Ross v Smith [2012] NZHC 3034 (14 November 2012)

Last Updated: 21 November 2012

IN THE HIGH COURT OF NEW ZEALAND GREYMOUTH REGISTRY

CIV 2012-418-000063 [2012] NZHC 3034

BETWEEN MICHAEL EDMOND ROSS First Plaintiff

AND LILIAN MAY ROSS Second Plaintiff

AND LINDSAY BECKETT SMITH Defendant

AND BALLARAT TERRACE LIMITED Second Defendant

Hearing: 14 November 2012 (Heard at Christchurch)

Counsel: G T Gudsell QC and L Stevens for Plaintiffs

M B O'Regan for Defendant

Judgment: 14 November 2012

_{JUDGMENT OF WHATA J}

[1] Ballarat Terrace Limited (“BTL”) is a property development company. The plaintiffs and the first defendant are shareholders in that company.1 The company successfully purchased and subdivided land, and prior to 2008, achieved the sale of a number of lots. Since 2008 however, on one account, there have been no further sales of lots. Currently the company owes a substantial sum to creditors and the current accounts show that the plaintiffs are owed $765,358 and the first defendant is

_{owed $243,748. The assets of the company tally to approximately $710,000 based}

1 Following the delivery of my oral judgment Mr Gudsell advised that there is a dispute about whether the family trusts are the shareholders and he noted that the company records identify the plaintiffs and the first defendant as the shareholders. For the purposes of the liquidation, my

_{narration of the shareholding should not be seen as a final determination.}

ROSS V SMITH HC GRY CIV 2012-418-000063 [14 November 2012]

on current market valuation or approximately $442,000 based on a forced sale valuation.2 The plaintiffs complain that they have been severely prejudiced by the conduct of the first defendant, Mr Smith, who in effect ran and continues, until recently at least, to run BTL. The plaintiffs point to several irregular transactions all to the benefit of Mr Smith or related interests. The plaintiffs’ claims are largely supported by an independent report on BTL.

[2] The first defendant accepts that criticism can be levelled at him in respect of his lack of attention to appropriate company law obligations and procedures and in relation to his poor record keeping. He acknowledges that he should now stand aside from the company.

[3] The issues I must consider are:

(a) Whether BTL should be placed in liquidation; and

(b) Whether or not compensation should be paid by the first defendant to the plaintiffs in respect of the irregular transactions.

Background

[4] Mr and Mrs Ross hold, through a family trust, Pondarossa, 25 shares each in BTL. Mr Smith holds, through the Prospect Family Trust, 50 shares in the same company. BTL was incorporated to carry out a property development at Blue Spur Road, Hokitika, which involved the purchase of the property and its subdivision. In July or August 2005, the parties agreed that:

(a) The parties would make equal contributions to BTL, in proportion to their respective shareholdings, in order to fund the property development;

_{(b) Mr Smith would manage the contracting and surveying required for}

2 Refer independent assessor’s report pages 44 and 45.

the subdivision;

(c) Mr Smith would act as BTL’s accountant;

(d) Mr Smith would contact Mr and Mrs Ross when funds were required and when Mr Ross needed to sign documentation.

[5] Mr and Mrs Ross then paid $115,000 for their shares in the company.3

Various payments totalling $670,000 were then made by Mr and Mrs Ross to BTL in the period 5 October 2005 to 25 October 2008.

[6] By that time BTL had acquired two properties and obtained resource consent to subdivide those properties in June 2007. In October 2007 BTL entered into a loan agreement with Westpac for the sum of $666,000 executed by the first plaintiff, Mr Ross and Mr Smith, in their capacities as directors of the second defendant. This provided a loan facility for the company.

[7] On 15 August 2008 new titles were issued for the 22 lots of the subdivision and the mortgage was transferred to these new titles. Mr Smith says that the residue owing on this original loan was repaid on 15 December 2008 and this was achieved by way of a further secured lending arrangement to which he contributed. Between

10 September 2008 and 21 February 2011 lots 1-7, 11, 13, 16-20 and 22 were sold by BTL. Lot 6 was subsequently transferred back to BTL.

[8] In the period to December 2011, Mr and Mrs Ross received $114,760 from

BTL.

