This article deals with the seminal Court of Appeal decision (CoA Decision) released on 31 March 2021 in the proceedings commenced by the liquidators of Mainzeal Property and Construction Ltd (in Liq) (Mainzeal) against its directors for breach of director duties.
We have previously published an article regarding the High Court decision (HC Decision), which can be found here.
We have also released a comprehensive video outlining the rise and fall of Mainzeal which can be found here.
For the sake of brevity, this article will not discuss the distressed history of Mainzeal, but rather, will focus on the CoA Decision and its implications on directors of insolvent or near insolvent companies. This article is not a full discussion of the 178-page decision, rather, it is aimed to provide a brief summary. If you would like to read more about the history and context, the HC Decision and the video referred to above provide excellent context.
Importantly, when Mainzeal failed, it owed $110m to unsecured creditors.
Companies Act 1993 (Act)
The relevant director duties under the Act which were subject to the HC Decision and the CoA Decision are:
Section 135: Reckless trading
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.
Section 136: Duty in relation to obligations
A director of a company must 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.
HC Decision
Section 135
To give context to the CoA Decision, the conclusions of the High Court in determining that the directors of Mainzeal were in breach of s 135 are:
Mainzeal was balance sheet insolvent while trading, as the intercompany loan was not recoverable. The directors should have seen the warning signs and should not have classified it as an asset on their balance sheet.
The assurances provided by Mr Yan could not be reasonably relied upon by the directors. Further, they were contingent on Mainzeal’s continued operation.
Mainzeal’s usage of creditor funds as their working capital combined with the fact that its financial trading performance was poor and prone to significant one-off losses meant that the risk of creditors losing out was high.
The directors failed to seek independent legal advice regarding their obligations. This would have alerted them to the fact that the assurances provided by Mr Yan were not legally enforceable.
As a result, the directors were found to be in breach of their obligations under s 135. Consequently, they were ordered to pay $36m in compensation, with three of the directors liable for a maximum $6m each and the fourth director, Mr Yan, liable for a maximum of the full amount.
Section 136
The High Court held that the directors of Mainzeal did not breach s 136, as s 136 required “a focus on particular obligations under specific construction contracts that Mainzeal was entering into”. The specific transactions or obligations entered into were not identified in the pleadings.
The High Court further held that, even if the specific transactions were plead, the High Court would have still rejected the s 136 claim, stating that:
There would be no reason to conclude that the directors either did not believe that those obligations would be fulfilled, or that the reasons for believing they would be fulfilled were unreasonable. It would not have been apparent to the directors that Mainzeal’s failure would occur, or would likely occur immediately, or within a particular period of time, at least until very near to the point when Mainzeal failed.
In the High Court’s view, this “seems to be critical to establish liability under s 136 in these circumstances”.
CoA Decision
The issues on appeal in the context of insolvency and directors’ duties can be summarised as:
Did the directors breach s 135 of the Act?
Did the directors breach s 136 of the Act?
If the directors breached s 135, on what basis should compensation be assessed whilst also considering s 301 of the Act?
Section 135
The Court of Appeal agreed with the HC Decision’s findings of fact and also agreed with the finding that the directors breached s 135.
The Court, however, found that the s 135 breach did not result in any recoverable losses. The arguments that the liquidators put forward, being the ‘entire deficiency’, ‘net deficiency’ and ‘new debt’ approaches were in Court’s view inappropriate under s 135 and in the current scenario. In particular:
As the breaches of s 135 did not cause the company to become insolvent, the ‘entire deficiency’ approach was not relevant.
As the liquidators could not satisfy the Court that there had in fact been a ‘net deficiency’ between the date of the breaches of s 135 and the eventual liquidation, the ‘net deficiency’ approach could not be used. In particular, on a net basis, Mainzeal had fewer debts at the time of liquidation, then when the directors’ breaches of their duties started.
