Directors' duties and the case for vulnerable trading?

Watch this space

Originally published in LawTalk 930.

Earlier this year, in the space of 10 days, the New Zealand courts delivered two quite differing outcomes on the question of reckless trading under s 135 of the Companies Act 1993.

In the first judgment, delivered on 26 February 2019, Cooke J held the directors of Mainzeal Construction liable for ongoing trading in a “vulnerable state”, attributing to that complaint liability for the entirety of its trading losses on liquidation – some $110 million. Of this amount, he then imposed on the directors personally a compensation award under s 301 of the Act of $36 million.

In the second, delivered on 8 March 2019, the Court of Appeal (comprising Miller, Asher and Gilbert JJ) reaffirmed orthodox principles to find that ongoing trading by the director of a distressed residential property developer was not reckless, and raised doubts about whether any loss had arisen by the conduct complained of in any event.

Two starkly different results, albeit in response to different fact scenarios. Perhaps the more interesting point is to consider the reasoning from each and to keep an eye on which approach will take hold going forward.

Sections 135 and 301 of the Act

As a starting point, s 135 of the Act prohibits a director of a company from agreeing to and/or causing or allowing the business to be “carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors”.

If directors are found to be in breach of s 135, the usual protection afforded by the corporate veil can be overcome – and directors held personally liable for some or all of a liquidated company’s losses. On application by a liquidator, a creditor or a shareholder, the court can, under s 301, order the director to pay, by way of compensation, an amount that “the court thinks just”.

An orthodox approach – Debut Homes

Starting with the Court of Appeal’s judgment in Cooper v Debut Homes Ltd (in liq) [2019] NZCA 39, it involved an application by the liquidator of Debut Homes, a residential property developer, against its director (Mr Cooper). The action revolved around Mr Cooper’s decision, when the company was in financial difficulties, to complete and sell four houses that the company had been building. The company’s primary creditor on liquidation was the IRD, which was owed outstanding GST obligations.

The court assessed Mr Cooper’s decision. It found that a potential GST liability existed before he made his decision. It arose out of the company’s initial purchases of its development opportunities years earlier. The GST liability only crystallised on the sale of the properties, which occurred for fair market value. It was also apparent that an ‘as is, where is’ alternative sale would have likewise created a shortfall on the company’s GST liability.

In terms of the principles (see [24] – [33]), the court held that trading whilst insolvent does not automatically equate to director liability. The risk and loss to the company as a whole is relevant, not on a transaction by transaction basis. The terms “likely” and “substantial” must be given weight, so too the section’s heading “reckless trading”. Risk must be considered alongside the potential advantage, and exercising hindsight judgement is cautioned against, as this does not “fully and realistically comprehend the difficult commercial choices facing the directors”.

The court held that the decision to complete the houses and sell them for fair market value was a sensible business decision (at [61]). The alternative – some sort of walk away in November 2012 leaving unfinished houses – was the less sensible commercial option (at [65]). Therefore, the court concluded that Mr Cooper did not act in bad faith and was not reckless.

The court also observed that it was unclear whether the IRD, in fact, suffered any loss from Mr Cooper’s actions. Although it did not need to determine the level of compensation payable under s 301, it was not clear to the court that the IRD was in fact worse off than if Mr Cooper had decided to liquidate the company in November 2012. It did note, however, that the High Court’s approach of assessing the loss as being the full amount owing on liquidation was “clearly in error” (at [95]). The High Court judge failed to consider that much of the GST debt likely pre-existed the November 2012 decision and what would have been relevant as compensation was the increase to that pre-existing amount.

Mainzeal – a different approach?

Turning then to the High Court’s decision in Mainzeal Property and Construction Ltd (in liq) v Yan [2019] NZHC 255, released only 10 days prior. That decision relied upon some more novel concepts when assessing a breach of s 135 and the loss compensable for same under s 301.

