Reckless trading - company directors found guilty

In two recent cases, the High Court has found company directors guilty of reckless trading.

In the first case1, the court decided that a company director was liable for reckless trading under the Companies Act 1993 when he risked creditors funds while the company was facing insolvency. The court determined that the factors set out below amounted to the taking of illegitimate business risks.

Taking into consideration academic and judicial authorities on the reckless trading sections of the Companies Acts 1955 and 1993, the court concluded that the reckless trading provisions are only targeted at the taking of illegitimate business risks. Factors relevant to determining whether a business risk is legitimate include:

• "whether the risk was fully understood by those whose funds were in peril;
  
  
• where a company is insolvent or on the edge of insolvency, the persons primarily interested are the creditors not the shareholders;
  
  
• while there is no duty to cease trading as soon as a company becomes balance sheet insolvent, the tolerance of continuing trading is generally a matter of months; and
  
  
• whether the conduct of the director was in accordance with orthodox commercial practice".

The court's decision was influenced in this case by the fact that risks were taken with the money of trade creditors who were not notified of the risks, the company continued in this situation for a number of years, and there was limited observance of orthodox practices such as board papers, matching performance against forecasts, ensuring decisions were implemented and recording proceedings in minutes.

In the court's view, the directors did not follow the course that can be expected where a company faces insolvency - that is, determining the cause of insolvency and establishing a strategy for salvaging the situation.

In the second case, the court confirmed that reckless trading will only be found where illegitimate business risks have been taken. The court also considered whether proper accounting records had been kept in compliance with the company's financial reporting obligations.

In this case2, a company failed to make provision in its financial statements for a debt of over $1 million in unpaid excise duty assessed by Customs in 1992 (which the company disputed). Instead, the director's report attached to the company's financial statements from 1992 to 1996 noted that the company disputed the assessment. In 1997 the company recorded in its financial statements the debt assessed in 1992 as a contingent liability and mentioned a further audit carried out by Customs in 1997. An accountant gave evidence that the amounts assessed as owing in 1992 and 1997 should have been treated as actual, rather than contingent, liabilities.

The court decided that although it was not necessary to show the amount of the debt in the 1992 financial statements, because Customs' letter in 1993 contemplated that subsequent correspondence might alter the amount owing, the company should have made provision in its financial statements for the disputed debt. That disclosure should have been made even if the company was correct in treating the liability as contingent.

The Court noted that in deciding whether a business risk is legitimate, the length of time the company traded while insolvent and whether the director's conduct was in accordance with orthodox commercial practice are relevant factors.

In the court's view, it had been reckless for the company to continue trading from early 1994, which allowed a few months for the director to initiate some action.

1 Re South Pacific Shipping Ltd (In Liq), Traveller & Anor v Lower, High Court, 12 February 2004

2 Cellar House Ltd (in liq) Walker v Allen, High Court, Wellington 19-22 August, 15-17 October 2003; 18 March 2004

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