The Tax Benefits of Creating a Testamentary Trust

A Testamentary Trust has a myriad of tax benefits, which can play an integral role in maximizing the net income that beneficiaries of the Trust receive.

It is important that all trustees, as well as trust creators (or grantors), are aware of these advantages in order to seek the greatest return for the beneficiaries, and to maximise after-tax net income.

What is a Testamentary Trust?

Testamentary Trusts are trusts created by a ‘testamentary’ instrument (usually a Will). This means that a Testamentary Trust comes into effect after the person who created it has died. Testamentary Trusts are usually created to benefit a person’s spouse, children or grandchildren. For more information please read: Testamentary Trusts in Estate Planning.

It is important to note that Testamentary Trusts require their own tax file numbers, separate from the tax file number of the deceased estate. Deceased estates are not subject to the Medicare Levy; Testamentary Trusts are.

Benefit #1 – Marginal Tax Rates for the Testamentary Trust

At the Commissioner’s discretion, a Testamentary Trust’s income can be assessed under s99 of the Income Tax Assessment Act 1936 (Cth) (“ITAA”). Other trusts, such as an Inter Vivos Trust (which comes into affect while the trust creator is alive), are assessed under s99A of the same Act.

What does this mean? Under s99A, an Inter Vivos Trust will be assessed at the highest marginal tax rate for undistributed income, that is, at 49% inclusive of Medicare and Budget Levies. Under a Testamentary Trust, however, the Commissioner may choose to apply s99 which taxes the trustee at what is essentially a standard adult marginal rate. This marginal rate also excludes the tax free threshold of $18,200.

Under s99:

• • Any income between $670 and $37,000 is charged at a flat rate of 19%.
  • Any income between $37,000 and $80,000 is charged at a marginal tax rate of approximately 32.5%.
  • Any income between $80,000 and $180,000 is charged at a marginal tax rate of approximately 37%.

Benefit #2 – Discount on Capital Gains Tax for Disposal of Assets

Section 99, under which a Testamentary Trust can operate, allows trustees to access a 50% discount on Capital Gains Tax for assets that are sold off. This is provided they have been held for over 12 months. Most other types of trusts are subject to s99A which does not provide access to this discount.

Benefit #3 – Personal Income Benefits

A person will either be a “beneficiary” or a “beneficiary under a legal disability”. A beneficiary under a legal disability can include minors (under 18), bankrupts who have not been discharged and persons who are deemed “mentally impaired”.  The beneficiaries will be assessed as follows:

• • An ordinary beneficiary (not under a legal disability) will have their personal income assessed under s97 of the ITAA. This means their personal income tax will be assessed at marginal tax rates which are subject to the $18,200 tax-free threshold.
  • A beneficiary under a legal disability (who is not a child) will be assessed under s98(1) of the ITAA. Here the trustee will be assessed by the ATO on the beneficiary’s behalf. The trustee will then issue a Beneficiary Tax Statement to the beneficiary. (Implications for this below).
  • Further to the above, pursuant to s102AG(2)(a) of the ITAA, a child (who is a beneficiary with a legal disability) will have their income from a Testamentary Trust classified as “excepted trust income”. This means their income will be assessed at adult marginal rates, entitling them to the $18,200 tax-free threshold they otherwise would not have been able to access.

In addition to receiving marginal tax rates, beneficiaries under a Testamentary Trust are also entitled to “franking credits”.

Overall Effect

A beneficiary to a Testamentary Trust will therefore be entitled to marginal tax rates when being assessed on income from the trust, while also receiving distributed franking credits. This maximises their overall net income.

While these are some of the nuances of taxation involved in a Testamentary Trust, if you are creating a trust, it is important to seek legal advice to help decide which trust structure is best for your personal circumstances. If you are a trustee of a Testamentary Trust legal advice can also assist in capitalising on the tax benefits available to you and the beneficiaries of the trust.

This article was written by Andrew Lind (Director).

