Eaton v LDC Finance Ltd (in Rec)
[2012] NZHC 1105
•23 May 2012
IN THE HIGH COURT OF NEW ZEALAND CHRISTCHURCH REGISTRY
CIV-2008-409-001140 [2012] NZHC 1105
BETWEEN STEPHEN DESMOND EATON, SEDDON JAMES MARSHALL Plaintiffs
ANDLDC FINANCE LIMITED (IN RECEIVERSHIP)
First Defendant
ANDPERPETUAL TRUST LIMITED Third and Counterclaim Defendant
ANDANDREW JOHN HARDING, MURRAY SCHOFIELD
Second Counterclaim Defendants
Hearing: 20, 21, 22, 23, 29 February and 1, 2, 5, 6, 8, 29 and 30 March 2012 (Heard at Wellington and Auckland)
Appearances: J B M Smith, P R W Chisnall and J D Haig for Plaintiffs and Second
Counterclaim Defendants
D J Goddard QC, P J Woods and N K Caldwell for First Defendant
Judgment: 23 May 2012
JUDGMENT OF FOGARTY J
This judgment was delivered by Justice Fogarty on
23 May 2012 at 11.30 a.m., pursuant to r 11.5 of the High Court Rules
Registrar/Deputy Registrar
Date:
Solicitors:
Gibson Sheat, PO Box 2966, Wellington 6140
Anthony Harper Lawyers, PO Box 2646, Christchurch 8140
Lane Neave, PO Box 13149, Christchurch 8141
Gilbert Walker, PO Box 1595, Shortland Street, Auckland 1140Copy to:
JBM Smith, PO Box 5722, Lambton Quay, Wellington 6145
PRW Chisnall/J D Haig, PO Box 5817, Lambton Quay, WellingtonD J Goddard QC, PO Box 1530, Wellington 6140
EATON V LDC FINANCE LIMITED (IN RECEIVERSHIP) HC CHCH CIV-2008-409-001140 [23 May 2012]
Table of Contents
Introduction ..........................................................................................................[1]
A Narrative of primary facts ..........................................................................[5] F & I’s business ......................................................................................................[5] LDC’s business, with a prospectus .......................................................................[13] Dealings between F & I and LDC........................................................................[17] F & I in receivership ............................................................................................[19] The use of the deposits .........................................................................................[23]
B Do the plaintiffs have a proprietary interest in the $8 million held by LDC? ...................................................................................................................[42] (i) Was F & I in breach of offering securities to the public? .........................[85] (ii) Does s 3(2) exclude some deposits from the breach? ................................[93] (iii) What is the character of the statutory trust, given that the deposits were
used in trading?....................................................................................................[97] (a) The plain language of s 36A ....................................................................[105] (b) Section 36A read in the light of its purpose............................................. [115] (c) Section 36A read in the context of involving the law of trusts ................ [117] Conclusion that there is a trust for a class......................................................... [118] (iv) Whether the sums being pursued by the plaintiffs are the property of this trust? .................................................................................................................[122] Conclusion that the receivables of F & I are trust property ..............................[136]
C Are Perpetual and/or LDC bona fide purchasers for value without notice of the breach of trust? ......................................................................................[137] Does Perpetual have the defence of being a bona fide purchase for value? .....[141] Did LDC have notice on 4 September 2006? .....................................................[160] The test for notice...............................................................................................[162] The Sinclair test..................................................................................................[167] The Macmillan test .............................................................................................[182] Was LDC on actual notice as at 4 September 2006? .........................................[193] Constructive notice of LDC as at 4 September 2006 .........................................[221] Actual notice of LDC in 2007.............................................................................[234] Constructive notice of LDC................................................................................[258] Was Perpetual on notice in 2006 and 2007?......................................................[262]
Subsidiary issues...............................................................................................[276] Re-assignment of the Three Stores and The Tavern loans ..................................[276] Counterclaim by LDC against Messrs Harding and Scholfieldfor breach of warranties ..........................................................................................................[285] Counterclaim by LDC against Messrs Harding and Scholfield and Perpetual seeking a declaration of priority of Perpetual's security interest ......................[301] Recovery of costs of the receivership of F & I ...................................................[304]
Judgment...........................................................................................................[305]
Introduction
[1] The plaintiffs seek relief in equity. This is a representative action. The plaintiffs are representatives of the remaining unpaid depositors of an insolvent money lending partnership which traded as “Finance & Investments” (“F & I”). They are pursuing a sum of about $8 million held by another failed finance company, LDC Finance Ltd (“LDC”). That sum is the cash equivalent of assets realised by the receivers derived from assets of F & I which were either assigned to LDC or over which LDC took a charge in two transactions, one in May 2006 and the other in March 2007.
[2] These proceedings allege that the plaintiffs, as unpaid depositors, have a proprietary interest in that sum being held by LDC. LDC disputes that. Second, LDC argues that even if the plaintiffs have a proprietary interest, LDC has the defence of bona fide purchaser for value without notice. This is a knowing receipt claim. The pleadings also allege a knowing assistance claim, against other parties, which may be the subject of a separate trial. The names of these two parties have been removed from the intituling. There is no issue estoppel in respect of them.
[3] These are the two principal contentions between the parties and are at the heart of the dispute. There are a number of other issues which can be approached as sub issues in the context of these two contentions or side issues.
[4] The parties did not agree on the ordering of issues for analysis. This judgment follows the following organisation:
A Sets out a narrative of the uncontested primary facts of the case.
BExamines whether the plaintiffs have a proprietary interest in the $8 million held by LDC.
CExamines whether LDC (and its trustee, Perpetual) have the defence of being bona fide purchasers for value of the F & I receivables, without notice.
D Subsidiary Issues.
A Narrative of primary facts
F & I’s business
[5] F & I’s partners were Mr A J Harding and Mr M Scholfield. In the 1960s both men were car salesmen and were involved in separate car sales businesses. By the early 1970s they had joined forces and each owned 50 per cent of Andrew Harding Car Sales. Mr Harding had been running a very small finance operation with his car sales business and when they became partners in the car sales they also became partners in that business which they then called “Finance and Investments”.
[6] Of necessity, Mr Harding brought some capital to that business, but it was small, and not proved. The F & I business got its start in financing from a deposit of
$20,000 (a substantial sum in 1973) from Mr Dick Shuttleworth and a deposit of
$60,000 from Mr Lloyd Cole, the owner then of LDC Investments Ltd (“LDCI”).
This was by a deposit from LDCI to F & I. It is not clear whether the whole of the
$60,000 was taken at once. The scale of the new business was such that F & I did not want to have idle money sitting in the bank. On the probabilities, F & I took the advances from Mr Cole in small amounts. F & I had a separate ledger for the Cole/LDC deposits and ran it under a different business name, Nelson Vehicle Advances. This business was subsequently sold to Finance and Discounts Ltd in
1986.
[7] F & I’s businesses operated like a bank. It had only two operating bank accounts, a cheque account and a call account. The main account was the cheque account. All depositors’ funds were deposited in the cheque account as were interest paid on loans and repayments of loans. Funds were drawn from the same cheque account to meet the business expenses, rent and wages etc, pay profits to the partners, and make loans to lenders, and to repay deposits.
[8] Surplus funds in the cheque account were placed in the call account in order to be placed on term deposit and to earn some interest. Little use was made of overdraft facilities.
[9] In the absence of a prospectus F & I were able to operate without any trustee oversight as to the adequacy of shareholder funds and the ability to repay depositors. F & I were trading on a basis of taking most deposits on call. Some depositors were on six months at an interest rate a percentage above the call rate. The call rate was always higher than that offered by the trading banks. Like banks, F & I was borrowing short and lending long. So it was always vulnerable to a run on its deposits if its depositors lost confidence.
[10] In 1978 the Securities Act 1978 (“the Securities Act”) was enacted. The prohibition against allotting securities offered to the public without a prospectus came into effect when s 37 of the Securities Act came into force on 1 September
1983. Prior to that time there was no obligation on F & I to trade under a prospectus.
[11] The purpose of the Securities Act is to ensure that before the public subscribe for securities they have access to reliable financial information enabling them to make an informed judgment as to whether to invest or not. The content of this information is scrutinised and its continuing validity supervised by both trustee and by a government agency, then the Securities Commission. These various obligations tend to be summarised by saying that the business has to operate within the terms of its prospectus. Any would be investor is provided with an investment statement and informed that there is a registered prospectus. Typically a registered prospectus will set limits on the liabilities that the business can assume, broken down into classes,
relative to the businesses shareholder funds.1 The content is fixed by regulations
made under the Act.2 If these limits are broken the trustee intervenes and the business can no longer trade normally, and indeed, it can only trade according to directions of the trustee, while in breach of the prospectus.3 As we will see, this
predicament happened twice to LDC. It needed more capital before it could register
1 See Securities Regulations 2009, Schedule 2, r 14(1)(c)(ii).
2 See Securities Act 1978, s 39; Securities Regulations 1983, Part 1; Securities Regulations 2009, Part 1.
3 See Securities Act 1978, s 49; Securities Regulations 2009, Schedules 2 and 15.
a new prospectus. It accessed more capital on two occasions, both from F & I, one each in 2006 and 2007.
[12] F & I did not, however, change its manner of business to comply with the Act. Messrs Harding and Scholfield received, they said, legal advice that they did not need a prospectus because they were not advertising or otherwise actively soliciting deposits. They also believed that because they were trading as a partnership rather than limited liability company, that meant the Act did not apply.
LDC’s business, with a prospectus
[13] The business of LDC was started by Mr and Mrs Cole, as LDCI. In 1990 a significant borrower of LDCI was unable to repay its debt. One of the partners of Carran Miller, a Nelson firm of chartered accountants, was a guarantor of this debt. This led to LDCI being acquired in 1999 by the partners of Carran Miller. As it happened, prior to this acquisition, Messrs Harding and Scholfield had been intending to acquire the business and had in that context been appointed directors of LDCI for a few months. In the end they did not participate in the sale. They retired as directors.
[14] In early 2004, the New Zealand Institute of Chartered Accountants, in the course of a regular review of Carren Miller Ltd, questioned the directors of LDCI as to whether or not LDCI was compliant with Securities Act in respect of offerings to the public. As a result of that review the directors informed the Securities Commission of the current operations of the company. The Commission ruled that LDC was not compliant due to subscriptions being received from the public as a result of application forms and deposit slips being made available at the counter. Following this ruling by the Commission, LDC was incorporated on 5 February
2004. It purchased the business of LDCI. On 18 June it entered into a debt securities trust deed with Perpetual Trust Ltd. LDCI and the directors of LDCI, Mr Miller and Mr Elliott, entered into an enforceable undertaking to the depositors with LDCI. This undertaking is dated 3 September, but records:
8.As at the date of this undertaking LDC Investments has confirmed that –
(a) LDC Investments has informed persons who currently hold securities allotted in possible breach of the Securities Act of their rights in terms of section 37 of the Securities Act; and
(b) LDC Investments has offered each such person the opportunity to either have their original subscription refunded together with interest (if applicable) or offered, via LDC Finance, to invest their original subscription together with interest (if applicable), in new securities on the basis of the investment statement of LDC Finance.
[15] By this mechanism Carren Miller Ltd were able to transit from LDCI operating in breach of the Securities Act to LDC, as a compliant business. But as part of that process they had to offer to refund all the deposits made to LDCI.
[16] In December 2004, Eagle Finance Ltd, a company formed by Mr John Jannetto, and with a prospectus, was acquired by LDC. The firms merged in 2004 and Mr Jannetto was appointed director of LDC and became managing director of LDC.
