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Focus: Insolvency & Restructuring – November 2008

The Bell Group litigation – the lessons learned

In brief: Partner Diccon Loxton (view CV) looks at the recent decision of the Western Australian Supreme Court in the Bell Group Ltd litigation, which is a timely case study of the legal issues involved in work-outs and corporate guarantees.

How does it affect you?

  • Banks and company directors may want to take a more cautious approach in work-outs, and in the standard procedures that apply whenever members of corporate groups give guarantees.

Introduction

On 28 October 2008, Justice Owen of the Western Australian Supreme Court handed down his 2643 page, 1,084,735-word judgment in the Bell Group litigation. The case concerned an attempted work-out in the last economic crash in 1989 and 1990, and it is perhaps ironic that the case took as long as the longest boom in living memory, and so the judgment is released in time for its lessons to be learnt in this crash.

However, the Bell Group case turned very much on its facts. Once the court made the findings of fact that it did, there is little that is surprising in the consequences that flowed from those findings.

Nevertheless, the case is an extremely useful case study of the legal ramifications of work-outs, when banks take security from a troubled borrower and its related entities. There are lessons to be learned. Further, there are concerning aspects in some of the statements of the judge as to the law, and as to the manner in which he examined the facts. Banks and directors may need to take a more cautious approach in the future, not only in work-outs, but also in the normal day-to-day situation where banks take guarantees or security from members of a corporate group.

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The facts

The Bell Group Limited (TBGL), an Australian listed holding company, and its English subsidiary had borrowed money from banks on an unsecured basis. The loans were guaranteed by various members of its corporate group.

An offshore subsidiary of TBGL had issued subordinated convertible bonds, guaranteed on a subordinated basis by TBGL. The funds raised in the bond issue were on-lent to TBGL and its finance subsidiary.

Following its takeover by the Bond Corporation Holdings Limited, and a market decline, TBGL was in some financial difficulty. A number of its bank loans were on demand which it could not repay. Its main assets and cashflow sources were a publishing business, and its investment in, and fees from, other companies controlled by Bond (including Bell Resources Limited) which were having their own difficulties.

It entered a 'refinancing' transaction with the banks under which:

  • the term of the debt was extended;
  • the banks obtained guarantees and security over principal assets from many members of the group, some of which had not previously guaranteed the debt;
  • the borrower and guarantors undertook that all asset sale proceeds were to be used to pay down the bank debt or paid into escrow; and
  • the on-loans of the subordinated bond issue proceeds were expressly subordinated.

Most of the refinancing and security documents were executed in early 1990. In April 1991, TBGL appointed a provisional liquidator, and the banks then realised the assets subject to their security.

TBGL and a number of its subsidiaries, the liquidators, and the trustee for the bondholders sued the banks.

Among other things they alleged that the companies were insolvent when they entered into the refinance transactions and gave the securities, and that their directors were in breach of their directors' duties. They said that the banks knew of the breach, and consequently the banks were liable as constructive trustees to return the proceeds of realisation of the securities, and the refinance transactions should be set aside.

In addition, the trustee for the bondholders said that the on-loans of the subordinated bond issue proceeds from the offshore subsidiary to TBGL and its finance subsidiary were unsubordinated. This would have had the effect of effectively making the bonds unsubordinated.

Further, there were various claims that the banks' conduct amounted to an equitable fraud on the companies and their creditors including the bondholders, and claims that the security should be set aside under bankruptcy legislation as it then affected Australian corporations (the law has since been changed).

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The principal findings

The court found that:

  • TBGL and its subsidiaries were insolvent when they entered into the refinancing transaction and gave the securities;
  • the directors knew or should have known that the companies were insolvent, or nearly insolvent;
  • entering the transaction and giving the securities involved a breach of the directors' fiduciary duties; and that the banks knew of that breach, and
  • the banks were therefore liable as constructive trustees.

However, the on-loans from the offshore subsidiary to TBGL and its finance subsidiary were subordinated, so that the bondholders were effectively subordinated.

The court dismissed claims of equitable fraud on the part of the banks.

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Changes in the law since the case

The case was decided on the law as at 1990. It is important to remember that there have been a number of changes in the law since then. In particular, the insolvency laws applicable to corporations (including as to voidable transactions) have changed significantly. There have been some changes in directors duties: the Corporations Act 2001 now contains (in section 181) obligations on directors paralleling their general law duties acting in good faith and for a proper purpose. This is a civil penalty provision, which means that a bank knowingly involved in the breach can be liable for compensation. On the plus side for banks, there is now s187, which allows a company to put provisions in its constitution allowing it to act in the best interests of its holding company if it is not insolvent. The statutory 'indoor management rule', then in s68A, and now in s128 and s129, has been changed to favour outsiders.

