Finance & Markets Update - April 2009

• Held: Charge Void During Administration
• A Guarantor's Right of Subrogation: The Decision in Bofinger v Kingsway Group Ltd
• Intellectual Property & Technology: Maximize Value, Minimize Risk, in Good Times & Bad
• Hall-v-Poolman 
• Legislative Amendments in NSW to Impact on Mortgagees

Held: Charge Void During Administration

Some months after the charge was registered with ASIC, the chargor and chargee agreed that the chargor’s liability under a guarantee not otherwise related to the charge should also be secured by the charge. This agreement was formalised by a letter “designating” the guarantee a Transaction Document.

The decision

The Queensland Supreme Court held that designation of the guarantee as a Transaction Document had the effect of increasing the value of the Secured Money under the charge, albeit not in excess of the maximum prospective liability as notified to ASIC when the charge was registered.

The increase in liability secured by the charge constituted a "variation in the terms of the charge" within the meaning in s 268(2) of the Corporations Act (Act). That section requires notification within 45 days of the variation to ASIC if the variation has the effect of "increasing the amount of debt or increasing the liabilities" secured by a charge. His Honour, McMurdo J intimated that such a notification should be made using an ASIC Form 311B and that the notification would need to be accompanied by a copy of the designation letter.

Since no notice of this variation was lodged, the charge was void by virtue of s 266(3) to the extent that it secured the increased liability as against a liquidator or administrator.

1. the actual Transaction Document (designated by the letter) needed to be lodged; or
2. all Transaction Documents referenced in the charge needed to be lodged.

His Honour took a purposive approach to the ASIC notification provisions stating that the failure to notify ASIC of the designation under s 268 of the Act could “leave the public completely uninformed of a variation to a registered charge, which might have resulted in an important change to the reach of the charge by the addition of a distinct and substantial liability”. His Honour seemed primarily concerned about public notification of the liability actually secured by the charge.

Although it is common practice to specify that the charge secures a maximum prospective liability in the ASIC Form 309 used to register it, his Honour still held that an increase in liability, not in excess of the notified maximum prospective liability, secured by the charge is required to be notified to ASIC.

We see difficulties with this finding given the absence of an obligation in the Act to notify ASIC of the amount actually secured by a charge. Whilst one may insert this amount in the description of the liability in the ASIC Form 309, this seems impractical given that an ASIC Form 311B would have to be lodged each time a borrower draws on facilities associated with the registered charge.

Next steps

Whilst remarkably unexpected, the decision is yet to be affirmed or overturned. Thus the prudent lender may consider adopting the following course of action:

1. in the context of existing facilities, if a document is added to the definition of “Transaction Document”, and this variation has the effect of increasing the liability secured by the relevant charge, lodge an ASIC Form 311B attaching the relevant documentation with ASIC; and
2. in the context of the provision of new facilities, consider whether taking “all monies” security is more appropriate rather than defining the liability secured by reference to “Transaction Documents”.

A Guarantor’s Right of Subrogation: The Decision in Bofinger v Kingsway Group Ltd

Introduction

The primary issue in the decision of Bofinger v Kingsway Group Ltd [2008] NSWCA was whether the guarantors, Mr and Mrs Bofinger, were entitled on the principles of subrogation to the benefit of the first mortgage given by B & B Holdings Pty Ltd (Borrower) to Kingsway Group Ltd (Kingsway) in priority to the rights of the second mortgagee, Reckley Pty Ltd (Reckley), and the third mortgagee, John Skehan. The Bofingers were directors of the Borrower.

The Borrower, who was in liquidation, carried on business as a developer. It had constructed seventeen townhouses and a detached house on land at Enmore (Properties). In order to build the Properties, the Borrower entered into loan agreements with three separate lenders to whom it gave mortgages over the Properties as security for the loans. The first mortgage to Kingsway secured a loan of $8,728,000, the second mortgage to Reckley secured a loan of $1,400,000 and the third mortgage to John Skehan secured a loan of $350,000. The guarantors entered into guarantees with each of the lenders, which were secured by first, second and third mortgages over their home and investment unit.

