Insolvency Update: Don’t Shoot First And Ask Questions Later - Liquidators Replaced For Issuing Demand Without Proper Foundation

In the decision of Gadsden V MacKinnon (Liquidator), in the matter of Allibi Pty Ltd (in liq),¹ the Federal Court of Australia considered an application to replace the liquidators of Allibi Pty Ltd (in liquidation) (Allibi) pursuant to sections 90-10, 90-15 and 90-20 of the Insolvency Practice Schedule (Corporations) (IPS).

Allibi entered into a sale transaction to sell its primary business and undertakings which completed in April 2018.  It was subsequently wound up in June 2022 on the application of a creditor based on debts that had been raised before completion of the sale but which had been disputed by Allibi.  Shortly after they were appointed, the liquidators of Allibi (Liquidators) issued a demand against the directors of Allibi for $69m, being the alleged personal benefit received by the directors from the sale transaction.

The directors then applied for orders to replace the Liquidators on the basis that (amongst other things) the Liquidators had maintained and published serious allegations against the directors without taking proper steps to satisfy themselves that there was a proper factual, legal or rational basis for those allegations.

Background facts

The background to the matter is relatively complex, but the relevant facts can be summarised as follows.

Allibi was incorporated in 2007 and was appointed as the trustee of the Billi Unit Trust.  Allibi (in its capacity as trustee) owned and operated a business that developed and marketed commercial “under the sink” water filtration and dispensing systems.  The directors of Allibi were John Gadsen and Daniel Lindsay (the Directors).

In around 2016, Allibi entered into discussions with a UK company named Waterlogic Holdings Pty Ltd (Waterlogic) which was interested in purchasing Allibi’s business.  Waterlogic did not want to acquire the business by purchasing the units in the Billi Unit Trust, so the following sale structure was negotiated and agreed:

• a new company named Billi Australia Pty Ltd (Billi Australia) would be incorporated;
• the Allibi business would be sold by Allibi to Billi Australia; and
• Waterlogic would purchase all of the shares in Billi Australia.

Billi Australia was incorporated on 13 March 2018.  On the same date, Waterlogic entered into a share sale agreement to purchase all of the shares in Billi Australia (Share Sale Agreement).  On 12 April 2018, Allibi and Billi Australia entered into an asset sale agreement by which Allibi agreed to sell its business to Billi Australia (Asset Sale Agreement), and Billi Australia agreed to assume certain liabilities in connection with the business, with the consideration for the sale to be paid to the unitholders of the Billi Unit Trust.

The Share Sale Agreement and the Asset Sale Agreement completed on 27 April 2018. 

Importantly, as at the date of completion:

• a trade creditor of Allibi, Asian Electronics Manufacturing Services Pty Ltd (AEMS), had issued a demand to Allibi on 12 January 2018;
• Allibi had replied on 19 January 2018 denying any liability; and
• no further action had been taken by AEMS by 27 April 2018.

After completion, the following events took place:

• AEMS served a statutory demand on Allibi on 13 July 2018, but withdrew this demand on 14 July 2018;
• AEMS then issued a new demand to Allibi on 13 November 2020, which was also denied by Allibi (via its solicitors);
• on 31 January 2022, AEMS obtained default judgment against Allibi in the County Court of Victoria.  This occurred because AEMS had served the proceedings at Allibi’s registered office, but that office had been controlled and occupied by Waterlogic since 27 April 2018, Waterlogic did not pass on the documents to Allibi, and Allibi did not know about and did not respond to the proceedings; and
• on 1 June 2022, AEMS obtained winding up orders against Allibi.  Again, this occurred because the application was not brought to the attention of Allibi and Allibi did not know about and did not respond to the application.

The Directors did not become aware of these matters until 2 June 2022.

Approximately two months after their appointment, the Liquidators became aware of the Asset Sale Agreement, and the potential argument that Billi Australia might have in fact assumed the liability to AEMS (although this might also have been impacted by a settlement of a separate dispute involving Waterlogic, Billi Australia and Allibi in February 2019).  The Liquidators issued a letter to Billi Australia asking if Billi Australia accepted that it was liable for the AEMS debt, but Billi Australia denied this claim.

The Liquidators then issued a demand to the Directors on 30 August 2022 for $69m, alleging that the Directors had breached their duties in relation to the Asset Sale Agreement and expressly reserving their right to report the matter to ASIC.  The Liquidators’ letter detailed allegations that the step in the sale process of the sale of the business from Allibi to Billi Australia had been an unreasonable director related transaction, and/or an uncommercial transaction, and/or had involved multiple breaches of duty by the Directors.  The Liquidators issued their statutory report the next day to creditors and to ASIC which listed the $69m claim against the Directors as an asset of Allibi.

The Directors (via their solicitors) vigorously denied the claim including on the basis that:

• there were no grounds for the allegation of an unreasonable director related transaction.  The step of transferring the business to Billi Australia was only part of the overall transaction and had been a requirement of the purchaser Waterlogic;
• there were no grounds for the allegation of an uncommercial transaction.  When viewed as a whole, the transaction was clearly commercial.  Further, the transaction had resulted in all of Allibi’s non-related party creditors being paid and Allibi had $800,000 in cash following completion; and
• there were no grounds for the allegation of breach of duty.  Specifically, in relation to the AEMS debt, as at the time of completion AEMS claim had been denied and AEMS had not taken any further steps.

The Directors (via a related entity that was a creditor in the liquidation (Aqueduct)) issued a request to the Liquidators pursuant to section 70-45 of the IPS seeking documents and information in relation to the $69m demand issued to the Directors.  The Liquidators did not respond to the request from Aqueduct.

