Why would liquidators seek to recover from third parties?
The first port of call for a liquidator is to attempt to claw back assets through ‘voidable transactions’, such as unfair preference claims or claims for unreasonable director-related transactions. Similarly, where there is a personal guarantee by directors, the liquidator will often seek to recover from the real and personal property of the director.
Often, however, it is difficult for a liquidator to prove these claims (especially where poor records have been kept). And even where a claim might be legally sound, a director may be broke and/or personally bankrupt, making recovery infeasible.
What liquidators need is a mechanism for recovering from third parties — this is where Barnes v Addy comes in.
What is an action based on Barnes v Addy?
Where a liquidator suspects fraud, the fraud often won’t resemble a straightforward theft, and will instead involve a sophisticated transaction (often disguised). This is where the breadth of wrongdoing that may be pursued under Barnes v Addy comes in.
Barnes v Addy (1874) LR 9 Ch App 244 was a decision of the English Court of Appeal in Chancery. This case established that parties could be liable for a breach of trust where there was ‘knowing receipt‘ or ‘knowing assistance‘ by a third party in that breach of trust. In brief:
- Knowing receipt occurs where people receive property held in trust or by a fiduciary, with knowledge that it was given in breach of trust or fiduciary duty.
- Knowing assistance occurs where there was a breach of trust or fiduciary duty (by someone other than the defendant) and the defendant helped that person to breach with a ‘dishonest state of mind’.
While there is some disagreement in the case law, it is worth noting that in both cases the third party does not necessarily need to be consciously aware of the wrongdoing, and may be liable on the basis of ‘constructive’ knowledge.
How can Barnes v Addy be applied in the case of insolvency in Australia?
There are two general ways in which Barnes v Addy may be applied to insolvency:
- Where assets were held in trust by the insolvent company and have ended up in the hands of a third party (for example, where the company was a corporate trustee for a trading trust).
- Where assets were transferred on to a third party as a result of a director’s breach of fiduciary duty. We discuss the cases where this might apply below.
The application of these concepts in Australia has long been affirmed by the courts. In Farah Constructions Pty Ltd v Say-Dee Pty Ltd  HCA 22 (Farah Constructions), the High Court of Australia confirmed that there could be knowing receipt with respect to a breach of fiduciary duties (though the court also found, on the facts of that particular case, that no breach of fiduciary duty had actually occurred).
In Westpac Banking Corporation v Bell Group Ltd (No 3)  WASCA 157 (Bell), the Supreme Court of Western Australia found that, in acquiring security over the goods of a company that was insolvent, financiers could be liable for knowing assistance. We discuss this case in greater detail below.
Which director duties might be covered?
Company directors and officers in Australia have a range of duties under the Corporations Act 2001 (Cth), industry-specific legislation and the common law.
A subset of those duties are the duties to act in good faith and in the best interests of the company. These duties are known as fiduciary duties.
It was generally held, following the decision of the High Court of Australia in Breen v Williams (1996) 186 CLR 71 that this only applied where a director was in breach of a proscriptive duty. That is, a fiduciary duty that prohibits certain conduct, rather than positively requiring it. Those duties were:
1) The ‘no conflict’ duty. A director must not come into conflict with the interests of the company.
2) The ‘no profit’ duty. Directors must not use their position in the company for personal profit.
3) The misappropriation duty. Directors must not misappropriate company property for their own or a third parties’ benefit.
More recently, in Bell, the court raised the possibility that liability could be extended more generally to the fiduciary duties of directors (ie. liability applies to their ‘positive duties’ as well).
For more information on this debate check out Hon JD Heydon QC’s Modern fiduciary liability: the sick man of equity?
How might liquidators apply this?
As in Bell, where the defendants included banks, financiers and lenders can be a useful option for liquidators to pursue, where the liquidator believes there has been a breach of fiduciary duty by the director and either knowing receipt or knowing assistance by that third party.
This might also be used by liquidators to pursue other third parties such as illegal phoenix operators (who have benefited from the sale of an insolvent company’s assets for below market value). It could also be used to pursue family or friends of directors who appear to have benefited from the director’s misconduct (though note, in Farah Constructions, the court neglected to find that a director had a positive duty to inform business partners of potentially lucrative property deals).
And what is the key takeaway for directors?
The potential for a third party to be found liable under Barnes v Addy (and note, third parties could include family members of the director) means that the director must take care with transactions prior to insolvent administration. Directors should not get too ‘creative’ with these 11th hour transactions. This means no illusory transactions and ensuring that all transactions are properly documented. It can be very difficult for a director to defend such an action where record keeping is poor.
One of the mistakes that directors make is that they do not properly document transactions made before a winding up. Undocumented transactions before a winding up may appear to be a good idea at the time but when looked at by a third party later these same transactions may appear dodgy. It would be sensible for all transactions of property to be at least documented in a contract that specifies the consideration offered in return for the property.