FEDERAL COURT OF AUSTRALIA

Cook (Liquidator), in the matter of Italiano Family Fruit Company Pty Ltd (in liq) v Italiano Family Fruit Company Pty Ltd (in liq) [2010] FCA 1355

IN THE MATTER OF ITALIANO FAMILY FRUIT COMPANY PTY LTD (IN LIQUIDATION) acn 107 879 096

THE COURT DIRECTS THAT:

1.    The plaintiffs are justified in paying the proceeds of the preference recoveries to the National Australia Bank.

THE COURT ORDERS THAT:

1.    The plaintiffs’ costs of this application be costs in the liquidation.

Note:    Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules. The text of entered orders can be located using Federal Law Search on the Court’s website.

IN THE MATTER OF ITALIANO FAMILY FRUIT COMPANY PTY LTD (IN LIQUIDATION) acn 107 879 096

REASONS FOR JUDGMENT

Introduction

1    The defendant, Italiano Family Fruit Company Pty Ltd (in liquidation) (the company), was a fruit and vegetable wholesaler. In 2007 it encountered financial difficulty and was placed into voluntary administration. In July 2007, the creditors resolved that the company be wound up. The plaintiffs, Messrs Cook and O’Connor, who had been the company’s administrators, became its liquidators. The liquidators have a small fund of around $50,000 that remains to be distributed between creditors. The liquidators wish to know whether the fund should be paid to the National Australia Bank (NAB), a secured creditor that is owed around $1.2 million, or whether it should be distributed between the unsecured creditors whose claims exceed $3.8 million. To that end, they seek directions under s 511 of the Corporations Act 2001 (Cth). The amount at stake is disproportionately small to the importance of the questions that are raised by the application.

2    Prior to its administration, the company had granted securities to several of its creditors. One security was a fixed and floating charge in favour of NAB. The charge agreement has not been put into evidence, but I understand it to be in standard terms, charging in favour of NAB the company’s present and future assets. Notwithstanding the company’s insolvency, neither NAB nor any other secured creditor appointed a receiver over the company’s assets, although some secured creditors exercised rights under fixed charges.

3    Following the commencement of the winding up, the liquidators took control of the company’s assets and, to the extent those assets were not liquid, realised them. As part of that process, the liquidators sold certain assets the subject of NAB’s floating charge. This produced an amount of around $500,000.

4    The proceeds from the realisation were not paid to NAB. Rather, the liquidators applied them, first, in payment of the claims of employees who enjoyed priority under s 556 of the Corporations Act (their claims were assessed to be $245,983) and, second, in payment of the costs of the liquidation.

5    While the liquidators liaised with NAB about realising the assets, they did not inform NAB of their intention to pay the amounts due to employees; that is, the payments were made without the bank’s knowledge or consent. The liquidators explained that they did not inform NAB of their intention to pay the employees out of the recoveries of floating charge assets as they assumed that creditors such as banks are familiar with the priority provisions in the Corporations Act. The liquidators did, however, later inform NAB that those payments had been made and NAB did not complain.

6    Around the time the liquidators paid out the employees’ claims, they made demand on two former creditors for repayment of amounts that were alleged to be unfair preferences. Almost a year later, one claim was settled. The other was settled a short time after that. The full proceeds from these settlements were received by December 2009. It is the balance of that money (the liquidators’ costs having been taken out) that is the subject of this application.

7    The liquidators’ position is (and the problems raised by the application are) neatly summarised in a recent report they sent to creditors:

It is a commonly held view that the proceeds of preference recoveries are not available to secured creditors and are available to meet the costs of the liquidation and for distribution to unsecured creditors.

We are of the view that the law in this regard is not resolved and that, as a matter of equity in this instance, the [bank] may well be entitled to the benefit of funds recovered from preference payments. … [I]n brief, the argument relates to the fact that priority creditors and the costs of the liquidation have been paid in full from the assets subject to the floating charge. Had the preference recoveries occurred sooner, or payment of priority creditors delayed, the proceeds of the preference recoveries would have been applied to the payment of priority creditors or the costs of the liquidation. In that case the [bank] would have received a greater amount from the realisation of floating charge assets and it would seem inequitable that this outcome should be altered by timing issues.

8    The precise legal issue that is raised for consideration is whether NAB is to rank pari passu with the ordinary unsecured creditors in relation to the distribution of the preference recoveries or whether it has a higher claim to those funds which will prevail over the claims of ordinary unsecured creditors.

9    While NAB has been given notice of the liquidators’ application it has chosen not to appear. It cannot be criticised for this. The amount at issue is probably too small to warrant NAB incurring any legal costs.

Are preference recoveries caught by the charge?

10    Logically this is the first issue to be resolved, for if the preference recoveries are assets subject to NAB’s charge, the bank’s proprietary interest would defeat the claims of unsecured creditors.

11    The background against which the issue is to be considered is this. First, causes of action accruing to the company (eg actions for breach of contract, breach of duty, etc) and the proceeds of those causes of action are property of the company and caught by a charge over the company’s present and future property: Re Anglo Austrian Printing and Publishing Union [1895] 2 Ch 891; Movitor Pty Ltd (recs and mgrs apptd) (in liq) v Sims (1996) 19 ACSR 440, 449; Re Oasis Merchandising Ltd [1998] Ch 170, 181.

12    Second, the right to bring a preference or similar action (eg an action for insolvent trading) (which I will generally refer to as a preference action) as distinct from the proceeds recovered in such an action cannot be brought by any person other than a liquidator. That is, it is a right which cannot be assigned.

13    Building on this background it has been accepted that money recovered in preference actions that can only be brought by a liquidator are not caught by a charge over the company’s current and future assets. The basis for this seems to be that because the chargee cannot sue to recover the preference it is not entitled to benefit from the liquidator’s ability to get in the property. Whether this acceptance is warranted requires investigation.

The early cases

14    The early cases were decided when the relevant Bankruptcy Act preference provisions were applied to company windings up. The effect of those provisions (eg s 44 of the Bankruptcy Act 1914 (UK) and s 95 of the Bankruptcy Act 1924 (Cth)) was to make the preferential payment recoverable only in a suit brought by the liquidator (or trustee in bankruptcy) and not in a suit brought by a secured creditor: Re Zucco; Ex parte Cooper (1875) LR 10 Ch 510 (a bankruptcy case) and Willmott v Linden Celluloid Co (1886) 34 Ch D 147 (a company case). According to the relevant sections a preferential payment was “void as against the liquidator” or “void as against the trustee in bankruptcy”.

15    In Re Yagerphone Ltd [1935] Ch 392 the liquidator recovered a preference which was then claimed by the chargee (a debenture holder) as property subject to the charge. Bennett J held that the property (money) ceased to be property of the company when it was paid to the creditor. He went onto say (at 396) that the amount which was later recovered as a preference “was not the property of [the company], nor property in respect of which it could … be said that [the company] had even a contingent interest”. Bennett J also said (at 396) that when recovered, “the money did not become part of the general assets of [the company], but was a sum recovered by the liquidator impressed in their hands with a trust for [the unsecured] creditors”.

16    The decision in Yagerphone was examined by the High Court in N A Kratzmann Pty Ltd (in liq) v Tucker (No 2) (1968) 123 CLR 295. At trial the liquidator of the applicant obtained a declaratory judgment that a preferential payment to the respondent (a company that was also in liquidation) was void as against the liquidator together with an order that the amount be paid in full. The question which arose for consideration on appeal was whether the applicant was entitled to an order that the amount be paid in full or whether the applicant was only entitled to prove in the respondent’s winding up. That required the High Court to analyse the nature of a preference claim. In the course of that analysis the High Court (at 298) drew a distinction between two types of preferential transactions. One type was a conveyance of land or transfer of specific chattels (ie specific property). The High Court said that in that type of case the court may order that the specific property be transferred to the liquidator or the company (or trustee in bankruptcy) and, if the respondent is insolvent (or bankrupt), the liquidator (or trustee in bankruptcy) has a proprietary claim to the specific property. The second type of transaction was where the preference is a transfer of money. In that instance, the liquidator (or trustee in bankruptcy) has no claim to specific or identifiable property in the hands of the respondent; rather, the liquidator (or trustee in bankruptcy) has an unsecured claim against the respondent provable in the respondent’s liquidation (or bankruptcy). Hence, according to the High Court, it was not appropriate for the judge to have ordered the respondent to pay the full amount of the preference. Instead the liquidator should have been required to prove in the winding up of the respondent and recover its proportionate share of the available funds.

