Article – the Full Federal Court in COT v Lane – statutory priorities apply on the bankruptcy of trading trustees, the principle of ‘hotchpot’, and the treatment of preference recoveries of payments of trust money

In November 2020 the Full Federal Court handed down a decision worth noting, addressing questions that had arisen in the bankruptcy of an individual who had run a business in his capacity as trustee of a trading trust – Commissioner of Taxation v Lane [2020] FCAFC 184 (COT v Lane). The judgment was delivered by Allsop CJ, with whom Perram and Farrell JJ concurred.

COT v Lane was an appeal from two decisions of Derrington J. The first decision concerned issues similar to some of those which the Full Federal Court had considered in the context of insolvent corporate trustees in March 2018 in Jones (liquidator) v Matrix Partners Pty Ltd, re Killarnee Civil & Concrete Contractors Pty Ltd (in liq) [2018] FCAFC 40; 260 FCR 310 (Jones/Killarnee), and which the High Court had pronounced upon in June 2019 in Carter Holt Harvey Woodproducts Australia Pty Ltd v The Commonwealth [2019] HCA 20; 368 ALR 390 (Carter Holt/Amerind). To see my previous articles on those cases see here (Jones/Killarnee) and here (Carter Holt/Amerind).

The second decision the subject of appeal in COT v Lane concerned the question of when a payment is recovered as an unfair preference, and the impugned payment out had been of trust moneys applied in payment of trust debt/s – is the recovered money to be treated as available for distribution for trust creditors only, or does it form part of the bankrupt’s general estate? To see my article on Derrington J’s decision at first instance see here.

Summary Conclusions

The questions considered and answered by the Court in COT v Lane arose in the administration of the bankrupt estate of a Mr Warwick Gordon Lee, who had been trustee of the Warwick Lee Family Trust. The three questions were these –

  1. Whether the priority regime in ss 108 and 109 of the Bankruptcy Act 1966 (Cth) applied to the distribution of the proceeds of sale of the assets of the Warwick Lee Family Trust. Their Honours’ answer: yes it does and, especially after the more recent appellate judgments, the primary judge had erred in concluding that the priority provisions did not apply.
  2. Whether in the distribution of the personal estate of the bankrupt amongst all creditors in this case, the trust creditors must bring into hotchpot the amount which they had received from the proceeds of sale of the assets of the Trust. Their Honours’ answer: yes they did, and the primary judge had been correct to so conclude.
  3. Whether, in dealing with the proceeds of preference recoveries relating to payment of trust moneys to the ATO, the trustees in bankruptcy were required to use those proceeds only for distribution to trust creditors or whether the proceeds of recovery were general non-trust assets of the bankrupt estate. Their Honours’ answer: yes they were, and the primary judge was correct to so conclude.

Takeaways – Significance of this decision

The first issue – that the statutory priority regime applies in bankruptcy law also in the context of trading trusts (not just in corporate insolvency law) – is confirmed. There was strong obiter to this effect by the High Court in Carter Holt/Amerind in the judgment of Gordon J in particular (see [173]-[174]), but this is now confirmed in ratio at Full Federal Court level.

The third issue – that in the bankruptcy context preference recoveries relating to payments of trust debts using trust moneys do not form part of the bankrupt’s general estate and may be used only for distribution to trust creditors – is also important to have clarified at appellate level. I discuss this further below, including the question mark that still floats over the position on this issue in the corporate insolvency context.

It is the second issue which may be of more interest to some, and flows from the now-settled position – confirmed in Carter Holt/Amerind – that trust assets may only be distributed in an insolvent administration to trust creditors. It is: that in a distribution of the non-trust assets in an insolvency administration of a trustee, trust creditors seeking to participate may be required to “bring into hotchpot” any amount they had received from the proceeds of trust assets.

This is in effect equity’s effort to ameliorate the fact that, due to the constraint of only trust creditors sharing in distributions of trust assets, non-trust creditors are disadvantaged. In practice, many creditors trading with a company or a person may have no idea whether they are trading with that company or person acting in their own capacity or in a trustee capacity. It becomes something of a snakes-and-ladders proposition. Suppose the trustee company goes into liquidation or the trustee individual becomes bankrupt. And suppose that all or most of the remaining or recoverable assets are trust assets. Those creditors who, it turns out, had traded with that company or person in their trustee capacity, go swooping up a ladder into a superior position of being able to participate in any distribution of trust assets. Those less fortunate creditors who, it turns out, had traded with that company or person in their own capacity, find themselves skidding down a snake, unable to participate in any distribution of trust assets.