The irregularities

[9] The plaintiffs in their submissions helpfully identify their core complaints under six headings, namely:

3. Mr Gudsell highlighted to me that this is still an issue between the parties. For the purposes of the liquidation this observation by me should not be taken as a final determination of that issue.

(a) An unauthorised loan from FM Custodians Limited;

(b) Sales of lots in the subdivision to the first defendant and related entities;

(c) Unauthorised sale of the lots in the subdivision to third parties; (d) Inadequacy of documentation by the first defendant;

(e) Incorrect and/or misleading online annual returns; and

(f) Unauthorised change of business status in the second defendant’s

financial statements.

[10] Specific concerns include (supported by detailed affidavit evidence from

Mr and Mrs Ross) the following:

(a) That the loan from FM Custodians Limited was obtained for the sole benefit of Mr Smith or his interests;

(b) The sale of lots to the first defendant and related entities resulted in a substantial transfer of benefits to Mr Smith and trusts or companies associated with him (including Lots 5, 13, 20 and 22);

(c) Lot 6 was used as security for a loan from South Canterbury Finance for the sole benefit of the first defendant or entities related to the first defendant; and

(d) The benefits of sales to third parties were not properly accounted for with benefits accruing to Mr Smith or entities operated by him rather than BTL (including in respect of Lots 2, 3, 4 and 7).

[11] Also helpfully, the plaintiffs have produced a table identifying the value of the benefit they say is gained by the first defendant as a consequence of his management of the company:

_{Transaction Nature of benefit Amount of benefit}

FM Custodians Limited loan

Sale of Lot 5 to First Defendant & his wife Sale of Lot 13 to the Dimmick Family Trust Sale of Lot 20 to First Defendant and Prospect Securities Limited

$264,000 loan $264,000

Land $160,000

Value of land $210,000

Land $315,000

Sale of Lot 22 to Prospect Ventures Limited

Land at below market value

$230,000 (excluding
$50,000 due to the
_{Second Defendant)}

Sale of Lots 2, 3 4 to Zu

_Wei

Barter Card credit $60,000

Sale of Lot 7 to Xu Wei Barter Card credit/advance

$160,000

_{TOTAL $139,000}

The first defendant’s response

[12] The first defendant, Mr Smith, concedes:4

... when viewing all matters together a “reasonable” bystander would consider the current state of affairs as unfairly prejudicial to the first and second plaintiffs. That state of affairs is best exemplified by the acknowledgment the first defendant has provided of the imbalance in the current account entitlements of shareholders to be recovered from company assets.

[13] The defendant however says that he should be given due allowance for the fact that he has firstly brought the land development project to a successful conclusion with the issue of titles some four years ago, secondly has continued to maintain and service the development in different market conditions to those that were anticipated when the project first commenced, and has continued to service the residue of borrowings since the initial refinance of the Westpac facility in late 2008.5

_{[14] Mr Smith also contends that:}

4 At paragraph 27 of the submissions.

5 Refer paragraph 26, and see the affidavit of Mr Smith at paragraph 27.

(a) Other than the transaction involving Lot 22, other lots transferred to the first defendant or related entities were at value debited through the current account of the Prospect Trust.

(b) As to Lot 22, Mr Smith says it has very poor access and that a substantial amount of money will have to be spent to secure access to a likely building site.

(c) As to other transactions to third parties, Mr Smith says they were completed, in short, for value and in relation to Lot 13 (a property sold to Mr Smith’s brother-in-law) a balance of $60,540 was assigned to the Prospect Trust and debited to the trust’s current account in the company.

(d) He also says that some of the lots in the subdivision (without clarifying which ones) were transferred either to himself or his wife or to related entities to enable him to raise funds to continue to maintain the development and outgoings and costs, but that in each case the value has been debited through the current account of the Prospect Trust as a shareholder in BTL.

Independent report

[15] On 13 June 2012 Chisholm J made various orders relating to BTL and in particular an order seeking an independent investigation into the accounting records of BTL to verify the current financial position of the same company and to direct the first defendant as to the day to day management of BTL and to report to the Court on the findings of the investigation. In short, the report is highly critical of the management of the company and its financial reporting. The report concludes:

108. In my opinion the books and records of Ballarat Terrace Limited have been poorly maintained.
     
109. In my opinion the records fail to meet the minimum requirements as specified by the Section 174(1) and 174(2) of the Companies Act

1993.

