Linton v Telnet Pty Ltd

LOWER COURT JURISDICTION : Supreme Court - Equity Division LOWER COURT FILE NUMBER(S) : ED 3332 of 1995 LOWER COURT JUDICIAL OFFICER : Hulme J

COUNSEL : Appellant - B W Walker SC & S P Gullotta Respondent - I V Gzell QC & F G Lever SOLICITORS : Appellant - Michell Sillar, Sydney Respondent - Barry Lazarus, Sydney CATCHWORDS : BREACH OF FIDUCIARY DUTY - regard by directors to interests of group not particular company - whether Charterbridge test to be applied.(1); BREACH OF FIDUCIARY DUTY - regard by directors to interests of creditors - when required.(2); WHETHER DISREGARD OF INTERESTS OF CREDITORS PART OF CASE AT TRIAL - was not - leave to file notice of contention involving that case refused.(3); PARTICIPATION IN BREACH OF FIDUCIARY DUTY - knowing receipt case - whether knowledge or notice - on any version of the requisite knowledge or notice, no.(4) (1) Charterbridge Corporation Limited v Lloyds Bank Limited (1970) 1 Ch 62 Reid Murray Holdings Limited (In Liquidation) v David Murray Holdings Pty Limited (1972) 5 SASR 386 Australian National Industries v Greater Pacific Investments Pty Limited (In Liquidation) (No 3) (1992) 7 ACSR 176 Northside Developments Pty Limited v Registrar General (1990) 170 CLR 146 Equiticorp Finance Limited v Bank of New Zealand (1993) 32 NSWLR 50 referred to. (2) Walker v Wimborne (1976) 137 CLR 1 Kinsela v Russell Kinsela Pty Limited (1986) 4 NSWLR 722 Nicholson v Permakraft (NZ) Limited (1985) 3 ACLC 453 referred to. CASES CITED: (3) Suttor v Gundowda Pty Ltd (1950) 81 CLR 418 Coulton v Holcombe (1986) 162 CLR 1 Multicon Engineering Pty Ltd v Federal Airports ion NSWCA 15 October 1987 unreported applied. (4 ) Barnes v Addy (1874) 9 Ch App 244 Ninety Five Pty Ltd v Banque Nationale de Paris (1988) WAR 132 Agip (Africa) Ltd v Jackson (1990) Ch 265 Royal Brunei Airlines Sdn Bhd v Ming (1995) 2 AC 378 Equiticorp Industries Group Ltd v The Crown (1996) 3 NZLR 586 Koorootang Nominees Pty Ltd v Meldrum Jeffriess Group Pty Ltd (1998) 3 VR 16 Baden Delvaux and Lecuit v Société General pour Favoriser le Dèveloppement du Commerce et de l'Industrie en France SA(1983) BCLC 325 (1992) 4 All ER 161 referred to. DECISION : Appeal allowed and cross-appeal dismissed; Declaration and orders 2, 3, 5 & 7 made by Hulme J on 24 June 1998 set aside, and in lieu thereof order that the summons be dismissed and the plaintiff pay the defendant's costs of the proceedings before Hulme J; Order that the respondent pay the appellant's costs of the appeal and the cross-appeal; Appellant to have a certificate under the Suitors Fund Act if qualified; liberty to apply within 14 days.

THE SUPREME COURT OF NEW SOUTH WALES COURT OF APPEAL CA 40502 of 1998 ED 3332 of 1995 BEAZLEY JA GILES JA SHEPPARD AJA

2 GILES JA: Osborne Computer Corporation Pty Limited ("OCC") built personal computers. It was wholly owned by Osborne Computers Limited ("OCL"), the shareholders in which were interests associated with Mr Stanley Falinski. The directors of OCC were Mr Falinski and Mr John Linton. The directors of OCL were Mr Falinski, his wife Mrs Jill Falinski, and Mr Linton.

3 OCC sold the computers to Telnet Pty Limited ("Telnet") for resale to the public. The shareholders in Telnet were two companies respectively representing interests of Mr Falinski and Mr Linton, each having an equal shareholding. The directors of Telnet were Mr Falinski and Mr Linton. The Linton shareholding company was Jalana Pty Limited ("Jalana"), the shareholders in which were Mr Linton and his wife Mrs Annette Linton. Mrs Linton was nominally the sole director of Jalana, but it is evident that the affairs of Jalana, which acted as the trustee of a family trust, were directed by Mr Linton.

4 Telnet traded under the name Osborne Computers Australia. OCC and Telnet were the operating entities in what was called the Osborne Computers group. The companies were not related as parent and subsidiary or as siblings, and were not a group in the normal sense of the word. But they were under the common control of Mr Falinski and Mr Linton and operated as manufacturer and retailer of the computers, and the evidence of Mr and Mrs Linton displayed that they thought in terms of "Osborne", or of "the company", meaning the group, without distinguishing between OCC and Telnet. The record keeping, including accounting, within the group was deficient, and in particular the accounting system did not satisfactorily separate the transactions of the two entities.

5 In August 1992 Mrs Linton bought a home at 11 Little Street, Mosman ("the property") for $2,000,000. Some of the purchase price was paid with cheques drawn by Telnet - two cheques each for $200,000, one cheque for $18,672, and one cheque for $1,060,000. With the failure of the Osborne group in 1995 came a claim by Telnet that the property was held on trust by Mrs Linton to the extent to which the purchase price was paid from funds of Telnet.