The Court also provided a definitive ruling that the ‘new debt’ approach cannot be used in assessing the quantum of damages for a s 135 breach. This is because the duties of a director under s 135 are owed to the company, rather than individual creditors. To allow a ‘new debt’ approach would necessarily involve a calculation of losses to individual creditors, rather than to the Company itself. In essence, it would allow for older creditors to achieve a windfall, and newer, unpaid creditors would receive a shortfall. This is because distributions would have to be made on a pari passu
Section 136
The Court of Appeal overturned the High Court’s decision regarding s 136.
The Court held that claims for s 136 did not have to be specifically plead, as they do not have to relate to discrete defined acts. Rather, they apply to all obligations entered into by the company.
The Court then held that it would take the narrow interpretation, whether, as a matter of fact, there were reasonable grounds for believing that obligations would be performed when due. If there are reasonable grounds, then there would be no breach of s 136. This is to be determined objectively. It did not matter that the directors of Mainzeal believed that obligations would be performed when due; the Court held that a reasonable director would not have believed that there were reasonable grounds for the performance of obligations.
The Court found that the creditors who dealt with Mainzeal were exposed to an abnormal level of risk, which the Court stated was the precise harm that s 136 was designed to prevent.
Accordingly, the Court held that the ‘new debts’ approach is appropriate for claims under s 136.
This is because any new obligations undertaken by the directors when there is no reasonable belief that these obligations can be performed when due are likely to be ‘new debts’.
If new debts cannot be accounted for under s 136, there is no logical link behind the wording of the provision and potential claims for losses.
The Court of Appeal has subsequently reverted the case back to High Court to determine the appropriate quantum of compensation under s 136.
We are yet to receive a Decision on this.
But we expect this amount to be significantly higher than $36m that was previously ordered. Based on the approach adopted by the Court of Appeal, our view is that the High Court ought to order that the directors pay $64m – $75m in compensation. However, this amount may be adjusted through the process of the Court exercising discretion available under s 301.
Implications in the Insolvency Context
There are three potential starting points in quantifying claims against directors who are trading companies insolvently or potentially near insolvently:
Net Deficiency: This is usually the starting point in most cases for breaches of s 135 and is calculated by taking the financial position of the company at the date that it should have stopped trading, and the date of liquidation. The difference is then considered a net deficiency (if negative) and becomes a starting point in quantifying the director’s liability.
Entire deficiency (or whole debt): This is generally used when a single or multiple discrete quantifiable breaches of s 135 are the cause of the insolvent liquidation, and but for these breaches, the company would otherwise be solvent. The whole debt(s) of the company are treated as a deficiency and become a starting point in quantifying the director’s liability.
New debt: This is unavailable for breaches of s 135, however, this will likely be the new starting point for breaches of s 136. All new debts incurred after the start of the breach of director’s duties are added and this amount then becomes a starting point in quantifying the director’s liability.
For directors, this means that there will be additional risks when dealing with insolvent or nearly insolvent companies. The new debt approach for breaches of s 136 presents a big hurdle for any attempts to trade out of insolvency, as the determination of reasonable grounds to believe that an obligation will be able to be performed when due is of an objective standard.
We expect to see more claims against directors who may have honestly believed that they were trying to achieve the best outcome for their creditors by trading out of insolvency but would be liable for new debts if they are ultimately unsuccessful.
Both the HC Decision and the CoA Decision reiterate that the risk to directors who are reckless, or do not fully appreciate their solvency status, is high. Directors need to carefully evaluate a company’s position once it becomes insolvent and to soberly consider the prospect of continuing to trade.
At the time of this article, it is not known whether the decision will be appealed to the Supreme Court. Although, appeals are likely for cases of this magnitude.
If you are in a challenging position as a director, our team of experts can assist and guide you through your company’s insolvency. contact the team at Norling Law at info@norlinglaw.co.nz or you can book a consultation here: https://norlinglaw.co.nz/consultation-brent/
Original tax debt can quickly get out of control with the accruing interest and penalty fees. This may result in the debtor becoming insolvent and facing bankruptcy (for individual debtors) or liquidation (for companies) proceedings commenced by the Inland Revenue Department (“IRD”).