In many cases of insolvent trustees, the hotchpot principle will only have room to apply if a trustee acted in more than one capacity, the trust creditors’ debts are not fully satisfied by the distribution of trust assets, and they look to participate in a distribution of non-trust assets. In that case, the principle of hotchpot will require there to be equality of treatment of equal-ranking creditors (whether trust or non-trust) by requiring such trust creditors to account for the amounts they had already received in the insolvency administration before participating in the general distribution.

Even outside of the context of insolvent administrations involving a trust and a general estate, there is the potential for the principle of hotchpot to play a larger role in some of the cases coming through our commercial courts over the next few years. We are already seeing the courts starting to deal with unregistered managed investment schemes de-cloaked by the impact of the COVID-19 pandemic. In some cases, multiple investment funds may have been pooled and invested together, with some investors receiving some returns and others not yet at the time of collapse. Also, cross-border insolvencies with differential entitlements of creditors to participate in distributions in different jurisdictions may give rise to the operation of the principle of hotchpot, as equity attempts to achieve fairness between creditors of the same rank. We watch this space with interest.

* This ends the summary snapshot of the propositions to be drawn from COT v Lane, and comments as to their significance. For those wanting a more detailed understanding of the Full Federal Court’s judgment, read on.

Facts

Mr Lee was the sole trustee of the Warwick Lee Family Trust. Prior to his bankruptcy, Mr Lee operated the business of a Subway franchise in Brassall, a suburb of Ipswich in Queensland, on behalf of the trust. In his capacity as trustee he employed a  number of staff and incurred a number of significant liabilities.

Administration of the Bankrupt Estate

The Bankruptcy Trustees kept and maintained two separate accounts when administering the bankrupt estate of Mr Lee. One account comprised assets of Mr Lee held by him and liabilities incurred by him in his capacity as trustee of the trust (Trust Estate). The second account comprised the personal assets and liabilities of Mr Lee that were held and incurred by him in his individual capacity (Personal Bankrupt Estate) (see [12]). The proceeds from the sale of the Subway franchise business, $448,659.49, were allocated to the Trust Estate.

Preference Recovery

In the course of the administration of Mr Lee’s bankrupt estate, the Bankruptcy Trustees recovered an unfair preference payment of $322,447.58 from the ATO, which had been paid by Mr Lee in discharge of tax liabilities arising from the operation of the Subway franchise. Of this sum, $171,659 had been paid using Mr Lee’s own money, and the balance of $150,778.58 had been paid from funds of the trust. I pause here to note that in trust law terms, the payment of the trust debt by the trustee using his own money, gives rise to a trustee’s right of recoupment/reimbursement from trust property – one of the two types of the right of indemnity held by trustees. In contrast, the payment of the trust debt by the trustee directly using trust money is an exercise of the other type of a trustee’s right of indemnity – the right of exoneration. The Bankruptcy Trustees had apportioned the unfair preference recovery accordingly between Mr Lee’s Personal Estate on the one hand (the $171,659 proceeds of the exercise of his right of recoupment) and the Trust Estate on the other ($150,788.58 payment using trust moneys) (see [14]).

The question was whether they were right to do so. The debate centred on the recovery of payment of trust money, and whether the Bankruptcy Trustees were correct in their treatment of the $150,778.58 as trust money “once again” upon its recovery (see issue 3 below).

Issue 1. Whether the priority regime in s 109 applies to the use of the right of exoneration

The Commissioner claimed a priority pursuant to s 109(1)(e) of the Bankruptcy Act in respect of a superannuation guarantee charge debt in the administration of Mr Lee’s bankrupt estate. The liability was incurred by Mr Lee in the course of operating the Subway franchise business in his capacity as trustee of the trust. The primary judge had held that the Commissioner was not entitled to priority, and that the provisions of ss 108 and 109 of the Bankruptcy Act did not apply to the distribution of trust funds, which were to be paid to the trust creditors pari passu.

The primary judge had so held prior both to the High Court’s decision in Carter Holt/Amerind in June 2019, and to another decision of the High Court in December 2019 – Boensch v Pascoe [2019] HCA 49; (2019) 375 ALR 15. In COT v Lane, both the appellant and respondents submitted that the primary judge’s finding on this issue could not stand after the High Court’s decisions in Carter Holt/Amerind and Boensch v Pasco. The Full Federal Court agreed (see [35]). The scheme of priority applies to the distribution of trust funds in a bankruptcy.