17    It was in its discussion of the second type of preferential transaction (the payment of money) that the High Court looked at Yagerphone. It largely approved Bennett J’s approach. It observed (at 301) that while it may be that money preferentially paid was subject to the charge at the time of payment, the money recovered is not the same money because the statute does not revest the money in the company (or bankrupt): it requires the creditor to pay to the company or liquidator (or trustee in bankruptcy) an amount equal to the value of the preference. The High Court considered Bennett J’s statement that preference recoveries do not form part of the assets of the company. It interpreted that statement to mean that the liquidator’s (or the trustee in bankruptcy’s) title to the recovered money does not depend upon his/her succession to any right belonging to the insolvent company (or bankrupt) and, therefore, could not be subject to a prior charge that had been granted by the insolvent company (or bankrupt). The High Court said (at 300) that it would make no difference if the charge had crystallised prior to the payment because the money recovered is not the same as the charged money.

18    The position is different, the High Court said (at 302), with preference recoveries of specific property, where title to the property recovered is revested in the company and thus is subject to a prior charge. Although not absolutely clear, the better view of the judgment is that, here, the High Court was confining its attention to the recovery of property in respect of which the charge had crystallised prior to its disposition.

19    While the relevant legislation made a preferential disposition void as against the liquidator, it is accepted that the company is the appropriate recipient of the preference action proceeds. So, in Octavo Investments Pty Ltd v Knight (1979) 144 CLR 360, the High Court said that while the action is brought by the liquidator, the appropriate order to make is to require payment (or retransfer) to the company rather than the liquidator. The High Court pointed out (at 372) that recovered preference money does not vest in the liquidator and that to order that money be paid to the liquidator tends to confuse his/her position with that of a trustee in bankruptcy (where the recovered preference money does vest in the trustee).

Difficulties with the early cases

20    It must be said that the decision in Yagerphone and the acceptance of that decision by the High Court holding that preference recoveries are not subject to a charge, coupled with the distinction that has been drawn between the recovery of specific property and money has produced uncertainty, if not unintended results, in several respects.

21    One area of uncertainty is whether a prior charge attaches to the recovery of a money preference where the money paid to the creditor can be traced either into money or specific property held by the creditor. What is recovered may properly be described as property belonging to the chargee via tracing: Buchler v Talbot [2004] 2 AC 298. As a matter of principle, if a charge has crystallised before the preferential payment is made there should be no objection in that circumstance to the charge attaching to the money/specific property recovered. The chargee might, in his/her own action against the creditor, be able to claim the traced money/specific property, although his/her claim may be subject to defences not available to defeat a liquidator’s claim. Whether or not this is correct after Kratzmann is far from clear.

22    Another area of uncertainty concerns the liquidator’s power to “sell” the proceeds of preference claims. It has long been the position that a trustee in bankruptcy and a liquidator can “sell” actions which vested in the insolvent person or the proceeds of those actions, notwithstanding the rule against maintenance and champerty; the bankruptcy cases include Kitson v Hardwick (1872) LR 7 CP 473; Sears v Lawson (1880) 15 Ch D 426; Guy v Churchill (1880) 40 Ch D 481; among the company cases are Re Park Gate Waggon Works Co (1881) LR 17 Ch D 234; Davidson (Liquidator of Larkhall Collieries Ltd) v Hamilton (1906) 14 SLT 202; and Norglen Ltd (in liq) v Reeds Rains Prudential Ltd [1999] 2 AC 1. If a preference claim is not “property” of the company then those claims, or the proceeds of those claims, cannot be “sold”. English and Australian courts have not agreed on the current position.

23    Another, more significant problem concerns the liquidator’s right to reimbursement of his/her costs and expenses. Costs and expenses are usually only allowed to be recovered out of the company’s “assets” or “property”. If preference actions proceeds are not property of the company then the liquidator is not entitled to recover his/her costs out of them.

24    Because of the importance of the general topic to several aspects of insolvency law it may be helpful to address it first. As the position in the UK and Australia has diverged it is beneficial to look at each jurisdiction separately. Logically one would normally deal with the cases on a topic by topic basis eg the liquidator’s power of sale, costs, etc. But to see how the law has developed a better understanding is obtained by considering the cases chronologically.

The UK position

25    In Re M C Bacon Ltd [1991] Ch 127, a liquidator sought to claim costs incurred in an unsuccessful action against a bank to set aside a floating charge as a voidable preference as expenses incurred in the winding up. The effect of the claim would have been to have the costs paid out of the assets subject to the charge. Millett J (as he then was) rejected the claim. One reason was that a preference action is not an action to realise or get in an asset of the company because when recovered the proceeds are held by the liquidator on statutory trust for the unsecured creditors: at 136-7, citing Yagerphone. Another reason was that even if the action was one to realise or get in an asset of the company, the liquidator could not recover the costs of unsuccessful litigation under r 4.218(1)(a) of the Insolvency Rules 1986 (UK).

26    In Re Oasis Merchandising Services Ltd [1998] Ch 170, at issue was the validity of an agreement entered into by a liquidator in purported exercise of his statutory power to sell “the company’s property”. By the agreement, the liquidator purported to assign the proceeds of an action for wrongful trading against the directors (which only the liquidator could bring). It was accepted that the assignment would be void under the general law because it was champertous. Accordingly the assignment would only be valid if it was authorised by the statute. The Court of Appeal held that the liquidator had no power to assign the proceeds of the action under the statutory power to sell the company’s property because the fruits of the action were not property of the company.

27    Peter Gibson LJ delivered the judgment on behalf of the Court. He noted that not only liquidators but administrators and administrative receivers were empowered to sell “the company’s property”. The expression, he reasoned (at 181), must have the same meaning regardless of whether it applies to liquidators or other insolvency practitioners. He observed (also at 181) that it would be surprising if an administrator or receiver (who could continue in office after liquidation) could sell the fruits of a preference action by the liquidator. This, he said, indicated that a distinction should be drawn between assets which are the property of the company when the liquidation commences (eg a misfeasance action against a director and the proceeds of that action) and assets that are recoverable only by a liquidator (eg a preference action, an action for insolvent trading and the proceeds of those actions). The former is property of the company and capable of being assigned; the latter is not and cannot be assigned. The reasoning in M C Bacon (that preference recoveries do not form part of the assets of the company) was expressly approved (at 182).

28    Not long after the decision in Oasis, the holding in M C Bacon was questioned. Re Exchange Travel (Holdings) Ltd (No 3); Katz v McNally [1997] 2 BCLC 579 involved a successful claim against the directors of a company to recover a preferential payment. At issue was whether the liquidators could recover their costs of the proceeding out of the proceeds of the claim. The Court of Appeal, although ultimately not required to resolve the point, cast doubt on Millett J’s reasoning in M C Bacon. In the course of his reasons Phillips LJ said (at 587) that “Millett J’s analysis … seems to me to run counter to a clear and straightforward statutory scheme”. He held that the costs incurred were “expenses in the winding up” and that the preferential recovery was on an “asset” under the Rules to which resort could be had for reimbursement. Morritt LJ agreed. He said (at 595) that Oasis and M C Bacon would produce a “surprising” result if they were to be followed. He was of the same view as Phillips LJ, that although preference recoveries did not form part of the property of the company it did not follow that they were not assets in the hands of the liquidator out of which the costs and expenses of the liquidation could be paid. In any event, he said (at 595-6) the liquidator could recover his costs in accordance with the well known principle of equity that “a trustee properly bringing proceedings for the benefit of his trust is entitled to an indemnity out of the trust fund for the costs properly incurred including the costs of the other side if he loses”. Reference to these equitable principles can also be found in Re Regent’s Canal Ironworks Co; Ex parte Grissell (1876) LR 3 Ch D 411, 427 and Buchler v Talbot [2004] 2 AC 298, [32].

29    In Mond v Hammond Suddards (No 2) [2000] Ch 40 the liquidator recovered a sum of money that was paid after the winding up had commenced on the basis that the payment was “void” under s 127 of the Insolvency Act 1986 (UK). The receivers claimed that the money was subject to their charge. The liquidator disputed this and, in any event, claimed that the sum was an asset from which he was entitled to claim the costs of the liquidation in priority to the chargee. The costs that he sought to recover included the costs of the proceeding. The trial judge held that the money was subject to the charge (in the UK void transactions are treated differently to preference and similar actions) but that because it was an asset of the company the liquidator was entitled to his costs in the liquidation paid in priority to the secured creditor. On appeal, the liquidator did not challenge the judge’s finding that the money was subject to the charge: the appeal centred on the question of whether the liquidator was entitled to be paid out of the charge proceeds the costs of unsuccessfully arguing that the money was not subject to the charge. The Court of Appeal held that the liquidator was not entitled to his costs because the costs of unsuccessful litigation are not properly to be treated as expenses of the winding up, citing M C Bacon. No reference was made to Re Exchange Travel.

