LEGAL COMMENTARY

Notes of lecture to Lawyers and Accountants specializing in Trust law (19 September 2023)

Trading while insolvent

• Two-fold insolvency test: (1) balance sheet (assets and liabilities) (2) liquidity (paying debts as they fall due

What are directors’ duties

• largely statutory – originated in Chancery Courts in England as fiduciary in nature – directors entrusted with company assets.  (The leading exposition of directors’ duties was that of Romer J in Re City Equitable Fire Insurance Company Ltd. [1925] 1 Ch. 407: duties are fiduciary in nature but directors are not trustees (at 426).)
• Companies Act 1993, (relevantly to present discussion) sections 131 (duty to act in good faith and in the best interests of the company), 133 (proper purpose), 135 (reckless trading – substantial risk of serious loss to creditors), 136 (belief on reasonable grounds that company will be able to perform obligations it enters into), 137 (duty of care), 145 (use of company information)  {set out in Mainzeal SC Judgment, paras. 117-121).   Section 301 (Mainzeal, para. 122.
• Distinguish duties owed to shareholders and to the company – section 169(3).  Ss. 131, 133, 135, 136, 137, 145 are all duties owed to the company and not to shareholders.
• The Companies Act does not specify any directors’ duties owed to creditors

When do directors assume duties to creditors?