Dealings between F & I and LDC
[17] In September 2006, F & I purchased preference shares in LDC for the sum of
$1.5 million. This was financed by a loan from LDC to F & I of the same amount. In the same transaction, LDC agreed to provide working capital to F & I of
$500,000, a sum which later increased to in excess of $700,000 plus interest. The indebtedness of F & I to LDC was secured by a security interest under the Personal Property Securities Act 1999 (“PPSA”).
[18] In March of 2007, there was a further transaction between the two companies. F & I purchased 25 per cent of the ordinary shares of LDC and in consideration assigned the benefit of four major loans to LDC, who thereby acquired an equitable interest in those loans.
F & I in receivership
[19] F & I and LDC both suffered a run by depositors in 2008 at the same time. They both went into receivership, LDC appointing the receivers of F & I. The
receivers were partners of PricewaterhouseCoopers (PwC). The firm already had experience with both businesses.
[20] At the time of the receivership of F & I, its liabilities consisted of unsecured investor claims (depositors) amounting to $15,935,943; an advance of $2.896 million from LDC; and a bank overdraft of $192,008.
[21] As to assets, at the date of receivership F & I had 706 loans outstanding with a total face value of $13.3 million. However, those loans along with the other assets were subject to LDC’s secured interest granted in 2006 and the equitable assignment of four major loans granted in 2007. During the F & I receivership, LDC enforced its secured interest charge over F & I’s assets, and the assignment of the F & I loans, and collected the sum of $7,792,197.36. This sum is being held on an interest bearing deposit pending the outcome of this litigation; it is now about $8 million.
[22] In addition, F & I had a little cash in the bank, some fixed assets of low value including general office equipment, furniture and computer assets, a property in Kaikoura, and its 25 per cent shareholding in LDC. (The latter was not really an asset as LDC was also in receivership and it was unlikely there would be funds available to F & I.) The balance sheet insolvency of F & I is unknown and not relevant in this case. What is relevant is that there are now no outstanding creditors of F & I except for the remaining unpaid depositors, LDC and the bank.
The use of the deposits
[23] As already noted, F & I operated like a bank. The Court had the benefit of two excellent briefs of evidence from two expert forensic accountants, Messrs M P Stiassny for the plaintiffs, and Mr P J Munro for the defendants. In every material particular the two experts agreed. The common context of both of their instructions were to examine LDC’s proposition that the assets held by LDC cannot be traced back to the depositors with F & I.
[24] Mr Stiassny’s instructions were stated by him as follows:
I understand … that it has been suggested by LDC that relative entitlement to the proceeds should be determined (at least in part) by tracing the proceeds back to the contributors of the funds comprising the advance being repaid by each instalment of the proceeds.
In that context we have been asked to:
(a) carry out a tracing analysis of a sample loan or loans;
(b) provide our view as to the availability and efficacy of tracing through F & I’s bank account to determine the composition of specific loan receivables at issue, and also to determine what would be required to trace individual depositor’s funds through into specific finance receivables;
(c) analyse F & I’s financial information to determine the
sources and uses of its funds overall;
(d) trace the use of LDC payments to F & I; and
(e) analyse F & I’s current bank account and call bank accounts to identify instances when they were overdrawn.
[25] Mr Munro stated his instructions as follows:
The four areas that I have been requested to investigate are:
(a) whether or not funds deposited into F & I’s bank account
were able to be traced to any loan advance;
(b) whether F & I’s cash position went into overdraft;
(c) whether I was able to identify the funding source of certain receivable assets (otherwise known as “the Assigned Loans”) received by LDC from F & I as part of a recapitalisation transaction prior to the respective receivership appointments; and
(d) whether I was able to identify the use by F & I of funds deposited by a number of depositors.
[26] Transactions with depositors’ funds were recorded as transactions between the depositor and F & I and transactions with borrowers were recorded as transactions between F & I and the borrower. No record was maintained as to how a receipt from a borrower was applied either:
(a) among depositors who were due repayments at the times the funds were available; or
(b) to further loan advances; or
(c) to F & I’s own purposes.
[27] F & I’s accounts were collected by way of electronic record. It was common ground that the computerised records were accurate.
[28] Because all F & I’s business was transacted through the current bank account, all money borrowed by the partnership and contributed back into the business by the partners, repayments of loans and two payments of $500,000 each, were mixed in the current bank account.
[29] The partners of F & I do not assert any claim to the funds recoverable from F
& I receivables. Since the receiverships, the F & I partners have contributed their personal assets to the common pool for the benefit of depositors.
[30] Mr Stiassny considers that the above facts are relevant to the characterisation of the competition for the funds in this case between LDC and the unpaid depositors of F & I. He says:
This is not a case involving competition among F & I depositors themselves (as I am aware arises in the context of receiverships where several creditors may claim a special interest in funds or property). No individual depositor is attempting to claim his or her money back from F & I in whole or in part. Instead the depositors into F & I are all claiming together as one group against LDC as the entity who received and holds the funds at issue.
[31] It was, therefore, Mr Stiassny’s position:
I consider there should be no need to analyse individual depositors’ deposits because of the depositors’ agreement to share in proportions. The depositors’ funds should in my opinion be able to be aggregated and treated as one.
[32] Notwithstanding that qualification, Mr Stiassny then examined whether there were any tracing exercises attributing LDC’s receivables, making up the $8 million to any one depositor was possible. His answer is no. Mr Munro agrees.
[33] In addition to the constant mixing of all funds through one bank account, LDC contends that there is a difficulty for the plaintiffs in the composition of the $8 million. Mr Stiassny explains it this way:
There is real difficulty in ascertaining what of F & I’s loan receivables were realised by PWC to comprise the total $7,792,197.36 taken (in payment of what PWC had calculated F & I owed to LDC). I understand the relevant cashflows are a combination of funds taken from the F & I bank account, and funds received by LDC or others direct into their own bank account. For example, the The Tavern (F1009) and Three Stores Limited (C1245) are individual loans as specified in F & I’s ledgers. But we have been informed that The Tavern and Three Stores loans were in fact not realised by PWC. Those loans were transferred back to F & I for collection and PWC simply took the balance of those loans outstanding from F & I’s current bank account. So while the collections may be attributed to these nominated loans, the actual funds as appropriated were from other sources. In addition we are not aware of what receivables comprised the balance of funds taken as given in the references ‘F & I (12727)’ and ‘F & I (12728’) and ‘F & I current account (GL6123)’.
[34] Mr Stiassny addressed past overdrafts:
I note that F & I’s current bank account was overdrawn on a number of occasions. Even after offsetting credit funds available in the call (interest bearing) bank account, the net balance was negative on 32 occasions in the period we have reviewed. I understand an overdrawn account can present issues as to tracing however, I consider in this instance it would be reasonable to aggregate the loans ledgers with the bank accounts such that the total of those assets would be treated as the value of the tracing facilities. I form this opinion on the basis that neither the bank, nor the partnership, is claiming the funds at issue. The sole point of such a tracing exercise would be to establish the interests of the Depositors and LDC such that, in my view, the interests of other parties might be put to one side.
[35] Mr Stiassny did not think it was practical at this time to trace the funds at issue to the standard of “the legally acceptable principles”, which he did not define. He said if indeed it were possible:
… the volume of transactions would render such an exercise inordinately expensive and the results would necessarily simply reflect the rules adopted such that the outcome would be of limited relevance when the F & I depositors have already agreed to put aside the competition between their claims in order to share pro rata.
[36] However, as instructed, his team endeavoured to do that analysis and concluded it was futile.
[37] Mr Munro’s brief responded to Mr Stiassny as well as setting out his views. Mr Munro presented a useful summary of his findings which I set out in its entirety. With one exception, 6.5, his summary records the consensus between the two experts:
6.1All depositor funds were deposited into the F & I Cheque account and intermingled with other types of funds. As the funds were mixed and there is no one irrefutable tracing method that can be used, the deposits cannot be traced to any one particular loan advance (or to a group of loan advances);
6.2F & I’s Cheque account was overdrawn on 182 working days between 2 October 2001 and 6 September 2007. I agree with Mr Stiassny that the total cash balance was overdrawn at least 32 times, which includes the 6 working days prior to receivership;
6.3Due to the sheer volume of transactions through the Cheque account and intermingling of funds, direct tracing or matching of investor deposits with loan advances is not clear. Investor deposits are not available to be traced to individual loan advance transactions, specifically they cannot be traced to the Assigned Loans;
6.4Due to the volume of transactions and the fact there is no defined method to determine the order of priority of the tracing of funds (it could be argued numerous different ways of how the deposits were applied by F & I, with no one argument better than another) tracing is not able to be completed on the use of the depositors’ funds;
6.5My views align with the evidence presented by Mr Stiassny in terms of the intermingling of funds limiting the specific traceability. However, there are a few points of analysis that Mr Stiassny puts forward that I believe are legal argument to be decided by the Court, namely:
(a) The aggregation of depositors’ claims as one (which he
suggests may eliminate the need for tracing);
(b) The aggregation of the bank account overdrafts with the loan ledger (which he suggests is relevant to the issue of whether the overdraft position affects the ability to trace).
6.6Mr Stiassny also proposes evidence around possible tracing rules (i.e. FIFO [first in first out] on a whole day basis) but acknowledges that there are different approaches that could be applied and which would result in a different outcome. I concur with this position and note that differing approaches would give different outcomes.
[38] There is complete agreement between the experts on propositions 6.1 – 6.4 and 6.6. As to 6.5, Mr Stiassny states his view. It is essentially a legal viewpoint and one upon which Mr Munro properly did not join. I received Mr Stiassny’s views
in this regard as part of the totality of his evidence, but do not rely on the prescriptive legal elements of his opinion. Later in this judgment I will come back to the significance of the fact of aggregation of claims by the unpaid depositors.
[39] The bulk of the briefs of Mr Stiassny and Mr Munro were demonstrating the conclusions that they reached, by way of specific examples of futile analyses. I am not going to burden the length of this judgment by going to the examples.
[40] Significantly, both accountants have a similar view as to the character of various rules of tracing such as FIFO which can be drawn from different cases. Mr Munro put it this way:
7.14There are numerous methods that can be applied to attempt to trace any particular funds intermingled with other deposits in an account. Each method has its own rules to abide by, to remain consistent in the treatment of the funds. From an accounting perspective, I agree with Mr Stiassny’s statement that “there is no demonstrative history of support for them [rules for tracing] and I accept that another analyst could come out with another set of equally supportable, but similarly equally challengeable rules that would produce a different result.”
[41] Mr Munro goes on to make these practical points:
7.15Any principle that was to order transactions that happen within a day would be unworkable (Mr Stiassny concedes this). Not only would this be due to the impracticability of working out the timing of when the transactions actually occurred during the day, but in reality, due to New Zealand’s banking system, all transactions are processed overnight at the same time, meaning no order can be ascertained. The only exception is if a transaction is processed as a same day payment.
7.16Mr Stiassny chose to analyse the transactions applying the FIFO principle on a whole day basis. At first this approach seems reasonable; however this principle will not provide a realistic picture of the situation where the funds have been deposited, for a particular purpose, to be withdrawn the same day.
7.17For example, it could be reasonable to believe that F & I management transferred funds from the Call account to cover loan advances that were to be paid out of the Cheque account on the same day.
7.18This is relevant to the example given in Mr Stiassny’s brief of evidence of the analysis of the sources of the $650,000 advance to Three Stores Limited, as there was a $630,000 transfer from the Call
account to the Cheque account (on the same day as the $650,000 was advanced) which, under the analysis of Mr Stiassny’s brief, was not accounted for as a potential source of funds for the advance.