At Norling Law, we have extensive experience negotiating settlements with the IRD. The settlement with the IRD could be in the form of a provisional payment plan and/or partial principal debt/interest/penalties write-off. When faced with a settlement proposal, the IRD has a set of requirements that they must consider. At Norling Law, we take these requirements into account when formulating a settlement proposal.
In the event the debtor is not in a position to settle the debt, we can provide advice on other alternatives to bankruptcy and liquidations. The sooner the issue with the outstanding debt is addressed, the more options could be available.
Below we set out a recent example of negotiations conducted by us on behalf of a client, which resulted in a significant write-off of the client’s debt to the IRD.
Our client was in significant arrears with the IRD, amounting to approximately $260,000. This particular client, due to unforeseen circumstances, failed to meet its tax obligations over a period of approximately 4 years.
Our client came to Norling Law for assistance when the IRD had served it with liquidation proceeding and there was a hearing date scheduled in the High Court.
First, we explained the consequences of liquidation and provided our client with general insolvency advice. We also provided an outline of various steps and timelines that would take place in the liquidation proceeding, which helped to reduce the client’s stress levels.
We also interviewed our client and each director and explored:
the personal and financial circumstances they were experiencing at the time of non-payment;
the ability to settlement;
the steps they have taken to restructure the management of the company in order to prevent future non-payments; and
other matters relevant for an application for financial hardship.
We then conducted negotiations with the IRD on behalf of the client focussing on these four areas. The outcome was an astounding $204,000 reduction in the tax payable. Our client was able to avoid liquidation and resolve the matter entirely by paying a lump sum of $20,000 and the balance of $36,000 in monthly installments over a period of 3 years.
Our client could draw a line in the sand and move on with business free of the stress of having outstanding arrears with the IRD and the threat of liquidation.
Whether a reduction of the debt owed to the IRD could be achieved would depend on various circumstances associated with the non-payment of tax, position of the debtor and etc.
The New Zealand Government has announced a proposed amendment to the Property Law Act 2007 that would entitle commercial tenants to cease rent and outgoing payments to their landlord where the tenant’s business has suffered a material loss of revenue due to COVID-19.
As at the date of publishing this article, the draft Bill identifying the intended changes has not yet been published. Accordingly, there is still some ambiguity around the specifics. However, the Cabinet Economic Development Committee’s Minute of Decision dated 3 June 2020 and Mr Little’s submissions to the Cabinet Economic Development Committee provide some guidance on what we might expect to occur.
Proposed changes
The proposed changes are set out below.
The amendments to the Property Law Act will imply a clause into leases of businesses that meet eligibility criteria that requires a fair proportion of rent and outgoings cease to be paid when a tenant’s business has suffered a material loss of revenue because of the restrictions put in place to combat COVID-19.
To be eligible, the criteria is as follows:
the business has 20 or fewer full-time equivalent staff per lease site.
the business is New Zealand based.
the business has not already come to an agreement for a rent abatement with their landlord.
The amendments provide clear rules that must be followed when determining what factors must be considered in determining a fair proportion, based on the principles that the interests of the landlord and the tenant should both be taken into account, and the financial burden of COVID-19 fairly proportioned.
The amendments seek to provide clear guidance on what other measures parties may agree to as a temporary change to support them both through the pressures caused by COVID-19.
It will be a requirement that any commercial lease disputes under the amendments to be settled in arbitration in accordance with the Arbitration Act 1996 (with rights of appeal).
It is intended to supporting parties to access arbitration in a timely and cost-effective manner through a government subsidy provided for streamlined arbitrations at a rate of $6,000 per arbitration. This would be delivered through providers who would receive the $6,000 including GST per dispute to deliver a fixed-rate streamlined arbitration service and the parties will be liable to pay any costs exceeding $6,000.
To be eligible one party must also be a small or medium enterprise receiving the Wage Subsidy.
