Reckless Directors of Mainzeal ordered to pay $36 million

Reckless Directors of Mainzeal ordered to pay $36 million

The Authors of this article are Brent Norling and Jeff Greenwood.

Introduction

Mainzeal Property and Construction Ltd (in liquidation) (“Mainzeal”) was a big domino. When it fell in 2013, it created a large domino effect across the industry with many still suffering today as a result of funds being unpaid.

The High Court’s recent decision in Mainzeal Property and Construction Ltd (in liq) v Yan and Others [2019] NZHC 255 is a significant development in the Mainzeal saga, one of New Zealand’s biggest corporate collapses, and represents an important contribution to the body of law surrounding breach of directors’ duties under the Companies Act 1993 (“the Act”).

At the liquidation date of Mainzeal unsecured creditors were owed approximately $110 million, which was owing to:

  •  Unpaid sub-contractors ($45.4 million);
  •  Construction contract claimants ($43.8 million);
  •  Employees not covered by statutory preferences ($12 million); and
  •  Other general creditors ($9.5 million).

The proceeding was brought by the Liquidators seeking orders against the former directors that they contribute between $32.8 and $75.3 million to Mainzeal.

The Liquidators of Mainzeal successfully argued that the directors breached their duties to Mainzeal under the Act. Cooke J’s detailed judgment canvases the events which lead to Mainzeal’s eventual demise and the subsequent breach of director’s duties.

At the time of this article it is not known whether the decision will be appealed to the Court of Appeal. Although, appeals are likely for cases of this magnitude.

Background

Mainzeal was incorporated in 1987 and soon became one of New Zealand’s largest construction companies building some of New Zealand’s most well-known structures.

In 1995 Richina Pacific Group (“RPG”) acquired the majority shareholding of Mainzeal and established a board with several board members holding appointments in Richina Pacific Group as well as Mainzeal. Members of the Board included Richard Yan, Dame Jenny Shipley and subsequently Sir Paul Collins.

RPG is a Chinese company with significant asset holdings base in China. In the decision, Mr Yan, who is also a board member of RPG noted that, through various business deals, RPG acquired substantial land rights which are now worth over than $700 million.

RPG’s ability to directly transact with Mainzeal was severely limited due to heavy restrictions imposed by the Chinese government. In order to get around this, RPG used several related entities as conduits to transact with Mainzeal.

These entities provided assistance to Mainzeal’s commercial projects through funding in the form of intercompany loans. Similarly, RPG used these entities to extract funds from Mainzeal through the use of intercompany loans. Importantly, the directors were not aware of the full extent of the intercompany loans and it was only in late 2009 that Dame Jenny Shipley requested a report to ensure full transparency of the intercompany loans. A core reason why the Board had not previously queried the intercompany loans was because of assertions made through Mr Yan and others that RPG would financially back the loans.

In 2005 Mainzeal experienced a significant loss of $7.5 million and in 2006 the financial statements indicated that Mainzeal was owed significant amounts totaling $39.4 million from entities related to RPG. A key problem with these receivables was that the related entities which owed the loans to Mainzeal were insolvent with one of the entities having a negative equity of over $44 million.

In 2012 Mainzeal experienced cash flow problems and was unable to secure funding from New Zealand Banks or RPG. Mainzeal was placed into receivership on 6 February 2013 and liquidation on 28 February 2013.

Breach of Director’s Duties- Reckless Trading

The breach of director’s duties centers around reckless trading under section 135 of the Act. The section makes directors liable if they take unreasonable risks with the solvency of the company or trade it when they know that it is insolvent.

Cooke J held that the essential pillars of the section are:

  • the duty which is imposed by s 135 is one owed by directors to the company (rather than to any particular creditors);
  • the test is an objective one;
  • it focuses not on a director’s belief but rather on the manner in which a company’s business is carried on, and whether that modus operandi creates a substantial risk of serious loss;
  • what is required when the company enters troubled financial waters is what Ross (above at [48]) accurately described as a “sober assessment” by the directors, we would add of an ongoing character, as to the company’s likely future income and prospects.

The sober assessment includes looking at whether a director has reasonable assumptions in relation to likely income streams.

Interestingly, section 135 of the Act is not a prohibition against trading while insolvent. Rather, it limits the ability for a director to trade a company while insolvent.

Cooke J held that the directors had breached their duty under s 135 of the Act for a number of reasons. These are discussed below.

Policy of Trading Whilst Insolvent

The directors disputed that Mainzeal was balance sheet insolvent due to the intercompany loans which were owed to Mainzeal.

This argument was rejected as the related entities were not in a position to repay the loans and there was no formal arrangement with PRG requiring them to repay the loans.

Cooke J did not accept the argument that the Financial Statements were audited and that the auditors had recorded the intercompany loans on the balance sheet. Cooke J noted that Mainzeal’s balance sheet insolvency meant that Mainzeal used cash flow advantage of cash flows associated with the construction industry as working capital and that, as a result, sub-contractors were left owed $45.5 million.

