A mere conviction of wrongdoing is no substitute for evidence

A closely watched class action in the Federal Court has foundered over the way the applicant drafted its pleadings. On 18 March 2011, Justice Perram handed down his decision on an application to amend some particularly otiose pleadings in Mercedes Holdings Pty Ltd v Waters (No 3) [2011] FCA 236.

The case concerned the failed Gold Coast Mortgage Fund, MFS, in which investors lost millions. It was an IMF litigation funded class action by unit holders against the auditor KPMG and directors of the former responsible entity of the fund known as MFS Investment Management who sought leave to amend their claim and to discontinue their action against an employee, which is required under section 33V of the Federal Court of Australia Act 1976.

Amendment Application
This application is pursuant to Order 13 rule 2 of the Federal Court Rules. Generally it is inappropriate to permit an amendment which is bound to fail.

The proposed amended application was 676 pages in length, accompanied by a 13 page aide-memoire to assist its understanding. The current pleadings were criticised by the court on an earlier motion on 14 May 2010  for leave to amend (with leave refused) for being “prolix, repetitious and frequently obscure”.

The applicants sought leave to amend to claim on the grounds:

  1. that the value of their units was reduced by the actions of the auditor and the directors. It is well established that beneficiaries of a trust may not sue on the trust’s behalf unless there are exceptional circumstances. However the unit holders were not suing on the trust’s behalf but on their own behalf. The court did not accept that the principle of reflective loss which applies to corporations (preventing a shareholder suing a third party to recover loss caused to its shares) necessarily applies to a trust. The court found that a claim based on reflective loss was arguable at trial and depended upon what the trust instrument says about capital reduction and unit holder suits. The court permitted this amendment;
  2. that the auditors did not carry out an audit to ensure compliance with the compliance plan for three years contravening section 601HG(3)(b)(i) of the Corporations Act. In fact an audit had been conducted. The court rejected the inference that the auditor had breached it duty in failing to conduct an audit at all simply because the auditor in its report (a) did not explicitly state that a compliance audit had been carried out or (b) did not detect any of the alleged compliance failures. Neither (a) nor (b) demonstrate that no audit was conducted. The court noted “there is something distinctly surreal about an allegation of no audit which relies upon the audit report apparently produced as a result of an audit which did not happen” and found it to be hopeless and refused leave;
  3. that the auditors had reasonable grounds to suspect the compliance plan failure and failed to inform ASIC of it in contravention of section 601HG(4). This claim was refused because the court rejected that the auditor’s awareness of those failures could be inferred simply because she had not seen sufficient evidence of compliance to the contrary;
  4. that the auditors were aware of certain related party transactions from the financial statements and abstained from further enquiry, so breaching section 601HG(4) which requires an auditor to inform ASIC of a contravention. The claim intended was one based on constructive knowledge through willful blindness but it was not pleaded correctly. All that was pleaded was that the auditor ought to have read certain documents to establish willful blindness. The court rejected it as embarrassing because it did not identify why the auditor ought to have read those documents which would lead her to know something that she would have to report. The same inadequacy had been criticised in the earlier motion for leave to amend an earlier version of the same pleadings. Those pleadings used the formula “ought to have read” to establish awareness and were found by the court to be “insufficiently formulated and hopeless”. This deficiency was not corrected on a second attempt;
  5. that the auditors owed the members a duty of care to members in carrying out their audit of the fund’s compliance with its compliance plan (excluding members who acquired units at a discounted price reflecting loss already). This was accepted by the court as a viable claim;
  6. that certain directors breached their general law and statutory duties (Section 601FD(1)) as directors of the responsible entity for failing to take certain steps which should have been done and if they had been done, the fund would have avoided making a number of inappropriate investments. Section 1325(2) permits members to sue fund officers, employees and auditors who have breached their statutory duties. The court refused this amendment because the inference was to be drawn from a sample of documents, from which minutes of board and credit committee meetings were missing. This made the sample forensically useless.

“The unavoidable truth is that the applicants simply have no idea what has happened within this Fund apart from a conviction that something went wrong.”

The court found the only claim viable was the claim for negligence against the auditors but nevertheless refused to grant leave because it was not articulated. The court described the state of the pleadings as intolerable, particularly as the two volume pleadings was drawn from a relatively small sample of documents not including minutes of meetings and from what that sample was said not to contain. It cannot be inferred from such a sample that the fact that actions were not disclosed means those actions were not taken.

This same criticism was made in the earlier motion, where it was noted that “an allegation that something was not done accompanied by a particular to the effect that there is no record that it was done appeared more than 400 times in the proposed pleading”. The court in the earlier motion cautioned that “a plaintiff can not win a case where it is alleged that something did not happen merely by proving that he knew of nothing which would indicate that it had” and this seems not to have been heeded.

The court did acknowledge the difficulty in getting the documentation from the liquidators of the former responsible entity because their solicitors said that they would need to consider which documents were the funds and which documents were the former trustee’s and that exercise would cost around $2m because of the very large number of documents. Only the physical documents were produced and that comprised a very small sample of the universe of available documents and did not include minutes of meetings. These omissions rendered the sample forensically useless.

Discontinuance against an employee of the responsible entity
The case against the employee was for breach of duty under section 601FE of the Corporations law in making improper use of his position to gain an advantage, by representing to members the it was in their interests to subscribe for new units and not redeem their existing units.

Discontinuance is permitted if it represents “a fair and reasonable compromise” and “has been undertaken in the interests of the group members as a whole, and not just in the interests of the applicant and the respondent”.

The court refused to grant leave because:

  1. it could not say whether the case against the employee was strong or weak;
  2. the case against the employee could be established independently of any wrongful conduct of the directors;
  3. the employee’s assets or insurance might be useful if the directors have insufficient assets or insurance to meet any claim; and
  4. the court cannot proceed on the basis that the case is frivolous because it is assumed that grave allegations of misconduct are pleaded on the basis of facts known to the pleaders. 

The court refused to grant leave for the proposed pleadings and made a number of criticisms about the way in which the pleadings were drawn. The court described them as intolerable, too long (bordering on abuse of the court’s processes) and drawn from an inadequate sample. The court imposed a 50 page limit on any further attempts to replead.

The court declined to order summary dismissal in the absence of a formal application but that is clearly the next step in the proceedings.


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