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Trustees liable to pay liquidators for company’s losses

This item has been adapted from an article written by Marilyn Hay

In the case of Rowmata Holdings Limited (in liq) v Hildred, the High Court has held that liquidators of a company were entitled to repayment of GST receipts from associated parties (two trusts) that had received them.

Background

The matter arose from a sale and purchase agreement for the purchase of land where two trusts (the purchasers) did not have the financial ability to settle. Before settlement date a company incorporated by the purchasers claimed a GST refund from the purchase some of which it paid out to the trusts in settlement of debts. When the purchasers subsequently defaulted at settlement date, the GST refund became repayable to Inland Revenue but there were no funds held by the company to meet this liability. The company went into liquidation and the High Court agreed with the liquidators that they were entitled to recover the entire amounts claimed from the trustees of the trusts.

Facts

  • Mr and Mrs Hildred (the Hildreds), Southland dairy farmers were trustees, together with Mr George Cole, a Taranaki farmer and family friend, of the Rowmata No 1 Trust and the Rowmata No 2 Trust (the Rowmata 1 and 2 trusts).
  • The Hildreds farming business was run through the Rowmata 1 and 2 trusts. The trusts operated as a single informal partnership.
  • On 15 August 2008, the Hildreds signed an agreement for sale and purchase of a farm. The purchase price was $6.4m plus GST – making a total of $7.2m. The agreement was signed by the Hildreds “on behalf of the Rowmata Trust” although there was no such entity as the Rowmata trust.
  • It was intended the title would ultimately be taken by a new company to be formed called Rowmata Holdings Limited (RHL). The Hildreds were to be directors of the new company.
  • Under the agreement for sale and purchase the Hildreds had 10 working days to obtain finance and their solicitor’s approval. If the contract was declared unconditional, there was then a reasonable delay before a deposit was payable and 10 months before final settlement. The deal was structured this way so as to allow the purchasers time to obtain and use the GST refund on the purchase price to pay the deposit and then to maximise the time post-deposit to secure funding before being required to settle. A 10% deposit ($720,000) was payable when the agreement became unconditional although this was later amended so that the deposit could be paid in two instalments of 5% or $360,000.
  • The Hildreds made the agreement unconditional on 5 September 2008 without guaranteed bank funding to complete the purchase. The Hildreds then decided to incorporate RHL with the intention that it would take title on settlement.
  • RHL was duly incorporated on 11 September 2008. Two parcels of one share each were issued. One was held by the trustees of the Rowmata No 1 Trust and the other was held by the same individuals as trustees of the Rowmata No 2 Trust. The Hildreds were the directors. On 3 September 2008, a week prior to RHL’s incorporation, the Hildreds opened a bank account in the name of RHL.
  • The first tranche of the deposit ($360,000) was credited by the bank to the Rowmata Trusts Partnership account and was then transferred to the new company account. The deposit was then paid (via solicitors) to the vendor from the RHL account on 5 September 2008. So there was an initial bank advance to the Rowmata 1 and 2 trusts which then on-lent that advance to RHL.
  • On 23 September 2008, the vendor issued a GST tax invoice to RHL thereby treating that company as if it were the purchaser. On 6 October 2008, RHL submitted its GST return claiming a refund of $737,500. The refund was paid on 17 October, with Inland Revenue presumably accepting that RHL was to take title and so would be the recipient of the taxable supply in terms of s 20(3) of the Goods and Services Tax Act 1985.
  • On 20 October 2008, RHL repaid the $360,000 loan to the Rowmata 1 and 2 trusts by transferring that amount to the Rowmata Trusts Partnership Account. On 10 December 2008, the company paid to the vendor from its own funds the second tranche of $360,000. This left $17,500 in RHL’s account.
  • A deed of novation was drawn up to replace the “Rowmata Trust” with RHL in the agreement for sale and purchase as the new contracting party. Although the deed was drafted and executed by the Hildreds and Mr Cole as trustees it was never executed by the vendors, accordingly the novation.
  • Between September and December 2008 the global financial crisis (GFC) occurred. Farm land prices tanked and stock values fell in response to both the crisis itself and collapsing commodity prices. The bank tightened its requirements and the Hildreds attempted to draw in further equity investors to make up the shortfall. Their attempts failed and they proved unable to settle the purchase.
  • RHL’s accountant attempted to settle with Inland Revenue the question of the $737,500 GST refund. RHL offered to repay $17,500 but this offer was rejected and Inland Revenue applied to the High Court to liquidate the company. An order was obtained placing RHL in liquidation. The plaintiffs were appointed liquidators. The liquidators asked the Court to reach through the company to its directors to make them account for the GST refund originally paid to RHL. The liquidators maintained that this was appropriate because the Hildreds breached their duties as directors under ss 131(1), 135, 136 and 137 of the Companies Act 1993. They also made a separate claim against the Hildreds and Mr Cole as trustees of the two mirror trusts under ss 292, 297 and 298 of the Companies Act 1993, s 348 of the Property Law Act 2007 and equitable doctrines of restitution. The liquidators maintained that the trusts were the true purchasers, not the Hildreds personally.