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Lessons learnt and points to watch

Insolvency

Judging whether a company is insolvent is often a difficult call. In making that call directors of companies in financial difficulty, and those dealing with them, may need to look more critically at the ability of the company to pay its debts and, in some cases, examine it over a longer timeframe. In the particular facts of this case, the court looked over a period of 12 months, longer than most other cases. However, the judge said that his primary focus of attention was the period of a little over four months in the future.

The court took a more critical view of the cash flow and cash forecasts, analysing their components, and applied hindsight - looking at subsequent events in judging whether a company was insolvent at a particular time.

The judge found that solvency is a question of fact to be determined in light of all the circumstances which were known or ought to be known at the time. However, he went on to say that evidence of what in fact did ultimately happen - hindsight evidence - was admissible if it shed light on the actual position at the time and on the state of affairs that was, or that ought to have been, known at the time.

The case recognises that the solvency test in Australia starts with a cash flow test but finds that that is not the end of the question. The balance sheet test is also relevant and insolvency is ultimately to be judged by a full consideration of the company's entire financial position based on 'commercial reality'. In particular, the judge said directors cannot 'rely on some faint hope that help is at hand and all will be well. The word "reality" in the phrase "commercial reality" has a bite.'

The judgment also gives some useful guidance on the ability of a company to take into account the sale of assets in considering its present solvency, emphasising two things in particular:

  • if a company owed a debt which it believed it could meet by the sale of an asset, it would need to form the view that that asset could be sold for the required value before the debt fell due for payment; and
  • if a major income-generating asset is to be sold to meet liabilities, the company must take into account the fact that that sale would deprive it of future income which might otherwise be derived from that asset and so 'rob the company of the ability to meet other liabilities due later but nonetheless in the foreseeable future.'
The corporate benefit test

As those taking guarantees from companies, in good times or bad, will know, it is traditional to ensure that there is sufficient 'corporate benefit' for each individual guaranteeing company in the group, and not just the group. This arises because the directors of each company have a duty to exercise their powers in good faith in the best interests of that company, and for a proper purpose. In this case the court held that there was insufficient corporate benefit, and that the directors of each individual company breached those duties.

There are a number of aspects to the judgment which will give cause for thought in future practice.

  • The mere fact that the companies were being 'kept alive' by the restructure was held not to be a sufficient corporate benefit, if there was no plan for survival, and all the assets would be diverted to the secured creditors. Those involved in work-outs will need to ensure that there is a plan showing a prospect of continued operation, or a realistic contemplation of such a plan.
  • The standard to be applied in analysing the position of the directors of each individual company was quite high. The banks suggested that there was sufficient corporate benefit for many subsidiary companies because they borrowed funds from TGBL under inter-company loans. Those inter company loans would be called unless TGBL's bank funding was extended. The court held that the companies should also look at their position as creditors. Although the directors of English companies had separate advice, and gave careful consideration to their position, they were still held to be in breach of their duties, because they had not analysed the credit risk of companies which had taken inter-company loans from them. Curiously, in the judgment there is little analysis of the position of the individual companies.
  • Because the companies were at or near insolvency, the directors of each company had to consider the interests of its creditors even though there is no duty to the creditors per se. This is well accepted, but in applying these principles to the facts, the judge required the directors to look at the position of identified individual creditors. He also said that the obligation to consider the creditors occurs short of insolvency when the decision may have adverse consequences for them or propel the company towards an insolvency administration. This is a broad statement. This type of analysis may restrict the number of cases in which shareholders can ratify what otherwise might have been a breach of duty.
  • The decision also makes life more difficult for those seeking to give or defend corporate guarantees in the future by emphasising the duty not to act improperly as a separate duty from the duty to act in good faith in the best interests of the company. In the judge's view, for something to be not improper required it to be for the purposes of the company's business. To determine that purpose, he had regard to the objects set out in the company's memorandum of association, something that has not been done for a generation, and in fact could not be done for more modern companies which do not have a memorandum of association.
    It will limit the efficacy of s187 of the Corporations Act. That section was designed to allow solvent companies to act in the best interests of their holding company if authorised by the constitutions. But it only deals with the best interests duty, not the proper purposes duty.
  • The plaintiffs had said that there was a duty to avoid conflicts of duties, that is, between the directors' duties to different companies of which they are director. If this had been upheld, it would have made life very difficult for directors of companies in corporate groups, but it was not. The judge held there was only a duty not to act in conflict with the directors' own interests.
  • The duty to act in good faith in the best interests of the company is normally thought of as being subjective - the courts do not second guess directors' decisions. On that basis, if the directors made an unreasonable decision, the decision could still be in good faith, but the unreasonableness would mean the court was more likely to draw an inference that they were not acting in good faith, that is, that directors have not actually made the decision for the stated (unreasonable) reasons. The judge overall confirmed that approach. However, he went on to say that the court still had an ability to overturn a decision if no reasonable director could have thought it in the best interests of the company. Thus, at the end, the court left itself an objective test in applying its sanction.
  • Lenders and their lawyers will also need to be cautious in relation to future transactions. The court placed great significance on the fact that the lenders' lawyers had been closely involved in the drafting of the minutes for each guaranteeing company, and that the minutes for each company were identical.
Constructive trusts – knowledge of banks

