Court of Appeal highlights need to amend the Companies Act in latest Mainzeal decision

The Court of Appeal has released its decision in the claim against the former directors of Mainzeal,[1] upholding the decision that they were liable for reckless trading, and also finding them liable for incurring obligations without the reasonable belief that the company will be able to perform the obligation when required. However, the Court of Appeal overruled the initial award of damages, and sent the proceedings back to the High Court for damages to be reconsidered. This has left the outcome for creditors still unclear many years after the company was liquidated.

The Court of Appeal also called for a review of the Companies Act 1993 (Act), saying:

“The legislation governing insolvent trading in New Zealand is unsatisfactory in a number of respects. The Act should be reviewed to ensure that it provides a coherent and practically workable regime for the protection of creditors where directors decide to keep trading in circumstances where a company is insolvent or near-insolvent.”

Background

Mainzeal was a well-known New Zealand construction company, building everything from large-scale residential developments to significant commercial projects. In 1995, the majority shareholding in Mainzeal’s holding company was purchased by a Chinese investment consortium (Richina Pacific), headed by Richard Yan. By 2004, Mainzeal was wholly owned by Richina Pacific. Mr Yan was a director of Mainzeal, and was joined by Dame Jenny Shipley, Peter Gomm, and Clive Tilby.

From 2004, Richina Pacific regularly extracted funds from Mainzeal for use elsewhere in the group, particularly for investment in China of approximately $35 million. In return, Richina Pacific provided Mainzeal support for its ongoing operations, usually either by being a guarantor for Mainzeal’s construction bonds, by providing those construction bonds itself, and providing “letters of support” in which it said it would provide financial assistance when needed.

The group was restructured in 2009, after a difference in view arose amongst the shareholders of Richina Pacific, some of whom did not want to have investments in New Zealand. From April 2009, Mainzeal was expected to be a standalone business entity, financially self-sufficient from Richina Pacific. Despite this expectation, after the restructuring Richina Pacific continued to request funds from Mainzeal, and continued to provide letters of support.

Following a difficult trading period in 2012, Richina Pacific declined to provide further support to Mainzeal, and Mainzeal went into receivership in early 2013, followed soon after by liquidation. Unsecured creditors claimed approximately $110 million. The liquidators commenced proceedings alleging breaches of sections 135 and 136 of the Act.

The High Court’s decision

In the High Court, Cooke J decided that the directors of Mainzeal had breached section 135 of the Act and were liable for reckless trading, noting that:

• Mainzeal’s financial trading performance was generally poor and prone to significant one-off losses, which meant it had to rely on a strong capital base or equivalent backing to avoid collapse.
• There was no assurance of group support on which the directors could reasonably rely if adverse circumstances arose.
• Mainzeal was trading while balance sheet insolvent because the intercompany debt was not in reality recoverable.

Justice Cooke decided that the directors were liable to pay a cumulative amount of $36 million.

No section 136 breach was made out on the evidence presented. The relevant contractual documentation was not in evidence, the particular obligations arising from four key construction contracts had not been put to the directors, and nor were the reasons for believing that the obligations would be performed challenged at trial.

The Court of Appeal’s decision

The Court of Appeal first considered whether the directors breached sections 135 and 136 of the Act, and then looked at how compensation for the breach of those duties should be assessed.

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 Court of Appeal upheld Justice Cooke’s decision in the High Court, confirming that the directors were liable for reckless trading. They said:

“Mainzeal had for many years adopted a deliberate policy of trading while balance sheet insolvent, using creditors’ funds as working capital. The directors knew this. As O’Regan J observed in Fatupaito v Bates, where a company has negative shareholders’ funds the decision to keep trading is a decision which necessarily involves risk for creditors. Directors must be very cautious before embarking on a course of continued trading, in the hope that this will enable the company to restore solvency. In the present case, the directors were not cautious…

In those circumstances, the one thing that it was not open to the directors to do was to continue to trade on without taking urgent corrective action.”

This may not have been determinative if the directors had been actively exploring their options. The Court of Appeal pointed out that:

“It was reasonable for the directors to take some time to explore all realistic alternative courses of action and endeavour to avoid an insolvent liquidation. If they were actively engaged in seeking advice and attempting to address these issues, they could not be criticised and would not be exposed to liability under s 135. It was their striking failure over an extended period to engage with the realities of the company’s situation and take any meaningful action to address those issues that leads us to confirm the Judge’s finding that they breached s 135 no later than 31 January 2011.”

