The Court of Appeal has delivered its eagerly anticipated judgment in proceedings brought by the liquidators of Mainzeal Property and Construction Ltd against its former directors, including Richard Yan and Dame Jenny Shipley. In those proceedings, the liquidators sought compensation for breach of certain statutory duties of directors engaged on a company’s insolvency: sections 135 (reckless trading) and 136 (incurring obligations) of the Companies Act 1993.

Although differing from the High Court’s judgment in several respects, the Court of Appeal concluded [t]he liquidators were the successful party in relation to liability, and have established that they are entitled to an award of compensation in respect of the directors’ breaches.

The Court agreed with the High Court that the directors had traded recklessly (in breach of s 135). It disagreed with the High Court’s approach to compensation arising from their doing so, finding that no loss was attributable to this breach of duty. However, unlike the High Court, the Court of Appeal found that the directors had also caused Mainzeal to commit to obligations without reasonable grounds for thinking that it would be able to fulfil those obligations (in breach of s 136). It considered there was loss attributable to these actions and referred the case back to the High Court to determine the amount of compensation to award to reflect this.

Coming on the heels of the Supreme Court’s decision in Debut Homes Ltd (in liquidation) v Cooper late last year, this decision makes a significant contribution to the law on directors’ duties and insolvency. It also provides directors, insolvency professionals and the wider corporate governance community with helpful guidance on how to respond when a company enters or approaches insolvency.

MinterEllisonRuddWatts acts for the liquidators in these proceedings.

Background

Mainzeal, formerly one of New Zealand’s largest construction companies, went into liquidation in 2013 owing around $110m to unsecured creditors. Its liquidators brought proceedings against the directors under sections 135 and 136 of the Companies Act 1993, alleging primarily that the directors had traded Mainzeal recklessly and allowed it to commit to obligations without a reasonable basis for thinking that it could meet them.

The High Court found the directors had traded recklessly. In particular, Mainzeal was balance sheet insolvent, trading poorly, prone to significant one-off losses and ultimately reliant on assurances of support from its shareholder, Richina Pacific, that was informal, conditional, non-binding and constrained by Chinese foreign exchange regulations including in relation to funds that had earlier been extracted from Mainzeal. Nevertheless, the directors permitted Mainzeal to continue trading, including by exploiting the lag between the time Mainzeal was paid by principals and when it had to pay its sub-contractors. The Court then exercised its discretion to order the directors to contribute $36 million to Mainzeal, representing a portion of the net deficiency on liquidation. This was the highest award ever made in a reckless trading case in New Zealand.

Court of Appeal judgment

The Court of Appeal upheld the High Court’s finding in relation s 135 that the decision to trade Mainzeal without taking any of a number of steps available to them to manage the company’s perilous financial situation (especially in relation to related party support) involved an unacceptable risk to creditors.

Unlike the High Court, the Court of Appeal also found that the directors had breached section 136. It found that the directors did not have a reasonable basis for believing that Mainzeal would meet:

• long-term obligations agreed to after January 2011 (e.g. obligations to principals and for retentions under large construction contracts) given the ever-present risk of failure from that date as a result of the company’s significant balance sheet insolvency which the directors were taking no meaningful steps to address; and
• all obligations from July 2012 (the date from which Mainzeal persistently failed to meet its due debts until liquidation).

The Court of Appeal found there was no loss arising from the directors’ breach of s 135. The Court agreed with the High Court that there was no net deterioration in Mainzeal’s financial position between January 2011 and liquidation but rejected its reliance on the net deficiency on liquidation. Nor did it consider new debt incurred from January 2011 to be an appropriate measure of loss for breach of s 135. However, the Court did consider this to be an appropriate measure for a breach of s 136. Referring to Debut Homes, it considered the directors were liable for the amount of all obligations Mainzeal assumed without a reasonable basis (i.e. those described in the previous paragraph), with some adjustments to be determined by the High Court.

Our view

This decision is undoubtedly significant. It includes a careful and detailed analysis of the mechanics of the insolvent trading provisions of the Companies Act. More broadly, it provides practical guidance on what sections 135 and 136 require directors to do when managing insolvency risk.

The Court addressed various steps which Mainzeal’s directors could and should have taken in the context of that company’s financial predicament which provide helpful guidance for directors of companies in similar circumstances.

The Court also made the following recommendations which are of more general application to the approach directors should take to manage risk in relation to s 135 where the company is in a precarious financial position:

• squarely confront the company’s financial situation and assess the risk of serious loss to creditors;
• do not continue to trade in a “business as usual” manner if it is likely to create a significant risk of serious loss to creditors;
• only trade on if that decision is reached based on a sober assessment of the likely consequences of doing so and if it has realistic prospects of enabling the company both to service existing debt and meet the new commitments which that ongoing trading will attract (as opposed to simply “robbing Peter to pay Paul”); and
• if a return to solvency appears unlikely, it is not appropriate for the directors to trade the business on in an effort to rescue all or part of the business. They must either cease trading or appoint an administrator to pursue any rescue attempt.

The Court’s finding in relation to section 136 adds detail regarding obligations incurred in the course of continued trading. Where a company is in such a precarious position that it cannot meet even short-term debts as they fall due, that company should cease trading. There may however be difficult situations where a company’s position is secure in the immediate future, but its long-term outlook is less certain. In these circumstances, even if continued trading is appropriate, directors should think seriously about whether the company’s medium-to-long-term financial position is strong enough to make commitments extending out over a longer period of time.

The legal landscape in the area of directors’ duties and insolvency has proved fertile ground over the last year. This morning’s decision adds an important chapter.