Sterileair Pty Ltd v Papallo, George Ralph

[1998] FCA 1446

FEDERAL COURT OF AUSTRALIA

CORPORATIONS – transfer of business between companies – sale of shares – covenant by new company to pay old company’s debt to vendor shareholder – whether sham – whether financial assistance in connection with acquisition of company’s share

Corporations Law s 205

Scott v Commissioner of Taxation (Cth) (No 2) (1966) 40 ALJR 265 applied
Snook v London & West Riding Investments Ltd [1967] 2 QB 786 applied
Sharrment Pty Ltd v Official Trustee in Bankruptcy (1988) 18 FCR 449 applied
Charter House Investment Trust Limited v Tempest Diesels Ltd [1986] BCLC 1 applied
Milburn v Pivot Ltd (1997) 149 ALR 439 applied
Cashmere Pacific Ltd v New Zealand Dairy Board [1996] 1 NZLR 218 applied
Independent Steels Pty Ltd v Ryan [1990] VR 247 applied
Burton v Palmer [1980] 2 NSWLR 878 applied
E H Dey Pty Ltd (in liquidation) v Dey [1966] VR 464 mentioned
Jury v Vogt (1993) 10 ACSR 718 mentioned

Trevor v Whitworth (1887) 12 App Cas 409 mentioned

STERILEAIR PTY LIMITED v GEORGE RALPH PAPALLO and CATHERINE ANNE PAPALLO
NO. NG 278 of 1998

HEEREY, TAMBERLIN and HELY JJ
16 NOVEMBER 1998
SYDNEY

IN THE FEDERAL COURT OF AUSTRALIA
NEW SOUTH WALES DISTRICT REGISTRY	NG 278 of 1998

BETWEEN:

STERILEAIR PTY LIMITED
APPELLANT

AND:

GEORGE RALPH PAPALLO
FIRST RESPONDENT

CATHERINE ANNE PAPALLO
SECOND RESPONDENT

JUDGES:

HEEREY, TAMBERLIN AND HELY JJ

DATE OF ORDER:

16 NOVEMER 1998

WHERE MADE:

SYDNEY

THE COURT ORDERS THAT:

1. The appeal is dismissed.

2. The appellant pay the costs of the respondents, including reserved costs.

Note:Settlement and entry of orders is dealt with in Order 36 of the Federal Court Rules.

IN THE FEDERAL COURT OF AUSTRALIA
NEW SOUTH WALES DISTRICT REGISTRY	NG 278 of 1998

BETWEEN:

STERILEAIR PTY LIMITED
APPELLANT

AND:

GEORGE RALPH PAPALLO
FIRST RESPONDENT

CATHERINE ANNE PAPALLO
SECOND RESPONDENT

JUDGES:	HEEREY, TAMBERLIN AND HELY JJ
DATE:	16 NOVEMBER 1998
PLACE:	SYDNEY

REASONS FOR JUDGMENT

THE COURT:

On 20 December 1991 the appellant Sterileair Pty Limited (then called Loreglow Pty Ltd) entered into an agreement in writing (hereinafter “the loan agreement”) with the respondents George Ralph Papallo and Catherine Anne Papallo to pay the sum of $100,000 by specified monthly payments, together with interest, over a period of ten years.  The agreement recited that Mr and Mrs Papallo “have agreed to advance a loan of $100,000 to (Sterileair) for a period of ten years”. 

After payments had been made for some years under the agreement, Sterileair came under the control of new owners. Sterileair then commenced proceedings in this Court seeking to set aside the loan agreement on two grounds: (i) that it was a sham and, (ii) in the alternative, that it contravened s 205 of the Corporations Law, as it involved the giving of financial assistance for the purpose of or in connection with the acquisition of Sterileair’s shares. 

Lehane J dismissed the claim and gave judgment for Mr and Mrs Papallo on their cross claim for $78,854.07, being the balance due under the loan agreement, including interest. 