(a) that the property was not held on trust to the extent to which the $418,672 was paid from funds of Telnet; (b) that the property was held on trust to the extent to which the $1,060,000 was paid from funds of Telnet; and (c) that the trust in (b) arose in July 1995, so that an occupation fee and allowances should be paid and calculated with reference to that date. The claim in relation to the $418,672 failed because it was found that the constituent amounts were repayment of $400,000 lent by Mrs Linton to Telnet and interest on that sum. The claim in relation to the $1,060,000 succeeded because it was found that the amount was a loan by Telnet to Mr Linton, on-lent or given by him to Mrs Linton, being a loan made in breach of Mr Linton's fiduciary duty owed to Telnet of which Mrs Linton acquired knowledge. The trust was held to have arisen in July 1995 because it was found that Mrs Linton acquired her knowledge at that time. 7 Mrs Linton appealed, contending that Mr Linton had not been in breach of fiduciary duty and that, even if he had, she did not have such knowledge or notice of his delinquency as would give rise to the trust as found. Telnet cross-appealed, contending that it should not have been found that the amount of $418,672 was repayment of money lent by Mrs Linton and interest, and also contending that Mrs Linton should have been found to have had sufficient knowledge or notice to give rise to the trust in August 1992 (this affected the occupation fee and allowances). By a notice of contention Telnet also sought to uphold the finding of breach of fiduciary duty on grounds other than those on which the trial judge had so found, grounds material also to the back-dating of Mrs Linton's knowledge or notice from July 1995 to August 1992. The notice of contention as filed did not extend to the contention as argued, and there was an issue over whether Telnet should have leave to amend the notice of contention to accommodate its argument.

8 It is convenient first to deal with the cross-appeal in relation to the $418,672. In February 1992 solicitors holding $400,000 on behalf of Mrs Linton paid it, according to their records, to "Osborne Computers". It was deposited in a bank account conducted by OCC. At the time Telnet did not have a bank account. Telnet had a bank account from July 1992, from which the $418,672 was paid towards the purchase of the property, but there was no record of OCC paying the $400,000 to Telnet. Telnet submitted that his Honour had inferred that the payment by Telnet towards the purchase of the property was intended to be a repayment of the $400,000 and interest, and that the inference should not have been drawn.

9 The submission did less than justice to Hulme J's reasons. His Honour accepted that Mrs Linton believed that the $400,000 paid by Telnet was repayment of the money she had provided, and that Mrs Linton did not distinguish in this respect between OCC and Telnet - in her eyes she had lent the money to "Osborne" or "the company". Mr Falinski and Mr Markham, the accountant for Telnet and probably the group, signed the cheques, but did not give evidence. Mr Linton gave evidence, but was not asked about this loan. In the absence of other direct evidence, his Honour concluded that it was "very probable" that the payment of the $400,000 was "intended by all involved" to be repayment of the $400,000 paid to "Osborne Computers". No doubt this was what Telnet described as an inference that the payment by Telnet towards the purchase of the property was intended to be a repayment of the $400,000 and interest. But there was more, and his Honour's reasons relied on more.

10 Putting aside what his Honour said about the calculation and payment of the $18,672 as interest, the evidence included a purported loan agreement dated 23 February 1992 between Mrs Linton as lender and Telnet as borrower, signed by Mr Falinski on behalf of Telnet and by Mrs Linton, and a receipt dated 24 February 1992 on the letterhead of Osborne Computers Australia signed on behalf of Telnet, in each case for $400,000. It was submitted to his Honour that the documents were shams, but that had not been put to Mrs Linton and their authenticity was not challenged by other evidence. The loan agreement recorded that Telnet was to use the money to pay certain invoices from a Taiwanese company, and his Honour noted that this was "a little odd" when Telnet did not make purchases, but he also said that there was no attempt to prove or disprove the use of the money for that purpose. He said -

"In the circumstances I think I should, and in any event I am disposed to, regard the documents as genuine. In the light of this and the payment of the $18,316 by Telnet it seems to me that the proper conclusion to draw is that there was an agreement by Telnet to borrow and by Mrs Linton to lend to Telnet, $400,000. That sum was paid on her behalf. It was paid to an account which in the circumstances I have referred to and in the light of Mr Linton's position should be regarded as one nominated by Telnet. The fact if it be such that Telnet did not itself receive the funds does not seem to me to affect the conclusion that they were lent by Mrs Linton to Telnet. Indeed although Ms Smith said that she could find no record of Osborne Computer paying the $400,000 to Telnet, there was no evidence that it had not been applied in some way to Telnet's benefit but whether this be so or not, so far as Mrs Linton is concerned, the payment of the funds to Telnet's nominee means that she lent the money."

11 The conclusion that the $418,672 was repayment of money lent by Mrs Linton and interest was thus supported by more than an inferred intention at the time of the payment towards the purchase of the property. There may have been reason to doubt the authenticity of the loan agreement and the receipt of 24 February 1992, but his Honour was hardly assisted to translate the doubt into denial of authenticity, and it was well open to him to regard them as genuine. Treated as genuine documents, although in the case of the loan agreement a layman's document and providing for repayment on 30 April 1992, they pointed to a loan to Telnet even though the money was paid into OCC's bank account. While there was still inference in his Honour's conclusion, in my opinion the conclusion was available and has not been shown to be incorrect. The cross-appeal in this respect should fail.

12 I go then to the appeal in relation to breach of fiduciary duty. The finding of breach of fiduciary duty was arrived at after acceptance, in his Honour's words, of "the substance of the evidence of Mr Linton as to the circumstances leading to the receipt of the $1.06M". The acceptance came after expressed reservations concerning Mr Linton's credibility, and in particular the statement that some of his evidence was impossible to accept and in his Honour's view deliberately untrue.