Reliance on Group Support

The courts are skeptical when directors rely upon shareholder or related parties support in order to maintain solvency. In these circumstances the Courts will carefully assess whether a director can reasonably rely upon such support. Provided that it is reasonable for a director to rely upon shareholder support then section 135 of the Act may not be breached.

It was argued that the directors were able to rely upon the financial assistance of RPG and, accordingly, did not breach section 135 of the Act. Cooke J rejected this argument because the directors placed unreasonable reliance upon RPG’s representations for the following reasons:

  • RPG’s financial assistance was not clearly formulated and it was not entirely clear what assistance RPG was willing to provide.
  • RPG never expressed their assistance in an unlimited form and it was unreasonable for the directors to presume that their support would be unlimited.
  • RPG never entered into any legally binding agreement with Mainzeal regarding their financial support.
  • The directors should have made enquiries in relation to Chinese law and the ability of RPG to pay funds to Mainzeal.

Financial Trading Position

Liability under section 135 of the Act will only arise if there is a substantial risk of serious loss to creditors. The Court noted while Mainzeal had hoped to generate income from the Christchurch Earthquake Rebuild and various new contracts, Mainzeal’s trading position was poor and that, without group support, vulnerable to substernal loss to creditors.

Outcome

Cooke J held that the directors had breached section 135 of the Act and were ordered to contribute to the liquidation. In determining the quantum of the directors’ contribution, Cooke J discussed a number of different approaches in quantifying the directors’ liability to repay company debts.

Interestingly, Cooke J rejected the Liquidators’ and defendants’ various approaches to calculating the quantum for the directors’ breaches.

Cooke J rejected the Liquidators’ view that the directors should be liable for company debts from the date the Liquidators considered that Mainzeal should have been placed into liquidation. Cooke J held that the Liquidators’ approach was not appropriate because the breach arose from the way the directors traded Mainzeal, with financial reliance on RPC, rather than from a notional date where Mainzeal, in the view of the Liquidators, should have ceased trading.

It was also held that the starting point for assessing the directors’ liability was $110 million. Cooke J then reduced this sum to $36 million. This figure was close to the amount that RPG would have been legally liable to pay Mainzeal.

Once the quantum had been decided, Cooke J went on to discuss each directors’ individual liability. Cooke J held that Mr Yan should be liable for the full $36 million. This was due to his conflict of interest, him misleading the directors and his personal profiting as a result of funds extracted from Mainzeal.

In determining the other directors’ liability, Cooke J held that each should be liable for $6 million. This discount was due to a number of mitigating factors discussed in the judgment.

Implications for Directors

The decision reiterates that the risk to directors who are reckless 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.

Directors will also need to ensure that their reliance on representations made by shareholders or related parties is not unreasonable. It would be prudent for directors to formalise and verify any representations made by third parties to reduce the risk of breaching section 135.

Further, directors should be careful to contextualise financial statements and not place undue weight on financial reports.

Practically, the shield of trading as a ‘limited liability’ company will only remain a shield if the directors remain compliant with their ongoing obligations under the Act.

Injunctions to stop a Company Receivership

Injunctions to stop a Company Receivership

The Authors of this article are Brent Norling and Anna Cherkashina (who were also successful Counsel in the decisions analysed below).

Receivership is a process in which a secured creditor appoints a receiver to collect and sell the debtor’s assets over which the secured creditor has a security.

A private receiver (as opposed to a Court appointed receiver) cannot be appointed unless there is a contractual power to do so. Such contractual power is generally set out in the security agreement which creates security over all or some of the debtor’s assets. The security agreement would also prescribe when and in which circumstance such power can be exercised.

Only the occurrence of the default specified within the security agreement will give the right to the secured creditor to appoint a receiver. Failure to make payments on time is the most common default after which secured creditor appoint receivers in New Zealand.

Once receiver is appointed, the receiver will take control over the assets subject to the security, will run the business (if business is subject to the security), and will sell the assets to repay the secured creditor from the proceeds. In New Zealand, receiverships are conducted under the Receiverships Act 1993.

In this article, we address the Court’s power to intervene in the secured creditor’s exercise of power of appointment of the receiver through the issuance of an injunction. Injunctions in the context of a private receivership can be sought to:

  • Preclude appointment of a receiver. Such injunction being appropriate where no receiver has been appointed yet, but there is risk of appointment; or
  • Restrain the actions of the receiver in a receivership. Such injunction being appropriate where the receiver has already been appointed.

Court’s power to issue injunction

Injunctions can be permanent or interim. A permanent injunction is sought to permanently preclude actions, whereas the interim injunction is sought to preclude actions on an interim basis until the substantive proceeding (i.e. the main dispute) is resolved. Depending on the type and complexity of the proceeding, the substantive proceeding could take 12 months or more to be resolved. In such circumstances, it is necessary to seek an interim injunction to preserve status quo in the meantime.