110. In my opinion the Annual Reports, which include the Statement of Financial Position; Statement of Financial Performance; and Notes to the Financial Statements; cannot be relied upon to accurately reflect the assets and liabilities, and performance of the company in each of the years that these Reports have been produced.

111. In particular the related party transactions (and the origination of these by way of various accounting entries) are considered to be of considerable concern. There appears to be limited information to support the benefits, which the interests of Mr Lindsay and Mrs Danielle Smith appear to have obtained, through these accounting entries.

112. The company may be due material amounts from interests associated with Mr & Mrs Smith including Prospect Ventures Limited, Prospect Securities Limited, CTI Developments Limited, TYTM Development Limited and Zalas Creek Investments Limited.

113. In my opinion until the unsecured liabilities of the company are determined with accuracy any distribution will not be possible.

114. In my opinion the most prudent and equitable method to satisfy all creditors and determine any return to shareholders would be for the company to be placed into liquidation. This would allow for a timely realisation of assets; the receipt of formal proofs of debt from all creditors (pursuant to section 304 of the Companies Act 1993); and for any disputes in relation to the amounts outstanding to any creditor, to be determined in terms of section 284 of the Act.

[16] It is unnecessary for the purposes of this judgment to go into the detail of the report. In summary there appears to be a number of transactions undertaken by Mr Smith for his sole benefit or for the benefit of a related party that have not been appropriately dealt with in relevant financial reports. In addition to non-compliances with annual reporting requirements under s 174(1) and (2) of the Companies Act

1993 the report writer observes:

(a) The annual report for the year ended 31 March 2007 fails to adequately disclose the basis for the amounts of $50,000 and $65,000 (a total of $115,000) being capitalised to development costs and credited to the shareholders’ account of Prospect of $115,000 (Prospect, being a related entity to Mr Smith);

(b) The annual report for the year ended 31 March 2008 fails to adequately disclose from 2007 the basis for the amounts of $50,000 and $65,000 (a total of $115,000) being capitalised to the

development properties and credited to the shareholders’ current

account of Prospect of $115,000;

(c) The annual report for the year ended 31 March 2008 fails to adequately disclose the basis for the general journal entries of

$12,000, $15,000, $13,250 and $80,000 respectively;

(d) Various irregularities in the financial reporting for sales of Lots 2, 3 and 4;

(e) The unauthorised transfer of $60,000 from BTL to Prospect following the sale of Lot 7;

(f) In the financial accounts for the year ended 31 March 2009, sales have been unrecorded by $160,000 in respect of Lot 6 and the debit charged to either management fee or accounts receivable of $160,000 from Prospect Securities is incorrect;

(g) The accounting records in relation to Lot 16 understate the appropriate management fee and sales by $315,000 and if this is not the section which was to be accorded the management fee then the current account of Prospect should have been charged with the amount of $315,000 as a drawing;

(h) In respect of Lot 13, no resolutions by directors or shareholders or notifications in the interest register have been located which approve the transfer of the entire proceeds of the sale to Prospect Family Trust in reduction of the current account;

(i) The financial accounts to 31 March 2010 cannot be relied upon to be a true and fair reflection of the financial position of the company as at

31 March 2010 and the performance of the company in the trading period from 1 April 2009 to 31 March 2010;

(j) No agreement has been cited between BTL and Prospect Ventures

Limited (a related company) for the construction of buildings on a property at 112 Sewell Street, Hokitika, owned by BTL;

(k) The sale price for Lot 22 appears to be under recorded by $230,000;

(l) No minutes or agreements/resolutions have been cited authorising

BTL to transfer Lot 1 to TYTN Development Limited on 9 April

2010;

(m) Lot 16 was transferred to the Prospect Family Trust on 16 October

2008, converted to Lot 2 DP 414297 and transferred back to BTL. There is no directors’ minute resolving to acquire this property or the basis for the combination and acquisition. The sale of Lot 2, previously Lot 16 (to Zalas Creek Investments Limited) is a related party transaction, not recorded in any minute, resolution or in the interest register. The deposit for the transaction was to be $175,000 and this is recognised as an amount due from Zalas. There is no documentation to support the advance to Zalas of that sum or any terms and conditions which are associated with such an advance;

(n) In relation to other entries for the period ended 31 March 2011, costs of sales of $128,218.80, $103,849.64 and $16,043.27 have been credited to Prospect Ventures Limited, but no evidence could be located to support that these costs have in fact been incurred.

