Supreme Court forecast – storms ahead for directors

 The main issue was whether a director was in breach of his directors’ duties under the Companies Act 1993 (Act) by continuing to trade against the background of an insolvent or nearly insolvent company.  

This is the first time that New Zealand’s highest court has considered these issues in detail and its decision is significant.  It is relevant to all directors of companies in New Zealand and raises the risks for directors of companies in financial distress.

We discuss the key insights and learnings from the case below.

The Headlines 

The key takeaways for directors arising from the Supreme Court’s decision include: 

• There will be a low tolerance for directors who trade on insolvent businesses that have little or no prospect of recovery.

• If continued trading would result in a shortfall to creditors, it is irrelevant that some creditors would be better off and the overall deficit was projected to reduce – it is not possible to compartmentalise creditors.

• It is not legitimate to knowingly “rob Peter to pay Paul” by meeting existing obligations from new obligations that are unlikely to be met.

• In situations of insolvency or near insolvency, a director will be in breach of their duties if the interests of all creditors are not considered, and that breach may be exacerbated by a conflict of interest.

• Where the company has no prospects of returning to solvency, directors need to act early and consider using either the formal mechanisms available under the Act or informal mechanisms that approximate their key features (i.e. consultation with all creditors).

• The benefits of formal mechanisms include the involvement of all creditors in any decision making about the company’s future and an independent insolvency practitioner (recognising that directors are not appropriate decision-makers in situations of actual or near insolvency due to conflicting interests and a lack of impartiality by being too close to the business).

• Where a director allows a clearly insolvent company to trade on without using formal or informal insolvency mechanisms, this will be in breach of their duties and will lead to relief being ordered by the court.

The upshot is that directors of a company in material financial distress with little or no chance of recovery will need to address the situation early in a manner that is consistent with their directors’ duties and the appropriate formal or informal insolvency mechanisms.

Where directors elect to trade the business on, this course of action should be recorded and documented to ensure evidence that the interests of all creditors have been considered and that the business is salvageable based on a reasonably cogent position.

As a related consequence, we anticipate increased use of insolvency and restructuring processes together with an increase in the cost of Directors and Officers Insurance cover (or reduced scope) due to the elevated risk profile for directors.

The Facts 

Debut Homes Ltd was a residential property developer.  Mr Cooper was its sole director and he and his wife owned all the shares in the company.  The company had been balance sheet insolvent since March 2009 but had been supported by shareholder advances and, up until the end of October 2012, had paid all its debts as they fell due.  By the end of October 2012, the company was in real financial difficulty. 

In early November 2012, based on projected costings showing a surplus of $170,000, Mr Cooper decided to wind down Debut’s operations by completing and selling existing projects (with no new developments to be undertaken) as soon as possible.  However, the projected costings did not account for interest costs or GST payable and to accrue on the sale of the remaining projects.  At the time this decision was made, Mr Cooper knew that the company would have a forecast GST deficit of over $300,000 once the wind-down was complete.

By the end of February 2014, the last remaining project had been completed and sold.  In order to complete the projects, new trade debt of approximately $28,000 had been incurred which was largely funded by advances from the Coopers’ trust.  During this period of trading, Mr Cooper worked in the business with no pay.

On 7 March 2014, Debut was placed in liquidation on application by Inland Revenue.  By then, Debut owed the Coopers approximately $210,000 and over $200,000 of the loan from the Coopers’ trust was outstanding. In addition, the new trade debt of over $28,000 was owed together with over $450,000 of GST.  The liquidators brought proceedings against Mr Cooper for (among other things) breach of sections 131, 135 and 136 of the Act and sought compensation under section 301 of the Act.

The Issue 

The case primarily concerned whether Mr Cooper had breached any of the following relevant directors’ duties as set out in the Act and, if so, what relief was appropriate:

• Section 131: the duty to act in good faith and in what the director believes to be the best interests of the company;

• Section 135: the duty not to agree to, cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors (i.e. to avoid reckless trading); and

• Section 136: the duty not to agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when due.

Where a director has breached any of these duties to the company and the company is placed in liquidation, section 301 of the Act gives the court power to order that director to contribute such sum to the assets of the company by way of compensation as the court thinks just.

The Decision 

The High Court found Mr Cooper to be in breach of all three directors’ duties in sections 131, 135 and 136 of the Act and ordered him to pay compensation of $280,000 to the company.  The Court of Appeal overturned the High Court judgment on the basis that Mr Cooper’s decision in early November 2012 to trade the business on in the circumstances was a “perfectly sensible business decision” and one that was “[o]verall… likely to improve the return rather than cause loss to [Debut’s] creditors”.

