What is an Unreasonable Director-Related Transaction?

In article:

An unreasonable director-related transaction is one of the claw-back actions that liquidators have to recover lump sum payments to company directors for a relatively long period before an insolvent liquidation. It was designed to fill any holes in the voidable transaction regime for large corporates but it can equally apply to directors of small-to-medium sized enterprises.

In the winding up of a company, it is the task of the liquidator to gather up as much of a debtor company’s assets as possible for distribution to unsecured creditors. Once collated, these assets are distributed to unsecured creditors pari passu (in proportion to the amount they are owed). 

In order to increase the pool of potential assets available, liquidators often look for transactions prior to the winding up that might be “voidable” under section 588FE of the Corporations Act 2001 (Cth) (henceforth all references to sections are references to this Act). One important type of voidable transaction is the ‘unreasonable director-related transaction’ under section 588FDA.

Here we explain when a transaction might be voidable under that section, how these transactions differ from another type of voidable transaction, uncommercial transactions, and how liquidators pursue claims under this section. 

What is required for a transaction to be an unreasonable director-related transaction? 

The elements of this type of voidable transaction are set out in section 588FDA. 

First, there must be a transaction made by the debtor company. Many types of transactions are eligible. Paragraph (1)(a) of that section specifies that payments, conveyances, transfers, issues of securities and/ or the incurring of an obligation in relation to such transactions will count.

Second, paragraph 1(b) states that the transaction must be between the debtor company and:

• a director of the company
• a close associate of a director
• a person on behalf of, or for the benefit of, a director or close associate

A close associate could be anyone, but often includes family members or business partners of the director. 

Third, paragraph 1(c) requires that a reasonable person in the company’s circumstances would not have entered into the transaction, having regard to: 

• the benefits and detriments of the transaction to the company 
• the benefit to any other party to the transaction

Notably, there is no requirement in section 588FDA that the debtor company be insolvent at the time that the transaction is made. This distinguishes section 588FDA from insolvency common law and statutory duties where creditor rights are triggered upon the actual insolvency of the debtor company. 

What is the purpose of making unreasonable director-related transactions voidable? 

Section 588FDA provides a relatively new tool for liquidators in the context of a winding up — it was introduced in a 2003 amendment to the Corporations Act 2001 (Cth). The purpose of this section was to allow liquidators to claim back payments made to directors prior to liquidation, such as large bonuses paid to directors. You can read more about this in the Explanatory Memorandum that accompanied that amendment. 

The broad terminology used in section 588FDA, with its focus on what is ‘unreasonable’, is intended to capture transactions that might not otherwise count as voidable transactions. 

The type of voidable transaction that an unreasonable director-related transaction most closely resembles is an ‘uncommercial transaction’. Under section 588FB, an ‘uncommercial transaction’ is a transaction that a company enters into where it may be expect that a reasonable person would not have done so, having regard to the benefits and detriments to the company.

Given that a transaction between a company and a director or their associate could also be ‘unreasonable’ in the sense described above, why does there need to be a separate section in the Corporations Act 2001 (Cth) for unreasonable director-related transactions? There are (at least) two reasons why a liquidator may pursue a claim under section 588FDA rather than an uncommercial transaction:

• In order to be voidable, uncommercial transactions must occur when the company is insolvent (there are certain exceptions to this under section 588FE). There is no such requirement for an unreasonable director-related transaction. 
• Unreasonable director-related transactions can occur up to four years before the liquidator is appointed (the ‘relation-back period’). By contrast, an uncommercial transaction must have occurred within the 2 years prior to liquidator appointment. 

All in all, it might be observed that section 588FDA places a higher bar on the conduct of directors when it comes to preserving the interests of the creditors of the company, than it does on other individuals. This reflects the position of trust that directors are in with respect to the company.

What counts as unreasonable?

The test for section 588FDA is whether the transaction was unreasonable. This raises the question – what counts as unreasonable? 

The focus is on the benefits and detriments to the company, as well the benefits to the director or their associate. While the reference to benefits and detriments may make the test sound identical to the test for uncommercial transactions in section 588FB, the reference to how ‘commercial’ the transaction is in the latter section may mean that the courts are likely to read that section more narrowly than they would section 588FDA. 

It is worth noting that the focus is still on the reasonableness of the company’s conduct, rather than the director’s. For example, there is no requirement that a director breached their duties, such as the duty not to allow insolvent trading (see Smith v Starke, In The Matter of Action Paintball Games Pty Ltd (In Liq) (No 2) (2015) 109 ACSR 145). 

The most obvious unreasonable director-related transaction is where a company pays its directors large lump sum payments at the 11^th hour before a company is put into external administration. For example, the managing directors of One.Tel paid themselves $7 million in bonuses in 2001 immediately before placing the company into voluntary administration. In response to those payments the Prime Minister announced that the law would be amended to void that type of transaction.

Does insolvency matter in an unreasonable director-related transaction? 

As discussed, under the terms of the Corporations Act 2001 (Cth), insolvency is not required in order for this type of transaction to be voidable. However, the insolvency of the company may still be relevant insofar as it goes to the reasonableness of the transaction (see Weaver & Jones v Harburn [2013] WASC 441). In many cases, it will be more reasonable for a company to enter into transactions with a director or their associate when the company is solvent, than where it is insolvent. 

Note that as there is no empirical research available as to how often liquidators use this section to void transactions, so we cannot say how often the solvency or insolvency of the company is relevant in actual cases. 

How do liquidators approach unreasonable director-related transactions? 

When a liquidator has identified transactions that might be potentially voidable, they will consider which sections of the Corporations Act 2001 (Cth) might be used to void the transaction.  

Where the liquidator has identified transfers of cash or property, they may assert that the transfer is both an uncommercial transaction and an unreasonable director-related transaction in an attempt to recoup that amount. One advantage to the liquidator in pursuing an unreasonable director-related transaction is that they will not have to prove the insolvency of the debtor company. 

Given the breadth of section 588FDA, it may be difficult for the liquidator to prove that a company’s conduct was unreasonable, and therefore that the transaction is voidable. On the other hand, it may be difficult for any incoming lawyer of the defendant directors to fully evaluate the claim (they are unlikely to have access to all the material on the circumstances of the company at the time of the transaction in question which might support any claim of unreasonableness). In order to avoid litigation on the issue, the liquidator may choose to settle for a lesser amount than that initially claimed. Importantly, this is a settlement between the debtor company and the liquidator — not one that requires court approval.