7.19Also, another quandary for an analyst is to how to order the transactions in the following day. Are they to be sorted large to small or vice versa, alphabetically by product or depositor, or by some other way? All scenarios would produce a different result.
B Do the plaintiffs have a proprietary interest in the $8 million held by
LDC?
[42] The pervasive argument for LDC is that inasmuch as an F & I depositor is the beneficiary of a trust, that depositor has lost any right to the funds held by LDC because of the inability to trace. Indeed, from the time that the funds were used by F
& I for lending or any other purpose, a proprietary interest on those deposits was lost and the individual plaintiffs’ depositors were confined to a personal claim against the trustees of the trust. Mr Goddard QC put it this way in his mini-opening: “[The case law on tracing into a mixed fund] only apply if LDC was paid out of a mixed fund that included the depositors’ money.”
[43] Mr Goddard QC acknowledged that the Court was likely to find there was some trading by F & I in breach of the Act, so that there had to be a trust of some sort. Later in this judgment I will be examining the nature of that trust. It drives off the application of s 36A of the Securities Act. Section 36A provides:
Subscriptions must be held in trust
An issuer must ensure that subscriptions for securities offered to the public are held in trust for the subscribers until the securities are allotted or until the subscriptions are repaid to the subscribers under this Act. (Emphasis added)
[44] Before going into the question of the extent to whether or not F & I was offering securities to the public and so triggering s 36A, it is appropriate to set out the cornerstone argument of LDC.
[45] The argument by the defendants against tracing centres upon a different description of the trust. The defendants argued that the trust established by s 36A is a separate trust for each individual subscriber, who can assert an individual claim to
the funds he or she paid to the issuer only if those funds are identifiable. Mr Goddard submitted:
In circumstances where there is no statutory provision for pooling of investor funds in a single trust, but rather separate trusts for each subscriber whose funds are received, there is no collective beneficial claim to assets shared by the body of investors as a whole. Each has an equitable right to his or his own funds, and can sue to protect that right separately from – and potentially in competition with – the other investors.
…
In a case where the claim is proprietary, that means that the represented group can make out ownership rights in respect of particular assets only by showing that one or more members of the group hold those rights. The essential starting point remains the funds paid over to F & I by members of the group, and a process of tracing of those funds into the assets that the plaintiff group claims as now representing their funds.
[46] “Ownership rights” or, more commonly, “a proprietary interest” should not be confused with the common law of property. A proprietary interest to an equity lawyer is simply a claim which equity will recognise of a beneficial interest in property.4
[47] Mr Goddard argued:
… it is important to bear in mind that the inquiry begins while the assets are in F & I’s hands, and that if at any stage it ceases to be possible to follow a plaintiff depositor’s funds into identifiable assets in the hands of F & I, that plaintiff depositor has no proprietary claim to any assets of F & I, or to the assets subsequently disposed of by F & I. …
Thus for example if a depositor’s money was paid into the F & I account while it was overdrawn, the depositor has lost the ability to trace because there is no longer an identifiable asset in which that claimant can assert a beneficial interest: Re Registered Securities Ltd [1991] 1 NZLR 545 at 554.
[48] The material facts, however, of Re Registered Securities Ltd are important. When these are taken into account, the case distinguishes itself.
[49] Registered Securities Ltd (“RSL”) was a wholly owned subsidiary of the
New Zealand Mortgagee Guarantee Company (“NZMG”). RSL carried on business
as a contributory mortgagee company. It solicited and received funds from the
4 Sinclair Investments (UK) Ltd v Versailles Trade Finance Ltd [2011] EWCA Civ 247 at [89].
public and purported to advance such funds on contributory mortgages of land for specific investors.
[50] The provision of “contributory mortgages of land for specific investors” is quite contrary to the way in which F & I traded. Depositors with F & I were given no promise at all that their funds would be allocated to specific loans. On the contrary, F & I operated as a bank. By contrast, the persons who deposited with RSL, on the other hand, did so on the understanding that their deposits would be identifiably placed with contributory mortgages.
[51] RSL often lent to unsound borrowers on poor security. At the time of the appointment of provincial liquidators there were 8,500 persons who had made in all some 15,000 payments to RSL for investment in mortgages. RSL then held 206 mortgages; 125 were first mortgages securing $59.76 million and 78 second mortgages securing $38.04 million. Parts of the principal of some mortgages and the whole of one large mortgage had not been expressly allocated to investors. As well, there were 788 separate investments totalling $4.28 million which had been not allocated to any mortgage.
[52] Somers J, who wrote the judgment for the Court of Appeal, said:5
… the primary question is, and has been, whether mortgages purporting to have been allocated by RSL in whole or in part to specific investors are to be dealt with by the liquidators on the footing that those investors are the beneficial proprietors of such mortgages or interests therein or whether the proceeds of the mortgages should be distributed pro rata among all the investors presently unpaid or some class or classes of them and, if so, which.
[53] Pausing here, the issue in Re Registered Securities was one of allocation of receivables amongst the investors. That is a different issue from this case. In this case, all the unpaid depositors have agreed to become a class and have joined together pursuing the litigation. None of these unpaid depositors are asserting any
specific interest in any asset.
5 Re Registered Securities Ltd [1991] 1 NZLR 545 at 547.
[54] In Re Registered Securities in the High Court, Barker J held that investors to whom mortgages were allocated by RSL, as evidenced by certificates issued by it, had a proprietary interest to the extent certified.6
[55] RSL was described in its own literature as being a custodian of its investors’ funds. It did not purport to be trading as a finance company. It was promising specific investments. Clause 20 of its brochure included this proposition:
On receipt, funds are lodged in one of two RSL Trust Accounts – the First Mortgage Trust Account or the Second Mortgage Trust Account. They are then lodged in one or more specific mortgages, and they can be traced as individual investments from the time they are received until they are repaid to the investor on maturity.
[56] These differences in material facts are important for identifying the obligations of the fiduciary (trustee). Obligations of the fiduciary are always specific to each trust. Where express trusts are created, the trustees’ obligations are defined by the terms of the trust. Where trusts are imputed, the fiduciaries’ obligations are defined by the Courts’ recognition of the fiduciary obligation arising in the particular context, by the application of the principle that a person in control of another’s assets cannot use them unconscionably.
[57] Given the way that RSL was operating, it was inevitable that those investors with RSL whose investments were allocated into specific identifiable mortgages were in a different class from those investors whose funds were not so allocated. There are two different classes of beneficiaries.
[58] Where, in a trust, individual investors or groups of individual investors fall into different classes, then different rules can apply. Equity selects rules which achieve justice. It is important to keep in mind that in RSL the Court was dealing with a trust comprising of funds obtained by promising investors that their funds would not be mixed except by way of contribution into a specific mortgage. Thereby the express terms of the RSL trust were to keep apart the separate
investment of each beneficiary.
6 Re Registered Securities Ltd (in liquidation); National Bank (NZ) Ltd v Tuck (1990) 5 NZCLC
66,248 at 66,263.
[59] There are many authorities which recognise that equity selects the appropriate method of doing justice to beneficiaries depending on the context. In Re Registered Securities, the Court of Appeal applied the rule in Clayton’s Case.7 This is the rule that where a trustee mixes the funds of more than one beneficiary and there is a subsequent shortage as between beneficiaries, the money that the beneficiary first paid in is the first drawn out (FIFO). This is one of the “legally acceptable rules” that the two experts endeavoured to apply to the facts of this case, and found futile.
[60] Somers J pointed out:8
The automatic application of the rule in Clayton’s Case as between beneficiaries will not in our view withstand scrutiny. In the first place, the rule is founded on presumed intention. It is in truth a fiction and cannot be allowed to work an injustice.
[61] It is difficult to overstate the importance of that observation of Somers J, which is consistent with dicta in many United Kingdom cases.9 Inasmuch as Clayton’s Case and other like rules are founded on a presumed intention, they cannot be applied to a trust which is expressly founded on a different intention, or to a constructive trust which imposes fiduciary obligations on the holder of a mixed fund, incompatible with such rules. The correct approach in equity is to select such rules
consistent with the particular trust being enforced, and which rules will achieve equity as between the beneficiaries.
[62] As the two expert accountants, Messrs Stiassny and Munro repeatedly emphasised in their evidence that all such rules, e.g. FIFO and LIFO, are essentially arbitrary. They are applied to achieve the goal of doing equity, but only where that is appropriate to the application of a particular trust obligation. It follows that to do equity the context and consequential nature of the fiduciary obligations enforced should dominate the selection of the mechanism used to ascertain the beneficiaries’
rightful claims on any assets.
7 Clayton’s Case (1816) 1 Mer. 572.
8 Re Registered Securities, above n 5 at 553.
9 See for example Barlow Clowes International Ltd (in liq) v Vaughan [1992] 4 All ER 22 at 39 per
Woolf LJ.
[63] It is useful to read in support of the experts’ views, Underhill and Hayton’s
comment on Clayton’s Case:10
Where the assets of two trusts have been mixed (other than in a current banking account) any losses or gains in the value of the mixed fund are shared rateably according to the values of the mixed assets of each trust. Where mixing occurs in a current banking account the rule in Clayton’s Case has traditionally been applied to attribute the first drawings out to the first payments in unless this produces an inequitable result. However, the courts are now so quick to find that application of the rule in Clayton’s Case would be inequitable that it is effectively a dead letter. (Emphasis added)
[64] On the particular facts of Re Registered Securities, one can understand why those investors who were specifically allocated mortgages were in a superior position to the other investors. But it is quite wrong to elevate the decision in Re Registered Securities as to some general proposition that a beneficiary loses the ability to trace because there is no longer an identifiable asset into which that claimant can assert a beneficial interest because the depositors funds had been mixed with other funds.
[65] Before I leave Re Registered Securities, I would note that on my reading of it, Somers J would agree. Here is another comment, carefully qualified, by Somers J at the bottom of page 553:
It must follow in our view that where a trustee mixes the funds of different beneficiaries a withdrawal which is expressly or by implication intended to be to the account of one particular beneficiary must be so treated. In such a case there is no apparent equity in that beneficiary entitling him to impose part of the loss on the other. (Emphasis added)
[66] In this case, however, there was no differentiation by the proprietors of F & I, who were the trustees, as to one particular beneficiary over another except in repaying them when they sought to withdraw their funds. But, of course, those beneficiaries who were repaid are no longer able to make claims against the assets of
the trust.
10 D Hayton (ed) Underhill and Hayton’s Law Relating to Trusts and Trustees (18th ed, LexisNexis, London, 2010) at [90.1].
[67] Essentially, LDC’s arguments against the availability of the remedy of tracing in this case presupposes that one depositor is in conflict with another. This is simply contrary to the facts.
[68] Counsel for LDC and Perpetual, seek to deploy the rule in Clayton’s Case against the plaintiff beneficiaries so as to completely destroy their claim against LDC. The application or not of Clayton’s Case is better decided in an argument between beneficiaries. No such dispute exists here. It is agreed that the $8 million fund reflects the realisable value of the assets of F & I acquired by LDC in the 2006 and 2007 transactions.
[69] As already noted, LDC submitted that the case law on tracing into a mixed fund applies only if LDC was paid out of a mixed fund that included the plaintiffs’ depositors’ money.
[70] LDC counsel were not able to cite any case where beneficiaries’ money had been mixed with other beneficiaries’ money so that as a consequence the beneficiaries only had a personal claim against the trustee and could not follow to the mixed fund.