13 The substance of the accepted evidence of Mr Linton was as follows: (a) In late 1991 Mr Linton was dissatisfied with the return he was receiving for years of effort in the Osborne group, and could see no point in continuing. He told Mr Falinski that he proposed to return to England. (b) Mr Falinski asked what it would take for Mr Linton to stay. Mr Linton said that the current business plan should deliver between $3,000,000 and $4,000,000 in gross profits, that he wanted his share, and that his share would be a minimum of $1,000,000. Mr Falinski said, "Well, as long as we make that sort of money I have no problem in making the commitment that we will make a shareholders' distribution and you will get the money that you are entitled to". (c) In early 1992 Mr Linton told Mr Falinski that if the latter did not honour the agreement "I will not be here on 1 July". (d) As the year progressed there were other conversations in which Mr Linton insisted on payment and asked Mr Falinski whether arrangements had been made to pay a dividend. (e) In June or July 1992 Mr Falinski said that he did not wish to pay the sum under consideration as a dividend, and that it would be better to make a loan pending the sale of the company, something then in contemplation, interest free and for five years. A document was created to record this. (f) In early August 1992 Mr Linton said that he must have the money immediately, and the cheque for $1,060,000 was provided payable in the manner indicated by Mrs Linton's solicitor. 14 The evidence included an unexecuted form of agreement dated 3 July 1992 providing for payments to Jalana for Mr Linton's services and Jalana's copyright material until 30 June 1997. It included - "5) Provision of Interest Free Loan a) In recognition of the irreplaceable value of John Linton to the achievement of the previous 5 years results and the planned next 5 years results it is agreed that Stanley Falinski will procure an interest free loan to John Linton of $A1,000,000,00 [sic] for a period of 5 years. b) These loan monies will be made available through Telnet but will be sourced directly from an equivalent amount of money loaned to Telnet from other parties. The sources of these funds will be from loans made to Nimari Pty Ltd by Tunmoss Pty Ltd and Fernik Pty Ltd. c) This loan of $A1,000,00 [sic] will not become payable until 25th July 1997 unless Telnet Pty Ltd is sold in whole or in part to a third party. In that event any monies received by John Linton or by his assignees, are to be repaid to Tunmoss Pty Ltd and Fernik Pty Ltd up to a maximum of $A1,000,000. d) At the end of the loan period the loan monies are to be repaid directly to Tunmoss Pty Ltd and Fernik Pty Ltd." 15 Nimari Pty Ltd was an earlier name of OCC. The parts played by Tunmoss Pty Ltd and Fernick Pty Ltd were not explained, save that it seems that they were Falinski companies. Hulme J said, correctly, that the evidence relating to this document was slight; it had been given to the administrator of Telnet by Mr Linton's solicitor in July 1995, and that it was the document created as referred to in (e) above could be inferred but was far from clear.

16 While at other times Mr Linton may have taken the position that the $1,060,000 had been payable to him as a dividend, in the course of his evidence he affirmed that it had been payable to him as a loan. In accepting the substance of Mr Linton's evidence as earlier outlined, his Honour found that it was a loan. The question then was whether it was a loan made in breach of Mr Linton's fiduciary duty owed to Telnet.

17 Hulme J cited figures for the Osborne group for the financial years to 30 June 1992 and 30 June 1993, saying that he did so in order to "give some relativity to the amount of $1.06M" and saying that while it was a large sum of money "it must be considered in the context of the affairs of Telnet and of the group". The figures were - Group 1992 1993 Sales $111,995,821 $157,851,124 Gross Profit 28,500,581 32,680,044 Net Profit 1,106,875 (2,640,166) Closing Inventory 12,506.187 14,592,940

Telnet 1992 1993 Total assets $1,547,108 $3,315,039 Net assets (17,693) (5,502,821) Operating Profit (15,261) (5,485,128) Accumulated losses - (9,609) (17,943) At beginning of year At end of year (17,943) (5,503,071)

"Although a director of Telnet, Mr Linton was clearly entitled to prefer his own interests in deciding to return to the United Kingdom rather than remain in Australia working for it and other companies in the group. He was equally entitled to place some price on staying. As he and Mr Falinski were the only directors of Telnet, and Mr Falinski suggested and agreed with the making of the loan it is in my view impossible on the evidence to regard the transaction in its general nature or in the method of its approval as itself a breach of Mr Linton's fiduciary duty to the company. It would, I suspect, have been a solemn farce and a waste of time and thus the company's resources in the form of Messrs Falinski and Linton to have the decision made any other way and in any event there is no evidence that Mr Falinski did not have authority to approve the proposed loan in Mr Linton's absence or formal non-participation. In light of the other figures I have mentioned and the absence of any evidence bearing on Mr Linton's abilities or worth to Telnet, the size of the loan does not alter this conclusion. However there were some other features about the loan which lead to the conclusion that Mr Linton was guilty of a breach of his duty to Telnet. He was a bankrupt and, it may be inferred, had little prospect of readily repaying, out of anything but the money borrowed, the loan should Telnet so wish. In these circumstances the fact that the loan was unsecured meant that there was a breach of the directors' duty. This conclusion becomes even more inevitable when one has regard to other evidence given by Mr Linton. He said that after the discussion with Mr Falinski in September or October 1991 during which he 'believed it would actually happen for the first time' he told his wife that he would give her $1M out of what he was going to receive for his five years work and that 'subsequently we would have discussed it constantly'. His evidence was that he did give her the money.