Case law pre-Mainzeal

• Nicholson v. Permacraft [1985] 1 NZLR 242 (CA (Sir Robin Cooke: cited more often than read) – capital dividend paid to shareholders  (with their assent) as part of restructuring held not to be recoverable by action against the directors when company later became insolvent (directors found to have acted honestly). 
• But cf. Cooke J (obiter at 249-250): duties of directors are owed to the company but (i) there may be facts which require the directors to “consider the interests of creditors” [cf. actionable duties to creditors], in particular “creditors are entitled to consideration … if the company is insolvent, or near-insolvent, or of doubtful insolvency or if a contemplated payment or other course of action would jeopardise its solvency”; (ii) balance sheet solvency is not enough – “as a matter of business ethics” directors must also consider the company’s ability to discharge promptly debts owed to current and likely future trade creditors; (iii) future new creditors may be in a different situation and must take the company as they find it and be “guardians of their own interests”; (iv) limited liability is a privilege and should not be abused but “a balance has to be struck” and “there is no good reason for cultivating a paternal concern to protect business people perfectly able to look after themselves”. 
• Note that Cooke P. did not express the obligation to consider the interests of creditors in terms of a legal duty.
• The High Court of Australia explicitly stated later that, short of misfeasance, expropriation of corporate assets or fraudulent preference, directors do not “owe an independent duty to, and enforceable by, the creditors by reason of their position as directors”: Spies v. R. (2000) 201 CLR 603, 636: “To give some unsecured creditors remedies in an insolvency which are denied to others would undermine the basic principle of pari passu participation by creditors.”  (cf. Walker v. Wimborne (1976) 137 CLR 1 (HCA), 7 (per Mason J)
• There have however been suggestions that controlling shareholders at least may be directly liable to creditors where a company is insolvent and continues to trade or dispose of assets.  This has been most pronounced in the United States through what is referred to as the “trust fund doctrine” under which the company’s assets in an insolvency situation may be regarded as a trust fund under which controlling shareholders (quaere directors) are regarded as trustees for the creditors.  Cf. Kuwait Asia Bank v. National Mutual Life Nominees [1990] 3 NZLR 513 (PC) – 40% shareholder of insolvent company not vicariously liable for conduct of director it appointed.
• At the same time, there has been some sympathy for the dilemma faced by directors who reasonably believe that there is a prospect of trading out and thereby avoiding losses to current creditors.
• This issue was considered by the Supreme Court in the Debut Homes case [Debut Homes (In liq.) v. Cooper [2020] NZSC 100].  The sole director was found to have breached his duties under s.131 (good faith and best interests of the company) because, at a time when the company was insolvent, he embarked on a course of action that had the effect of repaying some (only) present creditors when he knew that other creditors (including GST owing to IRD) would not be paid.
• The Supreme Court ruled that it was primarily for a director to decide what was in the best interests of the company i.e. the test was subjective because: “Courts are not well equipped, even with the benefit of expert evidence, to second-guess the business decisions made by directors in what they honestly believed to be in the best interests of the company”. To do so, the Court continued, “would also be judging directors’ decisions with all the dangers of judging with the benefit of hindsight” (para. 112).
• The Court however qualified that ruling, importantly, in 3 ways: (a) the directors had to give actual consideration of what was in the company’s best interests; (b) in an insolvency or near-insolvency situation there was an obligation to consider the interests of creditors (citing Cooke P. in Permacraft); (c) where there was a conflict of interest; (d) where the directors’ decisions were irrational (para. 113).  Compare Mainzeal at para. 113.
• The Court did say that the obligation to consider the interests of creditors was consistent with the “stakeholder model of corporate governance” (para. 29) but noted that this did not amount to a “duty” to creditors (fn.17), thus bringing New Zealand law on the point in line with the Australian case law (Spies) though not referring to it.
• There are two decisions subsequent to Debut Homes, that are worthy of comment.  The first was the decision of the Court of Appeal  in Arnerich v. DHC Assets [2021] NZCA 225. The Court considered a situation where a builder creditor, who was the sole creditor, had brought its own proceeding under section 301 against the director of a corporate trustee which owned the land that was being developed in circumstances where the trustee had made distributions to beneficiaries in the trust (primarily the director and his family) without first making provision for the contingent indebtedness of the builder.   The High Court and the Court of Appeal found the director liable under section 131 on the basis that he had been in a position of conflict of duty and interest when authorising the distributions.  Both Courts noted that the director’s duty under s. 131 is owed to the company, (para. 112) not to creditors.   The Court of Appeal noted also that the Supreme Court in Debut Homes had left open the question of whether compensation could be awarded to a creditor directly rather than through the liquidator but thought that option was available to it in the case before  it because the liquidator had elected not to participate in the proceeding and had advised the Court that she abided the Court’s decision (para. 142).
• The second case was Dempsey Wood Civil Ltd. v. Gapes [2021] NZHC 2362, a Judgment of Fitzgerald J.  This case also concerned a development company that was unable to pay its builder who sued the company’s director for breaches of duty under ss. 131, 135 and 136.  Debut Homes and the Court of Appeal’s Judgment in Mainzeal (which had not then reached the Supreme Court) featured in her Judgment.  Her decision was that the director had breached his duties under ss. 135 and 136 but not under s.131 (holding on the facts that he had subjectively believed that the company’s assets exceeded its liabilities and that creditors would be repaid (paras. 212, 232).  Fitzgerald J. referred to the view expressed by the Court of Appeal in Mainzeal that, although a company may have entered troubled waters, “it need not ‘leap’ straight into liquidation or some other arrangement by which it ceases trading” (para. 155) but on the evidence ruled that the continued trading by the company “in an essentially ‘business as usual’ mode was likely to give rise to a substantial risk of serious loss” and that the director was under a duty not to allow the company to trade with that risk to creditors (para. 176).   

