Rateable Distribution of Trust Funds Ordered Due to Tracing Impossibility

The NSW Supreme Court ordered a rateable distribution of trust funds due to the impossibility of tracing individual beneficiaries' funds. The court relied on the Corporations Act 2001 and the Trustee Act 1925.

OUTCOME: Allowed

Reported Decision : (2003) 44 ACSR 719

New South Wales Supreme Court

CITATION : [NAME_1] v [NAME_2] [2003] NSWSC 129 HEARING DATE(S) : 3 March 2003 JUDGMENT DATE : 7 March 2003 JURISDICTION: Equity JUDGMENT OF : Austin J DECISION : See under "Conclusion"

CATCHWORDS : CORPORATIONS - winding up - distribution of trust funds - difficulty or impossibility of tracing - whether Court should order pooling of funds and proportionate distribution to known claimants LEGISLATION CITED : Corporations Act 2001 (Cth) s 479(3) Trustee Act 1925 (NSW) s 63 Clayton's Case; Devaynes v Noble (1816) 1 Mer 572 [35 ER 781] CASES CITED : Hagan v Waterhouse (1991) 34 NSWLR 308 [NAME_3] v [COMPANY_4] of New South Wales (1998) 44 NSWLR 451 Re [COMPANY_5] (in liq); application of Sutherland [2002] NSWSC 641 Australian Securities & Investments Commission (P) [NAME_8] (D1) PARTIES : [COMPANY_10] (D2) [COMPANY_12] (D3) and eight others [NAME_14] as liquidator of [COMPANY_10] (In liquidation) and five other companies (A) FILE NUMBER(S) : SC 4319/01 COUNSEL : [redacted] [NAME_16] (Solicitor) (P) SOLICITORS : [redacted] [NAME_18], Solicitor for Australian Securities & Investments Commission (P)

