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“when a company enters troubled waters” – the NZ approach to director conduct

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While Australia considers how it should re-shape its insolvent trading laws, this June 2016 New Zealand decision illustrates how our neighbour’s comparative legal approach works, although in a lay down misère case which the two directors did not defend.

 

NZ law

Without offering a detailed comparison, NZ law sets out the duties of a director under the heading ‘directors’ duties’ in its Companies Act 1993. The relevant sections, with Australia’s broadly equivalent Corporations Act 2001 (CA) provisions in italics, are:

s 131 (duty to act in good faith and in the best interests of the company); s 181 CA

s 135 (prohibition against reckless trading); s 588G CA

s 136 (duty to have company only undertake obligations with which it can comply); no real equivalent in the CA

and

s 137 (duty of care); s 180 CA.

Two remaining sections, not relevant in this case, are s 138, the director’s reliance on information and advice (s 588H(3) CA), and s 380, which is the new criminal offence of dishonestly incurring debt; s 588G(3) CA.

The main relevant issues here for Australian law reform are what types of actions on the part of a director constitute the taking of “a substantial risk of serious loss to the company’s creditors”. NZ case law draws a distinction between legitimate and illegitimate risks in business, only the latter warranting a finding of reckless trading: see Löwer v Traveller (2005) 9 NZCLC 263,889, where the Court found that the company’s circumstances warranted the shutting down of the business, not the taking of further extensive risks by way of continued trading.

Directors of a company facing insolvency are expected to address the reasons for the decline and put worthwhile strategies in place to address the situation if they decide to continue trading. Good commercial governance of the company is relevant; hence poor books and records will assist a liquidator’s claim.

Recklessness of course involves more than mere negligence, and the NZ courts have referred to the inherent risks of business, one that is accepted generally in the international debate about the promotion of proper entrepreneurial business conduct.  Directors may indeed have their companies take risks in business, this often being necessary to promote the company’s enterprise, but there is a balance required.

How well the law can set down a proper balance is a real test, although the limitations of the written law should be acknowledged, with other social and economic disciplines needed to support its purposes.

Attention to the promotion of a culture of corporate and tax compliance, to regulation of anti-competitive conduct, and to promotion of financial and business competence are but some supports that are needed for any laws that seek to protect creditors.

The bakers

The directors in this case had traded their bakery business from 2005 without much regard for the NZ tax authority in particular, and other creditors, each director withdrawing money for themselves along the way. The company was assessed to have been balance sheet insolvent in 2006, and cash flow insolvent by 2009, the company going into liquidation in 2015.

Of note is the fact that the directors appeared not to have taken any advice at all; for good reason they may have thought, because the advice would have been to shut the bakery down, and their line of tax free income.

The NZ liquidators succeeded in claims against the directors for:

  • breaches of duties to act in the company’s best interests, and in good faith, under s 131 of the NZ Companies Act 1993;
  • reckless trading – s 135;
  • agreeing to incur obligations without a belief that the obligations could be fulfilled – s 136; and
  • failing to exercise the care, diligence and skill that a reasonable director would exercise in the same circumstances – s 137.

Section 131

There was a breach of this section, the duty being a subjective one. It extends to creditors once a company is of doubtful solvency.

As to this,

If a director believes that the duty to act in the best interests of the company is a duty always to act in the best interests of the shareholders, and never in the interests of the creditors, in a situation of doubt as to the solvency of the company, the director cannot be said to be acting in good faith. Creditors are persons to whom the company has ongoing obligations. The best interest of the company includes the obligation to discharge those obligations before rewarding the shareholders: Sojourner v Robb [2006] 3 NZLR 808, (on appeal Robb v Sojourner [2007] NZCA 493; [2008] 1 NZLR 751).

The directors continued to trade while the company was insolvent. In doing so they disregarded the interests of the company’s creditors; in particular, they made extensive withdrawals from the company, presumably for their own benefit, throughout this period. As a result, the company and its creditors suffered increasing losses until the company was finally placed into liquidation. Such losses were suffered as a direct result of the directors’ failure to act in good faith and in the best interests of the company.

Reckless trading – s 135

The relevant breach in terms of the wording of s 135 was that the directors carried on their bakery business in a manner likely to create a substantial risk of serious loss to the company’s creditors.

The duty imposed is one owed by directors to the company (rather than to any particular creditor); the test is an objective one; and it focuses not on the directors’ belief, but on the manner in which a company’s business is carried on, and whether the modus operandi created a substantial risk of serious loss.

What the law expects “when a company enters troubled waters is a sober assessment by the director of an ongoing character, as to the company’s likely future income and prospects”.

Their reckless trading commenced in at least July 2009 in breach of their duties under s 135.

Section 136

They also allowed the company to incur obligations without believing at the time on reasonable grounds that the company would be able to pay when required to do so. Section 136 requires both a subjective and objective test.

Overlaps

While there is an overlap between the breaches of directors’ duties in ss 135 and 136, s 135 focuses on directors engaging in a course of action, and s 136 on incurring specific liability.

Section 137

Under s 137, a director of a company must exercise the care, diligence, and skill that a reasonable director would exercise in the same circumstances. The test is an objective one and the directors’ personal knowledge and experience are not relevant.

Here,

the defendants held positions as directors of a relatively small trading business common to the general business community and the economic culture of New Zealand. Reasonable and prudent directors would not extract substantial drawings from the company solely for their own personal benefit when their company was facing both balance sheet and trading insolvency. Reasonable directors would not carry on and incur further liabilities when they ought to have known that those obligations and liabilities were unlikely to be satisfied.

Damages

The standard approach to making orders under s 301 of the Act is to assess the extent of the deterioration in a company’s financial position between the date of breach and the date of liquidation. Once that figure has been ascertained, three factors – causation, culpability and the duration of the trading – are then relevant to the exercise of the court’s discretion.

On one aspect, culpability, which is linked to deterrence, the court expressed the range of the director’s involvement to be between “blind faith or muddledheadedness [and] actions or instances which are plainly dishonest”.

The outcome

Both these defendants bore culpability for the company’s eventual position. They were effectively the directing minds of the company and as directors they ought to have known over what was almost eight years of the company’s insolvency, that it was in dire and worsening financial circumstances. With this knowledge, they ought to have carefully proceeded in their management of the company, and in particular not favoured themselves personally at the expense of company creditors, but they failed to do so repeatedly. They were ordered to repay over NZ$300,000. CGES Limited (in liquidation and receivership) v Kelly [2016] NZHC 1465.

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