Director Duties When a Company is Faced with Insolvency

The recent decision of Debut Homes Limited (in liquidation) v Cooper [2020] NZSC 100 is especially relevant for company directors given the present financial uncertainties caused by COVID-19.  The case summarises director duties under the Companies Act 1993 (“the Act”) for companies facing insolvency.

In short, directors need to be extremely careful when their company is faced with liquidation. Where a company becomes insolvent, directors should look to the formal and informal alternatives to liquidation contained in the Act.  If those mechanisms fail, then generally the only other option is liquidation.

Choosing to continue trading while insolvent will expose directors to significant personal risk, even if directors have taken professional advice to continue trading.  If there is no reasonable prospect of returning to solvency, it will make no difference if directors honestly think that some of the creditors will be better off by continuing to trade.

It is noted that the Court did not decide whether it is legitimate for a business suffering temporary liquidity issues to continue trading in the hope of salvage and if so, for how long.

History

Mr Cooper was the sole director of Debut Homes Limited (“Debut”).  Debut was a residential property developer and had been balance sheet insolvent since 2009.  Mr Cooper made the difficult decision to wind down the company in 2012.

Mr Cooper was advised that completing and selling existing company projects would create a surplus of $170,000 to repay secured creditors.  Mr Cooper was also advised that completing those projects would result in GST payable of over $300,000.  No provision was made for the GST.

Debut completed and sold its remaining projects the following year.  In doing so, various debts were incurred and paid, both with secured creditors financing the projects, and unsecured trade creditors supplying materials and labour.  Mr Cooper focused on the position of those creditors, while neglecting to pay the GST payable on the sale of the properties.

For a period of approximately 18 months leading up to completion of the development work on the properties, Mr Cooper worked full-time for Debut and received no salary.

When the IRD placed Debut into liquidation in March 2014, there was money owing to the IRD, trade creditors, and Mr Cooper’s family trust.  Debut’s liquidators brought proceedings against Mr Cooper for a breach of director duties.

In the High Court Mr Cooper was found to be in breach of sections 131, 135, and 136 of the Act.  Mr Cooper was ordered to pay $280,000 compensation to the company under section 301 of the Act.  The High Court also rejected a section 138 defence that he was entitled to rely upon professional advice that he had taken at the time.  The Court of Appeal overturned that decision, saying that Mr Cooper had made a “perfectly sensible business decision”.  The Supreme Court reversed the Court of Appeal decision and re-instated the High Court decision.

Statutory Considerations

The Court considered the following director duties:

• Section 131: The duty to act in good faith and in the best interests of the company;
• Section 135: The duty to avoid “reckless trading”;
• Section 136: The duty not to agree to the company incurring an obligation unless the director believes on reasonable grounds that the company will be able to perform the obligation when due.

The Court rejected a section 138 defence (directors may rely upon professional or expert advice), finding that the professional advice received was too general in nature to act as a proper defence.

Section 301, which governs consequences for a breach of the Act, was also discussed.  When a company is placed into liquidation, section 301 of the Act empowers a Court to order that director to contribute such sum to the assets of the company by way of compensation as the Court thinks fit.

Court Analysis of Director Duties

Section 131 – Directors to act in good faith

Mr Cooper submitted that the steps he had taken improved the overall asset base of Debut and minimised the ultimate loss to creditors as a whole.

The Court noted that the section 131 test is subjective.  However, section 131(b) also requires directors to assess the interests of all creditors, not just some.  The Court held that Mr Cooper had failed to consider the interests of the IRD by not paying Debut’s GST obligations.

In effect, Inland Revenue (and thus the taxpayer) was being used as an involuntary bank.  Mr Cooper had subsequently breached section 131.

Section 135 – Acting in a manner likely to cause substantial risk to the company

Mr Cooper argued that completing the remaining company projects was a sensible business decision that had the potential of providing higher returns than immediate liquidation would have done.  Mr Cooper also did not consider Debut’s financial position as salvageable.

The Court noted that other formal and informal insolvency mechanisms were available under the Act to increase returns to creditors.  Had these not been available, the only proper course was liquidation.

The Court held that by continuing to trade and knowing that by continuing to trade would result in a shortfall, is a clear breach of section 135.

Section 136 – Incurring only obligations that the company can perform

Mr Cooper’s course of action effectively gave secured creditors (one of which was Mr Cooper’s own family trust) a higher rate of return at the expense of incurring other liabilities which would not be paid (GST).

The Court held this was a clear misinterpretation of section 136 by Mr Cooper.  The company was clearly not going to be able to perform its GST obligations, and it was not legitimate to “rob Peter to pay Paul”.

Key Learnings

If a company reaches the point where continued trading will clearly result in a shortfall to creditors and the company is not salvageable, then continued trading will be in breach of section 135 of the Act.

A breach will occur whether or not continued trading is projected to result in higher returns to some of the creditors than would be the case if the company had been immediately placed into liquidation, and whether or not any overall deficit was projected to be reduced.

There will be a breach of section 136 of the Act if directors agree to debts being incurred where there are no reasonable grounds to believe the company will be able to perform its obligations when they fall due.

When faced with insolvency, there will be no breach of section 131 if a director honestly believed it was acting in the best interests of the company.  However, there will be a breach of section 131 if a director failed to consider the interests of all creditors.

The emphasis is that at all times (including where a company is insolvent) directors must comply with their duties under the Act.

Daniel acknowledges the assistance of Andrew Hong in preparing this article.

Daniel is a Director and leads our Dispute Resolution Team. He can be contacted on 07 958 7477.