The High Court’s decision

The High Court held that the plaintiffs were entitled to judgment. The High Court ordered that the defendant trustees pay the plaintiffs $720,000 plus interest. The Court found as follows:

Were the Rowmata 1 and 2 trusts the purchasers?

1. On 15 August 2008 when the agreement for sale and purchase was signed, the Hildreds intended the purchaser to be the Rowmata 1 and 2 trusts purchasing as a partnership. It did not matter that RHL was intended at some point and in some way to take over the transaction. What mattered was the Hildreds’ intention on the date of purchase.

Did Mr Cole then retrospectively ratify the purchase as the third trustee?

2. The purchase was ratified by Mr Cole and was completed by the Rowmata 1 and 2 trusts.

3. Mr Cole knew he had not signed the agreement for sale and purchase and, as a trustee, he should have known that cl 12.1 of both trust deeds provided that his signature was necessary to create a binding contract in the names of the two trusts. It was Mr Cole’s responsibility to know that. Mr Cole could not claim ignorance of such an essential element of his role as a trustee in order to exclude his own responsibility.

4. When Mr Cole executed the deed of novation, he adopted the purchase that made novation necessary and upon which it was based (Thompson v Hickman [1907] 1 Ch 550 cited).

5. A ratifying trustee must know he or she is adopting the transaction and must have some knowledge of the facts of the transaction. However, it is not necessary that the ratifying party must understand the legal consequences of ratification (McEwan v Johnstone [1918] NZLR 49 (SC) cited).

6. The authorities are clear that a party can impliedly ratify or adopt a contract by behaving in a manner inconsistent with its rejection (Clark v Libra Developments Limited [2007] 2 NZLR 709 (CA) cited).

7. Mr Cole was entitled to indemnification from trust assets in accordance with s 38(2) of the Trustee Act 1956 unless entering into the contract was itself a breach of trust but this matter was not raised before the Court. Can RHL claim its deposits back?

8. RHL was unable to recover the deposits. RHL met a legal obligation owed by the Rowmata 1 and 2 trusts. The payment by RHL discharged the Rowmata 1 and 2 trusts’ obligation under the agreement to pay the deposits. It therefore bound all parties including RHL (Simpson v Eggington (1855) 10 Ex 845 cited).

9. There was no basis upon which the principles of restitution that applied in Falls Road Properties v Fletcher (2011) 25 NZTC ¶20-093 (HC) had any application to this case. Reckless trading

10. In terms of s 135 of the Companies Act, by having RHL pay the deposits on their behalf, the Hildreds, as directors of RHL knew that this was likely to create a substantial risk of serious loss to Inland Revenue.