Executors and Tax Returns

When attending to the estate of a deceased person; executors and tax returns matters can be complex.  One of an executor’s many responsibilities in relation to the estate of a deceased person is to finalise the deceased’s taxation matters.  Whilst there is no longer an ‘inheritance tax’ in Australia, there are likely to be income tax and capital gains tax issues in most estates, which must be finalized by the executor prior to distributing the estate among beneficiaries.

The Australian Taxation Office has recently revised some of the information available of its website in order to make these matters simpler to understand for both executors and beneficiaries. Prior to obtaining professional accounting assistance to finalize the deceased’s taxation matters, the information available provides useful general information for executors to understand the factors that impact upon the taxation treatment of  various payments and other transactions which are likely to be dealt with in the course of the estate’s administration.

Superannuation will also need to be addressed by executors in the majority of deceased estates, and payouts may be subject to taxation. The revised information published on the ATO website also provides an explanation of the treatment of superannuation death benefits, and the various factors which affect the treatment of these payments for taxation purposes.

If the deceased was actively engaged in the workforce prior to their death, a ‘death benefit employment termination payment’ may be made to the estate by their employer. Components of these payments may be taxable, whilst others may be tax free – professional advice on the treatment of these payments for taxation purposes is essential. The calculation of taxation liability depends on whether or not the beneficiary was a dependent of the deceased, and the total amount of the payment. However, the information published by the ATO provides executors with a useful starting point for understanding both how these payments are calculated, and factors that are relevant to their taxation treatment.

For more information regarding Executors and Tax Returns

Please contact our Business Development Team or call us on (07) 3252 0011 to book an appointment with one of our specialist Estate Lawyers today.

Directors signing on behalf of Companies are not personally liable

The recent Supreme Court  case of Reozone Pty Ltd v  Rene Santoro [2016] NSWSC 1383 confirms that a Director will not automatically be personally liable for a company’s liabilities if the guarantee was signed with a qualification on behalf of the company.

Facts

• • Elite Plant Hire Pty Ltd (Elite) was in the business of renting vehicles, plant and machinery.

• • Rene Santoro (Santoro) signed a Loan Agreement from Sydney Trucks and Machinery (STM)for the supply of machinery and vehicles to Elite.

• • The Loan Agreement provided that Santoro granted a charge over all her present and future real “estate/property” to secure payment of money owed by Elite to STM.

• • Santoro’s signature appeared on the Loan Agreement above the words “Customer Signature” and “Accepted for and on behalf of the Company Name Rene Santoro Director ELITE PLANT HIRE PTY LTD”

• • Santoro ‘signature did not appear on the Loan Agreement in the space below the words “GUARANTOR: I Rene Santoro …secure payment by granting a charge over all real estate/property held now or in the future”

• • Elite went into liquidation and STM claimed that Santoro charged her real property with payment of debts owed by Elite to STM

Issue

The Court considered the question whether by her signature on the Loan Agreement Santore indicated to a reasonable person in the position of STM that  she granted a charge over her personal real property as security for Elite’s debts

Decision

1. 1. The Court considered a number of similar cases and found that the question is whether objectively a party has indicated that they accept personal liability by the placement of their signature on the relevant document. In this regard the document should be considered as a whole and the circumstances in which it came to be entered into.
   2. The Court found that Santoro did not sign the contract without qualification in the execution clause and the only signature on the document was expressly a signature on behalf of Elite.  In those circumstances it would be natural for the other party to assume, where a party signs with a qualification as agent for the company and not otherwise, the signatory is not accepting personal contractual liability.

Lessons for Directors

Directors should always qualify their signature on documents executed on behalf of a company and include the words “for and on behalf of XYZ Pty Ltd” to avoid any inference that they are accepting personal contractual liability.  However, the Courts will decide any dispute in this regard by considering the contract as a whole and also the circumstances in which it came to be entered into.

State Street Australia and Section 203D of the Corporations Act

On 7 June 2016, Beach J, Federal Court of Australia, handed down his judgement for the case, State Street Australia.[1] In his decision, Beach J considered the interpretation of s 203D of the Corporations Act 2001 (Cth) (the “Act”), which delineates a statutory process for the removal of directors by members of a public company. One of the issues in dispute was whether the section provided an exhaustive codification of the process for a removal of a director, or whether the section should be read as merely one method of removal, without prohibiting other methods provided by a company’s constitution.