The guarantors voluntarily sold their home and their investment unit and paid the net proceeds of $1,519,234.10 to the first mortgagee, Kingsway. Kingsway then, using its power of sale, sold most of the Properties in further reduction of its debt. After paying off the balance of its debt, Kingsway paid the surplus of approximately $700,000 to Reckley and also delivered to Reckley the certificates of title to the unsold Properties, as well as a discharge of Kingsway’s mortgage for each of the unsold Properties.

The guarantors, by reason of the fact that they had sold their own properties and applied the proceeds in reduction of Kingsway’s debt, claimed to be entitled to the benefit of the security held by Kingsway after its debt had been discharged. Their claim was based on the principles of subrogation in equity, as well as under section 3 of the Law Reform (Miscellaneous Provisions) Act 1965 (NSW) (Miscellaneous Provisions Act).

The decision at first instance

Young CJ in Eq held that Reckley had not acted unconscionably in retaining the surplus proceeds of sale and the certificates of title to the unsold Properties and that the guarantors had no right of subrogation. In paragraphs [43] and [44] of his judgement, he held that clauses in the guarantee and mortgage entered into by the Bofingers with Reckley clearly showed that the sureties were not to claim their rights of subrogation in prejudice of the rights of Reckley. As such, his Honour found that the right of subrogation was given away by contract.

The decision of the Court of Appeal

Giles JA began his judgement by summarising the principle of subrogation as the general entitlement of a guarantor who has discharged the debtor’s obligation to the benefit of a mortgage given by a debtor to the creditor.

The guarantor’s entitlement to the benefit of the mortgage adjusts the interests of the creditor, debtor and guarantor. If there is a second mortgage then the interests of a third party arise. It raises the question whether the guarantor who is entitled to the benefit of the first mortgage can assert an entitlement in priority to the rights of the second mortgagee and similarly any subsequent mortgage. Equity and section 3 of the Miscellaneous Provisions Act place the guarantor in the shoes of the first mortgagee but do not demand that the guarantor retain the first mortgagee’s priority.

Giles JA found that Reckley advanced its funds with the knowledge of the first mortgage to Kingsway and presumably with knowledge of the guarantee given by the Bofingers to Kingsway. As well as its mortgage, Reckley also took a guarantee from the Bofingers and a mortgage in support of the guarantee. It was the clear intention, as between Reckley and the Bofingers, that Reckley would have resort to the Properties mortgaged by the Borrower after Kingsway but before the guarantors. The guarantors undertook obligations to Reckley that were inconsistent with their assertion of an entitlement in priority to the rights of Reckley and this displaced the priority that would otherwise arise.

Handley AJA, while agreeing that the principles of subrogation did not apply, preferred to decide the matter by applying the rule in Otter v Vaux (1856) 69 ER 943. Handley AJA stated that the rule in Otter v Vaux prevents a mortgagor, who has paid off the mortgage debt, keeping the mortgage alive against a later mortgage created by himself. Applying the rule, Handley AJA held that the Bofingers could not have claimed a priority over Reckley if the securities granted by the Borrower had been realised first. Kingsway would then have resorted to the securities granted by the Bofingers and Reckley would have been entitled to the surplus once Kingsway had been paid off. His Honour stated that if the rule in Otter v Vaux does not apply in principle to a guarantor of more than one mortgage, a decision that it does is a very modest development of the equitable principle.

Sackville AJA also agreed that the principles of subrogation did not apply to the facts of the case. His Honour held that a right of subrogation does not arise merely because a third party, whether a guarantor or otherwise, pays out the amount due by a mortgagor to the mortgagee. His Honour cited the following passage in the judgement of Kearney J in Cochrane v Cochrane (1985) 3 NSWLR 403 with approval: “The principle is based on equity’s concern to prevent one party obtaining an advantage at the expense of another which in the circumstances of the case is unconscionable.” His Honour, therefore, preferred to decide the matter by looking at whether the conduct of the first mortgagee was unconscionable.

At paragraph [68] his Honour held that there was nothing unconscionable or unjust in the first mortgagee, having satisfied its own loan by exercising its power of sale over the properties granted by the Borrower as security, applying any surplus proceeds of sale to the second mortgage. The arrangements between the Borrower, the guarantors and the mortgagees were not intended to allow the Bofingers, by paying out the first mortgagee, to transform the second mortgagee from a secured creditor of the Borrower to effectively an unsecured creditor.

