Court removes liquidators for apparent bias

The Full Court of the Federal Court has found that a conflict of interest arose in circumstances where liquidators were required to investigate transactions with an entity that also refers work to the liquidators (ASIC v Franklin; Re Walton Construction Pty Ltd [2014] FCAFC 85).

Practitioners should be careful to avoid any situation where an appointment might create an obligation that conflicts, or may be perceived to conflict, with the personal interests of them or their firm. Courts will remove liquidators in these circumstances even where it might cause significant inconvenience and expense to the liquidation.

Background

Craig Walton was the sole director and secretary of Walton Construction Pty Ltd and Walton Construction (Qld) Pty Ltd, two construction companies. In 2013, the companies were in financial difficulty. They retained the Mawson Group, a business advisory and restructuring company, to provide advice.

In late September 2013, the companies entered into a number of transactions with companies owned by or associated with the Mawson Group. The transactions were apparently unsuccessful in salvaging the Companies. The Mawson Group referred Mr Walton to Lawler Draper Dillon (now PKF Lawler) (LDD) for the purposes of appointing voluntary administrators. The Mawson Group had regularly referred work to LDD since early 2012.

On 3 October 2013, Mr Walton appointed Glenn Franklin, Stirling Horne and Jason Stone of LDD (liquidators) as administrators of the Companies. The liquidators were appointed at meetings of creditors held on 8 November 2013.

It became apparent during the course of the administration that the liquidators would be required to investigate the companies' pre-administration transactions with the Mawson Group. Various creditors raised concerns with the liquidators about whether a conflict of interest would arise, but a majority of creditors (which included the Mawson Group) voted to appoint them at the second meeting of creditors of the companies.

On 16 December 2013, ASIC applied to the Federal Court to have the liquidators removed due to a conflict of interest, and for a declaration that the liquidators had not properly disclosed a relevant relationship to creditors. Justice Davies rejected the application.

ASIC appealed to the Full Court of the Federal Court, on the following grounds:

• that the liquidators should be removed due to a reasonable apprehension that they lacked independence and impartiality in the discharge of their functions; and
• that the liquidators were obliged to disclose the previous relationship between the companies and the Mawson Group in their declaration of independence and relevant relationships (DIRRI), and failed to do so.

ASIC was successful on the first ground and unsuccessful on the second ground.

Bias

A liquidator must be independent, and seen to be independent. A court may remove a liquidator where there is an actual or reasonable apprehension of bias in the liquidator's conduct.

ASIC alleged that there was a reasonable apprehension of bias on the part of the liquidators , given the apparent need to investigate the companies' transactions with the Mawson Group on the one hand, and the liquidators' expectation of ongoing referral work from the Mawson Group on the other.

The Court observed that the test for bias in the case of liquidators is whether (a) a circumstance exists that might lead the liquidator to make a decision for a reason other than merit; and (b) that circumstance might actually lead the liquidator to make a decision for a reason other than merit. The court described this as the "double might" test.

The Court noted LDD's ongoing relationship with the Mawson Group, and that referrals from the Mawson Group had constituted about $500,000 (10%) and $250,000 (5%) of LDD's insolvency division's revenue in the 2012 and 2013 financial years respectively. Further, the "referral relationship" had "only recently been formed and … the number of referrals had been slowly increasing". Given the significance of the revenue involved for LDD, and the likelihood of LDD's interest in continuing the relationship with the Mawson Group, the Court found that a reasonable fair-minded observer might consider LDD had a conflict of interest. In the circumstances, the Court found that the liquidators' interest in not jeopardising future income might lead them not to discharge their duties with independence and impartiality.

The Court also raised a concern with the Mawson Group's referral of the companies to the liquidators , in circumstances where the Mawson Group would likely be aware that the pre-administration transactions would be investigated by the liquidators . The Court drew an analogy with litigants not being able to choose their own judges to conclude that a fair-minded observer might think the Mawson Group's influence on choosing a liquidator would be a "cause for disquiet".

Accordingly, the Court concluded there was a reasonable apprehension that the liquidators had a conflict of interest, and ordered that the liquidators be removed.

DIRRIs

Section 436DA of the Corporations Act requires administrators to declare any "relevant relationships" to creditors. Section 60 sets out certain prescribed forms of relationships that must be declared, including as between an administrator and an associate of the company under administration. The liquidators disclosed their firm's association with the Mawson Group and explained why the referral relationship did not compromise their independence. The liquidators made no declaration about the relationship between the Mawson Group and the Companies.

ASIC contended that creditors needed to know about the relationship between the Mawson Group and the companies, in order to make an informed assessment of the liquidators' declaration.

The Court found that the requirement to state a relationship "did not cover the entire field of conflict of interest or duty". Just because an investigation or proposed investigation into a transaction might lead to the administrator having a conflict, does not mean that a "relevant relationship" arises for the purposes of preparing a DIRRI. The focus of an administrator's obligations in preparing a DIRRI is on the relevant relationships as contained in section 60 and on the administrator's belief regarding those relationships.

ARITA Code of Professional Practice

Practitioners will be aware that the most recent edition of the ARITA Code of Professional Practice imposes an obligation on practitioners to disclose the source of a referral that leads to their appointment. In response to the Court's decision, ARITA has inserted a new clause 6.6.1 into the Code, which will come into effect on 18 August 2014. Clause 6.6.1 requires practitioners to disclose any referral, and provide reasons for why they do not believe the referral results in a conflict of interest or duty, in either a DIRRI or, where no DIRRI is required, where the referring entity provides consent to disclose the relationship.

Practitioners should nonetheless note Justice Robertson's comments (with which Justice Jessup agreed) that the Code should not be taken into account by courts in construing the sections of the Corporations Act that relate to DIRRIs. This is consistent with Federal Court authority that a breach of the Code will be a disciplinary matter for ARITA, and will not necessarily indicate a breach of the law.

Outcome

The Court ordered that the liquidators be removed as liquidators of the Companies. It acknowledged that this would cause "considerable inconvenience and expense in the liquidations", but could see no alternative.