12 Jul 2016

Trust companies in liquidation - dealing with priority debts

By Mikhail Glavac

The decision in In the matter of Independent Contractor Services (Aust) could mean more reliance upon fair entitlements guarantee funding provided by the Commonwealth in relation to the liquidation of trading trusts.

A recent decision of the NSW Supreme Court has some interesting implications for liquidators of trustee companies dealing with any recovered trust funds and priority debts. At the same time, the Court reconsidered the manner in which it will approach a liquidator's remuneration (In the matter of Independent Contractor Services (Aust) Pty Limited ACN 119 186 971 (in liquidation) (No 2) [2016] NSWSC 106).

A trustee company goes into liquidation

Independent Contractor Services (ICS) was a staffing agency which supplied persons whom it had retained (contractors) to deliver services on behalf of information technology and engineering consultancies.  The business used a structure whereby ICS was trustee of a discretionary trust called the Independent Contractor Services Trust (ICS Trust).  The primary beneficiary and appointor of the ICS Trust was a related entity of ICS. 

The contractors applied to become general beneficiaries of the ICS Trust, and acknowledged that they were not employees, and had no right or entitlement to any income or capital of the ICS Trust.  Receipts from clients and payments to Contractors were processed through the ICS Trust bank account.  The only function of ICS was to act as trustee of the ICS Trust.  In an earlier judgment, Justice Brereton had considered whether the trust arrangement was a sham, but concluded that it was not (In the Matter of ICS Real Estate Pty Ltd (in liquidation); and In the Matter of Independent Contractor Services (Aust) Pty Ltd (in liquidation) [2014] NSWSC 479).

After completing an audit of ICS's PAYG withholding, the Commissioner of Taxation determined that ICS had a superannuation guarantee charge liability for failure to withhold amounts paid to the contractors of over $2.2m.  A superannuation guarantee charge is a priority debt under section 556(1)(e) of the Corporations Act 2001 (Cth).  Together with administrative penalties, the ATO lodged a proof of debt in the liquidation of ICS for just under $11.6m. The contractors claimed they were owed $232,368.84 as beneficiaries of the ICS Trust. There were also unsecured trade creditors of ICS who lodged proofs of debt in its liquidation.

In the administration and liquidation of ICS, the liquidator recovered funds totalling around $200,000. After the costs of the external administration of the company, there was $130,980 available for distribution, before allowing for liquidator’s remuneration.  The liquidator applied to the Court for approval of his remuneration, and directions in relation to how he should distribute the remaining funds.

Trust funds and the superannuation guarantee charge liability

Justice Brereton held that the recoveries made by the liquidator were ICS Trust funds, which were not beneficially owned by ICS. The debts owed to the ATO were liabilities incurred by ICS in its trustee capacity, and that ICS was therefore entitled to be indemnified for those liabilities from the ICS Trust assets pursuant to the trustee's lien.

Did this mean the superannuation guarantee charge liability was entitled to section 556 priority, as a liability payable out of trust assets pursuant to the trustee's lien?  Justice Brereton held that it was not, for two independent reasons.

First, on the facts of the case the contractors in respect of whom the superannuation guarantee charge liability arose were not "employees" as defined in section 556.  This precluded section 556 priority:

"although the expanded definition applies under [section 12 of the Superannuation Guarantee (Administration) Act 1992 (Cth)] to make superannuation guarantee charge payable notwithstanding that the contractors are not strictly employees, the ensuing liability is not one in respect of an “employee” for the purposes of s 556, and is thus not entitled to priority under s 556(1)(e)(i)."

Second, Justice Brereton found that section 556 was "concerned only with the distribution of assets beneficially owned by a company and available for division between its general creditors".  It therefore does not apply to trust funds, including trust funds the subject of the trustee's lien.  Noting that Re Suco Gold Pty Ltd (1993) 33 SASR 99, which had held that liabilities were to be paid from the trust property in the order laid down in section 556, was "virtually universally accepted to be incorrect", Justice Brereton held that the correct position was that:

"the company, as trustee, had, and its Liquidator now has, a right of indemnity from, and lien over, the trust assets, which has priority over the interest of the beneficiaries, for liabilities it incurred in acting as trustee. As all the company’s liabilities were incurred in its trustee capacity, all its creditors (including in particular the ATO in respect of superannuation guarantee charge and PAYGW penalty) are entitled to be subrogated to the Liquidator’s lien. The statutory priority referred to in s 556 does not apply in respect of trust assets, and the creditors share pari passu in the trust assets, after providing for the costs of administration including the Liquidator’s remuneration and expenses."

Liquidator's remuneration ‒ the ad valorem approach

Another aspect of the decision was Justice Brereton's consideration of the liquidator's application that the Court approve his remuneration in the amount of $49,510.  Justice Brereton only allowed remuneration of $30,000, and expressly criticised the practice of seeking remuneration based solely on time reasonably spent at standard hourly rates. Instead, he approved and applied an ad valorem approach to assessing a liquidator's remuneration:

"ad valorem remuneration, while not without shortcomings, is inherently proportionate, incentivises the creation of value rather than the disproportionate expenditure of time, was — until the relative recent proliferation of time-based costing — conventional, and is still contemplated by the relevant statutory provisions."

Justice Brereton arrived at the $30,000 figure having regard to the size of the funds in the company, the totality of work undertaken and time expended by the liquidator and his staff, the challenges presented, and the extent to which others (including lawyers and debt collectors) were engaged and remunerated for associated work.

Implications for liquidators of trustee companies and section 556 priority

Justice Brereton's decision has significant implications for the treatment of priority debts in the liquidation of a trustee company, which, given their prevalence in the market, is a frequent issue for liquidators, and may prove especially vexing for the employees of trading trusts.

For example, the contractor / employee distinction is a technical one based on the facts. If the contractors had been employees, they would have had section 556 priority for any unpaid wages and leave entitlements.  In respect of trust funds claimed by the company, such debts would only rank pari passu with other unsecured creditors pursuant to the trustee's lien.  This has the potential to result in a significantly worse recovery in liquidation for employees of trustee companies, notwithstanding that there is no clear policy justification for treating employees differently based upon the business structure adopted by the employer.  The practical result may be more reliance upon fair entitlements guarantee funding provided by the Commonwealth in relation to the liquidation of trading trusts.

Furthermore, it must be noted that the decision in Independent Contractor Services (No 2) is inconsistent with other authority, notably Suco (which was the decision of the Full Court of the Supreme Court of South Australia).  It would be premature to say that the position adopted by Justice Brereton is the settled law.  A prudent liquidator may, therefore, feel compelled to seek directions before distributing trust fund assets, which is likely to inflate the costs of appointments to insolvent trading trusts, at least until there is superior court authority which settles the point.

In addition, Justice Brereton's findings with respect to what was fair and reasonable remuneration for the liquidator are likely to spark controversy.  He was at pains to note that the Court ought not "discourage liquidators from undertaking small but difficult liquidations" in respect of its approach to the question of remuneration.  However, he separately noted that "in smaller liquidations" questions of "proportionality, value and risk loom large" and "liquidators cannot expect to be rewarded for their time at the same hourly rate as might be justifiable where more property is available".  These observations can be expected to be at the forefront in the minds of insolvency practitioners when they are deciding whether to accept an appointment to a small company, given that they act under the same obligations regardless of the size of the company to which they are appointed.

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