Conclusion

Whilst the Court of Appeal has confirmed the right of lenders to rely on security documents which contractually remove the right of guarantors to be subrogated in the absence of unconscionable conduct, perhaps the most interesting aspect is Handley AJA’s comments on extending the rule in Otter v Vaux.

Intellectual Property & Technology: Maximize Value, Minimize Risk, in Good Times & Bad

Prismex Technologies [1] is a classic example of how the intricacies of intellectual property rights and licences can frustrate the aims of a financier and destroy the value of assets in insolvency.

This case was a liquidator’s nightmare. There were dual company structures to minimise insolvency risk: one to own the intellectual property, and one to exploit it under licence. There was a charge over the IP rights that had been passed from a bank to another debtor. There were patents. There were trade marks. There were assertions about constructive trusts and equitable ownership of IP rights. There were self-help measures: trespass to land and conversion and destruction of intellectual property.

When the dust settled, the purchaser had bought a business from the liquidator but failed to obtain the business’ key IP asset. Because it continued to use the patented technology in question, it was found liable for patent infringement. It successfully hit back with various claims about misuse of its branding. Finally, former directors of the insolvent company were found to have trespassed on land, converted some of the goods embodying the intellectual property, but rightfully repossessed others.

Intellectual property and technology issues are not always so obvious, nor do they always so markedly govern the outcome of a receivership, administration or liquidation. Nonetheless, today’s commercial reality is that IP rights form a substantial part of many companies’ balance sheets.

Just in the last 3 months DibbsBarker has been involved in numerous IP issues in insolvency matters including software licensing; sporting equipment brand name usage; and the sale of a publication’s “mast-head”.

Our Intellectual Property & Technology team can help you identify IP assets, to maximize their value, and to minimize risks arising under intellectual property & technology laws. Our IP&T lawyers regularly team up with our Financial Services group to advise specifically in relation to:

• identifying and protecting intellectual property rights;
• creating, protecting and enforcing securities over IP;
• the registration of securities and interests in IP, and the different priority system that applies to those interests;
• the survival of IP and IP licences into receivership, administration and liquidation;
• disclaiming or enforcing IP licences;
• disposing of encumbered IP;
• dealing with IP rights in the administrator’s or liquidator’s moratorium against recovery of property;
• clawback of IP rights; and
• maximizing the sale value of IP rights;

Hall-v-Poolman

The much anticipated judgment in the appeal of the decision of his Honour Justice Palmer has been handed down by the NSW Supreme Court, Court of Appeal on 31 March 2009.

The appellant was successful and the order of Justice Palmer referring the conduct of the liquidators for an inquiry pursuant to section 536 Corporations Act 2001 (Cth) was set aside. No further order was made.

Whilst the order was set aside the appeal’s success was limited. Out of the various points raised by the appellants within the appeal they succeeded on only the following issues:

• Justice Palmer failed to give sufficient weight to the question of public interest in the prosecution of insolvent trading and unfair preference claims by liquidators; and 
• Justice Palmer erred when he said that whenever a liquidator enters into a litigation funding agreement he should approach the Court for directions.

Even though the appellants failed on every other point of appeal the above issues were sufficient grounds for the Court to set aside the order of Justice Palmer and consider re exercising the Court’s discretion under section 536 of the Act.

Having determined that the order should be set aside, on the basis that Justice Palmer erred in determining that the discretion should be exercised, the court then addressed the question whether the discretion should be exercised or not.

However by the time of the hearing the Appeal Court was faced with an entirely different set of circumstances to those faced by Justice Palmer. The main proceedings against the directors had been settled including costs and the second proceedings, against the ATO and the ATO’s claim for an indemnity from the director, had also been resolved including costs. Given all issues had been resolved including issues as to costs the inquiry if ordered would have little or no effect.

Those circumstances led the Court to form the view that there was no utility in exercising the discretion and ordering an inquiry. On this basis the Court simply set aside the order of Justice Palmer and made no further order.

As is often the case in appeal decisions the judgment of the Court is not only important for liquidators by reason of the success of the appeal and in particular the finding that it is not necessary for liquidators to apply to the Court for directions every time they sign a litigation funding agreement but also because of the findings and determinations that were upheld by the Court of Appeal.

