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/
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.
66% of businesses fail. Because of our expertise, we see a lot of these businesses. There are many reasons why a business can fail, and a dispute between the shareholders is one of the reasons which is common.
As such, it is important to properly document arrangements between the shareholders before hands are shaken. Having a robust and a tailored to your personal needs shareholder agreement can help to avoid disputes. Also, if the shareholders do end up in dispute, the shareholder agreement can make the resolution of the dispute simpler and faster.
Based on our experience, a poorly drafted or a ‘templated’ shareholder agreement often causes more problems than not having one at all!
This guide is intended to give the top issues to be discussed, agreed and documented upfront between the prospective shareholders to reduce the chances of dispute. It is important that prospective shareholders turn their minds to these issues and document them properly.
Right to appoint and remove directors
Who has this right?
How is it triggered?
Minority Shareholders
How are they protected so that unanimous shareholder approval is required for some company decisions? Or do they not require this?
Exit strategies
If someone wants to leave, do shareholders have freedom to dispose of shares freely?
Are there pre-emption rights?
Can they sell to third parties?
What happens if a shareholder dies? Will the other shareholders be in business with their spouse or children or are there rights to purchase from existing shareholders?
What valuations apply to the transaction?
Are minority shares worth less (because they hold less control) or are all shares equal in value?
Nature of business
Are there any restrictions over the nature of the business and any change of this business?
Raising Capital
How will this occur?
What is the maximum commitment each shareholder is obliged to make? What happens if a shareholder does not make a contribution? Are they ‘kicked out’ or is their share simply diluted?
How will share dilution be avoided? Will it be avoided?
Dividends and other monetary contribution
Is there a policy for dividends?
Will certain shareholders agree to waive dividends for an agreed period or permanently?
Are shareholder’s drawings to be allowed and if yes, in which circumstances?
Directors
Do the directors have freedom of action, for example to invest in a new capital project or charge the company’s assets?
How are day to day decisions made?
How are the directors to be remunerated?
Do major transactions require 75% shareholder agreement or will it require a unanimous decision?
Business plan
Is there a business plan?
Non-compete covenants
Can shareholders compete with the company while still being shareholders?
Can shareholders compete with the company for a period after they sell their shares (say for 12 months)?
Shareholder disputes
How are shareholder disputes to be resolved? Arbitration? Mediation? Court?
Can there be an automatic forfeit of shares in certain defined circumstances? If so, what?
If a liquidator is appointed, the liquidator may elect to pursue the director. This will likely include claiming:
All losses of the company (creditors);
Liquidation costs (i.e. cost of administering the liquidation);
Legal costs
We have been involved in pursuing many directors for breaching their duties. We have also assisted directors who have had allegations of breaches made against them. We can see this debate from both sides of the table.
While there has been a mixed reaction, many directors have been found liable to cover the costs of the liquidator.
The Court of Appeal has sent a firm message to liquidators.
The outcome is that the historical approach may not be viable going forward.
Mr and Mrs Shaw
Mr and Mrs Shaw are trustees of their family trust.
Their trust owned a farming enterprise and later a glazier and manufacturer of aluminium joinery.
One of its supplies refused to supply materials to a trust, rather it required supply to a corporate entity.
Consequentially, the Shaw’s incorporated Aluminium Plus for this purpose. The Shaw’s were the sole directors.
Aluminium Plus was a conduit for the Trust. It didn’t have a bank account. It simply passed supplied from the supplier to the Trust. The Trust paid the suppliers invoices directly.
However, the Shaw’s later took the view that supplies were defective and caused both entities not to pay.
The supplier later obtained judgment by default against Aluminium Plus (not defended).
Aluminium Plus was later liquidated by the High Court.
The Liquidators’ Claim
The liquidators issued a proceeding in the High Court. Justice Brown upheld the liquidators’ claims that the Shaw’s were guilty of reckless trading and negligence in breach of their duties.
The Shaws’ recklessness arose from their election to release the Trust from its obligation to pay its suppliers on Aluminium Plus’ behalf for supplies of materials. This decision exposed the supplier to the risk of loss because Aluminium Plus had no income or assets to pay the invoices then outstanding. The Shaws’ negligence lay in releasing the Trust from its agreed role as funder of Aluminium Plus’ purchases in circumstances where there was no other source of funding and the prospect of an offsetting counterclaim was speculative.
