Re Leo Bernard Mccarthy and Valerie Joan Mccarthy v Michael Jaunay Mount and Westpac Banking Corporation [1993] FCA 109 (24 March 1993)

FEDERAL COURT OF AUSTRALIA

Re: LEO BERNARD McCARTHY and VALERIE JOAN McCARTHY
And: MICHAEL JAUNAY MOUNT and WESTPAC BANKING CORPORATION
No. 68 and 69 of 1991 - Part X
FED No. 152
Number of pages - 19
Bankruptcy

COURT

IN THE FEDERAL COURT OF AUSTRALIA
BANKRUPTCY DISTRICT OF THE STATE OF SOUTH AUSTRALIA
SOUTH AUSTRALIA DISTRICT REGISTRY
GENERAL DIVISION
O'Loughlin J.(1)

CATCHWORDS

Bankruptcy - s122 of Bankruptcy Act - preferential mortgage - financial circumstances of debtors as known to respondent bank - inferences to be drawn therefrom.

Bankruptcy Act 1966 (Cth) s122, s231

Law of Property Act 1936 (SA) s55b

Bank of Australasia v Hall [1907] HCA 78; (1907) 4 CLR 1514

Sandell v Porter [1966] HCA 28; (1966) 115 CLR 666

M. and R. Jones Shopfitting v The National Bank of Australia Ltd. (1983) 68 FLR 282

Rees v Bank of New South Wales [1964] HCA 47; (1964) 111 CLR 210

In re Blackpool Motor Car Co. Ltd; Hamilton v Blackpool Motor Car Co. Ltd. (1901) 1 Ch 77

Re Weiss; Ex parte White v John Vicars and Co. Ltd. (1970) ALR 654

Spedley Securities Ltd. (in Liq.) v Western United Ltd. (in Liq.) (1992) 7 ACSR 271

Downs Distributing Co Pty. Ltd. v Associated Blue Star Stores Pty. Ltd. (In Liq.) [1948] HCA 14; (1948) 76 CLR 463

Freer v Dot'n Line (Australia) Pty. Ltd. (1992) 10 ACLC 1304

HEARING

ADELAIDE, 13, 14 July, 28 August, 1 and 3 September 1992
24:3:1993

Counsel for the Applicant: Mr J. Cudmore

Solicitors for the Applicant: Messrs Ward and Co

Counsel for the Respondent: Mr P. Zappia

Solicitors for the Respondent: Messrs Ross and McCarthy

ORDER

1. That the applicant bring in, within 14 days of the date hereof,

short minutes of order in terms consistent with the reasons of the
Court published this day.
2. Liberty to apply and liberty to speak to the minutes.
3. Further consideration of the application herein adjourned.

Note: Settlement and entry of order is dealt with in Bankruptcy Rule 124.

DECISION

O'LOUGHLIN J. In these proceedings, Michael Jaunay Mount, the trustee of the assigned estates of the debtors, Leo Bernard McCarthy and his wife, Valerie Joan McCarthy, seeks a declaratory order that a memorandum of mortgage executed on 14 January 1991 by the debtors over their house property at Yorke Avenue Belair in favour of the respondent, Westpac Banking Corporation ("the bank") is void against the trustee as a preference to the extent to which it secures the payment to the bank of any moneys owing by the debtors to the bank prior to 14 January 1991. In addition to seeking consequential orders for accounts and redemption, the application also seeks an order for an inquiry into the damages suffered by the debtors from the alleged failure of the bank to supply to the debtors or to the trustee particulars of the amounts purportedly secured by the mortgage as required by s55b of the Law of Property Act 1936 (SA). Subsection (1) of that section provides:

"Notwithstanding any covenant to the contrary, a mortgagee
shall be deemed to have covenanted with the mortgagor that
where the mortgagee makes demand of any amount in pursuance
of the mortgage, he will at the request of the mortgagor,
supply him with reasonable particulars of how the amount of
the demand is arrived at."

2. The Deeds of Assignment were executed by the trustee and the debtors on 12 July 1991 in accordance with the provisions of Part X of the Bankruptcy Act, 1966 (Cth) ("the Act").

