Mercedes Holdings v Waters (No 5) [2011] FCA 1428

Investors in an MFS Fund brought a class action against the responsible entity of the fund, certain directors and its auditors.

Two previous attempts to amending the pleadings were refused as only the claim in negligence against the auditors was found to be viable.

Nevertheless the investors now applied for leave to pursue both the auditors and directors with further amended pleadings. Many of the complaints about the pleadings were rejected by the court because the allegations were arguable and the complaints could be dealt with by way of defence.

Claim against the auditors

The auditor challenged the claim on the following bases:

Class Action Group definition unclear
The group definition was found to be clear because only those investors who suffered a loss and did not redeem prior to the moratorium on redemptions were included.

Auditor’s duty of care
The auditor complained that the person to whom the auditor held herself out to as having the necessary experience was not pleaded. The court found this could be identified by further particulars and that the auditor could owe a duty to unitholders.

Moreover the court found that the identity of the person to whom a duty is owed does need to be pleaded as known reliance by such person is not an element of the duty.

Future unitholders
The duty could be owed to future unitholders because they are identifiable and not simply the world at large.

Whether compliance plan audit requirement creates a duty of care?
The court acknowledged that the statutory right to damages and criminal penalty only existed if no audit was conducted but no mention was made in the section of an audit conducted negligently. The court found it was unclear whether a negligent audit gave rise to a right to damages given there was no direct authority either way.

Hence leave was given to pursue it as a separate claim for breach of statutory duty even though leave had strictly only been given in the earlier proceedings to pursue a negligence claim at common law. This was done because the statutory claim was viable and could be filed in fresh proceedings.

Compliance Failures
The technical complaints were rejected by the court. In particular the court found that it was not necessary to plead each of the exceptions to the alleged related party transactions. The same complaint was rejected in relation to the directors.  The court found that it is a matter for the defence. The court noted that this had already been determined in the earlier proceeding and should not have been raised again.

The auditor also complained about the allegation that the compliance plan requirement that all investments be selected to minimise risk was breached because certain investments were unsecured. The court held that whether the particular unsecured investments minimise risk is a triable issue depending on the standing of the recipients of the funds and not a pleading point.

The technical objections to the pleading of causation were rejected. The auditor complained that where the pleadings alleged that if the auditor’s duty had been discharged in relation to the audits, some or all of the compliance failures would have been detected, the pleadings did not say why the failures would have been detected. The court rejected this and found that this was unnecessary given the allegation was that a competent audit would have brought the problems to light.

A second complaint was made in relation to the allegation that if the auditor’s report has been given to the directors, they would have ensured compliance. The auditor objected on the basis that this was inconsistent with the directors being unaware of the breached. However the court found that the case was not that the directors were unaware but that they ought to have been aware and hence there was no inconsistency.

A third complaint was made in relation to the allegation that if ASIC had been notified of the breaches, they would have ensured compliance, because it did not identify what steps ASIC would take or how it would prevent breach. The court found this to be a matter of evidence and dismissed it.

The court granted leave to the unitholders to proceed against the auditor in the form of their proposed pleading.

Claim against the directors

The unitholders were permitted to proceed against the directors because they had now formulated a coherent case against them.

Liability for constitutional breaches before their appointment
The court found that whether reading the financial statements and their notes in the years prior to their appointment was sufficient to indicate to properly diligent directors that there were unsecured loans and related party transactions which had not been approved was a question for trial.

Unsecured loans
The case against the directors was that the Fund was not permitted to make unsecured loans. The Constitution authorised investments in accordance with the Trusts Act and the court noted that it would be inappropriate to decide whether this did or did not include unsecured loans because the statutory history had not been considered. The court accepted that it was therefore arguable that the Constitution did not permit unsecured loans to persons not banks.

Related Party loans
The court found in relation to the related party loans, that there was no need to plead that the exceptions did not apply and it was up to the directors in their defence to refer to the notes that related party transactions were on ordinary commercial terms and so fell within the exception.

Critical questions at trial will involve the following:

  1. what may be drawn from the financial statements;
  2. the extent to which the directors read the financial statements;
  3. the extent to which the directors were entitled to rely upon the financial statements and headings describing unsecured notes as ‘investments’ and descriptions which omitted any reference to whether the investment was secured or unsecured, without reading any further; and
  4. the extent to which they complied with their 601FD(1) duty under the Corporations Law to ensure compliance with the constitution.

The court noted that the answers will turn on the true status of the financial statements in the life of the Fund and that will require a great deal more knowledge about its operation than is available on a pleading debate.

The court also permitted allegations that the directors should have brought to the attention of the other directors that the unsecured loans and related party transactions without member approval should not have been made, should have objected to them and prevented them, and reported the breaches to ASIC and taken steps to divest the Fund of the unauthorised investments.

The court permitted the action against the directors to proceed.

Individual Director Allegations

The unitholders also claimed that one of the directors knew the Fund had acquired  unsecured related party loans (in this regard the court accepted that it was arguable that personal covenants in the form of a guarantee do not make the loan secured because they are personal covenants); imprudent, unsecured and related party loans where the right to payment was limited to rights under a participation agreement and also investments that were “high risk and speculative” in another fund run by it and therefore a related party, with no benefit given in return. The court found these allegations arguable.

The court also found it arguable that where the related party is another RE, it nevertheless does receive a benefit despite holding the property on trust so enlivening the provision which requires member approval.

The court permitted the separate allegations made against the one director to proceed.

The court held that another director’s personal insolvency agreement did not bar the current proceedings against him, because the claim for statutory compensation under section 1325 Corporations Act for breach of section 601FD Corporations Act and damages at general law are not claims for breach of trust, and not provable in bankruptcy. However the pleadings incorrectly alleged his capacity as director when he was merely an officer and no longer a director and the court granted leave provided this was corrected.

The court criticised the waste of the earlier pleadings and noted that a new case had now been pleaded. The court ordered the investors to pay the costs thrown away by these amendments forthwith rather than at the end of trial given the unfairness and the fact a trial was a good way off. However the court refused indemnity costs given the difficulties in obtaining the fund documentation.

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