[71] Secondly, it is a basic principle of trust law that funds invested in breach of trust do not lose the character of being the property held by the fiduciary for the beneficiaries. The fact that it is an unlawful investment or that there were some costs incurred along the way does not mean that the resultant asset is no longer a trust asset. If it is a trust asset it is subject to a claim by the beneficiaries. Underhill and
Hayton formulates the law as this:11
If a trustee or other fiduciary has, in breach of trust or other fiduciary obligation, converted trust or fiduciary property into some other form, the property into which it has been so converted becomes subject to the trust or other fiduciary obligation. If all the beneficiaries or principal and all principals are of full age and capacity, then they can collectively elect to adopt the transaction, and take the property as it then stands; but failing such election, the property must be reconverted if it is not an authorised investment. In that case any gain accrues for the benefit of the beneficiaries or principal and any loss falls on the trustee or other fiduciary. (Emphasis added)
11 Ibid.
[72] If all the beneficiaries’ entitlements are mixed into one fund which contains no other funds in respect of which there are claims by other persons, then equity has no difficulty in allowing the beneficiaries to wind up the trust and make a direct claim to those assets, as is noted by Underhill and Hayton above. This remedy is available even though no individual beneficiary can identify his or her deposit in the mixed fund. Where funds are mixed particularly with the wrongdoer trustee’s assets, then there are various methods deployed by equity all designed to give the beneficiary a remedy. Mixing is not fatal.
[73] As well as arguing that the fund is mixed because all the depositors’ money has been mixed together, LDC argued that there was some capital injected into the business and the business went into overdraft from time to time. As to overdraft, Mr Goddard argued that all depositors’ money that was used to reduce overdrafts is immediately lost leaving those depositors only with a personal remedy against the trustees. Similarly, he argued that where depositors’ money is used to pay the rent, or other costs, or take profits, the deposits are lost.
[74] For the purposes of the analysis, at this stage I want to focus on the proposition that over a period of time the depositors’ funds were mixed with capital introduced by the principals to the business, and we know that at least two lots of
$500,000 was introduced by each partner.
[75] So far as other contributions to the fund are concerned, the position is clear. Re Hallett’s Estate12 provides that where money held on trust is mixed with the trustee’s personal money, the whole of the resulting fund is treated as trust property and can, following a successful tracing exercise be claimed by the trust beneficiaries. The trustees are presumed to act honestly where personal funds and trust funds are mixed and when there is a shortfall the trustee is presumed to intend to deplete their own funds first.
[76] There is no difficulty with beneficiaries who form a class claiming as a class against a mixed fund. The most recent, and much quoted case in this regard, is
12 Re Hallett’s Estate (1879) 13 Ch. Div. 696.
Foskett v McKeown.13 In this decision, Mr Murphy took out a life insurance policy on his own life and later declared the policy and its proceeds to be held on trust for his children. He paid the first two premiums out of his own funds. He paid at least the fourth and fifth premiums by takings funds that were held on express trust for the purchasers of land in a development site in Portugal. There was a dispute between the children and the beneficiaries of the express trust over a share of the proceeds of the policy, after Mr Murphy committed suicide. This is a case which divided the Court of Appeal and the House of Lords. The majority in the House of Lords held that both the children and the purchasers could trace to the proceeds of the policy
rateably according to their respective contributions to the premiums paid.14
[77] Lord Millett described the case as:15
… a textbook example of tracing through mixed substitutions. At the beginning of the story the purchasers were beneficially entitled under express trust to a sum standing in the name of Mr Murphy in a bank account. From there the money moved into and out of various bank accounts where in breach of trust it was inextricably mixed by Mr Murphy with his own money. After each transaction was completed the purchasers’ money formed an indistinguishable part of the balance standing to Mr Murphy’s credit in his bank account. The amount of that balance represented a debt due from the bank to Mr Murphy, that is to say a chose in action. At the penultimate stage the purchasers’ money was represented by an indistinguishable part of a different chose in action, viz the debt prospectively and contingently due from an insurance company to its policyholders, being the trustees of a settlement made by Mr Murphy for the benefit of his children. At the present and final stage it forms an indistinguishable part of the balance standing to the creditor respondent trustees in their bank account.
[78] And:
A beneficiary of a trust is entitled to a continuing beneficial interest not
merely in the trust property but in its traceable proceeds also …16
In principle it should not matter (and it has never previously been suggested that it does) whether the trustee mixes the trust money with his own and buys the new asset with the mixed fund … 17
… it is impossible to distinguish between the case where mixing precedes the investment and the case where it arises on and in consequence of the investment.18
13 Foskett v McKeown [2001] 1 AC 102 (HL).
14 Ibid at 109 per Lord Browne-Wilkinson.
15 Ibid 126-127.
16 Ibid at 127.17 Ibid at 130.
[79] Lord Millett went on to say that in Re Hallett’s Estate Jessel MR acknowledged that where an asset was acquired exclusively with trust money, the beneficiary could either assert equitable ownership of the asset or enforce a lien or charge over it to recover the trust money. But the Master of the Rolls appeared to suggest that in the case of mixed substitution the beneficiary is confined to a lien. Any authority that this dictum might otherwise have is weakened by the fact that Jessel MR gave no reason for the existence of any such rule, and none is readily apparent. Lord Millett cited an abundance of authority critical of the rule, including
the great Learned Hand J who, in Primeau v Granfield,19 expressed himself in
forthright terms:
On principle there can be no excuse for such a rule.
[80] Lord Millett, having quoted these authorities, went on to say:20
Accordingly, I would state the basic rule as follows. Where a trustee wrongfully uses trust money to provide part of the cost of acquiring an asset, the beneficiary is entitled at his option either to claim a proportionate share of the asset or to enforce a lien upon it to secure his personal claim against the trustee for the amount of the misapplied money. It does not matter whether the trustee mixed the trust money with his own in a single fund before using it to acquire the asset, or made separate payments (whether simultaneously or sequentially) out of the differently owned funds to acquire a single asset.
Lord Millett further said:21
Innocent contributors, however, must be treated equally inter se. Where the beneficiary’s claim is in competition with the claims of other innocent contributors, there is no basis upon which any of the claims can be subordinated to any of the others. Where the fund is deficient, the beneficiary is not entitled to enforce a lien for his contributions; all must share rateably in the fund.
The primary rule in regard to a mixed fund, therefore, is that gains and losses are borne by the contributors rateably.
[81] This is exactly what the contributors seek to do in this case. They are the remaining class of unpaid depositors. They are not seeking to recoup any
repayments made to earlier depositors. They are simply seeking, as a class, to
18 Ibid at 131.
19 Primeau v Granfield (1911) 184 F 480 at 482.
20 Foskett v McKeown, above n 13 at 131.21 Ibid at 132.
pursue assets of F & I which on the evidence were substantially acquired by misuse of depositors’ money generally with some historic contribution of small amounts of equity. The trustees who might in theory have made a claim for contributions to equity were the sum being pursued not deficient, are not pursuing this claim. The bank overdrafts have been repaid. Accordingly, it is irrelevant to the tracing exercise that historically the funds of the depositors were mixed with bank credit and some modest equity introduced into the business by the partners.
[82] This analysis still leaves unanswered LDC’s argument that this class of unpaid depositors cannot claim these proceeds of $8 million because they cannot prove that their contributions contributed to the acquisition of the asset now held by LDC. I answer that submission in the course of examining just exactly what was the trust created by s 36A of the Securities Act.
[83] For the foregoing reasons, I think it is an error of law and a distraction to proceed on the basis that because each depositor in F & I was separate, then if there is a trust, no matter what the trust is, the right to trace disappears when the deposits were used by F & I to trade in breach of s 36A, if that section is breached.
[84] The next part of the analysis as to whether or not the depositors have a proprietary claim begins by addressing four sub issues:
(i)Was F & I in breach of offering securities to the public, in order to trigger the application of s 36A?
(ii)If F & I was in breach, do some of the unpaid depositors fall into the exceptions in s 3(2) of the definition of “offers to the public”?
(iii)What is the character of the s 36A statutory trust, or a consequential trust, given that the deposits were used in trading?
(iv)Whether the sums being pursued by the plaintiffs are the property of this trust?
(i) Was F & I in breach of offering securities to the public?
[85] F & I at all material times traded without a prospectus. It could only do this without breaching the Securities Act if it was not offering securities to the public.22
[86] By the conclusion of the evidence there was little further contest between counsel as to whether or not F & I was offering securities to the public. Section 3 of the Securities Act provides:
3 Construction of references to offering securities to the public
(1) Any reference in this Act to an offer of securities to the public shall be construed as including—
(a) A reference to offering the securities to any section of the public, however selected; and
(b) A reference to offering the securities to individual members of the public selected at random; and
(c) A reference to offering the securities to a person if the person became known to the offeror as a result of any advertisement made by or on behalf of the offeror and that was intended or likely to result in the public seeking further information or advice about any investment opportunity or services,—
whether or not any such offer is calculated to result in the securities becoming available for subscription by persons other than those receiving the offer.
(2) None of the following offers shall constitute an offer of securities to the public:
(a) An offer of securities made to any or all of the following persons only:
(i) Relatives or close business associates of the issuer or of a director of the issue:
22 Securities Act 1978, s 37(1) provides: No allotment of a security offered to the public for subscription shall be made unless at the time of the subscription for the security there was a registered prospectus relating to the security.
(ii) Persons whose principal business is the investment of money or who, in the course of and for the purposes of their business, habitually invest money:
(iia) persons who are each required to pay a minimum subscription price of at least $500,000 for the securities before the allotment of those securities:
(iib) persons who have each previously paid a minimum subscription price of at least $500,000 for securities (the initial securities) in a single transaction before the allotment of the initial securities, provided that—
(A) the offer of the securities is made by the issuer of the initial securities; and
(B) the offer of the securities is made within 18 months of the date of the first allotment of the initial securities:
(iii) Any other person who in all the circumstances can properly be regarded as having been selected otherwise than as a member of the public:
(b) An invitation to a person to enter into a bona fide underwriting or sub-underwriting agreement with respect to an offer of securities:
(c) Repealed.
[87] There is no doubt that F & I’s mode of trading fell within s 3(1)(b). F & I operated from a “high street” storefront in Nelson. It had a large sign naming the business, “Finance and Investments”. There was ample evidence that persons learning of F & I’s business from word of mouth, not being “relatives” or “close business associates” of the principals of the business, would walk in and make inquiries. Their deposits would be taken. They would receive in return a note recording the amount of the deposit, the interest promised and the term. Most deposits were on call. F & I operated as a bank.
[88] There were some depositors, as one would expect, who could be described as “relatives” of the principals, and no doubt some who could be described as “close business associates”.23 LDC did not seriously dispute, however, that a significant
number of the public responded to an offer of securities within the terms of s 3(1)(b).
23 See Securities Act 1978, s 3(2)(a)(i).
[89] F & I did not advertise. It placed a small notice for a few years in a local yachting club annual report. There is no significant evidence that these few advertisements triggered s 3(1)(c).
[90] There was no evidence of any separate offers (distinct from the general trading of F & I as a store front lender) which would fall within s 3(2)(a). No doubt some members of the families and close business associates did deposit with F & I because they knew the principals and trusted them, but that is quite a different matter from whether or not the principals sought out any particular relatives or close business associates to solicit their deposits. There is no evidence they did.
[91] F & I deliberately traded without advertising and relied upon its general reputation in town and maintaining and staffing a high street business premises taking deposits from whoever walked in or posted in deposits. Accordingly, there is no doubt that F & I was trading in breach of the Securities Act.
