New Zealand Supreme Court reviews directors' duties (again)

Deciding the parameters of directors' personal liability for actions, or omissions, when a company continues to trade while it is or near insolvent requires a balance to be struck between allowing directors latitude to try to rescue the company and protecting the company's creditors.

In its decision in Mainzeal¹, the Supreme Court has confirmed where that balance lies in New Zealand. The Court's guidance will help directors navigate the often challenging path through a period of financial difficulty. Directors should tread carefully and seek advice when the company is insolvent or near insolvent.

Key takeaways

• Directors must monitor the performance of the company. Directors must monitor the performance and prospects of the company at all times, but this is particularly important where it may be approaching insolvency. If there is a substantial risk of serious loss to creditors or doubt as to whether obligations incurred will be able to be honoured, the directors need to address how they can continue to comply with their duties and protect creditors.
• Directors must act reasonably. Much of the Supreme Court's approach centres on the need for directors to act reasonably, as well as honestly and diligently. The Mainzeal directors relied on unenforceable assurances of support from group companies, which the Court found was unreasonable. This was a factor in the directors being found liable.
• Directors should take advice. Directors should take early advice as to how best to meet their duties in the circumstances. This will usually involve input from legal and financial advisors. The Court was critical of the Mainzeal board's failure to take external legal advice on solvency issues and their directors' duties under sections 135 and 136 until quite a late stage.
• Directors of complex companies will be held to a higher standard. Not all directors are held to the same standard. The more complex the company the higher the level of skill and diligence expected of its directors.
• Directors are allowed some time to take stock. If the company is in a position where there is a substantial risk of serious loss to creditors or doubt as to whether obligations incurred will be able to be honoured, the directors are allowed some time to take stock and decide on a plan of action. Directors will not generally be liable for continuing to trade during this period, but they might be if substantial new obligations are taken on without measures in place for them to be met.
• Directors continuing to trade need to have a sound strategy. If the directors decide to continue to trade, they must have a robust strategy to resolve the issues the company is having. A strategy of long-term trading while insolvent will not usually be acceptable.
• Creditors should be protected. The interests of both the creditors as a whole and of individual new creditors should be protected. Liability under section 135 is directed at protection of the creditors as a whole, and therefore compensation under this section is based on the net deterioration in the amount available to creditors during the period since the company should have ceased trading. Liability under section 136 is, however, directed at protection of individual creditors, and therefore compensation under that section is based on the amount of new debts incurred when there were not reasonable grounds for believing they would be honoured.

The History and the Outcome

The story of Mainzeal's collapse is well known. Mainzeal Property and Construction Limited went into receivership and was shortly thereafter placed in liquidation, owing approximately $110 million to unsecured creditors. The liquidators brought claims against the directors of Mainzeal, alleging the directors had agreed to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to creditors in breach of section 135 of the Companies Act 1993 (Act), and that the directors had agreed to the company incurring obligations to creditors at a time when they did not have reasonable grounds for believing that the company would be able to perform those obligations when required to do so, in breach of section 136 of the Act.

The liquidators succeeded in the High Court on the section 135 claim, and were awarded $36 million (down from a starting point of $110 million) in compensation, but they were unsuccessful on the section 136 claim. The Court of Appeal held that the directors had breached their duties under both sections 135 and 136. However, it concluded that the directors' breaches under section 135 did not result in any loss to the company, and so no compensation was awarded for that breach. The Court of Appeal ordered that case be sent back to the High Court to determine the amount of compensation due for the section 136 breach. The Supreme Court appeal intervened.

The Supreme Court found that the directors of Mainzeal had breached their duties under both sections 135 and 136 and ordered them to pay $39.8m in damages. Richard Yan was held liable for the whole amount and the other three directors' liability was limited to $6m each.

When do the duties under section 135 or 136 arise?

Directors have a duty, under section 135, not to 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 the company’s creditors.

Under section 136 they have a duty 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.

The point in a company's decline where these duties become relevant is not expressly linked to the company's state of solvency, or the time at which it becomes insolvent. When a substantial risk of serious loss arises, or when obligations are incurred with no reasonable grounds for believing they can be performed, will be entirely fact specific. The Supreme Court, when looking at the English cases, acknowledged the difference under English law where statutory liability for wrongful trading occurs at a potentially later stage in the company's decline.

The following diagram shows the English law triggers for directors’ liability.

Compare this to the New Zealand law position: A likelihood of substantial risk of serious loss to creditors or potential for the company to incur an obligation which a director cannot reasonably believe it will be able to perform is more likely to happen as a company moves closer to insolvency but could happen at any point.

Do directors need to be reckless or otherwise at fault to be liable under section 135?