This decision is the latest in a growing trend where the Courts (both state and federal) have been required as part of their decision making process to consider the impact litigation funding has had and will continue to have on the judicial system Given the current financial climate it is an area that will undoubtedly grow.

Consequently it is appropriate to undertake a review of the findings of the Court in this action and other recent decisions including the decision of the Federal Court in IMF (Australia) Limited –v- Meadow Springs Fairway Resort Limited (In Liquidation) 2009 FCAFC 9.

A more detailed and in depth review of these decisions will shortly be available on our website.

Legislative Amendments in NSW to Impact on Mortgagees

Mortgagee’s Power of Sale

There has been debate in Australia for many years about whether the duty on a mortgagee exercising power of sale is a duty to:

• act in good faith; or
• obtain the best price possible.

Recent developments

It is perhaps not surprising that in the current economic climate and increasing mortgage default rates, there has been mounting political pressure on governments which has resulted in recent legislative changes in Queensland, with New South Wales to follow shortly.

In December 2008 the Property Law (Mortgagor Protection) Amendment Act 2008 was passed by the Queensland parliament .The legislation amended section 85 of the Property Law Act 1974 (Qld) by extending the existing duty on a mortgagee exercising power of sale (i.e. a duty to take reasonable care to ensure that the property is sold at market value) to situations where property is sold by a receiver under a delegated power or by the mortgagee as attorney for the mortgagor. The amendments also specified the steps which the mortgagee is required to take for a “prescribed mortgage” in order to satisfy the duty and created an offence for a mortgagee under a prescribed mortgage for failing to follow those steps. The offence carries penalties for up to $15,000.

Whilst the amendments may not alter the way a prudent mortgagee exercises its power of sale, what is significant is the introduction of a statutory penalty rather than a mortgagee simply being liable in damages for a sale at an undervalue.

New South Wales is soon to follow with legislative amendments of its own. Following media announcements of government initiates in mid-2008, more recently, on 25March 2009, the NSW government announced that laws would be introduced to stop banks and other lenders selling repossessed houses at less than their market value.

On 2 April 2009 the New South Wales lower house passed the Real Property & Conveyancing Legislation Amendment Bill 2009. The Bill incorporates into the Conveyancing Act and Real Property Act the current statutory duty contained within section 420A of the Corporations Act but in so doing, it extends the duty to sales by mortgagees of property owned by non-corporate mortgagors.

The legislation introduces a new section 111A into the Conveyancing Act which provides as follows :

“Duties of Mortgagees and Chargees in Respect of Sale Price of Land

1. A mortgagee or chargee, in exercising a power of sale in respect of mortgaged or charged land, must take reasonable care to ensure that the land is sold for:

(a) if the land has an ascertainable market value when it is sold – not less than its market value; or

(b) in any other case – the best price that may reasonably be obtained in the circumstances.”

The new section will also apply to agents appointed by a mortgagee or chargee to sell the mortgaged or charged land. It will also apply to mortgages and charges whether made before or after the commencement of the section, but only in relation to a sale arising as a consequence of the default occurring after the commencement of the section.

The new section also extends to mortgages and charges under the Real Property Act.

Other amendments

The legislation also contains the following changes relevant to mortgagees:

• it places further restrictions and limits on the rights to compensation under the Torrens Assurance Fund; and
• introduces a new sec 56 C into the Real Property Act which requires mortgagees to take reasonable steps to confirm the identity of the mortgagor before presenting a mortgage for lodgement. The mortgagee must keep a written record of the steps taken to comply with the requirements and a copy of any associated documents. The Registrar General may require the mortgagee to answer questions and produce documents in determining whether or not the mortgagee has complied with this section. If the mortgagee fails to comply with the requirement to confirm the identity of the mortgagor and the execution of the mortgage involved fraud against the registered proprietor of the land, the Registrar General may cancel any recording in the Register with respect to the mortgage. This power to cancel any recording extends to circumstances where the requirements to take reasonable steps to confirm the identity of the mortgagor may have been complied with but the mortgagee had actual or constructive notice that fraud was involved.