[92] It is of no surprise to the Court that Mr M G Noone, a partner of PwC, came to that conclusion on the very day he visited Nelson in January 2007 to meet with the principals of LDC, Mr David Miller and Mr Jannetto, and Mr Andrew Harding of F
& I. Mr Noone not only told Mr Harding that F & I were not compliant with the Securities Act, but that he and Mr Scholfield could go to prison. Of course he was mistaken on the later point, but the fact he said it reveals he was quite confident, on the first day, that F & I was trading in breach of the Act.
(ii) Does s 3(2) exclude some deposits from the breach?
[93] LDC argued that those depositors who might be classed as “relatives” and “close business associates” did not fall within offers to the public. In that regard, LDC seeks an inquiry as to who in the present class of plaintiffs should be excluded from any relief, because they are “relatives” or “close business associates” within s 3(2)(a).
[94] The plaintiffs, however, do not make that argument. They are united. Furthermore, they rely on the opening phrase in s 3(2)(a):
An offer of securities made to any or all of the following persons only
(Emphasis added)
[95] There is no advantage to LDC in arguing the potential class of beneficiaries is a smaller class than the plaintiffs. This is because there is a gross deficit between the fund being pursued of $8 million and the face value of the 706 outstanding loans. As earlier noted, that face value at the date of receivership was $13.3 million. It will have a much higher value now with added interest. In broad terms, if the depositors succeed in these proceedings they are unlikely to secure more than 50 cents in the dollar. There was some evidence that some members of the partners’ families made significant deposits. But there is no suggestion that they were of any significance measured against the total book of deposits unpaid on receivership. Even if they were excluded, as LDC argues they should be, it would be of no consequence to LDC as the total face value of remaining depositors would easily consume the $8 million.
[96] I conclude that F & I was always trading in breach of the Securities Act, and there is no live dispute in these proceedings of interest to LDC as to the membership of the class of plaintiffs.
(iii) What is the character of the statutory trust, given that the deposits were used in trading?
[97] F & I traded in breach of s 37 of the Securities Act from the time that section came into force and down to the date of its receivership. That means at various times either s 37(5) as originally enacted, or s 36A applies. As originally enacted, s 37(5) provided:
(5) Where subscriptions for securities are received by or on behalf of an issuer, but, by virtue of this section, the securities may not be allotted, or for any reason the securities are not allotted, the issuer shall ensure that—
(a) At all times while held by it, the subscriptions are kept in a trust account on behalf of the subscribers; and
(b) The subscriptions, together with such interest (if any) as has been earned thereon, are repaid to the subscribers as soon as reasonably practicable.
[98] There was no issue as to how this section was intended to apply. It is presuming a compliance with the law.
[99] F & I have never complied with s 36A nor its predecessor s 37(5). Whatever might have been the law under s 37(5) and before it, there is no doubt that from
15 April 2004 when s 36A came into effect and replaced s 37(5)(a), F & I have been in breach of s 36A.
[100] Section 36A provides:
36A Subscriptions must be held in trust
An issuer must ensure that subscriptions for securities offered to the public are held in trust for the subscribers until the securities are allotted or until the subscriptions are repaid to the subscribers under this Act.
[101] Questions then arise as to whether (a) the statutory trust survives the breach and, if so, what are its characteristics; or (b) whether there is another trust to be recognised by equity.
[102] There were two competing arguments in this Court. Mr Goddard, for the defendant, argued that s 36A applies in respect of each subscriber in a unitary fashion. He argued that the receipt and use of deposits was in breach of trust. However, the deposit was almost immediately lost in the mix of funds being expended and loaned out, so the remedy of the depositors is against Messrs Harding and Scholfield personally. It goes no further.
[103] The alternative argument is that the plaintiff depositors are a class. They own the assets of the trading partnership (which was trading in breach of trust) and can now trace those assets collected by LDC from F & I’s receivables.
[104] In my view, there are three sets of reasons, all of which drive to the same conclusion, namely: that as a consequence of the breach of s 36A, Messrs Harding and Scholfield held the receivables of the partnership in trust for the unpaid depositors at any one time. This crystallised upon receivership into the class of unpaid depositors. These depositors are the beneficiaries of the trust. They are
beneficiaries according to their contribution; that is, in the traditional language of equity, pari passu. I deal with each set of reasons in turn.
(a) The plain language of s 36A
[105] Section 36A uses the phrase “are held in trust for the subscribers until the securities are allotted or until the subscriptions are repaid to the subscribers under this Act”.
[106] The term “subscribers” is anticipatory. For at the time the trust arises they are not subscribing to script, because there is no script to be allotted. Script can only be allotted after a prospectus is in place,24 which can only occur where a trust deed
has been executed between the issuer and a trustee.25 Yet the plain language of
s 36A requires the trust to be in place until steps are taken to enable valid allotment of securities. The trust exists prior to valid allotment of securities. It is a trust for the depositors.
[107] Second, the language “in trust for the subscribers” is plural. It does not say in
trust for each subscriber.
[108] There is no difficulty in equity with the concept of a trust for a class of beneficiaries. Trusts for classes of beneficiaries are common place. In family trusts it is common place for there to be trusts for children or grandchildren or a member of the family.
[109] An instance of a class trust in the financial world is the case of Brazzill & Others v Willoughby & Others.26 KSF, a subsidiary of an Icelandic Bank, carried on business in the United Kingdom as a deposit taker pursuant to an authorisation issued by the Financial Securities Authority (the FSA). The depositors included members of the general public, institutions, local authorities and others. Some depositors were protected under the Financial Services Compensation Scheme but
others were not. In October 2008, KSF’s parent company collapsed causing KSF’s
24 See Securities Act 1978, s 37(1).
25 See Securities Act 1978, s 33(2).
26 Brazzill & Ors v Willoughby & Ors [2010] EWCA Civ 561.
liquidity position to deteriorate as a result of a loss of public confidence. The FSA required KSF to open a trust account with the Bank of England and to pay into that account an amount equal to “deposits” received from “customers” on or after
2 October 2008. KSF paid some $147 million into this account. However, KSF had received a further $141 million in deposits from financial institutions and customers but had not paid corresponding amounts into the account. There was a doubt as to who were the beneficiaries of the trust. It was held that the supervisory notice served by the FSA created a trust for a class of beneficiaries comprising all KSF’s account holders in respect of whose deposits payments should have been made into the account in accordance with the notice whether or not money was so transferred.
[110] To the extent that its first issue is comparable, the recent decision of the Supreme Court of the United Kingdom in In the matter of Lehman Brothers International (Europe) (In Administration)27 supports this reasoning. This case arose from the insolvency in administration of the Lehman Brothers group of companies. Lehman Brothers International (Europe) (“LBIE”) was regulated by the Financial Services Authority (“FSAUK”). The FSAUK issued the Client Assets Sourcebook (CASS 7) for the safeguarding and distribution of client money. Regulation 7.4.16G of CASS 7 provides, amongst other things, that:
Under the alternative approach, client money is received into and paid out of a firm’s own bank accounts … A firm that adopts the alternative approach will segregate client money into a client bank account on a daily basis, after having performed a reconcilation of records and accounts of the entitlement of each client for whom the firm holds client money with the records and accounts of the client money the firm holds in client bank account and client transactions accounts to determine what client money requirement was at the close of the previous business day.
[111] CASS 7 (7.7.2R) further provides that:
A firm receives and holds client money as trustee (or in Scotland as agent) …
[112] The Supreme Court unanimously held that the statutory trust under CASS 7 arrises on receipt of clients’ money. In reasoning to this conclusion, Lord Hope said:
47. … The modern approach of the court to construing commercial or
regulatory documents is to prefer a purposive to a literal approach.
27 In the matter of Lehman Brothers International (Europe) (In Administration) [2012] UKSC 6.
…
62. On the first issue Briggs J and the Court of Appeal were in agreement that the statutory trust arises on receipt of the money; and this court, I understand, unanimously agrees that they were right. …
[113] Lord Hope then went on to summarise Briggs J in these terms:
63. …
(1) Where money is received from a client, or from a third party on behalf of a client, it would be unnatural, and contrary to the primary purpose of client protection, for the money to cease to be the client’s property on receipt, ….
(2) … Under the alternative approach an immediate trust of identifiable client money does provide protection, though mixed funds are subject to a variety of risks.
[114] Subsequent issues were decided in accordance with the regulations, not on any general principles of trust law.
(b) Section 36A read in the light of its purpose
[115] The Securities Act 1978, like all statutes, has to be interpreted in the light of its purpose. The context of the Act is that it is addressing the allotment of securities to subscribers (i.e. depositors). Securities legislation addresses businesses taking subscriptions from numerous persons. Where a number of depositors are placing money with a lender, it would be extremely unusual for the lender to be required by law to open a separate bank account for each depositor. Of course the lender, as normal business practice, would give an individual receipt to the depositor, but the deposit, albeit a cheque, internet deposit or cash, would be accepted by the issuer’s bank and credited to the issuer/lender’s bank account. Immediately the individual deposits are be irretrievably mixed.
[116] It matters not whether the lender has one, two or any number of accounts. We can be sure, however, that the natural context for construing s 36A is that there will be pooling of deposits. Yet, on a strict construction of Mr Goddard’s argument, the trust character of the funds is lost on pooling, leaving the depositors only with a personal claim against the trustees. That argument destroys the benefit of the trust
upon the receipt of the funds. For equitable relief confined to a personal remedy against the trustees only duplicates the available common law remedy in contract. Section 36A has the purpose of protecting the deposit by reserving a proprietary claim by the depositor as a beneficiary. To achieve its purpose, s 36A has to be applied as a trust for a class, with proprietary claims which survive the mixing of deposits.
(c) Section 36A read in the context of involving the law of trusts
[117] When Parliament used the term “trust”, without defining it, it clearly intended that the Judges applying the Securities Act apply the law of trusts. A trust is a relationship where a person holds property on behalf of others. You cannot have a trust without there being property being held on behalf of others. If a person holds property but does not hold it on behalf of others there cannot be a trust. There has to be certainty of property and certainty of object (that is, beneficiaries).
Conclusion that there is a trust for a class
[118] These contextual considerations reinforce the plain language of s 36A. It can be read confidently in the plural.
[119] Section 36A is creating a trust for a class of subscribers/depositors. The property held on their behalf are their subscriptions/deposits. The maxim equality is equity applies so the deposits when banked into a pool will be held pari passu; that is, in proportion to each other both as to amount and time of deposit. The time of deposit is relevant to dividing the accrual of interest being paid by the bank who has taken the deposit.
[120] Those deposits are the subject of the trust. They are the property of the trust. They are held on behalf of the depositors. Any other interpretation would defeat s 36A.
[121] It matters not that there may be some other funds deposited in the same bank account. For equity has appropriate rules for allocating property between mixed
classes of claimant. Take a simple example. A person has in his bank account a credit of $100,000 and then takes another $100,000 by way of deposit in breach of s 36A. That person now becomes a trustee of 50 per cent of the account, to hold it on behalf of the depositor. It matters not that it is impossible to separate the original credit of $100,000 from the deposit of $100,000. It is sufficient that there is certainty as to the extent of the claim that can be made by the beneficiaries on the fund. There can be because there is no doubt as to the obligation of the owners of the lender under s 36A to hold those deposits on trust for the depositors.
(iv) Whether the sums being pursued by the plaintiffs are the property of this trust?
[122] The F & I trustees have been constantly in breach of trust since 1 September
1983, when the Securities Act came into force. Funds by depositors have never been held simply for the depositors. They have been used to add value to the deposits by carrying on the business of money lending. They have been expended either by way of loans to borrowers or, to meet the ongoing costs of making loans, being used to fund both fixed and variable costs e.g., rent (fixed) and postage (variable). They have been used to repay other depositors. Profits have been withdrawn against book records of profits on loans made and interest due. Those withdrawals are likely to have been funded at least in part from deposits. As Lord Millet put it in Foskett v
McKeown:28
The claimant claims the new asset because it was aquired in whole or in part with the original asset. What he traces, therefore, is not the physical asset itself, but the value inherent in it.
