When a company enters troubled financial waters, directors face difficult decisions about when and how to continue to trade. They have a number of core duties, and are exposed to personal liability if they breach those duties.
In a significant new decision concerning the liquidation of Debut Homes,
Madsen-Ries v Cooper,1 the Supreme Court has restated the duties that apply. The Supreme Court found that the director, Mr Cooper, was personally liable for continuing to build four properties while there was a shortfall to creditors. In doing so, it disagreed with the Court of Appeal, which had had said that Mr Cooper had made a “perfectly sensible business decision" that was likely to improve the return to creditors as a whole.
While the decision clarifies aspects of the law, the difference on the facts between the Court of Appeal and Supreme Court highlights the real risks that directors face, particularly given the current economic environment.
Debut Homes was a residential property development company. By the end of October 2012, it was in financial difficulties, with a substantial debt owed to the IRD. It also had four properties yet to be completed.
The director discussed the company's financial position with the company's accountant. The accountant said that there would be a GST deficit of at least $300,000 if the company completed those properties, as compared with an immediate liquidation.
The director decided that creditors as a whole would be better off if the company completed the outstanding properties. The company proceeded to complete the work, and in doing so made repayments to the company's secured creditors, whose debts were personally guaranteed by Mr Cooper and his trust.
No amounts were left over to pay the GST liability arising from the sales. The company was later placed into liquidation on the application of the IRD.
The High Court found that Mr Cooper had breached his duties. It considered that Mr Cooper knew that there would be a significant shortfall to the IRD, but nevertheless elected to proceed with completing the properties. It said that Mr Cooper's decision was improper.
The Court of Appeal reversed the High Court's decision. It said there would have been a shortfall to the IRD even if the company had elected not to complete the properties. In the Court of Appeal's view, the decision to complete the houses was a “perfectly sensible business decision" that was likely to improve the return to creditors rather than cause them loss.
The Supreme Court reversed the Court of Appeal and reinstated the High Court's decision. In doing so, it addressed a number of key issues relating to directors' duties.
If the company cannot return to solvency, directors must start an insolvency or restructuring process
An important consideration for the Supreme Court was that, by November 2012, it was clear that there would be a shortfall to creditors under any realistic scenario. Further, it was not enough that the overall shortfall would be reduced by ongoing trading. The Court ruled that, if there is a shortfall, some form of insolvency or restructuring mechanism is required.
That could be a formal insolvency process, such as a liquidation, receivership, creditors' compromise, scheme of arrangement, or voluntary administration. It could also be less formal, such as an informal compromise with creditors, provided that this is done in a way that is consistent with the directors' duties and involves all classes of creditors.
The touchstone in each case is the involvement of all classes of affected creditors and a corresponding loss of absolute control by the directors. Directors in these circumstances who continue to operate without reference to creditors are at risk of breaching their duties.
Continuing to trade a company that cannot be returned to solvency is reckless trading, even if trading would benefit creditors as a whole
Under the Companies Act, directors must not engage in reckless trading. The Supreme Court ruled that Mr Cooper had breached that duty here by continuing to trade.
The Court emphasised that, by November 2012, Mr Cooper knew that completing the properties would lead to a GST shortfall of at least $300,000. That loss was certain, and it was serious.
The Court ruled that if continued trading would result in a shortfall to creditors without engaging a formal or informal insolvency mechanism, then there was a breach of the director's duty not to engage in reckless trading. Importantly, it is not an answer to a claim for breach of duty that some creditors were better off as a result, or that the overall deficit to creditors was projected to be reduced.
Directors can “agree" to involuntary obligations such as tax debts
Directors also owe an obligation under the Companies Act not to agree to the company incurring obligations without a reasonable belief that the company can perform them.
The Court rejected a submission by Mr Cooper that the duty only applies to contractual obligations incurred with the agreement of the director, rather than tax debts. It said that the duty applied here because Mr Cooper had allowed Debut Homes to enter into the sale and purchase agreements knowing that this would result in the company incurring a GST liability. As Mr Cooper knew the company could not meet the GST liability, the duty had been breached.
The Court said that it was not legitimate to enter into a course of action to ensure some creditors have a higher return where this can only be achieved by incurring new liabilities to other creditors which will not be paid.
The duty to act in good faith in the best interests of the company is subjective
There is some debate in the case law about the nature of a director's duty to act in good faith in the best interests of the company. The Court ruled that the duty is subjective, requiring the director to act in what
they believe to be in the best interests of the company. It also said that the director's actions should not be judged solely in hindsight. However, the Court considered that a director could not subjectively believe that they are acting in the best interests of the company in an insolvency scenario if they have failed to consider the interests of all creditors, including prospective creditors. Directors are particularly at risk of breaching this duty if they have a conflict of interest, for example if they are also a creditor of the company or guarantor of some of the company's debt, and have an incentive to favour certain creditors over others.
As a result, the Court found that Mr Cooper had breached the duty here.
Tailoring the remedy to the breach
The Court also addressed the appropriate remedies for a breach of directors' duties (an issue of particular interest as we await the decision of the Court of Appeal in the
The Supreme Court held that, although duties are owed to the company rather than to creditors, the consequences for directors will not necessarily be measured in terms of a company's financial loss. If directors have breached a duty of loyalty, or if they breach duties by incurring obligations without a reasonable belief that they can be met, then other remedies are possible. These include orders that directors restore property they have received from the company, and/or pay compensation measured by reference to debts a company has incurred.
The Court also held that, although the remedy was primarily compensatory, the courts are also entitled to take into account the need to deter directors from breaching their duties in assessing the appropriate remedy.
The Supreme Court restored the orders made in the High Court under which Mr Cooper was required to pay $280,000. It also partly set aside a general security agreement securing a further advance made to the company by Mr Cooper's trust after November 2012, on the ground that it would not be just and equitable for the trust to receive the funds the liquidators would recover from Mr Cooper for breaching his duties.
What does this mean for directors?
The stark differences between the approaches of the Court of Appeal and the Supreme Court show the genuine challenges for directors of a near-insolvent company when making a decision as to whether to continue trading.
The key in this case was Mr Cooper's knowledge that the company would not be able to meet the GST liability that would arise from completing the properties. In those circumstances, the Court considered that a decision as to whether to continue to trade should have been made in the context of a formal or informal insolvency process in which all creditors had the ability to participate.
The position may be different where there is less certainty as to whether there will be an ultimate shortfall, or while a director is pursuing the possibility of a formal or informal insolvency process. In these circumstances, directors are likely to be allowed a period of time to understand the company's position and options. Indeed, there may be circumstances when continuing to trade is a reasonable risk, even if the company does ultimately fail.
In its judgment, the Supreme Court acknowledged uncertainty about the parameters of directors' choices in such situations, but decided not to give any guidance on these issues in its decision.
If you have any questions about the matters raised in this article, please get in touch with the contacts listed, or your usual Bell Gully adviser.
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.