Directors' business decision questioned in reckless trading case

In the Autumn 2006 issue of Commercial Quarterly we reported on Mason v Lewis where, according to the court, the directors had fallen short of the mark in their monitoring and management of a company even though they had acted honestly and in good faith throughout the life of the company. In this recent case, once again, the court indicates that directors' business decisions and practices will be scrutinised closely in the event of insolvency.

This judgment¹ does not impose any new requirements on directors but it does highlight the need for directors to comply with orthodox commercial practice and exercise particular caution when a company’s solvency is in issue. It also provides a useful illustration of the different type of decisions which can lead to directors being personally liable to contribute in cases of insolvency.

Background facts

In this case a husband and wife (the Borrells) owned some farm land which they were subdividing into four separate blocks for sale. In order to comply with the conditions of the subdivision they found themselves in the awkward position of having to acquire a new property for their farming business before they had the funds to pay the purchase price. However they managed to acquire a property by entering into an unconditional sale and purchase agreement with a 12-month settlement period (the vendors having refused to enter a conditional agreement) to allow sufficient time to fund the purchase from the sale of the subdivided blocks. The Borrells reached an agreement with the vendors to take immediate possession of the new property under a lease.

The decision to enter into the agreement does not appear to have been taken lightly by the Borrells. In fact the Borrells argued that they had assessed the risk of not completing the property transaction to be small – 5% at most.  Among the reasons they gave for reaching this conclusion were:

• it was reasonable for them to assume a buyer would be found for at least one of the larger subdivided blocks over the course of the 12-month settlement period. This assumption was based on the fact that they had already entered into agreements for the sale of two of the smaller blocks;

• bridging finance was available if they sold one of the larger subdivided blocks before the completion of the sale; and

• their dealings with one of the trustees of the vendors suggested that the vendors would remain co-operative in the event of a delayed settlement.

They had also taken advice from a real estate agent on the likelihood of obtaining buyers for the subdivided land within the twelve month timeframe and a solicitor (specialising in property transactions) had indicated that the risk they were taking was manageable.

Unfortunately for the Borrells all did not go well. They were unable to find a buyer for the subdivided blocks of land in time to settle the new property transaction and the agreement was cancelled.

Basis for proceedings

The case came before the court because the Borrells had established a company (Goatlands Ltd) to use as a vehicle to purchase the new farm property and had named it as their nominee under the sale and purchase agreement. As the nominee purchaser, Goatlands received a GST refund for the purchase of the property. The Borrells used this GST refund to pay the deposit to the vendors; pay for the first six month’s lease on the farm; and pay for some improvements to the property. However, when the agreement was cancelled, Goatlands became liable to pay back the GST refund to the Inland Revenue Department. Goatlands was unable to do so and was placed in liquidation.

The liquidators sought an order from the court under section 301 of the Companies Act 1993 (the Act) requiring the Borrells to contribute a sum to the assets of Goatlands for compensation on the basis that they had breached their statutory duties as directors. The liquidators contended that the directors were in breach of:

• section 135 for creating a “substantial risk of serious loss” to the IRD on the basis that they knew that if the subdivided land was not sold, Goatlands would not be in a position to repay the GST refund; and

• section 136 for permitting Goatlands to incur the obligation to repay the GST in circumstances where they did not have reasonable grounds to believe that it would be able to perform the obligation.

Court’s decision

Section 135 (reckless trading) claim

The court noted that this was not a usual reckless trading claim under section 135 in so far as it related only to the one-off spending of the GST refund and did not involve the directors continuing to trade to the potential detriment of trade creditors in circumstances where they knew that the company was insolvent.