Boensch v Pasco

In COT v Lane Allsop CJ considered the High Court’s 2019 bankruptcy decision in Boensch v Pascoe, which was handed down 6 months after its corporate insolvency decision in Carter Holt/Amerind (from [59]). In Boensch v Pascoe the High Court confirmed that a bankrupt trustee’s entitlement in equity to be idemnified out of trust property – or more particularly the equitable interest in trust property it generates – is property that belongs to the bankrupt and, being divisible among creditors, vests in the trustee of the bankrupt’s estate. I pause here to explain why the High Court so held in Boensch v Pascoe (this is explained in more detail in my article on that decision here) –

  1. Upon a person becoming bankrupt, section 58 of the Bankruptcy Act vests “property of the bankrupt” in the trustee of the estate of the bankrupt.
  2. Excluded from the “property of the bankrupt” which vests in the trustee in bankruptcy is property held in trust by the bankrupt for another person: s 116(2)(a)of the Bankruptcy Act.
  3. It was settled in Octavo that where a person who is a trustee becomes bankrupt, and he/she has incurred liabilities in the performance of the trust, that person’s right to be indemnified out of trust property gives rise to an equitable interest in the property held on trust. This takes that property outside the exclusion in s 116(2)(a), on the basis that the exclusion is limited to property held by the bankrupt solely in trust for another person: [2] per Kiefel CJ, Gageler and Keane JJ.
  4. The bankrupt’s entitlement in equity to be indemnified out of the trust property, giving rise to the equitable interest in the trust property, is property belonging to the bankrupt that is divisible among the bankrupt’s creditors. The right of indemnity is therefore property that vests in the trustee in bankruptcy: [2] per Kiefel CJ, Gageler and Keane JJ.

As Kiefel CJ, Gageler and Keane JJ concluded in Boensch v Pascoe (quoted with approval in COT v Lane at [59]) –

Where the legal estate in the property held on trust by the bankrupt passes to the trustee of the estate of the bankrupt, it passes with all the equitable interests that were impressed on it when it remained in the hands of the bankrupt: equitable interests of the bankrupt as well as equitable interests of the beneficiaries of the trust.

Carter Holt/Amerind

Allsop CJ gave careful consideration to the High Court’s decision in Carter Holt/Amerind from [40], drawing out key aspects. His Honour noted that the reasons of the second plurality (Bell, Gageler and Nettle JJ), with whom Gordon J agreed, emphasised that a trustee’s right of indemnity confers on the trustee a beneficial interest in the trust assets. Allsop CJ cites key passages of the second plurality’s reasons, observing at [43] that –

These passages are important. The right of indemnity (including the right of exoneration) confers a beneficial interest in the trust assets. So, when the right is exercised and the assets sold, the beneficial interest in the trust assets is converted into proceeds that are the property of the company (though with the character of use dictated by their legal source).

Allsop CJ goes on to note that the second plurality in Carter Holt/Amerind then addressed the question of priorities. They held that it was wrong to presuppose that s 556 of the Corporations Act 2001 (Cth) cannot apply in terms to the proceeds of realisation of the right of exoneration to trust property, and that there was no reason why the statutory order of priorities should not be followed in the distribution of the proceeds of the trustee’s right of indemnity among trust creditors (see [46]-[47]).

Where there is more than one trust, or a trust and a general estate, Allsop CJ noted the second plurality in Carter Holt/Amerind approved the solution proposed by King CJ in In re Suco Gold of holding separate funds for each group of creditors, as cohering to the law of trusts and to common sense (see [48]). Gordon J did the same. Her Honour had observed that if there are multiple trusts, the insolvent trustee should be viewed as holding multiple funds, each directed to different groups of creditors (see [162] of Carter Holt/Amerind).

Importantly, Allsop CJ observed at [60] that although Carter Holt/Amerind concerned the interpretation of s 433 of the Corporations Act in relation to the distribution of trust assets in a receivership, the reasoning is equally applicable to the statutory priority provisions which apply to liquidation (ss 556, 560 and 561of the Corporations Act). It is also clear that much of the reasoning applies to the statutory priority regime under the Bankruptcy Act. As Gordon J stated in dicta in Carter Holt/Amerind at [173]-[174], there is no logical or countervailing reason why the principle would be any different under the bankruptcy regime. The principles of equity and trusts governing a trustee’s right of indemnity apply equally to both personal and corporate trustees: Jones/Killarnee at [32].

