Can third party mortgages to non-creditors jump the queue?

Would you challenge a security granted by a company (in liquidation) to a third party who was not a financier, not a creditor, had no contractual relationship with the company and had no legal or equitable interest entitling it to charge the property in its favour?

This question was faced by the liquidators of 640 Elizabeth Street Pty Ltd (in liquidation) (640) who sought to set aside a mortgage granted by the company to a non-creditor as an “uncommercial transaction”[1] within the meaning of the Corporations Act 2001 (Cth).

The Supreme Court of Victoria (on appeal from an Associate Judge’s decision) found against the liquidators and held that the mortgage was not an “uncommercial transaction”.[2]  Consider the following:

• 640 owned property at 640 Elizabeth Street, Melbourne (Property) which it wanted to develop as residential apartments.
• 640 entered into a joint venture agreement for the Property’s development pursuant to which the joint venture parties appointed a special purpose vehicle as development manager/ nominee (Developer).
• The Developer entered into a building contract for the construction of the development pursuant to which the contractor tendered retention money, in the usual course, to be held in escrow by the Developer pending completion of the development.
• After practical completion, the contractor learned that the Developer had used the retention money to discharge secured debts to third parties.  The contractor was still owed amounts by the Developer pursuant to the contract.  The Developer was also behind on payments to the ATO and other creditors.
• In light of the contractor’s demands for payment and concerns over the misappropriation of the retention sum, 640 and the Developer entered into an agreement whereby 640 mortgaged the Property to the contractor.
• The mortgage granted by 640 was described as security for the Developer’s payment obligations to the contractor under the contract.
• The Developer was not party to the agreement.
• The joint venture agreement did not confer a proprietary interest in the Property on the Developer or any other party.

(It was accepted that “the transaction” comprised the agreement between 640 and the Developer and the mortgage between 640 and the contractor).

“Uncommercial transactions” of a company are those which no reasonable person in the company’s circumstances would enter into, taking into account:

• the transaction’s benefits (if any) to the company;
• the transaction’s detriment to the company;
• the benefits conferred on third parties by the company’s entry into the transaction; and
• any other relevant matters.

These transactions are typically characterised by “the recipient receiving a gift or obtaining a bargain of such magnitude that it [cannot] be explained by normal commercial practice”[3] and involve consideration which “lacks a commercial quality”.[4]  They do not necessarily involve undervalue (although that’s frequently the case),[5] but rather an objective assessment of the benefits and the detriments to the respective parties.

640’s liquidators argued that:

• There was no benefit to 640 in granting the mortgage to the contractor because the mortgage secured debts owing by the Developer and not 640.
• Conversely, there was a clear detriment to 640 in granting the mortgage because absent the mortgage, 640 could not be liable for the debts.  The granting of the mortgage, they said, effectively made a non-liability a secured liability.
• There was a benefit to the contractor in receiving the mortgage as it acquired security over the Property to which it was not otherwise entitled and it suffered no detriment as a result.
• The transaction was not explicable by ordinary commercial principles.

Dismissing all of the liquidators’ contentions, the Court held that:

• 640 received a benefit from entering into the mortgage by avoiding a claim or exposure to a claim brought by the contractor (whether directly against the Developer or as a derivative claim brought by the Developer).[6]  This was because the joint venture agreement required 640 to indemnify the Developer for expenses it owed to the contractor, including legal fees.  The benefit was, in the Court’s view, a commercial one.
• There was no detriment “of any real substance” to the net position of 640’s unsecured creditors by entering into the mortgage because one way or the other, 640 was liable for the contractor’s claim. [7]  The Court said it followed that funds would have been disbursed by the contractor to the Developer in priority to any distributions to 640.  This finding involved a detailed consideration of provisions of the joint venture agreement including arguments that funds held by the Developer were impressed with a trust.
• The benefit to the contractor in being granted the mortgage was not so disproportionate as to render the transaction “uncommercial”.  The Court described the benefit as “not that great…not…so extravagant or out of all proportion so as to render it uncommercial”.[8]
• The reasonableness of the transaction, assessed against the objective standard, was not a separate determination to the other considerations before the Court.  The transaction was not at an undervalue, rather it was precisely the sort of transaction a reasonable commercial person in 640’s position would enter into having regard to the circumstances and in light of the potential for litigation threatened by the contractor.[9]

Lavan Legal comment

This decision highlights the importance of considering a company’s specific circumstances at the time an allegedly “uncommercial transaction” was entered into.  The Court’s reasoning supports the need to balance the benefits and detriments to the respective parties taking into account the commercial exigencies, beyond a purely technical analysis of the parties’ legal rights and obligations.