In the context of receiverships, most commonly interim injunctions are sought. This is to preserve the assets over which a receiver has been appointed, or is about to be appointed, while the substantive dispute (e.g. determination whether there has been a default, whether the security agreement is defective, or a declaration be made that the receiver was appointed invalidly) is underway.

When the Court determines whether to issue an interim injunction, there are three stages to the consideration of the application, being:

  • The application must establish that there is a serious question to be tried in the substantive proceeding.
  • The balance of convenience must be considered by the Court, which requires consideration of the impact on the parties of the granting of, and the refusal to grant, an order.
  • An assessment of the overall justice is required as a check.

Further, prior to the issuance of the interim injunction, the Court will need to be satisfied that the applicant has provided a sufficient undertaking as to damages sustained through the injunction.

Injunction to preclude appointment of receiver

Application to Court can be made to stop the secured creditor from exercising its power of appointment in the following circumstances:

  • Where the security agreement does not provide for a power to appoint a receiver or there is a challenge as to validity/enforceability of the agreement, however, the secured creditor threatens to appoint a receiver.
  • Where the event of default which would have triggered the appointment of the receiver under the security agreement has not occurred or not all necessary pre-requisites for appointment under the agreement have been complied with (e.g. notice of default with the right to remedy the default has not been issued but required to be issued under the agreement), however, the secured creditor threatens to appoint a receiver.

One of the recent examples where an application was made to Court seeking an interim injunction to preclude the appointment of the receiver was subject to the proceeding in Greenfield Global Ltd v MKAH Ltd [2017] NZHC 1298 where we were successful in restraining the powers of a creditor who wished to appoint a receiver.

In Greenfield Global Ltd v MKAH Ltd, the secured party made a number of threats to appoint a receiver over all assets of various companies unless payment was made. There was a dispute between the parties as to the calculation of the debt. In the secured creditor’s view, funds were still outstanding. However, the companies’ position was that the debt had already been paid in full. The companies proposed informal resolutions, including appointment of an independent accountant to resolve the dispute with calculations (and in the interim, deposit funds equal to the disputed amount into a trust account), however, the secured creditor still demanded immediate payment or there would be a receivership.

At the time, the companies employed over 50 staff, whose jobs could be lost if the companies went into receivership, and a permanent harm to the companies’ reputation and goodwill would have been caused. As a result, the companies commenced proceedings in Court seeking a declaration that no debt was owed and as such, there was no default which would have entitled the secured creditor to appoint a receiver. A without notice application was also made seeking an interim injunction precluding the secured creditor’s right to appoint the receiver.

The Court agreed that it was appropriate to issue the interim injunction and made orders. The Court also awarded costs against the secured creditor on the basis of unreasonable conduct which resulted in the application being necessary.

Injunction to restrain actions of receiver

Application to Court can be made to restrain all or specific actions of the receiver in a receivership in the following circumstances:

  • Even though the receiver has already been appointed, the power of appointment or the occurrence of the default which could trigger the appointment is challenged in the substantive proceeding.
  • A particular step undertaken by the receiver within the receivership is considered to be outside of the scope authorised under the security agreement.

One of the recent examples where an application was made to Court seeking an injunction to restrain the actions of the receivers was subject to the proceeding in Alpine South Fishing Ltd (in Rec) v Kim [2018] NZHC 2579.

In Alpine South Fishing Ltd (in Rec) v Kim, the secured party, Mr Kim, appointed a received over the assets of Alpine South Fishing Ltd (in Rec) (“Alpine South”) due to non-payment of debt.

Alpine South, and its director, Mr Choi, commenced proceedings seeking a declaration that the security agreement was a nullity and the appointment of the receivers was invalid. Mr Choi argued that due to limited English he did not understand the meaning of the security agreement at the time of execution and also maintained that Mr Kim represented the meaning of the agreement to him differently. Mr Kim denied that Mr Choi’s level of English was inadequate to understand the agreement, and in any case, Mr Choi was advised in native language by Mr Kim’s solicitors, and provided with opportunity, to seek legal advice prior to execution. Mr Kim also denied that he misrepresented the meaning of the agreement to Mr Choi.

An application was also made by Alpine South and Mr Choi seeking an interim injunction restraining the receivers from taking further steps pending the determination of the substantive proceeding. Mr Kim opposed the application on the basis that no serious question to be tried had been established, the balance of convenience lied in favor of Mr Kim, and it was inappropriate to restrain the receivers from taking further steps without adequate security (secured funds pending resolution or adequate undertakings).

The Court agreed that based on the evidence presented to Court, the prospects of Alpine South and Mr Choi succeeding in the substantive proceeding were low, however, the Court was not prepared to make a finding that there was no serious question to be tried (as further evidence could be introduced at the trial). However, the Court found that the balance of convenience lied with Mr Kim and that the interim injunction would not be appropriate. Accordingly, we were successful in defending the application for injunction and the application was dismissed.

