BREACH OF DIRECTORS’ DUTIES

The Supreme Court recently issued a decision that is relevant to any business facing hard trading conditions

The Supreme Court has issued a new decision, Madsen-Ries and Levin as Liquidators of Debut Homes Limited (in liquidation) v Cooper, which reviews the law relating to breaches of directors’ duties. The decision provides important guidance for company directors when facing hard trading conditions.

The Supreme Court found that companies in insolvency or near-insolvency situations must use the various formal mechanisms provided in the Companies Act 1993 (the Act), rather than trying to trade through. A copy of the decision is available here: courtsofnz.govt.nz/assets/cases/SC-29-2019-Debut-Homes-v-Cooper.pdf

Background
The defendant, Mr Cooper, was the sole director of Debut Homes Ltd, a residential building company. At the end of 2012, one of Debut Homes’ financiers decided to cease funding them. Based on advice from the company’s accountant, Mr Cooper decided to wind down operations, while completing existing developments but not taking on any new projects. It was expected that once the company wound down, there would be approximately $300,000 owing in GST to IRD.

The decision to wind down operations, rather than cease trading immediately, was to the benefit of the homeowners of the completed residential properties and unsecured trade creditors, who supplied materials and labour, but was to IRD’s detriment as the company neglected to pay GST on the sale of the properties.

The High Court and Court of Appeal
The High Court decided that Mr Cooper had breached his duties as a director, and ordered him to pay $280,000 to the liquidators of Debut Homes, to cover some of the shortfall to creditors.

The Court of Appeal overturned the High Court’s decision, determining that the decision to complete the houses was a “perfectly sensible business decision”.

The Supreme Court
The Supreme Court overruled the Court of Appeal and restored the decision of the High Court, including ordering Mr Cooper to pay $280,000.

In coming to its decision, the Supreme Court reviewed each director duty contained in the Act:

Section 135 – reckless trading
Under this section, a director must not agree to the business of the company being carried on, or cause or allow the business of the company to be carried on, in a manner likely to create a substantial risk of serious loss to creditors.

The Supreme Court decided:
“If a company reaches the point where continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading
will be in breach of s135 of the Act…
this applies whether or not continued trading is projected to result in higher returns to some of the creditors than would be the case if the company had been immediately placed into liquidation,
and whether or not any overall deficit was projected to be reduced.”

Section 136 – duty to not incur obligations
Under this section, a director must not agree to the company incurring an obligation unless the director reasonably believes that the company will be able to perform the obligation as and when required. The focus of this section is on a particular obligation, rather than the business as a whole.

The Supreme Court’s view on section 136 is:
“It is not legitimate to enter into a course of action to ensure some creditors have a higher return, where this is at the expense of incurring new liabilities which will not be paid. In other words, it is not legitimate to ‘rob Peter to pay Paul’.”

Section 131 – duty to act in good faith and in best interests of the company
This section requires a director to act in good faith and in the best interests of the company.

The Supreme Court confirmed that this is a subjective test and that the courts are not well-equipped to second-guess business decisions made by directors.  However, the Court also noted that there are a number of exceptions to the subjective test, including where:

• There is no evidence of actual consideration by the director of the best interests of the company.
• In an insolvency or near-insolvency situation, there is a failure to consider the interests of creditors.
• There is a conflict of interest, or the action was one no director with any understanding of fiduciary duties could have taken.
• A director’s decisions are irrational.

In this case, Mr Cooper had failed to consider the interests of all creditors in an insolvency situation. Instead, he considered some creditors, but discounted the interests of others.

What should the director have done?
The Act has a number of mechanisms available for dealing with insolvency and near-insolvency situations:

• A creditor’s compromise, which usually involves all or part of a company’s debts being cancelled and must be approved by a majority of creditors.
• A court-approved creditor’s compromise, where the court must also agree that the compromise is fair and reasonable to all creditors.
• Voluntary administration, which provides for the appointment of an administrator to maximise the chances of the company’s survival, and which also must be approved by a majority of creditors.
• Liquidation, to wind up the operation of the company.

A feature of all of these mechanisms is that the decision-making is placed in the hands of either the creditors or an independent party. The Supreme Court noted that:

“The removal of decision-making powers from directors in such circumstances is a recognition that directors are not the appropriate decision-makers in times of insolvency or near-insolvency.  This is because their decisions may be compromised by conflicting interests and, even where that is not the case, they may be too close to the company and its business to be able to take a realistic and impartial view of the company’s situation.”

If a company is or may be insolvent, a director must consider the views of all of its creditors. Quite when and how this is done remains a difficult balancing act.

If you are a director of a company which is in an insolvency or near-insolvency situation, it is critical for you to take steps to deal with the situation as quickly as possible, otherwise you face potentially significant personal liability.

NEED MORE INFORMATION?
If you need advice on any of the above, please contact Alysha Hinton on (04) 471 9452 or at alysha.hinton@duncancotterill.com, or your local Duncan Cotterill advisor (duncancotterill.com).

Duncan Cotterill is a full-service law firm with offices in Auckland, Wellington, Nelson and Christchurch. Its dedicated construction and projects team can help make your business a success by working with you to put the deal together.

Disclaimer: the content of this article is general in nature and not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose.