TGIF 16 February 2024 – Court finds cross-collateral mortgage vulnerable to challenge by liquidator

The Federal Court has recently delivered judgment in the case of Cooper as Liquidator of Runtong Investment and Development Pty Ltd (In Liq) v CEG Direct Securities Pty Ltd [2024] FCA 6, a case where a liquidator was successful in having a mortgage declared as an unreasonable director-related transaction.

Key Takeaways

• To declare that a transaction is an unreasonable director-related transaction and voidable, the Court must be satisfied that, on an objective test assessed at the time the transaction was entered into, a reasonable person in the company’s position would not have entered into the transaction.
  
  
• In assessing whether a payment or disposition of property occurred ‘for the benefit of’ a company director, it will be sufficient to establish the director received an indirect benefit, such as a reduction in contingent liability under a separate agreement.
  
  
• Lenders should exercise caution when relying on cross-securities granted by related entities. They should be mindful that transactions without reasonable commercial justification may be vulnerable to challenge by liquidators.

Background

On 12 December 2014, the plaintiff company – Runtong Investment and Development Pty Ltd (now in liquidation) (Runtong) – executed a mortgage over real property located in Adelaide (the Land) in favour of the respondent company, CEG Direct Securities Pty Ltd (CEG). That security was secondary to a pre-existing mortgage in favour of the National Australia Bank. CEG subsequently registered its mortgage, took possession of the Land on 27 February 2018, and entered into a contract for the sale of the Land to a third party on 27 July 2018.

Runtong (by its liquidator) applied to the Federal Court to avoid the mortgage on grounds that the transaction was voidable as an unreasonable director-related transaction pursuant to sections 588FE and 588FDA of the Corporations Act 2001 (Cth) (Corporations Act).

The liquidator submitted that:

• The mortgage was part of a series of securities provided to secure over $15 million borrowed from CEG by Australian Datong Investment & Development Pty Ltd (Datong) and Futong Investment & Development Pty Ltd (Futong).
  
  
• Runtong, Datong and Futong were related in the sense of sharing two common directors, each of whom had provided personal guarantees to CEG for repayment of the borrowed funds.
  
  
• Runtong’s mortgage had the effect of reducing each director’s contingent liability under the personal guarantees.

The case turned upon whether a reasonable person in Runtong’s position would have granted the mortgage to CEG, from whom Runtong had not sought (and did not require) any funding at the relevant time.

Decision

The Court made a declaration that the mortgage was an unreasonable director-related transaction. O’Sullivan J also concluded that the transaction was voidable under section 588FE(6A) of the Corporations Act and ordered that CEG pay $1.9 million for the benefit of Runtong’s creditors (together with costs and interest).

In finding that a reasonable person in Runtong’s position would not have granted the mortgage to CEG, O’Sullivan J applied an objective test, assessed at the time the transaction was entered into. His Honour concluded:

• The mortgage offered no discernible commercial benefit to Runtong, which was not named as a ‘borrower’ in any loan agreement with CEG.
  
  
• The mortgage was detrimental to Runtong by exposing the company to potential liability for over $15 million.
  
  
• The mortgage was granted ‘for the benefit of’ two of Runtong’s directors, who each received an indirect financial benefit in the form of a reduction of their exposure on their personal guarantees to CEG.

The Court did not consider it necessary for the liquidator to establish that:

• Runtong was insolvent at the time the mortgage was granted.
  
  
• CEG was notified of any risk of Runtong becoming insolvent.
  
  
• The transaction constituted a breach of directors’ duties.

Once established that the mortgage was, on its face, an unreasonable transaction for Runtong, the onus shifted to CEG to raise a commercial explanation. CEG was unable to meet that evidentiary burden, the Court not accepting that the three companies belonged to a ‘property development group’ and that the taking of cross-securities was common commercial practice.

Comment

This case provides an important caution to lenders seeking to rely on cross-securities.

When taking cross-securities, lenders should consider any ‘red flags’ that the transaction might be uncommercial for the counterparty or security providers. Where cross-collateral is provided by entities in a corporate group, this may provide lenders some comfort that the transaction will benefit the mortgagor (or grantor, as the case may be).