[123] It is a feature of this case that the business had a credit deposit with its trading bank from cash flow for almost the entire time of its more than 30 year history. It very rarely went into overdraft. It did not depend on overdraft facilities. There was only one injection of capital of $500,000 each by the two shareholders. In an analysis done by Mr Stiassney over the period from 1 April 2002 to the receivership in 2007, all but $3 million of $139 million moving through the accounts
came from deposits or receivables of loans.
28 Foskett v McKeown, above n 13 at 128.
[124] Applying Article 90.1 of Underhill and Hayton, it is plain that during the business, in breach of trust, the deposits have been substantially, and progressively, converted into receivables. These receiveables are the substitute for the deposits. They were deliberately obtained, by loans, in order that interest could and was obtained, from the funds deposited, at a higher rate than the interest promised to the depositors, so that the trustees could and did make a profit. Equity requires the trustees to account for the profits and for the capital earning the profits. As both are the property of the beneficiaries.
[125] An alternative equitable approach, with the same consequence, is to reason that given that it was a successful business until its collapse in 2006-2008, the expenditure on fixed and variable costs and the drawing of profits from the firm are, in equity, deemed to be drawn from the margin between the liabilities to repay the deposits with promised interest as a cost, and the receivables of repayment of the
loans together with interest as an asset.29
[126] Either way, the trustees, Messrs Scholfield and Harding, have in breach of trust converted the deposits into another form of wealth, the receivables. But those receivables, so converted, become subject to the same trust and are so property of the trust held for the benefit of all the beneficiaries who have not been repaid their deposits.
[127] Those beneficiaries who were repaid naturally fall out of the trust class of beneficiaries. This is so, because you can only be a beneficiary of the trust if you are capable of making some claim on the trustee. Or, to put it another way, you can only be a beneficiary of a trust if the trustee has a fiduciary obligation to you. If you have been paid out and have no further claim there is neither a claim nor an obligation. You simply fall out of the class of unpaid beneficiaries.
[128] The wrongdoer trustees had no claim at any time on the receivables of F & I
and the balance in the bank accounts against the claims of the beneficiary depositors. For all the profits from trading, even in excess of the interest entitlements at common
29 See above at [70].
law, belonged to the depositors. Trustees must account for all profits earned in breach of trust.30
[129] This position existed at least from 2 May 2006. On that day the trustee partners learned that F & I’s $7 million of advances to Halifax Finance Ltd were likely irrecoverable. Halifax borrowed from LDC and from F & I. It did not have the ability to repay its loans and was subject to a first charge in favour of LDC ahead of F & I. Indeed, F & I needed, it thought at the time, about $500,000 as a loan from LDC to maintain its liquidity. In fact, as it turned out, it needed more than that. As at 2 May 2006, F & I no longer had a positive margin between its liabilities to its depositors and its book of receivables, written down to reflect realistic recoveries. Messrs Harding and Scholfield could only hope that with liquidity funding from LDC, F & I would be able to meet its liabilities as they fell due, trade on, and, over time, absorb the loss in Halifax. As wrongdoer trustees Messrs Harding and Scholfield had no claim at all on the receivables from the loans, which on any view were almost entirely funded from deposits, let alone any claim on the deposits. The position in equity of the partners was that they were trustees holding the deposits and receivables for the depositors, unpaid, so that the deposits and receivables were the property subject to the trust.
[130] The position would be otherwise if the trustees had both traded in breach of trust and successfully augmented the working capital of the business with more equity and overall made significant profits. In such a situation there would be a claim capable of being made by the trustee in breach of trust against the assets of the finance business being a mixed fund of depositors’ property and trustees’ property.
[237] Given the state of LDC, PwC were advising that it was not possible to bring in an outside investor. That left the only source of additional capital being the good loans of F & I. F & I’s future was now utterly entwined with LDC’s future. Both had to reach an agreement, to have any prospect of survival.
[238] PwC prepared two reports for LDC, one on LDC (PwC/LDC), the other on F
& I (PwC/F & I).
[239] The first draft of PwC/LDC on 31 January, in paragraph 2.4, included these passages as to F & I.
They have some 385 depositors, being family and friends and their wider personal network, from whom they [have] taken funds for investment. They have built the business over the last 30 years so that now they have some 19 million in depositors’ funds …
Of the 22 million however, some 6.9 million is owed to F & I by SCM [an LDC subsidiary]. Given that, unless a substantial recovery can be obtained from the Heli-Logging loans, the estimate of the recoverable SCM book is some $6m to $8m, thus the SCM debt to F & I is virtually certain of not being recovered.
In addition, Harding is of the view that a further $0.5m of provision would be required on the F & I book, thus making F & I’s net recovery some $14.5 million - compared to public funding of $19 million.
[240] Internal e-mails from LDC directors from that time, January 2007, record LDC directors understanding that it was the view of Maurice Noone of PwC and Mark Russell of Buddle Findlay, that F & I were trading in breach of the Securities Act. This information was first conveyed orally by Maurice Noone to the directors of LDC and to Mr Andrew Harding in Nelson at a meeting on the same day that Mr Noone visited the business premises of F & I for the first time at the end of January 2007. On 1 February 2007, Kevin Elliot, a director of LDC, wrote to his fellow directors, David Miller and John Jannetto, saying:
We may need to make certain that John Fitchett [F & I’s lawyer] understands that F & I are not compliant with Security Regulations because they are operating as a partnership. The possibility of merging F & I into LDC and becoming compliant that way must be an incentive for them.
[241] The next day, on 2 February, John Jannetto sent an e-mail to his fellow directors, Kevin Elliot and David Miller, saying:
I also told him [Andrew Harding] I believed, based upon what Mark and Maurice have advised, that F & I need a prospectus and that they are at risk of taking money from the public regardless of the advice of Fitchett.
[242] It is common ground that there was an issue from this time common to LDC, F & I and PwC as to whether or not F & I was compliant with the Securities Act.
[243] On 3 March 2007, PwC prepared for LDC a high-level review of F & I (PwC/F & I). In this report, PwC recorded that F & I:
(a) Is currently insolvent, in that investors’ deposits exceeded finance
assets by approximately $7.3 million.
(b) Is currently operating at a loss, and requires a further $2 million of funds to be injected and on-lent to create a break even position.
(c) Is likely in breach of the Securities Act regarding the taking of moneys without a prospectus.
(d) Through operating via a partnership structure, all personal assets of the partners are at risk.
This business in the short term will face a liquidity crisis, and a high profile local failure will occur. Time is not on the side of F & I. Only if it is highly probably that current proposals will substantially improve the position, in the short term, should they enter into the arrangements.
[244] Similarly, as regards LDC, this PwC/F & I report said LDC:
(a) Requires approximately $4 million in new equity in order to comply with trustee covenants.
(b) Needs to issue a new prospectus as a matter of priority in order to remove the current and potentially misleading prospectus from the market.
(c) In order to be capable of seeking interest from potential purchaser[s], needs to “tidy up” the balance sheet through removal of the Halifax advances and the Heli-Logging advances.
Without the immediate injection of new capital, bringing the company into compliance with the Trust Deed, and the issuance of a new prospectus, the directors [of LDC] need to seriously consider whether they can continue to trade without incurring personal liability.
[245] Perpetual received the PwC/LDC report both in its original form and then in an edited form. In the original form in paragraph 2.4 (above), it named the F & I partnership, the number of depositors, and the size of the book.
[246] The PwC/LDC edited report rewrote 2.4. As provided to Perpetual and onto the Companies Office, it now recorded only the following:
Relationship with Finance Investments
This is an unincorporated partnership between Andrew Harding and Murray Scholfield. Harding and Scholfield have car dealer backgrounds and are both now semi-retired.
As part of the arrangements between Paul Brownie of Halifax, F & I and
LDC, we understand that LDC agreed to provide F & I with $1 million in
funding. This loan is secured over the finance receivables book of F & I, which we understand has no other charges against it.
F & I had an original loan facility from LDC of $2 million, of which $1.5 million was applied to subscribe to new preference shares in LDC, with the remaining $500,000 to provide additional working capital to F & I. This working capital facility has since been temporarily increased to $1 million.
[247] On 22 March 2007, F & I and LDC entered into two agreements. F & I agreed to subscribe for the 4 million LDC shares in exchange for $4 million in receivables, and a deed of assignment of those receivables was also entered into. Perpetual’s consent was sought for the issue of the shares to F & I.
[248] The draft prospectus, proffered to Perpetual for approval with this second deal, described the agreement between LDC and F & I as follows:
This agreement is with a privately-funded Nelson-based finance partnership, for that partnership to subscribe for $4,000,000 worth of ordinary shares in the Company. The consideration for the subscription for these ordinary shares will be an assignment to the Company of certain financing receivables. The company’s directors have received professional advice confirming the quality of those receivables and have confirmed that the value of those receivables is no less than the value of the new share capital in the Company.
[249] The trustee, Perpetual, did not receive the PwC/F & I report.
[250] The draft prospectus was submitted to the Companies Office and generated the same day a large number of questions from Mr John MacPherson, including asking if any of the four finance companies to whom LDC lent funds raised money from the public and/or had a prospectus. It also asked for a copy of PwC’s report. The edited report was eventually forwarded to the Companies Office.
[251] In April 2007, Perpetual required due diligence on F & I’s receivables. In May, Perpetual’s solicitor was of the opinion that LDC’s prospectus was misleading and Perpetual informed LDC of this in June of 2007. Perpetual continued to have concerns throughout July.
[252] In August, LDC suffered a run on its funds and requested Perpetual to appoint a receiver on 3 September. PwC was appointed receiver of LDC on 4 September and of F & I on 5 September.
[253] I have no doubt that the modifications to the PwC report sent to Perpetual and known to be going to be forwarded on to Mr John MacPherson at the Companies Office were designed with the knowledge of the LDC directors to deflect Perpetual and the Companies Office from identifying the possibility that F & I were trading in breach of the Securities Act.
[254] Were Perpetual and/or the Companies Office to take an interest in this fact, such interest would generate an inquiry which at the very least would withhold approval by Perpetual to the amended prospectus, and so further impede LDC’s return to trading.
[255] Already as a result of PwC’s first report, LDC was not able to trade because of PwC’s view that LDC was trading in breach of its prospectus. Time was of the essence. It is undoubtedly true that the reason for modifying the PwC/LDC report was to disguise the true character of F & I’s trading and to ensure that execution and performance of the second agreement between LDC and F & I went ahead, so that LDC could continue trading and not have to close the stores. In that sense an inquiry conducted by either Perpetual or the Companies Office could have been fatal to LDC’s business, let alone identification of an actual breach of the Securities Act by F
& I. It needs to be kept in mind that the focus of the directors of LDC was on commercial survival. In such a context they had no inclination or reason to inquire into the ramifications of dealings with assets of F & I acquired by F & I in breach of a statutory trust.
[256] There is no evidence that either the directors of LDC, PwC, or Perpetual were on actual notice that the depositors of F & I could have a claim on the receivables of F & I. Due to the commercial exigencies, LDC’s directors and PwC did not seek an opinion from Mr Mark Russell of Buddle Findlay, who again documented the second transaction. He was told that F & I were a privately funded finance company. He was not asked to, and he did not, give advice as to the ramifications of dealing with F
& I if it was trading in breach of the Securities Act.
