Examining the DNA of managed investment schemes

FOR excitement, and some really interesting case law, nothing beats a crisis.

Enter the Environinvest case (Shephard [as receiver and manager of Environinvest Ltd] v Downey [as liquidator of Environinvest], (2009)).

This is a case that examines the DNA of managed investment schemes.

The principal conclusions are that, despite what the constitution and other scheme documents say, both the ‘scheme’ to be wound up and the ‘scheme property’ to be realised may be defined more broadly than the strict legal terms of the documentation. A scheme only terminates when the winding up of the scheme has been completed.

Like the Basis Capital case (Basis Capital Funds Management Ltd v BT Portfolio Services Ltd (2008)), there does not appear to have been detailed submissions on the decision’s domino effect:

• for all agricultural and property schemes that expressly (and now illegitimately) provide that investors hold legal interests in scheme property;
• for responsible entities (REs) and their officers in relation to ensuring that scheme property is held by the RE (or its custodian), for ensuring that the constitution makes adequate provision for custody and dealing with scheme property and for winding up a more broadly interpreted ‘scheme’;
• for third parties dealing with responsible entities with non-complying constitutions; and
• for agricultural scheme investors in terms of tax matters.

Facts

The Environinvest case involved a number of belly-up forestry registered managed investment schemes (schemes).

There were unregistered schemes as well, but they have been ignored for the purposes of this article.

Environinvest was the RE, and investors (the growers) entered into a lease and management agreement under which Environinvest agreed to prepare, plant and maintain eucalyptus trees for the growers.

Of course, tax considerations had driven the structure. Ownership of the trees was an essential feature of the structure. As Judd J, the trial judge, observed:

“The broad position adopted by the growers in relation to the trees is supported by ASIC [Australian Securities and Investments Commission] and seemed to be predicated upon the assumption that the scheme documents succeeded in meeting a requirement of the Australian Taxation Office that, for scheme expenditure to be an allowable deduction against income, the trees must be owned by the growers and not held upon trust for them as scheme members.”

The growers had to own the trees to get tax deductions and the leases said as much, acknowledging the growers’ ownership of trees on each allotment during the continuation of the lease.

Just saying the growers ‘owned’ the trees doesn’t make it so.

The ownership of the trees under the constitutions and leases is a vague concept when you drill down into, and compare it to, the legal ownership of property under Torrens title systems, equitable notions of proprietary interests and 19th century (or older) cases concerning the ownership of crops and trees.

For Environinvest, its expenses outran its income and realisable assets. Financial disaster was followed by the appointment of receivers by Commonwealth Bank of Australia (CBA), the senior creditor, which held a registered charge over all of Environinvest’s assets and undertakings.

The receivers applied to the court for an order directing Environinvest to wind up the schemes pursuant to section 601ND(1)(a) of the

Corporations Act 2001 (Cth) on the grounds that it was just and equitable to do so; Environinvest was hopelessly insolvent and the schemes had failed and were not viable.

The growers opposed the application, arguing that the receivers did not have standing to apply for winding up of the schemes and that it was not just and equitable to wind them up because it was not in the interests of the growers to do so.

Jurisdiction

Did the receivers have standing to make the application and the court power to make an order that the schemes be wound up?

Yes. The property charged to CBA was all the undertaking and property of Environinvest and its business, as RE of the schemes formed part of its undertaking with consequential rights and obligations under each constitution and the Corporations Act. (The deed of appointment of receivers expressly acknowledged that the powers of the receivers extended to Environinvest acting in its capacity as RE.)

Managed investment schemes require a functional and solvent RE. Environinvest is insolvent and in liquidation.

And so it was just and equitable to wind up the schemes, given Environinvest’s and the schemes’ positions.

What was the scheme property that was to be called in?

Notwithstanding that the constitutions defined scheme property narrowly and specifically excluded the trees, the trees were scheme property. In Judd J’s view, to hold otherwise would have been to remove the trees from the regulation of scheme property, which would emasculate the Corporations Act by stripping the schemes of effective regulation: “… the Act does not permit that outcome.”

An alternative view is that the protection of an RE holding scheme property is not needed if the growers themselves have the legal ownership. See, for example, the Australian Securities and Investments Commission’s policy on small-scale property syndicates where investors themselves appear on the legal title. Query also the negative impacts on the previous flexible use of schemes for types of financial undertakings other than trusts.

When you think about the importance of scheme property in constitutions and the implications for compliance if scheme property has not been properly identified, the Environinvest decision will certainly have important consequences.

“The Act defines scheme property and requires the RE to ensure that scheme property is clearly identified as scheme property” (breach 1). An RE must ensure that scheme property is properly valued (breach 2) and that the constitution complies with the Act (breach 3). An RE must report significant breaches to ASIC (breach 4). The list could go on and on.

What was the ‘scheme’ to be wound up?

Obviously, a scheme is not an entity.

Each of the schemes was defined by the constitution and project documents, which create relationships between the parties.

The scheme documents include the leases, management agreements, powers of attorney and “any other documents required to be entered into by a grower to hold an interest in the project”.

Add to that mix the ‘project property’ or ‘scheme property’, as defined in the constitutions, and the scheme begins to take shape as a series of agreements, arrangements and undertakings with defined relationships, objectives, inputs and outcomes.

Thus, the scheme to be wound up includes, but is not limited to, scheme property.

The narrow definition of scheme property in the constitution must not be allowed to detract from the broad responsibility of the scheme liquidator to wind up the scheme.

Further, merely because scheme documents characterise a right, interest or asset as owned by an investor does not remove it from the scheme for the purposes of winding up.

Did the leases terminate upon the making of an order that the schemes be wound up?

No: “Winding up a scheme is a process, not an event.”

An order that a scheme be wound up has no immediate statutory effect, as is the case of an order winding up corporation.

Implications

A “scheme is not wound up until all scheme property has been called in, realised and any final distribution made to members”.

Consider the implications of this for drafting constitutions.

The Corporations Act obliges the RE to ensure that the constitution of a registered scheme makes adequate provision for its winding up. If you are the drafter of a constitution, have you done this when, as is typically the case, the constitution refers to termination of the scheme, a trust for conversion and distribution, and then the making of a final distribution?

Consistent with the Basis Capital case (admittedly in the context of application money), there was no consideration of the possibility that the nature of the trust might change.

Is a provision referring to termination of a scheme before the final winding up invalid as a result? Semantics? Maybe, maybe not.

Environinvest is on appeal.

James Lonie is a partner at Henry Davis York.

This is an edited version of an article that first appeared in Financial Services Newsletter 8.2 in July 2009.