Conclusion

Appointment of receivers is a draconian remedy and it can destroy the company’s business, reputation, credit rating and goodwill. Unsurprisingly, receiverships often result in the companies going into liquidation.

It is important for the secured creditors to verify, before appointing a receiver (or before making threats to do so), that the security agreement provides:

  • for a right to appoint the receiver and that the agreement is valid;
  • that there is a default or event that triggers the right to appoint a receiver;
  • that default or event has occurred and that appropriate procedure has been undertaken prior to the appointment (if the agreement prescribes a compulsory procedure, for example, the issuance of the notice of default).

It is also prudent to explore options and alternatives to ensure receivership is the most appropriate course of action.

Otherwise, an application for an injunction stopping the appointment of receiver, or the continuance of the receivership, could be made, and a cost award could be ordered against the secured creditor.

Remuneration of Directors

Remuneration of Directors

Directors of companies are entitled to receive money from their company, such as salary or wages, bonuses, fridge benefits and loans.

There are strict statutory requirements relating to the process the directors can be paid money from the company. These requirements have been imposed to recognise the directors’ position of power within a company, the position of potential conflict when the director authorises payments to him/herself, and to impose on the director additional checks to reduce the chances of unfair payments.

Nevertheless, it is still common in New Zealand, especially amongst small to medium size companies, that directors take drawings (be it for service of running the company in lieu of salary or in addition to the salary), or receive a salary, without complying with the mandatory statutory processes.

In such circumstances, any monies paid to a director could be treated as a loan repayable on demand.

While there are some directors who still manage to avoid liability for not following the proper processes, with the third parties becoming more aware of such practices, more directors start facing consequences. For example, if the company becomes insolvent and is placed into liquidation, the liquidator in almost all cases investigates and demands repayment of the funds, or if there is a shareholder dispute, often the other shareholder causes the company to demand immediate repayment of funds, or the Inland Revenue Department demands repayment of unpaid tax on the drawings taken from the company.

Interestingly, 63% of companies in New Zealand fail. On that basis, the risk is more than marginal.

Current account

Directors commonly misunderstand the concept of drawings.

Drawings are funds taken by directors (who are also shareholders) from the company for personal use and benefit. When directors take drawings from the company, and/or introduce funds into the company, this is treated as a running loan account between the company and the director.

Unfortunately, a large number of directors still believe that since they are in charge of and run the company, they are entitled to receive payments by way of taking drawings. In certain cases, this practice is engaged into due to the director’s ignorance of the legal requirements, in other cases, intentionally to avoid payment of the income tax.

However, if the director’s current account with the company is overdrawn (i.e. the amount of funds taken exceeds the amount of funds introduced), then the difference is treated in common law as a loan that is repayable on demand. From tax perspective, it is treated as an interest free loan that attracts a fridge benefit tax.

If the directors engage into the practice of taking drawings throughout the year, it is important that when the annual accounts are completed, a salary is declared in order to offset the drawings. However, the statutory requirements for authorisation of salary (outlined below) still need to be followed to avoid personal liability. Further, once a salary is declared, the directors become liable for personal income tax on that amount.

If the drawings are not offset with the salary, there is risk that a liquidator, in case of an insolvent company, or a business partner, in case of a business prone to shareholder disputes, might later demand repayment of these funds from the director. Further, the Inland Revenue Department reviewing the company’s accounts might demand payment of the fridge benefit tax. Such demands could go back to years of drawings made by the company and could result in financial hardship for the director.

Salary, wages and other monetary benefits

Section 161 of the Companies Act 1993 (“the Act”) creates strict processes for authorisation of payments to directors. These processes have to be followed by all companies registered in New Zealand, including companies having only one director and/or shareholder (as is commonly misunderstood amongst directors).

In brief, s 161 provides that:

  1. The board must authorise remuneration or provision of benefits to a director.
  2. The board must forthwith enter the authorisation into the interests register.
  3. Directors who vote in favour of authorisation, must sign a certificate stating that in their opinion the making of the payment or the provision of the benefit, is fair to the company, and the grounds for that opinion.

Section 161 further establishes that where the three elements of authorisation and certification were not complied with, or where no reasonable grounds existed for the opinion to make the payment, the director is personally liable to the company for the amount of the payment, or the monetary value of the benefit.

Personal liability may be avoided in circumstances where the director demonstrates that the payments of benefits were fair to the company at the time they were made, however, the onus of proof in that instance is on the director wanting to avoid liability.

Unfortunately, in New Zealand, non-compliance with s 161 is common.

If liquidators are appointed, and the requirements under s 161 were not met, they will likely take the view that such a salary/monetary benefit is repayable on demand. Below are examples of proceedings brought by liquidators of companies under s 161 against directors.