In concluding that the priority provisions of the Bankruptcy Act apply to the distribution of proceeds produced by exercise of a bankrupt trustee’s right of exoneration, Allsop CJ at [63] usefully distilled the key propositions in light of the High Court’s reasoning in Carter Holt/Amerind as these (my numbering) –

  1. The right of exoneration is a right that generates a proprietary beneficial interest in the so-called trust assets.
  2. These assets are owned by the trustee (to that extent), albeit in a constrained way.
  3. To exercise the right of exoneration is to take and use property which is property of the (trustee) company (or, here, of the (trustee) bankrupt) and so to deal with the proprietary beneficial interest of the company (or bankrupt) seperate from and prevailing over the beneficial interests of the beneficiaries.
  4. When the assets and such beneficial interest are sold they are transformed into funds of the company or bankrupt: as proceeds of the property of the bankrupt.
  5. The proceeds of the exercise of the right, by the sale of the property with the beneficial interest, have a limitation on their use: only for payment of trust creditors.
  6. The proceeds are nevertheless property of the company or bankrupt (even if they have such limits on their use) in the hands of the liquidator or trustee in bankruptcy and are subject thus to the priority provisions of the statute.

Allsop CJ observes at [64] that the second plurality’s judgment and that of Gordon J in Carter Holt/Amerind reveal two fundamental errors in the earlier approach of the primary judge and the cases his Honour had followed, including Brereton J in Re Independent Contractor Services (Aust) Pty Ltd (in liq) (No 2) [2016] NSWSC 106; 305 FLR 222 at [24]-[25], Robson J in Re Amerind Pty Ltd (receivers and managers appointed)(in liq) [2017] VSC 127; 320 FLR 118 at [84] and [92]-[94], Marckovic J in Kite v Mooney, in the matter of Mooney’s Contractors Pty Ltd (in liq)(No 2) [2017] FCA 653 at [140], and Siopis J in Jones/Killarnee at [174]-[178] –

  1. First, the right of exoneration is not merely a power or right to transfer assets to trust creditors. The right of exoneration creates a beneficial proprietary interest in favour of the trustee in the assets of the trust. The exercise of the right creates proceeds which are also property of the company or individual trustee, because the exercise transforms the proprietary interest of the company in the (trust) assets into funds able to be used by the company or individual trustee for proper purposes – to pay trust creditors and exonerate itself / herself / himself.
  2. Secondly, there is no proper basis for the assumption that the notion of property of the company (or bankrupt) to which the Corporations Act and Bankruptcy Act speak must only be property of the company generally available to all creditors, and not property of the company with restrictions on use by way of an equitable obligation to pay to only some unsecured creditors of the company (trustee), or here of the bankrupt person (trustee).

Allsop CJ notes that the reasons of the first plurality in Carter Holt/Amerind do not lead to a different conclusion (at [65]). His Honour observes that the exercise of the right of exoneration is capable of generating “proceeds” from the relevant trust assets, and it is those funds which, through the exercise of the right of exoneration, are properly characterised as “proceeds of the property of the bankrupt” under ss 108 and 109 of the Bankruptcy Act, or as “property of the company” under ss 433, 555 and 556 of the Corporations Act (at [66]).

Application

What that meant in the circumstances of this case was that when Mr Lee’s right of exoneration as trustee of the Trust vested in his trustees in bankruptcy, so too did the legal estate in all remaining trust assets. (It is worth noting that as at 31 March 2017 just before the hearing at first instance, the asset position of the Trust Estate was $599,782.02, and trust creditors were owed $1,317,165.35 (at [15]-[16]). This meant that the trustee’s right of exoneration filled and exceeded the total of the trust assets.) By virtue of the right of exoneration conferring a beneficial interest in the trust assets, Mr Lee’s trustees in bankruptcy were entitled to realise and distribute the trust assets and their proceeds to trust creditors in accordance with the statutory priority regime. The proceeds realised from the trust assets (being the profits from the sale of the Subway franchise) were to be distributed in accordance with the priority regime provided for in ss 108 and 109, up to the statutory cap set in the Bankruptcy Regulations (see [68]).

Issue 2. Whether the trust creditors must bring payment from trust assets to account by bringing them into hotchpot

At first instance, Derrington J had held that in the distribution of the personal estate of the bankrupt amongst all creditors, the trust creditors must “bring into hotchpot” the amount which they have received from the Funds as trust creditors (at [69]).