Section 203D(1) of the Corporations Act  states:

• • A public company may by resolution remove a director from office despite anything in:

    • • the company’s constitution (if any); or
    • • an agreement between the company and the director; or
    • • an agreement between any or all members of the company and the director.

If the director was appointed to represent the interests of particular shareholders or debenture holders, the resolution to remove the director does not take effect until a replacement to represent their interests has been appointed.

Decision

In deciding on this issue, Beach J expressed the view that “although s 203D(1) is mandatory in the sense that it overrides a company’s constitution to the extent of any inconsistency, it does not provide an exhaustive codification of the mechanism for removal.”[2] In reaching this decision, Beach J firstly considered the construction of the section, before turning to relevant authorities.

Reasoning

Notably, Beach J directly addressed the previous and conflicting decision of Bryson AJ in Scottish & Colonial Ltd.[3]  In Scottish & Colonial, Bryson AJ’s gave attention to the different wording of section 203D in contrast to its precursor section prior to the Corporate Law Economic Reform Program Act 1999 (Cth). Whereas the current section uses the word “despite”, the precursor section used the words “notwithstanding”.  Bryson AJ reasoned that the strong nature of the language in the current section showed an intention to diverge from the interpretation of earlier provisions and, considering the emphatic wording, the current section should operate regardless of whether a company’s constitution afforded directors with less or no protection.[4]

In considering a number of other authorities, Beach J concluded that Bryson AJ’s decision in Scottish & Colonial “is not consistent with the prevailing view”,[5] and an “outlier”.[6] Consequently, Beach J decided “not to follow it”.[7] In reaching this decision Beach J considered a number of cases, all of which either directly or indirectly move away from the position taken by Bryson AJ.[8]

Further to his analysis of Australian case law, Beach J also raised 6 points regarding the construction of the section in support of the conclusion that s 203D of the Act “provides a mechanism rather than the mechanism”[9] for the removal of directors by members in a public company. These points are briefly summarised as follows:

• • The section uses the language “may” rather than “may only…” Accordingly, the language is not restrictive.[10]

• • The section uses the phrase “despite anything”.[11] Implicitly, the interpretation of these words is limited only to any inconsistency in a company’s constitution.

• • “Nothing turns on the point that the section is not a replaceable rule.”[12]

• • Nothing can be read from the absence in the section of a predecessor subsection from a previous Act. This is because “Such a subsection [is] unnecessary given the plain text of s 203D(1).”[13]

• • Subsections (2) to (6) repeatedly refer to “the director” and “the resolution”. Thus, in the words of Beach J, “It is apparent that all other rights are attached to and triggered by the utilisation of the mechanism under subsection (1) only.”[14] The text does not indicate an intention for the rights in subsections (2) through to (6) to be conferred in all cases, but only where subsection (1) has been triggered. Hence, the application of section 203D is not given a comprehensive scope.

• • The proviso uses definite articles ( “the director” and “the resolution”) as a reference back to subsection (1). Thus, proviso is coupled with the operative part of the section and “cannot separately be said to be mandatory in all cases where the operative provision was not.”[15]

Future Lessons

Therefore it seems that a public company constitution (including companies limited by guarantee) can adopt an alternative process in their constitution for the removal of directors. Many charities and not for profits are incorporated by way of a company limited by guarantee.

Did you know that a public company constitution can allow for the removal of directors?

The removal of Directors has serious consequences, seek legal advice

Contact us. Call (07) 3252 0011 and speak with our Business Development Team today to book an appointment with our commercial lawyers.

Written by Andrew Lind (Director) and Callum Gibson (Graduate Law Clerk).

Footnotes

[1] State Street Australia Ltd in its capacity as Custodian for Retail Employees Superannuation Pty Ltd (Trustee) v Retirement Villages Group Management Pty Ltd [2016] FCA 675.

[2] Ibid, [16].

