Justice Ball’s landmark decision1 dismissing the lenders’ claims addressed various important issues that often arise when a borrower is facing financial distress in Australia, including:
- the definition of solvency, in particular where a company is paying its short-term debts but where large long-term debts are due in the distant future;
- the circumstances in which a company’s officers and employees may owe their lenders a duty of care and may be personally liable for representations made to lenders;
- issues of lender reliance and loss causation;
- the interpretation of material adverse effect clauses; and
- the extent to which assignees of debt may be able to bring proceedings for claims ancillary to the main debt obligations in their assignee capacity.
We analyse some of these issues in further detail below.
The decision will be of particular interest to:
- directors of Australian companies facing financial distress, for whom the definition of solvency is of critical importance to their day-to-day decision making and in discharging their duties to the company;
- insolvency practitioners, who are required to determine the precise date when a company becomes insolvent in various contexts in performing their functions; and
- lenders to distressed companies in Australia, particularly in relation to the extent to which they are able to take action beyond the consequences provided for under the relevant facility agreement in the event that contractual drawdown notices are inaccurate or misleading.
The key takeaways from the decision are that:
- a company is unlikely to be insolvent where, at the time of assessment, it is able to pay its short-term debts as and when they fall due, but may not be able to pay longer term debts (particularly where those longer term debts fall due on dates measured in years, not months) – this is particularly the case where the company has a broad, varied (and potentially liquid) asset base and/or is otherwise solvent on a balance sheet basis;
- borrowers, their directors, officers and employees are unlikely to owe lenders a separate duty of care in tort in respect of representations and warranties required to be given under a contractual obligation, but a duty may be imposed on individuals in limited circumstances including where they are asked to provide specific information to lenders outside the confines of the contract and where they occupy a position of particular knowledge, expertise or seniority;
- a lender is unlikely to be able to show reliance on a particular representation or warranty given by a particular individual under a finance document (and therefore fulfil one of the key criteria in demonstrating causation essential to any claim for negligence or misleading or deceptive conduct) unless the lender can show something particular about that representation made by that individual that caused it to advance funds;
- enforcing material adverse effect clauses, particularly those expressed in purely qualitative terms, is challenging, and the traditional reluctance of lenders in Australia to rely on asserted breaches of such clauses in isolation is well justified. Where possible, clauses expressed in quantitative terms or by reference to objectively measurable criteria are preferable;
- notwithstanding that Australian law generally prohibits assignments of a bare right to litigate, an assignee of a debt is more likely than not to be able to pursue a corresponding cause of action arising out of or in connection with, and assigned with, that debt, on the grounds that they had a genuine commercial interest in taking an assignment of the right to litigate.
Arrium went into voluntary administration in Australia in April 2016 and following that, liquidation, with approximately A$2 billion of debt owing to creditors.
The Arrium Proceedings comprised two separate claims bought by financier groups who had advanced monies to Arrium borrowers under existing syndicated and bilateral facilities agreements, and concerned, in particular, drawdown and rollover notices issued by the relevant Arrium entities in January and February 2016 under the facilities agreement.
The first group of lenders (including a Cayman-registered subsidiary of Anchorage Capital, Deutsche Bank and the Commonwealth Bank of Australia) (“Anchorage Claim”) claimed damages in excess of A$180m. The Anchorage Claim asserted that:
- Arrium’s former Treasurer and/or Treasury and Finance employees had made negligent misrepresentations in drawdown and rollover notices issued to the lender that (1) there had been no change in Arrium’s financial position since either 31 December 2012 or 30 June 2015 (depending on the facility in question), which had had a material adverse effect on the borrower’s ability to perform its obligations, and (2) no Event of Default or Potential Event of Default had occurred and continued unremedied;
- Arrium’s former CFO had breached a of duty of care allegedly owed to the lender by (1) directing that Arrium draw down all available monies under the facilities and (2) failing to ensure that the representations made by Arrium in the drawdown notices and rollover notices were accurate;
- the CFO and the Treasurer had each procured and been involved in misrepresentations made by Arrium negligently and in breach of contract by directing (or failing to prevent) those drawdowns being made; and
- the Treasurer had made separate, negligent, misleading representations in the course of one specific conversation with the lender concerning the accuracy of representations made in one particular drawdown notice and regarding the progress of the sale of Arrium’s mining consumables business.
