Directors are entitled to receive money from their company pursuant to certain legal obligations, like dividends, salary or wages and reimbursement of expenses paid by or on behalf of the company. However, if section 161 of the Companies Act 1993 (“the Act”) has not been complied with, any monies paid to a director is to be treated as a loan.
In brief, section 161 of the Act provides that:
The board must authorise remuneration or provision of benefits to a director;
The board must forthwith enter the authorisation into the interests register;
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 of the Act further establishes that where the three elements of authorisation, certification 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. However, if the director can prove that the payments or benefits were fair to the company at the time it was made, personal liability may be avoided.
Comments from the Judiciary:
Noncompliance with section 161 of the Act is common. Nonetheless, a director may invest substantial time into running a company and he may take a wage or salary from the company for his time. If liquidators are appointed, they will likely take the view that such a salary is a loan and consider that it is repayable on demand. A director will likely argue that they are entitled to the funds on a quantum meruit basis.
The Courts have previously taken the view that failure to comply will render a director personally liable for the salary and that no quantum meruit argument is available.
What is “fair” to the company is a subjective test. We are yet to have a substantial judicial authority on point but it is likely to take into account the directors, expertise, experience and value provided to the company.
Case in point:
National Trade Manuals Limited was placed into liquidation by the good people at the Inland Revenue. 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 to be defective as it did not satisfy the requirements of section 161 of the Act. Specifically, there was no certificate stating that the payments were fair, or the grounds for the opinion. The legal effect of non-compliance is that the director to whom the payment was made is personally liable to repay the payment or the monetary value of the benefit except to the extent that, the director can prove the payment or benefit was fair to the company at the time it was 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 amounts being sought.
Additionally, the Court was asked to consider section 107 of the Act. The effect is that all entitled persons (shareholders or any other person specifically provided for in the company’s constitution) can agree to pay a director otherwise than in accordance with section 161 of the Act. However, the agreement must be in writing. As there was no agreement in writing by the shareholder in this case, the Court held that the section could not assist the director in his defence.
The Court in its wisdom took the matter further in the event that it was mistaken. On that basis, the Court considered that section 108 of the Act will apply which would render any agreement pursuant to section 107 of the Act a nullity as the company could not satisfy the solvency test at the relevant time.
On that basis, the monies transferred to the director by the company were ordered to be returned to the liquidators.
Lessons from liquidations
Directors and those that advise directors ought to be familiar with the practice and procedures of obtaining remuneration and other benefits from companies. Section 161 of the Act is not overly onerous. Failure to comply will result in a demand from a liquidator (if one eventually gets appointed). A liquidator can look back 6 years from the date of liquidation.
Additionally, the company can take a claim against the director, as can the shareholders (with leave of the Court).
This article was also published in the 21 February 2014 edition of LawNews.
The real value in Directors and Officers cover is that is allows a besieged director to fall back on the policy to cover the legal cost of any litigation. This matters, because even if the director is liable having the cash to mount a defence can make a huge difference to the eventual outcome.
Maybe not…
Late last year, the Supreme Court held that directors are not entitled to claim on their insurance policies for their defence costs in priority of those who were pursuing them.
The Court analysed the statutory charge established in section 9 of the Law Reform Act 1936 on insurance monies payable to an insured to indemnify the insured for damages or compensation payable to third party claimants.
The majority of the Court (Elias CJ, Glazebrook and Anderson JJ) considered that the statutory charge attaches at the time of the occurrence of the event giving rise to the claim for compensation or damages. Reimbursement to directors of their defence costs is not within the statutory charge.
The facts
The case concerns the director’s liability insurance taken out on behalf of the Bridgecorp group of companies and another by those of Feltex Carpets Ltd. The policies in both cases covered claims for losses resulting from breaches of director duties but also the costs of defence of actions brought against the directors.
The receivers of Bridgecorp brought a claim against the directors seeking to recover investor funds. A shareholder of Feltex was also bringing an action against parties involved with the share issue. He was suing for himself and in a representative capacity for other shareholders.
Those in pursuit contended that defence costs ought not to be paid out of the policies if to do so would deplete the funds available to meet the liability that will be eventually established in the proceedings. The High Court agreed with this proposition, but the Court of Appeal did not.
The directors argued that until liability is established, payment of their defence costs may be made as they fall due under the policies.