In determining what a “fair proportion” is, the financial position of the lessor, the lessee, and any other relevant party ought to be taken into account, including the following factors:
The impact of the COVID-19 restrictions on the business, including the impact of restrictions that are no longer in place;
Any mortgage obligations relevant to the leased premises;
Any financial support available to them;
Their revenue and profit levels in recent years;
Their ability to survive financially the effects of official requirements to counter an outbreak of COVID-19;
Any difference in size and resources between the lessor, the lessee, and any other relevant party; and
Any other factor that is reasonably relevant.
The proposed amendments has been expressed to be similar to the “No Access in Emergency” clause currently in the standard ADLS lease form but also clearly requires that there is or has been a material negative impact on the tenant’s business due to COVID-19, whether or not the lessee is able to access the premises.
The parties ought to negotiate a fair proportion of rent and outgoings that would cease to be paid. The parties could consider whether, in the circumstances, it was most appropriate for this to take the form of:
No rent being payable for a period; or
Reduced rent being payable for a period, including reductions of varying levels over successive periods; or
A scheduled rent increase being deferred; or
Rent continues to be paid unabated; or
A mix of any of these options.
The amendments would also include a list of other types of measures that could be negotiated, such as a rent deferment, if that is fair in the circumstances. The amendment will therefore enable the parties to negotiate about these matters if they wish to, but this negotiation would not be mandatory.
If the parties cannot agree, they will then be obligated to commence the arbitration process.
Unfortunately, these changes will not apply to tenants who have already agreed with their landlord on the proportion of rent that they should pay in light of COVID-19.
However, it does not include situations where the landlord has insisted on strictly enforcing the terms of the lease in response to the tenant’s request for a rent reduction.
As to when the Bill would come into effect, the Cabinet Economic Development Committee agreed that the amendments will have retrospective effect. It would apply from the date of the policy announcement and extend for six months after enactment of the Bill.
Our Thoughts
We expect the amendments to the Property Law Act to be welcomed by business owners with commercial tenancies.
In our experience there are many tenants that have not yet settled with their landlords as there has been uncertainty and/or they did not have clause 27.5 in their lease.
This amendment levels the playing field for commercial tenants. Further, it goes much wider than clause 27.5 in that it doesn’t just relate to no access but the impact on the business itself.
We are available to assist parties negotiate commercial disputes and we offer a free 30 minute legal consultation where we can discuss the issues and formulate a strategy that works. You can book a consultation here.
The COVID 19 pandemic brings uncertainty not just to the public, but especially to business owners.
As at the date of writing this article, the government issued a level 3 alert, rising to level 4. We are about to be isolated and offices and other commercial buildings left inaccessible.
For business owners, this means among other things that all non-essential businesses must close. During this time, businesses will not have access to the premises. However, does this mean that it must pay for the time where there is no access?
If the lease is on the standard deed of lease from the Auckland District Law Society, then there may be reprieve.
Clause 27.5 provides that:
If there is an emergency and the Tenant is unable to gain access to the premises to fully conduct the Tenant’s business from the premises because of reasons of safety of the public or property or the need to prevent or overcome any hazard, harm or loss that may be associated with the emergency including:
…
(c) Restriction on occupation of the premises by any competent authority.
Then a fair proportion of the rent and outgoings shall cease to be payable for the period commencing on the date when the Tenant became unable to gain access to the premises to fully conduct the Tenant’s business from the premises until the inability ceases.
Clause 47.1(d) defines an “emergency” to mean a situation that:
(a) Is a result of any event, whether natural or otherwise, including an … epidemic; and
(b) Causes or may cause loss of life or serious injury, illness or in any way seriously endangers the safety of the public or property; and (c) The event is not caused by any act or omission of the landlord or tenant.
In the present circumstances, it is highly arguable that there is an emergency as there is an epidemic. This is supported by the fact that an epidemic notice was issued under section 5 of the Epidemic Preparedness Act 2006. Further, the epidemic may cause loss of life and the event is not caused by any act or omission of the landlord or tenant.
Assuming that there is an emergency and the tenant is unable to gain access to the premises to fully conduct its business, then clause 27.5 states that the tenant would not be liable for a proportion of rent and outgoings from when the tenant became unable to gain access until that inability ceases.