This was challenged on appeal by the Commissioner on the basis that there was no common fund on which both trust creditors and non-trust creditors could claim, that this was a precondition for hotchpot, and that therefore the hotchpot principle was inapplicable (see [73]-[78]). It was submitted that if the bankrupt had incurred debts both in a personal capacity and as a trustee there were effectively two (or more) “pools” of funds to be administered. Non-trust creditors have no right to share in the pool represented by the proceeds of the exercise of the right of exoneration in respect of any trust; that pool is not part of a common fund. There is no relevant common fund and no basis to call upon trust creditors to bring into hotchpot anything they have received by way of distribution of the trust estate before seeking to participate in the personal estate. The only circumstances where hotchpot might affect the matter, it was submitted by the Commissioner, were where there had been an intermingling of funds that should have remained separate or where there had been an inequitable distribution of funds.

Against this, the Bankruptcy Trustees submitted that trust and non-trust creditors are equal creditors within the same class of the one bankruptcy – unsecured creditors – and so to be treated equally. Whilst there were two separate funds, the Trust Estate and the Personal Bankrupt Estate, the proper characterisation of the funds was as one fund: the property of the bankrupt divisible amongst his unsecured and equal ranking creditors. They argued the Commissioner’s characterisation of the common fund was too narrow, and was inconsistent with the necessary equality of unsecured creditors in the one insolvency administration (see [79]). The Commissioner’s response to this was that trust and non-trust creditors are not equal, even though both are unsecured. The effect of Carter Holt/Amerind and In re Suco Gold, it was submitted, was the administration of separate estates. To require hotchpot would be to intermingle the trust estate and the personal estate of the bankrupt in a manner rejected by the conclusion that Re Enhill was wrong, so the Commissioner posited (see [80]).

The Commissioner’s submissions were not accepted. Prior to addressing the principles of hotchpot, Allsop CJ referred to passages in Carter Holt/Amerind and Jones/Killarnee, leading to this observation at [85]

…All (unsecured) creditors, trust and non-trust, are unsecured, equally ranking creditors of the one person: the (now bankrupt) trustee…[T]here arises a feature or incident of some property of the [insolvent] company or bankrupt individual (as trustee) and the personal obligation upon the company or bankrupt to which the liquidator or trustee in bankruptcy succeeds, which makes the proceeds payable to only some creditors. Otherwise, the creditors are equally ranking creditors of the one debtor, in the one insolvency, even if, for the working out of entitlements, there can be seen, in the one insolvency, to be separate funds.

The Principle of Hotchpot

Hotchpot is an expression of equity’s concern for equality, as Allsop CJ explained. “Equality is equity” is a maxim of equity law which is the source of a number of doctrines, including pro rata distribution, contribution, marshalling. Examples of the expression of the maxim take their form according to the nature of the common bond of interest or obligation concerned, and what is necessary to vindicate equality and avoid unconscionability in respect of the common bond. The sharing equally of burden by co-sureties requiring one co-surety to share pro tanto the benefit of any security from the principal debtor is an example stemming from the common bond of obligation. (See [87]-[90])

