Solicitors and advisors to face liability for directors’ breach

Introduction

The New South Wales Supreme Court has found a solicitor liable for facilitating unlawful ‘phoenix’ activity.¹ Phoenix activity consists of transferring business assets out of an old debt-laden company (which subsequently goes into liquidation) to a new debt free company. The new company carries on the business of the old company; but the assets are put beyond the reach of the creditors of the old company.

To date, the target of most court action in response to phoenix activity has been the directors of the old debt laden company. This new case—targeting the directors and their solicitor—is a timely reminder of the breadth of potential liability for professional advisors. It highlights regulator concern about advisers being involved in transactions designed to defeat creditors, and is a clear warning of potential action against advisers whose professional assistance has facilitated improper corporate conduct.²

In many cases the Australian Taxation Office (ATO) is a major unsecured creditor of the old debt laden company. The ATO considers that phoenix activity is a rising problem and has expressed its frustration at what it considers has historically been an inadequate response by the courts.³ Advisors can expect that the ATO will look closely at what opportunities Somerville presents to combat such activity.

Legal, accounting and other advisers need to be mindful of the potential that advice and assistance to clients may expose them to liability and the obvious reputational damage that would accompany any adverse publicity.

Liability for ‘phoenix’ trading activity

Breach of statutory duty by directors

In ASIC v Somerville, ASIC succeeded in obtaining declarations of breach of directors’ duties under the Corporations Act 2001 (Cth) (Corporations Act) against the directors of eight unrelated companies and their solicitor (Somerville), who advised and assisted each of those directors in relation to phoenix trading.

The directors separately sought advice from Somerville in circumstances of insolvency or near-insolvency. Somerville provided similar legal advice to each director, recommended and was involved in facilitating transactions to transfer the assets of each distressed company to a new company in return for ‘V class’ shares which carried a right to receive dividends from the new company. In no case was a dividend declared (or ever likely to be declared) by the new company.

Windeyer AJ of the New South Wales Supreme Court decided that there was ‘no proper basis for the transactions other than to keep the benefit of the assets in the new company without the burden of the liabilities’.⁴ The directors were found to have breached their statutory duties to act in good faith and for a proper purpose in the interests of the company – those interests including, in the context of insolvent or near-insolvent entities, the interests of creditors.⁵

The directors were also found to have breached the Corporations Act proscription on improper use of position or information under sections 182(1) and 183(1). Windeyer AJ was satisfied that the directors had misused their positions and information they held about the financial position of the original companies to:

• gain advantage for themselves (by continuing to direct companies which had the use of the transferred assets) and benefit the new company, and
• cause detriment to each of the original companies (by removing assets and substituting for those assets a right to dividends, if ever declared).⁶

Solicitor liable for ‘involvement’ in directors’ breaches of duty

Liability under the Corporations Act extends to persons ‘involved’ in a breach of certain duties. Section 79 provides that a person is ‘involved’ in another’s contravention of the Corporations Act if that person has, among other things ‘aided, abetted, counselled or procured the contravention’.

Ancillary liability under section 79 requires knowledge of the elements of the principal offence, although Windeyer AJ indicated a willingness in Somerville to infer that knowledge where appropriate:

Aiding and abetting a plan means helping or assisting or encouraging its implementation. Counselling means advising conduct (here wrongful conduct), and procuring means taking action to bring about the (improper) result in that there must be a causal connection between that action and the conduct impugned.⁷

Windeyer AJ was satisfied of a ‘direct causal connection’ between Somerville’s ‘involvement’ and the directors’ breaches of duty. He decided that none of the transactions would have taken place ‘but for’ Somerville’s involvement.⁸

That involvement extended to:

• advising on and recommending the impugned transactions
• preparing letters of advice and drafting the agreements
• preparing or facilitating all necessary documentation to carry out the transactions, and
• where necessary, arranging for settlement dates to take place prior to any imminent winding up and before personal liability attached to any director pursuant to an ATO director penalty notice.⁹

Windeyer AJ emphasised that Somerville’s conduct had gone further than simply providing advice. Rather, advice was given in order to carry out improper activity and he in fact carried out all the necessary work to realise that advice.¹⁰ 

It is worth noting, however, that in theory none of the acts undertaken by Somerville on behalf of his clients were particularly unique or special, although the context may have been unusual.

Penalty

Declarations of contravention were made against each of the eight directors and against Somerville. Windeyer AJ made orders restraining each of the defendants from engaging in similar conduct but reserved judgment on ASIC’s application for orders disqualifying the defendants from managing a company.