30    Finally, in Lewis v Commissioner for Inland Revenue [2001] 3 All ER 499 a liquidator made application for an order that he could use the funds of the company to bring proceedings against the directors for wrongful trading and preferences. The decision in Mond, that if unsuccessful in the proposed proceeding the costs could not be recovered, was not challenged. The point at issue was whether, if the proceedings were successful, the costs could be recovered. Peter Gibson LJ (who delivered the judgment of the Court of Appeal) held (at 511) that, on the basis of Oasis, preference recoveries do not form part of the assets of the company. Thus, even if successful, the liquidator’s costs of prosecuting the action are not recoverable from those assets. Re Exchange Travel was not followed. The Court of Appeal did not consider the liquidator’s equitable right to recover his/her costs out of the assets recovered, presumably because it was not raised.

31    This state of affairs was obviously unsatisfactory from the perspective of a liquidator. By amendments to r 4.218 of the Insolvency Rules, the position was improved in two ways. First, a liquidator is now able to claim expenses incurred in “the preparation or conduct of any legal proceeding” (emphasis added): r 4.218(3)(a)(ii). Second, a liquidator’s expenses are payable out of the assets of the company available for the payment of general creditors, which are taken to include the proceeds of any legal action, compromise, settlement, etc: r 4.218(2)(a)(i).

32    To summarise the UK position: (1) any preference proceeds are not the property of the company but are held on trust for the unsecured creditors; (2) because preference proceeds are not property of the company they cannot be assigned; (3) statute apart, the liquidator cannot recover his/her expenses in the winding up out of preference proceeds and cannot claim the expenses incurred in prosecuting preference actions out of the assets of the company; and (4) amendments to the Insolvency Rules have reversed the position in (3).

The Australian position

33    The UK approach, which is founded on a faithful application of Yagerphone, has not been followed in Australia. For example, in Movitor Pty Ltd (recs and mgrs apptd) (in liq) v Sims (1996) 19 ACSR 440, Drummond J considered whether the proceeds of an action for insolvent trading were property of the company capable of being sold by the liquidator. He concluded that the proceeds were property of the company because under ss 588M and 588W the liquidator recovers the money “as a debt due to the company” or alternatively as a sui generis right. Drummond J did not follow the decision in M C Bacon on the basis of the differences in the wording of the the UK and Australian statutes. The reasoning of Drummond J was approved by Lindgren J in Re Tosich Construction Pty Ltd (1997) 73 FCR 219, 235.

34    Re Starkey [1994] 1 Qd R 142 concerned s 221P of the Income Tax Assessment Act 1936 (Cth), which required the liquidator to pay unpaid group tax out of “assets … of the company”. The issue was whether the liquidator was liable to make those payments out of preference recoveries. The liquidator argued that by reason of the adoption of Yagerphone by the High Court in Kratzmann, preference recoveries were trust proceeds and not assets of the company. McPherson JA, with whom Pincus JA agreed, rejected this contention. He said that it was not clear that the High Court intended to adopt everything said by Bennett J in Yagerphone. McPherson JA went on (at 153-4) to say that:

If a secured creditor may not set in motion for his own benefit a procedure for avoiding preferences that exists for the benefit of the unsecured creditors, it is a logical consequence that he should not be able to claim the proceeds of avoiding such a preference when recovered. But it is another matter to say that the liquidator holds those proceeds in trust for the unsecured creditors if what is meant by that is a “trust” in the full sense of the word, under which the unsecured creditors are equitable owners of the assets in winding up. There is little in recent decisions to support that view of the rights of creditors.

He concluded (at 154) that:

While proceeds of payments recovered as preferences in winding up do not become the property of the company, nor the property of the unsecured creditor, they do form part of the general assets under the administration and control of the liquidator that are available for payment of the costs and expenses of winding up and the claims of unsecured creditors, including that of the Commissioner under s 221P.

35    In Elfic v Macks [2003] 2 Qd R 125, the Queensland Court of Appeal examined the validity of a litigation funding agreement entered into by a liquidator to obtain funds to pursue preference actions. The liquidator claimed authority to enter into the agreement from s 477(2)(c) of the Corporations Law. That section provided that “a liquidator of a company may sell or otherwise dispose of, in any manner, all or any part of the property of the company”. The section remains the same under the Corporations Act. The Court of Appeal said that, at least for the purposes of s 477, the proceeds of preference claims were to be considered “property of the company”. McMurdo P confirmed the decisions in Movitor and Tosich, saying (at [93]):

There is nothing in the provisions of the Law to suggest that moneys recovered under s 565 of the Law are to be held by a liquidator on terms different to those on which the liquidator holds the general assets of the company … Such a conclusion is also supported by the terms of the order made by the High Court in Octavo Investments Pty Ltd v Knight which required that the moneys recovered on a voidable preference claim be paid to the company not the liquidators.

Later, McMurdo P said (at [98]) that the same reasoning applies to claims under s 588FF (unfair preferences) and s 588M (insolvent trading).

36    McMurdo P also considered what McPherson JA said in Starkey. She said (at [93]) that although the language used by McPerson JA was confusing, she did not believe that he was intending to say that preference recoveries do not form part of the property of the company for the purposes of s 477 of the Corporations Law. She is likely to be correct. What McPherson JA seems to have intended to convey was that (1) preference recoveries are not held on strict trust for unsecured creditors; and (2) preference recoveries are to be treated in the same way as any other asset of the company. On the other hand, if McPherson JA did intend to exclude preference recoveries from the definition of property in s 477, his decision would now be inconsistent with Elfic.

37    Davies JA, with whom Cullinan J agreed, reached the same conclusions as McMurdo P, also noting (at [199]) that expenses incurred in prosecuting preference claims could only be recovered as a priority under s 556 if what is being recovered is property of the company. He also (at [205]) distinguished Oasis on the basis of the different legislative provisions in Australia and the UK.

38    It is not necessary to spend much time on the idea that preference recoveries along with other assets of a company being wound up are held on trust for creditors. The issue received attention in Mineral & Chemical Traders Pty Ltd v T Tymczyszyn Pty Ltd (in liq) (1994) 15 ACSR 398 where Santow J expressed doubt about the proposition that the assets are held on trust in a strict sense, considering Ayerst v C & K (Construction) Ltd [1976] AC 167, where the theory is best expressed. Also in Commissioner of Taxation v Linter Textiles Australia Ltd (in liq) (2005) 220 CLR 592, a tax case, McHugh J said (at [674]) that it is misleading to think of the assets of an insolvent company as being held on strict trust by the liquidator, citing Starkey and other cases. He went onto say (at [635]) that, if there is a trust, it is not one that equity would recognise.

39    All this may be true if one is only considering the effect of a winding up order. But quite a different analysis is required when the liquidator has got in the company’s assets. The liquidator is required by statute (s 538) and regulation (regs 5.6.01-5.6.10) to open a bank account and deposit all recoveries he/she receives into that account. The money in that account is, without any doubt, held upon a trust of the kind recognised by equity (see by analogy Sheahan v Carrier Airconditioning Pty Ltd (1997) 189 CLR 407, 428) albeit a trust where not all of the equitable duties imposed by a on a traditional trustee will apply.

40    Perhaps the most detailed consideration of Kratzmann is found in Re Fresjac Pty Ltd (in liq); Campbell v Michael Mount PPB (1995) 65 SASR 334, a decision of the South Australian Full Court. The issue in that case was whether property recovered under s 468 of the Corporations Law (which voids certain disposals of the company’s property after winding up) was subject to a floating charge over all the company’s current and future property. Doyle CJ (with whom Matheson J agreed) said (at 339) that recoveries under s 468 are analogous to preference recoveries. He emphasised (at 344) the distinction drawn in Kratzmann between the recovery of specific and identifiable property (to which the charge could attach) and the recovery of money (which would not be covered by a charge). Importantly, Doyle CJ (at 343) dismissed an argument that the secured creditor’s disentitlement to preference recoveries was based on the fact that preferences were expressed to be “void as against the liquidator”. He pointed out that preference actions to recover specific property were also based on transactions that are void as against the liquidator. He also observed (at 341) that the appropriate order in a successful preference action is to make an order in favour of the company, citing as an example the order made in Octavo, but that did not mean the money was caught by a floating charge. He succinctly explained the chain of events relating to monetary recoveries (at 339):

Once the money of the company was paid to the defendant, the money of the company had lost its identity. At the time of the payment and immediately thereafter the company had no rights in relation to the money paid to the defendant. Upon the making of the winding-up order the payment by the company to the defendant was avoided, having been made after the commencement of the winding up, and the result of that avoidance is that a new right to compel repayment of an equivalent amount of money arose … it is not possible, as it seems to me, to analyse the matter as if the payment had never taken place.