3. The trustee has advanced his claim against the bank by virtue of the preference provisions contained in subs122(1) of the Act; so far as material to these proceedings, that subsection is as follows:

"... a charge on property... by a person who is unable to
pay his debts as they become due from his own money (in this
section referred to as 'the debtor'), in favour of a
creditor, having the effect of giving that creditor a
preference, priority or advantage over other creditors,
being a... charge, executed...
(a) within 6 months before the presentation of a
petition on which, or by virtue of the
presentation of which, the debtor becomes a
bankrupt; or
(b) ...
is void as against the trustee in the bankruptcy."

4. By virtue of the provisions of s231 of the Act, s122 applies to Deeds of Assignment that are executed under Part X of the Act.

5. It is the case for the trustee that the execution by the debtors of the mortgage gave to the bank "a preference, priority or advantage over other creditors of the debtors at a time when the debtors and each of them were unable to pay their debts as they fell due from their own money" (Para 7 of the Statement of Claim). The bank has denied this assertion and has claimed:

"... that it executed the mortgage in good faith and for
valuable consideration and in the ordinary course of
business."

6. The bank has also denied that it failed to comply with the provisions of the Law of Property Act.

7. Mr. and Mrs. McCarthy were the only shareholders of McCarthy Marketing Pty. Ltd. ("the company"). That company was retained by Galaxy Homes Real Estate Pty. Ltd. as a "sales consultant"; in fact Mr. McCarthy was the only employee of McCarthy Marketing Pty. Ltd. and can be regarded, for practical purposes, as his company's alter ego. The retainer called for the introduction of clients who wished to build houses. The "selling" company, Galaxy Homes Real Estate Pty. Ltd., through its consultants (such as McCarthy Marketing Pty. Ltd.) would arrange for clients to enter into building contracts with the "building" company, Galaxy Homes Pty. Ltd., A consultant such as Mr. McCarthy's company earned commission of 3% of the value of a building contract; 1 % was payable on the signing of the contract and the remaining 1 % when the contract became unconditional.

8. The McCarthy's had been customers of Westpac since 1980 and customers at the Mitcham branch (of which the witness Mr. Schutz was manager) since 1988. For the purposes of these proceedings, it may be accepted that at all times, the relevant bank account at the Mitcham branch was that which was conducted in the name of McCarthy Marketing Pty. Ltd. That account however, was not used exclusively, for the company's business. Mr. and Mrs. McCarthy also used it for their personal and private accounts but they had, by Deed dated 6 April 1989, each guaranteed to Westpac repayment of the company's indebtedness.

9. The debtors' financial difficulties can be traced back to their decision to sell their matrimonial home and to build a new home. In March 1990 they signed a contract to buy a vacant block of land at 2 Yorke Avenue, Belair. They engaged Galaxy Homes Pty. Ltd. to build a house for them and borrowed $150,000 from Home Start Finance Ltd. ("Home Start") upon the security of a registered first mortgage. That fund was applied, in part, to complete the purchase of the land and the balance was used to pay the builder progress payments as work on the house proceeded. The debtors, however, fell into difficulties for they needed further money to complete the house and landscape the garden. They applied to Mr. Schutz for a loan of $20,000 but the bank rejected their application against his recommendation (Ex.A30 dated 24 July 1990). In the following month the debtors were able to borrow the $20,000 from Hindmarsh Financial Services Ltd. ("Hindmarsh") as a personal loan but it was still insufficient for their needs. They owed Galaxy Homes Pty. Ltd. about $18,000 which, ultimately, they secured by executing an unregistered mortgage over the house property on 7 January 1991, some 5 days outside the six month period to which s122 of the Act applies.

10. Calendar monthly repayments of $1,396 were required under the first mortgage to Home Start. The first of these fell due and was paid by the debtors from the company's bank account on 31 October 1990. That was the only monthly repayment that the McCarthys made.