[3] Scottish & Colonial Ltd v Australian Power and Gas Co Ltd [2007] NSWSC 1266

[4] State Street Australia as per Beach J at [27] quoting Scottish & Colonial Ltd at [17], [21], [39], and [41].

[5] State Street Australia, [33].

[6] Ibid, [26].

[7] Ibid, [33].

[8] Allied Mining & Processing Ltd v Boldbow Pty Ltd [2002] WASC 195; Attorney-General of the Commonwealth v Oates [1999] HCA 35; Dick v Comvergent Telecommunications Ltd [2000] NSWSC 331; Bisan Ltd v Cellante [2002] VSC 504; Central Exchange Ltd v Rivkin Financial Services Ltd [2004] FCA 1546; (2004) 213 ALR 771; Dalkeith Resources Pty Ltd v Regis Resources Ltd [2012] VSC 288

[9] Ibid, [17].

[10] Ibid.

[11] Ibid, [18].

[12] Ibid, [19].

[13] Ibid, [20].

[14] Ibid, [21].

[15] Ibid, [22].

Director’s duties – the bar has been raised

Directors duties and financial statements when put together carry a lot of weight.  The decision of His Honour Middleton J in Australian Securities and Investments Commission v Healey [and others] [2011] FCA 717 (the Centro Case) handed down by the Federal Court on 27 June 2011 held that the defendant directors had breached their director’s duties in failing to discharge their duties of care and diligence.

If you are a director of a company, especially one in which you are not involved in the day to day management of, this decision is cause for some sober reflection.

In our assessment the “bar has been raised” by this decision in the expectation that the law places on directors and their duties of care and diligence, especially in their function of representing to the world at large the financial position of the company as disclosed in the publicly available financial statements.

This judgement (131 pages of it) has particular relevance in relation to the procedure adopted for consideration of the financial statements of the company and the resolution to sign the directors declaration required.

The following extracts from the judgement indicate the tenor of the judgement (emphasis added).

1. 14. A director is an essential component of corporate governance. Each director is placed at the apex of the structure of direction and management of a company. The higher the office that is held by a person, the greater the responsibility that falls upon him or her. The role of a director is significant as their actions may have a profound effect on the community, and not just shareholders, employees and creditors.
   15. This proceeding involves taking responsibility for documents effectively signed-off by, approved, or adopted by the directors. What is required is that such documents, before they are adopted by the directors, be read, understood and focussed upon by each director with the knowledge each director has or should have by virtue of his or her position as a director. I do not consider this requirement overburdens a director, or as argued before me, would cause the boardrooms of Australia to empty overnight. Directors are generally well remunerated and hold positions of prestige, and the office of director will continue to attract competent, diligence and intelligent people.
   16. The case law indicates that there is a core, irreducible requirement of directors to be involved in the management of the company and to take all reasonable steps to be in a position to guide and monitor. There is a responsibility to read, understand and focus upon the contents of those reports which the law imposes a responsibility upon each director to approve or adopt.
   17. All directors must carefully read and understand financial statements before they form the opinions which are to be expressed in the declaration required by s 295(4). Such a reading and understanding would require the director to consider whether the financial statements were consistent with his or her own knowledge of the company’s financial position. This accumulated knowledge arises from a number of responsibilities a director has in carrying out the role and function of a director. These include the following: a director should acquire at least a rudimentary understanding of the business of the corporation and become familiar with the fundamentals of the business in which the corporation is engaged; a director should keep informed about the activities of the corporation; whilst not required to have a detailed awareness of day-to-day activities, a director should monitor the corporate affairs and policies; a director should maintain familiarity with the financial status of the corporation by a regular review and understanding of financial statements; a director, whilst not an auditor, should still have a questioning mind.
   18. A board should be established which enjoys the varied wisdom, experience and expertise of persons drawn from different commercial backgrounds. Even so, a director, whatever his or her background, has a duty greater than that of simply representing a particular field of experience or expertise. A director is not relieved of the duty to pay attention to the company’s affairs which might reasonably be expected to attract inquiry, even outside the area of the director’s expertise.
   19. The words of Pollock J in the case of Francis v United Jersey Bank (1981) 432 A 2d 814, quoted with approval by Clarke and Sheller JJA in Daniels v Anderson (1995) 37 NSWLR 438, make it clear that more than a mere ‘going through the paces’ is required for directors. As Pollock J noted, a director is not an ornament, but an essential component of corporate governance.
   20. Nothing I decide in this case should indicate that directors are required to have infinite knowledge or ability. Directors are entitled to delegate to others the preparation of books and accounts and the carrying on of the day-to-day affairs of the company. What each director is expected to do is to take a diligent and intelligent interest in the information available to him or her, to understand that information, and apply an enquiring mind to the responsibilities placed upon him or her. Such a responsibility arises in this proceeding in adopting and approving the financial statements. Because of their nature and importance, the directors must understand and focus upon the content of financial statements, and if necessary, make further enquiries if matters revealed in these financial statements call for such enquiries.
   21. No less is required by the objective duty of skill, competence and diligence in the understanding of the financial statements that are to be disclosed to the public as adopted and approved by the directors.
   22. No one suggests that a director should not personally read and consider the financial statements before that director approves or adopts such financial statements. A reading of the financial statements by the directors is not merely undertaken for the purposes of correcting typographical or grammatical errors or even immaterial errors of arithmetic. The reading of financial statements by a director is for a higher and more important purpose: to ensure, as far as possible and reasonable, that the information included therein is accurate. The scrutiny by the directors of the financial statements involves understanding their content. The director should then bring the information known or available to him or her in the normal discharge of the director’s responsibilities to the task of focussing upon the financial statements. These are the minimal steps a person in the position of any director would and should take before participating in the approval or adoption of the financial statements and their own directors’ reports.
   23. The omissions in the financial statements the subject of this proceeding were matters that could have been seen as apparent without difficulty upon a focussing by each director, and upon a careful and diligent consideration of the financial statements. As I have said, the directors were intelligent and experienced men in the corporate world. Despite the efforts of the legal representatives for the directors in contending otherwise, the basic concepts and financial literacy required by the directors to be in a position to properly question the apparent errors in the financial statements were not complicated.