41    The essence of Doyle CJ’s thesis is that the money recovered is not the charged money that was paid out or its substitute: it is money due on a cause of action by virtue of the avoidance of the payment. This is the same, he said (at 343), regardless of whether the charge has crystallised at the time of disposition (citing Kratzmannn). For this reason Doyle CJ concluded (at 345-347) that monetary recoveries are not subject to a charge. The position was different, Doyle CJ concluded, with specific property which revested in the company. Revesting results in the revival of the proprietary interest previously held by the chargee.

42    To summarise the Australian position: (1) preference proceeds are property of the company; (2) the liquidator can sell the proceeds; and (3) the liquidator can claim the general costs and expenses of the winding up and his/her remuneration out of preference proceeds because they are property of the company.

Reconciling the Australian and UK positions

43    In the UK, preference recoveries are not property of the company. In Australia, preference recoveries are property of the company. Is this divergence in law justified?

44    The courts in Movitor, Elfic and Oasis justified the difference because of the different wording in the statutes. The English provision (s 214) enables an order to be made for a defendant to make a contribution to the “company’s assets”. The Australian provisions refer to a payment “to the company” (s 588FF) and a “debt due to the company” (s 588M). It truth these provisions are not sufficiently different to produce opposite results. If a person is required, as in the UK, to make a “contribution” to the company’s assets it is difficult to see how this contribution could be characterised as anything other than property of the company.

45    The principal basis for the divergence arises from the distinction drawn in Oasis between property which exists at the commencement of the winding up (which is property of the company) and assets acquired after winding up (which are not property of the company as they are held on trust for unsecured creditors). That treatment of after-acquired assets has not been adopted in Australia.

The 1992 amendments

46    In 1992 amendments were made to the Corporations Law (which are duplicated in the Corporations Act) by the Corporate Law Reform Act 1992 (Cth) which, according to some, changed the position established by Kratzmann. By the amendments a new self-contained voidable transaction regime was introduced. One of the key provisions is s 588FF. It enables the court to make a variety of remedial orders in respect of what are defined as “voidable transactions”. Notably, the section enables the court to order a person who has benefited from a voidable transaction to make payments, or to transfer property, “to the company”. The preference provisions no longer refer to a preferential transaction being “void as against the liquidator”.

47    The rationale for s 588FF was set out in the Explanatory Memorandum to the Bill (at [1055]-[1056]):

Proposed section 588FF is an ‘enabling provision’, giving the Court very wide powers to make appropriate orders in respect of voidable transactions to fit the particular circumstances.

Under the Bankruptcy Act, the characterisation of the transaction as being one to which sections 120 to 122 apply renders the transaction void against a trustee in bankruptcy and, by virtue of Corporations Law section 565, void against a liquidator. Consequently, the Court is not involved and therefore there is less flexibility to do justice between the parties, when one or more may be innocent of any ‘wrong doing’.

48    A number of points are worth noting. First, the concept of a transfer being “void as against the liquidator” was omitted to give a new role to the court. Second, there is no suggestion that the new provisions were intended to overturn the decision in Kratzmann. The purpose of the voidable transaction provisions was described (at [1035]) as being to ensure that “unsecured creditors are not prejudiced” by preferential dispositions (emphasis added). See also the discussion in the Law Reform Commission’s report, General Insolvency Inquiry (Report No 45, 1998) (the Harmer Report) recommendations and Andrew Keay, Avoidance Provisions in Insolvency Law (1997) 334.

49    There is, however, an argument that by specifying that the recovered money or property be paid or transferred “to the company”, the amendments had the effect, perhaps unintended, of reversing Kratzmann. The argument runs broadly as follows: (1) a charge may capture future assets of a company acquired after the charge crystallises; (2) a charge could therefore capture preference recoveries if those recoveries are property of the company; (3) the Kratzmann approach assumes that preference recoveries are not property of the company, and therefore cannot be subject to a charge; and (4) the new amendments, by stipulating that recoveries are to be paid or transferred to the company, have the effect of either confirming or deeming the recoveries to be the company’s property, hence making them charged assets.

50    It took almost ten years for the argument to be raised in court. Jonsson Milner & Riaps Pty Ltd (in liq) v Tim Ferrier Pty Ltd [2001] QSC 10 involved an application to set aside a default judgment obtained by a liquidator in respect of a voidable preference. The default judgment was set aside. In the course of his reasons, Jones J (at [16]) suggested in obiter that the 1992 amendments reversed Kratzmann. He remarked (at [16]) that s 588FF(1)(a) may have changed the law by directing that preference recoveries be paid to the company rather than the liquidator. If s 588FF had changed the law, Jones J said (at [16]) that preference recoveries would be subject to a charge over the company’s future assets.

51    The judge in Jonsson Milner was not, however, referred to SJP Formwork (Aust) Pty Ltd (in liq) v Deputy Commissioner of Taxation (2000) 34 ACSR 604. There, Santow J reached the opposite conclusion, noting that in Kratzmann the trial judge had ordered that the preference recoveries be paid to the company rather than the liquidator (at 296) and that the High Court approved that position (at 304) when it referred to payment “to the respondent”, being the company in liquidation. Likewise Octavo made clear that prior to 1992 preference recoveries were to be paid to the company. SJP Formwork was preferred over Jonsson Milner in Tolcher v National Australia Bank (2003) 44 ACSR 727, [14]-[17].

Is Kratzmann correct as a matter of principle or policy?

52    This question has been much debated. If the reader is interested, some helpful commentary may be found in the following books and artices: Rebecca Parry, Transaction Avoidance in Insolvencies (2001); Andrew Keay, Avoidance Provisions in Insolvency Law (1997); Fidelis Oditah, Legal Aspects of Receivables Financing (1991); Roy Goode, Principles of Corporate Insolvency Law (3rd ed, 2005); Nancy L Sanborn, “Avoidance Recoveries in Bankruptcy: for the Benefit of the Estate or the Secured Creditor?” (1990) 90 Colum L Rev 1376; Andrew Keay, “Preference Recoveries: Who is Entitled to Them” (1996) 14 C&S LJ 442; Tim McGrath, “The Floating Charge and Void and Voidable Transactions” (2002) 10 Insolv LJ 37; Garry J Hamilton, “Are a Liquidator’s Recoveries Available to the Company’s Secured Creditors?” (2002) 20 C&S LJ 25.

53    There are essentially two questions that need to be addressed: (1) Should recoveries of specific property be treated differently to monetary recoveries; and (2) Should preference recoveries be subject to a charge over the company’s future property?

54    As to (1), the principal argument in favour of the distinction seems to be that the legislation provides that specific property revests in the company whereas when money is recovered it is because it is due under a separate cause of action unrelated to the company’s previous title to the money.

55    Unsurprisingly, there are good arguments against the distinction. First, there will be instances where the liquidator is able to choose between an order for the transfer back of property (a proprietary remedy) and an order for the payment in money to the value of the property (a personal remedy): see for eg s 588FF(1). In those cases, the liquidator is in an invidious position, knowing that the nature of the remedy he/she seeks (or the court chooses to order) will determine whether secured creditors or unsecured creditors benefit from the recovery.

56    Second, some so-called money claims are in reality claims for the recovery of specific property. That is so when what has been paid in money is readily identified, or possibly when money paid is traceable into money or property in the hands of the creditor (depending on one’s view of the correctness of Foskett v McKeown [2001] 1 AC 102).

57    Third, aside from the language used in the statutes, there is little reason, as a matter of strict policy, for distinguishing between the recovery of money and the recovery of specific property: logically it would seem that either all preference recoveries are subject to a charge or they are not. Perhaps this is why the distinction has not been adopted in the UK: Roy Goode, Principles of Corporate Insolvency Law (3rd ed, 2005) [11-140]; Rebecca Parry, Transaction Avoidance in Insolvencies (2001) [28.39].