11. One of the essential “pillars” of s 135 is that when the going begins to get tough for a company, directors must be able to demonstrate that they have stepped back and undertaken a “sober assessment” of the company’s likely future income and prospects (Mason v Lewis (2006) 3 NZLR 225 (CA) cited).

12. The Hildreds appeared not to have contemplated the possibility of the purchase collapsing and the GST refund paid to RHL having to be repaid to Inland Revenue. They actively blinded themselves to an obvious and growing risk throughout the third and fourth quarters of 2008. This amounted to causing the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the Inland Revenue (Mason v Lewis [2006] 3 NZLR 225 (CA) and Goatlands Ltd (in liq) v Borrell (2007) 23 NZTC 21,107 (HC) cited).

Performance of obligations

13. The Hildreds allowed RHL to enter into an obligation it could not perform in breach of s 136 of the Companies Act.

14. The test in s 136 is both subjective and objective. There must be actual belief in the ability of RHL to meet its obligations when they fall due, and there must be reasonable grounds upon which to base that belief (Goatlands Ltd (in liq) v Borrell (2007) 23 NzTC 21,107 (HC) cited).

15. The belief on reasonable grounds must be that RHL will be able to perform its obligation when required. A belief that it could probably do so, or even that it was likely that it could do so, was insufficient. Rather, the belief must be that it can certainly perform its obligations.

16. The fact that things did not work out for the transaction was irrelevant in determining whether, at the time, there was a reasonable basis looking forward for concluding that the transaction would be completed.

17. There was no objective basis for the Hildreds to conclude that a bank officer’s personal support for them and sympathy for their predicament could form the basis of any reasonable belief that the bank was committed to supporting the purchase.

18. The prospect of a rising market or equity investors did not provide a reasonable basis for belief in RHL’s ability to settle.

19. The long delay to settlement on its own did not provide a reasonable basis upon which to conclude with the level of certainty required by s 136 that RHL would meet its obligations as they fell due. Though delay to settlement maximised flexibility for the Hildreds, it produced a correlated increase in risk of change in market conditions.

20. When the GST refund was paid, the Hildreds had no bank support, RHL and the Rowmata 1 and 2 trusts had no money, the GFC had begun, the Hildreds had not started to look for equity investors with whom to share the risks of the transaction and RHL, as a single purpose company, did not trade and had no income.

21. Considering all these elements together, there was no reasonable basis upon which to believe that either the contract would be completed and RHL take title or, on failure of the contract, RHL would be in a position to repay the GST refund.

Care, diligence and skill.

22. The Hildreds’ belief in their ability to complete the transaction was not reasonable. It followed that the Hildreds could not be considered to have exercised the care, diligence and skill of a reasonable director in these circumstances.

23. The directors were negligent when they expended the $720,000 GST refund repaying the Rowmata 1 and 2 trusts and paying the second deposit in the increasingly problematic economic conditions of the second half of 2008.

24. Any prospect of the Hildreds failing to complete the transaction created a correlated prospect that RHL would have to repay the $720,000. It followed that diligent directors exercising reasonable skill and care would have chosen to retain the GST refund in order to be sure that it could be repaid on failure of the transaction. Diligent directors would have either found another source of funds from which to pay the deposits or not bought the property in the first place.

Best interests of the company

25. The Hildreds breached s 131(1) of the Companies Act as they failed to perform their duties as directors in the manner consistent with the best interests of the company.

26. By bringing the company into the transaction by means of having it claim and obtain the GST refund and then repay the Rowmata 1 and 2 trusts and pay the second deposit, the Hildreds exposed RHL to liability it could not meet. This was because the transaction was at serious risk of failing from the date of payment of the first deposit, which would entitle Inland Revenue to claim repayment of the refund

Reparations, compensation or contribution

27. Section 301 of the Companies Act gives the Court the power to order company directors to personally pay reparations, compensation or contribution where, as here, they have been found to have breached directors’ duties. In this case, the directors’ contribution under s 301 was assessed at 70% of the loss.