Divali and Sterileair

In 1989 a Mr Andrew Waters (then known as Wyles) was carrying on a business of cleaning industrial premises and a business of importing chemical cleaners.  He traded under the name Sterileair Aust.  Mr and Mrs Papallo agreed to invest in Mr Waters’ business.  A shelf company called Divali Pty Ltd was acquired.  Mr Papallo and Mr Waters became directors of Divali.  The Papallos acquired 27,998 shares and Mr Waters 9,332 shares.  Mr and Mrs Papallo lent sums in excess of $100,000 to Divali secured by a deed of charge over the company’s assets and undertakings.  During 1990 Mr Papallo worked full time for Divali, some of that time without remuneration and for another period for substantially less than he might reasonably have expected.

Divali did not trade successfully.  For the balance of the financial year ended 30 June 1989 it had an operating loss of $7,493.86.  For the 1990 year there was an operating loss of $139,820.11.  During 1990 and 1991 relations between Mr Papallo and Mr Waters deteriorated seriously.  In September 1991 Mr Papallo accused Mr Waters of diverting debtors’ payments to himself and other unfair and dishonest conduct.

In the meantime, in July 1991, Mr Waters, without the knowledge of Mr and Mrs Papallo, acquired Sterileair, it being then a shelf company.  Mr Waters registered himself as the holder of one share.  He intended that Mr Papallo should hold the other share.  Mr Papallo, whose evidence was generally accepted by his Honour, said in evidence that he knew nothing of the existence of Sterileair until mid September 1991 when an accountant telephoned him and said that she was preparing a new shelf company and needed his signature as a director.  Mr Papallo sent a fax to the accountant insisting that any proposals for restructuring Divali would come from him or his solicitor in writing.  He then taxed Mr Waters with this discovery.  Mr Waters threatened that he would use Sterileair in opposition to Divali with Mr Papallo only being a 50 per cent shareholder, rather than the current 75% - 25% arrangement. 

Further discussions continued in November, the upshot of which was an agreement that the parties would arrange to close down Divali and have it wound up.  In the meantime they would transfer all of the assets and liabilities, including the Papallo debt, to Sterileair.  A new loan agreement would be drawn up by a solicitor and a new charge given to replace the existing one given by Divali.

Mr Papallo and Mr Waters then approached Mr David Mills, a solicitor chosen to act for both parties to draft the necessary documents.  Mr Papallo said in evidence that, in the absence of Mr Waters, he gave the following instructions to Mr Mills:

“I have put a lot of money into this company.  Andrew and I have not been getting on terribly well recently, there’s been a fair bit of trouble with money.  I’m getting out and I’m handing over my shares and everything to Andrew on the understanding that he takes over all of the debts of the company and in return the company pays me the sum of $100,000 which I’m owed.”

The loan agreement was subsequently prepared.  It included the recitals and terms already referred to.  It was executed on 20 December 1991.

In the meantime, on 13 December 1991, Mr Papallo executed various documents including his resignation as a director of Sterileair, a transfer of one share in that company to Mrs Catherine Wyles (the mother of Mr Waters), his resignation as a director/secretary of Divali and a share transfer form in respect of the shares held by Mr and Mrs Papallo in Divali. 

At this time Sterileair was still a dormant shelf company which did not trade and had no assets or liabilities. 

After December 1991 Mr Papallo ceased to work for Divali.  In a manner which his Honour described as “seamless and informal”, and at a time which could not be pinned down with any accuracy, Divali ceased to trade.  Whatever assets it had were taken over by Sterileair which assumed at least some of its liabilities and continued to conduct the business formerly conducted by Divali.  His Honour held that this business did have “some value”, of which Sterileair obtained the benefit.  As already mentioned, Sterileair made payments under the loan agreement up until November 1995.  Divali was on 16 July 1992 wound up on the ground of insolvency on the application of its worker’s compensation insurer, who was owed $9,068.13 for arrears of premiums. 

The judgment below

Apart from dealing with some issues which have not been agitated on appeal, his Honour’s findings were as follows.

His Honour found the loan agreement of 20 December 1991 was not a sham.  The original agreement (ie the agreement for quitting Divali) to which Mr Papallo deposed was consistent with the events which followed.  The effect of that agreement was that the business undertaking and assets of Divali would be taken over by Sterileair; the liabilities included $100,000 of the sum owed by Divali to Mr and Mrs Papallo (the Papallos were, on their case, owed a significantly greater amount).  If the agreement did not involve a formal release of debt or security, it certainly involved a binding assent to a course of action which would render valueless any claim which Mr and Mrs Papallo might have had against Divali.  The terms of the agreement required also that Mr and Mrs Papallo transfer their shares in both Divali and Sterileair to interests associated with Mr Waters, and that Mr Papallo resign from any offices he held in either.  Mr and Mrs Papallo gave up something of value and Sterileair acquired something of value.  Thus the agreement was supported by consideration and was binding and enforceable.  The loan agreement embodied some of the terms of the total agreement, but not all of them.  To the extent that the loan agreement recited a consideration which was not the true consideration, it was inconsistent with the other terms of the agreement and simply as a matter of construction of the agreement as a whole, the recital as to Sterileair agreeing to advance a loan of $100,000 could and should be disregarded.  His Honour could see no reason why rectification would not be available if it were necessary.  His Honour accordingly rejected Sterileair’s case based on sham.  

Section 205 relevantly provided:

“(1) Except as otherwise expressly provided by this Law, a company shall not:

(a)whether directly or indirectly, give any financial assistance for the purpose of, or in connection with:

(i)the acquisition by any person, whether before, or at the same time as, the giving of financial assistance, of:

(A)shares … in the company: …

…

(4)For the purposes of this section, a company shall be taken to have given financial assistance in connection with an acquisition or proposed acquisition referred to in paragraph (1)(a) if, when the financial assistance was given to a person, the company was aware that the financial assistance would financially assist:

(a)the acquisition by a person of shares … in the company; …”

His Honour’s conclusions were as follows:

“It may be accepted that s 205(4) is not exhaustive of the requisite kinds or degrees of connection: Darvall v North Sydney Brick and Tile Co. Ltd (1987) 12 ACLR 537 at 561; see also the judgments on appeal, (1989) 15 ACLR 230. But, on the view I have taken of the matter, the essence of the present transaction was that the business of Divali, including its assets and its liabilities (the liabilities including a reduced obligation to Mr and Mrs Papallo) should pass to an entity controlled by Mr Waters. That object could, no doubt, have been achieved in a number of ways: ways other than those chosen might have included a simple acquisition by Mr Waters and his mother of all the issued shares in Divali coupled with a reduction in the amount owed by Divali to Mr and Mrs Papallo and a renegotiation of the terms of payment: another might have been a transfer of the business, assets and liabilities to a new company formed for the purpose by Mr Waters and his mother. Neither of those transactions would have involved financial assistance infringing s 205. Of course, I am required to consider the legal consequences of the transaction actually entered into, not hypothetical transactions which might have had a similar ultimate result. But a comparison between the actual and hypothetical transactions demonstrates, I think, that it is artificial in the extreme to regard the applicant’s assumption of the obligation to Mr and Mrs Papallo as providing financial assistance in connection with the acquisition of Mr Papallo’s share in the applicant. Certainly I think there is no intelligible sense in which it can be said that the assumption of the obligation was assistance for the purpose of the acquisition. Both the terms of s 205(4) and the judgments in Darvall, in my view, suggest that a relevant connection exists where it may be said that, albeit indirectly, what was done by a company financially assisted the acquisition of its shares. That is not, I think, a sensible description of what happened here, particularly given the circumstances in which (assuming he did so) Mr Papallo came to hold a share in the applicant in the first place. In short, I conclude that the making and carrying out of the contract which I have found did not infringe s 205.”

Sham

The recital to the loan agreement recorded an event which did not in fact occur and which it was never intended would occur.  Mr and Mrs Papallo did not lend money to Sterileair, at least in the sense of lending “new money” to it.  However this undoubted fact does not in our opinion lead to the conclusion that the whole transaction was a sham.  The essence of a sham is that something is not what it appears to be; that underlying the appearance of the transaction is a different reality, so that, for example, what appears to be a transfer is intended by the parties to be a mortgage:  Scott v Commissioner of Taxation(Cth) (No 2) (1966) 40 ALJR 265 at 279, Snook v London & West Riding Investments Ltd [1967] 2 QB 786 at 802, Sharrment Pty Ltd v Official Trustee in Bankruptcy (1988) 18 FCR 449 at 454-458.          

