Cross-security from related party declared void

Cooper as Liquidator of Runtong Investment and Development Pty Ltd (In Liq) v CEG Direct Securities Pty Ltd [2024] FCA 6
Can a court declare the grant of a mortgage by a party related to the borrower void as an unreasonable director-related transaction?

Overview

In this case, the Court found that a mortgage granted by an entity related to the borrower constituted an unreasonable director-related transaction. The Court rejected an argument by the lender that the transaction was reasonable because it is common practice for lenders to take “cross-securities” from related entities, as the lender did in this case. Instead, the Court found that the company’s directors indirectly benefited from the transaction and that there was a corresponding deprivation to the company, sending a warning to secured lenders that their cross-securities from related entities may be held to be void in the event of a future liquidation.

Background

Runtong owned vacant CBD land (the “Land”) in Adelaide which was subject to a $1.5 million mortgage in favour of NAB. Runtong had intended to construct a residential apartment tower on the land.

Two related companies which shared some common directors with Runtong – Futong and Datong – owned a separate piece of CBD land on which construction of a residential apartment was underway. Futong and Datong had borrowed money from CEG Direct Securities in 2014 to fund the construction costs. The companies’ directors (including those that were common to all three companies) had given personal guarantees to CEG in connection with the loan. In December 2014, Runtong also executed a mortgage (the “Mortgage”) over the Land in favour of CEG as part of a series of securities provided to CEG to secure Futong and Datong’s borrowings, which totalled slightly in excess of $15.1 million at that time.

On 27 February 2018, CEG entered into possession of the Land as mortgagee in possession, and on 2 March 2018, Runtong entered administration. Ultimately, on 18 June 2018, Runtong’s creditors resolved to wind the company up and Nick Cooper of Oracle Insolvency Services was appointed as Liquidator.

Shortly after the Liquidator’s appointment, CEG exercised its power of sale under the Mortgage and sold the Land for approximately $12.2 million. The Liquidator argued the 2014 grant of the Mortgage was voidable as an unreasonable director-related transaction within the meaning of s 588FDA of the Corporations Act, and sought an order under s 588FF(1)(a) that CEG pay to Runtong an amount equal to some or all of the money that Runtong paid under the transaction.

The Court’s Decision

To constitute an “unreasonable director-related transaction” under s 588FDA of the Corporations Act, a transaction must be for the benefit of a director of the company and one which a reasonable person in the company’s circumstances would not have entered into having regard to, among other considerations, the detriment to the company of entering into the transaction. Under s 588FE, the Court can declare an unreasonable director-related transaction void if it was entered into within 4 years of the relation-back day (which in this case was 2 March 2018, the date of the initial administration).

The Court agreed with the Liquidator that the grant of the Mortgage to CEG was an unreasonable director-related transaction, finding that Runtong’s directors benefited from the transaction. Given that the directors had given personal guarantees for Futong and Datong’s borrowings, CEG’s realisation of its security would have the effect of reducing the directors’ contingent liabilities under the guarantees, thereby occasioning an indirect financial benefit on the directors.

In addition, the detriment to the company in the circumstances was obvious and substantial. Exposing Runtong’s only asset to sale by CEG in the event loans obtained by Datong and Futong were not repaid, and with the potential of still further advances to Datong and Futong, was fraught.

Accordingly, the Court declared the grant of the Mortgage an unreasonable director-related transaction and ordered that CEG pay Runtong $1,983,100.40, representing the difference between the total value of the benefits provided by Runtong to CEG in the Mortgage ($12,143,300.47) and advances later provided to Runtong by CEG to fund construction on the Land ($10,160,200.07).

Implications on lending practice

One of the most interesting aspects of the judgment was the Court’s consideration of CEG’s argument that it is common practice for lenders to take “cross-securities” from related entities just as CEG did in this case, and that it would be rare for a lender not to do so in a situation where the security proffered by the borrower is inadequate. Therefore, CEG argued it was reasonable for the Mortgage to be granted.

The Court rejected this argument, finding that the only parties to the Mortgage were CEG and Runtong and that CEG was the only party who obtained a benefit by reason of the grant of additional security through the Mortgage. As a result, the Court concluded that a reasonable person in Runtong’s circumstances would not have granted the Mortgage.

The decision serves as a cautionary tale for secured lenders to scrutnise their cross-securities from related entities at the time they are given in order to ensure they are not held to be void in the event of a future liquidation.

Judge: O’Sullivan J.

Counsel for the Liquidator: Garry Bigmore KC and Arnie Narayan

Solicitor for the Liquidator: Travancore Legal & Advisory

Counsel for the Defendant: Alex Lazarevich

Solicitor for the Defendant: Ronayne Owens Lawyers

Omni Bridgeway (with a team headed by Heather Collins) provided litigation funding for this case one month prior to the hearing, offering the Liquidator adverse cost cover from the commencement