58    As to (2), some of the arguments for money recoveries falling outside the charge are as follows. First, a preference action is a “statutory right in and only in the liquidator to make such a claim and [therefore] could never have been property of the company subject to the charge” as Russell LJ put it in N W Robbie & Co Ltd v Witney Warehouse Co Ltd [1963] 1 WLR 1324, 1338. A related argument is that if Parliament wished for secured creditors to benefit from preference actions it could have conferred the right to bring the actions on secured creditors. One problem with these arguments is that they ignore the rule that recoveries of specific property may be caught by a charge (although that rule is not accepted in the UK). Another problem is that the argument conflates the cause of action with the proceeds of the action.

59    Second, as a matter of policy, charges over future property should only capture future property that comes into existence in the ordinary course of trading. In other words, floating charges allow for property to enter and exit the company in the ordinary course of business but preference proceeds are not property acquired in the ordinary course of business.

60    Third, there is a view that unsecured creditors should not have to bear the costs of unsuccessful preference actions when the proceeds would be subject to a charge (although this may be an argument against the liquidator using his/her power to bring the action rather than an argument against the existence of the power.

61    The arguments against preference recoveries falling outside the charge include the following. (1) As a matter of principle, the approach does not sit comfortably with the cases which establish that after-acquired property can be subject to a charge. (2) It is not clear why two causes of action brought by a liquidator, one accruing to him/her and one accruing to the company, should be treated differently. (3) If preference recoveries fall outside of the charge, this can lead to the perverse result where the more voidable distributions that are made, the better off the unsecured creditors are because the recovered money will no longer be subject to the charge. (4) There is a risk that the transferee could be successfully sued twice where the charge has crystallised prior to disposition following the decision in G & M Aldridge Pty Ltd v Walsh (2001) 203 CLR 662. The transferee may be required both to pay the amount of the preference to the liquidator but still be left open to a tracing claim at the suit of the mortgagee. This possibility is left open as a result of the High Court in Kratzmann holding that the liquidator’s right to recovery is an independent action that does not depend on the company’s title to the transferred property.

Conclusion

62    The present position rests on uncertain and, perhaps, unsound rules and distinctions. The question whether a charge should attach to preference recoveries ought not depend on the nature of the property recovered. Saying that money recoveries are held on some kind of trust for creditors explains the mechanism by which that money is excluded from the company’s general assets, but does not explain why it should be excluded in the first place. What is required is a careful consideration of the true role of the avoidance provisions, and, for the purpose of deciding who should benefit from them, an analysis of the competing interests of secured and unsecured creditors as well as an analysis of the liquidator’s ability to seek protection for his/her costs and expenses. As the cases show these are difficult issues not easily solved. The High Court hinted in G & M Aldridge (at [17]) that it may reconsider Kratzmann. If the High Court does not do so, Parliament should resolve this matter. In any event it is preferably for Parliament to do so, because in no small measure, questions of policy rather than legal principle are involved.

Subrogation

63    An alternative basis on which the bank might have a superior entitlement to the preference recoveries is, as the liquidators suggest, if the bank can be subrogated to the employees’ priority claims, which were paid out of floating charge assets on the belief that the property of the company was insufficient. The basis for this suggestion is that if the employees’ claims had been paid after receipt of the settlement proceeds from the preference actions, the employees would have been paid out of those proceeds.

When can employees be paid out of charged assets?

64    There are two circumstances in which employees are to be paid out of floating charge assets. They are provided for in ss 561 and 433 of the Corporations Act.

65    Section 561 states that:

So far as the property of a company available for payment of creditors other than secured creditors is insufficient to meet payment of:

(a)     any debt referred to in paragraph 556(1)(e), (g) or (h); and

(b)     any amount that pursuant to subsection 558(3) or (4) is a cost of the winding up, being an amount that, if it had been payable on or before the relevant date, would have been a debt referred to in paragraph 556(1)(e), (g) or (h); and

(c)     any amount in respect of which a right of priority is given by section 560;

payment of that debt or amount must be made in priority over the claims of a chargee in relation to a floating charge created by the company and may be made accordingly out of any property comprised in or subject to that charge.

The debts referred to in subsections (a) and (b) are certain debts owed to employees which by s 556 are given priority in a winding up. The amount referred to in subsection (c) is an advance made to the company to enable it to pay employee entitlements.

66    Section 433 applies (1) where a receiver is appointed, or another person takes possession or assumes control of property subject to a floating charge, on behalf of a debenture holder and (2) at that time the winding up had not commenced. In that event the section relevantly requires the receiver or agent to pay out of property coming into his/her hands certain debts in priority to any claim for principal or interest by the debenture holder. The priority debts include most of the priority debts payable out of floating charge assets under s 561 and in particular the employee entitlements.

67    In the UK, there is a counterpart to s 561, namely s 175 of the Insolvency Act. Like s 561, s 175 provides for the payment of priority debts out of floating charge assets so far as the assets of the company available for payment of general creditors may be insufficient to meet them. The effect of this section was considered in Buchler v Talbot [2004] 2 AC 298 in the context of an application by liquidators for the payment of their costs and expenses out of charged assets. The Law Lords explained that, as a general proposition, where a company is wound up and a floating charge over its assets has crystallised, two funds are created. The first comprises charged assets that are the beneficial property of the chargee, subject to the company’s equity of redemption. The second fund comprises non-charged or “free” assets, which are the property of the company. As a general rule, each fund bears its own debts. Section 175 alters this general rule. Lord Millett explained (at [57]), that the free assets of the company remain the primary source of payment for preferential debts. If, however, there are insufficient free assets to pay the preferential debts after the expenses of the winding up have been paid or provided for, then the preferential debts are to be paid out of the charged assets.

68    The result in Buchler – that a liquidator’s expenses are not preferential debts and hence are not payable under s 175 – was later altered by the introduction of s 176ZA. However, the distinction between free and charged assets is still reflected in ss 175 and 176ZA.

69    The right to have recourse to charged assets under s 561 is conditional on there being insufficient property of the company available to meet preferential debts. When is this assessment of the company’s property to be made? The question is of considerable importance in this case because at the time the company’s employees were paid, the company’s realised assets were insufficient to pay priority creditors. It was only later, when the company received the settlement proceeds, that the liquidators had some funds out of which to meet those claims.

70    In my view, there is to be only one assessment of the sufficiency of a company’s assets and that is to be made when enough is known about the company’s affairs. The assessment must take into account all actual and potential realisations. That is to say, the liquidator should not, as has occurred here, make an interim assessment of the company’s financial position, an assessment which only looks at the position at a single point in time. This is for several reasons.

71    First, arbitrary or even perverse results can arise if the sufficiency of the company’s assets is for the purposes of s 561 assessed on an interim basis. It is clear that, at the very least, the assessment cannot take place until the value of the priority debts payable under s 561 is known, as well as the value of those priority debts which, under s 556, have precedence over debts payable under s 561. The necessary information may be readily available or it may take some time to obtain. When the information is at hand, the company’s assets may not have been fully realised or, indeed, might not be fully known. To ignore possible future realisations and to take assets away from a secured creditor only to realise later that the secured creditor was not required to pay out particular creditors is, to say the least, unjust.

72    Second, the reference in s 561 to property being “available” for payment to creditors other than secured creditors does not connote property being “at hand”. Rather, it distinguishes between property which is available for general creditors (ie the company’s free assets) and charged assets. In this respect, the expression is similar to the “property available for payment of debts” taken from bankruptcy law: see eg Pt VI Div 3 of the Bankruptcy Act 1966 (Cth). That expression has a well understood meaning in bankruptcy law, and is used to distinguish between property available for payment to creditors and property excluded or exempted from payment to creditors.

73    It follows that s 561 only mandates payment of priority claims out of floating charge assets when it is clear that the liquidation will not realise free assets sufficient to meet those claims (after taking into account other claims which, under s 556, have precedence). In some windings up, it may become obvious at an early stage that there will be a deficiency in the company’s free assets. In other windings up, it may take much longer. In those cases the controller of the floating charge assets must make adequate provision for the payment of the priority debts before making any payment to the secured creditor.

74    How do ss 561 and 433 interact? In Stein v Saywell (1969) 121 CLR 529 Barwick CJ (at 545) described earlier equivalents of ss 561 and 433 as “complementary”. Section 433 becomes enlivened upon the appointment of a receiver or agent in possession prior to the commencement of a winding up. Section 561 is triggered upon the company being wound up, regardless of whether s 433 already applies. The operation of s 433 continues notwithstanding the subsequent winding up of the company. See also Re Custom Card (NSW) Pty Ltd [1979] 1 NSWLR 241; Perrins v State Bank of Victoria [1991] 1 VR 749.