National Trade Manuals Ltd (in Liq) v Watson

National Trade Manuals Limited was placed into liquidation by the Inland Revenue Department. The liquidators sought to recover sums paid to the director by the company. The director received a salary from the company, and the following resolution was purportedly made:

By credit to his current account shareholders remuneration for the 2005 year of sufficient monies to clear any debit balance in his current account at 31/3/05 or, $10,000.00 whichever is the greater figure.

The resolution was held by the Court to be defective as it did not satisfy the requirements of s 161. Specifically, there was no certificate stating that the payments were fair, or the grounds for that opinion. The legal effect of non-compliance is that the director to whom the payments were made was found to be personally liable to repay the payments or the monetary value of the benefits, except to the extent that the director could prove the payments or benefits were fair to the company at the time they were made.

The issue of ‘fairness’ was dealt with by the liquidators by allocating a salary of $1,000 per week to the director and deducting that from the amount being sought. Consequently, all other funds transferred to the director by the company were ordered by the Court to be returned to the company in liquidation.

Madsen-Ries v Petera

This was an appeal against a decision of the High Court that salaries paid to Mr and Mrs Petera by Petranz Limited (in Liquidation) (“Petranz”) were fair to Petranz when paid. The issue on this appeal was whether the Judge of the High Court, in reaching that conclusion, gave appropriate consideration to the very poor financial situation of Petranz at the time the remuneration was paid.

Petranz was a road transport business. It operated three trucks and specialised in moving containers. Mr Petera drove one of the trucks. Mrs Petera looked after its administrative needs.

The appellants, the liquidators of Petranz and Petranz itself, sued Mr and Mrs Petera as Petranz’ directors and shareholders. They claimed various breaches of duties and a debt due from Mr and Mrs Petera under the overdrawn current account (as shareholders) and for unfair remuneration (as directors).

The High Court Judge first found that the Peteras owed Petranz a total of $140,134.70 on their overdrawn current accounts. The Judge, however, declined the appellants’ application for the repayment of directors’ remuneration. The Judge went on to find the Peteras had, as alleged, breached duties they owed under the Act, including s 135 duty not to trade recklessly. The Judge also found that they had failed to keep proper accounting records as required under s 194 the Act.

The Court of Appeal rejected the liquidators’ approach as they were effectively claiming that the Peteras were liable for all creditors and liquidation costs as a result of breaches of director duties, and on top of this, for the amounts they were paid under the current account and as a salary. In the Court of Appeal’s view, this involved double counting.

The Court of Appeal held that the Peteras were able to retain amounts they were paid as a salary (and paid PAYE on) regardless of non-compliance with s 161 of the CA because the amounts were considered to be fair to the company. This is because:

  1. PAYE was paid, meaning the debt to the Inland Revenue Department did not become larger.
  2. Mr Petera worked 60 – 70 hours per week overseeing the operations and driving a truck.
  3. Mrs Petera worked circa 20 hours per week attending to the administrative requirements of the company.
  4. The company gained full value from the work carried out by the Peteras.
  5. In the circumstances, the salaries were fair to Petranz.

The Court of Appeal held that ‘fairness’ needs to be assessed from the prospect of the company, and not creditors. However, if directors take money while trading recklessly (or breaching another duty), they may be liable pursuant to a breach of duty cause of action.

Conclusion

Some directors still believe that since they manage a company, they are able to determine the way they receive salary or other monetary benefits from the company.

With the creditors, insolvency practitioners, business partners and the Inland Revenue Department becoming more aware of this practice, more and more directors face severe consequences for failing to follow the proper processes for authorisation of payments.

It is important that business advisors, accountants and lawyers working together with the directors of small to medium size companies emphasise the importance of following the proper processes for authorisation of payments to directors.

#Litigation #DisputeResolution #Liquidator #DirectorDuty #BreachesofDirectorDuty

Liquidator Confetti Requests for Documents and Information: Rights and Obligations

Liquidator Confetti Requests for Documents and Information: Rights and Obligations

Section 261(3) of the Companies Act 1993 provides liquidators with extremely wide statutory powers to require various categories of people to handover documents and information of the company in liquidation.

These categories of people include present and past directors, shareholders, employees, lawyers and accountants, or any person having knowledge of the affairs of the company.

Liquidators’ are also empowered to require these persons to be examined on oath on any matter relating to the business, accounts or affairs of the company.

Some liquidators issue notices like confetti!

If you are required by a liquidator to attend an examination, it is not something that should be taken lightly.

Examinations can be relatively onerous on examinees. You cannot refuse to answer a question on the ground of self-incrimination; and there are hefty penalties and fines for non-compliance.

Accordingly, there is no right of silence!

Failure to comply with a liquidator’s notice of examination will often result in the liquidator seeking a court order under section 266 of the Act that you produce the documents/information sought. Costs are awarded against you if the liquidator is successful in obtaining the order.