[257] However, there is no doubt that he or someone in Buddle Findlay did express the view that F & I was trading in breach of the Securities Act and he knew, and
LDC directors knew, that there was a conflict of advice in this respect between
Buddle Findlay and F & I’s legal advisor, Mr John Fitchett.
Constructive notice of LDC
[258] Again for the same, but reinforced, reasons, experienced commercial solicitors practising under the Securities Act and knowledge in trust law, at that time in January – April 2007, could have identified relatively easily a prior claim in equity by the depositors over the assets of the F & I partnership, particularly the receivables reflecting loans funded by deposits. The exigencies of immediate survival are the best explanation as to why this inquiry was not undertaken and why Mr Mark Russell was not asked to do more than document the transactions. But those exigencies do not, in my view, excuse LDC’s directors from not identifying the problem, by making inquiry.
[259] A distinction needs to be drawn here between receivers and banks conducting transactions which are normal and which are done relatively swiftly without a great deal of analysis. I am alluding again to the point made by Millett J, as he then was, in Macmillan.72 The facts here are different. This was not a routine transaction. It was an extraordinary transaction set in a crisis. It was done in the face of discussion of the fact that F & I was trading in breach of the Securities Act. Its context was one of trying to achieve the commercial survival of LDC which was in a precarious position as a result of PwC having identified that it was trading in breach of its
prospectus.
[260] When chartered accountants are engaged in doing unusual transactions, particularly to meet commercial exigencies, the need to examine the probity of the transaction, as to compliance with law and equity, is higher, not lesser. The very commercial exigency prompting the unusual transaction imposes an obligation of conscience to be on guard and to take care that other persons’ interests are not
defeated. The law would be a nonsense if it were otherwise.
72 Macmillan Inc v Bishopsgate Trust Plc and Ors (No.3 ) [1995] 1 WLR 978.
[261] I am quite satisfied that LDC was on constructive notice, because it ought to have inquired and identified, with the assistance of expert advisors, that it was entering into a transaction in May of 2007 to acquire assets over which there was a claim to a prior equity by F & I’s depositors. And it was not just any claim, it was a serious claim. The normal regulatory response would be to have stopped the transaction and required the assets of F & I to be liquidated and returned to the depositors. LDC’s directors feared that if Mr John MacPherson learned what they knew, he would insist on an inquiry at the very least.
Was Perpetual on notice in 2006 and 2007?
[262] At all material times Perpetual was the trustee of LDC and had been since
2004. Schedule 5 of the Securities Regulations 1983, which were replaced on 1
October 2009 by the Securities Regulations 2009, set out clauses deemed to be contained in trust deeds. Clause 1 provided:
(1) The trustee shall exercise reasonable diligence to ascertain whether or not any breach of the terms of the deed or of the terms of the offer of the debt securities has occurred and, except where it is satisfied that the breach will not materially prejudice the security (if any) of the debt securities of the interests of the holders thereof, shall do all such things as it is empowered to do to cause any breach of those terms to be remedied.
(2) The trustee shall exercise reasonable diligence to ascertain whether or not the assets of the borrowing group that are or may be available, whether by security or otherwise, are sufficient or likely to be sufficient to discharge the amounts of the debt securities as they become due.
[263] The transaction being way of proposal in 2006 was unusual. The issue of preference shares and its funding was by a circular transaction. The request for approval of that transaction met with a requirement from Perpetual to LDC, addressed to Mr John Miller and Mr K Elliott:
Hi,
Was the agreement signed on Friday?
Also, to be clear about the requirements before the consent for funding agreement can be processed – as we discussed at our meeting, your request
for consent should be accompanied by the homework you have completed on the F & I book, and the draft GSA.
[264] Perpetual was asking LDC to do the “homework”. For the transaction to be approved by Perpetual, F & I had to have the ability to repay the loan of $1.5 million made to it by LDC so that it could purchase the LDC shares. Otherwise the increase in equity was notional only and left LDC no better off. Mr Miller replied to that e- mail saying that the agreement had been fully executed and “we will now do due diligence on F & I’s book before completing the loan and the preference shares purchase agreement. When this was done, LDC will increase ordinary share capital by $1.5 million”.
[265] What Mr Miller was asked to do was to be satisfied that F & I had the ability to recover at least $1.5 million from the receivables over which LDC had a charge. This was an easy task, provided that the receivables belonged to F & I.
[266] In this context, it is important to keep in mind that Perpetual had no notice at all, in May 2006, that F & I might be trading in breach of the Securities Act. The Perpetual officers were residing in Christchurch. They were not working in the business district of Nelson.
[267] It was the argument for counsel for the plaintiffs that given the obligations in Schedule 5 of the Securities Regulations where the trustee delegated the duty to exercise reasonable diligence, then the trustee is in no better position than the delegatee by way of the doctrine of imputed notice. The relevant principles are set
out by Bowstead on Agency as follows:73
1.The law may impute to a principal knowledge relating to the subject matter of the agency which the agent acquires while acting within the scope of his authority.
2.Where an agent is authorised to enter into a transaction in which his own knowledge is material, knowledge which he acquired outside the scope of his authority may also be imputed to the principal.
3.Where the principal has a duty to investigate and make disclosure, he may have imputed to him not only facts which he knows but also
73 P Watts; F Reynolds; W Bowstead Bowstead and Reynolds on Agency (17th ed Sweet & Maxwell, London 2010) at 514.
material facts of which he might expect to have been told by his agents.
[268] I have already found that LDC had actual notice by May of 2006 that F & I might well be trading in breach of the Securities Act. Second, that LDC knew the regulatory consequences of that over the ability to retain assets in F & I against an obligation to repay deposits. As to that latter fact, that was clearly a matter which the Court will infer Perpetual knew. For Perpertual’s business was to act as a trustee pursuant to trust deeds set up in order to comply with s 37 of the Securities Act. The point can be put this way. Would Perpetual have approved the 2006 transaction had it known that it was likely that F & I was trading in breach of the Securities Act and had been trading in breach of the Securities Act since its enactment in 1983? The answer is clearly no. For Perpetual, a specialist trustee, would know, or ought to have known, that that conduct impugned and raised serious question marks as to the true beneficial ownership of F & I’s receivables. The facts which LDC knew can be imputed to Perpetual and the consequences of those sections can be inferred as constructive notice of Perpetual. By that combination, Perpetual was on notice in May 2006 of a prior equity over the assets at F & I, which assets were proposed to be charged to LDC.
[269] There is no substantial difference in 2007. It will be recalled that at that time
LDC was obtaining an injection of 25 per cent new equity by an issue of shares to F
& I, the sale of which was being funded by the acquisition of a significant part of the good book of F & I.
[270] Mr Styant was the officer in charge of supervising this transaction. He is now deceased. He was a victim of the Christchurch earthquake. However, a witness statement was taken from him in anticipation of the litigation. The gist of his statement was that he did examine the worth of F & I’s receivables being transferred. There is no doubt that those receivables were valuable. They were from F & I’s good book. It also seems clear, however, that he did not avert to the question of F & I trading in breach of the Securities Act.
[271] Mr Styant had started with Perpetual in 2007. He was not a lawyer or an accountant by training. He had considerable experience, however, in dealing in
financial assets. There is no evidence that he had any particular skills or experience in the requirements of the Securities Act. He recalled receiving PwC’s report on LDC both in its original form and in the second amended draft. He made notes as to the quality of the receivables. He did not make any notes against paragraph 2.4 of the original report in which was described the way F & I traded, and which information pointed to a breach of the Securities Act.
[272] He reiterated that Perpetual’s focus was on receivables and he had no reason to be on inquiry in respect of the status of F & I and that the nature of F & I as set out in paragraph 2.4 did not ring any alarm bells for him. He was aware that F & I did not have a trustee or a prospectus, but that F & I was probably not unique in that position. The fact that it had over 300 depositors established over 30 years was not surprising to him.
[273] As I have already noted, Perpetual held itself out as a competent person to supervise the performance of trust deeds entered into in order to comply with the Securities Act. Perpetual cannot avoid the consequences of notice by relying on the lack of experience of an officer employed to examine the merits of the 2007 transaction. There is no evidence that Mr Styant requested due diligence on the assets. He probably did not need to in that respect of the PwC report. But he ought to have known that it is one thing for borrowers to be able to repay the debts, it is another matter as to whether or not the debts belonged to LDC or were subject to a prior equity in favour of the depositors.
[274] Mr Styant did have a distinct recollection of later seeing the PwC/F & I review and being very disappointed it had not been disclosed earlier. He was very surprised to see PwC’s view stated that F & I was insolvent and likely to be in breach of the Securities Act. It was his statement, he said, that these were key matters that would have raised red flags for him if they had been disclosed at the time of the March 2007 agreement. He said he would have known that breaching the Securities Act would mean that the investments of F & I were void or voidable.
[275] I am satisfied on these facts that Perpetual was on imputed notice prior to the
2006 transaction and on imputed and constructive notice prior to the 2007
transaction of the presence of a claim in equity over the assets which proposed to be transferred to LDC.
Subsidiary issues
Re-assignment of the Three Stores and The Tavern loans
[276] LDC challenges part of the quantum of the stake of $8 million. It is the sum of $750,000 approximately before interest which reflect the receivables of two loans due by Three Stores and The Tavern to F & I. In July 2008, the solicitors for the plaintiffs and defendants in the common law pleading were negotiating the terms of setting aside the $8 million stake, pending the outcome of the litigation. It will be recalled at that time the plaintiffs were Messrs Harding and Scholfield and the claim was based on misrepresentations and misleading conduct in trade, that is at common law rather than equity. The proposal was to include in the money to be set aside by the receivers of LDC a sum equivalent to the receivables from Three Stores and The Tavern loans.
[277] On 26 June 2008, Gibson Sheat, acting for LDC, wrote to the solicitors for F
& I to inquire what funds were being held by the receivers of F & I and were advised that the receivers held the sum of $7,992,752 net of the receiver’s fees. An agreement was negotiated between the two firms of solicitors. It is recorded in a letter from Anthony Harper to Gisbon Sheat of 22 July 2008. It is notable that the agreement is recorded as being between John Fisk and Malcolm Hollis, the F & I receivers, LDC Finance Ltd (in receivership), Mr Eaton and Mr Marshall as trustees of Andrew Harding and Murray Scholfield, and Mr Harding and Mr Scholfield. The agreement provided that LDC would reassign the Three Stores Ltd and The Tavern loans to Messrs Harding and Scholfield and in consideration the F & I receivers would transfer to LDC cash received in the F & I receivership equivalent to the current balances of those two loans. That LDC would be entitled to retain the cash referred to above and would only be required to pay it back if the trustees were successful in setting aside the 2006 and March 2007 agreements. The agreement was also expressed to be without prejudice to the parties’ respective positions in respect of the July 2006/March 2007 agreements.
[278] LDC now argues that as the proceedings by Messrs Harding and Scholfield have been discontinued, there cannot be any Court order relating to those proceedings. LDC is entitled to retain the sum and the (current) plaintiffs have waived any right to question or set aside LDC’s ability to retain the cash paid to it.
[279] I disagree. There is some doubt as to whether there was any agreement at the time as to the status of Messrs Eaton and Marshall, the current plaintiffs. But there is no doubt that the context was of an agreement made in the face of litigation being brought by the partners of F & I to recover receivables obtained by LDC from assets assigned by F & I to LDC in 2006 and 2007. There is no suggestion in the letter agreeing the terms, which records that Messrs Eaton and Marshall are parties, although described as “trustees of Andrew Harding and Murray Scholfield”, that a Court order would be confined to any order arising out of the pleadings as they were in at that time in 2008. The operative clause was:
LDC, by its receivers will undertake that the proceeds of the assigned loans and funds repaid to LDC by F & I will be held by LDC Finance Ltd (in receivership) and will not be distributed without first giving 21 days notice to Scholfield and Harding and the trustees [Eaton and Marshall] care of their solicitors, Rout Milner and Fitchett [Harding and Scholfield] and Gibson Sheat [Eaton and Marshall] respectively, or in compliance with written agreement of the parties or a Court order.