75    Although the sections are “complementary”, there is a disconformity in the way that they operate. Section 433 imposes an obligation on the receiver or agent in possession which, unlike s 561, is not conditional on the free assets of the company being insufficient to meet priority debts. On close analysis there may be good reason for this. First, a receiver or agent in possession will often not know whether the company’s free assets are sufficient to meet priority claims under s 433 and it is not their duty to undertake this inquiry.

76    Second, the legislative history of ss 433 and 561 suggests that the sections were intended to operate differently. Predecessors of s 433 provided that payment had to be made regardless of the state of the company’s assets, but, in turn, also provided that payments could be “recouped as far as may be out of the assets of the company available for payment of general creditors”: see s 196(3) of the Uniform Companies Acts 1961. The right of recoupment still exists in the UK under the equivalent of s 433 of the Corporations Act, s 40 of the Insolvency Act. The right of recoupment is an important part of the statutory scheme: it allows for employees to be paid quickly when a receiver is appointed while at the same time ensuring that haste does not come at the expense of the wrong source of funds being used to pay the employees.

77    When s 196 of the 1961 Acts was substantially reproduced as s 331 of the Companies Act 1981 (Cth), the right of recoupment was removed. The Explanatory Memorandum to the Companies Bill does not explain why the right was removed. Removal of the right of recoupment would alter the entitlements of secured and unsecured creditors and the logic behind the statutory scheme. I do not think it can be said that Parliament intended this result in the absence of any express intention. In other words, the right of recoupment has survived the statutory amendments.

Breach of trust

78    Section 561 imposes a duty on a controller of floating charge assets to pay priority debts out of floating charge assets if the relevant conditions are satisfied. It necessarily follows that the controller is required to withhold funds from the secured creditor that are sufficient to pay priority creditors if it appears that the company’s property is likely to be insufficient. In these respects, s 561 mandates an incursion into the proprietary rights of the secured creditor. But s 561 does not permit a controller to appropriate the floating charge assets to pay out priority claims until the relevant condition (ie the deficiency in the company’s free assets) is satisfied.

79    A liquidator who has realised floating charge assets and has him/herself retained the proceeds (necessarily in an account established pursuant to reg 5.6.06 of the Corporations Regulations 2001 (Cth) and s 538(1)(a)) of the Corporations Act) is a trustee of them for the purposes of s 561. The proceeds are to be held on trust until it is determined whether the company’s free assets are insufficient to meet priority debts. The chargee is a beneficiary, or at least a contingent beneficiary, of the trust. Its rights, though, are subject to the claims of priority creditors. The priority creditors may also be contingent beneficiaries of the trust; the contingency being a deficiency in the company’s free assets. If not beneficiaries, at least the priority creditors have a contingent statutory right against the fund.

80    Here the priority claims were paid out of floating charge assets before there was satisfaction of the condition which would make those assets liable to meet the debts of priority creditors. Moreover, the payments were made without the bank’s consent. As events transpired, the floating charge proceeds should not have been applied to meet the priority debts. The result in that the liquidators have committed a breach of trust. The bank’s loss from this breach is equal to the value of the free assets that eventually became available to meet the priority claims; an amount of around $50,000.

Subrogation for breach of trust

81    The bank has a claim against the liquidators for breach of trust. One potential remedy for this breach might be for NAB to be subrogated to the extent of its loss to the rights of employees against the free assets of the company.

82    It has been said that the equitable principles relating to subrogation aim to adjust the interests of three parties (eg a creditor, a debtor and a surety) to avoid the unconscionable result of double recovery by the creditor or the inequitable discharge of a liability of the debtor: Registrar General v Gill (Unreported, NSW Court of Appeal, Gleeson CJ, Mahoney and Priestley JJA, 16 August 1994).

83    The High Court has recently confirmed that unconscionability rather than unjust enrichment is the rubric on which subrogation is built: see Bofinger v Kinsway Group Ltd (2009) 239 CLR 269. In that case the High Court tried to kill off, at least for the time being, attempts by unjust enrichment scholars to find an “all-embracing” theory to explain when subrogation would be available. Rather, the High Court said that subrogation as a remedy should be based on well-settled principles and available in defined circumstances that make it unconscionable for the defendant to deny the proprietary interest claimed by the plaintiff. This is not to suggest that unjust enrichment has no role to play – obviously it assists in comparing and contrasting the underlying rationales of recognised categories of subrogation, and ascertaining when new categories should be recognised. But, ultimately, as Australian law currently stands, an incremental approach to developing the law of subrogation is the order of the day.

84    There are conflicting lines of authority as to whether a claimant whose money has been misappropriated and used to pay a debt is entitled to be subrogated to the rights of the former creditor against the debtor. One line suggests that there is no right of subrogation. The leading case is Re Diplock [1948] Ch 465. The facts are so well known as not to require repeating. For present purposes it is sufficient to note that some payments which were misapplied by the executors distributing the estate to various (volunteer) charitable organisations had been used by those organisations to pay out debts, both unsecured and secured. The Court of Appeal held (at 548-550) that the beneficiaries whose funds were misapplied were not for various reasons entitled to be subrogated to the rights of both secured and unsecured creditors whose debts had been paid off with the misapplied funds. The Court gave several reasons.

85    First, subrogation would require the debts to be “revived”, and the charities were justified in refusing their revival. Second, it would be inequitable to grant the beneficiaries a charge over the property to give effect to a right of subrogation. In this context, the Court of Appeal (at 546-547) considered the problem of granting a charge over “mixed assets”, being assets acquired with a combination of the volunteer’s assets and the claimant’s assets. One type of mixed asset is acquired with a combination of the claimant’s money and the volunteer’s money. In that case, the Court of Appeal said, the equitable remedy is for a charge over the mixed asset. Another type of mixed asset is one acquired with a combination of the claimant’s money and the volunteer’s non-monetary asset. An example is where land had been improved using the claimant’s funds and the volunteer has contributed the land itself. In that case, at least where the volunteer has contributed land, the Court of Appeal (at 548) held that it would be inequitable to order a charge over the value of the land and force the landowner to submit to a sale of the land to enforce the charge. Presumably, this is because of the special character of land. Partly for this reason, the Court denied the beneficiaries a right to seek a proprietary interest in improvements in the relevant charities’ land.

86    It is important to note that the question of subrogation in Re Diplock arose in relation to payments used to pay off (1) a loan given to fund works to be executed on a charity’s land and (2) a mortgage over another charity’s land. Accordingly, the Court treated the issue of subrogation as analogous to the question whether beneficiaries could trace into improvements in the land. In both cases, the Court of appeal held that the remedy should be denied because (1) there was a mixed asset to which the volunteer had contributed land (or its equity of redemption of the land) and (2) there was a perceived inequity in creating a charge, the enforcement of which would require the land to be sold.

87    The reasoning in Re Diplock has been treated by some as establishing a general rule that where an innocent volunteer recipient has received misapplied trust funds and used them to discharge a debt, no right of subrogation is available. This rule has been applied in later cases, albeit sometimes with reservations: see eg Trevor Maxwell Whithand v Glyn Jenkins (Unreported, Supreme Court of Victoria, Mandie J, 6 February 1987); Commonwealth Bank of Australia v Mohamad Saleh [2007] NSWSC 903, [39]. See also Jacob’s Law of Trusts in Australia (7th ed, 2006) [2711].

88    There is, however, a line of cases that reject the Re Diplock approach and permit subrogation as a remedy where funds have been misapplied. The leading case is Boscawen v Bajwa [1996] 1 WLR 328. A building society, Abbey National, made an advance to fund the purchase of a property. The funds were paid into the purchaser’s solicitor’s client account on the condition that they were to be used for the completion of the sale and would be returned if for any reason completion did not take place. The money was forwarded to the vendor’s solicitor’s client account to be held on trust pending execution of the transfer and release of the title deeds. In breach of trust, the money was applied prior to settlement to discharge an existing mortgage over the property. The sale later fell through. Abbey National sought to be subrogated to the rights of the secured creditor whose mortgage had been discharged with the misapplied funds.

