Directors' duties: factors to weigh up before making business decisions

It is inevitable that a director's business decisions and practices will be scrutinised closely by a company's shareholders, liquidators and aggrieved creditors in the event of a company's insolvency. In this article, senior associate Graeme Switzer and solicitor Sukhdeep Johal analyse two recent High Court cases to illustrate the standards applied to, and types of actions required from, directors wanting to avoid the possibility of being ordered to dig into their own pockets to repay an insolvent company's debts.

It is important for all directors to be aware of their duties under sections 131 to 137 of the Companies Act 1993, and in particular, the requirement for directors to act in good faith and in the best interests of the company.

The High Court recently examined two cases to assess whether the directors had failed to meet their statutory duties in situations where the company was, or was near to being, insolvent. The focus for both cases was on the reckless trading provision in section 135 of the Act which provides that a director must not:

• agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company's creditors; 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 the company's creditors.

Both cases involved plaintiffs making applications under section 301 of the Act, which empowers the court to make orders where directors (and other persons referred to in section 301) have been guilty of negligence, default or breach of duty or breach of trust (or other matters referred to in section 301) in relation to the company, including that the director(s):

• repay or restore the money or property or any part of it with interest at a rate the court thinks just; or

• contribute such sum to the assets of the company by way of compensation as the court thinks just.

Where the application is made by a creditor under section 301, the court can order the director to pay or transfer the money or property or any part of it with interest at a rate the court thinks just to the creditor.

Boutique Tanneries Limited (in liquidation) and Anor v Handley¹

The claim

In this case, the company and its liquidators sued the sole director of the company for contributing to the deficiency on the company's liquidation on the basis that the director had breached his duties:

• to act in good faith and in the best interests of the company;

• not to agree to, 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 the company's creditors;

• not to agree to the company incurring an obligation unless the director believes on reasonable grounds that the company will be able to perform the obligation; and

• to exercise the care, diligence and skill that a reasonable director would exercise in the same circumstances.

They also sued the director for breaching the obligation to keep proper accounting records under section 194 of the Act.

The decision

The court found the director had breached duties owed to the company under section 135 (reckless trading) and section 137 (duty of care) of the Act and the director was ordered to contribute $100,000 to the losses caused. The director was also found to have breached the duty to maintain proper accounting records.

These findings were made, notwithstanding that the sole director had suffered poor health as a result of strokes and a heart condition. The director had also kept the company trading and honoured all commitments except to the IRD.

The judge acknowledged the director's ill health was a mitigating factor to the extent of his culpability. However, the judge also pointed out that the liquidators were entitled to argue that the director could have contracted other appropriate expertise to manage the company in his incapacity or to cease trading earlier. Therefore, the level of the director's culpability was treated as relatively high, but not to the extent to attribute financial responsibility for 100 percent of the loss.

On the liquidators' second cause of action alleging the director owed a duty to the company to keep proper accounting records, the judge considered it was clear the director was responsible for the absence of records. However, the judge was not satisfied that in this case the level of recoveries available to meet the costs of the liquidation and pay creditors had been substantially frustrated by the absence of records. This was reflected in the relatively low amount of $20,000 ordered to be contributed in relation to breach of this duty.

Basis for decision

In assessing the nature of the duty not to trade recklessly (under section 135) the court referred to the following summary of the law in the Court of Appeal's decision in Mason and ors v Lewis (discussed in the Autumn 2006 issue of Commercial Quarterly), which stated the "essential pillars" of section 135 as:

• the duty which is imposed is one owed by directors to the company (rather than to any particular creditors);

• the test is an objective one (that is, the director is to be assessed against a reasonable director in the same position as the director under scrutiny);

• a focus not on a director's belief but rather on the manner in which a company's business is carried on, and whether that modus operandi creates a substantial risk of serious loss;

• what is required when the company enters troubled financial waters is a "sober assessment by the directors, ... of an ongoing character, as to the company's likely future income and prospects".