However in the present case appearance and reality coincided.  The parties intended that Sterileair should pay a sum of $100,000 with interest over a ten year period to Mr and Mrs Papallo.  The parties intended that the Papallo shareholdings in Divali and Sterileair should be transferred to interests associated with Mr Waters.  The commercial reality was that Mr Waters and Mr and Mrs Papallo had agreed to go their separate ways, that Mr Waters would make, as it were, a fresh start in the same business with Sterileair and that Sterileair would take over the existing liability of Divali to the Papallos.

Counsel for Sterileair argued that the transaction was a sham because some subsequent purchaser of the Waters’ interest in Sterileair would be deceived into thinking that the Papallos had in fact lent $100,000 to Sterileair.  It is true that at the end of 1991 there was some mention of Mr Waters possibly selling his interest at some time in the future and the loan agreement makes express provision for that eventuality:  cl D.  And as it happened, such a sale did in fact take place.  But on this argument, as at 1991 the Papallos were joining with Mr Waters in a plan to deceive some hypothetical future purchaser.  What reason the Papallos would have for taking part in such a scheme was not explained.  Nor is it apparent why the parties should, in 1991, have assumed that Mr Waters would not disclose to any future purchaser the true nature of the transaction, which after all was hardly a novel one.  In any event, even if there was a plan to include a false recital with a view to the deception of a potential purchaser, that is not a reason for treating the agreement as unenforceable as between the original contracting parties, when the obligations specified in the agreement were obligations which the parties intended that Sterileair should assume. 

In our opinion, the learned trial judge was correct in rejecting the sham argument.

Financial assistance for the acquisition of Mrs Wyles’ share in Sterileair

In Charter House Investment Trust Limited v Tempest Diesels Ltd [1986] BCLC 1 at 10 Hoffman J said, speaking of “financial assistance”,

“The words have no technical meaning and their frame of reference is in my judgment the language of ordinary commerce.  One must examine the commercial realities of the transaction and decide whether it can properly be described as the giving of financial assistance by the company, bearing in mind that the section is a penal one and should not be strained to cover transactions which are not fairly within it.”

The authorities are comprehensively reviewed by Goldberg J in Milburn v Pivot Ltd (1997) 149 ALR 439 at 466-472. We gratefully adopt his Honour’s analysis.

In our opinion it could not be said that there was here any financial assistance for the purpose of or in connection with the acquisition by Mrs Wyles of her one share in Sterileair.  That share was in all probability in fact worthless at the time of its acquisition by Mrs Wyles.  At any rate there was no basis for saying that it was worth more than its nominal value of $1.  Mrs Wyles thus did not need to be “put … in funds to acquire” the share:  Cashmere Pacific Ltd v New Zealand Dairy Board [1996] 1 NZLR 218 at 224. There was not here something that was “wanted or needed by the purchaser for the purchase”: Independent Steels Pty Ltd v Ryan [1990] VR 247 at 254.

“Assistance” involves something in the nature of aid or help.  It cannot exist in a vacuum; it must be given to someone.  No assistance was given by Sterileair to Mrs Wyles as the purchaser of the share.  Whilst an obligation was incurred by Sterileair in favour of Mr and Mrs Papallo, it was not for the purpose, or for purposes which included the purpose, of facilitating the transfer of the share from Mr Papallo to Mrs Wyles.  Nor did the incurring of the obligation have that effect.  The incurring of the obligation did not infringe the underlying principle that persons who acquire shares in a company should do so from their own resources, and not with the financial assistance of the company itself. 

The business Divali was about to quit had some prospects; Mr Papallo thought it was “about to turn the corner”.  Subsequently the business under the ownership of Sterileair proved to be profitable.  But this does not mean that Mrs Wyles needed, or obtained, financial assistance in connection with the acquisition of her one $1 share.

Not only was there in our opinion no “financial assistance” for the acquisition of the share, there was not the necessary purpose or connection which s 205 requires. (Counsel for Sterileair put his case only on the “in connection with” limb of the section.) While the covenant of Sterileair under the loan agreement undoubtedly involved a “diminution in the company’s resources” (see Burton v Palmer [1980] 2 NSWLR 878 at 881), that was for the purpose of, or in connection with, the acquisition of the assets of Divali. The commercial reality was that for Mr Waters’ vehicle, Sterileair, to get access to the business of Divali so that he could carry it on free from interference by the Papallos, Sterileair had to take over Divali’s debt to them. Viewed in this light, the acquisition of Mr Papallo’s share in Sterileair was no more than a tidying up.