The Supreme Court considered the "fault" element of liability under section 135. If fault is considered as a spectrum between completely subjective and completely objective, the Supreme Court comes down somewhere in the middle. The Court found that:

• The directors do not actually need to have realised that there was a likelihood of substantial risk of serious loss to creditors. An objective approach should be taken when determining if there is such a risk.
• However, when considering if there has been a breach of duty, the courts will consider the reasonableness of the directors' actions on the basis of what the directors were actually aware, or should have been aware if they had exercised the required skill and diligence.
• Not all directors are held to the same standard. The more complex the company the higher the level of skill and diligence expected of its directors.

Should section 136 be limited to particular types of obligation or ones the director has expressly agreed to?

The directors argued that liability under section 136 should be limited to situations where the director has taken an affirmative action to agree to the particular liability being incurred and/or that it should only apply to obligations which are not incurred in the ordinary course of trading.

The Court rejected those arguments. It concluded that section 136 is not confined to obligations of a particular kind, and may be invoked in relation to a course of trading to which the director has agreed.

How should compensation be calculated?

The Court found that (with limited exceptions):

• Compensation for breach of section 135 should be assessed on a net deficiency basis. This means the directors may be liable for the amount by which the company's position worsened from the time the company should have stopped trading and the time it went into liquidation.
• Compensation under section 136 should be calculated on a new debt basis (ie the amount of new debts incurred).

The difference in approach is because section 135 focuses on protecting the company's creditors as a group but section 136 focuses on the protection of individual creditors.

There is a disconnect with compensation under section 136 in that while compensation is based on the new debts incurred, those new creditors will not receive that compensation directly, and if there are debts payable in priority to them, may not receive any of it at all. Instead, compensation will be paid to the company and the liquidators will need to distribute it in accordance with the insolvency waterfall.

Can directors continue to trade where there is a substantial risk of serious loss on the basis that ceasing to trade would be worse?

One can see a logic in continuing to trade even where there is a substantial risk of serious loss to creditors on the basis that the overall outcome of doing so would be better than ceasing to trade immediately. For example, a retailer trading though a busy Christmas period might improve the overall position of the company as compared to ceasing to trade immediately.

The Supreme Court did not endorse that approach. In the Court's view section 135 is at least in part based on a premise that it is not desirable for a company to trade on in circumstances where those who deal with it in future are exposed to a substantial risk of serious loss.

The Court said a continued trading approach may have been possible if New Zealand law included a similar provision to the English wrongful trading regime, which provides a defence to creditors if, in continuing to trade while insolvent, the directors take every step with a view to minimising loss to creditors as they ought to have taken. But New Zealand law does not have that.

Given that compensation for a breach of section 135 is calculated on a net deficiency basis, if section 135 was considered alone, it might be possible to justify such an approach. If you have, by continuing to trade, made the overall position better, or at least have not worsened it, then while you may be found to have breached section 135 no compensation will be ordered (though there may be concerns around disqualification for the directors depending on the circumstances).

Section 135 is not the end of the story however. Section 136 requires the interests of individual new creditors to be protected. Loss to new creditors is not guaranteed when continuing to trade, it may be possible to protect their interests using strategies such as advance payments and trusts, but that would require very careful navigation by directors and is not likely to be advisable in most cases.

Directors of English companies can perhaps more easily adopt a continued trading strategy, though they must still do so cautiously, as they have the benefit of the defence of minimising loss to creditors mentioned above; loss for wrongful trading is usually calculated on a net deficiency basis as it is for section 135; and there is not an equivalent provision to section 136 expressly protecting the interests of individual creditors rather than the group. This can be a benefit as, in the right circumstances, carefully conducted continued trading can lead to a better outcome for stakeholders in the business.

Why were the directors not ordered to contribute equally?

The liquidators brought their claim under section 301 of the Act. That section allows the court a discretion as to what a person is required to pay in compensation for a breach of duty.

The Supreme Court held that the maximum amount which can be awarded is the loss calculated on the net deficiency or new debt basis, as discussed above. The discretion goes to whether there should be a reduction in the amount the directors are ordered to pay, and to the apportionment of liability among the directors. This remains a wide discretion.

The starting point for the Court in this case was that the directors would be jointly and severally liable for the full $39.8m of new debt. The Court found that given the differing levels of culpability between Mr Yan and the other directors, it would not be just to make a joint and several award for the full amount. The liability of the other directors was limited to one sixth of the full amount, rounded down to $6.6m plus interest from the date of liquidation to the date of payment.

What next?

While the decision provides some welcome clarity for directors as to what is required of them, both the Supreme Court and the Court of Appeal have suggested that a review of the directors' duties regime by Parliament is in order. We agree. A holistic consideration of how best to balance creditor protection against the policy objectives of encouraging businesses to grow and allowing directors to make decisions in difficult circumstances, to potentially rescue the company, would be beneficial.

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¹ Yan and others v Mainzeal Property and Construction Limited (in liquidation) and another [2023] NZSC 113