The result
The charge arising out of section 9 secures the full amount of the eventual liability to the third party claimant and arises immediately on the event giving rise to the claim.
The charge attaches to the insurance money up to the limit of the policy. This is no surprise, but to confirm, the insurer will not have to pay more than the cover requires. Conversely, if the claim is for less than the insurance, a director will likely be able to deduct the reminder in his defence costs (this was not the case in the current proceedings).
Third parties are able to have a direct right of action against the insurer to enforce the charge. The Court considered that the insurer is deemed to have the same liabilities as the insured (to the extent of the charge).
The Court held that the case arose because the policies in issue from QBE and AIG covered the defence costs as well as third party liability. The Court considered that the insurers and the insured had made a poor bargain because the policies had not been properly drawn as they overlooked the effect of section 9.
Common practice to be changed?
Prior to this dispute the insurer would have likely responded, allowing the insured director to mount a vigorous defence to the claims. The custom in such situations was that the insured could make use of the policy to pay lawyers to defend any claim. The problem with this approach was that the cost of the litigation often eroded a substantial part of the policy, leaving the victorious claimant nothing but a claim in the director’s bankruptcy.
The effect of this approach, as Justice Anderson pointed out, was that the claimant ended up paying for the defence. It was an absurd situation riddled with moral hazards. If the insurance company was facing a claim greater than the policy cover then they would always litigate no matter how hopeless the defence was. If they lost any legal costs come off what they had to pay and they could potentially burn the plaintiff off in litigation costs.
The future of indemnity insurance?
This decision does not just affect public liability cover but all similar policies, but for most directors it will be the public liability policy that matters.
The decision has provoked an outpouring of angst from industry cheerleaders, especially over a couple of non-commercial comments in the decision regarding how directors could fund litigation but here is the key issue as explicitly recognised by the Court; if the claim is without merit and the director takes no action then the insurance company will be liable for any award given.
It is inconceivable that a profit-seeking insurance company will sit back and do nothing as a hopeless case proceeds.
However, for most directors the value in having public liability cover is the ability to defend valid claims where actual breaches have occurred and it is here that the decision hurts.
The insurers, in such a situation, will have no incentive to help pay for a defence if the value of the claim is at or above the value of the policy. To do so would be throwing good money after bad, so they may look to settle the matter quickly and leave the director at the mercy of the aggrieved.
There is a further silver lining for the insurers in that they now have a new policy to market; a policy to cover director’s legal defences in the event that they are sued which will be in addition to the public liability cover.
Our view
From the perspective of a liqiudator, this is a good decision as liquidators are in the business of holding directors liable for breaches of their directors’ duties. This decision increases the ‘pot of gold’ should liquidators sue successfully as the estate will not be whittled down by funding the director’s defence. Further, insurers will have an increased incentive to come to the table to settle claims.
From the perspective of directors who feel that they may need to rely on their public liability or Directors and Officers liability cover, call your broker.
Section 261 of the Companies Act 1993 (“the Act”) confers on a liquidator the power to seek the books, records, or documents of the company from certain persons who have documents in their possession or control. Two recent cases, Official Assignee v Grant Thornton [2012] NZHC 2145 and Petterson v Gothard (No 3) [2012] NZHC 666 have defined the reach of that power.
In Official Assignee v Grant Thornton, the Official Assignee who was the liquidator of Rockforte Finance Limited sought to use its powers under s 261 of the Act to seek documents in the possession of Grant Thornton, Rockforte’s auditors. Grant Thornton resisted, claiming that their documents were not those of the Rockforte’s, but rather those of Grant Thornton. The Court agreed.
Section 266 of the Act goes further, allowing the Court to order a person to hand over their own documents to the liquidator. The Court stated:
I accept the submission of counsel for Grant Thornton that s 261(3)(b) gives the Assignee power to make enquiries of Grant Thornton, but it does not give him power to require production of documents that belong to Grant Thornton rather than the company. The power to require production of another person’s documents, which has been described as an extraordinary power, is a discretionary power reposed in the Court, to be exercised on application under s 266(2).
Accordingly, when a party holds documents which are not documents ‘of the company’ but are documents ‘about the business, accounts, or affairs the company’, Parliament has left this to the Courts to determine whether the documents ought to be handed to the liquidators.