Some immediate ‘good governance’ implication questions

1. 1. Does your board have the right mix of wisdom, experience and expertise? If not, what steps will you take to seek that?
   2. Do your directors have the ability to read and understand financial statements? If not, what training is going to be organised?
   3. What does a familiarity with the financial status and regular review of the financial statements require? Monthly?
   4. Do your directors have the time and the ‘head space’ to read, understand and enquire into the financial statements? They might be wise, experienced and expert but if they may simply not have the time needed.
   5. Do you ask your co-directors – have you read, understood and enquired into the financial statements?
   6. Do your directors understand that they have the freedom to delay the adoption of the financial statements, ask the hard questions and insist on answers and further specific professional advice if required?
   7. What does monitoring corporate affairs and policies require? Are policy changes reported to the Board and in certain cases not able to be adopted without the approval of the Board?

Company Boards are increasingly asking us to have a ‘half day work-shop’ with their Board to unpack and explain their duties and provide practical advice on applying those duties. The agendas for such a workshop can be tailored for each board and often covers other ‘big ticket’ legal, risk, compliance and tax issues.

What does using Best Endeavours or Reasonable Endeavours mean?

The High Court of Australia recently shed some light on the extent of a party‘s obligations to use best endeavours or reasonable endeavours in Electricity Generation Corporation v Woodside Energy Ltd [2014] HCA 7.

Contracts

These types of obligations commonly occur in distribution agreements, intellectual property licenses, mining and resources agreements and construction contracts.

High Court’s Observations

The High Court confirmed that arguments usually proceed on the basis that the obligations that flow from the terms “reasonable endeavours” and “best endeavours” are substantially similar.

The High Court’s observations about a party’s obligation to use “reasonable endeavours” and “best endeavours may be summarised as follows.

Not Absolute or Unconditional

Firstly, the obligation to use “reasonable endeavours” or “best endeavours is not absolute or unconditional.

Role of Reasonableness

Secondly, the nature and extent of the obligations will necessarily depend on what is reasonable in the circumstances.  The circumstances that dictate what is reasonable may also include circumstances that affect the relevant party’s own business and as explained by His Honour Mason J in Hospital Products Ltd v United States Surgical Corporation[1984] HCA 64, the qualification of reasonableness is directed at situations where the business interests of the obligor would prevail over the interest of the other contractual party.

Defined in Contract

Thirdly, some contracts contain their own standard of what is reasonable “by some express reference relevant to the business interest of the obligor”.

Conclusion

While the obligations to use “reasonable endeavours” and “best endeavours” in Australia may be substantially the same, the extent of a party’s obligations in this regard is not absolute and will always be tempered with reasonableness and any specific parameters laid down in the contract under consideration.

For more information regarding best endeavours or reasonable endeavours

Please contact our Business Development Team or call us on (07) 3252 0011 to book an appointment with one of our Commercial Lawyers today.

Changes to ATO Director Penalty Regime – Personal liability of Directors for Company debts

The personal liability of directors for company debts has been significantly changed by recent amendments to the Tax Administration Act 1953 (Cth).

Former ATO Director Penalty Regime

Under the previous ATO Director Penalty regime, directors would be held liable for a company’s unremitted PAYG withhold tax (i.e. the estimated income tax withheld from employee salaries and director fees) if the director did not comply with an ATO-issued Director Penalty Notice (“DPN”).  The former regime effectively allowed directors to avoid personal liability by placing the company into administration within 21 days of receipt of the DPN.

New ATO Director Penalty Regime

Some of the material changes to the director penalty regime include:

1. 1. Directors will be personally liable not only for company PAYG withholding tax but also for employee superannuation guarantee charges.
   2. Directors will not be able to avoid personal liability by placing a company into administration where the company has not lodged its necessary returns and the PAYG and/or superannuation debts are at least 3 months overdue.
   3. A new director will not be held personally liable for PAYG withholding tax and superannuation obligations within 30 days of commencement as a director.
   4. Where the company has not remitted PAYG withholding amounts in respect of fees or salary paid to a director or associate, the ATO can prevent the director or associate from claiming a PAYG credit on their personal tax returns and levy PAYG withholding non-compliance tax on the director or associate (i.e. effectively, requiring the director to personally pay the PAYG income tax that ought to have remitted to the ATO by the company).

The new director penalty regime applies to private companies (“Pty Ltd”) and public companies (“Ltd”), including not for profit companies limited by guarantee.  In addition, committee members of incorporated and unincorporated associations are also liable under the director penalty regime.  The new regime came into effect on 29 June 2012 and, taking a conservative approach, applies retrospectively.

Particularly for new directors it is important that during the first 30 days after their appointment they undertake rigorous due diligence of the company’s PAYG and superannuation records.  If the director is not satisfied with the outcome of those enquiries he or she ought to take independent advice immediately with a view to resigning.

For more information regarding the Personal Liability of Directors for Company Debts

Please contact our Business Development Team or call us on (07) 3252 0011 to book an appointment with one of our Commercial Lawyers today.

Insolvency trumps loss of bargain claim

The recent Court of Appeal case of the Gilligan ‘s Backpackers Hotel & Resort Pty Ltd & Anor v Mad Dogs Pty Ltd [2016] QCA 304 demonstrates that a claimant’s insolvency can in some cases be a remedy for a claim of damages flowing from repudiation of a contract.

Facts

• • Gilligan ‘s Backpackers Hotel & Resort Pty Ltd (GBH) owned and operated a hotel in Cairns
  • Mad Dogs Pty Ltd (Mad Dog) operated a food and cartering services business
  • GBH repudiated a three year supply contract with Mad Dog by wrongfully terminating the contract;
  • Mad Dog subsequently terminated the contract and sued GBH for damages for repudiation;
  • Mad Dog was successful in the Supreme Court and was given judgment in the amount of $351,193.57 for loss of its bargain.

Was Mad Dog ready willing and able to perform the contract?