Liquidators will often use their powers of examination to determine whether an examinee has committed any wrongs and to assess whether it is worth pursuing the examinee for, say, breach of director’s duties (if the examinee is a director/past director) or, to set aside payments received (if the examinee is a creditor of the company).

Examinations are sometimes window-dressed as a friendly plea for ‘help’ seeking your assistance to ‘help’ sort out matters with the failed company.

Prior to commencing the examination, liquidators will not let you know the full range of matters they intend to question you on; and will try to elicit ill-considered answers from you by asking unexpected questions. As the examinations are conducted under oath, any documents or information you give to the liquidator can and often will be used against you (and others) in subsequent court proceedings.

It is important to understand that liquidators’ right to obtain documents/information is not unfettered and that there are limits which apply. Some documents will fall plainly outside the liquidator’s reach. Some documents will not. We have been involved in hundreds of these examinations, on both sides of the table and we often see examinees unwittingly, and to their detriment, volunteer documents/information which the liquidator is not entitled to ask for.

The class of persons the examinee belongs to will affect which types of documents/information the liquidator will and will not be entitled to. For example, letters of advice provided by lawyers to directors of the company may be subject to privilege (and therefore not available to the liquidator) if the file was opened in the name of the director, and not in the name of the company. For directors and/or shareholders, there is a great deal more confusion surrounding which documents liquidators are entitled to request. There is a distinction between documents ‘of’ the company and documents ‘relating’ to the company. Which category examinees fall into will depend on the request of the liquidator and the specifics of any court order sought.

What is frequently overlooked is that any person who receives a liquidator’s notice of examination is entitled to legal representation. Examinations under s 261 of the Act are similar to court proceedings and can have serious consequences for the examinee if he or she is unaware of his or her legal rights. A competent lawyer will protect you by filtering the liquidator’s questions and requests to ensure they are within the scope of its powers and to make sure that the liquidator is not abusing their statutory powers.

Overall the key takeaways are:

  • Liquidators have extremely wide powers to request various information from you.
  • Liquidators often request from you information which they are not entitled to.
  • It is very prudent to have legal representation if you receive a liquidators’ request for information.
  • Unwitting disclosures of information can result in serious consequences.

 

#261 #Liquidator #liquidation #examination #underoath #interview

Phoenix Companies: The How, the Why and what to Avoid.

Phoenix Companies: The How, the Why and what to Avoid.

Just like the mythical bird that rises from the ashes, a phoenix company rises from the ashes of an old, failed company.

It has become commonplace for directors of failed companies to simply burn the old company and set up a new company with a similar name, trading in the same business as if nothing had happened. This is a phoenix company.

Directors typically use a similar name because they see some value to the trading name of the old failed business.

There are strict rules that apply to phoenix companies. There is a general prohibition on directors from being involved in phoenix companies. However, like all good laws, there are exceptions.

Understandably, if a director does this, it can be a source of contention for creditors of the failed company. As far as they are concerned, the director is still trading, using the old company assets and staff and is trading as if nothing happened. Meanwhile, they are owed money for goods or services provided. They naturally get frustrated.

Implementing the restructure of a company into a phoenix is just as much a legal exercise as it is an accounting and public relations one.

Why incorporate a phoenix company?

Phoenix companies are usually created due to the company being in financial difficulty or a dispute with creditors or a claimant.

A new company is formed and, largely, the old company is transferred into the new one (selected staff, assets, business etc). However, the old company’s debts are not.

However, usually directors ensure that ‘key’ suppliers are looked after, as are secured creditors (such as the bank). In fact, a proper restructure will not be possible without obtaining consent of secured creditors, as this is usually a requirement under security documents.

This doesn’t seem fair?

To creditors, it is not fair. In fact, there is a general prohibition on directors of a failed company becoming directors of phoenix companies.

If the assets have been transferred from the old company to the new for less than market value, then there are numerous remedies and recourses for creditors of the old company. These include:

  1. Suing the director or persons acting on the director’s instructions; for
  • Breach of director’s duties; or
  • Fraud.
  1. Actions recovering unlawful distributions.
  2. Transactions at an undervalue, as set out in s 297 of the Companies Act.

There is no duty on owners of a company to keep a business running. The common law position is also that directors cannot be prevented from working for a company in the same line of business as the company for which they formerly worked. The starting point is that a director of a failed company is prohibited from:

  1. Being the director of the phoenix company;
  2. Taking part directly or indirectly in promotion, formation or management of the phoenix company; and
  3. Being directly or indirectly be concerned in or take part in the carrying on of the business of a phoenix company.

As mentioned above, assets themselves can be transferred for market value. This should be done using the method which generates the most value, but only once this transfer has been approved by the shareholders (see s 129 of the Companies Act 1993).

Directors need to ensure that in any transfer they comply with the many duties of directors, for example, use of company information and rules around self-interested transactions.

