The Supreme Court has released its decision in the claim against the former directors of Mainzeal (Richard Yan and others v Mainzeal Property and Construction Limited (In Liq)  NZSC 113), upholding the Court of Appeal’s decision that the directors were liable for both reckless trading and for incurring obligations without the reasonable belief that the company will be able to perform the obligation when required.
The Supreme Court also determined how damages should be calculated, overruling the Court of Appeal’s decision to remit the case to the High Court for damages to be determined. This long running case is now finally at an end.
The liquidators made a number of concessions in relation to the amount claimed, so that the question of damages could be determined immediately, and wouldn’t require a further hearing. The Supreme Court came up with a damages amount of $39.8 million plus interest accrued since 2013, for which Yan was liable for the full amount, but the other directors only a portion ($6.6 million plus interest each).
The Supreme Court’s approach
The Supreme Court undertook a full review of the origins of the relevant section of the Companies Act 1993 (Act), noting that the duties of directors and the rights and interests of company creditors have their origins in common law and equitable principles.
Breach of section 135: reckless trading
Under section 135, a director must not let 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 Supreme Court noted that the interpretation of section 135 could sit on a continuum from a subjective approach where “liability would arise only if a director recognises that certain trading activity is likely to create a substantial risk of serious loss to creditors and, despite such recognition, nonetheless agrees to the company engaging in, or causes or allows it to engage in, that activity” to an objective approach, where the likelihood of substantial risk of serious loss is assessed “without regard to what the director knew or ought to have known. All that has to be shown is that the director agreed to, allowed or caused trading in that way.” In the middle of the continuum are two fault-based approaches, a business judgment test under which liability depends on irrationality, or a test based on negligence.
The Supreme Court decided that:
- “An objective approach is to be taken in determining whether the business of the company was carried on in the prohibited manner (so that subjective awareness of the likelihood of substantial risk or serious loss is not necessary).
- However, when assessing whether the actions of the directors in agreeing to, or causing or allowing that trading were in breach of s 135, the courts will proceed on the basis of those facts and circumstances of which the directors were aware, or should have been aware, if exercising appropriate care, skill and diligence…
- As to the levels of care, skill and diligence required, the more complex the company the higher the level of skill and diligence expected of a director.”
The Court determined that on a matter of principle, “is undesirable for a company to trade on in circumstances in which those who deal with it in the future are exposed to substantial risk of serious loss; this irrespective of the benefit trading on may confer on existing creditors.” Directors of an insolvent, or nearly insolvent, company are entitled to take time to take stock of the situation and obtain advice, but this can only be a short-term situation. “The period of time for directors to take stock will be what is reasonable in the particular circumstances (including the complexity of the company’s affairs and the urgency of the presenting situation).”
In this case, the directors were in breach of section 135, and permitted Mainzeal to continue to trade beyond a reasonable time.
Breach of section 136: incurring an obligation without reasonable grounds to believe it can be met
Section 136 states that a director of a company 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.
Previously this section has been used in connection with particular transactions, however the Supreme Court agreed with the reasoning of the Court of Appeal in respect of section 136, which had said that section 136 is not only concerned with entry into specific obligations, instead finding that:
“the class of obligations to which the directors agreed was much broader than this: it extended to all new obligations undertaken in the ordinary course of Mainzeal’s business”.
As a result, there did not need to be detailed evidence about the considerations taken by the directors when specific obligations were entered into.
The Supreme Court decided to squarely set out the implications of the judgment for directors in the future. Every director should read these points in full (at paragraphs 269 to 273 of the judgment), but in summary:
- Directors have a continuing obligation to monitor the performance and prospects of their company, and they should squarely address the future of the company if such monitoring reveals concerns about the company’s solvency position, or other adverse factors.
- If there is potential for risk of loss to creditors or doubt as to whether there is a reasonable basis for belief that new obligations will be honoured, the directors must decide how the potential for breaches of sections 135 and 136 can be avoided. The courts will allow a reasonable time for directors to take professional or expert advice from sources independent of the company and to decide what course of action they should take.
- Directors should also recognise that a long-term strategy of trading while balance sheet insolvent is generally not acceptable.
- The courts must apply a standard of reasonableness when assessing the decisions of directors. In doing so, the courts will recognise that such decisions are likely to involve the exercise of business judgment.
As a result of this decision, directors will need to take a cautious and well-documented approach to a company’s operation, and ensure that they have comprehensive Directors and Officers’ Insurance cover. The decision also emphasised the importance of obtaining independent advice.
This is the final decision from the courts on Mainzeal, however, you may still hear more about this case. The Supreme Court reiterated the call from the Court of Appeal for a full review of the directors’ duties provisions in the Act.
We will provide a more detailed analysis of this decision in the days to come. In the meantime, if you have any questions about this decision, or about the duties that you hold as a director, please contact a member of our litigation and dispute resolution team.
Disclaimer: The content of this article is general in nature and not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose.