Mainzeal directors liable for reckless trading - what could this mean for other directors?

Thursday, April 4, 2019

The High Court has released its decision in the claim against the former directors of Mainzeal,[1] holding them liable for reckless trading in the years leading up to Mainzeal’s receivership.

Justice Cooke decided that Dame Jenny Shipley, Peter Gomm, and Clive Tilby all “acted in good faith, and with honesty”, but that they nevertheless breached their duties as directors. Richard Yan’s position was considered separately, as he was a director of both Mainzeal and its parent company, and had a clear conflict of interest. This decision should be carefully considered by anyone currently holding or contemplating a directorship.

Background

Mainzeal was a well-known New Zealand construction company, building everything from residential developments to large 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.

Richina Pacific regularly extracted funds from Mainzeal for use elsewhere in the group, particularly for investment in China. In return, Richina Pacific provided Mainzeal support for its ongoing operations, usually either by being a guarantor for Mainzeal’s construction bonds, or by providing those construction bonds itself.

The group was restructured in 2009, after a difference in view arose between 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.

Section 135: Reckless trading

The Companies Act 1993 provides that:

A director of a company must not

(a) agree to 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; or

(b) cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.

It is important to note that the prohibition is not on trading a company while it is insolvent. However, trading while insolvent will give rise to the possibility that section 135 will be breached.

Justice Cooke set out all of the various factors to be considered in respect of a claim of reckless trading. These were that:

  • the terminology of “agree” and “cause or allow” covers both directors who actually make the decision to carry on business in the relevant manner, and those who just go along with others’ decisions;
  • the relevant risk is that to creditors, not to the company – the concern is not that the company will be placed into liquidation, but that there will be a shortfall to creditors if that happens;
  • the risk to creditors must be substantial, not simply a normal business risk;
  • the risk must create a serious loss – a minor or modest loss is not relevant;
  • the manner of the operation of the business is the way that the business is undertaken and the decisions of the directors in relation to it, it encompasses issues beyond the question of whether to continue trading; and
  • there must be a causal link between the way that the business is being undertaken and the substantial risk of serious loss to creditors.

Trading while insolvent

A key focus of the case against Mainzeal’s directors was that they were trading while insolvent.

An assessment of solvency is the first step to determining whether the directors are trading recklessly. If a company is solvent, it is the shareholders’ funds that are at risk, not the creditors. If creditors’ funds are not at risk, there can be no breach of section 135. As Cooke J said:

“when a company is technically insolvent, or near to that point, it is not really the shareholders’ capital that is being risked any longer. In such a situation, the directors are risking the creditors’ money. To treat the creditors’ money as the capital of the business is not appropriate, and liability may follow if there is a substantial risk of serious loss to the creditors.”

However, assessing solvency is more complex when a company is part of a broader group. Justice Cooke acknowledged that “the group’s overall resources and policies will be relevant to assessing the particular company’s position, and the directors’ performance of their duties.”  In this case, Cooke J decided that the directors’ faith in the wider company was misplaced, and particularly that:

  • Richina Pacific’s expressions of support were not set out in clear terms, or in writing, and were not legally binding;
  • there was an expressed intention after the 2009 restructure that Mainzeal would be self-sufficient; and
  • Chinese regulations control the flow of funds out of China, and there was a real risk that funds would not be able to be provided at any given time.

Justice Cooke therefore decided that “the reliance on shareholder support was not reasonable in the circumstances”, and that the directors were therefore allowing Mainzeal to trade while it was insolvent.

Financial trading position

Despite the fact that Mainzeal was insolvent, and lacking support from the wider group, the directors may still have been in a comfortable position if Mainzeal’s trading position was sound. However, it is a feature of the construction industry that it is a volatile sector, with a significant risk of large one-off losses. It is this characteristic of the industry that has caused so many construction company failures in recent years, including now the voluntary administration of Arrow International.

New Zealand’s leaky building crisis has also put many construction companies in a precarious position. In the few years leading up to Mainzeal’s receivership, there were an increasing number of leaky building claims against Mainzeal. Justice Cooke recorded that:

“Mainzeal’s approach to provisioning for such liabilities involved it only making provision for the expected cash demands for each claim in that financial year, for example legal costs, with no provision made for any ultimate liability.”

Mainzeal’s method for settling these claims was to conduct any necessary repairs itself. Justice Cooke agreed that this was an effective strategy, but that it created risk for a significant unprovisioned loss if any claim was not effectively managed by that process.

Based on these factors, Cooke J decided that that Mainzeal’s trading position was vulnerable to failure, and there was a consequential risk of a substantial loss to creditors.

The High Court’s decision

In making the above findings, Cooke J said that:

“The policy of trading while insolvent is the source of the directors’ breach of duties, however, such a policy would not have been fatal if Mainzeal had either a strong financial trading position or reliable group support. It had neither.”

It was also a relevant factor that the directors did not seek any legal advice about their duties, even when they has concerns about the solvency of Mainzeal. Instead, responding to questions raised by Dame Jenny Shipley, Richard Yan made assurances which were accepted and relied on by the other directors. No advice was sought as to whether or not it was reasonable to rely on those assertions.

Justice Cooke therefore decided that:

“I am satisfied that the risks taken by the directors cannot be regarded as normal business risk taking. On the contrary, the directors allowed Mainzeal to continue to trade in highly unorthodox circumstances, which involved a very significant risk to the creditors. The directors here were not taking the normal risks that are inherent in the operation of a company of Mainzeal’s size.”

Justice Cooke summarised his decision that the directors were liable, saying:

“there are three key considerations that cumulatively lead me to conclude the duties in s 135 were breached:

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

Lessons for directors

Directors may well be concerned after reading this decision, wondering if anything could have been done by the Mainzeal directors to prevent this result. However, there are a number of aspects of the decision that point at steps that could have been taken. These include:

  • ensuring that the company is properly capitalised;
  • if reliance is placed on a wider group for solvency, ensuring that any assurances about funding are in writing, legally binding, and logistically possible;
  • particularly in high risk industries, adequate provisioning for an adverse event, to reduce the substantial risk of serious loss;
  • testing assurances and assumptions, using independent advice, to establish the reasonableness of views taken; or
  • as a last resort, resigning as a director of the company, if changes cannot be made to the company’s operation.

Richard Yan and Jenny Shipley, Peter Gomm, and Clive Tilby have advised that they are appealing this decision to the Court of Appeal. The liquidators are yet to state their position, but early indications are that they may also cross-appeal the size of the penalty awarded. It is likely to be late 2019 or early 2020 before any appeal is heard.

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. 

 

[1] Mainzeal Property and Construction Ltd (in liq) v Yan and Others [2019] NZHC 255

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.