Proprietary Claims Arising from the Reduction of a Director’s Mortgage Using Company Funds

Written by: Madison Walsh

A liquidator’s ability to recover value for creditors is not necessarily limited to personal claims against directors. Where company funds can be traced into a specific asset held by a director or related party, the liquidator may be entitled to assert a proprietary claim over that asset and protect that interest by lodging a caveat.

A common scenario arises where a company makes payments that are applied to reduce a mortgage secured over property owned by a director. In those circumstances, equity may recognise that the company has contributed to the acquisition, preservation or improvement of the director’s proprietary interest, giving rise to an equitable charge, equitable lien or constructive trust.

The Basis of a Proprietary Claim

A proprietary claim is not dependent upon establishing that the director derived a profit or benefit from the transaction. Rather, the critical inquiry is whether the company’s property can be identified in its substituted form.

As explained in Foskett v McKeown [2001] 1 AC 102, tracing is the process by which equity identifies value as it passes from one asset into another. Where misappropriated funds have been used to reduce mortgage indebtedness, the claimant may be entitled to assert a proprietary interest in the enhanced equity thereby created or preserved in the mortgaged property.

Accordingly, where company funds are applied in reduction of a mortgage secured over a director’s property, the company may acquire an equitable interest notwithstanding that legal title remains vested in the director. That equitable interest may be sufficient to support the lodgement of a caveat.

Tracing Through Mixed Bank Accounts

In practice, tracing claims frequently encounter evidentiary difficulties. It is uncommon for the available records to demonstrate directly that a particular company payment was made to a specific mortgage account.

However, the mixing of company funds with other monies does not necessarily defeat a tracing claim. In Re Diplock [1948] Ch 465, the Court recognised that trust property or misappropriated funds may remain capable of being traced notwithstanding their deposit into an account containing mixed funds.

The critical question is whether the company’s funds can be shown to have contributed to the subsequent reduction of the mortgage liability. Although direct evidence is preferable, equity may permit tracing on the basis of circumstantial evidence where the surrounding transactions support a reasonable inference that company funds formed part of the monies applied to discharge the secured debt.

Limits on Tracing

Tracing is not available in every case.

A significant limitation arises where the relevant account was overdrawn and remained overdrawn after receipt of the funds. In those circumstances, the funds are generally treated as having been applied in reduction of the account holder’s indebtedness to the bank rather than remaining identifiable as property capable of being traced. This principle was applied by the New South Wales Court of Appeal in Russell Gould Pty Ltd v Ramangkura [2014] NSWCA 310.

More broadly, tracing is concerned with identifying property, not compensating loss. A claimant must establish a sufficient evidentiary nexus between the original funds and the asset against which the proprietary claim is asserted. The claim will fail where the evidence does not permit the funds to be followed into the relevant asset through orthodox tracing principles.

Practical Difficulties in Establishing a Proprietary Interest

The strength of any proprietary claim will ultimately depend upon the available evidence.

At one end of the spectrum are cases where bank records, mortgage statements or other contemporaneous documents directly establish that company funds were applied to a mortgage account. In such circumstances, the tracing exercise may be relatively straightforward.

More commonly, the evidence is indirect. Financial records may show transfers into an account maintained with the same institution that held the mortgage, yet provide no clear indication as to the ultimate destination of the funds. In those circumstances, further investigation may be required to establish that the monies were in fact applied in reduction of the mortgage debt.

Bank statements, loan account records, settlement documents and contemporaneous accounting records will frequently be critical in establishing the necessary transactional pathway.

Caveatable Interest and Associated Risks

Where a liquidator can demonstrate that company funds were used to reduce mortgage indebtedness secured over a director’s property, the resulting equitable interest may constitute a caveatable interest.

Nevertheless, caution should be exercised before lodging a caveat where the tracing evidence remains incomplete. A caveat may be vulnerable to challenge where:

1. the intermediary account was overdrawn at the relevant time
2. the available evidence does not establish that the funds were ultimately applied towards the mortgage debt;
3. intervening transactions obscure the connection between the company funds and the mortgage reduction; or
4. there are plausible alternative explanations for the disposition of the funds.

Evidence that company funds were transferred into an account maintained with the mortgagee bank may justify further enquiries, but it will not ordinarily, without more, establish a proprietary interest in the property.

Before asserting such an interest, a liquidator should obtain all available banking and loan records to determine whether the funds can be traced into the reduction of the secured indebtedness.

Practical Considerations for Liquidators

Before lodging a caveat, a liquidator should seek to establish:

1. the source of the relevant company funds;
2. the account into which those funds were deposited;
3. whether the account was in credit or overdrawn at the relevant time;
4. the flow of funds from that account to the mortgagee; and
5. the extent to which the mortgage indebtedness was reduced.

Ultimately, the viability of any proprietary claim will depend upon the liquidator’s ability to establish a clear and convincing evidentiary chain connecting the company’s funds to the reduction of the mortgage debt. Where that connection can be demonstrated, tracing principles may provide a powerful mechanism for recovering value from assets held by directors or related parties and, in turn, increasing returns available to creditors.