The Supreme Court reversed the Court of Appeal’s decision and reinstated that of the High Court.  In doing so, the decision gives a clear indication as to how courts are to examine the course of action and decisions of directors who elect to trade the business on in situations of actual or near insolvency where there is no prospect of recovery.

The Judgment 

The Supreme Court judgment carefully considered the nature and extent of the directors’ duties as set out in sections 131, 135 and 136 of the Act, with a focus on the clear wording of the legislation.  The key points and guidance provided by this decision are as follows:

• If a company reaches the point where continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading will be a breach of section 135, regardless of whether or not some creditors would be better off than would be the case if the company had been immediately placed into liquidation, and whether or not any overall deficit was projected to be reduced.

• If directors agree to debts being incurred where they do not believe on reasonable grounds that the company will be able to perform the obligations when they fall due, then there will be a breach of section 136. Further, such obligations do not need to arise from direct contractual arrangements.

• The test in section 131 is subjective. There will be no breach of section 131 if a director honestly believed they were acting in the best interests of the company.  However, if that belief was unreasonable in the circumstances, it will be difficult to convince the Court that it was honestly held.

• In an insolvency or near-insolvency situation, there will be a breach of section 131 if a director fails to consider the interests of all creditors. Such a breach may be exacerbated by a conflict of interest.

• Where there are no prospects of a company returning to solvency, it makes no difference that a director honestly thought some of the creditors would be better off by continuing trading. In those circumstances, there are alternatives to liquidation that are open to directors, including the formal mechanisms under Parts 14 and 15A of the Act or informal mechanisms (provided these accord with directors’ duties, the scheme of the Act and the salient features of the formal mechanisms, such as ensuring all affected creditors are consulted and agree with the proposed course of action).

• Where directors allow a clearly insolvent company to continue trading without using one of the available formal or informal mechanisms, this will be in breach of their directors’ duties and will lead to relief being ordered under section 301.

• Where there have been breaches of directors’ duties, any relief ordered under section 301 must respond to and provide redress for the particular duty or combination of duties breached and it is not designed to be punitive.

• Relief under section 301 can be compensatory or restitutionary in nature and must take account of all the circumstances, including the nature of the breach or breaches, the level of culpability of the director, causation and duration of the breach, holding the director to account and reversing the harm to the company. In accordance with these principles, there are differences in approach to relief for breaches of specific duties as follows:

• • Section 131:  Here, the choice of relief would depend on the nature of the breach;
  • Section 135:  In most cases, the appropriate starting point would be an amount equal to the deterioration in the company’s financial position between the date when trading should have ceased and the date of actual liquidation – the “net deficiency approach”;
  • Section 136:  As this section concentrates on the incurring of obligations by the company to individual creditors, it is appropriate that the relief should be restitutionary in nature.  That is, operate to reverse the harm to the company caused by incurring the obligations.  The net deficiency approach to relief would not respond to a breach of section 136 and would have no deterrent effect on directors incurring new obligations to pay old debts (“robbing Peter to pay Paul”).

Comment

Ultimately, the Debut Homes case has raised the risk profile for directors who decide to trade the business on in situations of actual or near insolvency.  Whether or not to stay the course will be a big decision for directors and increased recourse to formal and informal insolvency mechanisms seems likely.  Similarly, we anticipate increased costs or reduced scope of Directors and Officers Insurance cover.

If you are a director of a company which is in material financial distress, it is essential for you to deal with the situation early and ensure that your course of action and decisions are informed by appropriate legal and accounting advice.  Please get in touch with Sarah Gibbs or Erich Bachmann from our Business Advice Team or your usual contact at Hesketh Henry for any advice or assistance that you require.  Our Insolvency and Restructuring experts, including Glen Holm-Hansen, can also provide guidance in this area.

The full decision can be found here.

Hesketh Henry solicitor Sean Gamble was recently awarded second place in the Society of Construction Law essay competition for his essay on insolvency in the construction industry and reckless trading.  Sean’s essay considered the Court of Appeal’s decision in Debut Homes.  You can read Sean’s essay here. 

Disclaimer:  The information contained in this article is current at the date of publishing and is of a general nature.  It should be used as a guide only and not as a substitute for obtaining legal advice.  Specific legal advice should be sought where required.