The key propositions identified by Allsop CJ are as follows –

  1. The general principle is that a person who is seeking to participate in the distribution of a fund must bring into hotchpot anything he has already received therefrom. (See [93])
  2. In dealing with mixed or intermingled funds and whether or not payments out should be required to be brought to account, the proper approach depends on the circumstances, the practical difficulties involved, and what will be an equitable distribution as the best answer that the circumstances of the case allow. (See [92] and the authorities there cited, as discussed by Barrett J in ASIC v Idylic Solutions Ltd [2009] NSWSC 1306; 76 ACSR 129 at [64]-[67])
  3. What is the relevant fund? How is it appropriately characterised? In the case of mixed funds, it can be seen as the one pool of money augmented and depleted over time to which all have contributed, and some participated by withdrawal (see [94). This was how Barrett J conceived of the one fund in ASIC v Idylic, which concerned the application of hotchpot to a mixed fund brought about by the management of two unregistered managed investment schemes where investors, who had been promised lucrative returns, had contributed to a pool of funds. From time to time some investors had received “returns” from the fund. The questions for decision included the characterisation of the mixed fund and whether or not investors who had received returns should bring those returns into hotchpot in the sharing of what remained (see [92]). The contradictor had argued there that the mixed fund should not be seen as one fund, but as a series of funds, reconstituted from time to time as money was returned to investors, such that once funds were returned, later contributors had no interest in the previously returned funds. Barrett J rejected this characterisation of multiple and successively reconstituted funds as failing to “afford necessary weight to the nature of a common or collective investment pool“. His Honour took the view the contributions were mixed and lacked any identity to the respective contributors, whose rights became “proportionate rights in relation to the fund as it exist[ed] from time to time” (see [94] of COT v Lane, citing ASIC v Idylic at [74]).
  4. The principle of hotchpot has been applied to the working out of entitlements in insolvency, in circumstances of transnational or multi-jurisdictional insolvencies where equal creditors may have different rights in different jurisdictions (at [98]-[102]).
  5. The principle of hotchpot can apply where one can see two funds: one of which is reserved to one group of creditors. Insurance or companies legislation protecting local creditors are familiar examples (at [103]).
  6. There the principle to be applied is that where a winding up is proceeding in different jurisdictions, subject to priorities by reference to local law, all creditors of the company are as far as possible to be treated equally, wherever they are and wherever their debts were contracted: at [104], citing Re Standard Insurance Company Ltd [1968] Qld R 118. In that case, a New Zealand company was ordered to be wound up in New Zealand. Similar, but ancillary, orders were made in all Australian States and Territories where the company had traded. A provision of the then Queensland Companies Acts required that all land in Queensland of a foreign company in liquidation should be applied, in the first instance, to paying debts contracted in Queensland. Lucas J there held that the benefitted Queensland creditors were not entitled to rank for or receive any further dividend from the other assets of the company in Queensland until the other creditors reached dividends at a level of equality with Queensland creditors. In New Cap Reinsurance [2003] NSWSC 842; 177 FLR 52, a provision of the Insurance Act 1973 (Cth) reserved assets in Australia of an insurer in liquidation to the discharge of Australian liabilities first. Windeyer J applied the hotchpot principle in circumstances where one group of creditors had access to assets of the company denied to others (at least in point of timing), but where under the statute (s 556) the creditors were of equal ranking. (See [106])
  7. The principle in such cases applies even though one can see from the effect of the statute that there are two funds available. Indeed that is the point: one group of creditors (of equal standing to others) has access to more than one fund of assets of the insolvent company, whereas other (equally ranking) creditors have more limited access to the assets of the insolvent company. The difference in rights of access arises from a statute that gives some creditors an advantage, but one that does not transform them into secured or truly priority creditors (at [106]).
  8. Participation by claims of equal degree in separate funds administered in a single winding up is logically to be treated in the same way as participation by claims of equal degree in several concurrent windings up“: per Barrett J in Re HIH Casualty and General Insurance [2005] NSWSC 240; 190 FLR 398 at [108]. (See [107]) This is achieved by way of hotchpot (see [108]).
  9. The reason hotchpot applies where there are different funds available to some creditors but not others ranking equally is this: “A creditor who seeks to share in the assets of a debtor in an administration must bring to account the benefits of recovery from other assets of the debtor, whether by execution, self-help or through participating in a second administration“: Akers v Deputy Commissioner of Taxation [2014] FCAFC 57; 223 FCR 8 at [134]. (See [110])
  10. The most potent informing principle is the notion of fair and equal treatment of all creditors, and the pari passu distribution of the assets of the debtor company. The principle of pari passu distribution adopted by the primary judge is informed by fairness and equality…[T]he available principle of hotchpot…is based on the same notions of fairness and equality“: Akers at [138]-[139].

Application of hotchpot in COT v Lane

Allsop CJ referred to the Commissioner’s submission that a common fund is a prerequisite for the application of the hotchpot principle. His Honour held that if that characterisation of there being one fund in the administration was a prerequisite, then it was satisfied. Proper weight must be given to the equitable consideration of equality amongst equally ranking creditors: all being unsecured and entitled to the proportionate payment called for by s 108 in the one bankruptcy administration. As Allsop CJ succinctly observed: the fact that only certain creditors could share in the distribution of trust property, where other creditors of equal rank were left to share just in the general estate, does not deny the operation of the doctrine of hotchpot. It calls it forth. (See [111])