11. The debtors' problems were compounded when, in November 1990, Galaxy Real Estate Pty. Ltd. terminated the company's consultancy arrangement. That consultancy was the company's and, in turn, the McCarthys' only form of income and save for the payment of any outstanding commissions, it meant that neither the company nor Mr. and Mrs. McCarthy were in receipt of any form of income. At that stage, the debtors were committed personally to calendar monthly repayments to both Home Start and Hindmarsh; they also owed Galaxy Homes Pty. Ltd. $18,000 and they were guarantors in respect of the company's leasing obligations to Westpac for a Toyota Lexcen motor car and a Rover Quintet motor car. Their relationship, at that stage, with Mr. Schutz and Westpac can be gleaned from an objective study of the letters that the bank had written them and, likewise, an assessment of the bank's attitude to them can be aided by an examination of its internal memoranda in the preceding months.

12. In March 1990, the bank had given the company overdraft accommodation up to $5,000 but on 10 April it had to write pointing out that the account was overdrawn to $7,313 (Exs.R16 and A29). Mention has already been made of the bank's refusal in July 1990 to advance the debtors a loan of $20,000.

13. In August the bank twice wrote to the company (Ex.R7 and R8) complaining that the state of the overdraft exceeded the agreed limit of $5,000 and in the same month an internal review by the "Manager Credit" (Mr. Horsnell) (Ex.A31) was highly critical of the manner in which the account had been maintained. His endorsement on the monthly report, which was directed to Mr. Schutz, read: "The account trend developing here is not to our liking. We are unsecured and this is to be the limit of your assistance". In September 1990, an internal memorandum noted that the account had been "out of order since 26/3/90" (Ex.A36) and in the following month the debit balance had blown out to $13,582.91. On 6 November 1990 (Ex.A33) Mr. Horsnell asked for a full report including "reason for excess, term and defined source of clearance".

14. That then was the history of the company's account during the latter part of 1990 and the state of the company's account was a reflection of the financial state of the debtors. It is against that background that one must evaluate the meeting that took place between Mr. McCarthy, and Mr. Schutz on 24 December 1990. According to Mr. McCarthy he "pleaded" with Mr. Schutz "if there was some way that he could give us, allow some increase in our overdraft to tide us over Christmas." (p 59) Mr. McCarthy's evidence continued:

"Well, I said that, because as he knew it was Christmas, it
was the day before Christmas and we didn't even have money
for presents for our family or food or anything."

15. Although this statement appears to be highly emotive, it is supported by the fact that, at that stage, the bank had commenced to dishonour cheques that were drawn on the company's account. Not having any other form of income available to him nor any other cash resources, one can easily imagine that Mr. McCarthy would regard his position as desperate. He had approached Galaxy but they refused to assist him; the bank was his only hope. The bank was well aware of the plight of the debtors. Exhibit A37, an internal bank memorandum dated 24 December 1990 from Mr. Schutz to his superior officer (Mr. Horsnell) spoke of an agreement to "increase limit to cover carry on and clear outstanding lease payment and place us in 'a preferred position'." The memorandum did not mention a mortgage or "security" but it commenced with a reference to "our phone call of even date". I find that the use of the expression "a preferred position" was attributable to the proposal to take security from the debtors in the form of a mortgage over their house property. Mr. Horsnell's reply of 31 December (by way of an endorsement on Ex.A37) was short and to the point:

"We are left with little choice. No excesses to be allowed.
Pressure for early sale/clearance."

16. The reference to an "early sale" related to the debtors' on-going proposal that they had put their new home on the market for sale and that they would discharge their company's obligations to the bank out of the proceeds of that sale. The debtors did in fact sell their home. On 28 April 1991, they entered into a contract of sale for $235,000; settlement took place on 11 July and out of the proceeds of settlement the amount owing to Home Start Ltd. and Galaxy Homes Pty. Ltd. was duly discharged. By agreement between the parties, the balance remaining from the proceeds of sale were paid into Court to await the outcome of these proceedings.

17. For the trustee to succeed in this action, he bears the onus of establishing, on the balance of probabilities, that the requisite type of preference was given by the debtors to their creditor. He must therefore, first, establish that there has been a transaction to which subs122(1) applies. In this case there is no doubt that the memorandum of mortgage that was executed by the debtors on 14 January 1991 would constitute a "charge on property". Next, the trustee must prove that the debtors were "unable to pay (their) debts as they became due from (their) own money". I am satisfied that the evidence justifies such a finding. I accept Mr. McCarthy's evidence (to which reference has already been made) that on 24 December 1990 his (and his wife's) position was desperate. He was out of work, they could not pay their commitments under their mortgage, they could not pay Galaxy Homes Pty. Ltd. or Hindmarsh, and they could not meet their liabilities as guarantors of their company's car leasing obligations.

