Supreme Court decision on duties and liability of directors of insolvent or near insolvent companies
Updated: Sep 10, 2021
A brief summary for directors and their general accountancy advisers
Since this decision (in September 2020) and the Court of Appeal’s decision in Yan v Mainzeal (in March 2021) we have seen increasing numbers of directors seeking advice on the scope of their duties where their companies are in financial difficulty.
The law in this important area is not without controversy – a point noted by the Supreme Court. That Court has also recently granted leave for the Mainzeal decision to be appealed, so the law is likely to be further developed in the near future.
What happened in Debut Homes?
The key facts in the Debut Homes case were:
The Company was run by a sole director and carried out residential property developments. It was placed into liquidation in March 2014.
The High Court found that the Company had been “balance sheet insolvent” (its liabilities were greater than its assets) since 2009, but it had been supported by shareholder advances and had been “cashflow solvent” (able to pay its debts as they fell due) until late 2012.
By then, cost overruns and increasing debt meant the Company was in real financial difficulty. Accounting advice at that time forecast a deficit of $130,000 following the completion and sale of the remaining titles in the development. The deficit would mean the IRD would not be paid all of the GST due to it.
Based on that advice, the director decided that the Company should cease trading after completing and selling the remaining unfinished properties.
At the date of liquidation (after the sale of the properties), approximately $400,000 was owed to the shareholders or their Trust and there were trade creditors of $28,700 and a GST debt of $450,000 (including $84,000 interest and penalties).
Which director duties were breached?
Following High Court and Court of Appeal hearings, the case advanced to the Supreme Court. That Court found that the director had breached his duties under the following provisions of the Companies Act 1993 (Act):
Section 135, known colloquially as “reckless trading”. This duty prohibits directors from agreeing, causing or allowing the business of a company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors;
Section 136, which prohibits directors from agreeing to a 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; and
Section 131, which requires directors to act in good faith and in what they believe to be the best interests of the company.
(Although they were not referred to in Debut Homes, there are other statutory duties including section 133, which requires directors to exercise their powers for a proper purpose, and section 137 which requires directors to exercise the care diligence and skill which a reasonable director would exercise in the circumstances. The Court did consider section 138, which entitles directors, in certain circumstances, to rely on reports, statements, and financial data and other information prepared or supplied, and on professional or expert advice given, but found that it did not apply in this case).
The Supreme Court ordered the director to make a contribution of $280,000 towards the assets of the Company for distribution to the Company’s creditors. So that the contribution was applied solely to unrelated creditors, the liquidators were granted leave to reapply to the Court for an increase in that contribution if parties related to the director succeeded in proving in the liquidation as unsecured creditors the amount owed to them.
The Court helpfully summarised its conclusions on director duties as follows:
If continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading will be reckless trading (in breach of section 135 of the Act). This applies even where:
continued trading is projected to result in higher and better returns to some creditors than would be the case if the company had been immediately liquidated; or
the Company’s overall deficit is projected to be reduced.
Section 131 will not be breached if the director honestly believed they were acting in the best interests of the company. However, it will be breached if a director, in an insolvency or near-insolvency situation, fails to consider the interests of all creditors. Such a breach may be exacerbated by a conflict of interest (for example, where a director has guaranteed certain debts of the company and acts to reduce their exposure under the guarantee).
Informal mechanisms (such as various types of informal creditor arrangement) may be used for dealing with an insolvency or near insolvency situation. However, these must be used in a way which accords with directors’ duties and the scheme of the Act.
Directors who allow a clearly insolvent company (one which has no prospect of salvage) to continue trading without using one of the available formal or informal mechanisms will be in breach of their duties as directors.
Where a breach of director duties occurs, relief will be granted to the company (or in certain circumstances its creditors) under section 301 of the Act. Such relief can be compensatory or restitutionary in nature depending on the situation.
In determining the appropriate relief, the Court must take account of all the circumstances, including the nature of the breaches, the level of culpability of the director, causation, duration of the breach, the need to hold the director to account and what is required to reverse the harm to the company.
Directors of insolvent or near insolvent companies which are not projected to be salvageable will risk personal liability for breach of their duties as a director unless they initiate a formal mechanism (such as liquidation, creditors compromise, voluntary administration or receivership), or an informal mechanism which will in effect produce the same result.
The Court made it clear that different considerations can apply in relation to the duty to avoid reckless trading (section 135) where the relevant business was of a high risk/high reward nature, or where the business might be salvageable (for example, where the business is suffering temporary liquidity issues).
TWA Legal Limited frequently assists Chartered Accountants and their director clients to apply these principles in practice. We can also advise on the factors to be taken into account to establish whether a company in financial difficulty may be salvageable, and suggest practical steps for directors to take to minimise the prospect of liability for breaches of duty.