GBH did not dispute that it had repudiated the contract or that Mad Dog was entitled to terminate the contract.  However on Appeal GBH argued that Mad Dog should not have been awarded any damages for loss of its bargain due to GBH’s wrongful termination of the contract, because Mad Dog was insolvent at the date of termination and therefore was not ready, willing and able to perform the agreement. GBH also relied on s 588G of the Corporation Act 2001 (Cth), which provides that a director of an insolvent company has a duty to prevent the company from incurring more debt.  A director who is aware or on reasonable grounds suspects insolvency, also contravenes s 588G and is guilty of an offence, if he or she allows the company to incur further debt.  Both parties accepted that Mad Dog would naturally have incurred further debt if it continued to perform the contract.  Therefore, if Mad Dog was insolvent, it was unable to lawfully conduct its business.

Mad Dog was Insolvent

The Court of Appeal overturned the court at first instances judgment and found that Mad Dog was insolvent at the date of termination.  It follows that Mad Dog was therefore not able to perform the agreement.  Accordingly, Mad Dog was also not entitled to any damages for the loss of its contract.  This case serves as reminder for defendants that the solvency of a claimant is an important factor to consider in determining whether a party is ready willing an able to perform the contract.

For more information regarding insolvency

Please contact our Business Development Team or call us on (07) 3252 0011 to book an appointment with one of our Commercial Lawyers today.

Lavin v Toppi – A Guarantor’s Right of Contribution From a Co-Guarantor

Can this right be extinguished if the creditor waives its right to demand payment from one co-guarantor?

CASE NAME: Lavin v Toppi [2015] HCA 4

Each co-guarantor at law is generally required to contribute equally to the repayment of a debt and if one guarantor pays more than their share of the debt, they have a right to seek a contribution from a co-guarantor in compensation of the overpayment (see Burke v Lfot Pty Ltd (2002) 209 CLR 282 at 299, [38]).

However, what confused the usual situation in the case of Lavin v Toppi [2015] HCA 4 was the fact that the Bank had entered into an agreement with one of the guarantors which provided that the Bank would not enforce its rights against the guarantor, provided the guarantor paid a certain amount towards the debt.

1. Legal issue in dispute

Did this agreement extinguish the rights of the other guarantors to seek a contribution from the guarantor who entered into the agreement?

2. Brief relevant facts

Ms Lavin and Ms Toppi were joint directors and shareholders in a company, Luxe Studios Pty Ltd (“Luxe”). Luxe had a number of loans with the National Australia Bank (“NAB”) which were later consolidated into one loan in the amount of $7,768,000 (“the Loan”).

The Loan was guaranteed jointly and severally by Ms Lavin, a company associated with Ms Lavin, Ms Toppi, Ms Toppi’s husband, and Luxe Productions Pty Ltd (another company jointly owned and controlled by Ms Lavin and Ms Toppi) (“the Guarantors”).

In November 2009, Luxe went into receivership. In March 2010 the NAB made demands upon each of the Guarantors for payment of the balance of the loan. The Guarantors failed to meet those demands and therefore the Bank commenced proceedings against the Guarantors to enforce the guarantee.

A property owned by Luxe was sold in May 2010. NAB retained the proceeds of the sale. Luxe remained indebted to the Bank for an amount of approximately $4 million.

Ms Lavin and the company associated with Ms Lavin filed a cross-claim against the NAB seeking a declaration that the guarantee was unenforceable because they had allegedly been unconscionably procured into the guarantee.

A Deed of Release and Settlement was entered into between Ms Lavin, the company associated with Ms Lavin and the NAB to settle the matter, which provided, among other things that Ms Lavin agreed to pay the NAB:

1. 1. $1.35 million for the guaranteed debt; and
   2. $1.73 million for other personal loans.

(“the Settlement Sum”)

The Deed provided that the Bank would not sue Ms Lavin and the company associated with Ms Lavin (“the Appellants”) in respect of the guarantee, provided Ms Lavin paid the Settlement Sum.

The Settlement Sum was paid by Ms Lavin and the proceedings between the NAB, Ms Lavin and the company associated with Ms Lavin were dismissed by consent.