(o) Entries identifying accrued interest in the sum of $78,707 on the

shareholders’ current account is not supported by work papers.

[17] Overall, the independent investigator concludes:

106. There are a significant number of transactions which are related party transactions where there is little or no information to support the recorded transaction. Transactions appear to have limited detail to support the basis or the quantum. In a number of cases, transactions with related parties do not appear to have been disclosed adequately, or the basis or resolution by the directors to support these entries/transactions identified and located.

Jurisdiction

[18] Section 174 of the Companies Act 1993 provides:

174 Prejudiced shareholders

(1) A shareholder or former shareholder of a company, or any other entitled person, who considers that the affairs of a company have been, or are being, or are likely to be, conducted in a manner that is, or any act or acts of the company have been, or are, or are likely to be, oppressive, unfairly discriminatory, or unfairly prejudicial to him or her in that capacity or in any other capacity, may apply to the Court for an order under this section.

(2) If, on an application under this section, the Court considers that it is just and equitable to do so, it may make such order as it thinks fit including, without limiting the generality of this subsection, an order-

(a) Requiring the company or any other person to acquire the shareholder's shares; or

(b) Requiring the company or any other person to pay compensation to a person; or

(c) Regulating the future conduct of the company's affairs; or

(d) Altering or adding to the company's constitution; or

(e) Appointing a receiver of the company; or

(f) Directing the rectification of the records of the company; or

(g) Putting the company into liquidation; or

(h) Setting aside action taken by the company or the board in breach of this Act or the constitution of the company.

(3) No order may be made against the company or any other person under subsection (2) of this section unless the company or that person is a party to the proceedings in which the application is made.

[19] The parties agree that the leading authority on the meaning of the words “oppressive,” “unfairly discriminatory” or “unfairly prejudicial,” is Thomas v H W Thomas Ltd.6 It is authority for the following propositions:

(a) The terms or concepts oppressive, unfairly discriminatory and unfairly prejudicial are not three distinct alternatives to be considered

separately but overlapping expressions reflecting the underlying concern of the subsection that conduct of the company which is unjustly detrimental to any member of the company is a legitimate foundation for a complaint;

(b) Fairness is not to be assessed in a vacuum and it is a matter of balancing all the interests involved having regard to principles governing the duties of a director and the rights and duties of a majority shareholding in relation to a minority to recognise that s 174 is a remedial provision designed to secure standards of fair dealing.

[20] I also accept the defendant’s submission that the relevant test is whether a reasonable bystander would regard the conduct as unfairly prejudicial to the applicant shareholder.

[21] On the question of relief, I should take into account the following matters:7

1. The purpose of the remedial relief is not punitive but remedial;

2. Any order should be directed clearly to provide a remedy of an appropriate character;

3. I should be wary of intervening in the management of the company to any extent greater than is strictly necessary to provide the appropriate remedy;

4. The Court has a very broad discretion to select the remedy appropriate to the situation before it and to not hesitate to be creative and flexible in fashioning a remedy to fit the case.

Assessment

[22] The plaintiffs seek:

(a) Liquidation of the company; (b) Compensation from Mr Smith;

(c) Costs of the independent assessor to be paid by Mr Smith.

Liquidation

[23] Dealing first with liquidation, I have little doubt that this is a case where a liquidator must be appointed. The first defendant has endeavoured to deflect the appointment of a liquidator on the basis that it would unnecessarily incur costs and there remains an opportunity for the plaintiffs to recover their investment without the appointment of a liquidator. But all of that belies the facts of this case. The first defendant, at best, has been woeful in his management of the company. At worst, he has been dishonest. I make no finding in relation to the latter as Mr Smith has not been tested under cross examination and it would not be fair to find against him simply on the papers. But it is plainly obvious to me that Mr Smith or his related entities have incontrovertibly benefitted from the assets of the company to the detriment of Mr and Mrs Ross. As he accepts, the imbalance in the current account entitlements is evidence of this. When the uncontested independent report is then brought into play, it is clear that there have been numerous related party transactions involving hundreds of thousands of dollars or more. These transactions have been accounted for by way of reductions to the current account of Mr Smith’s Prospect Trust. All of this was and is by way of chimera because in effect, Mr Smith or related parties received the company assets without any benefit in fact accruing to the company. Mr Smith claims that he has made contributions without any clear supporting evidence (except reference to bank statements that record interest payments made on the company’s debt). The need for intervention in this case is therefore obvious.