Banks will need to be careful what they ask for, and even more careful about what they choose not to ask for.

The judge said the banks were constructive trustees because they received property in breach of directors' duties and they knew of the breach. He said the duties to act in good faith in the best interests of the company and for a proper purpose were fiduciary duties and any person who received company property in breach of those duties, knowing of that breach, would be liable in respect of that property as constructive trustee.

The decision gives significant guidelines as to what would be the knowledge of banks. It sets out in what circumstances the knowledge or state of mind of a bank's employees, the bank's lawyers, or other banks, acting formally or informally, as agent or arranger for the bank can be imputed to the bank.

It also confirms that to have sufficient knowledge as a constructive trustee in this type of case, the bank must have (i) actual knowledge; (ii) wilfully shut its eyes to the obvious; (iii) wilfully and recklessly failed to make such enquiries as an honest and reasonable person would make; or (iv) have knowledge of circumstances which would indicate the facts to an honest and reasonable person.

The judge held that there was not only actual knowledge, but knowledge of the type referred to in (iii) and (iv). The banks knew of the insolvency, or enough facts to draw the inference of insolvency. They knew of the terms of the refinancing. They also recklessly failed to make enquiries they would normally make.

The court placed great significance on the fact that they dropped a requirement for solvency certificates, and also did not ask for updated cash flows, when he found that banks normally ask for both.

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The lessons learnt – practical tips

It is important to remember this case is just one first instance decision. However, assuming that the approach of Justice Owen's decision is followed in future cases, some lessons that can be taken from the Bell Group case include:

When groups of companies are in financial difficulties or seeking a workout

Directors:

  • obtain and critically examine forward-looking cashflows showing a prospect of paying, continuing or refinancing existing debt;
  • examine the position of each company in determining corporate benefit;
  • for each company, don't create security in favour of one group of creditors, unless there is a plan or a reasonable prospect of a plan for the company to continue to pay creditors;
  • treat with great caution any proposed guarantee from a company which has not previously given a guarantee of the debt; and
  • ensure that the minutes of any meeting are accurate and a meeting is actually held for each company.

Banks:

  • examine the position of each company in determining corporate benefit;
  • obtain and critically examine cash flows showing a prospect of paying, continuing or refinancing existing debt;
  • be aware of the restrictions on directors (see above);
  • ask for your standard requirements in relation to information, certificates and the like, and do not give up the request without extreme caution;
  • in relation to each company, unless the corporate benefit is blindingly obvious, get defensible, reasonable statements (preferably not full minutes) setting out the reasons why the directors are entering into the transactions, and the corporate benefit for the company;
  • be very wary of accepting evidence of directors' resolutions which are implausible (that is, they set out formalities which may not be followed);
  • be very cautious in becoming involved in the drafting of directors resolutions; and
  • be cautious about accepting identical proforma minutes or resolutions for every company.
When companies in a solvent group are giving a guarantee of a new financing

Directors:

  • separately examine the position of each company in determining corporate benefit.

Banks:

  • ask for your standard requirements, be careful in giving them up;
  • in relation to each company, unless the corporate benefit is clear, get defensible, reasonable statements (preferably not full minutes) which set out the reasons why the directors are entering the transaction and the corporate benefit (not simply a statement that there is corporate benefit);
  • be very wary of accepting evidence of directors' resolutions which are implausible (that is, they set out formalities which may not be followed);
  • be cautious about proforma resolutions set for every single company; and
  • where possible ensure that every company's constitution has a provision under s187 of the Corporations Act, allowing its directors to act in the best interests of its holding company, but be aware there may still be a risk.

For further information, please contact:

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