The decision in Mason also made the point that the court must draw a distinction between the taking of legitimate and illegitimate risks and that where a company has little or no equity, directors will need to carefully consider whether continuing to trade has realistic prospects of generating cash that will service pre-existing debt and meet the commitments that such trading incurs.

On the facts of this case, the court noted that it was reckless of the director to default on his obligations to the IRD as, within one year of starting to default, he was ignoring a liability that would rapidly threaten the solvency of the company. Had the IRD enforced payments earlier than it did, the company would have been under-resourced to make the payments and further, the IRD's preferential claim would have led to losses for the remaining creditors who, at the time, were only being paid as a result of IRD payments being ignored.

In assessing a director's duty under section 137, the court noted the duty imports obligations of exercising the care, diligence and skill that a reasonable director would exercise, taking into account:

• the nature of the company;

• the nature of the decision; and

• the position of the director and the nature of the responsibilities undertaken by him or her.

The section 137 assessment required an objective assessment, which meant that the sole director was to be assessed against a reasonable director in the same position, namely a sole director of a relatively small trading business without guidance from a board. No credit was to be given for a particular director's lack of any requisite experience or knowledge. Further, while the director's personal circumstances may be taken into account in considering the quantum of the penalty to be imposed, they could not be any excuse for imposing a different objective standard of care when considering the breach of section 137.

Of more general note is the court's reference to the effect of external market conditions on the director's decisions. In this case the industry in which the company operated had suffered a down-turn. The court noted that the director had not mismanaged into insolvency a business that was trading in an industry enjoying positive conditions. The judge stated that the prospect of an up-turn in industry conditions might possibly warrant a decision to continue trading for somewhat longer than would otherwise be justified. However, the judge went on to note that whilst an industry down-turn makes it more difficult to operate any company successfully, ultimately that cannot lessen the obligation to cease trading when the continuation of business is likely to create a substantial risk of serious loss to the company's creditors.

Jordon and Vance v O'Sullivan and Ors²

The facts

The plaintiffs in this case were the liquidators of Condrens Parking Limited. Four of the defendants were at various times the directors of Condrens (together the directors). The fifth defendant was a company (Parking New Zealand Limited) of which Mr O'Sullivan (one of the directors) was at all material times the sole director and shareholder. The basic legal proposition that the plaintiffs relied upon in this case is where a company is, or is near to being, insolvent, the duties that the directors owe to that company require them to consider the interests of the company's creditors.

The claim

The liquidators claimed that the directors breached duties they owed to consider the interests of Condrens' creditors in relation to two aspects of Condrens' business:

• First, the directors O'Sullivan, McKinley and Condren were all (directly or indirectly) shareholders in a related company called Car Parks International Ltd (CPI) and advances were made by Condrens to CPI (the CPI Advances). The liquidators claimed that the CPI Advances, which were shown in Condrens accounts as assets at face value, were in fact irrecoverable and without those assets Condrens was balance sheet insolvent (it had negative shareholders funds).

• Second, the directors caused or allowed Condrens to enter into, or assume liability under, long-term leases of three car parking buildings (the Specified Leases). They did this when, considering Condrens' financial position, they were required to act with heightened caution and particular regard to the interests of creditors. The directors were in breach of these requirements because they failed to assess properly or provide for the risks associated with entering into the Specified Leases. Those risks essentially related to Condrens obtaining sufficient car parking revenue to meet lease outgoings and associated overheads.

With respect to the CPI Advances, the plaintiffs alleged the directors breached sections 131, 135 and 137 and with respect to the Specified Leases, sections 135, 136 and 137.

Justice Clifford stated:

"The basic legal principal articulated by the plaintiffs, that is, where a company is, or is near to being, insolvent, the duties that directors owe to the company require them to consider the interests of the company's creditors, has a well known pedigree."

In relation to this, Justice Clifford cited the cases Nicholson v Permakraft (NZ) Ltd³ and more recently the Court of Appeal case of Robb v Sojourner⁴.