His Honour at [112] drew together the fact that various circumstances can give rise to differential access to particular property of a bankrupt or insolvent company – a statute or rule that creates an advantage to a creditor (such as insurance or companies legislation); a statute or rule that creates a disadvantage to a creditor (such as the rule against proof of a foreign revenue creditor); or features of the property, otherwise owned beneficially by the individual or company, which makes it available only to some creditors. Such differential access might, from one perspective, be seen to create two or more “funds”. However –

[T]he common bond of interest [as equally ranking creditors of an insolvency administration of one person or company]…that calls forth the doctrine of hotchpot derives from that very circumstance… : the equally ranking character of the creditors by s 108, the lack of security over, or proprietary interest in, the funds held…, the funds being the property of the bankrupt as proceeds available for distribution to unsecured creditors (albeit of a certain limited class), and in such circumstances the affront to equality and fairness by some equally ranking creditors being given unequal priority by what might be the mere chance of the creditor’s rights arising by reference to the trust.

That’s the snakes-and-ladders point.

On the proper characterisation of the concept of one common fund, his Honour observed, the common fund is comprised of all the assets of the insolvent company or bankrupt available for payment to ranking unsecured creditors, irrespective of any features of the property or of circumstance of legislation and the like which may direct some assets to some equally ranking creditors and not others (at [113]).

Allsop CJ reasoned that the advantage of trust creditors having sole access to the distribution of trust property is not an advantage built on a circumstance which takes them out of a position of equally ranking unsecured creditors with access to all the property of the insolvent administration. Their common bonds of interest with creditors of equal ranking call forth the requirement to stand back and bring to account their advantage of access to some assets of the administration to which other equally ranking creditors are denied (at [115]).

I note that in practical terms, the principle of hotchpot will only operate to assist the general creditors where there are sufficient non-trust assets available for distribution in the insolvent administration. There will be cases where all assets are trust assets, such that the question of hotchpot does not arise.

It is useful to have regard to his Honour’s conclusions in practical terms, as to what the proper approach to distribution was in this case (see [116]) –

  1. first, priority trust creditors would receive a distribution from the Trust estate (including the ATO’s SGC claim, limited by the statutory cap),
  2. secondly, all trust creditors would receive a distribution from the Trust estate (funds permitting),
  3. thirdly, all priority creditors, with creditors in each s 109 cascading priority to be treated separately, would receive a distribution from the Personal Bankrupt Estate, and those creditors from step one who had not had their debts fully discharged would be required to bring into hotchpot should there be any other creditors of equal priority to them (here the ATO had no other creditor of equal priority), and
  4. fourthly, all creditors would receive a distribution from the Personal Bankrupt Estate (funds permitting), with those creditors in step two being required to bring into hotchpot the distribution received from the trust estate.

Issue 3. The proper treatment of the proceeds of the preference claim against the ATO

In 2018 I wrote on the first instance decision of Derrington J which was the subject of the appeal on this issue – see here. As noted above, the relevant preferential payment impugned was a payment of $322,447.58 to the ATO in payment of a trust debt. Of this sum, $171,659 was paid out of Mr Lee’s personal funds. This gave rise to a right of recoupment for Mr Lee as trustee, to reimburse him for his own outlay for a debt of the trust. This accrued to the benefit of his Personal Bankrupt Estate. However the balance of $150,788.58 was paid using trust moneys, and this is what gave rise to the question – would the recovery in respect of the payment of these moneys accrue to the Trust Estate (distributable only to trust creditors), or the general Personal Bankrupt Estate?

The Commissioner submitted that the payment of the sum representing the preference came back to the trustee in bankruptcy for the benefit of the whole estate, not just the trust creditors (at [128]). This was not accepted.

Allsop CJ observed that the resolution of the question requires close attendance to the operation of the Bankruptcy Act, and to the underlying purposes of the powers, obligations and rights of the trustee in bankruptcy (at [130]). His Honour made seven points about the text of s 122 of the Bankruptcy Act (and authoritative discussion of its predecessor) (at [134]) –