Breach of section 136: incurring an obligation without reasonable grounds to believe it can be met

Section 136 provides 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.

In the High Court, Cooke J found that there was insufficient evidence to determine whether the directors had breached that provision.

The Court of Appeal decided 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 regarding specific obligations that were entered into. Instead, the Court of Appeal said that:

“We do not consider that it was necessary for a claim in respect of the obligations arising out of these four projects to be specifically pleaded, or put to the directors, in order for the liquidators to succeed in respect of these obligations. Rather, we have found that the global claim that the directors should not have agreed to Mainzeal entering into new obligations from 31 January 2011 onwards succeeds, at least so far as this subset of obligations is concerned, for the (generic) reasons in relation to the company’s overall financial position and trading strategy that were pleaded and argued at trial by the liquidators.”

The Court of Appeal therefore found that the directors had breached section 136.

Compensation

A significant portion of the High Court’s decision was devoted to calculating the amount of compensation payable by the directors for the breach of section 135. The amount ordered to be paid was based on the “entire deficiency” in the liquidation.

The Court of Appeal decided that the “entire deficiency” approach was not the appropriate basis for compensation for a breach of section 135. They noted that this was “not a case where, prior to the breaches of duty by the directors that were the subject of these proceedings, the company was solvent”, and the directors should not be liable for something that was not attributable to their conduct.

The Court of Appeal then went on to consider the “new debt” approach to calculating compensation. They said that:

“one of the policy concerns at which ss 135 and 136 are aimed is the risk to new creditors of dealing with hopelessly insolvent companies, in circumstances where the directors should have made the decision to stop trading.”

Other countries, including the United Kingdom, have statutory schemes that enable directors to be held liable for new debt in these circumstances. However, in New Zealand, section 135 is framed to consider creditors and the business as a whole. The new debt approach was therefore held not to be available.

However, the new debt approach is available for a breach of section 136. The Court of Appeal referred to the recent decision of Debut Homes,[2] and explained that:

“in order to make s 136 work in practice, the new debts incurred in breach of that provision must be treated as a form of harm to the company, disregarding offsetting benefits to the company from the relevant transactions. This approach is not without its difficulties, but is preferable to adopting an approach that renders s 136 a dead letter in many of the cases where its policy rationale is squarely engaged.”

The quantification of the amount payable under the new debt approach has been referred back to the High Court for determination as the Court of Appeal was not in a position to determine this amount. There has been no indication of what the new damages award will be, but the liquidator has indicated that they expect a significant increase, possibly up to $63 million, plus interest.

Comment

The risk of a breach of section 136 should become a serious consideration for all directors of a company with questionable ongoing and contingent solvency. In this decision, the Court of Appeal has held that while Mainzeal did not need to cease trading, continuing to enter into obligations without a reasonable belief in the ability to perform them was a breach of section 136. However, quite how a large construction company could continue to operate without taking on substantial new contracts was not discussed.

The manner in which Mainzeal was governed from 2004 onwards makes for bad reading, and both the High Court and the Court of Appeal concluded the directors clearly breached their duties to the company in light of this poor governance. The difficulty both courts appear to have grappled with is deciding which of section 135 or 136 is then best suited to provide a remedy for those breaches.

In addition, the question of compensation payable for breaches of these directors’ duties is still very uncertain. The Court of Appeal specifically noted that the new debt approach to compensation had difficulties, and called in the judgment for these provisions of the Act to be reviewed. It would be useful to see some certainty in the legislation, both around the duties themselves and the damages payable for breaches of those duties.

It is unfortunate that the proceeding now has to return to the High Court for damages to be assessed, and with the potential for further appeals. As has been seen in the recent consultations on access to justice, there can be considerable delays in obtaining hearing time in the courts. Creditors who are waiting for this litigation to end to see if there will be any money left over to repay them could face many more years of delay.

With a potential appeal to the Supreme Court, and the referral of the damages issue back to the High Court, this proceeding is not over yet. In the meantime, if you have any questions about this decision, or about the duties that you hold as a director, please contact our litigation and dispute resolution team.