When a payment of trust money is recovered as an unfair preference, does it become trust money once again?

Last Friday Derrington J in the Federal Court in Queensland tackled this question which remains unresolved in Australia, in  Lane (Trustee), in the matter of Lee (Bankrupt) v Commissioner of Taxation (No 3) [2018] FCA 1572. That is, when a payment is recovered as an unfair preference, and the original payment out was of trust moneys applied in payment of trust debt/s, does the recovered money become impressed with the trusts once again, or does it form part of the bankrupt’s general estate? (Or, on a liquidation, the company’s?) As a fungible, of course the funds recovered are not the same funds as those paid to discharge the debt.

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 the suburb of Brassall 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. 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 to pay this tax debt, and the balance of $150,778.58 had been paid from funds of the trust. The Bankruptcy Trustees had apportioned the unfair preference recovery accordingly between Mr Lee’s personal estate on the one hand and the trust on the other.

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 becoming trust money “once again” upon its recovery.

Submissions

In broad terms, the Bankruptcy Trustees submitted that the funds recovered by them were impressed with the terms of the trust such that they (in the shoes of Mr Lee) would only be entitled to use them to discharge liabilities owing to trust creditors. His Honour noted the Trustees also seemed to submit that the trust creditors would be entitled to be subrogated to the equitable lien which attached to those funds in support of the trustee’s right of exoneration (at [7]).

The Commissioner generally submitted that the monies repaid by him were not subject to the terms of the trust and was available to be used by the Bankruptcy Trustees to meet the claims of all creditors (at [7]). The Commissioner submitted that although the trust funds were paid to him by Mr Lee as trustee utilising the right of exoneration, when an equivalent amount was repaid, the money was held free of all trust obligations and could be used to discharge the debts of non-trust creditors (at [20]).

Decision

As Derrington J observed at [25] that to date there is no sufficiently authoritative statement on this topic.

His Honour’s key reasoning is at [19]. He observes that attention needs to be focused on the entitlement to recover the sum paid from trust funds pursuant to Mr Lee’s entitlement to exonerate himself in respect of debts incurred in his capacity as trustee. Mr Lee’s entitlement to use trust funds only arose by reason of his position as trustee and because the debt arose from the administration of the trust. He concludes that the right to recover the payments of trust money from a transaction which was avoided was a right which was held for the benefit of the trust. Hence that right of recovery would be trust property vested in the trustee in that capacity and not in his / her /its personal capacity. “Rights which accrue from the performance of trust obligations tend to be trust property”, he adds.

At [24] his Honour concludes: “It would appear to be axiomatic that the right to receive repayment from the Commissioner consequent upon the avoidance of the preference payment was a right which vested in Mr Lee qua trustee such that the right is property of the trust, albeit one in which Mr Lee also had a beneficial interest.” He takes the view that at the very least, the right to receive the funds would be subject to the fiduciary duty that Mr Lee is not to profit from his position as trustee (at [28]).

Derrington J’s conclusion meant that the Trustee’s of Mr Lee’s bankrupt estate were correct to apportion the unfair preference recovery between the trust and Mr Lee’s general estate, in accordance with the source of the original payments that had been avoided. That is, the impugned payments of trust monies recovered as unfair preferences were to be treated as held for the benefit of trust creditors only (see [32]).

Conclusion

This should provide some guidance to bankruptcy trustees where the bankrupt had been a trustee who made preferential payments prior to bankruptcy.

However the question is more likely to arise 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 some of his Honour’s reasoning was particular to the bankruptcy context (see [12]-[15]), and 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.

His Honour observes at [15] that the Bankruptcy Act confers no right of recovery or cause of action on the Bankruptcy Trustee (s 122 simply operates to avoid the preferential payments). It follows from this, his Honour says, that the Bankruptcy Trustee’s claim to recover the money is derivative upon a general law right acquired from the bankrupt. His Honour goes on to conclude that this right of the bankrupt is trust property which vests in the Bankruptcy Trustee by virtue of s 58 of the Bankruptcy Act (at [24]).

However 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 unclear whether the Courts would take the view where the impugned payment out had been a payment of trust money, that the rights of recovery under s 588FF are themselves trust property. And whether it would follow 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.

Derrington J’s view expressed more than once was that neither a trustee, nor anyone claiming through it, has an entitlement to profit from their position as trustee and recover funds that had been a payment of trust moneys for their personal use (see eg at [31]). Perhaps this will inform the approach the Courts take to this difficult question.

Current state of uncertainty in the liquidation of trustee companies and the bankruptcy of individual trustees

Given that this case decides a question which leads to a conclusion as to whether unfair preference recoveries are available to all creditors or only trust creditors, one more point should be  noted. This is a Federal Court bankruptcy decision (in Queensland). For most of Australia, on the liquidation of a trustee company, proceeds of the trustee’s right of exoneration and supporting lien are not generally available for distribution to non-trust creditors. They may only be used to pay trust creditors. This was confirmed by the Full Federal Court in March of this year in Killarnee – Jones (Liquidator) v Matrix Partners Pty Ltd; Re Killarnee Civil and Concrete Contractors Pty Ltd (in liq) [2018] FCAFC 40; (2018) 354 ALR 436 (Killarnee). See my distillation of the propositions for which Killarnee stands as authority here, and my article reviewing the judgment and considering each of those propositions in more detail here.

In Victoria, however, a five member bench of the Court of Appeal in February of this year in Amerind concluded on this issue that until a subsequent appellate decision decides otherwise, Re Enhill continues to apply in Victoria and should continue to be followed by trial judges here, and the proceeds of the trustee’s lien on a bankruptcy or liquidation are available for division amongst the company’s creditors generally, not only among trust creditors –  Commonwealth of Australia v Byrnes and Hewitt as receivers and managers of Amerind Pty Ltd (receivers and managers apptd)(in liq) [2018] VSCA 41; (2018) 354 ALR 789 (Amerind). See my article reviewing that judgment here. Derrington J’s disapproval of this position can perhaps be seen in his observation at [9] that:  “In general terms, the decision in Amerind concluded that a corporate trustee’s right of exoneration, being the entitlement to use trust funds to pay trust debts, transmogrifies on insolvency into a right to use trust funds for the [trustee company’s] non-trust debts.”

Of course Amerind dealt with other issues as well, principally whether a trustee’s right of indemnity is property of the company, and whether upon the liquidation of a trustee company the distribution of property is governed by the statutory priority regime. Special leave to appeal to the High Court in Amerind has been sought and in August 2018 was granted, although the appeal has not yet been heard.

I note too that Derrington J’s earlier decision in the bankruptcy of Mr Lee dealing with whether trust assets can be used to pay all creditors or only trust creditors, and whether the scheme of priority in s 109 of the Bankruptcy Act applies to trust assets / proceeds of the trustee’s right of indemnity and lien –  Lane v Deputy Commissioner of Taxation [2017] FCA 953; (2017) 253 FCR 46 – has been appealed by the Commissioner. However given the granting of leave to appeal to the High Court in Amerind the Lane appeal it is not presently being progressed (see [9]).