  1. The avoidance of the transfer of property is as against the trustee in bankruptcy.
  2. Section 122 operates to make a payment void so that, in favour of the bankruptcy trustee, the creditor is to be considered as having received money which is part of the bankrupt’s estate, and the creditor’s debt is considered not paid.
  3. The trustee in bankruptcy’s remedies as to monetary recovery include: a suit at common law, for moneys had and received (now in restitution) or an order for payment under the Bankruptcy Act (s 30 under the 1966 Act).
  4. That the avoidance is as against the trustee in bankruptcy (not generally or as against the debtor, now bankrupt) means that the sequestration order marks the event to which the section speaks and the date of commencement of the bankruptcy marks the earliest time from which the avoidance operates.
  5. The provision does not provide for avoidance entitling the debtor to sue to recover the payment to which the trustee in bankruptcy succeeds by force of s 58. Rather, it is the trustee in bankruptcy’s common law action because, by force of the statute and the making of the payment void as against the trustee in bankruptcy, the creditor is to be treated as having received money which belonged and belongs to the estate of the bankrupt.
  6. The creditor is remitted to the remedy that it had: to prove in the bankruptcy.
  7. The purpose of the section is to ensure that the administration of the estate takes place in the order prescribed by the Bankruptcy Act and that the payment not dislocate the working of the statute: in language referable to the notion of the fraudulent preference to avoid a fraud on the administration of the bankruptcy.

Allsop CJ went on to make four further conclusions about the present case, based on a reading and understanding of the Bankruptcy Act against the background of equitable principle and the law of trusts at [135]

  1. The moneys belonging to the bankrupt estate that the creditor is taken to have received were the proceeds of the exercise of the right of exoneration and thus property of the bankrupt estate representing the bankrupt’s proprietary interest in the trust property.
  2. The creditor is remitted or restored to its position as a trust creditor enjoying its right of subrogation to the bankrupt’s (trustee’s) beneficial interest in the trust funds.
  3. The preference that is the subject of the operation of s 122, by treating the payment as void as against the trustee in bankruptcy, is one concerned with, and only with, the relative mutual standing or positions among trust creditors. There could be no preference if there were only one trust creditor.
  4. The purpose of the operation of s 122 in these circumstances is to prevent the dislocation of the proper distribution to the trust creditors that would have taken place had the preference payment not taken place and had the money been retained by the bankrupt and vested in the trustee in bankruptcy.

Allsop CJ concluded that the clear purpose of s 122, the nature of the preference as against only trust creditors, and the consequences of the remittal of the preferred creditor to its rights assist in shaping the clear obligation on the trustees in bankruptcy to hold and use the proceeds for the evident statutory purpose of removing the dislocation of the proper order of priorities that occurred by the payment of the preference. For the liquidator to use the funds to benefit non-trust creditors would be to disadvantage the trust creditors who had been originally disadvantaged by the preference, by not allowing them to take full advantage of the recovery in circumstances where the erstwhile preferred creditor had been remitted to its position as a trust creditor in the full amount. This would undermine the intended operation of s 122 to eliminate as far as possible the dislocation of order of payment provided for by the Bankruptcy Act in its operation in the context of a trust. (See [148])

Final comment – what of the position as to preference recoveries relating to payments of trust money in corporate insolvency?

We have an answer to the question in bankruptcy law. However the question also arises in the corporate context, and will be particularly acute where a company was trustee of more than one trust, or also acted at times in its own capacity. The difficulty here is that at both first instance and on appeal, although with different emphasis, the reasoning of the Courts was particular to the bankruptcy context. It is unclear if it would apply in the same way in the corporate context. Once again, because the Corporations Act fails to grapple explicitly with the liquidation of trustee companies and the issues which arise where trusts are involved, we are left with the question unresolved. Directions may need to be sought.

For example, unlike the Bankruptcy Act, s 588FF of the Corporations Act does provide a right of recovery and to seek other orders. For unrelated reasons , pursuant to s 588FF the right to bring the application is that of the liquidator, but the Court’s power is inter alia to order payment to the company. It is not yet established whether the Courts will take the view that any unfair preference recoveries received by a liquidator which had originally been payments out of trust moneys, were themselves subject to the obligation to use them in the manner required of the original funds, being for the purposes of discharging trust debts only, rather than available to the company in liquidation’s creditors generally.

Allsop CJ’s analysis at [134]-[135] discussed above is explicitly based on a reading and understanding of the Bankruptcy Act, against the background of equitable principles and the law of trusts. That said, there may be a good argument that despite the differences between the relevant provisions of the Bankruptcy Act and Corporations Act, the same reasoning would produce the same result in the corporate insolvency context. As Gordon J observed in Carter Holt/Amerind and Allsop CJ observed in Jones/Killarnee on the question of statutory priorities (see above), it may be argued that there is no logical or countervailing reason why the principle would be any different under the bankruptcy regime. The principles of equity and trusts governing a trustee’s right of indemnity apply equally to both personal and corporate trustees. Another space to be watched with interest.

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