Whether he did was not the subject of debate during evidence or address but it seems to me that the probability is that he did. Placing property in her name seems to have been a practice followed by Mr and Mrs Linton. Thus the recoverability of the money lent by Telnet was made more difficult and doubtful. In the way the transaction came about it is not, I think, possible to divorce the knowledge Mr Linton had of what he was going to do in this regard from his position as a director of Telnet and thus there has been a breach of his fiduciary duty." 19 Central to his Honour's finding of breach of fiduciary duty was that Mr Linton was a bankrupt. The evident reasoning was that the bankruptcy meant unlikelihood of repayment of the loan otherwise than from the money lent, and when the money lent was to go to Mrs Linton and the loan was unsecured there would not be repayment from the money lent: so there was a breach of fiduciary duty. The problem with the reasoning was that Mr Linton was not a bankrupt. He had been a bankrupt, but was discharged from bankruptcy in 1989. Telnet acknowledged that his Honour was in error in this respect, and that the error vitiated the finding of breach of fiduciary duty as made. It did not seek to support the finding on the basis stated by his Honour.

20 Hence Telnet sought to uphold the finding of breach of fiduciary duty on other grounds. The notice of contention as filed was relevantly to the effect that Hulme J should not have accepted the substance of the evidence of Mr Linton as to the circumstances leading to the receipt of the $1,060,000, but that contention was not taken up. Instead, Telnet applied to amend the notice of contention to add -

"3. That his Honour ought to have found that the loan of $1,060,000 by Telnet Pty Limited to John Linton was made in breach of the directors' fiduciary duty to the company in light of its lack of solvency and the consideration which ought, in the circumstances, to have been given to its creditors." Mrs Linton opposed the application to amend the notice of contention. Submissions were received both on whether leave should be given to amend the notice of contention and on the substance of the proposed contention, and the question of leave was reserved to be dealt with in the Court's judgment. 21 Telnet's submissions on appeal in support of the finding of breach of fiduciary duty rested in part on the fact that the loan was interest free and unsecured, but it was not said that that alone brought breach of fiduciary duty. It was said that the decision to make the loan was not minuted and its making was not properly recorded, as is correct, but I do not think that in the circumstances of an effectively two man joint venture enterprise those deficiencies significantly contribute to a finding of breach of fiduciary duty. The gravamen of the contention, built upon the fact that the loan was interest free and unsecured, was that there was substantial evidence of the financial instability of Telnet, so as to impose upon its directors an obligation to consider the interests of creditors, and that the making of the unsecured loan was detrimental to the interests of creditors. So, it was said, on the test expressed in Charterbridge Corporation Limited v Lloyds Bank Limited (1970) 1 Ch 62 at 74, an intelligent and honest man in Mr Linton's position as a director of Telnet could not have reasonably believed that making the loan was for the benefit of Telnet having in mind the interests of Telnet's creditors.

22 There was reference in the appeal to whether the Charterbridge test was the proper test to apply. In Equiticorp Finance Limited v Bank of New Zealand (1993) 32 NSWLR 50 at 147-148 Clarke and Cripps JJA indicated reservations about the test, pointing out that directors are bound to exercise their powers, bona fide, in what they consider is in the interests of the company and not for any collateral purpose, that subjective states of mind, motives, and intentions are material, and that an objective test of how an intelligent and honest man would have acted may be at odds with the nature of the directors' duty. Recognising that the Charterbridge test was put forward for when the directors had not considered the interests of the relevant company at all, because they had considered only the interests of the group of which the company was part as a whole, their Honours nonetheless suggested that it might be preferable to find a breach of duty where the directors failed to consider the interests of the relevant company but then to inquire into the consequences of the breach. The present case was one where the directors may not have considered the interests of Telnet as distinct from the interests of the Osborne group. Telnet adhered to the Charterbridge test in its submissions; Mrs Linton adverted to the alternative approach, but did not present any detailed argument on the point. In the circumstances, where the Charterbridge test has been applied many times (for example, Reid Murray Holdings Limited (In Liquidation) v David Murray Holdings Pty Limited (1972) 5 SASR 386; Australian National Industries v Greater Pacific Investments Pty Limited (In Liquidation) (No 3) (1992) 7 ACSR 176), and Telnet did not seek to depart from its approach but adopted it, I consider that the present case should be decided by the application of the Charterbridge test.

23 In Walker v Wimborne (1976) 137 CLR 1 it was said that, where a group of companies is involved, the transaction in question must be viewed according to the criterion of the interests of the company in the group which is about to participate in the transaction, and that the interests of that company are measured by the interests of its creditors as well as its shareholders: see per Mason J (with whom Barwick CJ agreed) at 6-7, referring to -

"… the fundamental principles that each of the companies was a separate and independent legal entity, and that it was the duty of the directors of Asiatic to consult its interests and its interests alone in deciding whether payment should be made to other companies. In this respect it should be emphasised that the directors of a company in discharging their duty to a company must take account of the interests of its shareholders and its creditors. Any failure by the directors to take into account the interests of creditors will have adverse consequences for the company as well as for them. The creditor of a company, whether it be a member of a 'group' of companies in the accepted sense of that term or not, must look to that company for payment. His interests may be prejudiced by the movement of funds between companies in the event that the companies become insolvent."

