The need for legislative reform
The Supreme Court endorsed the Court of Appeal’s view that a legislative review of directors’ duties would be appropriate, observing that there is a “general incoherence” in relation to at least one aspect of those duties.
We agree. It is now 30 years since the Companies Act was passed. In our view, the directors’ duties provisions in the Act should be reviewed to ensure that they remain fit for purpose and that they strike the right balance between protecting creditors and allowing directors to exercise their business judgment.
Balance between creditor protection and directors’ business judgment
The Supreme Court observed that the Companies Act must balance two competing policy tensions, giving directors a wide discretion in matters of business judgment, while at the same time ensuring that creditors are protected from directors abusing their powers.
This tension was considered most recently by the United Kingdom Supreme Court in the Sequana decision. In that case, the Court said that directors are required to take into account the interests of creditors, but only when there is no reasonable prospect of the company avoiding liquidation.
In Mainzeal, by contrast, the New Zealand Supreme Court ruled that the New Zealand Companies Act is much more focused on creditor protection. It ruled that the New Zealand Act resolves the tension between directors’ business judgment and the protection of creditors, in favour of creditors. The Act, it said, “reflects a policy of creditor protection.”
Accordingly, the New Zealand Court said that it only derived “limited assistance” from the Sequana case, and that the New Zealand Act contemplates that directors may incur liability “well before” the trigger for liability in the United Kingdom.
As a result, New Zealand’s company law prohibits directors from accepting levels of business risk that are permissible in other jurisdictions.
The Supreme Court ruled that section 135 of the Companies Act, which is titled “reckless trading”, does not require directors to act recklessly in order to incur liability. Instead, it is enough that they act negligently (in creating a substantial risk of a serious loss to creditors). The Supreme Court said that the term “reckless” is only used in the heading of the section, not the body, and that the heading is “an artefact of the legislative history.”
Traditionally, section 136 was seen as prohibiting directors from specifically agreeing to enter into particular obligations. The Supreme Court has interpreted the section so as to apply to all obligations that are incurred as an inevitable consequence of a manner of trading, even if the directors were not aware of them and even if they were not voluntarily assumed. In addition, the Court has ruled that the section allows for claims by new creditors, even if the position of creditors as a whole improves by continued trading such that there is no claim under section 135 for reckless trading.
Claims by individual creditors
Normally when a company enters into a formal insolvency, the liquidator or receiver will bring a claim for the benefit of the company (and therefore creditors as a whole). In Sequana, the United Kingdom Supreme Court emphasized the importance of this, saying that it is the company’s creditors “as a whole” who gain an interest in the company when the company is insolvent. This is because individual creditors may have different (and even conflicting) interests.
The New Zealand Supreme Court did not follow this approach. It said that section 301 of the New Zealand Companies Act gives each creditor the right to bring claims for compensation directly against directors, without the need to rely on a liquidator to bring a claim.
Section 301 gives a liquidator the right to sue a director for (1) misapplied money or for (2) compensation for breach of sections 135 and 136. However, it only gives creditors the right to sue a director for (1) misapplied money. Despite this, the Supreme Court said that it was “not sensible” that section 301 doesn’t also give creditors a right to sue a director for (2) compensation for a breach of sections 135 and 136.
The Supreme Court concluded that there had been a drafting slip in section 301, and that the reference to creditors suing for misapplied money should have been a reference to creditors suing for compensation for a breach of sections 135 and 136. It said that this was a purposive interpretation, and that section 301 should be interpreted in accordance with this purpose, rather than the words. In order to determine that purpose, the Supreme Court relied on a submission from the Department of Justice to the Select Committee considering the Act.
In our view, any legislative review should consider whether the Companies Act should allow such direct claims. Otherwise, there is a real risk that creditors will be in a race to the courtroom door, trying to secure payment of their debts by directors in priority to the payment of other creditors’ debts. That would upend the liquidation process and the policy of pari passu distributions to unsecured creditors, and result in unnecessary and inefficient litigation.
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.