[24] Mr Smith does not oppose liquidation per se, but says that a preferable approach is to in effect hand over control to the plaintiffs. But the plaintiffs do not want that burden. They want speedy, independent resolution. In these circumstances, I can see no other option but to liquidate the company. This is not a punitive act. Rather, I see real merit in appointment of a liquidator who can take all necessary steps to put the company on a proper footing and if necessary take steps to recover funds properly owing to the company.

Compensation

[25] I accept the first defendant should disgorge the benefits obtained by him at the expense of the plaintiffs. There are however three problems with this claim. First, there is a procedural issue as to whether Mr Smith was properly on notice of the claims to compensation. Second, the plaintiffs must establish that the benefits obtained by Mr Smith (or related entities) were at their expense – that is, that they have suffered a loss, or whether it is simply the company’s loss. If the latter, the proper course is for the liquidator to seek compensation from Mr Smith or his related parties. The third problem is that the plaintiffs must prove the quantum of liability.

[26] As to notice, the pleadings were filed in May, several months ago, supported by detailed affidavits asserting various acts of misconduct or misappropriation by Mr Smith. The relief then sought was for orders liquidating BTL. Initially the claim went unanswered until September, when Mr Smith instructed Counsel. An amended statement of claim was filed on 10 October, with general relief sought under s 174. A statement of defence was filed on 23 October and Mr Smith’s affidavit lodged on

30 October. No substantial challenge was made to the claims or the evidence of misconduct or misappropriations identified by the plaintiffs. Instead, Mr Smith accepted that there was an imbalance in the current accounts, but otherwise simply asserted he was acting in the interests of the company and/or for value. In the absence of any real evidence justifying Mr Smith’s conduct, the plaintiffs particularised their claims to compensation.

[27] Mr Smith says that had he known from the outset that a claim of compensation was going to be made, he would have produced a detailed account of the contributions he had made. He says that he proceeded on the basis that any question of compensation would be dealt with by the liquidator, not by this Court on this application.

[28] The plaintiffs greet this claim with incredulity. They say Mr Smith has been on notice about serious claims against him and that he must have known that he was personally at risk of liability.

[29] I have to say that I am also incredulous about Mr Smith’s response. The allegations levelled against him are very serious and I would have expected a far more substantive and detailed response from him justifying his conduct, including evidence demonstrating, in clear terms, the contributions he now says he made to BTL. Be that as it may, in formal procedural terms, the claim to compensation has only recently been particularised, and after the exchange of evidence. I appreciate that the plaintiffs could only reasonably understand the full scope of their claims to compensation in light of the information produced by Mr Smith. But the claims are significant and must be dealt with fairly to Mr Smith, including with an appropriate opportunity to debate the quantum of any liability. And I think it would be discordant with s 174(2) to grant relief without affording him an opportunity to produce evidence that might properly bear on quantum. I will come back to what that means below.

[30] Turning then to the substance of the claim to compensation. In order to make out a claim to compensation, the plaintiffs must show that they have suffered loss as a consequence of Mr Smith’s actions. Plainly Mr Smith has transferred BTL’s assets or managed the resources of BTL in the way that he has or related parties have obtained financial benefit from the company. Indeed there is no probative evidence contradicting the benefits obtained by Mr Smith or related parties set out in the table produced by the plaintiffs and recorded at para [11] above.