24 In the present case, as in Walker v Wimborne, OCC and Telnet were not members of a group in the accepted sense of that term, involving common or interlocking shareholdings allied to unified control or capacity to control. A benefit to one of them from a transaction would not have derivative benefits for the other as shareholder in the first company. Nonetheless, in particular circumstances a transaction benefiting one company in a group may have derivative benefits for another company in the group otherwise than via a shareholding, see Northside Developments Pty Limited v Registrar General (1990) 170 CLR 146 at 183; Equiticorp Finance Limited v Bank of New Zealand at 146-147. A loan to Mr Linton from the funds of Telnet, in order to ensure retention of Mr Linton's services for both OCC and Telnet, could have been seen as for the benefit of Telnet both directly and also derivatively to the extent to which Mr Linton's services to OCC ensured the supply of computers and otherwise the successful conduct of Telnet's retailing business. It is no doubt this to which Hulme J referred when he said, in the passage set out earlier in these reasons, that the transaction could not be regarded "in its general nature" as a breach of Mr Linton's fiduciary duty to Telnet. Further, the shareholders in Telnet represented the interests of Mr Falinski and Mr Linton, and when Mr Falinski and Mr Linton agreed upon the loan it would be unrealistic to approach the question of breach of fiduciary duty by regard to the interests of Telnet's shareholders.

25 These considerations underline that Telnet's submissions on appeal in support of the finding of breach of fiduciary duty concentrated on the interests of Telnet's creditors in addressing whether the Charterbridge test was satisfied. Inattention to the separate interests of Telnet, and to the interests of its shareholders, were unlikely to bring success to Telnet, and so it framed and put the proposed contention at the level of the interests of creditors. And that led to Mrs Linton's opposition to the application to amend the notice of contention, because she said that the case mounted against her before Hulme J had not been one of failure to have regard to the interests of Telnet's creditors.

26 When directors should have paid regard to the interests of creditors can be difficult to decide, and depends on the particular facts. In Nicholson v Permakraft (NZ) Limited (1985) 3 ACLC 453 Cooke J's statement of principles included (at 459) -

"The duties of directors are owed to the company. On the facts of particular cases this may require the directors to consider inter alia the interests of creditors. For instance, creditors are entitled to consideration, in my opinion, if the company is insolvent, or near insolvent, or of doubtful solvency, or if a contemplated payment or other course of action would jeopardise its solvency. The criterion should not be simply whether the step will leave a state of ultimate solvency according to the balance sheet, in that total assets will exceed total liabilities. Nor should it be decisive that on the balance sheet the subscribed capital will remain intact, so that a capital dividend can be paid without returning capital to shareholders. Balance sheet solvency and the ability to pay a capital dividend are certainly important factors tending to justify proposed action. But as a matter of business ethics it is appropriate for directors to consider also whether what they do will prejudice their company's practical ability to discharge promptly debts owed to current and likely continuing trade creditors.

To translate this into legal obligation accords with the now pervasive concepts of duty to a neighbour and the linking of power with obligation. It is also consistent with the spirit of what Lord Haldane said. In a situation of marginal commercial solvency such creditors may fairly be seen as beneficially interested in the company or contingently so. On the other hand, to make out a duty to future new creditors would be much more difficult. Those minded to commence trading with and give credit to a limited liability company do so on the footing that its subscribed capital has not been returned to the shareholders, but otherwise they must normally take the company as it is when they elect to do business with it. Short of fraud they must be the guardians of their own interests.

In the case of a supplier who already has an established trade relationship with a company, there is of course a distinction between current and future debts. It seems to me neither necessary nor desirable, however, to use that distinction so as to limit the duties of the directors of the debtor company to considering whether debts already incurred can be paid. If the company's financial position is precarious the fortunes of such suppliers may be so linked with those of the company as to bring them within the reasonable scope of the directors' duties. They may continue to give credit in ignorance of a change damaging to their prospects of payment."

In Kinsela v Russell Kinsela Pty Limited (1986) 4 NSWLR 722 it was said that the judgment of Cooke J was a comprehensive and authoritative analysis of the principles of law to be applied, and while the passages there cited from his Honour's judgment were in some respects less and in other respects more than the passage I have set out, the statement of principles in its entirety was regarded with evident approval. Street CJ (with whom Hope and McHugh JJA agreed) said (at 733) -

"I hesitate to attempt to formulate a general test of the degree of financial instability which would impose upon directors an obligation to consider the interests of creditors. For present purposes, it is not necessary to draw upon Nicholson v Permakraft as authority for any more than the proposition that the duty arises when a company is insolvent inasmuch as it is the creditors' money which is at risk, in contrast to the shareholders' proprietary interests. It needs to be borne in mind that to some extent the degree of financial instability and the degree of risk to the creditors are inter-related. Courts have traditionally and properly been cautious indeed in entering boardrooms and pronouncing upon the commercial justification of particular executive decisions. Wholly differing value considerations might enter into an adjudication upon the justification for a particular decision by a speculative mining company of doubtful stability on the one hand, and, on the other hand, by a company engaged in a more conservative business in a state of comparable financial instability. Moreover, the plainer it is that it is the creditors' money that is at risk, the lower may be the risk to which the directors, regardless of the unanimous support of all of the shareholders, can justifiably expose the company.

The foregoing, and like, considerations point to the desirability of avoiding an attempt to enunciate principles in wide-ranging terms. Having said that, however, I reiterate my own respectful agreement with the passage in the judgment of Cooke J (at 457-460) to which I have already referred." 27 In the present case there was at best scanty attention before Hulme J to the considerations material to whether Mr Linton (and Mr Falinski) were required to consider the interests of creditors. An understanding of the course of the proceedings is essential when considering whether Telnet should be permitted to rely on the proposed contention.