28. Although prudent and reasonable directors would have had financial arrangements either in place or well in hand before proceeding with the purchase, the GFC was in part responsible for the Hildreds’ predicament and the GFC was not their fault.

29. The Hildreds’ culpability arose from the fact that by 20 October when the risk of the company through failure of the purchase was real enough, they chose to make the company repay the $360,000 advance from the trust representing the first tranche of the deposit. By 10 December, when the transaction stood a high likelihood of failure, the Hildreds chose to disperse the second tranche of the deposit to the vendors. It was their lack of regard for the interests of the company and preference of their own interests over those of Inland Revenue as the primary creditor that was the essence of their culpability in this case.

Transaction at undervalue

30. The liquidators were entitled to recover the entire expenditure in accordance with s 297 of the Companies Act. RHL paid $720,000 on behalf of the trustees of the Rowmata 1 and 2 trusts and received nil value in return because it had no right at that point under the contract. Both payments were made by RHL within two years of 29 July 2010, the date upon which Inland Revenue applied to liquidate RHL. RHL was rendered unable to meet its debts when they fell due as a result of making the two payments. Transactions for inadequate consideration

31. Section 298 of the Companies Act did not apply to the transactions.

32. The two deposits on 5 September and 10 December were made to the vendors not to the Hildreds, or to the Rowmata 1 and 2 trusts. These payments benefitted the trusts but the test in s 298(2) is not benefit but disposition. The repayment on 20 October from RHL to the trusts would not have been caught by s 298 because it repaid an advance of the same sum meaning that there was no value differential. Insolvent transaction

33. The provisions of s 292 of the Companies Act were satisfied. Section 292 provides that a transaction by the company is voidable by the liquidator if it is an insolvent transaction within two years of an application to the High Court to liquidate the company.

34. At the time RHL repaid the advance from the Rowmata 1 and 2 trusts, it either owed Inland Revenue $720,000 or carried a contingent liability to pay that amount but had no income, cash or other assets and no reasonable prospect of obtaining any such income, cash or assets prior to the contingent liability crystallising.

35. The repayment to the Rowmata 1 and 2 trusts of the advance meant in terms of s 292(b) that the trusts received more by that means than they would have received when the company was liquidated. Intention to prejudice creditors

36. The vendors in this case acted in good faith and without any knowledge that the dispositions could be set aside under s 348 of the Property Law Act 2007. Although the transaction ultimately failed, the vendors gave valuable consideration in exchange for the deposits – that is, they maintained the transaction on foot until after the contractual settlement date.

37. In these circumstances it would be inappropriate to require the vendors to return the deposits as to do so would potentially lead to the settlement between the vendors, the Rowmata 1 and 2 trusts and RHL being reopened. Nor for the same reason, would it be appropriate to require the vendors to pay reasonable compensation to Inland Revenue. The appropriate source for such payments was obviously the Rowmata 1 and 2 trusts, not the vendors.

Restitution

38. The liquidators claimed that RHL was entitled to have the Rowmata 1 and 2 trusts repay the equivalent in value of the deposits because the condition upon which RHL made the payment was that the company would receive title on settlement and this condition failed completely. Such a claim was really a common law version of the statutory restitution claim that had been allowed under s 297 of the Companies Act. The claim to restitution was well founded and the liquidators were entitled to restitution of the sum paid.

39. The Rowmata 1 and 2 trusts were unjustly enriched when they received benefits from RHL’s two payments. The first benefit arose in satisfying the Rowmata 1 and 2 trusts’ obligation to pay the deposits in the absence of a successful novation or nomination under the contract. The second benefit arose in such payments being treated by the parties to the transaction as reducing the Rowmata 1 and 2 trusts’ overall liability by $720,000 when they came to calculate and agree on a final settlement sum in October 2009.

References:

Rowmata Holdings Limited (in liq) v Hildred HC Dunedin [2013] NZHC 2435 CIV-2011-412-663, 18 September 2013.

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