The Directors then applied to the Court under sections 90-10, 90-15 and 90-20 of the IPS for orders to replace the Liquidators on the grounds that the Liquidators had (amongst other things):

• failed to conduct the winding up with the required degree of impartiality and objectivity; and
• made serious allegations against the Directors, demanded $69m under threat of legal proceedings and an adverse report to ASIC, and published these allegations on the public record (via the statutory report) without first taking proper steps to satisfy themselves that there was any proper factual, legal or rational basis to make the allegations or the demand.

The Liquidators opposed the application.

Summary of arguments in the proceeding

The Directors argued that:

• there was overwhelming evidence that when the Liquidators made their $69M demand, they were aware of the terms and effect of the Asset Sale Agreement including that Allibi had no interest in the proceeds of the sale of business to Waterlogic other than as trustee of the Billli Unit Trust, as well as the history of claims and statutory demands made by AEMS, and the circumstances in which Allibi was place in liquidation;
• the Liquidators had never clearly articulated the legal and factual basis of their claims against the Directors, which could not be reconciled with the known facts of the case; and
• the Liquidators’ conduct had been exacerbated by the threat to report the Directors to ASIC. 

For their part, the Liquidators:

• put on evidence that it was their usual practice (and they believed that it was common practice in the “industry”) as liquidators to identify potential claims at an early stage in a liquidation and to issue letters of demand in respect of these claims, although it was not uncommon for the scope or even the nature of the claims to alter between the time of the demand and the time of the proceedings (if any) due to further information received and the development of the liquidator’s investigations; and 
• argued that they had acted appropriately and that the worst that could be said about them was that they might have not been right in citing the value of the claim at $69m (being the full net value of the sale) and that they could have used an interim value being the total of all known creditor claims at the time of the transaction. 

Relevant law

Sections 90-15(1) and (3b) of the IPS provide that “[t]he Court may make such orders as it think fit in relation to the external administration of a company”, including “an order that a person cease to be the external administrator of the company”.

Under section 90-15(4) of the IPS, the matters the Court may take into account include:

• whether the liquidator has faithfully performed, or is faithfully performing, the liquidators’ duties;
• whether an action or failure to act by the liquidator is in compliance with the Corporations Act 2001 (Cth) (Act) and the Insolvency Practice Rules;
• whether an action or failure to act by the liquidator is in compliance with an order of the Court;
• whether the company or any other person has suffered, or is likely to suffer, loss or damage because of an action or failure to act by the liquidator; and
• the seriousness of the consequences of any action or failure to act by the liquidator, including the effect of that action of failure to act on public confidence in registered liquidators as a group.

An order for removal of a liquidator may appropriately be made where it is demonstrated that it would be for the better conduct of the liquidation to the general advantage of persons interested in the winding up or in the best interests of the liquidation.  An applicant (for removal of a director) may rely on any conduct or inactivity by a liquidator – the overall considerations are the interests of the liquidation and the purpose for which the liquidator was appointed.²

It has also been held that external administrators have “a duty to carry out reasonable investigations into potential claims so as to form an opinion as what future course of action is in the creditors’ interests”.  In doing so, they are “required to take into account time, cost and uncertainty associated with litigating actions”, but a decision to litigate or not “should only be reached after careful consideration of the claims which can only be brought following a liquidation”.³

The decision

The Court ultimately found that the circumstances as to the Liquidators’ demand were so unsatisfactory as to justify the Liquidators’ removal and considered it unnecessary to deal with any other arguments for removal of the Liquidators.

In particular, the Court found that:

• the demand involved very serious allegations and claims for which no proper foundation had ever been proffered by the Liquidators;
• there is significant authority to the effect that Court proceedings cannot be used or threatened for obtaining some collateral advantage, and to do so is an abuse of process;
• it was on any view an abuse of process for the Liquidators to demand $69m (particularly where the Liquidators said at trial that it should have been obvious that the real value of the claim and therefore of the demand was really only the total of the proven debts as at the time of the sale transaction, being around $500,000);
• it was not appropriate for the Liquidators to issue letters of demand by way of ambit claims;
• there was a clear collateral purpose of the demand, being to facilitate some kind of commercial negotiation and resolution;
• because liquidators are officers of the court, it is axiomatic that they should not make demands for the payment of large sums of monies founded on asserted causes of action for which there is no proper basis, nor should they act oppressively or harshly by seeking to exert pressure via the spectre of legal costs or threatening to cause undue embarrassment (such as by a report to ASIC); and
• there is no support in the provisions of the IPS for the argument that liquidators can make serious but purely speculative allegations in the hope that they may bear fruit or drive a party to the bargaining table.

The Court held that proper cause for removal had been shown, and the orders sought should be made to maintain confidence in the integrity of the administration. 

The Court also held that the order was also appropriate because a reasonable bystander would, on reasonable grounds, have lost confidence in the Liquidators, in circumstances where their actions had revealed that they lacked a sufficient understanding about a matter fundamental to their role. 

Lavan comment

This case serves as an important reminder that demands should not be issued and litigation should not be threatened unless there is an appropriate basis for the asserted claim.  It also provides a useful red flag as to the dangers of pursuing an ambit claim.

The case also makes clear that the obligation of the liquidators to identify “possible recovery actions” for the purposes of their reports to creditors pursuant to section 40-40(3) of the IPS has clear limits, and does not permit or allow the pursuit of highly speculative allegations. 

If you have any questions about this decision, or about the tests to be applied when considering or making a demand against another party in the context of potential litigation, the experienced Lavan team is here to help.