28 Telnet brought its claim by summons, relevantly seeking declarations as to the holding of the property on trust. Nothing in the summons described the basis, other than the fact that Telnet's money was used in the purchase of the property, for the relief claimed. Mrs Linton did not seek particulars, and no particulars were provided. The affidavit evidence filed on behalf of Telnet included the report to creditors of the administrator appointed in July 1995 to the companies then in the Osborne group. It attributed the failure of the group to poor management, said to be evidenced inter alia by "unsecured loans to directors and related entities apparently now irrecoverable", but the loan of the $1,060,000 was not specifically identified as one of the loans. While the report expressed the view that the companies were insolvent at April 1995, the administrator also said that insolvency at an earlier time might reasonably be expected but he was "unable currently to comment with any certainty as to an earlier time at when [sic] 'suspicion of insolvency' should have arisen". A bundle of documents apparently tendered by consent included financial statements for Telnet to 30 June 1993, with comparative figures to 30 June 1992, from which the Telnet figures cited by Hulme J were taken. The financial statements were dated in April 1995. Neither the terms of the summons nor the inclusion of this material in the evidence pointed to Telnet's case being a case of failure to pay due regard to the interests of Telnet's creditors.

29 Indeed, it is clear that at the commencement of the hearing that was not part of Telnet's case. As appears from a chronology and summary of Telnet's case provided to his Honour at the commencement of the hearing, Telnet saw the case as one in which it had simply to show that it paid the purchase price of the property, and Mrs Linton then had to establish that the money paid by Telnet was her money; the summary asserted that the money was not repayment of a loan by Mrs Linton or a loan by Telnet to Mr Linton, and that "the inescapable and obvious conclusion is that … Telnet paid the purchase price for the property". There was not a word about breach of fiduciary duty or the Charterbridge test, let alone failure to pay due regard to the interests of creditors.

30 It is clear enough that Telnet's case became more sophisticated by the time it made its submissions to Hulme J, but even then (as can be seen from the copy of its written submissions with which we were provided) the primary case was that Telnet's money was used for the purchase of the property and that it should not be accepted that there was a loan of $1,060,000 to Mr Linton: "The money was simply removed from Telnet and used to purchase the house". It was then said that the payments by Telnet "in these circumstances" could only have resulted from breaches of fiduciary duty by Mr Linton, and in the midst of a long section headed "John Linton's breach of fiduciary duty" it was said -

"7. Even if there are loan arrangements, they are contrived. They would constitute a clear breach of fiduciary duty by John Linton as a director of Telnet. Telnet had carried forward losses in 1992 and 1993. It did not have $1,060,000 to lend to a director (or give away). When creditors are considered, the transaction has nothing to do with the best interests of Telnet. There is a clear and substantial conflict." [Emphasis added] But the promise of consideration of creditors was not fulfilled. Later paragraphs listed a rather confusing collection of matters apparently put forward to support the breach of fiduciary duty, but they did not include anything directed to demonstrating that the financial position of Telnet was such that Mr Linton was required to consider the interests of creditors. 31 Hindsight is a wonderful thing, and in hindsight it was imperative that Telnet be required to particularise the matters which it said led to the trust of the property, including, if breach of his fiduciary duty by Mr Linton was involved, the matters on which it relied for the breach. That was not done, and if it had been done the resolution of the present question would have been greatly assisted. From what I have said so far, if failure to pay regard to the interests of creditors became part of Telnet's case, it should have been reflected in the evidence led by Telnet and in its cross-examination of Mr Linton and perhaps Mrs Linton.

32 I have already noted the report to creditors and the financial statements of Telnet, which were or can be regarded as evidence led by Telnet. There was otherwise no evidence led by Telnet to establish insolvency or concern for solvency as at August 1992, or the effect on Telnet's ability to pay its creditors of the loan of $1,060,000, for example by an accountant's report. Endangering of creditors called for evidence directed to those issues with reasonable clarity. The material time was August 1992, and the Osborne group did not fail until mid-1995. As can be seen from the figures for the group in the judgment of Hulme J, the group might have been thought to be in a reasonably sound position as at 30 June 1992, and its sales and gross profit increased during 1993. While the net loss for the year ended 30 June 1993 could later be seen as the beginning of its decline, peril to creditors on a group basis as at August 1992 did not leap out from the figures. Telnet itself had a small deficiency in net assets and a small operating loss as at 30 June 1992, and its fortunes certainly declined markedly thereafter, but that did not necessarily mean peril to its creditors as at August 1992 if a loan of $1,060,000 was made to Mr Linton. Telnet had to get in money from which it could make the loan. The unexecuted form of agreement of 3 July 1992 provided for the money to be got in from Tunmoss Pty Ltd and Fernik Pty Ltd through OCC. I have already referred to the uncertain status of that document, but there was no evidence that the money was got in in that way, or of how it was got in at all. It may have been, indeed it might be thought likely, that Telnet's creditor for $1,060,000 was OCC or some other Falinski company, a creditor which (through Mr Falinski's eyes) did not regard its interests as in danger or was willing to accept the position and which was willing to stand behind other creditors. The number, extent and nature of Telnet's creditors as at August 1992 was not the subject of evidence. Investigation of all this would be very material to a finding of breach of fiduciary duty on the ground for which Telnet sought to contend by the proposed contention.