Burton is a helpful guide, being a fact situation quite close to the present case. The plaintiff and the defendant had operated a private company but had fallen out and agreed to go their separate ways. Two deeds were executed, one providing for the sale by the plaintiff to the defendant of the plaintiff’s shares in the company and the other for the payment by the company to the plaintiff of money alleged to be owing to him. The company’s obligation under the latter deed was guaranteed by the defendant. The plaintiff sued for the balance due under both deeds. The NSW Court of Appeal upheld the rejection by the trial judge of an argument that the transaction contravened s 67 of the Companies Act 1961 (NSW), the then equivalent of s 205.

Mahoney JA (with whom Samuels JA generally agreed) in dealing with the defendant’s submission that the transaction as a whole contravened the section said (at 885):

“This submission, reduced to its essentials was: that the plaintiff would not have entered into the transaction for the sale of the shares if he had not been assured that the company would pay to him the amount which (it is assumed for this purpose) it owed to the plaintiff; that the company covenanted to pay that amount to the plaintiff; and that that constituted the provision of financial assistance in connection with the transfer of the shares.  I think it should be accepted that the plaintiff, if he was to sell his shares to the defendant and Mr Bretton, would have desired to sever all connection with the company and that therefore he would not have been prepared to sell his shares without the company providing for the discharge of its indebtedness to him; the plaintiff, as I understand his submissions, did not significantly contest this.  It is, in my opinion, not to be seen as unusual that a shareholder in a private company should have such a requirement.

I do not think that the mere agreement of the company to pay its present indebtedness is ‘financial assistance’, even if the agreement be made to satisfy a condition imposed by the vendor of its shares.  (I put aside for this purpose cases in which the company does financially what it is not obliged to do, eg, pays a debt earlier than it was legally obliged to do; I shall refer to this kind of case subsequently.)  It has been said that if a company owes money to the purchaser of its shares, it may discharge its debt to the purchaser so that he can pay the vendor and may itself draw a cheque in favour of the vendor of the shares for this purpose:  Spink (Bournemouth) Ltd v Spink [1936] Ch 544 at 548, 549. A fortiori, a company which owes money to the vendor is, in my opinion, not required, under pain of contravention of s 67, to refuse to pay that which it is obliged to pay. For it to make such a payment, or to make arrangements for that purpose, does not, I think, constitute the giving of financial assistance.”

Mahoney JA then referred to what he described as the “special case” of E H Dey Pty Ltd (in liquidation) v Dey [1966] VR 464. His Honour commented as to that case:

“McInerney J held that what had happened constituted the giving of financial assistance, for two reasons:  because it assisted the purchaser to obtain a reduction in the amount of money which they would have been required to find in payment for their shares; and because it enabled the vendor to ask or accept a lower price for his shares than he would have been required to have if he had been required to pay the debt to the company (at 470).  I would, with respect, think that his Honour’s decision was clearly right:  the company gave up a valuable right for no return to itself and for the purpose of enabling the sale of its shares to be effected.  Both the form of the transaction and the financial reality of it were inconsistent with the section.

However, I do not feel able to accept as correct the recent decision in Armour Hick Northern Ltd v Whitehouse (The Times, 26 August 1980).  This was a decision of Judge Mervyn Davies, sitting as a High Court judge.  A full report of his Honour’s decision is not presently available.  In that case, the company owed money to the proposed vendor of the shares and the indebtedness was due and payable.  The vendor was ‘only willing to sell those shares if the indebtedness … was discharged in full’.  His Honour held that the company, in paying its indebtedness, gave financial assistance in connection with the transfer of shares.  This gives to ‘financial assistance’ and, in particular, to ‘assistance’ a meaning which, I think, the words do not bear and goes beyond what I take to have been the purpose of the section.”