How to become a director of the phoenix company

There are three statutory exceptions in the Companies Act which allow directors to become directors of the new phoenix company, despite having been a director of the previous company. They include the exception for a person named in a successor company notice, exception for a temporary period while application for exemption is made and exception in relation to non-dormant phoenix company known by pre-liquidation name of failed company for at least 12 months before liquidation.

The first statutory exception can happen in a situation where the phoenix company has bought the old business from the failed company’s liquidator or receiver, and the director has notified all creditors in a way that complies with the statutory requirements, via a successor company notice.

The second exception is only a temporary solution and lasts for up to 6 weeks after the commencement of the liquidation.

The third exception is applicable if the phoenix company has been trading for at least 12 months before the failed company’s liquidation, with the same or a similar name.

Risks to directors who participate in a phoenix company

There is the potential for directors to be accused of fraud if they allow the failed company to enter into contracts knowing that the company is about to stop trading and that the contracts being entered will not be performed. Directors also need to be mindful of voidable preference claims. The risk here is that transactions can be set aside under some circumstances, if a payment from the company has preferred one creditor over another and the creditor has received more than they would have under the liquidation.

If a director breaches the phoenix company rules, they can be liable upon conviction for up to 5 years’ imprisonment or a fine of up to $200,000, banishment from acting as the director of any company or being personally liable for the debts of the phoenix company.

Phoenix companies are often used because they maintain a connection with the previous company. There are however, risks that directors need to be aware of before engaging in this process.

No director of a failed company ought to contemplate a phoenix restructure without first obtaining expert legal (and accounting) advice.

More information

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Liquidation of corporate trustees

Liquidation of corporate trustees

It is well reported that New Zealanders are keen establishers of trusts. Thanks to trusts, property owners are able to create comfort that if they ever fail, they will be able to retain the benefit of their property.

A trust is not a separate legal entity, as such the trustees are generally personally liable. That is unless they limit their liability, however, this is usually reserved for “independent” trustees.

As a result, it has become popular to appoint companies as trustees. This way the individuals who are the governing mind of the trust are able to place another layer of protection to their personal liability.

Corporate trustees also provide certain practical efficiencies. For example, when the individual behind the trustee changes, the appointer can simply change the director of the company; there is no need to convey the property to a new trustee and as such, legal fees are lower.

However, as with individuals, there could be significant consequences if the corporate trustee incurs debts and does not pay them. Some believe that by replacing an insolvent corporate trustee with another entity, and transferring all trust assets to that entity, it ensures that the assets are safe from the creditors. Such belief is “usually” wrong, as the Companies Act 1993 applies to corporate trustees in the same way it applies to any other company, meaning that the corporate trustee can be placed into liquidation and then the liquidator is able to investigate potential methods of recovery.

Liquidators who get involved with liquidations of corporate trustees get themselves into an area that is governed not only by the insolvency law, but also by the trust law. This imposes additional duties on the liquidators and creates issues that are not straight forward.

Appointment of liquidator

If a corporate trustee is placed into liquidation, and that trustee still holds its office as a trustee, the liquidator essentially assumes duties to take control and administer the trust assets until a new trustee is appointed. As a result, it is important that the liquidator consenting to the appointment of a corporate trustee is familiar with the duties owed by trustees in equity and under the Trustee Act 1956. Also, it is important that upon appointment the liquidator reviews the trust deed as it might impose additional duties that the liquidator should be aware of.

Payment of debts

A commonly held belief is that the assets of the trust are not assets of the company, and therefore they are not available to pay creditors. However, this is not always the case.

By virtue of s 38 of the Trustee Act 1956, a corporate trustee, as any individual trustee, is entitled to be indemnified from the trust property for debts that are properly incurred in the course of administering the trust (“the trust debts”). It is questionable and has not been determined in New Zealand whether the right to indemnity can be limited or removed by a trust deed. However, in our view, it is relatively arguable that it cannot.

The trustee’s right of indemnity gives rise to an equitable charge over the trust assets. Such charge entitles the trustee to keep the assets until it has indemnified itself. As a result, where a corporate trustee, which has not been replaced yet, is placed into liquidation, the liquidator has a right to retain the trust assets and seek indemnity to repay the trust debts.

In cases of corporate trustees which existed solely to administer the trust, most, if not all, debts would be the trust debts and could be repaid by the liquidator by pursuing the trust assets.

Further, it is well established that the trustee’s equitable charge can survive replacement by a new trustee. As a result, if the retired corporate trustee is replaced as trustee and does not hold trust assets any more, the liquidator has a right to request payment from the new trustee, and where there is no cooperation, commence proceedings seeking a sale order and payment from the trust assets.

Similar orders have recently been sought and obtained by the liquidators in Ranolf Company Limited (in Liq) v Bhana [2017] NZHC 1183. Ranolf Company Limited (in Liq) (“Ranolf”) was a corporate trustee of a family trust and incurred trust debts. When Ranolf was placed into liquidation, certain members of the family attempted to hinder the trust assets by removing Ranolf from its position as trustee and failing to indemnify Ranolf from the trust assets. Consequently, the Court made orders charging land owned by the trust with payment of Ranolf’s trust debts and a sales order.