IN THE SUPREME COURT OF NEW SOUTH WALES EQUITY DIVISION

AUSTIN J

FRIDAY 7 MARCH 2003

4319/01 AUSTRALIAN SECURITIES & INVESTMENTS COMMISSION V [NAME_8] & ORS

JUDGMENT (Revised for typographical errors 7 March 2003) 1 HIS HONOUR: This is an interlocutory application by [NAME_13] as liquidator of the following six companies: [COMPANY_10]; [COMPANY_12]; [COMPANY_20]; [COMPANY_22]; [COMPANY_23]; and [COMPANY_23] ("the Companies"). The primary relief sought by [NAME_13] is as follows: "A direction, in the circumstances outlined in [his affidavit] and any other evidence presented to the Court in support of this interlocutory application, that notwithstanding the terms and conditions of a trust deed or other instrument governing the administration, management or winding up of the [NAME_26] ( [NAME_26] ) of which the defendant companies are trustees [as detailed in a schedule to the application] the applicant ( Liquidator ) is justified in proceeding and making a first and final distribution of the funds ( Funds ) comprising the remaining property of the [NAME_26]: (a) as if and on the basis that the Funds comprise a single fund; and (b) in the following order of priority: (i) first in payment of the Liquidator's remuneration, costs, charges and expenses of and in connection with the winding up of the Companies (including his costs of this interlocutory application); and (ii) second pari passu among all of the persons who are adjudged by the Liquidator to be beneficiaries of the [NAME_26], in proportion to the amount adjudged by the Liquidator to be the amount of their claim(s) against the property of the Trust(s) of which they are a beneficiary." 2 If the Court makes a direction in the terms sought, [NAME_13] intends to give notice of his intention to distribute the property in accordance with Part 70 rule 16 of the Supreme Court Rules. 3 A schedule to the interlocutory application lists 14 [NAME_26] of which [NAME_10] is Trustee, and two [NAME_26] of which [NAME_11] is Trustee. The [NAME_26] bear comfortable names like "[COMPANY_27]" and "[COMPANY_28]". 4 The motive force behind this dry and technical application is a very sorry tale of funds mismanagement causing substantial losses to inexperienced "retail" investors. [NAME_13] became receiver and manager of the Companies, and subsequently liquidator, following an investigation by [NAME_1] into the affairs of an accountant named [NAME_9]. [NAME_1]'s investigation followed complaints after Mr [NAME_2] induced some of his clients to acquire units in unit [NAME_26] for investment purposes. [NAME_10] and [NAME_11] were the trustees. Many of the clients (whom I shall call "the Unitholders") were elderly, and some have passed away, so that their interests are being represented by executors and beneficiaries. None of them were sophisticated investors. 5 [NAME_13]'s investigations as receiver and liquidator have confirmed the worst fears of the investors. All but a small amount of the money they paid to [NAME_2] has been lost. The total amount of the investments exceeded $4 million - his current estimate is $4,537,368. [NAME_13] now holds $105,439.44 in cash and intends to seek recovery of an additional $44,242 held in the trust account of [NAME_2]'s solicitor. History of the [NAME_26] 6 It appears that the 14 [NAME_26] of which [NAME_10] is the Trustee ("the [NAME_10]") were established in the late 1980s by [NAME_29], an investment adviser, for his clients. [NAME_2] and [NAME_29] had a business relationship in which [NAME_2] prepared tax returns for [NAME_29]'s clients. [NAME_2] became a director of the trustee company, [NAME_10]. 7 According to information supplied to [NAME_13] by [NAME_2], [NAME_29] orally represented to Unitholders of the [NAME_10] that their funds would be invested in bank-backed securities, yielding a fixed quarterly interest payment. In fact a total of approximately $3.6 million from the trust funds was lent to [NAME_29] and/or entities connected to him. The loans were secured by mortgages on properties owned by or linked to [NAME_29]. In the period between the late 1980s and 1993, funds were intermingled between the [NAME_26] to satisfy interest payments, loan payments and redemptions. 8 The money taken by [NAME_29] was repaid in three instalments, two on 14 June 1995 and one on 6 February 1997, by interests associated with [NAME_29]. However, [NAME_13] says that he cannot be certain that the particular [NAME_10] were repaid these funds in their entirety. [NAME_13] has provided me with a schedule that shows that $3,563,333 was paid out by seven lender [NAME_26] of which [NAME_10] was Trustee. The repayments on 14 June 1995 were, in total, $1,333,333 less than the total amount that [NAME_29] had taken from the [NAME_26]. The June 1995 repayments were applied at [NAME_2]'s direction to meet interest payments, redemptions and loan repayments, as well as to fund losses of [NAME_21], at that stage one of [NAME_29]'s companies. The repayment in February 1997 was by a company owned and controlled by [NAME_29] named [COMPANY_31], which paid $1,299,505 to [COMPANY_27]. Some of these funds were applied by [NAME_2] to meet interest and redemption payments, and to make loan repayments, but the balance was applied towards the purchase price of three rural properties in the Mudgee district, two acquired in the name of [NAME_21] and one in the name of [NAME_2]. 9 [NAME_13] has prepared another schedule which summarises in more detail the application of the [NAME_29] repayments. His evidence is that while he can identify how the money was used to purchase the three properties which I have mentioned, he has been unable to determine whether the balance of the money paid in was correctly distributed to or among the various [NAME_26] from which the money was taken. 10 In 1992 [NAME_29] was the subject of an investigation conducted by [NAME_1], which resulted in his being banned from acting as a securities representative for 10 years. [NAME_2] took over complete management of the affairs of the [NAME_10] as an investment adviser. 