The Supreme Court has today released its decision in Yan v Mainzeal Property and Construction Limited (in liquidation) [1] (Mainzeal), upholding the Court of Appeal’s finding that Mainzeal’s directors were liable for insolvent trading and ordering Mainzeal’s directors to pay $39.8 million plus interest, with the liability of three of the four directors capped at $6.6 million plus interest.

MinterEllisonRuddWatts acted for the liquidators in the Mainzeal litigation.

Significance of decision

The decision is of significance to directors operating financially distressed businesses. It provides much needed guidance about what they must do or not do to avoid potential liability for breach of the statutory duties engaged on a company’s insolvency: primarily sections 135 and 136 of the Companies Act 1993 (the Act) [2]. 

Emphasising the creditor protection focus of sections 135 and 136, the decision reinforces the Court’s previous decision in Debut Homes, [3] albeit softening somewhat the flintiness of that earlier decision by acknowledging the practical challenges confronting directors and mandating that their actions be viewed through the lens of reasonableness.

The decision has the following implications for directors:

• directors have a continuing obligation to monitor the performance and prospects of their company;
• directors should squarely address the future of the company if that monitoring reveals that by reason of the company’s solvency position, or other adverse factors, there is:
  • potential for substantial risk of serious loss to creditors; or
  • doubt as to whether there is a continuing reasonable basis for belief that obligations to be incurred will be able to be honoured;
• should any such potential or doubt exist, directors must decide how the potential for breach of their duties can be avoided;
• directors may need to take professional or expert advice from sources independent of the company;
• if deciding what course of action to take, directors should deal directly with the issues that have given rise to the concern. They should determine whether the associated risks can be eliminated or sufficiently managed and mitigated under a plan for continued trading that offers a reasonable basis for concluding that:
  • there is not a substantial risk of serious loss to creditors; and
  • they can be confident that obligations incurred will be honoured;
• principles of sound corporate governance should be adhered to in developing a strategy for continued trading (if that is what the directors opt to do) and monitoring progress;
• a long-term strategy of trading while balance sheet insolvent is generally not acceptable, unless there are reliable assurances of external support;
• the courts must apply a standard of reasonableness when assessing the decisions of directors, such that:
  • in relation to decisions to trade on, the courts will accept that business judgment is involved;
  • the courts will allow a reasonable time for directors to assess risk, review the options to meet that risk and decide what course to take, including time to take advice;
  • where advice has been taken, this must be factored into an assessment of the reasonableness of the directors’ actions;
• judges will acknowledge that:
  • decisions that were reasonable when made may nonetheless turn out badly and that in difficult situations, there will often be scope for more than one reasonable course of action; and
  • directors are often required to make complex decisions under pressure of time and events and sometimes with knowledge that remains incomplete despite their best efforts;
• although directors will not normally be liable for continuing to trade during the taking stock period, that may not be the case if substantial new obligations are taken on without measures in place to allow for them to be met.

Mainzeal

Mainzeal had been one of the largest commercial construction companies in New Zealand. However, its business was highly volatile and impacted by leaking building claims which beset the construction industry.

Mainzeal’s balance sheet suggested a net asset position. However, it included advances to related companies which were not recoverable. Disregarding these, Mainzeal was balance sheet insolvent. Restoring solvency required shareholder support. However, assurances of support were informal and not legally enforceable, and restructuring within the group left Mainzeal with a parent without substantial assets.

Mainzeal was consequently in a vulnerable position and reliant on creditors for its working capital needs. A draft report by Ernst & Young received by the board in January 2011 identified the key concerns. During 2012, Mainzeal experienced increasingly acute cashflow difficulties resulting from issues associated with a major contract. These were discussed at a board meeting on 5 July 2012, prior to which Mainzeal’s position was described in an email as “precarious”. Short term funding was required to enable debts to be paid as they fell due. By November 2012, the company had begun selling assets to deal with its cashflow difficulties.

On 6 February 2013, Mainzeal was placed in receivership. On 28 February 2013, liquidators were appointed. As at the date of liquidation, the shortfall owed to unsecured creditors was around $110 million.

In 2015, the liquidators commenced High Court proceedings against Mainzeal’s directors for breach of sections 135 and 136 of the Act. The liquidators alleged the directors had permitted the company to trade insolvently over a number of years with resultant loss to creditors

Statutory provisions

The statutory duties applicable to directors of companies are set out in Part 8 of the Act. These include two statutory duties specifically engaged when a company is insolvent or near insolvent: sections 135 and 136.

Section 135 imposes a duty to avoid “reckless trading”. It provides that directors must not agree to, cause or allow the business of a company being carried on in a manner likely to create a substantial risk of serious loss to creditors.

Section 136 imposes a duty in relation to obligations. It requires that directors not agree to the company incurring obligations to creditors unless at the time they believe on reasonable grounds that the company would be able to perform those obligations when required to do so.

Claims for breach of these provisions are typically brought by a liquidator under section 301 of the Act. Under this section, the Court can require a director found to be in breach to contribute such sum to the liquidation as the Court thinks just.

These provisions have long been criticised, the Court of Appeal describing them as “unsatisfactory in a number of respects” [4]. 

High Court [5]

The High Court heard the claim in September 2018. In its decision, released on 26 February 2019, the Court held that the directors breached section 135 of the Act, but not section 136.

The Court found the directors breached section 135 for three main reasons:

1. Mainzeal was trading while balance sheet insolvent because the advances to related companies were not in reality recoverable;
2. there was no assurance of group support on which the directors could reasonably rely if adverse circumstances arose; and
3. Mainzeal’s financial trading performance was generally poor and prone to significant one-off losses, which meant it had to rely on a strong capital base or equivalent backing to avoid collapse.