18. These factors are all material considerations in assessing whether the debtors were unable to pay their debts as they became due from their own money, but they are not conclusive or exhaustive. It is also necessary to have regard to the debtors' assets and income and the arrangements (if any) that were in place for the payment of creditors. But, in the circumstances of this case, the position was hopeless. There were some outstanding commissions allegedly owing by one or other of the Galaxy companies to the company. The figure of $8,000 was mentioned in evidence; it was also mentioned in the bank's internal memorandum of 24 December 1990 (Ex.A37). The reality, however, of the company receiving that money in the foreseeable future when Mr. and Mrs. McCarthy owed a related company in the same group a greater sum was virtually non-existent.

19. When assessing whether debtors are unable to pay their debts as they become due from their own money, it is important to bear in mind that the test bears upon the realities of the circumstances as they exist at the time when the preference was allegedly given and the immediate future. The classical exposition of the test is that of Griffith C.J. in Bank of Australasia v Hall [1907] HCA 78; (1907) 4 CLR 1514 at 1528:

"The words 'as they become due' require, as already pointed
out, that some consideration shall be given to the immediate
future; and, if it appears that the debtor will not be able
to pay a debt which will certainly become due in, say, a
month... by reason of an obligation already existing, and
which may before that day exhaust all his available
resources, how can it be said that he is able to pay his
debts 'as they become due,' out of his own moneys?
It was suggested, but the argument was not pressed, that the
debtor's affairs should be regarded from the point of view
of a balance sheet of assets and liabilities. This is not
what the Statute says... The question is not whether the
debtor would be able, if time were given him, to pay his
debts out of his assets, but whether he is presently able to
do so with moneys actually available."

20. It is true, as Barwick C.J. explained in Sandell v Porter [1966] HCA 28; (1966) 115 CLR 666 at 670 that a debtor's own moneys are not limited to his cash resources immediately available. They extend to moneys which he can procure by realization, by sale, by mortgage or by pledge of his assets within a relatively short time: see also M. and R. Jones Shopfitting Co. Pty. Ltd. v The National Bank of Australia Ltd. (1983) 68 FLR 282 at 287-288. But even in December 1990 and January 1991 Mr. Schutz knew that the McCarthy's were having difficulties in completing their house and a sale was not expected until at least April. That could not be classified as a relatively short time. As Taylor J. explained in Rees v Bank of New South Wales [1964] HCA 47; (1964) 111 CLR 210 at 230:

"The question is not whether the debtor would be able, if
time were given to him, to pay his debts out of his assets,
but whether he is presently able to do so with moneys
actually available."

21. Mr. Zappia, counsel for the bank, submitted that Mr. and Mrs. McCarthy were not debtors of the bank in December 1990 - January 1991. If that submission is correct then the bank would not be their creditor and s122 of the Act would not be available to the trustee. His submission was based upon the premise that the bank account was in the name of their company, that the accommodation that the bank gave was primarily given to the company, that any liability that the McCarthys had to the bank was secondary and arose only by virtue of their role as guarantors, and that they had no primary liability to the bank unless and until the bank made demand on them under the guarantee. There being no such demand in existence on 14 January there was, according to the argument, no relationship of debtor and creditor. This submission is unsound. It confuses the relationship between the bank and the McCarthys with the rights of the bank to institute proceedings for the recovery of moneys from the McCarthys. Those rights of recovery were inhibited by the need to serve a demand for payment before action, but that does not mean that there was not a debtor/creditor relationship. The conclusive answer to this argument, however, can be found in clause 15 of the Deed of Guarantee that the debtors executed in favour of the bank on 6 April 1989. Under that clause they accepted the role as principal debtors to the bank in respect of any moneys that may be owing by their company to the bank.

