Caution to Lenders: Real Property Mortgage Successfully Challenged as Unreasonable Director Related Transaction

Real property mortgages, whether freehold mortgages or leasehold mortgages, are a ubiquitous feature of a real property financing deal. However, like any other transaction, they are subject to claw-back risk in a liquidation scenario, where a liquidator may challenge the validity of previous transactions.

In Cooper as Liquidator of Runtong Investment and Development Pty Ltd (In Liq) v CEG Direct Securities Pty Ltd [2024] FCA 6, the Federal Court found that a real property mortgage was an unreasonable director related transaction under section 588FDA of the Corporations Act 2001 (Cth) (the Corporations Act). Consequently, the mortgagee was required to pay some of its enforcement proceeds to the liquidator.

In this article, we highlight the key lessons, facts and findings from this case.

The facts

Runtong Investments and Development Pty Ltd (the Mortgagor) granted a mortgage in favour of CEG Direct Securities Pty Ltd (Mortgagee) over certain of its freehold land (the Runtong Land).

The mortgage was not security for a debt of the Mortgagor. Rather, it was security for the Mortgagee’s loan to certain related entities of the Mortgagor – namely, Australian Datong Investment & Development Pty Ltd (Datong) and Futong Investment and Development Pty Ltd (Futong and, together with Datong, the Borrowers). In the parlance of Finance lawyers, this is what is known as a “third party security” – i.e., a security provided for the debt of a third party, rather than the direct debt of the security provider.

The security package of the Mortgagee also included, among other things, personal guarantees from certain natural person directors. This included two directors who were common directors of the Mortgagor and the Borrowers.

In February 2018, the Mortgagee enforced its mortgage in relation to the Runtong Land and, ultimately, sold that land in accordance with that process. In October 2018, the Mortgagee received approximately A$12 million in accordance with the settlement of that sale.

In the meantime, in March 2018, the Mortgagor appointed administrators and, three months later, the Mortgagor’s creditors resolved to liquidate the Mortgagor. The liquidator brought proceedings challenging the Mortgagee’s mortgage as an unreasonable director-related transaction.

The statutory regime

Section 588FDA of the Corporations Act sets out a three-stage test to determine whether a transaction is an unreasonable director-related transaction.

A transaction of a company is an unreasonable director-related transaction if, and only if:

1. there is a “transaction” (namely, a payment or a share issue by the company, or some other disposition of the company’s property);
2. the payment, issue or disposition is made to a director of the company or a close associate of a director of the company or for the benefit of any such person; and
3. a reasonable person in the company’s circumstances would not have entered into the transaction.

Findings

Was there a transaction?

The parties to the proceedings agreed that the entry into the mortgage was a “transaction” – namely, a disposition of the Mortgagor’s property, being the Runtong Land.

Was that transaction for the benefit of a director of the Mortgagor?

1. The plaintiff argued that the mortgage created a contingency which benefited the directors of the Mortgagor because the liability of the directors under their personal guarantees would be reduced as a result of any sale of the Runtong Land.
2. The defendant argued that there was no unreasonable director-related transaction because:
   1. the mortgage was granted for the benefit of the Mortgagee;
   2. it was a transaction between the Mortgagor and the Mortgagee; it was not a transaction made on behalf of, or for the benefit of, any director; and/or
   3. the mortgage was granted in exchange for an increase to the total secured liabilities, and therefore an increase to the total liability of the directors under the personal guarantees, therefore, it could not be said to benefit the directors.

The court accepted the plaintiff’s argument, and rejected the defendant’s submissions. The Federal Court noted that the fact that, although the mortgage directly benefited the Mortgagee, the directors received an indirect benefit which was sufficient to engage section 588FDA.

Would a reasonable person in the Mortgagor’s circumstances have entered into that transaction?

In considering this question, the court had regard to the factors set out in the legislation – namely:

1. the benefits (if any) to the company from entering into the transaction;
2. the detriment to the company from entering into the transaction;
3. the respective benefits to other parties to the transaction; and
4. any other relevant matter.

The court held that, at the time the Mortgagor entered into the mortgage, “there is no evidence to suggest it was to [the Mortgagor’s] benefit to encumber the [Rungtong Land] whether for cash flow purposes or otherwise, [nor was there] any adequate commercial explanation [for the transaction]”.

The fact that, nearly a year after the mortgage was executed, the Mortgagee provided certain financial accommodation to the Mortgagor for the purposes of a separate project on the Runtong Land (the Runtong Development), did not alter this conclusion. The relevant assessment under section 588FDA is carried out at the time of entry into the transaction.

Conversely, the court noted that the “detriment to the [Mortgagor] is obvious and substantial”. Essentially, the Mortgagor had offered its only asset as collateral if the Borrowers did not pay its loans. The court concluded that a reasonable person in the Mortgagor’s circumstances would not have entered into the mortgage.

Although the benefit the Mortgagee received from the mortgagee-in-possession sale was around $12 million, the court did not require the Mortgagee to pay that amount back to the Mortgagor in full. Rather, the Mortgagor was permitted to partially reduce that payment by an amount equal to the advances subsequently provided to it for the purposes of the Runtong Development, on the basis that the value of the Runtong Land increased as a result of that work done on the Runtong Development and a reasonable person would have provided security up to the value of those advances.

What next?

In light of this ruling, it is imperative for lenders and financiers to carefully assess the potential risks associated with taking securities from related entities, especially in transactions involving directors. Ensuring that all parties receive a clear and direct benefit from the transaction is crucial to mitigate the risk of future claw-back claims. For more detailed guidance on navigating these complex legal landscapes and protecting your interests, get in touch with Andrew Vincent and Peter Mutema.