11 Another phase in the misuse of trust funds began in 1993. [NAME_2] acquired [NAME_29]'s interest in [NAME_21], and primarily using funds from the [NAME_10], he bought out the company's only other shareholder to become its sole owner. During the period 1993 to 1995 [NAME_2] diverted funds from the [NAME_10] to support the operations of [NAME_21], which at that stage carried on a soil testing business in New South Wales and Queensland. The business incurred losses and was terminated in 1996. 12 [NAME_2] has informed [NAME_13] that the loss on the soil testing business was in the vicinity of $800,000 to $900,000, and that the loss was funded by money advanced from the [NAME_26]. [NAME_13] has not been able independently to verify the amount of the loss, but he has identified various payments and advances from the [NAME_26] to the company prior to 1996. 13 During the period 1993 to 1996, and subsequently, [NAME_2] also directed the application of trust money between the [NAME_10], as necessary to pay Unitholders' interest entitlements and to make redemptions. This resulted in a very substantial co-mingling of the funds of the various [NAME_26]. As not all of the bank records are available, [NAME_13] has not been able to ascertain the full extent and nature of these funds transfers. 14 In 1996, in an attempt to recoup money that had been diverted from the [NAME_10], [NAME_2] initiated the development of an olive grove and processing project in Mudgee. The project involved the purchase of two properties at Mudgee by [NAME_21], the purchase of a property called "[NAME_32]" in [NAME_2]'s name, and the sale by [NAME_2] of interests in the project to "partners" who each purchased a share in the Mudgee properties from [NAME_21], which would provide vendor finance and take a mortgage over the partner's interest. The company would on-sell the mortgages to a third party for cash, and then reimburse the [NAME_10]. [COMPANY_23] and [COMPANY_23] were formed to manage the olive grove project. The purchase money of $67,384.48 for [NAME_32] came partly from [NAME_21] and partly from [COMPANY_27], although the source of $2,228.50 is unknown. [NAME_13] has proceeded on the basis that the proceeds of any sale of the Mudgee properties are held on constructive trust for the Unitholders of the 14 [NAME_10]. 15 In 1996 [NAME_2] established two new unit [NAME_26], the Illawarra Unit Trust and the Botany Unit Trust, the trustee being [NAME_11]. The money invested in those [NAME_26] was used to meet interest payments and redemption obligations of [NAME_10], and also to meet loan repayments paid to [NAME_21] and to [COMPANY_23] to fund improvements to the olive grove properties. [NAME_13] has been able to prepare a schedule summarising proceeds and payments in respect of these two [NAME_26]. 16 [NAME_2] sought to entice existing Unitholders of the [NAME_10] to transfer their investments into the two [NAME_11] by offering high interest rates. He required existing unitholders of the two [NAME_11] to give 12 months notice of intention to redeem their investments. He attracted new investors to the [NAME_11] and used their monies to meet redemption requests from the [NAME_10]. 17 The cash held by [NAME_13], $105,439.44, comprises credit balances in three [COMPANY_10] bank accounts and one [COMPANY_11] bank account, the proceeds from the sale of [NAME_32] and the sale of properties held by [NAME_21]. As I have said, there is $44,242 held in the trust account of [NAME_2]'s solicitor. [NAME_13] says this sum represents some of the funds used for the purchase of [NAME_32] which derived from [COMPANY_27], and that it is held on constructive trust for the benefit of Unitholders. [NAME_13]'s investigations 18 [NAME_13] became receiver and manager on 2 October 2001. Since that time he and his staff have inspected and, as far as possible, reconstructed the financial and other records of the Companies and the [NAME_26]. In many cases the records were incomplete. They have inspected properties and other assets, interviewed [NAME_2] and various others associated with the Companies and the [NAME_26], conducted a public examination of [NAME_33] (who worked in [NAME_2]'s accounting practice), and obtained the production of documents from Ms [NAME_33] and various banks and others. I have not identified any further investigations that (having regard to reasonable cost constraints) [NAME_13] should undertake beyond what he has done. 19 There is a separate trust deed for each of the 16 [NAME_26]. [NAME_13] has not been able to locate the trust deed for five of the [NAME_26]. He has identified 131 individual Unitholders, who had invested in the [NAME_26] since the late 1980s. He has prepared a table showing the number of Unitholders in each Trust, the number of units on issue in each Trust, and the value of the units issued. He has expressed the view, based on his investigations, that [NAME_2] directed the funds of the [NAME_26] to · himself and other related parties for private purposes; · [NAME_21] to acquire properties; · [COMPANY_23] to develop the property; and · other [NAME_26] to meet redemption demands and interest payments. Communication with [NAME_1] 20 [NAME_13] has issued six reports, four to Unitholders and two to the Court, outlining his investigations. In his reports to Unitholders he foreshadowed that it may be necessary for him to seek the Court's direction as to the distribution of the funds. He held a meeting of Unitholders on 17 December 2002, when he informed Unitholders who attended that he would proceed with the present application. No-one spoke in opposition to the application and his sense of the mood of the meeting was that those present supported his approach. Through his solicitors, [NAME_13] has informed [NAME_1] of the present application. Upon receiving confirmation that the issue had been discussed with and understood by Unitholders, [NAME_1] has confirmed in writing that it supports the application. Mixing of trust moneys 21 This is a case where funds deriving from the 14 [NAME_10] and the two [NAME_11] have been mixed, in the sense that, repeatedly, funds in one trust have been applied to meet obligations of other [NAME_26]. There has also been a physical mixing in bank accounts, and additionally mixed funds have been applied to acquire assets, the proceeds of sale of which remain. The mixing has not led to a single asset such as a bank account, but instead there are several bank accounts and the proceeds of several asset sales. 