The Australian unit trust industry recently experienced financial difficulties. The formal legal process of handling those difficulties has revealed gaps in the Australian regulatory map.
This article highlights some of those problems and the Government’s response to them.
It is not yet clear whether the sector’s current problems arise from the GFC or whether (and to what degree) they are the result of purely domestic factors. In respect of the latter issue, it is possibly relevant that Australia has, since the mid-1980s, been moving its retirement incomes policy from a largely State-funded one to one in which retirees are encouraged to fund their own retirement, with the state’s resources being reserved for a social safety net. The result has been a significant expansion of retail (or "Mum and Dad") investment activity, either directly or through the medium of private sector pension funds.
One thing which is clear is that one segment of the sector has been noticeably affected by financial stress: agricultural unit trust schemes. These involve the vending of financial interests in agribusinesses.
As the cases discussed below show, the collapse of these schemes has shown that there are gaps in the Australian regulatory regime for handling the insolvency of unit trusts in general. This is surprising, because the statutory requirements for unit trusts were completely rewritten in 1998, largely in response to the near collapse of the unlisted property trust segment of the unit trust industry in 1991. That statutory regime was extensively reviewed and given a clean bill of health in 2001.
Despite this, the current round of collapses has seen a major increase in litigation in the sector, as liquidators seek court directions on the performance of their duties.
The single responsible entity model
To some degree, the problems arise from the statutory model for unit trusts.
Until the 1998 amendments, unit trusts operated on a system of split responsibility. A trustee held the trust property and a separate manager managed the trust business. As well as holding the trust property, the trustee was responsible for ensuring that the scheme manager properly discharged its duties.
A key change in 1998 was the formal abolition of the split between trustees and scheme managers. In a strictly legal sense, the trustee and scheme manager were abolished and replaced by a single "responsible entity". The objective was to overcome the possibility of a "responsibility gap" between trustees and scheme managers, which could result in defaults in the operation of the trusts. A less important change was the rebranding of unit trusts as "managed investment schemes". As a matter of practice, responsible entities are now commonly referred to as "REs" and managed investment schemes as "MISs" (a convention which will be followed in this article).
Despite the fact that it is not required by statute, most MISs are structured as trusts. The RE holds the scheme assets on trust and is liable to investors for the operation of the scheme. However, it is common for the management function to be outsourced (although ultimate responsibility remains with the RE).
Chapter 5C of the Corporations Act 2001 (Cth) contains the main provisions governing MISs. Only seven of the 68 sections in Ch 5C deal with insolvency. They effectively provide that a MIS can be wound up in accordance with its constitution (if the constitution contains such provisions) or by order of a court.
The recent round of litigation arising from the collapses of schemes has showed that the legislation does not satisfactorily answer two questions:
- who should actually liquidate an insolvent MIS?
- who should pay for the liquidation?
Responsibility for liquidating an insolvent MIS
It is common to refer to an MIS as being "insolvent" or an "insolvent trust". In fact, the Corporations Act defines "insolvency" in terms which apply to corporations, rather than MISs: since an MIS has no legal personality, it cannot incur the debts the inability to pay which is the basis of the definition of insolvency.
Scheme property is held and scheme debts are incurred by the RE (which has a right of indemnity from scheme property in respect of these debts). "Insolvent MIS" therefore, actually describes an MIS in which the scheme property is insufficient to meet the scheme liabilities to scheme creditors, whether or not the RE itself is solvent.
Part 5C.9 of the Act provides that an RE is required to ensure that an MIS is wound up in certain circumstances. Curiously, the Act does not specify that insolvency is a ground for winding up. However, there is a general "just and equitable" ground for winding up. The courts have held that insolvency provides a reason for winding up on this ground.
The Corporations Act also does not specifically provide a procedure for dealing with an insolvent MIS (in the terms referred to above) in circumstances where the RE is also insolvent in its own right.
What normally happens is that an external administrator (voluntary administrator, receiver or liquidator) is appointed to the insolvent RE. That external administrator then either handles the liquidation of the MIS himself or applies to the court to appoint of a separate liquidator to the MIS.
In once recent decision, the court appointed a liquidator to the insolvent MIS. It also awarded priority to the RE and the other parties to the winding up application for their costs, out of the MIS’s assets, ahead of the costs of the liquidator of the MIS. Presumably as a result of this, no liquidator would be found for the MIS. As a result, the liquidator of the RE was appointed liquidator of the MIS.
Appointing the same person as liquidator of both the RE and the MIS may appear to have some advantages, along the lines of those which are perceived to arise from appointing the same person to be the voluntary administrator of a failed company and then, when the company enters liquidation, its liquidator. These apparent advantages result from not having to "reinvent the wheel’, by utilising the RE liquidator’s knowledge of the operation, finances and problems of the MIS. On the other hand, appointing the same liquidator to both the RE and the MIS can give rise to problems. The first of these is that the liquidator of the RE is the liquidator of the RE company. As such, his function is to protect the interests of the creditors of that company (and, if there are any funds left over after paying the creditors, the interests of its shareholders). In contrast, the liquidator of a MIS must look to the interests of the investors in the scheme itself.