89    Two arguments were raised against subrogation. The first was that it would be inconsistent with Re Diplock. To this, Millett LJ (as he then was), who wrote the leading judgment, said (at 339-341) that the Re Diplock approach was not without its difficulties and was in need of reappraisal. As to the concern in Re Diplock about “reviving” debts, he observed that the discharge of the creditor’s security is certainly not a bar to subrogation in equity. Millett LJ also noted that the concerns expressed in Re Diplock about the inequity of imposing a fresh charge may have been misplaced. Ultimately, he said that the decision in Re Diplock is best understood as being confined to the particular circumstances of the case.

90    The second argument raised in Boscawen against subrogation was that the mere fact that the claimant’s money was used to discharge someone else’s debt does not entitle him to be subrogated to the creditor whose debt is paid – there must be an intention that the monies be used to discharge the relevant debt, and an intention to obtain the benefit of any security by subrogation. Again, the Court of Appeal rejected this argument. Millett LJ noted (at 338) that where a claimant intends to make an unsecured loan to a borrower who then uses the money to discharge a secured debt, subrogation cannot operate so as to give the claimant security, ie put him/her in a better position than he/she bargained for. But that situation is distinguishable from one where the claimant had no intention whatsoever for his/her monies to be used by the defendant. He explained (at 339), in a passage worth citing:

In cases such as Butler v Rice and Ghana Commercial Bank v Chandiram [1960] AC 732, where the claimant paid the creditor direct and intended to discharge his security, the court took the claimant's intention to have been to keep the original security alive for his own benefit save in so far as it was replaced by an effective security in favour of himself. In the present case the Abbey National did not intend to discharge the [secured creditor’s] charge in the events which happened, that is to say, in the event that completion did not proceed. But it did not intend its money to be used at all in that event. If Butler v Rice and similar cases are relied upon to support the proposition that there can be no subrogation unless the claimant intended to keep the original security alive for its own benefit save in so far as it was replaced by a new and effective security, with the result that the remedy is not available where the claimant had no direct dealings with the creditor and did not intend his money to be used at all, then I respectfully dissent from that proposition. I prefer the view of Slade LJ in Re TH Knitwear (Wholesale) Ltd [1988] Ch 275 at 286 that in some situations the doctrine of subrogation is capable of applying even though it is impossible to infer a mutual intention to this effect on the part of the creditor and the person claiming to be subrogated to the creditor's security. In the present case the payment was made by [the vendor’s solicitors], and it is their intention which matters. As fiduciaries, they could not be heard to say that they had paid out their principal's money otherwise than for the benefit of their principal. Accordingly, their intention must be taken to have been to keep the [secured creditor’s] charge alive for the benefit of the Abbey National pending completion. In my judgment this is sufficient to bring the doctrine of subrogation into play.

91    Millett LJ (at 334-5) viewed subrogation as one of a number of proprietary remedies which equity could fashion to suit the circumstances of a particular case. So, if a plaintiff can trace his/her monies to an asset in the hands of the defendant, a constructive trust might be available; if the monies have been used to improve the defendant’s property, a charge on that property may be appropriate; if the monies have been used to discharge a debt, subrogation may be suitable.

92    There are several Australian cases that have assumed that subrogation is available as a remedy when funds have been misapplied and are traceable to a payment discharging a debt: eg Gertsch v Atsas (1999) 10 BPR 18,431, [19]-[20]; National Australia Bank Ltd v Rusu [2001] NSWSC 32, [51]; Raulfs v Fishy Bite [2008] NSWSC 1195, [25]; Lygon Nominees Pty Ltd v Zeccola (Unreported, Supreme Court of Victoria, Mandie J, 26 May 1998). There are UK authorities to a like effect: eg Scotlife Home Loans (No 2) Ltd v Melinek (1999) 78 P & CR 389; Primlake Ltd (in liq) v Matthews Associates [2007] 1 BCLC 666.

93    In my view, the Boscawen approach is to be preferred to that in Re Diplock. I would only make a few additional comments in relation to Re Diplock. First, the reasoning in Re Diplock should be confined to land and, perhaps, other property of a special nature. Principles regarding specific performance might be relevant by analogy. Thus, if, for example, the subrogation claim related to paying off a debt incurred to fund an investment, the claim would have been allowed in Re Diplock.

94    Second, as Millett LJ said in Boscawen (at 341), in Re Diplock an order might have been framed to avoid the perceived injustice of forcing a sale of land under a charge. For example, the charities might have been given reasonable opportunity to obtain finance to meet the beneficiaries’ claims. This would have put the charities back as close as possible to their original position and prevented them retaining a windfall at the beneficiaries’ expense.

95    Third, there is much to be said for the view that Re Diplock was not intended to create an absolute rule, and should be confined to its peculiar facts: see eg George v Biztole Corporation Pty Ltd (Unreported, Supreme Court of Victoria, Ashley J, 26 February 1996).

96    Fourth, in applying Re Diplock, it is important to distinguish between tracing and subrogation. It is undoubtedly the case that a claimant cannot trace into funds which have been paid by a volunteer to discharge a debt – the assets have ended up in the hands of a bona fide, for value and without notice, creditor. But it is altogether a different matter whether there remains a right of subrogation against the volunteer. Cases establishing the non-entitlement to tracing are sometimes cited, erroneously in my opinion, for similarly denying a right of subrogation: see eg Re J Leslie Engineers [1976] 1 WLR 292, cited in Jacob’s Laws of Trust (7th ed, 2006) [2711].

97    Fifth, there is considerable force in the argument that if a volunteer has applied misappropriated funds to discharge a debt, the volunteer should not be in a better position than if he had applied the funds to purchase an asset. In either case, the volunteer’s assets have effectively been swollen. This is not to suggest that the circumstances in which subrogation and other equitable remedies are available should be identical: cf David Friedmann, “Payment Under Mistake: Tracing and Subrogation” (1999) 115 LQR 195.

98    In the present case, the bank’s funds have been misapplied in breach of trust. To the extent that the bank has suffered loss, it should be subrogated to the rights of priority creditors who have been paid out with the bank’s funds. Absent subrogation, it would be unconscionable for the company (and its unsecured creditors) to benefit from a windfall produced by the breach of trust.

99    If, contrary to my view, Re Diplock were authoritative regarding subrogation, I would hold that it has no application to the instant facts. The liquidator cannot be treated as an “innocent volunteer”. The liquidator was a trustee acting in breach of trust by misapplying funds.

Subrogation to the employee’s priority claims against free assets

100    I have observed that the effect of s 561 is that floating charge assets which may be required for payment of priority debts must be held until it is clear whether or not those debts can be paid out of the company’s free assets. Until that time, the funds cannot be applied to meet priority debts, although it may be possible, if sufficient is known, to pay an interim dividend to the priority creditors. As a matter of policy, this may be an undesirable outcome given that it could delay the payment of money owing to employees, which may cause real hardship to them and their families. Equally, chargees may for good reason wish to see employees paid as soon as possible, but not if this would mean that the payments are at the chargee’s expense even if it turns out the company has sufficient free assets available.

101    Can this problem be avoided? It could be if a chargee who agrees to release funds to pay out priority creditors is later subrogated to the company’s free assets. Several issues arise as to whether an early payment arrangement would be effective.

102    The first issue, whether the liquidator could pay priority creditors out of charged assets, should not be a problem. If the chargee gives its fully informed consent, the duty owed by the liquidator to the chargee to retain the funds until it is known whether the condition in s 561 has been satisfied will not be breached. If priority creditors are also beneficiaries of the trust they could hardly complain if they accept the payments in discharge of the debt due to them.

103    A more difficult issue is whether the right of subrogation would exist. A preliminary point here is that the supposed arrangement could not give rise to the statutory subrogation created by s 560. That section, broadly speaking, provides that where payment has been made by a company in respect of certain employee entitlements out of monies advanced for that purpose, the person making the advance is entitled to be subrogated to the employees’ claims provable in the winding up. The section would not apply to an early payment arrangement, because there would not be a relevant “advance”. For the purposes of s 560, an “advance” requires the creation of a debtor/creditor relationship in respect of the payment: Lombe v Wagga Leagues Club Ltd (2006) 56 ACSR 387, [27].

104    Whether equity would grant a right of subrogation raises, in turn, several issues. The first is whether the Corporations Act is intended to exclude an equitable right of subrogation. In my view, there is no intention to do so. To the contrary, the intention of the Act, as manifested in provisions such as ss 433, 556, 560 and 561, is to facilitate the payment of employee entitlements and other priority claimants. Recognising a right of subrogation under an “early payment” arrangement is consistent with this intention.