22. The test that was applied in In re Blackpool Motor Car Co. Ltd; Hamilton v Blackpool Motor Car Co. Ltd. (1901) 1 Ch 77 and approved in Bank of Australasia v Hall (supra) was to determine whether the claimant party could prove as a creditor in the bankruptcy administration of the other party. In this case, the bank, by virtue of the terms of the guarantee, could have clearly claimed as a creditor in the administration of the estates of Mr. and Mrs. McCarthy. I am satisfied that the relationship of debtor/creditor existed between the McCarthys and the bank. It follows, therefore, that I am of the opinion that the mortgage was given "in favour of a creditor". I am of the further opinion that it was given within six months of the execution of the Deeds of Assignments. In other words, the trustee has made out the third and fourth tests.

23. Mr. Zappia had argued that I should regard the mortgage as being effective as from 24 December 1990 - that being the date upon which Mr. Schutz, in the name of the bank, gave the debtors additional accommodation. But such a proposition is contradicted by the bank's internal memoranda (see Ex.A37). There may have been agreement in principle on that date, but it is quite clear that Mr. Schutz still considered it necessary to get his superior's confirmation to the arrangement.

24. I accept that the execution of a formal mortgage, which is merely the perfection of an earlier equitable mortgage, does not, without more, constitute the giving of a preference on the date of its execution. Gibbs J. explained this in Re Weiss; Ex parte White v John Vicars and Co. Ltd. (1970) ALR 654 at 662. But I do not consider that the evidence is sufficient to establish the existence of any such equitable mortgage on a date earlier than 14 January 1991. Exhibit R4, upon which Mr. Zappia placed so much reliance in arguing for the existence of an earlier equitable mortgage, is, in fact, against him. Exhibit R4 was a letter dated 2 January 1991 from Mr. Schutz to the company (but addressed to "Dear Leo and Valerie") in which the bank confirmed its "approval to offer you finance of $18,000 to assist with cover on and outstanding lease payments". The letter continued by nominating that the security that was required would include the mortgage and that "no part of the loan will be made available until" the security documents had been executed. The terms of that letter were accepted by the debtors on 7 January 1991 but that acceptance was not the creation of an equitable mortgage for it was only the acceptance of the terms that had been offered by the bank (including the term that no part of the loan would be available until the mortgage had been executed).

25. Much time was devoted by counsel to the state of the pleadings and whether they permitted the question of an earlier equitable mortgage to be raised by the bank. I find it unnecessary to investigate those arguments because of the findings of fact that I have made. In particular, I do not consider it necessary to rule on Mr. Zappia's late application to amend his defence and to include a counterclaim seeking declaratory relief.

26. It remains then to consider whether the bank obtained a preference "over other creditors". Mr. Zappia suggested that Hindmarsh was the only unsecured creditor of the debtors and that the evidence of Mr. McCarthy had established that Hindmarsh had a very relaxed and accommodating attitude to him and to his wife. But I fail to see the significance of such a submission. It is clear that if the mortgage is not void there will be insufficient funds available in the administrations to pay Hindmarsh in full. In other words the evidence has established that by obtaining the mortgage the bank obtained a preference over Hindmarsh.

"In general, to pay one of a number of creditors, and
neither paying, securing nor arranging with the others, is
to prefer the creditor who is paid." (Queensland Bacon Pty.
Ltd. v Rees [1966] HCA 21; (1965-1966) 115 CLR 266 at 283.

27. In my opinion, the trustee has made out his case under subs122(1) and it now becomes necessary to consider whether the protection afforded by subs122(2) is available to the bank. Subsections (2), (3) and (4) of s122, so far as they are material to these proceedings, are in the following terms:

"(2) Nothing in this section affects
(a) the rights of a purchaser, payee or
encumbrancer in good faith and for
valuable consideration and in the
ordinary course of business;
(b) ...
(c) ...
(3) The burden of proving the matters referred to in
subsection (2) lies upon the person claiming to have the
benefit of that subsection.
(4) For the purposes of this section:
(a) ...
(b) ...
(c) a creditor shall be deemed not to be
a purchaser, payee or encumbrancer
in good faith if the conveyance,
transfer, charge, payment or
obligation was executed, made or
incurred under such circumstances as
to lead to the inference that the
creditor knew, or had reason to
suspect:
(i) that the debtor was
unable to pay his debts
as they became due from
his own money; and
(ii) that the effect of the
conveyance, transfer,
charge, payment or
obligation would be to
give him a preference,
priority or advantage
over other creditors."