Although, the Court considered the burden on Grant Thornton to comply with the requests, the Official Assignee was successful in gaining its orders as it is necessary to put the liquidators in the same position as directors so far as knowledge of a Company’s affairs is concerned.
In Petterson v Gothard (No 3), the Court considered the case of the liquidator, Petterson, seeking to enforce his rights pursuant to ss 261 and 262 of the Act against the receivers, Gothard and Eagle. The liquidator issued a notice pursuant to s 261 of the Act seeking access to the records of the receivership which the receivers had resisted, claiming that the documents were the property of the receivers and not the company.
In determining whether s 261 of the Act was the appropriate authority for the liquidator to obtain the documents, the respective roles, functions and duties of receivers and liquidators was considered by the Court. The Court held that the following three functions of liquidators require access to books and records held by a receiver:
(a) Access might be required to some books and records for the purpose of compiling reports that must be lodged with the Registrar of Companies, under s 255 of the Act.
(b) There is a need for a liquidator to oversee any actions of the receivers that might prejudice the interests of preferential or unsecured creditors. This role has been described as that of “an official and independent watchdog” on the receiver. Section 30 of the receiverships Act (in requiring proceeds of circulating assets to be used for the benefit of preferential creditors) is a good example of a situation in which a liquidator may need to perform that role.
(c) Access to some books and records will be required in order to determine whether any actions should be commenced in relation to voidable transactions. A receiver does not have power to bring such proceedings. In assessing the importance of that right, regard must be had to the strict time limits within which a liquidator can act; for example, in the case of a voidable transactions and charges, a period of two years before the date of commencement of the Liquidation.
The Court found that the receivers papers were in fact those of the company and therefore s 261 of the Act applied. Accordingly, the receivers were ordered to make their own papers available.
Further clarification on s 261 of the Act
In Grant & Khov v McCullagh & Lawrence [2013] NZHC 2210, the liquidators of Ellis Construction Limited sought access to the receivership records of receivers, McCullagh and Lawrence. The liquidators sought the documents so that they could exercise their functions as set out by the Court in Petterson v Gothard (No 3). The receivers had resigned and held the view that the documents of the receivership belonged to the receivers and not the company.
In response the liquidators made an application pursuant to section 261 of the Act seeking an order to enforce the receivers obligations. Ultimately, the receivers provided the requested documentation before any orders were made by the Court. However, the issue of costs remained unresolved.
Costs implications of failing to comply with requests of liquidators
The liquidators sought costs on a High Court scale 2B basis with a 50% uplift on the grounds that they were the successful party and that the receivers had failed, without reasonable justification, to accept that they had an obligation to provide the requested documentation. The receivers sought that costs lie where they fall, or alternatively be ordered on a 1A basis. The receivers made a number of submissions, the most noteworthy being that the liquidators cannot claim for legal costs for in-house counsel.
In determining this matter, the Court began with the general proposition that:
… The determination of costs should be predictable and expeditious. To that end the High Court Rules provide a scale based on the nature of the application and the level of experience required to advance it.
The Court then emphasised that:
It is a fundamental aspect of the High Court Rules that the party who fails with a proceeding on an interlocutory application should pay the costs of the successful party.
In conclusion, the Court held that:
In this case there was clearly an arguable basis for the liquidators to bring the application. They have a statutory responsibility to investigate the company’s affairs. Events in receivership are part of that investigation (at least to the extent of investigating what funds were received and applied in the receivership, and hence whether there is any money then available for other creditors). The liquidators must have the right to call in all documents belonging to the company as part of this exercise.
The Court was satisfied that the provision of documentation by the receivers made the liquidators the successful party.
Importantly in relation to costs, the Court held:
I also find that the liquidators are entitled to costs, notwithstanding that the application was brought by in-house counsel. If they had not used in-house counsel, they would have had to engage a law firm and/or counsel, and would have been entitled to an award of costs to reflect those costs.
The Court awarded costs on a scale 2B basis in favour of the liquidators.
Liquidators are faced with the often difficult task of investigating the affairs of a Company. Cooperation is needed by those who hold documentation to undertake this task. In light of the various decisions coming from the Court, any persons who have an obligation under s 261 of the Act should bear in mind their obligations and the consequences of failing with those obligations.