105    I note that there are some authorities which hold that a claim for subrogation is inconsistent with some aspects of the insolvency or bankruptcy laws. But these authorities arise in different circumstances than are present here. So, for example, in Re Byfield (a bankrupt), Ex parte Hill Samuel & Co Ltd v The Trustee of the Bankrupt [1982] Ch 267, a bank had paid money on instruction from a bankrupt to his mother, unaware that on the previous day, the bankruptcy had been gazetted. The money was then used to discharge certain debts of the bankrupt. The bank, having unlawfully dealt with the bankrupt’s property (by paying it otherwise than in accordance with the trustee’s direction), sought to be subrogated to the rights of creditors who had been paid out. One reason Goulding J rejected the subrogation claim was that the statute provided a limited defence for persons who had dealt with the bankrupt’s assets prior to the bankruptcy being gazetted. To confer a right of subrogation on someone who had dealt with assets after the notice had been gazetted would, according to Goulding J (at 276), undermine the limited nature of the defence which parliament had conferred. No such issue arises here. Similarly, in Re T H Knitwear (Wholesale) Ltd [1988] Ch 275, a claim of subrogation was rejected on the basis that it would be inconsistent with special insolvency provisions regarding proving for Value Added Tax debts in insolvency. Again, no such issue arises here.

106    A more difficult case is Re Sara Properties Ltd (in liq) [1982] 2 NSWLR 277. There a mortgagee realised property upon which land tax was payable by the mortgagor company, which was in liquidation. The mortgagee paid the land tax to enable the completion of the sale of the land. The mortgagee proved for the balance of its debt and sought to be subrogated to the rights of the Commissioner for Land Tax in respect of the land tax, which was a priority debt. Rath J rejected the subrogation claim for several reasons. The first (at 279) was that where subrogation relates to a legal right, it can only be founded where the legal right subsists. He held that the rights of the Commission had been discharged by the payment. I do not think this proposition can be accepted. It is now well established that subrogation involves a legal fiction where rights formerly extinguished are “revived” for the purposes of subrogation: Boscawen, 340 (per Millett LJ); Bankque Financiere de la Cite SA v Parc (Battersea) Ltd [1999] 1 AC 221, 236 (per Lord Hoffmann); C Mitchell and S Watterson, Subrogation: Law and Practice (2007) Ch 3; Meagher, Gummow and Lehane’s, Equity: Doctrines and Remedies (4th ed, 2002) [9-035]; K Mason, J W Carter and G J Tolhurst, Restitution Law in Australia (2nd ed, 2008) [640].

107    The second reason Rath J rejected the mortgagee’s subrogation claim was that it was inconsistent with the statutory scheme for the distribution of an insolvent company’s assets. Rath J said (at 279-280) that the fundamental premise of the scheme was that assets are required to be distributed pari passu unless there is special provision made otherwise. To allow a priority payment by way of recoupment or reimbursement, he said, would require language that did not appear in the statute. I respectfully disagree with this reasoning. It assumes that the mortgagee could not stand in the shoes of the Crown whose debt had been extinguished. For the reasons set out above, I do not accept that the mortgagee was unable to stand in the shoes of the Crown. Indeed, Rath J acknowledged (at 281) that if the right of the Crown had been a prerogative right, there would have been no difficulty in keeping it alive for the purposes of subrogation – and presumably there would be no inconsistency with the winding up provisions. Further, the pari passu rule does not preclude subrogation. Just as an assignee of a priority debt may prove in a liquidation and obtain priority, the Act neither expressly nor impliedly excludes a party entitled to subrogation from proving in a winding up.

108    Next is the question whether equity would allow the remedy. In my view, equity would permit the chargee to be subrogated to the extent that floating charge assets have been used to pay priority claims which otherwise could have been paid out of the company’s free assets. The claim for subrogation might be thought of as novel in some respects, but is supported by analogous, well-established categories in which a right of subrogation is recognised.

109    It is clear that where a person (eg a surety) pays off a creditor’s debt, the person will, in certain well-defined circumstances, be entitled to subrogation. The rationale behind these cases, and the reason why equity intervenes, is that it would be unconscionable for the debtor to escape the liability which has been discharged by the person’s acts. Of course, the mere fact that one person pays off another’s debt does not automatically give rise to a right of subrogation against the debtor. There must be something more that generates the equity in favour of the payee.

110    An analogy can be drawn between the “early payment” arrangement and a situation where a person pays out a prior security, one of the classic cases for subrogation: Ghana Commercial Bank v Chandiram [1960] AC 732. In Cochrane v Cochrane (1985) 3 NSWLR 403, 405, Kearney J reviewed the authorities and said that a person is entitled to subrogation where he/she advances money to pay out the mortgage on the understanding that security would be available for him upon the mortgage being paid out.

111    The “early payment” arrangement is a similar arrangement but there are issues that might stand in the way of subrogation being available.

112    The first is that subrogation could be denied given that the chargee itself would not be paying off priority creditors’ claims. Rather, the chargee would be acquiescing to the liquidator using the chargee’s funds to pay the claims. This should not, however, be a problem. There are examples of subrogation where money lent to a company under an ultra vires contract is then used to discharge the company’s intra vires debts. Assessed in terms of unjust enrichment jargon (if that is still permissible), where a trustee has recourse to the chargee’s assets, the trustee’s act is as much a “subtraction” from the property of the chargee as a payment by the chargee itself.

113    The second potential problem is that the chargee is under no compulsion to enter into an “early payment” arrangement. A common bar to subrogation is where the claimant is a “volunteer”, “officious” or an “intermeddler”. This reflects equity’s concern for the autonomy of the debtor. As Bowen LJ put it in Falcke v Scottish Imperial Insurance Co (1886) 34 Ch D 234, 248: “Liabilities are not to be forced upon people behind their backs any more than you can confer a benefit upon a man against his will”. A related issue is whether a volunteer’s payment is effective to discharge a debt: see P Birks and J Beaton, “Unrequested Payment of Another’s Debt” (1976) 92 LQR 188; A Burrows, The Law of Restitution (2nd ed, 2002) 293-302.

114    The complexities caused by voluntary payments do not arise where the payments are not “voluntary”. In particular, a payment is not considered voluntary in the relevant sense where the claimant has been expressly or impliedly requested to act by the debtor: Owen v Tate [1976] 1 QB 402, 411; see also K Mason, J W Carter and G J Tolhurst, Restitution Law in Australia (2nd ed, 2008) [642]; Goff & Jones, The Law of Restitution (7th ed, 2007) [1-080]; cf P Birks and J Beaton, “Unrequested Payment of Another’s Debt” (1976) 92 LQR 188, 209. Under the “early payment” arrangement, the waiver would not have been unsolicited; to the contrary, the company, through its liquidator, would be party to the chargee’s actions.

115    In any event, it is unclear whether the voluntary nature of a payment is a bar to subrogation where prior securities have been paid out: see Meagher, Gummow and Lehane’s, Equity: Doctrines and Remedies (4th ed, 2002) [9-060]-[9-065]. The position appears to be that, in those cases, subrogation will be denied where subrogation would put the claimant in a better position than he/she bargained for. So, for example, a claimant who has intentionally made an unsecured loan to a defendant cannot then seek to be subrogated to the rights of a secured creditor paid out with loan funds. But this bar should not arise under the “early payment” arrangement, where the chargee intends to obtain a benefit.

116    A third issue is whether it would, in all the circumstances, be equitable for the chargee to be subrogated. In my view, equity’s intervention would be justified. In waiving its strict rights, the chargee has acted in the priority creditor’s interests, and not out of self-interest: cf Re Sara Properties, where the mortgagee had paid out the land tax “wholly for its own benefit”, and, accordingly, Rath J (at 280) denied subrogation. The company, through its liquidators, would be party to the payments, and it would be unconscionable for the company (and, indirectly, its unsecured creditors) to enjoy a windfall from the company’s debts being paid out of floating charge assets when they could have been paid out of the company’s free assets.

Direction

117    The liquidators wish to know whether they should pay the balance of the amounts recovered from the settlements of unfair preference claims to the company’s unsecured creditors or to the bank. For the reasons I have explained the bank is entitled to those funds and I will direct accordingly.

118    In giving this direction I have assumed there are no other claimants on the fund. There is no evidence suggesting the existence of other claimants. If the position is otherwise the liquidators will not obtain the usual protection when acting in accordance with the direction.

119    The liquidators’ costs of this application should be costs in the liquidation.

Associate:

Dated:    6 December 2010