[31] A critical issue remains however as to whether the plaintiffs have, in fact suffered a loss as a consequence of the unfairly prejudicial conduct of Mr Smith. Each impugned transaction needs to be examined on its own merits, to which I now turn:

(a) The FM Custodians Ltd loan involved the payment of $264,000 to BTL and then a payment of a cash equivalent to Mr Smith’s Prospect Trust as a shareholder in reduction of its current account balance. The effect of this is that BTL carries a debt while Mr Smith’s family trust benefitted by the value of that debt. Plainly if there was no valuable consideration for this payment, BTL would have a claim against Mr Smith. Mr and Mrs Ross will suffer loss if they are unable to

extract funds from BTL to pay the debt the company owes to them. But that loss remains inchoate pending the final assessment of the company’s capacity to pay the plaintiffs. In these circumstances, it seems to me that Mr Smith has for present purposes benefitted at the expense of BTL, not the plaintiffs in strict accounting terms. But I am not naive to the reality of the situation, namely that Mr Smith has left BTL in a parlous condition, whereby the likelihood of full recovery by Mr and Mrs Ross is low. I think therefore, that for the purposes of relief under s 174 in dealing with unfairly prejudicial conduct, I may look to the reality of the situation and find that the transfer of the loan monies was at the expense of the plaintiffs.

(b) Lots 5 and 20 were transferred to Mr Smith’s interests without value.

That is plainly at the expense of BTL. It therefore also reduces the capacity of the company to realistically repay Mr and Mrs Ross. I therefore consider, again that for the purposes of s 174, the plaintiffs have suffered a loss.

(c) Lot 22 was sold to Mr Smith’s interests at an under value of $230,000 and $50,000 is still owed to BTL. Like the previous transactions, this reduces the capacity for BTL to repay Mr and Ms Ross and the plaintiffs have suffered loss for the purposes of s 174.

(d) Lots 2, 3 and 4 were sold. $220,000 was paid to BTL. The sum of

$60,000 does not appear to be properly accounted for. On the information available to me however I am not able to say with surety that the company has not benefitted from this sum. I consider that this claim is better dealt with in the context of the liquidation.

(e) Lot 7 was sold for $160,000. $60,000 was then transferred to Mr Smith’s Prospect Trust and coded as a reduction in the current account. There is no evidence that the balance was paid into the second defendant, but there is an entry in the accounts suggesting a loan of $100,000 to Prospect Trust. I am satisfied that the $60,000

has been transferred at BTL’s expense without any apparent valuable consideration and this translates to a loss to Mr and Mrs Ross. I am not however sufficiently certain about the balance, recorded as a loan. That at least suggests an intention to repay the company and is properly actionable by the liquidator.

[32] Given the foregoing, subject to the final assessment of quantum, I am prepared to grant compensation as to liability in respect of the 50% (being the extent of any entitlement enjoyed by Mr and Mrs Ross) of the sums identified at (a)-(c) and for $60,000 in respect of item (e).

[33] As to quantum, as I foreshadowed above, I am going to allow Mr Smith ten working days to produce evidence of contributions made by him that might properly offset the sums specified above in [31]. In this regard, I am granting leave only to produce evidence of payments made or contributions in kind. I am not inviting generalised evidence of services rendered or other intangible contributions. Those types of contributions can be addressed by the liquidator if they have any merit. The plaintiffs have ten working days to respond or to seek other directions from the Court. In that regard I envisage resolving matters on the papers and I may be assisted by the independent assessor in terms of the merit of the claims made by the first defendant.

Costs for the independent assessor

[34] In terms of the costs for the independent assessor, given my findings and my acceptance of the independent assessor’s report, and given that the report identifies multiple irregularities, the costs of that report should be borne by the first defendant.

Result

[35] Accordingly there shall be the following orders: (a) BTL will be placed into liquidation;

(b) The liquidators shall be Dennis Clifford Parsons, and Katherine Louise Kenealy. I note that they consent to being appointed as liquidators and there is no objection to their appointment as liquidators;

(c) Mr Smith has ten working days to file evidence as to the contributions made by him to BTL (in accordance with my direction above);

(d) The plaintiffs have ten working days to respond or to seek further direction from the Court.

[36] I also find that Mr Smith is liable to the plaintiffs in terms of my direction above at [32], subject only to a final assessment of quantum of that liability following the receipt of evidence.

Costs

[37] I reserve leave to the parties to submit on costs and including in relation to liquidators, and simply indicate that in the normal course a matter such as this would attract a 2B categorisation.

[Court indicated timing of liquidation was 3.55 pm]

Solicitors:

Stevens Orchard Lawyers, Nelson, for Plaintiffs

Cameron & Company, Christchurch, for First Defendant