In those circumstances, the directors breached section 135 by continuing to trade instead of taking steps to procure legally enforceable and meaningful support required to repair Mainzeal’s balance sheet and thereby avoid liquidation. Those steps included threatening to resign as directors if the support was not forthcoming.

The Court found that liability for breach of section 136 had not been established. In the Court’s view, the section focused on particular obligations under specific contracts rather than the incurring of obligations generally which was the focus of the liquidators’ claim.

The Court considered that section 301 gave it a wide discretion to assess the consequences of a breach of section 135. Given its view that the breaches by the directors led to an insolvent liquidation that could have been avoided, the Court started its assessment with the total deficiency of $110 million owing to creditors on liquidation. The Court then applied discounts reflecting discretionary factors including causation and relative culpability in determining that $36 million was a fair contribution for the directors to make. Of this, Mr Yan was found liable for the full $36 million with each of the remaining directors being liable for $6 million, jointly with Mr Yan.

The directors appealed to the Court of Appeal and the liquidators cross-appealed.

Court of Appeal [6]

The appeal was heard in July 2020. Judgment was handed down on 31 March 2021.

The Court of Appeal found that by 31 January 2011 at the latest (following receipt of the draft Ernst & Young report), Mainzeal was in a very vulnerable state. By that date:

1. it was not reasonably open to Mainzeal’s directors to make decisions about continued trading on the assumption that advances to related companies were recoverable in full;
2. against the backdrop of the resulting large deficiency in Mainzeal’s balance sheet, it was no longer reasonable for directors to proceed on the basis of oral assurances that financial support would be provided to Mainzeal as and when required.

By trading on from that date while failing to engage in any meaningful way with the company’s unsatisfactory financial position and the risks this created for current and future creditors, the directors breached section 135.

The directors also breached section 136. Contrary to the High Court, the Court considered the provision was not restricted to entry into particular obligations but extended to all new obligations undertaken in the ordinary course of the company’s business.

Overall, the directors were found to be in breach of section 136 in respect of:

1. obligations to principals and bond providers under the four substantial construction contracts entered into after 31 January 2011. Given Mainzeal’s vulnerability arising from its balance sheet insolvency, there was a high risk that significant obligations with a longer time horizon undertaken in relation to those contracts would not be performed;
2. obligations to subcontractors under those contracts in relation to retentions; and
3. all obligations incurred on or after 5 July 2012. Although short term obligations were factually being met prior to then, there were no reasonable grounds for believing they would be able to be met from that date and the company was failing to do so.

In assessing compensation under section 301, the Court:

1. agreed with the High Court’s finding on the evidence that there was no net deterioration in the company’s position. Consequently, no compensation was found to be recoverable for breach of section 135; and
2. awarded compensation for breach of section 136 by reference to the amount of new debt incurred. The Court referred the proceeding back to the High Court to quantify this and determine whether it remained appropriate to apply any discount and to distinguish between Mr Yan and the other directors in allocating responsibility.

The directors were granted leave to appeal to the Supreme Court and the liquidators were allowed to cross-appeal. That appeal was heard in March 2022.

The Supreme Court’s Decision

The Supreme Court has upheld the decision of the Court of Appeal. Specifically, the Court has held that Mainzeal’s directors breached sections 135 and 136 of the Act. On the question of compensation for these breaches, the Court ordered that the directors contribute $39.8 million together with interest from 28 February 2013, with the liabilities of Dame Jennifer Shipley and Messrs Tilby and Gomm each limited to $6.6 million and interest.

The Court’s key findings were as follows:

• the directors breached section 135 of the Act. Their continuing to trade from 31 January 2011 (and potentially significantly earlier) without a substantial injection of capital or assurances of support on which reliance could reasonably be placed, created a substantial risk of serious loss to creditors;
• the directors breached section 136 of the Act. As the Court of Appeal found, the directors breached the section in relation to the obligations entered into under the four major construction contracts from 31 January 2011, and in relation to all obligations incurred from 5 July 2012;
• in relation to the approach to be taken to the assessment of compensation payable for these breaches, the Court agreed with the Court of Appeal that: 
  • no compensation should be awarded for breach of section 135 because generally compensation for breach of this section should be based on a net deterioration basis and there was no deterioration in Mainzeal’s financial position over the relevant period;
  • compensation for breach of section 136 should be assessed on the basis of the new debt incurred. Having regard to concessions made by the liquidators to avoid the cost and delay of a further quantum hearing in the High Court, the Court assessed $39.8 million on this basis as compensation. The Court was ”satisfied that it is more likely than not that the losses for which compensation can be awarded exceed the amount now claimed”.
• Mr Yan was found to be far more culpable than the other directors, and the other three directors to be equally culpable among themselves.

The Supreme Court recognised that the issues before it were of fundamental importance to the business community. The guidance the Court has provided for directors of financially distressed companies is to be welcomed.

Footnotes

[1] Yan v Mainzeal Property and Construction Limited (in liquidation) [2023] NZSC 113.
[2] The decision is also relevant to those managing the affairs of incorporated societies as they are subject to equivalent duties under the Incorporated Societies Act 2022.
[3] Madsen-Ries (as liquidators of Debut Homes Ltd (in liquidation)) v Cooper [2020] NZSC 100.
[4] Yan v Mainzeal Property and Construction Limited (in liquidation) [2021] NZCA 99 at [12].
[5] Mainzeal Property & Construction Ltd (in liq) v Yan [2019] NZHC 255.
[6] Yan v Mainzeal Property and Construction Limited (in liquidation) [2021] NZCA 99.