Established in 1968, Mainzeal was a long-standing New Zealand construction company. In 1995, Mainzeal’s ownership shifted to a Chinese group of companies. From 2004, Mainzeal extended loans to the group and funds were also withdrawn from Mainzeal by the group. But, support from the group flowed back into Mainzeal too (eg, group companies would support bonds on Mainzeal’s projects and provide sporadic cash injections). However, cash flow issues came to a head in late 2012 (a dispute with Siemens and multiple leaking building claims contributed) and the group declared it would not provide the necessary support to trade on. Mainzeal collapsed in February 2013.

The liquidators argued that Mainzeal had traded for many years while it was balance sheet insolvent. It was reliant upon group support from China that was not, in fact, enforceable and it relied upon a cash flow advantage of using subcontractors’ money as working capital. It therefore engaged its business in such a way as to expose creditors to a substantial risk of serious loss under s 135. The liquidators alleged counterfactual insolvency dates of either January or July 2011.

The directors, on the other hand, argued that Mainzeal was not balance sheet insolvent and could meet its debts as they fell due right up until its collapse. They said that Mainzeal must be considered as part of a wider (wealthy) group and they acted reasonably in reliance upon group support (which had been extended over a lengthy period). They argued that s 135 should not impose liability unless a company should cease trading but carries on regardless. Here, they argued that losses would have been greater if insolvency occurred earlier in time.

Despite the directors echoing the orthodox approach followed in Debut Homes above, Cooke J held that the directors acted in breach of their duties under s 135 for three key reasons (at [187]):

“Mainzeal was trading while balance sheet insolvent because the intercompany debt was not in reality recoverable”;

“there was no assurance of group support on which the directors could reasonably rely if adverse circumstances arose”; and

“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”.

The breach arose because the directors “agreed or allowed Mainzeal to engage in trade in a vulnerable state – being balance sheet insolvent, with a poor financial trading position, and depending on assurances of support in a way I have found to be unreasonable” (at [398]). Moreover, the directors should have raised their resignation “in effect, a tactic to put the company back into a proper position” (at [293]). Had they done so, it would have put sufficient pressure on the group to provide the necessary support to continue trading (at [423]).

In terms of the resulting loss and compensation award payable under s 301, the directors argued for the orthodox approach of compensating increased losses sustained by creditors from a counterfactual insolvency point (see, for example, Mason v Lewis [2006] 3 NZLR 225 (CA)). Under this approach, there was arguably no loss because creditors were better off with a 2013 insolvency than one in 2011. However, Cooke J held that an alternative approach applied, one that recognised the loss caused by the directors’ breach. That loss was the full amount owing on insolvency – $110 million. From that amount, the judge applied various discounts on account of causation, liability and duration of trading, saying “Standing back, I ask myself what proportion of the deficiency to creditors on liquidation it is fair for the directors to contribute in an overall way” (at [445]). Ultimately that amount was one third of the total, rounded to $36 million.

In reaching this outcome, Cooke J recognised that “The circumstances of this case can fairly be described as exceptional” (at [285]). In particular, it was not inevitable that the company would otherwise have failed – the key being his finding that, had the directors pushed the issue (even, if necessary, by threatening to resign), group support would have eventuated in an enforceable form so as to restore its financial position.

Where to next?

The outcomes in Debut Homes and Mainzeal stand in rather stark contrast. The latter stands to possibly chart a new path, whereby claims of vulnerable trading can be said to amount to recklessness; as well as an alternative approach to compensation, which assesses the starting point as the entire amount owing as at the date of liquidation. The former is a more orthodox and traditional approach, focusing on pure reckless trading. It adheres to a more rigid base for calculating losses, assessing the losses that are increased by the reckless trading and disregarding the full amount of debts owing on liquidation.

The judgment in Mainzeal has now been appealed by the directors (and cross-appealed by the liquidators). The interesting point to watch will be whether some of the more novel concepts embraced in the High Court’s judgment will be carried forward by the Court of Appeal. Whatever happens, it is very much a case of watch this space.

Also, the Supreme Court has granted leave to appeal in Debut Homes.

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