This update is the first in our three-part series on the Mainzeal decision. In this update, we summarise the Supreme Court’s decision. In part two, we consider how the Supreme Court has interpreted the duties owed by directors in the Companies Act. In the final part of our series, we set out practical guidance for directors.
The Supreme Court unanimously dismissed the directors’ appeal. It ruled that the directors breached their duties as directors under sections 135 and 136 of the Companies Act, in the same way that the Court of Appeal had found.
The Supreme Court also upheld the liquidators’ cross-appeal in relation to the amount of the directors’ liability. The Court of Appeal had ruled that there was insufficient evidence on this point, and remitted the proceedings to the High Court. The Supreme Court disagreed, ordering the directors to pay $39.8 million plus interest and costs to Mainzeal’s liquidators (with an apportionment between directors).
The Supreme Court ruled that, once a company is insolvent or bordering on insolvency, directors are required to have regard to the interests of creditors. The Court said that sections 135 and 136 apply that policy using language that makes it clear that their purpose is creditor protection.
Breach of section 135
Section 135 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.
The Court ruled that liability under section 135 depends on:
- a manner of trading that creates a likelihood of substantial risk of serious loss to creditors (to be assessed objectively); and
- fault on the part of directors by allowing the company to trade in that manner in circumstances in which they either recognised, or if they had acted reasonably and diligently, would have recognised, that risk.
The Supreme Court upheld the findings of the High Court and Court of Appeal that from at least 31 January 2011 the Mainzeal directors were in breach of section 135, for the following reasons:
- Mainzeal had been trading while balance sheet insolvent for many years. This was largely because significant amounts of money had been extracted from it for the benefit of its corporate group by way of advances that were not practically recoverable.
- Advice was given by external advisors that additional capital was required. Such capital was not provided.
- From 2008 Mainzeal generated little, if any, operating profit.
- The directors were aware of the precariousness of Mainzeal’s position.
- The directors could not reasonably have relied on assurances of support given to them by other companies in the broader group as mitigating the risk to creditors sufficiently to ensure compliance with section 135. These assurances were neither legally nor practically enforceable.
In short, the Court concluded that from 31 January 2011, the directors allowed Mainzeal to trade in a manner that was likely to, and did, create a serious risk of substantial loss to creditors. The judges said that Mainzeal was trading in such a manner that would have been apparent to the directors if they had acted with reasonable skill and diligence.
Breach of section 136
Section 136 of the Companies Act provides that a director must not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so.
The Court rejected arguments from the directors that:
- section 136 cannot apply to a course of trading (as opposed to incurring particular obligations); and
- liability under section 136 depends on affirmative agreement to the incurring of particular obligations as opposed to a general agreement to continued trading.
The Supreme Court agreed with the Court of Appeal that the directors breached section 136 in respect of four major projects. Although the directors argued that these breaches had not been specifically argued or pleaded, the Court considered that this aspect of the case was squarely on the table at trial. The Court also upheld the Court of Appeal’s liability findings in respect of all obligations entered into after 5 July 2012.
How should loss be determined?
Having found the directors in breach of their duties, the Court considered how to determine the loss for which the directors should be liable. There were two ways in which this could be assessed:
- first, under the net deterioration approach, the Court considers the extent, if any, that the financial position of the company (and that of its creditors as a whole) deteriorated between breach and liquidation dates; and
- second, under the new debt approach, the Court considers the gross amount of debt that was taken on following a breach of duty, and that remained unpaid at the date of liquidation.
Traditionally, loss for these types of breaches have been assessed under the net deterioration approach. If applied here, that would mean that the directors would not be liable for any loss, because the net financial position of the company actually improved after breach.
The Supreme Court ruled that the proper approach to quantification in respect of the section 135 claim was net deterioration. This is primarily because net deterioration reflects loss to the creditors as a whole and is consistent with the language of section 135 which is directed to substantial risk of serious loss to creditors generally rather than individual creditors. Because no net deterioration had been proved, the liquidators were not entitled to an award of compensation in respect of the established breach of section 135.
For liability under section 136, however, the Court agreed with the liquidators that a new debt approach was the proper measure of loss. It said that section 136 is focused on losses to particular creditors including groups of creditors. Given this, it said that the most logical basis for quantification is the loss that those creditors suffered.
The Supreme Court also concluded that, in contrast to the Court of Appeal, it had adequate evidence to quantify the loss associated with the breaches of section 136, and assessed that loss at $39.8 million.
Directors’ liability to the liquidator
The Court held that the Companies Act provides the Court with flexibility as to the orders it could make against each director.
The Court said that the total assessed loss, $39.8 million, was both a starting point and a maximum for the directors’ individual liability.
The Court held that one of the directors, Mr Yan was held liable for the full amount. It held that the liability of each of the remaining directors was limited to one sixth of that total.
The directors were also liable for interests and costs.
As the Supreme Court recognised, the Mainzeal judgment addresses issues that are “of fundamental importance to the business community”. We agree. In our view, it is important that the law on directors’ duties strikes the right balance between allowing directors to take business risks, while at the same time ensuring that creditors’ interests are properly protected. It is also important that the law is sufficiently clear to give directors the necessary certainty to manage their business.
It remains to be seen whether the Supreme Court’s decision strikes the right balance, and gives directors that certainty.
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.