Liability for advice alone?

The judgment in Somerville raises the question of where the line between advice and ‘involvement’ lies. Might liability attach to the giving of advice alone or was the ‘extraordinary’¹¹ step of imposing liability on a solicitor the product of his participation in the practical steps required to give effect to his advice? Or the number of occasions on which it took place—would a court infer knowledge of the principal offence on the part of a solicitor who went no further than providing legal advice on a single occasion?

These matters are left unclear. While first suggesting that advice alone could amount to ‘involvement’ within the meaning of section 79—if the result of that advice ‘brings about an action by directors’ in breach of the Corporations Act—Windeyer AJ then added:

[I]n other words, when advice is given by a solicitor to carry out an improper activity and the solicitor does all the work involved in carrying it out apart from signing documents, it seems to me that there can be no question as to liability.’¹²

ASIC Commissioner Michael Dwyer has endorsed the notion that advice alone could attract liability. In a September 2009 media release the Commissioner stated¹³:

[The Somerville decision] brings home to advisers the need to ensure that they do not get themselves in a position where their involvement amounts to advice, as in this case, to carry out an improper activity. Advisers who go beyond the normal giving of advice which cause their clients to breach the director duties provisions of the Corporations Act run the risk of themselves breaching those provisions by being involved in their clients’ contraventions.

What would be the result if the solicitor gave the advice and subsequently drafted the agreement? The authors suggest that activity would not fall foul of section 79. The addition of other facts however, may well tip the balance against the advisor.

Conclusion

By pursuing the legal adviser involved in the transactions in Somerville’s case, ASIC has signalled a preparedness to exploit other weaponry available to assist in its deterrent function. It remains to be seen whether ASIC will seek to extend the reach of the Somerville decision beyond conduct such as occurred there.

In times of economic stress, regulatory attention is likely to be focused upon insolvency¹⁴, including deterring fraudulent phoenix activity. The establishment of the Assetless Administration Fund ensures funding is available for liquidator investigations into failed companies in an effort to curb phoenix activity.¹⁵ Yet ATO Deputy Commissioner, Mark Konza, has made public statements expressing his frustration that the fight against phoenix trading is being thwarted by light penalties and a lack of prosecution activity.¹⁶

The Somerville case is also apposite in the context of large scale corporate collapses; where the public demand for a response is likely to be palpable.

However the implications of Somerville extend beyond the area of insolvency. While the involvement of the solicitor in Somerville went further than mere provision of advice, the decision may not be so confined and may foreshadow a period of broader liability of professional advisers.

The decision maps out new territory for liability to attach to professional advisers for giving advice in relation to conduct later deemed improper by ASIC and the courts. It is a salient reminder to all advisers that they must be mindful of their own potential liability for another’s breach by reason of the advice and assistance they have provided.

This article was written by Paul Wenk, Partner and Isabel Knott, Solicitor, Melbourne.

Endnotes

1. ASIC v Somerville & Ors [2009]  NSWSC 934 (Somerville).
2. See ASIC Media Release 08-110 ASIC launches action against alleged phoenix activity, Tuesday 27 May 2008; ASIC Media Release 09-174AD Legal adviser and company directors found liable in relation to ‘phoenix’ activity, Monday 14 September 2009.
3. Biannual hearing with Commissioner of Taxation before the Joint Committee of Public Accounts and Audit, Parliament of Australia, Canberra, 23 October 2009, PA8, PA24.
4. Somerville [2009]  NSWSC 934, [42].
5. Sycotex Pty Ltd v Bescher (1994) 13 ACSR 766 discussed in Somerville [2009] NSWSC 934, [35].
6. Somerville [2009] NSWSC 934, [43]-[44].
7. Ibid [40]-[41].
8. Ibid [48].
9. Pursuant to a notices issued under s 222AOE of the Income Tax Assessment Act 1936 (Cth)
10. Somerville [2009] NSWSC 934, [49].
11. See submission of counsel for Somerville cited at Somerville [2009] NSWSC 934, [49].
12. Ibid (emphasis added).
13. ASIC Media Release 09-174AD Legal adviser and company directors found liable in relation to ‘phoenix’ activity, Monday 14 September 2009 (emphasis added).
14. See, for example, ASIC Media Release 09-102AD ASIC launches online insolvency portal, Monday 1 June 2009.
15. See details of the Assetless Administration Fund on the ASIC website.
16. Biannual hearing with Commissioner of Taxation before the Joint Committee of Public Accounts and Audit, Parliament of Australia, Canberra, 23 October 2009, PA24.

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