The Court in Capelli v Shepard addressed this problem by appointing a committee of management (drawn from the ranks of creditors). The job of the committee of management was to direct the liquidator to apply to the court for directions if any conflict arose. Such an application was subsequently made in Environinvest Ltd v Great Southern Property Managers Ltd.
The MIS in question required the RE to lease the land on which the scheme conducted its business. The conflict arose when the liquidator was deciding whether to disclaim the lease. A disclaimer was in the interests of creditors of the RE, but could adversely affect the rights and entitlements of members of the MIS.
In normal circumstances, the simplest way out of this conflict would have been for the liquidator to have resigned as liquidator of either the RE or the MIS. That course was not really open, however, because:
- as previously noted, no-one was willing to take over the liquidation of the MIS; and
- the members of the MIS were happy with the liquidator’s conduct of the liquidation and apparently did not want him to resign.
The Court ultimately declared that the liquidator was permitted to disclaim the lease, notwithstanding the potential conflict with his role as liquidator of the MIS.
Conflicts also appeared to arise in Timbercorp Securities Ltd v WA Chip & Pulp Co Pty Ltd. There, the liquidators of the RE of an agricultural MIS applied to extend the time limit for deciding whether to disclaim a lease which it held for the purpose of the MIS. Concerned about the effect of disclaiming the lease on the investors in the MIS, the liquidators applied to the Court. The Court took the opportunity to remind the liquidators of the duties that they owned as liquidators of the RE:
"The liquidators seem to be of the opinion that by reason of ss 601FC and 601FD they are required to look after the interests of investors [in the MIS] even if that be at the expense of other creditors. In my view that is wrong. There is nothing in ss 601FC or 601FD that overrides the liquidator’s duty to those interested in the winding up. It would be quite extraordinary were that to be the case. I think the liquidators should readjust their priorities."
Costs of liquidation
A liquidator of a company is normally entitled to be paid his or her remuneration out of the funds of the company. The situation is not so clear in the case of an MIS when both the RE (which has a right of indemnity against trust assets) and the MIS are insolvent. Can the liquidator of the RE use the RE’s assets to pay the cost of liquidating the MIS?
Rubicon Asset Management Ltd concerned the insolvent RE of a number of insolvent MISs. All the scheme assets were charged, with the result that the RE’s right of indemnity against trust assets and its ability to recoup the costs of winding up the schemes were worthless. The RE asked the Court to allow it to use its own funds to wind up the MISs.
Although this would adversely affect the RE’s own creditors by reducing the pool of funds available to the RE’s unsecured creditors, the Court held that this only went to the exercise of its discretion, and did not affect its jurisdiction to make the order. Accordingly, it made the orders sought by the RE.
The Court held that most of the RE’s liabilities were in fact liabilities incurred as trustee of the schemes themselves. Even if the order diminished the amounts available to the RE’s creditors' entitlements, that outcome would be justified by the RE’s obligation (if it was insolvent) to wind up its schemes in accordance with the constitutions of the schemes.
One RE – many MISs
It is very common for a single company to be the RE for multiple MISs. If those MISs all become insolvent, the extent of the insolvency (and the available cash) may vary between the MISs. In Trio Capital Ltd (Admin App) v ACT Superannuation Management Pty Ltd, the Court was asked whether the voluntary administrator of an RE could "raid" the assets of one MIS to pay for the costs of liquidating another.
The RE’s assets were not sufficient to pay the administrator’s costs and remuneration for administering the RE and the MISs. The administrator therefore sought court approval for a structure under which the cost (including his remuneration) of administering those MISs which had no assets could be recovered from the MISs which had assets.
The application highlighted a policy conflict: – the statutory corporate insolvency regime (of which voluntary administration is one arm) depends upon there being an high level of assurance that external administrators will be paid; – on the other hand, each MIS (insofar as it was a trust) was a separate legal structure, and the administrator of a trustee of multiple trusts is required to act in the best interests of each trust.
The Court considered these issues and concluded that the interests of the members of MISs with assets took precedence over the administrator’s remuneration. The result was that the RE’s own assets should be applied to paying the administrator’s costs and remuneration relating to administering the RE and the MISs, in the same proportions. The funds of each MIS should then be applied to meeting the unmet costs and remuneration attributable to the cost of administrating that particular MIS
There have been a number of responses to the spate of litigation concerning insolvent REs and MISs. The Australian Securities and Investments Commission has addressed one component of the problem – insolvent REs. In a September 2010 consultation paper, the Commission proposed to use its regulatory powers to impose tighter financial controls on REs of registered MISs (ie. those with more than 20 investors).
This would not address the wider conceptual problems revealed by the cases discussed in this article.
This article will be published in an upcoming issue of International Corporate Rescue