Clause 27.6 provides a further option by giving either party the choice of terminating the lease by giving 10 working days written notice to the other if:
The tenant is unable to gain access to the premises for the period specified in the schedule; or
The party that terminates the lease can at any time prior to termination establish with reasonable certainty that the tenant is unable to gain access to the premises for that period.
Accordingly, depending on the period contained in the schedules, the tenant might also be able to terminate the lease.
What does this mean to tenants and landlords? It appears that the purpose of clauses 27.5 and 27.6 is to shift the burden of the cost of emergencies to the landlord. It is important to note that the operation of clause 27.5 does not require notice from the tenant. It means that clause 27.5 operates automatically and it would be highly arguable for tenants to rely on this clause for proportional rent and outgoings.
For landlords, this means that you need to anticipate for this potential outcome and make provision for less rental income.
We highly recommend that tenants and landlords work collaboratively during this period to ensure they both come out of stage 4 lockdown commercially viable. In many cases, the commercial relationship can continue once the dust settles as the reality for most landlords is they are likely to experience difficulty in finding replacement tenants during this time.
For more information, feel free to contact the legal experts at Norling Law for a free 30-minute no-obligation consultation which can be booked here.
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Covid-19 and the Obligations and Options for Business Owners
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For more information, feel free to contact the expert commercial dispute lawyers at Norling Law for a free 30-minute no-obligation consultation which can be booked here.
If you have ever ‘stood-by’ a customer who is going through a rough patch by continuing to supply goods/services on credit and holding off on receiving payment, some of us will know there can be a happy ending to this story. With your goodwill and support your customer might manage to trade out of its difficulties, your relationship is stronger than ever and most importantly – you can be repaid in full.
Unfortunately, for some business owners, the story does not always end so happily when the liquidator comes knocking unexpectedly.
If the customer is later placed in liquidation, the liquidator may require the creditor to repay all or some of the payments (or other monetary or non-monetary benefits) received by the creditor from the liquidated company. This is known as the liquidator’s power to ‘clawback’ preferential transactions and is provided for under s 292 of the Companies Act 1993.
Sounds pretty unfair, right?
Voidable transactions (or liquidator’s ‘clawback’) regime is one of the most controversial features of insolvency law in New Zealand. It is designed to protect creditors against the tendency of the directors of troubled companies to pay themselves and their favourite or aggressive creditors before anyone else.
Because directors facing troubled waters typically pay the creditors they have a bias towards. Those creditors are usually the ones who hold personal guarantees. The director has a personal incentive to pay those creditors first. It may be friends or family.
Theory behind the regime
According to the pari passu principle, each and every creditor of the company should share equally and proportionately in the fruits of the liquidation.
The principle recognises that it is unfair to other creditors if an individual creditor can jump the queue and be paid prior to the liquidation because it is favoured by the director of the company or because it is being more aggressive than others in its demands.
If payment has been made and the queue is jumped, the law works to make these payments voidable and provides the liquidator with powers to recover these payments for the common pool of creditors in the liquidation.
Operation of the regime in New Zealand
Pursuant to s 292 of the Companies Act 1993, the payments (or other monetary or non-monetary benefit) that the creditor received from the liquidated company may be considered voidable if the following criteria is satisfied:
At the time of payment, the liquidated company was unable to pay its due debts;
The liquidated company was later put into liquidation (either voluntarily or involuntarily);
The payment was within a certain period before the making of the application to the court to commence liquidation proceedings (in case of a court ordered liquidation), or before the shareholder resolution placing the company into liquidation was signed (in case of liquidation initiated by shareholders). This period is 2 years for transactions with related parties and 6 months for transactions with all other parties; and
The effect of receiving the payment enabled the creditor to receive more than what they would have otherwise received had they waited for the liquidation to run its course.
The meaning of “related party” is defined under s 291A of the Companies Act 1993. It primarily concerns familial relationships, related trusts, and close business relationships.