The court's decision

In assessing whether the directors had been reckless, several cases were cited, including reference to the summary of the "essential pillars" of section 135 as stated in the Court of Appeal's decision in Mason and ors v Lewis (noted above in the Boutique Tanneries case). In assessing the alleged liability under sections 135 and 136, Justice Clifford considered the common question of whether, regarding the CPI Advances and the Specified Leases, the directors engaged in illegitimate trading - in other words, whether the directors took illegitimate risks.

The court found the directors did not take illegitimate risks in making the CPI Advances. In the court's view, the directors had a fairly accurate understanding of those risks and covered the risks where necessary by the provision of additional capital.

Regarding the Specified Leases, the plaintiffs' challenge to the directors' business conduct was their failure to explicitly consider and provide for (in terms of additional capital resources) risks that were inevitably associated with their expansion strategy. The directors were required to approach the decisions with particular caution.

The court acknowledged the directors may not have met best practice corporate governance standards but Justice Cliiford concluded that the conduct of the directors, in committing Condrens to the Specified Leases, did not constitute reckless trading, or the taking of illegitimate business risks.

The reasons given by the court for reaching this conclusion included:

• the directors' conduct did not depart so markedly from orthodox business practice and involve such extensive and unusual risk to the creditors that it could be fairly stigmatised as reckless;

• the directors did undertake a sober assessment of the business decisions involved in entering into each of the Specified Leases;

• the directors investigated each of the car parking sites involved, reached a view as to the revenue the sites could generate – based admittedly on their own assessment of likely supply and demand factors – and they negotiated the terms of the leases in each case over some period of time; and

• their under-estimation of the risks involved in the start-up phase of each of the lease operations was not sufficient, in this case, to conclude that the directors breached the duties they owed to Condrens.

It should also be noted that in reaching that conclusion, the court considered it important that the directors had, very recently and in their capacity as shareholders, demonstrated a willingness to support the company's trading by the provision of further capital.

Practical implications

These cases provide good examples of the difficulties directors may find themselves in when dealing with a business that is insolvent or near insolvent. Some key points to note from these cases are outlined below.

• The court will apply an objective test rather than simply considering the director's particular individual circumstances when assessing whether a director has carried out his or her duties to the company and its creditors under the Companies Act.

• When considering a potential breach of the duty not to trade recklessly (under section 135 of the Act) the courts will make an assessment of whether directors have taken legitimate or illegitimate risks. Where a company has little or no equity, directors should consider very carefully whether continuing to trade has realistic prospects of generating cash that will service both pre-existing debt (including any debts owed to the IRD) and meet the commitments that such trading inevitably attracts.

• Personal circumstances such as old age and ill health may mitigate some of the potential culpability associated with insolvency, but where there are other options available to a director to prevent insolvency such as ceasing trading earlier or contracting expertise to manage the business the charged director will likely face the bulk of the potential penalties if he or she is held to have breached his or her duties. Such personal circumstances will not result in a different test being applied to the director's circumstances than is otherwise applied to section 137 of the Act.

• The prospect of an up-turn in the potentially insolvent company's industry conditions might possibly warrant a decision to continue trading for somewhat longer than would otherwise be justified, but that does not lessen the obligation to cease trading when the continuation of business is likely to create a substantial risk of serious loss to the company's creditors.

• Although failure to keep well maintained accounting records, in accordance with the Act, may not always directly contribute to the insolvency of a company, it should be remembered that it will constitute a separate cause of action under section 194.

 

¹ HC AK CIV 2006 404 2713 (July 2008)

² HC WN CIV 2004-485-002611 (May 2008)

³ [1985] 1 NZLR 242

⁴ [ 2008] 1 NZLR 751

Enquiries and information

For more information on any of the cases, articles and features in Commercial Quarterly, please email Diane Graham or call her on 64 9 916 8849.