30 May 2011

Insolvent managed investment schemes: uncertainty and conflicts

by Jennifer Ball, John Moutsopoulos

Few now remember that Chapter 5C of the Corporations Act can trace its origins to the afternoon of 23 July 1991. For the past year, the unlisted property trust industry had been in meltdown. The value of the assets held by the industry had fallen over 20%. Investors were scrambling to get out, and collapses seemed imminent.

As a result, on 23 July 1991, the Commonwealth announced an immediate 12-month freeze on redemptions. The subsequent temporary legislation to give effect to the freeze enjoyed the rare distinction of being specifically backdated to the precise minute that the Attorney-General announced it (4:50pm). To address the more long-term systemic issues highlighted by the crisis, Chapter 5C was inserted into the Act (in 1998), replacing the somewhat vague "prescribed interest" provisions that had hitherto governed the industry.

The Chapter 5C regime treatment of schemes which are not "liquid" seems to have responded reasonably well to the impact of the global financial crisis upon the liquidity of managed investment schemes (MISs) and the withdrawal rights of members. Whether Chapter 5C has been a total success is not within the scope of this article. However, it appears to be the case that those responsible for the drafting were so confident of the strength of their legislation that they omitted to deal, in any comprehensive way, with the possibility that collective investments would ever again experience systemic failure.

That appears to be the only explanation as to why Chapter 5C has proved to be so lacking and full of uncertainties when dealing with "insolvent" trusts.

A number of large MISs have recently become "insolvent". In addition it appears that there are at the time of writing some 30 responsible entities (REs) (out of total RE population of 600) that are the subject of external administration. But how does the Corporations Act apply where there is an "insolvent" trust or an insolvent RE (or both)? What uncertainties do administrators and liquidators face under the laws of insolvency as they interact with the law of trusts and the Chapter 5C regime? And what conflicts arise?

Of the 68 sections in Chapter 5C dealing with MISs (and the many provisions elsewhere in the Act which apply company law concepts to MISs (such as Chapter 6) and the innumerable provisions governing REs in the morass of Chapter 7), only seven deal with insolvency. In broad terms, those provisions provide that an MIS can be wound up in accordance with its constitution (if the constitution contains such provisions) or by order of a Court.

This is, perhaps, the ultimate "light touch" regime, as insolvency professionals and the courts are starting to realise: insolvent MISs and REs have replaced statutory demands as the most common subject of insolvency litigation. Two major issues have stood out: Who should liquidate an insolvent MIS? And who should pay?

Who should liquidate an insolvent MIS? And who should pay?

Strictly speaking, a MIS cannot become insolvent since it is not a legal entity. It is the RE that holds the scheme property and incurs debts to scheme creditors. The RE has a right of indemnity from scheme property in respect of these debts.

So an insolvent MIS is, in simple terms, really a reference to an MIS where the scheme property is insufficient to meet the scheme liabilities to scheme creditors, whether or not the RE itself is, as a legal entity, solvent[1].

Part 5C.9 requires a RE to "ensure that" an MIS is wound up in certain circumstances. Strangely, the Act does not spell out insolvency as a ground for winding up, a gap which Courts have filled by holding that insolvency provides a reason to order winding up on the "just and equitable" ground in s 601ND(1)(a): see the discussion in Capelli v Shepard (2010) 77 ACSR 35. Moreover, there is no statutory requirement for the RE to do the winding up itself. The Act also ignores the currently common phenomenon of having both an insolvent RE and an insolvent MIS. This has given rise to recent litigation[2].

Typically, a voluntary administrator, receiver or liquidator is appointed to the insolvent RE. As an officer of the RE, the external administrator has to ensure that the RE meets its responsibilities for ensuring that it is liquidated and obligations to trust creditors in its capacity as trustee. There are two ways to do this: either the external administrator assumes responsibility for liquidating the MIS, or he or she asks the Court to appoint a different liquidator to the MIS.

The latter was the course initially adopted in Capelli v Shepard where the Court ordered that a liquidator be appointed to the scheme. It also ordered that the RE and the other parties to the winding up application have priority for their costs, out of scheme assets, ahead of the scheme liquidator's costs. It would be no surprise to learn that two months after the order that a liquidator should be appointed to the scheme, no-one had volunteered to take the job. The Court then ordered that the liquidator of the RE should be the liquidator of the scheme.


At first blush, the idea of having the same person as liquidator of both the RE and the MIS might appear to have the virtue of economy (in much the same way that Courts regularly endorse the appointment of a voluntary administrator as a liquidator on the grounds that appointing a new liquidator would waste the administrator's accumulated knowledge of the company's finances).

The reality, however, is that this is a course fraught with peril, for the following reasons.

The first is that the liquidator of the RE is like any other liquidator of a company: his or her first concern is the interests of the company's creditors and then the interests of its shareholders. However, the liquidator of a MIS also has a completely different set of "customers", in the shape of the investors in the scheme. This is again illustrated in the situation underlying Capelli v Shepard. The appointment of the RE liquidator as liquidator of the MIS was recognised as giving rise to a possibility of a conflict of interest. This was proposed to be addressed by the appointment of a committee of management which could direct him to apply to the Court for directions on dealing with any such conflict.

Environinvest Ltd v Great Southern Property Managers Ltd [2010] VSC 323 was such an application. This case illustrates why RE/MIS situations are more complex than the situation of a mere corporate trustee. As part of the MIS, the RE leased land on which the scheme conducted its business. It was in the interests of creditors of the RE for the liquidator to disclaim the lease. At the same time, such a disclaimer could adversely affect the rights and entitlements of members of the MIS.

The Court recognised that without its assistance, the liquidator would be compelled to resign as liquidator of either the RE or the MIS. This would normally be regarded as an unexceptional way to resolve a conflict, but the nature of this case militated against it, for two reasons:

  • as previously noted, there was no-one willing to take over the liquidation of the MIS;
  • the members of the MIS were happy with the way he had been conducting the liquidation and did not apparently seek his resignation.

The Court declared that the liquidator was permitted to exercise his power to disclaim the lease notwithstanding the conflict with his role as liquidator of the MIS.

Conflicts were also the subject of judicial consideration in Timbercorp Securities Limited v WA Chip & Pulp Co Pty Ltd [2009] FCA 901. 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 (s568(8)). The liquidators were concerned about the effect of disclaiming the lease on the investors in the scheme. The Court thought that this concern was based on a misconception [at 11]:

"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 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."

Another aspect of conflicts is the question who is to bear the cost of the liquidator's remuneration. In respect of MISs, there are two aspects to this question, both arising when, as is commonly the case, both the RE (which has the right of indemnity against trust assets) and the MIS are insolvent.

The first issue is whether the liquidator of the RE can use the personal assets of the RE to pay his costs and remuneration of liquidating the MIS.

This issue was addressed last year in Rubicon Asset Management Ltd [2009] NSWSC 1068. The RE of a number of insolvent schemes was itself insolvent. All the scheme assets were charged, so the RE's right of indemnity against trust assets and ability to recoup the costs of winding up the schemes, was worthless (a factor which, as the Court pointed out, also rendered nugatory any thought of appointing a separate liquidator). The RE applied for orders to be allowed to use its own funds to wind up the schemes. Although it recognised that this would adversely affect the RE's own creditors, the Court said that this was only a matter which went to its discretion. Making the orders sought, the Court said that:

  • the bulk of the RE's liabilities were in fact liabilities incurred as trustee of the schemes themselves;
  • even if there were a diminishing of the RE's creditors' entitlements, that was justified by the fact that an RE had a obligation (even if insolvent) to wind up its schemes in accordance with the scheme constitutions.

Balancing the demands of corporate creditors against those of MIS members is one issue. Another arises from the fact that a single RE will commonly be responsible for more than one MIS. What happens if the extent of insolvency varies between the MIS: can the RE "raid" the assets of one MIS to pay for the costs of liquidating another?

This was recently the subject of judicial consideration in Trio Capital Limited (Admin App) v ACT Superannuation Management Pty Ltd & Ors [2010] NSWSC 941. A voluntary administrator was appointed to an RE which managed several MISs. The RE itself had some cash. Some of the MISs had assets; others had none.

The administrator's costs (including remuneration) of administering the RE and the MISs far outweighed the RE's own assets. Accordingly, the administrator asked for Court approval for a structure under which the cost (including his remuneration) of administering the schemes without assets would be recovered from the MISs which had assets.

The Court recognised that this was a tricky issue. There were public policy reasons for ensuring that external administrators got paid but at the same time, an administrator of a trustee of multiple trusts had to act in the best interests of each trust.

The Court ultimately decided that the interests of the members of schemes with assets took precedence over the administrator's remuneration. The Court thought that the preferable course was first to apply the RE's own assets to paying the administrator's costs and remuneration relating to administering the RE and the MISs, in the same proportions. Each MIS should be liable for the costs and remuneration attributable to the cost of administrating that particular MIS.

What is ASIC's role and what about temporary REs?

The temporary RE regime has rarely been used in the 12 years since the Chapter 5C regime was introduced. The sole role of a temporary RE is to call a meeting of scheme members for the purpose of appointing a new RE. If one is not appointed at such meeting then the scheme must be wound up. The key reason why there is a reluctance by licensees to assume the role of a temporary RE appears to be because of the statutory vesting and novation regime contained in sections 601 FS and 601FT. Specifically, there is a fear of the unknown financial situation of the MIS and the risk that the putative temporary RE may become personally exposed for any short fall in scheme property and therefore impact the solvency of the temporary RE itself.

ASIC clearly has a role to play in this context for a few reasons not the least of which is the fact that a RE holds an Australian Financial Services Licence (AFSL) which may be in breach if the RE is insolvent and may also be in breach if the MIS is insolvent. ASIC has a discretion to suspend or cancel the AFSL because its starting position is that it is not appropriate for the RE to continue to hold an AFSL. However, cancelling or suspending an AFSL can have an adverse impact upon the MIS members.

In these circumstances, ASIC's practice appears to be a pragmatic one of effectively leaving the AFSL on foot so as to enable insolvency practitioners appointed as external controllers to the RE to be able to continue to operate the MIS for the purpose of determining whether to wind it up or to find a replacement RE. It could be characterised as the fashioning of a form of temporary RE regime.

Any way you cut it, the last three to four year GFC period has been extraordinary. As this article has sought to highlight, the insolvent MIS area has its issues and uncertainties. There is a view that this is an area that is potentially ripe for law reform. To some extent, the likelihood of some of these issues arising again will reduce in light of ASIC's recent proposals on the financial requirements that should apply to AFS licensees that act as a RE for a registered MIS.


This article was first published in the Insolvency Law Bulletin, Vol 13 No 3 (October 2010)

[1] The question of whether an RE which is otherwise solvent could itself become insolvent because it is operating an insolvent MIS in the sense defined above, can be a complex one because of the general principle that the RE is personally liable for debts that it incurs in respect of an MIS unless the creditors have agreed to limit their recourse to the scheme property. So an RE may find itself exposed to any shortfall which, among other consequences, might then adversely impact upon its regulatory capital position.

[2] The other common situation is of an insolvent RE and a solvent MIS which is still viable and where the members still wish to continue.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.