22 The precise ascertainment of the beneficial interest of each [NAME_34] in the remaining bank accounts and proceeds of sale would require an identification of funds in which the [NAME_34] had an equitable interest, and the tracing of those funds to their destination. But the principles upon which the tracing would be carried out are unclear. There is some support in the case law for applying the rule in Clayton's Case; Devaynes v Noble (1816) 1 Mer 572 [35 ER 781], according to which the first payment out of the mixed fund would be allocated to the first payment in. An alternative approach has received some support in case law and academic literature. According to this approach, the credit balance in the mixed fund is distributed amongst the beneficiaries of the funds that have been mixed, proportionately to their beneficial interests. 23 The case law and academic literature were recently reviewed by Campbell J in Re [COMPANY_5] (in liq); application of Sutherland [2002] NSWSC 641. I respectfully agree with his Honour's analysis. He referred, in particular, to the observations of Priestley JA in [NAME_3] v [COMPANY_4] of New South Wales (1998) 44 NSWLR 451, with which [NAME_3] agreed. Priestley JA referred to Hagan v Waterhouse (1991) 34 NSWLR 308, in which Kearney J (at 358-9) supported academic literature which had advocated the "rateable solution" over the "first in, first out" approach. Priestley JA expressed the opinion that Kearney J's decision should be approved by the Court of Appeal. 24 It seems to me that Australian authority has reached the point that the rateable solution is to be preferred to the first in, first out approach where trust funds are mixed, without qualification. However, Campbell J noted that some of the decisions (but not Priestley JA's dictum in [NAME_3]) preferring the rateable solution rely, as a ground for their decision, on the impossibility of carrying out a tracing exercise under the first in, first out rule. Campbell J then summarised the position as follows (at paragraphs [26] and [27]): "[26] If the dictum in [NAME_3] is applied as the law in New South Wales, the effect is that, where money held on several different [NAME_26] has been mixed in the one bank account Clayton's case cannot be used to identify for which of the beneficiaries the money in the account is held. …" "[27] If the [NAME_3] line is followed it has the advantage that the way in which the law decides the beneficial entitlement of beneficiaries whose assets have been mixed with those of other beneficiaries is the same, whether the mixing occurs in the bank account, or in some other form of assets…." 25 Campbell J then considered how it could be established, on a procedural and evidentiary basis, that it had become impossible to trace under the first in, first out rule. He suggested that if a single depositor could be identified who would, in accordance with that rule, be entitled in specie to some of the money remaining in the trust account, then impossibility would not have been established. In that event, he suggested, that person should be designated as a party to an application to establish, against a representative of the beneficiaries whose interests would be defeated by the application of Clayton's case, whether the dictum in [NAME_3] ought to be applied in that situation. 26 As I have said, the better view appears to be that in Australian law the dictum in [NAME_3] should be applied regardless of whether it is impossible on the facts to apply the first in, first out approach. If, however, the rateable solution were limited to cases where it was impossible on the facts to apply Clayton's case, then the rateable solution would apply in the present case, in my view. This is because the evidence shows that the defalcations by [NAME_29] exhausted the [NAME_10] after the beneficiaries had made their contributions. Consequently it appears from the evidence in this case that there is no beneficiary of the [NAME_10] who could succeed under the first in, first out rule. As regards the [NAME_11], the evidence is less clear but again, it appears to me that the evidence as a whole, especially exhibits AJL 19 and 20 and the evidence concerning loss of records, implies that impossibility is also established in respect of all of the beneficiaries of these [NAME_26]. Therefore this is a case where the application of the rateable solution is required. Conclusion 27 The rateable solution is reflected in the directions sought by [NAME_13]. As a practical matter, it is far and away the best solution in the circumstances. The fact that some of the trust funds have finished up as proceeds of sale of property acquired with the mixed funds does not prevent the application of this approach, as Campbell J pointed out in French Caledonia at paragraph [27], in the passage quoted above. I have therefore decided it is appropriate to give the direction sought by [NAME_13], in the exercise of the Court's powers under both s 479(3) of the Corporations Act 2001 (Cth) and s 63 of the Trustee Act 1995 (NSW). 28 I shall make the order sought by [NAME_13] with respect to costs, on the ground set out by Campbell J in the French Caledonia case at paragraphs [32] to [35]. I do so on the basis that [NAME_13] will, as he indicates, advertise under s 60 of the Trustee Act and Part 70 rule 16 of the Supreme Court Rules. **********

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