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Directors duties and the Supreme Court

The Supreme Court has recently reviewed the law relating to director’s duties making it clear that trading while insolvent will amount to a breach of a director’s duties even if a director believes that continued trading may benefit the company’s creditors as a whole: Madsen-Ries and Levin as Liquidators of Debut Homes Limited (in liquidation) v Cooper [2020] NZSC 100.

Background

Mr Cooper was the sole director of Debut Homes Limited (Debut).  Debut was a residential property developer.  By the end of 2012 Debut was balance sheet insolvent.  Mr Cooper, on advice from Debut’s accountant, decided to wind down the company’s operations as opposed to ceasing to trade.  The wind down involved Debut completing four residential properties.  This strategy enabled Debut to pay off some of its creditors.  However, Mr Cooper knew the plan would still leave Debut owing GST on the sale of the properties which was estimated to be over $300,000.  On 7 March 2014 Debut was placed into liquidation by IRD owing it a GST debt of $450,099 (including penalties and interest) and trade creditors approximately $28,700.

The High Court found that Mr Cooper had breached his duties as a director and he was ordered to pay the liquidators $280,000.  However, the Court of Appeal overruled that decision.  It found that Mr Cooper’s decision to continue trading was, overall, for the benefit of all of Debut’s creditors.  The Supreme Court overturned the Court of Appeal’s decision.  It found that Mr Cooper was in breach of the key duties of the Act.  The decision therefore provides a useful summary of those sections and their requirements.

Section 135 – Reckless Trading

The Act prevents a director of a company from agreeing 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 to cause or allow the business to be carried out in that manner.

The Supreme Court had no difficulty finding a breach of s 135.  As at late 2012 Mr Cooper knew that Debut’s financial position was not “salvageable”.  He also knew that the wind down strategy would result in the GST deficit.  The Court found that continuing to trade on in these circumstances was not merely a substantial risk but rather, “It was a certainty”.

Crucially:

It is also not an answer to s 135 that completing the properties was a sensible business decision in that it had the potential to benefit some of the creditors by providing higher returns than immediate liquidation would have done.  It is not possible to compartmentalise creditors in this fashion.  If continued trading would result in a shortfall, as Mr Cooper knew it would, then there was a breach of s 135, whether or not some creditors would be better off and whether or not any overall deficit was projected to be reduced.

The Court also referred to the compromise provisions in the Act and accepted the liquidator’s argument that there were formal and informal options that Mr Cooper could have explored to avoid breaching the Act and as alternatives to Debut’s immediate liquidation.

Section 136 – Duty in Relation to Obligations

Section 136 provides that a director must not agree to a company incurring an obligation unless the director believes at the time, and on reasonable grounds, that the company will be able to perform the obligation when required to.

Again, the Supreme Court had no difficulty in finding breach.  It rejected Mr Cooper’s argument that the section was confined to contractual obligations.  Mr Cooper made the decision to enter into the sale and purchase agreements for the properties knowing that would cause Debut to incur GST obligations that it could not pay. It was not legitimate for him to enter into a course of action to give some creditors a higher return at the expense of incurring new liabilities that would not be paid or as the Court said “to rob Peter to pay Paul”.

Section 131 – Duty to Act in Good Faith and in the Best Interest of the Company

Section 131 of the Act requires directors, when exercising their powers or performing duties, to act in good faith and in what the director believes is in the best interests of the company.

This section involves a subjective test.  In summarising the law, the Supreme Court noted that courts are not well equipped to second-guess business decisions made by directors as to what they honestly believed would be in the best interests of the company.  However, exceptions may arise where there is no evidence of any actual consideration of those best interests; where there is an insolvency or near-insolvency situation and a failure to consider the interests of creditors; where there is a conflict of interest or where a director’s decisions are irrational.

The Supreme Court found that Mr Cooper had failed to consider the interests of all of the creditors in an insolvency situation.  He had only considered the interests of some of them.  Furthermore, there was a conflict between his interests and Debut’s.  Mr Cooper favoured the repayment of the debts to secured creditors which, in turn, reduced his own personal liability, and the liabilities of his trust, under guarantees over paying GST and some trade creditors.

Assessment

This case highlights the risk to directors when a company is insolvent or near – insolvent.  It is not acceptable for a director to make assessments about the benefits of trading on without considering the interests of all of the creditors and not just some of them.   Directors need to carefully consider their options in this situation including creditors compromises, voluntary administration or liquidation.

 

This article is current as at the date of publication and is only intended to provide general comments about the law. Harkness Henry accepts no responsibility for reliance by any person or organisation on the content of the article. Please contact the author of the article if you require specific advice about how the law applies to you.

For further information

KFS-2

Karen Shaw

MDB-1

Murray Branch

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