These criteria affect liquidations commencing after May 2020, when changes to the Companies Act 1993 came into force. Liquidations which commenced prior to May 2020 are still subject to the old regime. Under the old regime, the period of 2 years applied to transactions with all parties (be it related or unrelated).
Unfortunately, no matter how well intentioned the creditor was, at the time of accepting payment, the law in this area is only concerned with the “effect” of the transaction – if the liquidated company’s payment had the effect of favouring the creditor above other creditors, that payment is at risk of being clawed back.
This comes as a shock to most clients who come to see us after receiving a letter of demand from a liquidator requiring them to repay their hard-earned cash received 2 years prior to liquidation (for related parties), or 6 months (for non-related parties).
If a liquidator believes the above criteria is met, the creditor will be served with a voidable transaction notice attempting to void the payments (“VT Notice”). If no response is made to formally object to the VT Notice in compliance with the Companies Act 1993 within the strict time limit of 20 working days, the transaction is automatically set aside.
If an objection to the VT Notice is made, the liquidator could still seek to void the transaction by making an application to Court under s 295 of the Companies Act 1993. However, since this option is considerably costlier, it is not always pursued by liquidators (e.g. where there is limited funding and/or questionable prospects of recovery). Most liquidators will determine whether they will commence proceedings, settle, or abandon the claim based on the objection they receive to the VT Notice.
On that basis, a full and robust objection usually has a positive impact on the outcome for creditors.
In our experience, when business owners are faced with this situation, there are 3 mistakes they make. In particular:
They offer too much information to the liquidator when the liquidator investigates the transaction without obtaining any advice from an expert. Often, the liquidator’s enquiries are masked with a ‘friendly’ invitation to assist with the course of the liquidation, and the business owners volunteer information that is favorable to the voidable transaction claim;
They settle the claim without obtaining expert advice on potential defences and whether all criteria of the voidable transaction claim is satisfied under the Companies Act 1993.
They do not appreciate the importance of responding promptly to the VT Notice (liability for the full amount is automatic if no response is received on time, irrespective of the availability of defences).
Liquidators are often aware of these mistakes. Unfortunately, some liquidators might even issue VT Notices like confetti (as in the case of s 261 notices, please see here) in full knowledge that if no response is received in time, then the business owner is liable for the full amount.
Defences
There are several defences to the voidable transaction claim.
For example, the creditor will have a full defence to a claim if, at the time the liquidated company paid the creditor, the following criteria was met:
The creditor acted in good faith (e.g. honestly);
A reasonable person in the creditors shoes would not have suspected, and the creditor did not have reasonable grounds to suspect, that the liquidated company was, or would become insolvent; and
The creditor gave value for the payment or altered their position in the reasonably held belief that the payment was valid and would not be set aside.
In most cases, creditors will generally be able to satisfy criteria (1) and (3) above. The defence usually turns to whether (2) can be satisfied. The law in this area is not well settled and to run a successful defence requires careful consideration of the facts on a case by case basis.
Another commonly raised defence is the exception of the ‘running account’. This exception to the voidable transaction regime might apply where the parties to a transaction were in a continuing business relationship. In such circumstances, the Companies Act 1993 directs to view all of the transactions that are part of that relationship as a single transaction. In these circumstances, the ‘preferential’ effect of the transactions can be reduced or illuminated in full.
Conclusion
Creditors ought to deal with liquidators carefully. They ought not give information that liquidator seeks without first considering whether the information is helpful and or harmful and to consider whether the liquidator is actually entitled to the information.
A creditor needs to act quickly if they receive a VT Notice so that transactions are not automatically set aside.
Our lawyers at Norling Law are experts in this field and routinely act for both business owners and liquidators. If you are the recipient of a VT Notice, our experts can help you to craft a carefully structured objection, and/or negotiate with the liquidator to achieve the best possible outcome for you.
Alternatively, if you intend to receive payment from an ‘at risk’ customer, we can help you to re-structure the transaction to minimise the risk of a future clawback.
Because there are ways to minimise the risk of a liquidator pursuing the transaction as a voidable transaction at a later date.