The second group of lenders (Bank of Communications, Westpac and the Hong Kong branch of Banco Bilbao Vizcaya Argentina) (“BoC Claim”) claimed damages in excess of A$140m. The BoC Claim asserted that:
- Arrium had made misleading misrepresentations in drawdown notices issued to the lenders because a material adverse effect had occurred and because Arrium was insolvent at the time those representations were made; and
- the CFO and Treasurer had engaged in that misleading conduct by (in the case of the CFO) directing that the drawdowns be made and (in the case of the Treasurer) by virtue of her authority to make decisions on drawdowns and was responsible for causing the issue of the drawdown notices.
A separate insolvent trading claim was also brought by Arrium’s liquidators against the former directors, which was settled during the course of the trial, but which raised issues relevant to key issues in the Anchorage Claim and the BoC Claim.
Solvency where large debts due in the future
Perhaps the most significant issue examined by the Court, given its critical importance to the day-to-day decision making of company directors and the discharge of their duties to the company, and its relevance to potential clawback remedies under Australian law, was whether Arrium was insolvent in January/February 2016 at the time the relevant drawdown and rollover notices were issued. The BoC Claim and the related insolvent trading claim specifically asserted that Arrium was insolvent at the time the notices were issued (this was a critical component of the BoC Claim, as pleaded, against the CFO and Treasurer).
Under Australian law, a company is solvent if, and only if, it is able to pay all its debts as and when they become due and payable. A company that is not able to make those payments is insolvent.
A claim that a company is insolvent at a given time usually involves an assertion that it is unable to pay its current debts, or its debts that will become due and payable in the short-term.
Atypically, the lenders in the BoC Claim (and Arrium’s liquidators in the insolvent trading claim) asserted that Arrium was insolvent as at January/February 2016 solely on the basis that it was unable to repay approximately A$871 million in debt facilities which were due to mature in July 2017 (that is, some 18 months into the future).
The lenders claim of insolvency was based on an assertion that the only way Arrium would be able to repay the maturing debt was through a sale of its mining consumables business (described as the “jewel in its crown”), and that by 7 January 2016 it was apparent that Arrium could not achieve a price for that business which would be sufficient to both repay the debt and enable Arrium to continue to operate a viable business in the meantime.
The Court adopted well-established principles that the test for solvency is “forward looking” and requires the Court to be “commercially realistic”. Whilst noting that the test involves some uncertainty and speculation, the Court also noted that the question of how far it should look into the future to determine the company’s ability to pay its debts as and when they fall due depends on the circumstances of each case. In this regard, the Court will normally not look too far into the future due to the unknowns and contingencies that exist in trying to predict the future. The Court also emphasised the need to assess solvency by reference to the circumstances as they were known (or ought to have been known) at the relevant time, and not with the use of hindsight.
Justice Ball dismissed the lenders’ assertion that Arrium was insolvent in January/February 2016 because, amongst other reasons:
- Arrium still had 16 months to address the maturing debts as at the time of the drawdowns, at which point in time it had a surplus of net assets - it could therefore be implied that Arrium would, if necessary, be able to sell those assets or raise finance on the security of those assets in order to repay the maturing debts;
- the fact that it was asserted to be “apparent” that Arrium could not obtain an acceptable price for its mining consumables business as at January 2016 was not directly relevant – the question was whether Arrium could do so before the debts matured;
- whilst the Court noted the considerable uncertainty regarding Arrium’s future, that uncertainty did not equate to a finding that there was no realistic prospect that Arrium would be able to sell the mining consumables business for an acceptable sum before the debts matured;
- in all the circumstances, it was too uncertain to say, in January and February 2016, that it was more likely than not that Arrium would be unable to generate sufficient cash to repay the debts on maturity in July 2017; and
- the fact that Arrium went into administration on 7 April 2016 (only seven weeks after the last drawdown was made) was not, of itself, evidence that it was insolvent as at that date, let alone the earlier January/February 2016 date asserted by the lenders, and was evidence only of the board’s opinion as at that date (because the board only needs to hold the opinion that the company is insolvent or likely to become insolvent to appoint an administrator under Australian law) – to hold otherwise would amount to an “impermissible use of hindsight”.
Whilst every case turns on its own facts, the decision indicates that it will be more difficult to come to a conclusion that a company is insolvent where it is necessary to have regard to debts falling due in a future period measured in years rather than months.
This may give comfort to directors of distressed companies that are able to pay their short-term debts as and when they fall due, but which have impending long-term debts which, in the absence of a sale or capital raising exercise, the company may be unable to pay.
