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.