Supreme Court releases decision on breach of directors’ duties

Friday, September 25, 2020

The Supreme Court has issued a new decision, Madsen-Ries and Levin as Liquidators of Debut Homes Limited (in liquidation) v Cooper [2020] NZSC 100, reviewing the law relating to breaches of directors’ duties.  The decision sets out important guidance for company directors and their advisors when facing hard trading conditions.  Throughout the decision, the Supreme Court emphasised that companies in insolvency or near-insolvency situations should use the various formal mechanisms provided for in the Companies Act 1993 (Act), rather than trying to trade through.

Background

The defendant, Leonard Cooper, was the sole director of Debut Homes Ltd.  At the end of 2012, one of Debut Homes’ financiers decided to cease funding them.  Based on advice from their accountant, Mr Cooper decided to wind down operations, completing existing developments but not taking on any new projects.  Mr Cooper expected that there would be approximately $300,000 owing in GST once the business was wound down.

For the next year, Debut Homes completed the remaining projects, and sold the houses.  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.  When the IRD placed Debut Homes into liquidation in March 2014, there was money owing to the IRD, trade creditors, and Mr Cooper’s family trust.

The High Court and Court of Appeal

The High Court decided that Mr Cooper had breached his duties as a director, and ordered him to pay $280,000 to the liquidators of Debut Homes, to cover some of the shortfall to creditors.

The Court of Appeal overturned the High Court’s decision, determining that the decision to complete the houses was a “perfectly sensible business decision”.

The Supreme Court’s conclusions on directors’ duties

The Supreme Court overruled the Court of Appeal, and restored the decision of the High Court.  The Supreme Court reviewed each duty, considering each within the overall scheme of the Act.

Section 135 – reckless trading

Section 135 of the Act says that a director must not agree to the business of the company being carried on, or 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 creditors.

The Supreme Court decided that:

“If a company reaches the point where continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading will be in breach of s 135 of the Act… this applies 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.” (emphasis added)

A director can no longer claim that it was a sensible business decision to continue trading because doing so would provide higher returns than an immediate liquidation if a shortfall was inevitable.

Section 136 – duty to not incur obligations

Section 136 of the Act says that a director must not agree to the company incurring an obligation unless the director reasonably believes that the company will be able to perform the obligation as and when required.  The focus of this section is on a particular obligation, rather than the business as a whole.

The Supreme Court’s view on section 136 is that:

“it is not legitimate to enter into a course of action to ensure some creditors have a higher return where this is at the expense of incurring new liabilities which will not be paid.  In other words, it is not legitimate to ‘rob Peter to pay Paul’.”

Section 131 – duty to act in good faith and in best interests of the company

Section 131 of the Act requires a director to act in good faith, and in the best interests of the company.

The Supreme Court confirmed that this is a subjective test, and that the courts are not well-equipped to second-guess business decisions made by directors.  However, the Court also noted that there are a number of exceptions to the subjective test, including where:

  • there is no evidence of actual consideration by the directors of the best interests of the company;
  • in an insolvency or near-insolvency situation, there is a failure to consider the interests of creditors;
  • there is a conflict of interest, or the action was one no director with any understanding of fiduciary duties could have taken; or
  • a director’s decisions are irrational.

In this case, Mr Cooper had failed to consider the interests of all creditors in an insolvency situation.  Instead he considered some creditors, but discounted the interests of others, including the IRD.

What should the director have done?

A director has a duty to act in the best interests of the company.  A vital component of this is maintaining solvency.

The Act has a number of mechanisms available for dealing with insolvency and near-insolvency situations:

  • a creditor’s compromise, which usually involves all of part of a company’s debts being cancelled, and must be approved by a majority of creditors;
  • a court-approved creditor’s compromise, where the court must also agree that the compromise is fair and reasonable to all creditors;
  • voluntary administration, which provides for the appointment of an administrator to maximise the chances of the company’s survival, and which also must be approved by a majority of creditors; and
  • liquidation, to wind up the operation of the company.

A feature of all of these is that the decision making is placed in the hands of either the creditors or an independent party.  The Supreme Court noted that:

“The removal of decision-making powers from directors in such circumstances is a recognition that directors are not the appropriate decision-makers in times of insolvency or near-insolvency.  This is because their decisions may be compromised by conflicting interests and, even where that is not the case, they may be too close to the company and its business to be able to take a realistic and impartial view of the company’s situation.”

If a company is or may be insolvent, a director must take into account the views of all of its creditors.  Quite when and how this is done remains a difficult balancing act.

Comment

If you are a director of a company which is in an insolvency or near-insolvency situation, it is critical for you to take steps to deal with the situation as quickly as possible.  This should include considering whether to utilise any of the mechanisms available through the Act, whether a creditors’ compromise, voluntary administration, or liquidation.

If you need advice on any of those options, please contact a member of our insolvency team.

A copy of the decision is available here.

 

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.

 

 

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