In early 2011, Ms Toppi and her husband (“the Respondents”) sold their home and used the proceeds of the sale to pay the balance of the guaranteed debt.

The Guarantors’ obligations were therefore discharged under the guarantee.

The Respondents commenced proceedings against the Appellants claiming a contribution of half of the amount paid by the Respondents which discharged the guarantee. The Appellants resisted these proceedings on the basis of the Deed of Settlement entered into between the Appellants and the NAB.

3. Primary Judge’s Decision 

The primary judge, referring to the case of Carr and Purves v Thomas [2009] NSWCA 208 (“the Carr case”), held that a creditor’s covenant not to sue a particular co-guarantor had no effect on the rights of guarantors to seek a contribution from the other co-guarantors. The Appellants were therefore ordered to pay a contribution for the amount claimed.

4. Court of appeal’s decision

The Appellants appealed arguing that the Carr case was not supported by case authority and was clearly wrong as a matter of legal principle. This argument was rejected by the Court of Appeal. It was held that:

“In point of principle, a covenant not to sue (in the usual form) does not alter an existing liability. Giving such a covenant means merely that the covenantor is in breach if it does sue.”

The covenant did not extinguish the Appellants’ liability under the guarantee.

Therefore, the Appellants and the Respondents continued to share liabilities of the same nature and extent so as to entitle the Respondents to recover contribution from the Appellants.

5. High court’s decision

The Court of Appeal decision was appealed by the Appellants to the High Court. The Appellants argued that the Respondents needed to show that their respective liabilities were “co-ordinate” (that is, of the same nature and quality).

Generally guarantors who are jointly and severally liable will have “co-ordinate liability”.

The Appellants argued that their liability was “qualitatively different” from the Respondents’ liability because Respondents’ liability was enforceable by the NAB, while the Appellants’ liability was not.

The High Court dismissed the Appellant’s arguments for the following reasons:

1. 1. The NAB’s covenant not to sue the Appellants did not extinguish the Appellant’s ongoing liability for the guaranteed debt because while the Bank could not sue by commencing legal proceedings, the Appellant’s liability remained enforceable by other means such as reliance upon the rights of recoupment under other securities (if any) between the Bank and the Appellants. Therefore the parties did share coordinate liabilities to the NAB under the guarantee both before and after the covenant was entered into. The nature and quality of the parties’ liabilities were not affected by the Deed; and
   2. The Respondents’ right to contribution from the Appellants arose in equity even before the Respondents made their disproportionate payment to the NAB and could not be defeated by the separate agreement of the NAB and the Appellants. From the moment of Luxes’ default or at the very latest, from the NAB’s demand on the Guarantors, each of the Guarantors shared a “common interest and a common burden” to pay to the Bank the whole of the guaranteed debt. Equity therefore requires a contribution to distribute equally, among those who have a common obligation, the burden of performing it.

The right of contribution among co-debtors is independent of any present right of the principal creditor.

A Bank cannot have the power to “select his own victim; and upon motives of mere caprice or favouritism, to make a common burden a most gross personal oppression”.

Therefore, the Deed could not serve to extinguish the right to a contribution.

Therefore it was ordered that the Appellants make a contribution of some $775,000.00, despite the Agreement with the NAB.

6. Implications for Guarantors

This case serves as a helpful reminder for co-guarantors, that entering into an agreement with the creditor regarding the sum of money to be paid by the co-guarantor does not necessarily resolve claims made against that co-guarantor by other co-guarantors.

When negotiating agreements in these situations, parties must carefully consider the possibility of other issues and liabilities arising in respect of persons who are not a party to the agreement, even though they may have a close connection to the situation.

Some ways to avoid a situation like this arising:

1. 1. Have all relevant persons take part in the negotiation and signing of the agreement;
   2. Ensure that the terms of the agreement are carefully drafted in a way that adequately protects your interests.

If you require advice regarding a similar situation and/or if you have any concerns or questions regarding guarantees, you should speak to our experienced Commercial Lawyers to assess your options.

If you would like to make an appointment to discuss your situation, please call us on (07) 3252 0011.