Further, the replacing trustee is under an obligation not to treat the assets in any manner which would compromise the original trustee’s lien. As such, if the corporate trustee in liquidation has been removed as a trustee (either prior or post liquidation), and the replacing trustee has done something that would compromise the original’s trustee’s lien (for example, disposed of the assets or distributed all assets to the beneficiaries), the liquidator could pursue the replacing trustee for breach of constructive trust. If the replacing trustee is a shell (which would usually be the case), tracing of the assets could also be available. However, obviously, at this stage litigation and recovery of the assets would be costly.

The Court is very unlikely to allow trust assets to be used to satisfy claims by creditors of the corporate trustee in circumstances where the debts were not incurred for the trust.

Where the trust property is insufficient to meet a trustee’s right of indemnity, the liquidator could also pursue the beneficiaries of the trust. However, this would be possible only in very limited circumstances where the trust structure satisfies certain pre-requisites.

Payment of liquidators’ fees

In addition to the payment of trust debts, the trust assets can be used to pay for costs, expenses and remuneration of the liquidators. This can be ordered either pursuant to s 38(2) of the Trustee Act 1956, which establishes the trustee’s right to remuneration out of trust assets, or the inherent jurisdiction of the Court.

However, the Courts allow recovery of the costs and expenses related to administration of the trust only. Generally, the costs of liquidation which are not related to the administration of the trust, will not be recoverable. Although, where a corporate trustee operated for the sole purpose of being a trustee, the general expenses of liquidation will be usually recoverable on the basis that they are related to the administration of the trust.

In Ranolf Company Limited (in Liq) v Bhana [2017] NZHC 1183, the liquidators have also successfully obtained orders charging the trust’s land with the payment of their reasonable fees and disbursements. Because of continuous attempts by certain family members to hinder the assets and prejudice the proceedings, the liquidators’ fees and disbursements were substantial. This case serves as an example of where the attempts to hinder assets from the creditors went wrong. Had the trust cooperated with the liquidators from the outset, the financial burden borne by the trust would have been significantly lower.

Distributions to beneficiaries

The liquidator may also set aside all distributions to beneficiaries made by the corporate trustee within 2 years of liquidation if, at the time of distributions, the corporate trustee was unable to pay its debts. This is pursuant to the voidable transaction regime in the Companies Act 1993. While beneficiaries could raise a statutory defence to voidable transactions under s 296(3) of the Companies Act 1993, usually these defences would be unsuccessful due to the fact that the beneficiaries usually provide no ‘value’ in return for the distributions. Further, the beneficiaries may have inside knowledge which means that the have knowledge of the financial position of the trust.

If the trust made distributions to beneficiaries with intend to prejudice creditors, or without receiving equivalent value in exchange, these distributions can also be set side within 6 years of the distributions being made under ss 334 – 450 of the Property Law Act 2007.

Duties of directors of corporate trustee

Directors of corporate trustees owe the same duties that are owed by directors generally in common law and under the Companies Act 1993.

In order to comply with their obligations, a director of a corporate trustee needs to be aware of the availability and value of the right of indemnity owned by the trustee.

Failure to know about the availability of indemnity and/or failure to pursue it, could potentially result in the breach of duty to act in the best interests of the company and/or being negligent. Similarly, if the value of the trust assets is insufficient to meet the liabilities incurred by the corporate trustee, arguably the director may be liable for reckless trading under the Companies Act 1993.

Further, a director of a retiring trustee, which causes the company to transfer the trust assets to the new trustee without satisfying the company’s indemnity rights, could also be in breach of a number of duties under the Companies Act 1993.

On liquidation, a director who breached his duties, could be pursued by the liquidator and held personally liable for all losses of the company (creditors and liquidator fees and disbursements).

What does come as a surprise to many is that this can still be the case for “independent” trustees as the Companies Act 1993 draws no distinction between directors. One is either a director or they are not. There was either a breach of duty, or there was not. However, the ‘independence’ may be relevant when it comes to the Court’s discretion in quantifying any liability. Although, there are currently no cases in New Zealand on this particular point.

Conclusion

Some liquidators still find liquidations of corporate trustees challenging and the pursuit of claims often requires specialist legal assistance. . Usually, only those liquidators who are either able to be self-funded or have a funder in place can pursue such claims.

As a result, those transferring trust assets from the insolvent corporate trustee to the new entity ‘sometimes’ succeed in removing trust assets from the creditors. However, with the growing number of corporate trustees going into liquidation, and the law becoming more settled in this area, it is expected that liquidation of corporate trustees will over time become more straightforward.

This artcile was also published in the March 2018 edition of Law Talk.

 

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