Mainzeal

• One might have thought that, given the legal framework that was determined  by the Supreme Court in Debut Homes, the writing was on the wall for the directors of Mainzeal when they decided to go to the Supreme Court, having lost in the High Court and Court of Appeal.
• Unsurprisingly, the Supreme Court, while considering earlier case law, ultimately set out at some length its analysis in Debut Homes (paras. 170-177).
• It also considered 2 more recent decisions of the UK Supreme Court in BTI 2014 LLC v. Sequana SA [2022] 3 WLR 709 and Stanford International Bank v. HSBC Bank [2023] AC 761.
• In Sequana, Lord Reed drew a distinction between a company which was financially stable and one that was insolvent or bordering on insolvency.  In the case of the former, creditors’ interests did not have to be considered “as a discrete aspect of the company’s interests for the purposes of the directors’ fiduciary duty to the company”; in the case of the latter, “creditors as a whole become persons with a distinct interest (possibly, depending on the gravity of the company’s financial difficulties, the predominant interest) in its affairs, as they are dependent on its residual assets, or on the possibility of a turnaround in its fortunes, for repayment”. 
• The Supreme Court in Mainzeal thought that this analysis was the policy consideration that underpinned ss. 135, 136 and 301. 
• The majority of the UK Supreme Court in Stanford Bank, to which the Court in Mainzeal also referred, had declined to recognize a “creditor duty” by directors (as opposed to a duty to the company) which, it was said “would cut across the law of insolvency”. 
• The Court in Mainzeal did not comment expressly on that proposition because the remedial provisions in section 301 which were available against directors for negligence were available not only to liquidators (as exercised in Mainzeal) but also to creditors.
• It did say however that there was a “tension” between the purpose of section 301 and its text as to the ability of creditors to obtain direct relief.  It thought that it had resolved this by giving priority to the purpose of the section, which was clear, and because the statutory language “if construed literally, makes not sense” (para. 376).
• The Court was clearly troubled with how to balance the differing interests of those who were creditors at the time decisions were made to continue trading and those who were creditors when the music stopped i.e. at the time of liquidation.  The Court said that, while the statutory provisions relating to directors’ duties were addressed to the conduct of the company’s business and the associated risks to the general body of creditors, that “does not mean that directors of an insolvent company, when deciding whether to trade on, can legitimately set off against the risk to future creditors (essentially those who will be out of pocket at liquidation) the advantages to current creditors of continued trading” (para. 361).  The Court did allow that directors in that situation are “entitled to take stock of the situation of the company and, for this purpose, to obtain advice” (paras. 214-215, 362 cf. section 138).  And paras. 245, 272-273.
• My assumption is that what the Court was saying was that there would be a tension created by competing claims between creditors at differing times which did not exist if there was simply a claim by a liquidator seeking to recover the losses existing at the time of liquidation but that, in considering the question of directors’ liability for breach of duty the reality of the situation faced by them when taking a decision whether to trade out of an insolvency or near-insolvency state had to be recognized.
• The Supreme Court in Mainzeal undertook an extremely thorough analysis of the facts and (not disagreeing with the Courts below) found that:

(a) over a lengthy period Mainzeal had traded while balance sheet insolvent, a fact which was recognized by the directors;
(b) again for some years Mainzeal had generated little, if any, operating profit (which presumably made a trading turnaround unlikely);
(c) trading projections that showed future profitability were not consistent with past performance and should have been viewed with “a degree of healthy scepticism”;
(d) the need for continued financial support was identified by the auditors and in an independent report but none was provided;
(e) Mainzeal had made a number of related-party loans to companies associated with Mr Richard Yan, who was in effect the controlling shareholder and a director of Mainzeal, repayment of which was not possible, a fact recognized by the directors;
(f) Mainzeal’s solvency was increasingly threatened by leaky building claims that were not adequately provided for;
(g) a so-called guarantee by Mr Yan and his company to provide financial support to Mainzeal were never more than a legally unenforceable letter of comfort which in any event was not given by a company in the Richina Pacific Group (owned and controlled by Mr Yan) that had any assets;
(h) the company’s solvency remained unresolved and “the decisions by the directors to trade on were essentially taken by default, trading-on being just the other side of the coin of not forcing the issue with Mr Yan and;  Richina Pacific” (para. 224);
(i) there was a history of Richina Pacific’s financial interests being preferred to those of Mainzeal, including forgiveness of a substantial loan and various company and loan restructuring that were deliberately intended to limit the risks to Richina Pacific to the detriment of Mainzeal.
(j) “window dressing” in the accounts – related party indebtedness recorded at figures that had been artificially reduced by transactions that took place on the balance date and were then promptly reversed (para. 50(c)).
*    In summary, the Court said that “the future of Mainzeal was very vulnerable to the actions and decisions of a single man – Mr Yan – [who] could be expected to act generally in accordance with the interests of the Richina Pacific group [and whose] communications … revealed attitudes to corporate governance … that could hardly have been reassuring for the directors” (para. 228(h)).

• That conclusion resulted in the Court’s assessment of compensation to the company payable by the directors of $39.8 million with the liability of each director, other than Mr Yan, being limited to $6.6 million and interest.

Conclusion

• It is doubtful that there is anything earth-shatteringly new by way of legal principle in the Judgment of the Supreme Court in Mainzeal.
• The facts, as found and substantially affirmed at each level of the Court system, fully justify the outcome. 

I acknowledge with thanks John Land, barrister and lecturer in Company Law at the Auckland University Law School for providing me with a copy of his lecture notes which contained useful references.