Later Mahoney JA said (at 887):

“The present submission does not rely on the suggestion that, if the company did not pay to the plaintiff what it owed him, the purchasers would have had to pay it, that is, it does not suggest that the purchasers were relieved of a financial burden which they would otherwise have had to bear or that they were being provided with money to discharge the financial burdens which they would otherwise have had to bear.  What the company did was to enable the transaction involving the purchase of its shares to go forward but what it did for that purpose was merely to pay what it presently owed.  If, apart from the proposal for the sale of its shares, the plaintiff had demanded that the company discharge its indebtedness to him, he would have been entitled in law to have it do so.  It would be expected that a company, assuming an indebtedness of this kind, would act properly and reasonably on the receipt of such a demand and meet its just obligations.  The alternative would be for it to refuse to pay, to be sued, and, in the end, to be forced to pay with costs.  I do not think that it was the purpose of s 67 to require a company, merely because the demand was made in the context of a proposal for the sale of its shares, to do otherwise than what it would ordinarily have been proper for it to do.  I do not think that the words ‘give any financial assistance’ require the adoption of such a view.  I therefore do not think that this submission should be accepted.

…

The mere fact that the company co-operated with the parties to the proposed transfer of shares is, of course, not of itself a contravention of s 67. It is perfectly proper for a company which is admittedly indebted to act reasonably and to attempt bona fide to come to an agreement as to the amount of indebtedness where that amount is not immediately apparent. Again, I do not think that s 67 requires a company to refuse to act in this way merely because the reason for the quantification of its indebtedness is that its creditor requires payment in the context of the transfer of shares in the company. The position will be different where the company, for a collateral purpose, agrees to indebtedness in an amount to which otherwise it would not have agreed; and the Court will scrutinize carefully the circumstances of such an agreement; compare Belmont Finance Corporation Ltd v Williams Furniture Ltd (No 2) [1980] 1 All ER 393.  But the present submission is made upon the assumption that the quantification of the company’s indebtedness was made bona fide and the sum arrived at was a proper quantification of it.”

True it is that in the present case the covenant by Sterileair to pay $100,000 plus interest was a fresh obligation and not an existing debt owed by the company, as in Burton.  But it was a genuine transaction designed to secure for Sterileair something of value to it, viz Papallo -free access to the business of Divali.  It was a normal commercial arrangement: Jury v Vogt (1993) 10 ACSR 718. It had nothing to do with providing money or money’s worth which would enable Mrs Wyles to acquire her share. We think therefore that it is not enough to satisfy the “in connection with” requirement to say, as counsel for Sterileair argued, that “but for” the Sterileair covenant to pay the Papallos, the transfer of Mr Papallo’s one $1 share to Mrs Wyles would not have taken place. Whilst “but for” considerations are material, they are not conclusive - the issue remains whether in a practical business sense financial assistance was given by the company in connection with the acquisition of its shares.

The prohibition against a company providing financial assistance for the purpose of, or in connection with, the acquisition of its own shares was first introduced into company legislation in the 1929 Act in the United Kingdom, following upon the recommendation of the Greene Committee in 1926.  It was thought that such transactions offended against the spirit of the rule in Trevor v Whitworth (1887) 12 App Cas 409. The House of Lords in that case held that a company could not purchase its own shares since this would result in a reduction of capital: see Gower, Principles of Modern Company Law (1992, 5th ed) pp 212, 226.  In other words, an outsider, and especially a creditor or potential creditor, should be able to rely on the subscribed capital of the company being represented by assets.  This expectation would be defeated if the company could buy back its shares, or deplete its assets to enable shareholders to acquire shares.

In the present case, no outsider would rationally think that Sterileair’s debt of $100,000 was in some way a diminution of assets for which the one dollar, purportedly subscribed by Mrs Wyles, had been applied. 

Orders

The appeal will be dismissed with costs, including reserved costs.

I certify that this and the preceding ten (10) pages are a true copy of the Reasons for Judgment herein of their Honours Heerey, Tamberlin and Hely JJ

Associate:

Dated:             16 November 1998

Counsel for the Appellant:	C J Bevan
Solicitors for the Appellant:	Schweiger & Co
Counsel for the Respondents:	R E Dubler
Solicitors for the Respondents:	Foulsham & Geddes
Date of Hearing:	9 November 1998
Date of Judgment:	16 November 1998