33 If the case were that Mr Linton was in breach of fiduciary duty because he failed to pay regard to the interests of creditors, the peril to creditors and his disregard of it should have been raised with him in cross-examination. It was not. I set out the extent of the most relevant cross-examination -

"Q. Because there were certainly no profits of any sort in Telnet in the financial years to 30 June 1992 or 30 June 1993, were there? A. A minimum. Q. Telnet made a loss in these years, didn't it? A. In 1992? No, It made a profit of $15,000. Q. (shown bundle of documents) Would you go please to the Telnet accounts which are at page 84? Do you recognise those as the accounts of Telnet for the financial year to 30 June 1993? A. Yes. Q. If you would go to page 86 - A. Sorry. We are talking about 1992. Q. Please let me ask the questions. Would you go to page 86 please? A. Yes. Q. Do you recognise your signature at the bottom of page 86? A. Yes. Q. You know that you, by signing those, were verifying the accuracy of the accounts? A. Yes. Q. Would you please go to page 94 of the bundle, the last page fo the accounts? A. Yes. Q. Do you see the bottom line? A. Yes. Q. Accumulated losses? A. Yes. Q. Have a look under the column for 1992? A. Yes. Q. Do you see that Telnet had accumulated losses at the end of 1992 of $17,000 odd? A. My answer to your original question was it made $15,000 profit in that year. HIS HONOUR: If you look at the top line, that confirms what the witness said. LEVER: Q. The fact is, though, at the end of the financial year to 30 June 1992 Telnet had accumulated losses of $17,943? A. Yes, Q. There was no money in Telnet to pay a dividend to you of $1 million, was there? A. No.

Q. In fact, in the next year, to 30 June 1993, Telnet lost $5.4 million, didn't it? A. According to those accounts, yes. Q. Those accounts are accurate, aren't they? A. They may well be. Q. You wouldn't have signed them if they weren't accurate, would you? A. I would have signed them if I was asked to sign them. Q. Whether they were accurate or not? A. Yes." 34 This was inadequate for the purpose now undertaken by Telnet. The inadequacy is emphasised by Mr Linton's evidence earlier mentioned that the current business plan should deliver between $3,000,000 and $4,000,000 in gross profits. Gross profits were not net profits, and the business plan was no doubt for the group rather than Telnet alone, but on that evidence Mr Linton foresaw success for the business plan and a profitable future. On the Charterbridge test the hypothetical director was to be placed in Mr Linton's position, and Mr Linton's expectation of a profitable future, and the significance of the business plan to Telnet's ability to pay its creditors both objectively and in Mr Linton's eyes, was squarely thrown up. Mr Linton was not tested on his expectation at all, on the significance of the business plan to Telnet's ability to pay its creditors, or on how both objectively and in his eyes the loan of $1,060,000 was related to or consistent with the interests of creditors. Further, Mr Linton had signed the 1993 financial statements dated in April 1995, by his signature attesting the statement in the document that there were reasonable grounds to believe that Telnet could pay its debts as and when they fell due. The document had been tendered by Telnet. Some cross-examination of Mr Linton on the statement was surely called for if it was to be said that the position was otherwise a year earlier, when the figures were much better.

35 It was necessary that Mrs Linton have knowledge or notice of the breach of fiduciary duty (I do not now enter into what knowledge or notice was required), and the matters relied on for the breach of fiduciary duty should have been put to her as matters of which she had knowledge or notice. That was not done in any effective way. Mrs Linton was asked whether she ever looked at the financial statements of Telnet, and she said no; she was asked whether Mr Linton had ever told her that Telnet had made a loss during the year to 30 June 1992, and she said no; she was asked the same about the year to 30 June 1993, and said the same; she was asked whether Mr Linton had ever said that he was worried about the financial aspects of "the company" (in context, perhaps Telnet), and she answered no. It had been established that Mrs Linton knew that Telnet was the Lintons' main source of income through Jalana, and Mrs Linton answered "I suppose so" to the question "During the period 1992 and following, Jalana was making smaller distributions to you and your husband, wasn't it?". She answered, "I can't remember" to the following question "Your income was dropping during late 1991 through 1992, wasn't it?", and when asked again whether the income she and Mr Linton "were receiving through Jalana from Telnet was dropping quite significantly during 1992", she answered "I don't know". Undoubtedly the cross-examiner was faced with little knowledge on Mrs Linton's part of the affairs of Jalana or of the underlying business, and it should be said that Hulme J accepted that her knowledge was "negligible or almost so" and said that he formed the view while she was giving evidence that she did not understand much of what she said she did and concessions she made were often unreliable. But there was really nothing in this cross-examination to flag for Mrs Linton a case of breach of fiduciary duty by Mr Linton through failure to pay regard to the interests of creditors.

36 In the end, the case on appeal for Telnet's financial position being such that its directors should have had regard to the interests of creditors came down to Telnet's deficiencies in net assets and its accumulated losses for the years ended 30 June 1992 and 30 June 1993 as set out earlier, with a little more detail from the financial statements which may be summarised as -

1992 1993 Current assets $839,678 $2,460,290 Current liabilities 1,458,729 8,784,278 Non current assets 707,430 854,749 Non current liabilities 106,072 33,582 Trade creditors 304,957 6,888,734

