2020 Litigation Forecast - Directors' duties and insolvent trading risk

Insolvent trading risk will continue to be a hot topic for directors and boards in 2020.

In 2019, the Mainzeal decision highlighted the risk that directors may be liable for breach of duties when a company experiences financial difficulties. It also piqued the interest of liquidators, creditors and litigation funders in pursuing insolvent trading claims. Significant decisions due to be handed down by senior courts in 2020 will ensure this remains an area of focus for boards and potential claimants alike.

In February 2019, the High Court found the directors of Mainzeal Property and Construction Limited (in liquidation) liable for insolvent trading prior to the company’s collapse in 2013, and ordered that they pay, in aggregate, $36 million in compensation to the liquidators5. Liability arose in circumstances where the company had been trading while balance sheet insolvent; there was no enforceable assurance of group support on which the directors could reasonably rely if adverse circumstances arose; and the company’s financial trading performance was poor and prone to significant one-off losses. An appeal of the decision is due to be heard by the Court of Appeal in April 2020.

The Mainzeal decision received widespread media coverage. Mainzeal had been one of New Zealand’s largest construction companies. The attention the decision received in part reflected this, as well as the profile of some of the defendants (one of whom was a former prime minister) and the substantial sum awarded as compensation.

The decision was sobering for boards. It provided a blunt reminder of the risks of operating in circumstances of balance sheet insolvency and the need to carefully scrutinise the robustness of shareholder support arrangements, particularly within corporate groups. Additionally, in what many viewed as a departure from the approach to assessing compensation typically taken in insolvent trading cases, the Court awarded compensation notwithstanding that it found the company’s liabilities in aggregate had actually decreased over the relevant period.

It is not uncommon for companies to experience periods in which their balance sheet is only marginally solvent or even insolvent. Nor is it uncommon for a company to be reliant on ongoing support from a parent or related company, for instance those fulfilling a treasury function within a corporate group. Scenarios such as these are particularly acute during times of economic volatility and business uncertainty. In the wake of the Mainzeal decision, we saw a noticeable up-tick in boards seeking legal advice on the risks of insolvent trading and the adequacy of shareholder support arrangements.

Within a few weeks of the Mainzeal decision, the Court of Appeal delivered its judgment in Cooper v Debut Homes Limited (in liquidation)6. Cooper concerned the failure of a small residential property development company and was at the other end of the scale from Mainzeal. It nevertheless also addressed the directors’ duties engaged on companies operating in circumstances of financial distress.

In Cooper, the Court of Appeal found that the director was not liable for insolvent trading notwithstanding that the company’s continued operation (to enable the completion and sale of various houses) resulted in the company incurring a significant GST liability to the Inland Revenue Department. The Court considered that the decision to continue to trade in the circumstances was consistent with the director’s duty to act in good faith and in the best interests of the company (which, in circumstances of insolvency, equated to the interests of the company’s creditors). The Court noted that the company’s total exposure at the time of liquidation was less than it would have been had it been placed in liquidation earlier, due to the price achieved from the sale of completed houses being greater than had they been sold earlier in an unfinished state.

An appeal from the Court of Appeal’s decision in Cooper was heard by the Supreme Court late last year. However, 2019 ended without the Supreme Court having released its decision. 2020 should see that decision handed down and also that of the Court of Appeal in Mainzeal. Both decisions will be significant for the guidance on insolvent trading claims. They should not only give greater clarity to directors of financially distressed companies about the risks arising and how they are best managed, but also influence the appetite of liquidators, creditors and their funders for bringing claims.

MinterEllisonRuddWatts acted on the Mainzeal case.

Footnotes

MinterEllisonRuddWatts minterellison.co.nz/our-view/learnings-for-directors-from-mainzeal-decision

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