[280] I consider that that clause was more significant than an earlier clause:
LDC shall be entitled to retain the cash referred to above and will only be required to pay it back if the trustees are successful in setting aside the July
2006 and March 2007 agreements (as defined in the proceedings
commenced by Harding and Scholfield);
[281] The undertaking is more broadly and accurately defined and reflects the parties to this agreement.
[282] The trustees Messrs Eaton and Marshall were parties to the agreement. From a substantive point of view, what happened later was that, as representatives of the beneficiaries of the trust, they took over the proceedings. There can be no suggestion that the responsible receivers of LDC, partners of PwC, ever intended by this agreement to defeat the beneficiaries’ rights to the F & I receivables, should they be able to sustain a claim.
[283] This is a highly technical and meritless argument advanced by LDC. It can be answered by applying the common law test of the officious bystander. Had someone at the time anticipated the move by the beneficiaries to take complete control of the proceedings from Messrs Harding and Scholfield and plead in equity rather than common law, the answer would have been “of course the agreement will extend to that”. For that is simply another way of challenging the 2006 and 2007 transactions.
[284] I note that this argument is not in fact being advanced by the partners of PwC. It is being advanced by LDC. At the time the contract was entered into, LDC and its receivers were clearly on notice that these two loans were subject to a claim of a prior equity. Contract cannot be used to erase the obligations of conscience of LDC should the depositors prior claim in equity be upheld. That was never the intention of the parties.
Counterclaim by LDC against Messrs Harding and Scholfield for breach of warranties
[285] The counterclaim by LDC against Messrs Harding and Scholfield seeks an order that they jointly and severally pay LDC the amount of any refund of all or any of the recovered funds or an indemnity in respect of any sums which LDC is ordered to pay to the second plaintiffs, including costs on a solicitor/client basis together with interest.
[286] The basis of the counterclaim is contract. It is founded upon breach of various financial representations and warranties that Messrs Harding and Scholfield as the partners of F & I gave in relation to their ability to enter in and perform the
2006 and 2007 transactions. These include warranties that F & I was solvent and was the sole, legal and beneficial owner of the assets.
[287] The loan facility agreement of 4 September 2006 is between LDC Finance Ltd as lendor and M Scholfield and A Harding partnership (trading as Finance and Investments) as borrower. Mr Scholfield and Mr Harding appear as parties of the third part as guarantors. But in the executed agreement that description of them as
parties has been struck out and likewise subsequent references to unlimited guarantees and indemnity from the guarantors has been struck out in clause 5.1(b), and variously wherever else the guarantees appeared such as in clause 7.3 in the subject of security. Section 7 of the agreement provides generally that securities are given as security for all amounts paid under this agreement. Security is defined in this agreement as being the general security agreement.
[288] It is a cornerstone argument of the defendants in these proceedings that the GSA agreement should be read independently of the funding agreement. This is commercial nonsense and inconsistent with the basic principles of the law of contract that where two agreements are signed for the one transaction, each agreement dependent upon the other so that neither one of those agreements would be signed but for the other, the two are to be read as one.
[289] In Smith v Chadwick,74 Jessel M.R. said:
... when documents are actually contemporaneous, that is two deeds executed at the same moment, ... or within so short an interval that having regard to the nature of the transaction the Court comes to the conclusion that the series of deeds represents a single transaction between the same parties, it is then that they are treated as one deed; and of course one deed between the same parties may be read to show the meaning of a sentence and may be equally read, although not contained in one deed but in several parchments, if all the parchments together in the view of the Court make up one document for this purpose.
[290] In Manks v Whitely75 (although this was a dissenting judgment, but the majority was reversed by the House of Lords in White v Delaney),76 Fletcher Moulton L.J. said of the rationale behind this principle:
... where several deeds form part of one transaction and are contemporaneously executed they have the same effect for all purposes such as are relevant to this case as if they were one deed. Each is executed on the faith of all the others being executed also and is intended to speak only as part of the one transaction, and if one is seeking to make equities apply to the parties they must be equities arising out of the transaction as a whole. It is not open to third parties to treat each one of them as a deed representing a separate and independent transaction for the purpose of claiming rights which would only accrue to them if the transaction represented by the selected deed was operative separately. In other words, the principles of
74 Smith v Chadwick (1882) 20 Ch.D. 27 at 62.
75 Manks v Whitely [1912] 1 Ch. 735 at 754.
76 White v Delaney [1914] A.C. 132.
equity deal with the substance of things, which in such a case is the whole transaction, and not with unrealities such as the hypothetical operation of one of the deeds by itself without the others.
This statement of principle in Manks was recently applied by the Court of Appeal in
Attorney-General v Forestry Corp of New Zealand Ltd.77
[291] There is no suggestion that Messrs Harding and Scholfield have not realised all the assets of F & I. Indeed, the business was placed into receivership.
[292] In my view, it is plain that the 2006 GSA which implements the 2006 loan facility agreement has to be read as not extending to those personal assets of Messrs Harding and Scholfield, outside of the partnership assets.
[293] The 2007 transaction is not so similarly qualified, so the question is more nuanced. The 22 March 2007 deed of assignment was again expressly between LDC and the “Murray Scholfield and Andrew Harding partnership”. There were no provisions for personal guarantees or any additional security taken over any assets of Messrs Scholfield and Harding outside of the assets in the F & I business. Counsel for Messrs Scholfield and Harding submit that the intention of the parties was, however, clear. There was a continuation of the limited liability of Messrs Harding and Scholfield.
[294] The context is beyond dispute. The second agreement was entered into because the first set of agreements in 2006 were insufficient. LDC needed even more equity to survive. It went back to Messrs Harding and Scholfield again. Messrs Harding and Scholfield were persuaded it was in F & I’s interest as much as LDC’s interest to do the transaction.
[295] The core of the 2007 transaction is the share subscription agreement. The representations and warranties appear in Part 3 of that agreement. They include the warranty that F & I hold sole legal and beneficial ownership of the assigned loans.
They include a warranty that Messrs Harding and Scholfield are not aware of any
77 Attorney-General v Forestry Corp of New Zealand Ltd [2003] 1 NZLR 721 at [46].
circumstances which could be reasonably expected to cause a prudent investor to regard the assigned loan as an unacceptable investment.
[296] There is a very significant weight to the submission for Messrs Harding and Scholfield that there was no suggestion that this time in 2007 they were putting their personal assets, in addition to the assets they had in F & I, on the line. Taking into account the context of the 2006 agreements, the probabilities are that the parties to the subsequent 2007 transaction did not intend to disturb the 2006 bargain limiting LDC to recourse to the assets of the F & I business. It is significant that in the 2007 documents, Messrs Harding and Scholfield are not described separately as parties to the agreement, but as one party called the “Murray Harding and Andrew Scholfield partnership”, as they were similarly described in 2006.
[297] If anything, LDC was in a better position to judge the potential impairment or claims against the assigned loans than F & I. LDC and F & I for material purposes had the same common financial predicament, the failure of Halifax. LDC knew in fact more about the failure of Halifax than did F & I. LDC were in receipt of unequivocal advice by March 2007 that F & I was trading in breach of the Securities Act. Whereas on the other hand, Messrs Harding and Scholfield were still taking comfort from the advice that they said they had received from their solicitor that they were trading within the law. Both sides, of course, were aware that there was an issue. It is highly artificial for LDC now to claim a loss for breach of the very risk which had been first identified by LDC and communicated to F & I and in the face of which LDC entered into the transaction.
[298] Messrs Harding and Scholfield plead an equitable estoppel.78 They argue that it is unconscionable now for LDC to set aside its earlier acceptance of the risk it was taking in dealing with F & I’s assets in order to sue Messrs Harding and Scholfield personally once the risk materialised.
[299] I am satisfied that in the context LDC assumed the risk of dealing with F & I, agreeing not to pursue Messrs Harding and Scholfield’s assets, and that it is
unconscionable to purport to rely on warranties in the 2007 transaction that LDC did
78 Walton Stores v Maher (1988) 76 ALR 513, 515.
not in fact rely on at the time. The circumstances required LDC to make express any change of position from the position that it adopted less than a year before in the first
2006 transaction. Both at common law by way of construction of this agreement, and by way of estoppel in contract, there is no merit in LDC’s arguments in respect of the 2007 transactions. Indeed, to find Messrs Harding and Scholfield personally liable for breach of these warranties in the 2007 transaction would be to substantially rewrite the bargain entered into by the two parties in March 2007. The truth is that the warranties that I have referred to and other similar warranties in the agreement are standard terms generated by the solicitors documenting the transaction and, if read out of context, are inconsistent with the true commercial bargain between LDC on the one hand and the Messrs Harding and Scholfield partnership on the other. I uphold the equitable estoppel argument.
[300] This counterclaim fails on the proposition that Messrs Harding and Scholfield were not liable to LDC for their personal assets beyond the assets that they had put into the business of F & I. This counterclaim is dismissed.
Counterclaim by LDC against Messrs Harding and Scholfield and Perpetual seeking
a declaration of priority of Perpetual’s security interest
[301] LDC also seek a declaration that Perpetual’s security interest created by the Deed of Trust between it and LDC has priority over any amounts which LDC is found liable to pay the second plaintiffs.
[302] The merits of this argument were addressed when considering whether or not Perpetual was a purchaser for value. I have found that Perpetual is not a bona fide purchaser for value.79 I have also found that Perpetual was on notice.80
[303] The application for declaration relies in the pleadings on the proposition that
Perpetual purchased this legal interest for value and without notice.81 This counterclaim is dismissed.
79 Above at [157].
80 Above at [275].
81 Amended statement of defence to fourth amended statement of claim and amended counterclaim,
16 September 2011, paragraph 128(c), (d).
Recovery of costs of the receivership of F & I
[304] The prayer for relief in the statement of claim seeks the costs of the receivership of F & I to be paid into Court for the benefit of the depositors. Argument in support of this issue was faint in the course of the trial. It has its roots in dissatisfaction by Messrs Harding and Scholfield as to the conduct of the F & I receivers, who were appointed by LDC. The question was not pursued in closing submissions. I am not sure whether the argument has been abandoned. It is a difficult argument to make given that there is no doubt that F & I was insolvent and had to stop trading. Receivership of F & I was inevitable. Out of caution I will not treat the issue as abandoned, but will provide for leave to enable the issue to be pursued.
Judgment
[305] (a) There is an order directing that the sum of $7,792,197.36, together with accrued interest, be paid into Court for the benefit of the depositors.
(b)Leave is reserved to pursue the claim that the costs of the receivership of F & I should be recovered by the plaintiffs.
(c) Leave is reserved to apply for any directions to enforce the trust.
(d)The counterclaim by LDC against Messrs Harding and Scholfield for breach of warranties is dismissed.
(e) The counterclaim by LDC against Messrs Harding and Scholfield and Perpetual for a declaration that Perpetual’s security interest has priority over any amounts which LDC is liable to pay the plaintiffs is dismissed.
(f) The plaintiffs are entitled to costs against LDC.
(g) Messrs Harding and Scholfield are entitled to costs against LDC on both counterclaims.
(h) Leave is reserved to Perpetual to apply for costs against LDC. (i) The quantum of costs is reserved.
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