Those figures were taken from financial statements produced much later, in 1995. Whether there were management accounts which would have revealed the position to Mr Falinski and Mr Linton in August 1992 was not investigated in the evidence, although, of course, it could be said that as directors they should have known that the financial position was as the accounts later prepared revealed. Mr Linton was not asked about that. There was undoubtedly a grave deterioration in the 1993 year, but it must not be forgotten that the relevant time was August 1992. When was the deterioration evident? It was said in the financial statements that they had been prepared on a going concern basis on the basis of support from a major creditor. There was no investigation of who the major creditor was - inference, or perhaps only speculation, might suggest OCC. Who the creditor was, and what the support was, were material to the interests of creditors, both the major creditor and the other creditors. 37 There are two ways of seeing the application to amend the notice of contention in the light of what I have said in the preceding paragraphs. One way is that, in the absence of particularisation or other express confinement, Telnet's case for breach of fiduciary duty was at large, so that it was entitled to rely before Hulme J on disregard of the interests of creditors and should therefore not be precluded from relying on appeal on disregard of the interests of creditors in accordance with the proposed contention. The other way is that, although not confined by particulars or express statement, Telnet's case before Hulme J was so conducted that it was not open to it, even before his Honour, to mount a case of disregard of the interests of creditors of the kind now sought to be put forward, and so in accordance with the principles considered in Suttor v Gundowda Pty Ltd (1950) 81 CLR 418; Coulton v Holcombe (1986) 162 CLR 1, and Multicon Engineering Pty Ltd v Federal Airports Corporation (CA, 15 October 1987, unreported) it should not be permitted to mount that case on appeal. In my opinion the latter way is to be preferred. Because of the basis on which he found breach of fiduciary duty Hulme J did not address the issue so delicately proffered, but not backed up, by the reference to creditors in Telnet's written submissions, but if he had I consider he would have been obliged to decline to entertain a case founded on disregard of the interests of creditors as now put on appeal.

38 Accordingly, I consider that the application to amend the notice of contention should be refused. But I should add that it does not matter, since in the circumstances I have outlined I do not think that it could properly be found that as at August 1992 Telnet was insolvent, that there should have been concern for its solvency, or that its solvency would be jeopardised by the making of the loan of $1,060,000, so as to require the directors to consider the interests of creditors. It may or may not have been necessary for the directors to consider the interests of creditors - there was inadequate investigation of the position to warrant the conclusion that it was.

39 It follows that the appeal should be allowed: the breach of fiduciary duty found by Hulme J can not be upheld, and no other breach of fiduciary duty has been made out to take its place.

40 It is therefore unnecessary to consider when Mrs Linton might have acquired knowledge or notice of breach of fiduciary duty. But I should say that, even if Mr Linton breached his fiduciary duty to Telnet in the manner for which Telnet sought to contend in the proposed contention, I do not think that knowledge or notice in Mrs Linton sufficient for a trust of the property to the extent of the $1,060,000 was made out.

41 On principles stemming from Barnes v Addy (1874) 9 Ch App 244, a constructive trust could be imposed on Mrs Linton if she received the $1,060,000 with knowledge or notice that its provision by Telnet involved breach of fiduciary duty by Mr Linton. The nature of the knowledge or notice required has been much debated, in particular whether it is necessary that it involve dishonesty or want of probity on the part of the person in the position of Mrs Linton (see for example Ninety Five Pty Ltd v Banque Nationale de Paris (1988) WAR 132; re Montagu's Settlement Trusts (1987) 1 Ch 264; Agip (Africa) Ltd v Jackson (1990) Ch 265 (Millett J); (1991) Ch 547 (CA); Royal Brunei Airlines Sdn Bhd v Ming (1995) 2 AC 378; Equiticorp Industries Group Ltd v The Crown (1996) 3 NZLR 586; Koorootang Nominees Pty Ltd v Meldrum Jeffriess Group Pty Ltd (1998) 3 VR 16). The five categories of knowledge or notice constructed by Peter Gibson J in Baden, Delvaux and Lecuit v Société General pour Favoriser le Dèveloppement du Commerce et de l'Industrie en France SA (1983) BCLC 325; (1992) 4 All ER 161 are well known, although not always thought helpful (see for example Royal Brunei Airlines Sdn Bhd v Ming at 392). Telnet submitted that Mrs Linton fell within category (c), wilfully and recklessly failing to make such enquiries as an honest and reasonable person would make, or category (d), knowledge of circumstances which would indicate the facts to an honest and reasonable person, or as a last resort category (e), knowledge of circumstances which would put an honest and reasonable person on enquiry.

42 The evidence on which Telnet relied for the knowledge or notice, however, was at best slight. I have already summarised what was put to Mrs Linton in relation to knowledge of the affairs of Telnet and the money which came to Jalana from Telnet, and have noted Hulme J's acceptance that Mrs Linton's knowledge of Jalana's affairs and of business generally was negligible or almost so. In the end Telnet relied for Mrs Linton's knowledge or notice only on the answer "I suppose so" to the question concerning Mrs Linton's knowledge that Jalana was making smaller distributions to her and Mr Linton during the period 1992 and following. In my opinion this does not approach establishing relevant dishonesty or want of probity, if that be necessary, or fulfilling any of the categories in the Baden case. Thus even assuming an underlying breach of fiduciary duty, the appeal would have had to be allowed because, no matter which version of the test for the requisite knowledge or notice be applied, knowledge or notice in Mrs Linton sufficient for the imposition of a trust had not been established.

43 The orders to be made are complicated by some procedural orders made by Hulme J together with the substantive orders, and by the fact that Mr Linton was a party to the proceedings before Hulme J although not to the appeal. I believe that the orders proposed below will meet the case, but there should be liberty to apply for any variation or additional order necessary to give effect to these reasons. I propose the following orders - 1. Appeal allowed and cross-appeal dismissed. 2. Declaration and orders 2, 3, 5 and 7 made by Hulme J on 24 June 1998 set aside, and in lieu thereof order that the summons be dismissed and the plaintiff pay the first defendant's costs of the proceedings before Hulme J. 3. Order that the respondent pay the appellant's costs of the appeal and the cross-appeal. 4. Appellant to have a certificate under the Suitor's Fund Act if qualified. 5. Liberty to apply within 14 days.

44 SHEPPARD AJA: In this matter I have had the advantage of reading the judgment to be delivered by Giles JA. I am in agreement with his Honour's reasons and conclusions, and with the orders which he proposes.

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