28. The question of onus switches at this stage and the bank bears the task of proving on the balance of probabilities that it was (in the terms of paragraph 122(2)(a)) an "encumbrancer in good faith and for valuable consideration and in the ordinary course of business." On the other hand, the party who seeks to invoke the operative provisions of paragraph (c) of subs122(4) bears the burden of showing that the stipulated conditions of its operation are satisfied (Spedley Securities Ltd. (in Liq.) v Western United Ltd. (in Liq.) (1992) 7 ACSR 271 at 278 per McLelland J.).

29. I accept that the evidence establishes that the bank gave valuable consideration in return for the mortgage. It granted increased accommodation and it agreed not to enforce its existing rights of recovery with respect to the company's overdraft or to take action because of the arrears of payments under the leases for the cars.

30. I turn next to the question of good faith. Mr. Schutz, in his evidence, said that he neither believed nor suspected that the debtors were insolvent in January 1991 and he did not believe and he did not suspect that the bank was obtaining a preference when it accepted the mortgage. I can not accept this evidence. The hopeless financial circumstances of the debtors were well known to Mr. Schutz; he even used the word "preferred" when reporting to his superior and seeking confirmation of the arrangements that he had made with Mr. McCarthy on 24 December 1990. He knew that the only real prospect of the bank being paid rested in a sale of the new house at a good price. I cannot accept his explanation that he used the word "preferred" as meaning that it was preferable to be a secured creditor than an unsecured creditor.

31. I am not suggesting that Mr. Schutz gave false evidence. On the contrary! I am satisfied that, in retrospect, he has now convinced himself that in 1991 he and the bank merely acted as any prudent creditor would have acted. McLelland J. has conveniently summarised the question of "good faith" in Spedley Securities v Western United (supra) at 278 where he said:

"I respectfully agree with the observation of Wootten J in
Re Chisum Services Pty Ltd (1982) 7 ACLR 641; 1 ACLC 292 at
297 that for the purpose of s122(2), 'good faith is a
subjective condition, requiring that the payee act with
propriety and honesty'. In my opinion, subject to the
operation of s122(4)(c), a creditor is a 'payee... in good
faith' within the meaning of s122(2)(a) if at the time of
the payment to him he neither believed nor suspected that
the payment was such as to give him a preference over other
creditors of an insolvent debtor: cf Re Chisum Services, loc cit."

32. But that does not resolve the question. By virtue of the provisions of paragraph 122(4)(c) the bank shall be deemed not to be an encumbrancer in good faith if the mortgage was executed under such circumstances as to lead to the inference that the bank knew, or had reason to suspect, that the McCarthy's were unable to pay their debts as they became due from their own money and that the effect of the mortgage would be to give the bank a preference over other creditors. In assessing whether a creditor "had reason to suspect", the test is an objective one: Downs Distributing Co Pty. Ltd. v Associated Blue Star Stores Pty. Ltd. (In Liq.) [1948] HCA 14; (1948) 76 CLR 463 at 475-476 per Latham C.J.; Freer v Dot'n Line (Australia) Pty. Ltd. (1992) 10 ACLC 1304 at 1308 per White A.C.J. Viewed objectively, and notwithstanding Mr. Schutz's subjective assessment, it is inevitable that one must conclude that the financial history of the McCarthys in the preceding six months coupled with the loss of Mr. McCarthy's job and his impassioned plea to Mr. Schutz on Christmas eve would have given any reasonable bank officer "reason to suspect" the issues of inability to pay debts and preference.

33. I am therefore of the opinion that the mortgage is void against the trustee by virtue of the provisions of s122 of the Act but only in respect of moneys that were owing to the bank prior to 14 January 1991. The bank must give full and detailed particulars to the trustee in respect of such financial accommodation as was granted by the bank to the debtors on or after that date. I direct that it do so within 14 days of this date. I apprehend that the supply of such information by the bank will amount to due compliance with the requirements of s55b of the Law of Property Act 1936 (SA).

34. The bank must pay the applicant's costs including any reserved costs. I direct the applicant to bring in, within 21 days, short minutes of order in terms consistent with these reasons: liberty to apply and liberty to speak to the minutes; further consideration of the matter adjourned.