Nevertheless, Justice Lang considered that the “illegitimate risk” approach applied in previous authorities (and recently approved  by the Court of Appeal in Mason v Lewis²) was still appropriate on the facts. Under this approach, the judge noted:

• directors will be permitted to take risks so long as those risks do not place the company’s creditors at substantial risk of serious loss;

• creditors will generally only be at risk in the event that the company becomes insolvent to the point where it is in danger of becoming insolvent; and

• “sober assessment” of the level of risk must be given to any transaction that has the potential to cause the company’s complete demise. In such cases, directors “should only proceed to commit the company to the transaction if, objectively viewed, the risk of failure is sufficiently small to warrant the company taking it. If the risk of failure is substantial, in the sense of real and significant, it should not be taken.”

On the facts Justice Lang did not consider that the Borrells had made such a sober assessment. He made note of the fact that they were in a catch 22 situation when they had made the decision to enter into the sale and purchase agreement which, in effect, had prevented them from making a “considered” decision. The judge also did not agree with the Borrells’ assessment of the risk of failure on the facts. In particular, he did not think that it was reasonable for the Borrells to have relied solely on an extended settlement date for the sale of the subdivided properties as a means to fund the purchase of the farm. This coupled with the fact that they had no backstop such as bridging finance in the event of a sale not going through, led the judge to conclude that the risk they took was closer to 25% than the 5% estimate given by the Borrells. At 25% the risk was of such magnitude to amount to a “substantial risk” for the purposes of section 135  Their actions fell outside the scope of orthodox commercial behaviour because “an orthodox approach would have been to protect the company against the risk” that the Borrells had identified.

Section 136 (duty in relation to obligations) claim

Section 136 provides that:

“A director of a company must not agree to the company incurring an obligation unless the director believes at the time on reasonable grounds that the company will be able to perform the obligation when it is requires to do so.”

Justice Lang noted that in addition to the requirement that the directors have reasonable grounds for believing the company will be able to meet the obligation, the words “will be able” in this section suggested that there needs to be a degree of certainty in the directors’ minds that the company will be able to perform the obligation when it is required to do so. On the facts the judge noted that the Borrells could not have believed with any degree of certainty that the blocks of land would sell in the required time period. Nor for the reasons given for the claim based under section 135 did the court find that there were “reasonable grounds” for the Borrells to have such a belief.

Defences rejected

The court also rejected the Borrells’ contention that they had a defence under section 138 of the Act from any breaches of sections 135 or 136, on the basis that they had obtained favourable advice from a real estate agent and a solicitor who specialised in property transactions in respect of their plans to purchase the new property.

Under section 138, if directors can show they obtained advice from appropriately qualified professional advisers or experts and have followed that advice, the Court may find that there has been no breach of duty. However, this defence is only available if the directors had reasonable grounds to rely on the advice. In the case of the real estate agent, the Court did not consider that any reasonable person would have relied on his opinion as giving an assurance that the subdivided blocks would sell within the required period. Similarly the advice the Borrells received from the solicitor to the effect that the risks they were taking were “manageable ones” was not sufficient to come within this section because the solicitor was not aware of the Borrells’ overall financial position (namely, that they had no access to bridging finance if they did not find a purchaser for one of the two large blocks of subdivided land).

Final outcome

In determining the amount the Borrells had to contribute under section 301, the court found that on the facts the only relevant factor to take into account was the extent to which the Borrells’ decision to spend the GST refund could be regarded as culpable. This, the court considered, was not at the “top end of the scale” since they had tried to allow sufficient time for the sale of their existing property and had taken the advice of a real estate agent and their solicitor. Furthermore, it was noted by the Court that the failure of Goatlands was to a certain extent beyond their control.

The court concluded that it would be just and equitable for the Borrells to make a contribution that reflected the extent to which they took an “illegitimate risk” in deciding to use the GST refund before they knew whether they could arrange funding in time for completion. This had been assessed at 25% by the Court in the course of determining liability under section 135.  Accordingly the Court made an order for the Borrells to contribute approximately 25% of Goatlands’ outstanding debts to the assets of Goatlands.

¹ Goatlands Ltd (in liquidation) v Borrell (High Court Hamilton , CIV 2005-419-1643, 14 December 2006, Lang J)

² [2006] 3 NZLR 225 (CA)

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