Duty of care to lenders and personal liability
The Court determined that no duty of care was owed to the lenders by any of the Arrium entities, the CFO, the Treasurer, or the other Arrium employees, save in respect of a single telephone conversation between the Treasurer and one lender (where the Court found that no breach of the duty occurred).
In reaching this decision, the Court concluded, among other things, that:
- the individual employees did not owe a duty of care to the lenders because
- the representations and warranties contained in the rollover and drawdown notices were given by the Arrium borrowers in each case, not the signatories personally. The Court considered that a finding that the notices were given by the individual signatories would give rise to a situation where those signatories would be forced to either incur personal liability by signing the notices or risk breaching their duties as employees by refusing to sign the notices which they had been asked to sign under their contracts of employment;
- the notices formed part of a contractual mechanism between Arrium and the lenders, pursuant to which the lenders could exercise contractual remedies against the Arrium entities if the representations or warranties were breached;
- there was no particular knowledge or expertise of the individuals on which the lenders would be relying; and
- the lenders were not vulnerable to any failure by the signatories to take reasonable care;
- the Arrium entities did not owe a duty of care to the lenders because:
- the consequences of the representations and warranties being incorrect was set out in the facility agreements, which were negotiated between sophisticated parties capable of protecting their own interests;
- there is no reason why the law should impose a different set of obligations and liabilities to those already set out in the relevant contract; and
- there is no duty in tort to take reasonable care to perform a contract;
- the CFO did not owe a duty of care to the lenders because any direction to draw down funds constituted part of Arrium’s internal operations, and a duty of care cannot be imposed on an employee in favour of a third party every time the employee makes a decision (and communicates that decision to another employee) which may affect the third party;
- the CFO was not liable for inducing or procuring any negligent misstatements on behalf of Arrium because:
- there was no corresponding duty of care owing by Arrium in the first place (as noted above);
- in any event, Arrium had not made any negligent misstatements as a question of fact;
- the drawdown and rollover notices were issued as part of Arrium’s normal functions, and there was no evidence that the CFO had any particular involvement with the decision to issue them.
The Court found that the Treasurer did owe a duty of care to one particular lender in making representations during a telephone conversation held at the request of that lender so it could better understand Arrium’s financial position. The Court noted that, in those circumstances, the Treasurer must have understood that the lender required further information and would rely on that information due to the Treasurer’s position of seniority, and further the lender had no other means of finding the information out for itself (thus making it “vulnerable” to a lack of care by the Treasurer in providing the information). However, the Court found that, as a matter of fact, there was no breach of the duty by the Treasurer because there was no evidence that the information provided was inaccurate or that certain alleged representations had been made by the Treasurer.
For lenders, Justice Ball’s decision emphasises that it will, in the absence of something more, be difficult for them to show that they are owed a duty of care in tort by their borrowers (and directors and employees of those borrowers) in relation to representations and warranties given in accordance with the terms of the underlying finance documents. This reinforces the importance of ensuring appropriate remedies are included in the contractual arrangements. In particular, Australian Courts will be hesitant to impose a duty of care on individual employees where to do so may put them in a position of conflict with the duties owed to their employer, and where the relevant conduct concerns purely internal decision-making.
For directors and officers, it is a timely reminder that they may, in certain circumstances, owe a duty of care to the company’s lenders where the lenders make specific requests for information of them based on their seniority, expertise and responsibilities, particularly where those requests are made outside the ambit of the underlying contractual terms.
MAC and MAE clauses
In each of the Anchorage Claim and the BoC Claim, a key issue was whether a representation made by the Arrium borrowers that there had been no changes in their financial position since certain dates, which had had a “material adverse effect” in their ability to perform their obligations under the facility agreement, was true (“MAE Representation”).
This is a complex example of a material adverse effect (“MAE”) clause, commonly found in loan agreements, share and asset purchase agreements, amongst other documents. The difficulty with MAE and material adverse change (“MAC”) clauses is that they are usually (as was the case in Arrium) expressed in broad, qualitative terms, such that there is almost always the potential for dispute as to their proper construction. For this reason, it is rare in Australia to see a lender rely solely on a breach of a MAE or MAC clause to call a default or allege a breach.
The interpretation of the clause in Arrium turned on (1) whether there had been a change in Arrium’s “financial position” since the relevant dates in each case and (2) if there had, whether that change had a “material adverse effect” on Arrium’s ability to perform its obligations under the loan agreements.
The Court confirmed that interpretation of MAE and MAC clauses are subject to the traditional approaches to contractual interpretation. That is, they are construed by reference to the words used (giving them their ordinary meaning), the context in which they appear, and what a reasonable business person would understand them to mean.
Ultimately, the Court found that certain of the many factors asserted by the lenders did constitute a change in “financial position” (particularly changes in cash flow, debt levels and liquidity, changes in gearing and interest cover ratios and the auditors’ inclusion of a note in Arrium’s accounts regarding uncertainty over Arrium’s ability to continue as a going concern). However, the Court found that only the auditors’ note constituted a “material” change, such that there was a MAE only with effect from the date of the adoption of that note. That date fell after the date on which the relevant drawdown notices and rollover notices were issued, such that the MAE Representation made in those notices was true.
Secondary debt trading in Australia
The Anchorage Claim gave rise to a further specific issue regarding the plaintiff’s right to bring the Anchorage Claim in the first place. The issue arose because Anchorage had acquired its interest in the relevant loans on the secondary market after Arrium had entered voluntary administration. The assignment of the loans to Anchorage included an assignment of “ancillary claims” which any original lender had arising out of or related to the assigned loans.
In Australia, the general principle is that, subject to certain exceptions, a bare right to litigate is not assignable. However, it has been held in some circumstances that where the assignee has a “legitimate commercial interest” beyond the cause of action itself, an assignment of the cause of action will be permitted (certain statutory causes of action, such as those for misleading conduct contrary to the Australian Consumer Law, remain absolutely incapable of assignment, and therefore the focus in the Anchorage Claim was on the purported assignment of common law claims in negligence).
When the plaintiffs sought leave to amend their original claim to join the CFO as a defendant in 2019, the CFO opposed that application on the basis that Anchorage was an assignee of a bare cause of action, the assignment of the cause of action was invalid, and the claim against him was therefore “doomed to fail”.
The primary judge in the amendment application (being Ball J) rejected the CFO’s submissions on the basis that it was at least open to argue that Anchorage had a legitimate commercial interest beyond that of the cause of action itself (i.e. because it was an assignee of the underlying debt). The New South Wales Court of Appeal refused the CFO’s application for leave to appeal 2, on the basis that:
- some of the claims brought against the CFO were untouched by the assignment issue (because some of the plaintiffs were not assignees), and so it was preferable not to refuse leave to amend the claim to join the CFO as a matter of case management;
- it was at the very least arguable within the scope of existing authority that the assignment of the cause of action was valid, because it was arguable that Anchorage had a legitimate commercial interest beyond that of the cause of action itself; and
- the principle preventing the assignment of bare causes of action (including the underlying public policy) is not settled beyond argument, and therefore the matter could not be determined on a summary interlocutory application.
In the Arrium Proceedings, Bell J did not need to definitely address the assignment issue because he determined that the causes of action asserted by the lenders did not exist. However, he noted the authorities which confirmed that:
- a proprietary right and other rights assigned with it (such as a right to litigate) will be sufficiently connected to support the assignment of the latter if it can be said that the assignee has a genuine commercial interest in taking an assignment of the latter with the former; and
- there has been a change in public policy away from the view that “trafficking” in litigation is a social evil, towards a recognition that assignment of legal rights performs a useful social function in ensuring that losses are borne by those responsible for them.
His Honour therefore noted that:
- had it been necessary to do so, he would have concluded that the assignments of causes of action against the Arrium entities based on representations made in the drawdown and rollover notices were valid, on the basis that any claims in negligence (if they existed) were assignable with the assigned debts because they would have been available as an alternative to a claim based on the facility agreements themselves; and
- it seemed a “small step” to therefore say that the assignees also had a genuine commercial interest in taking an assignment of accessorial claims and the direct claims against the CFO, Treasurer and individual employees, because those claims were intimately connected to the claims against the Arrium entities themselves and were a means of protecting the assignees in the event the claims against the Arrium entities were not recoverable.
What this highlights for secondary debt traders in Australia is that the law in relation to assignments of a right to litigate continues to develop and evolve. Whilst it remains important to distinguish between an assignment of rights and obligations under debt instruments, and assignments of “ancillary” rights to litigate in respect of causes of action arising out of those instruments, the Arrium case indicates that a Court is more likely to allow an assignee to exercise a bare right to litigate where that right forms part of or is ancillary to a broader acquisition of a debt on the secondary market.
Authored by James Hewer, Scott Harris and Zachary Forrai.