Brown J ordered the Shaws to pay compensation of $125,884.59, comprising Aluminium Plus’ debts of $99,005.03 plus the costs and disbursements of the liquidation of $26,879.56.
The Court of Appeal Decision on Breach of Duty
The Shaws challenged the decision of Brown J. They say they were not reckless.
The Court of Appeal agreed with Brown J. The nature of Aluminium Plus was that it had no assets or income to meet its liabilities other than from recourse to matching payments made by the Trust. Its solvency was entirely dependent upon the Trust’s financial support. The nature of the directors’ decision was to release the Trust from its contractual obligation to indemnify Aluminium Plus against all liabilities. Insolvency was its inevitable and immediate consequence, leaving the creditors’ interests without protection.
The Court of Appeal was satisfied that the Shaws’ decision to release the Trust for Aluminium Plus’ liability, at a time when it was otherwise indebted to its supplier, was in breach of their duty to exercise the care, diligence and skill expected of a reasonable director in those circumstances given that its inevitable and immediate consequence was to render Aluminium Plus insolvent.
The Court of Appeal Decision on Compensation
However, the Court of Appeal held that Brown J erred in allowing all the liquidators’ costs of $26,879.56 within the compensation award.
It was held that:
Section 301 provides, among other things, that if a director has been guilty of negligence the court may order the director to contribute such sum to the assets of the company by way of compensation as the court thinks just in the light of the director’s conduct. As the Judge correctly observed, the s 301 power is guided by the standard approach outlined by this Court in Mason v Lewis: by looking first to the deterioration in the company’s financial position between the date the inadequate corporate governance became evident and the date of liquidation, and then exercising judicial discretion by reference to the three factors of causation, culpability and the duration of the trading.
The Court considered that a compensation award should reflect the financial measure of the director’s contribution to the loss suffered by a company as a result of the acts or omissions underpinning his or her relevant breach of duty. However, the question of whether compensation should include the liquidators’ costs in undertaking the liquidation is less straightforward. The costs of administering a liquidation will generally be incurred regardless of whether the company’s directors are liable.
This was not an orthodox company liquidation or liquidator’s claim. The Supplier was Aluminium Plus’ only significant creditor when it was wound up. The other two creditors were for relatively minor amounts. The Court of Appeal held:
It would have been immediately plain to the liquidators that the company’s indebtedness was very modest; and that it had no assets available to meet creditors’ claims except for a contingent right of action against the Shaws.
Nevertheless, Ms Louise Craig, an employee of the liquidators, deposed at trial that the liquidators’ costs amounted to $38,404. However, unusually, the liquidators sought to recover costs of $43,187. Later at Brown J’s direction they amended their claim. They reduced it to $26,879 for costs which they say were not attributable to the litigation against the Shaws.
The Court of Appeal held that it was not easy to follow how non-litigation costs of $26,879 could justifiably be incurred in a liquidation relating to a very modest level of indebtedness.
Ultimately, The Court of Appeal held that the Liquidators were entitled to follow the course pursued. But they cannot expect to recover more than the usual award of legal costs and disbursements if successful. The purpose of an award of compensation is to recoup or indemnify the company for its losses attributable to a director’s breaches. While it may be appropriate to incorporate an allowance for the liquidator’s costs where they are necessarily incurred because of the relevant breach, care is required to ensure that the award is truly proportionate to the company’s actual loss.
The Court of Appeal held:
It is telling that the final award in the High Court — inflated by credit consultant’s and liquidation costs — more than doubled the suppliers actual debt. On any cost-benefit analysis, pursuit of this litigation was not a commercially rational exercise.
Ultimately the Court of Appeal removed the costs of the liquidation as compensation awarded to the Liquidators.
Our Comments
It has become a common practice in New Zealand for Liquidators to seek delinquent directors to pay liquidation costs.
Some well-respected commentators criticise this practice and would suggest that this should never occur.
We somewhat disagree.
On a practical level, many delinquent directors substantially increase the costs of the liquidation by the way in which they engage (or not engage) with the Liquidators. For example, they hide assets. They hide information and documents. They frustrate the process by being untruthful. The level of behaviour and the impact on liquidators and their resources cannot be underestimated. These directors ought to pay these increased costs of liquidation. The creditors ought not bear that cost out of any recovery (ultimately creditors would receive less).
However, for other directors, who have not engaged in this delinquent behaviour, like the Shaw’s, the Court ought to be slow to burden them with these additional costs. The purpose and scheme of the Act does not justify such an approach.
In our second issue in our series of articles on enforcement of judgments, we discuss warrants to seize property and sale, possession, charging and garnishee orders. All these options provide the judgment creditor with rights of recourse towards the judgment debtor’s assets.
Before you decide to apply for these orders, you need to consider whether the judgment debtor owns assets that could be pursued to satisfy the debt. This information might already be known by the time you obtain judgment. However, if it is not, there are several methods of assessing the judgment debtor’s asset position. These methods are discussed in our previous issue.
Warrant to seize property
This procedure is available in relation to the judgments obtained at the District Court.
A warrant to seize property enables a bailiff appointed by Court to visit the judgment debtor and seek payment of the judgment debt. If the judgment debtor does not pay, the bailiff can seize and sell any personal assets of the judgment debtor, except for:
The judgment debtor’s tools of trade to a value not exceeding $5,000.00; and
The judgments debtor’s necessary household furniture and effects, including clothing for the judgment debtor and their family, to a value not exceeding $10,000.00.
When the bailiff visits the judgment debtor, they will have identification and the warrant document with them. Bailiffs have legal rights to enter the judgment debtor’s property and take items which they believe belongs to the judgment debtor. If, after the seizure, the judgment debtor does not pay within 7 working days, the bailiff will sell the property at a public auction, and will apply funds from the sale to pay for any seizure and storage costs, and the remainder will be paid towards the judgment creditor’s debt.
The warrant cannot be used to cease and sell land. If the judgment creditor is willing to sell land, the judgment needs to be transferred to the High Court, where a sale order can be obtained (discussed below).
Garnishee order
This procedure is also only available at the District Court.
If a third party owes the judgment debtor money, the judgment creditor may apply to Court for that money to be paid directly to the judgment creditor. A garnishee order can be a useful tool to the judgment creditor as it may attach to money in bank account or solicitor’s trust account.
In the High Court, similar effect can be achieved through a sales order.
Sale order
This procedure is available in relation to judgments obtained at the High Court, or judgments from the District Court which are subsequently transferred to the High Court.
A sale order authorises a bailiff appointed by Court to seize personal property belonging to the judgment creditor and sell it to satisfy the judgment debt. In addition, it can also entitle the bailiff to sell land.
Sales orders have similar limitations in relation to the sale of the judgment debtor’s tools of trade and necessary household furniture of low value as under a warrant to seize property.
Possession order
A possession order authorises and requires the bailiff to deliver possession of the land or chattels to the judgment creditor. Possession orders are available where the judgment orders the judgment debtor to deliver possession of land or chattels to the judgment creditor.
If a judgment orders the judgment debtor to pay a sum of money and to deliver possession of land or chattels to another party, the judgment creditor may apply for both, sale and possession orders.
Charging order
A charging order prevents the judgment debtor from selling their property until the judgment debt is repaid. These orders are available in both, District Court and High Court.
Obtaining a charging order is a relatively quick process. Charging orders are usually obtained before the sale and/or possession orders to ensure that the judgment debtor does not dispose of the property by the time the sale and/or possession orders are made and administered. If the judgment debtor owns land, once the charging order is obtained, it entitles the judgment creditor to place caveat on the land’s title.
Conclusion
All of these options are useful tools for judgment creditors to consider if the judgment debtor owns valuable assets. These methods are efficient, as they usually result in a prompt payment.
If the proceeds from the sale are not sufficient to satisfy the debt in full, other enforcement options, such as an attachment order which was discussed in our previous issue, could be obtained in combination with these orders.
If you are considering applying for a warrant to seize property or sale, possession or charging orders, it is likely that legal assistance will be required, we invite you to contact our specialists for a no obligation discussion.
