Yesterday, the High Court ruled that the former directors of Mainzeal Property and Construction Limited (in liquidation) were liable for breach of their directors' duties by engaging in reckless trading, and ordered them to pay compensation totalling $36 million.
Mainzeal went into liquidation in 2013, with creditors owed in excess of $110 million. The liquidators of Mainzeal sued the company's directors for an alleged breach of their duties not to trade the company recklessly.
The liquidators claimed that the directors allowed Mainzeal to trade in an insolvent state for many years based on non-binding assurances from Richina, its parent in China, to provide financial support.
The High Court ruled that four Mainzeal directors were liable for reckless trading and ordered them to pay compensation of $36 million between them, with $6 million payable by each of three directors and a fourth director liable for the entire $36 million.
A director will be liable for a reckless trading claim if the company is insolvent and the directors' actions will cause a substantial risk of serious loss to creditors.
The Court pointed to two key factors in reaching its conclusion that the Mainzeal directors traded the company recklessly: Mainzeal's poor financial trading performance and its balance sheet insolvency.
Mainzeal's poor financial trading performance
The Court ruled that Mainzeal's trading position was unpredictable and generally very poor, making it vulnerable to failing with a consequential substantial loss to Mainzeal's creditors. The Court pointed to the following factors:
(a) Mainzeal had consistently failed to meet its budgets by significant amounts.
(b) Mainzeal's construction business involved a significant risk of large one-off losses, and it was entirely predictable that even one such loss would create significant financial pressure.
(c) Mainzeal's financial problems were compounded by the growing problem of significant leaky building claims in 2010, with Mainzeal underprovisioning its liability.
(d) When it became apparent that Mainzeal's business model was not working, the directors adopted a new business strategy. This involved significant risk in light of Mainzeal's existing financial issues, and created a further risk of one-off losses in the short term.
Mainzeal's balance sheet insolvency
The Court ruled that, despite Mainzeal's poor financial trading performance, the directors continued to trade while Mainzeal was balance sheet insolvent, and that this contributed to a substantial risk of serious loss to creditors.
The directors argued that the company was solvent as a result of letters of comfort and expressions of support from its parent, the Richina group. However, the Court ruled that Richina's letters of comfort and expressions of support were not clearly expressed and were not legally binding. Further, it said that the directors were aware that it would be difficult to access funds from China, where Richina is based. Accordingly, it ruled that the directors could not reasonably rely on any assurance of group support if adverse circumstances arose.
The directors also sought to rely on Ernst & Young's assessment that Mainzeal was a going concern. The Court rejected this argument, ruling that whether a company is a going concern is a different question from whether it is balance sheet solvent, and that there is a lower threshold for a company to be a going concern. In any event, it ruled that Ernst & Young's assessment was subject to a key assumption that Richina would offer financial support, which was not valid.
When assessing the damages payable by the directors, the Court rejected the standard approach of looking to the deterioration in the company's financial position between the date of the breach and the date of liquidation.
Instead, it applied a novel approach of adopting a starting point of loss based on the entire amount of the deficiency in liquidation, and then adjusting this figure on the basis of discretionary factors such as the duration of the breach and the directors' culpability. It remains to be seen if this novel approach will be accepted by the higher Courts if this case goes on appeal.
The Court considered the directors' insurance position. It ruled that the insurance position was not relevant to liability, but was potentially relevant to quantum. However, it ruled that it did not need to alter its assessment of damages on the basis of the insurance cover.
This decision will be of interest to directors, insurers, liquidators and litigation funders alike:
(a) Directors will need to consider their position carefully in light of the decision, especially where a company is in a poor financial trading position and/or close to insolvent.
(b) Insurers will be interested in this decision, given the cover they provide to directors. They may also be concerned that insurance arrangements are potentially relevant to the question of the amount of damages payable. Our view is that insurance arrangements should not be relevant in these cases.
(c) Liquidators are often looking to pursue directors to recover proceeds for creditors, but there are few cases brought by liquidators that are pursued through to trial. Liquidators will be buoyed by the outcome in this case in which the claim against the directors succeeded.
(d) The claim by the liquidators was funded by a litigation funder, and litigation funders may look to the positive outcome here to fund more cases against directors for breaches of duties.
This decision has been appealed, and so the High
Court's decision will not be the last word on the collapse of the Mainzeal
If you would like to discuss any of the matters raised in this article, please contact the authors or your usual Bell Gully advisor.
This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.