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.

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.