. This included breaching Chapter 2E of the Corporations Act (as modified to apply to registered schemes) by engaging in related party transactions without member approval. 

    In November 2019, ASIC banned some of the officers from the financial services industry. The ban was challenged, but upheld by the Administrative Appeals Tribunal in April 2020. In September 2020, ASIC commenced the civil penalty proceedings against four officers of Endeavour for their part in the unlawful transactions. 

    As the operator of a registered managed investment scheme, Endeavour and its officers had special duties to the scheme’s investors under Chapter 5C of the Corporations Act, including a positive duty to take reasonable steps to ensure that Endeavour complied with the law. Endeavour’s failure to obtain the scheme members’ approval for the transfer of funds to its related parties was central to ASIC’s successful action against the officers.

    Related party transactions 

    Transactions with related parties always involve heightened risk. In the 2002 civil penalty proceedings against officers of HIH Insurance Ltd, Justice Kim Santow observed that where a transaction involves a potential conflict, “the duty of care and diligence falls to be exercised in a context requiring special vigilance, calling for scrupulous concern on the part of those officers who become aware of that transaction to ensure that any necessary corporate approvals are obtained and safeguards put in place”. 

    Where the transaction involves a public company or an entity it controls, or a registered scheme as in Daly, the approvals and safeguards mentioned by Justice Santow include those imposed by Chapter 2E of the Corporations Act. Those provisions apply when a transaction engaged in by a public company — or an entity it controls — gives a financial benefit to a related party of the public company. Related parties include its directors, any entity that controls the public company, and directors of the controller. It also includes entities that they control (unless they are also controlled by the public company) and, in the case of directors, their spouses and children. 

    The basic principle is to require the approval of the public company’s members — or, in a registered scheme, the scheme members — for any transaction with a related party that could endanger its interests. This is subject to some exceptions, including for transactions that are wholly intra-group or that take place on arm’s length terms. 

    In Daly, the transfer of funds from the registered scheme operated by Endeavour to the IIOF triggered the approval requirement. The money flowed through the IIOF to other group entities and some officers in loans that failed to comply with protections described in the registered scheme’s PDSs and required by law. This included a failure by Endeavour’s officers to seek member approval as required by the Corporations Act. 

    Arm’s length terms 

    Transactions with related parties are not prohibited by the legislation, and transactions that take place on the equivalent of “arm’s length terms” do not require member approval. But directors who approve these transactions can expect a high level of scrutiny.

    In Daly, following earlier authority, Justice Elizabeth Cheeseman explained that a person seeking to rely on the arm’s length terms exception would need to show that the terms stack up against a hypothetical transaction entered into by a public company, which is “unrelated to the other party to the transaction in any way, financially or through ties of family, affection or dependence; free from any undue influence or pressure; through its relevant decision-makers, sufficiently knowledgeable about the circumstances of the transaction, sufficiently experienced in business and sufficiently well advised to be able to form a sound judgment as to what is in its interests; concerned only to achieve the best available commercial result for itself in all of the circumstances”. This is a high burden. The terms that “would reasonably be achieved by the hypothetical public company in this position, are the standard against which the terms of the transaction in question are measured”.

    In marginal cases, opinions might differ about what is a reasonable commercial outcome and expert evidence may be relevant. But in deciding whether the exception applies, a court will not “blind itself to common sense and obvious commercial prudence. A transaction may be so clearly improvident from the public company’s point of view that the court can see for itself that the transaction could never have resulted from an arm’s length dealing in which the public company was able to advance and protect its own commercial interests”. 

    The loans made by the IIOF were so imprudent that they could not have been on arm’s length terms. Justice Cheeseman found that the officers did not consider whether the transfer of funds from Endeavour constituted a related party transaction, or was non-compliant with the Act, the PDSs, and Endeavour’s internal policies and controls. They did not seek independent legal advice on the transaction. With other failures, this led Justice Cheeseman to conclude that the officers breached their duty of care in managing the registered scheme. 

    In any loan to a related party, there should be careful consideration of the terms of the loan. This necessarily includes consideration of the strength and value of any security offered. In the ordinary course, independent third party legal advice as to the appropriateness of the loan is apposite. Where Chapter 2E potentially requires member approval, failure to obtain it may amount to negligence on the part of the officers concerned.

    This article first appeared under the headline ‘Staying At Arm’s Length’ in the June 2023 issue of Company Director magazine.  

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