Creditors’ limited ability to pursue directors for breach of duties
The facts of Banks v Farmer [2021] NZHC 1922 will sound familiar to many. A gap in the market is identified and a business is set up to fill that gap. The issue many of these start-up businesses face is trying to convince investors to support them. Upon securing an investor there is subsequent pressure placed on the directors to make good on that investment. But sometimes everything might turn sour, with investors left trying to recover the money they put into these ventures.
The background of this case centres around a company named Mako Networks Holdings Limited (Mako), the company operated within the technology security market and the development of technological solutions for this area. Adam Banks (Mr Banks) was an investor in Mako, between 2011 and 2014 he had invested over $3.2 million in unsecured loans. Unfortunately, Mako was placed into liquidation and receivership when it owed creditors $34.5 million. Mr Banks brought these proceedings against the four directors of Mako (the Directors) on the basis they did not act in accordance with their obligations as directors.
Section 301 of the Companies Act 1993
Section 301 of the Companies Act 1993 (the Act) provides the High Court with the power to require a director (amongst other persons) to repay the money or return property of the company, or to make a contribution to the assets of the company by way of compensation. Under this section, liquidators, creditors, and shareholders are given the opportunity to make an application to the Court which is only triggered when the company in question is in liquidation.
An order made under this section will qualify as a judgment debt, therefore enabling liquidators, creditors, and shareholders to hold directors personally liable, resulting in the commencement of bankruptcy proceedings, if necessary, to enforce payment.
Application in Banks v Farmer
In the High Court decision, the third cause of action against the defendants was for a breach of their directors’ duties. Specifically, their failure to act in good faith and the best interests of the company, for carrying on business in a manner that was likely to create a substantial risk of serious loss to creditors, and for letting the company incur obligations that it was not able to perform and for their failure to exercise the care, diligence, and skill that a reasonable director would exercise in those circumstances.
Mr Banks relied on s 301(1)(c) of the Act to claim relief in the sum he advanced to Mako. In the alternative, Mr Banks sought the defendants restore or contribute $29,897,000.00 to Mako. He specifically referred to s 135 (reckless trading), s 136 (improperly incurring obligations), and s 137 (failing to exercise reasonable skill and care) as the directors’ duties that were breached.
In his discussion of the case, Moore J referred to the purpose of the Act regarding directors’ duties stating “Directors’ duties are not intended to prevent the taking of legitimate business risks or constrain genuine business judgment, but rather to protect shareholders and creditors against illegitimate abuses of directors’ power.” Moore J referenced that directors’ duties under ss 135 and 136 aim to protect shareholders and creditors from the directors taking big risks. These sections are intended to discourage directors from increasing their company indebtedness. Moore J also referenced that s 135 should only penalise illegitimate risk-taking. It was decided that there was no breach of s 135 before April 2014, and therefore this section failed.
Under s 136 it has to be established that when obligations were entered into a director of a company did not believe a company would be able to perform these obligations. Or that if there was a belief, it was an unreasonable one. Moore J also decided this section would fail as the defendants subjectively believed on reasonable grounds that Mako would be able to meet its obligation to Mr Banks as those obligations were due.
Section 137 relates to a duty of care. Moore J considered that by mid-2014, the Directors of Mako should have been aware of its looming cash flow issues. He considered that without a multi-million dollar contract coming into play, the company would not be able to meet its obligations. As such “at that point, a reasonable director, exercising due care, diligence, and skill, would have caused Mako to cease trading and go into liquidation” and it was concluded that a breach of s 137 was found.
Section 301 as a remedy for creditors
As s 137 was found to have been breached by the Directors, Moore J considered whether s 301(1)(c) could be used as a remedy with Mako no longer being at liquidation at the time of the trial.
Moore J held that s 301(1)(c) was unavailable as a remedy to Mr Banks as Mako was no longer in liquidation. At the time the proceedings were initiated, Mako was in liquidation, however, before the trial had begun, Mako was removed from the register. Moore J referred to the practical issues regarding the varying lengths of trials and securing a court date after an application has been filed. However, the law is clear, and the company must be in liquidation, otherwise, there will be no directors of a company to be held liable. It was noted that Mr Banks could have made an application under s 239 of the Act to restore Mako as a company. Yet, no applications were made.
The second consideration under this section was whether creditors could be personally compensated for a breach of directors’ duties. Moore J concluded that directors’ duties are owed to the company, not to specific creditors. As such, only a company is entitled to receive a remedy for a breach of directors’ duties. Moore J reviewed two conflicting decisions of the High Court on this issue. In Mitchell v Hesketh [1998] 8 NZLC 261,559 (HC), Master Venning was of the view there is a limit on the approach for creditors to obtain personal compensation. Where the claim was for “negligence, default, or breach of duty or trust about the company, the Court may only award relief by ordering that the director pay compensation to the company under s 301(1)(b)(ii).”
In the alternative decision, in Marshall Futures Ltd (in Liq) v Marshall [1992] 1 NZLR 316 (HC), Tipping J was of the view s 301(1)(c) permits creditors to be personally compensated in limited circumstances. Tipping considered whether “moneys which are the subject of the declaration of personal responsibility are payable to the company…for the benefit of the creditors of the company as a whole or whether they are payable directly to the creditor.” His conclusion was that monies would be payable if the claim was payable to the creditor directly, without needing the liquidator to be involved. However, this authority was not helpful to Mr Banks, as the liquidator would have had to be notified of the claim, which did not occur.
Conclusion of Moore J – what it means for creditors
In the decision Moore J decided in favour of the defendants, holding that Mr Banks was unable to recover directly under s 301(1)(c). Section 301(1)(c) allows the Court to order directors to pay or transfer money or property directly to applicant creditors. However, a relief under this section can only be ordered where a director has misappropriated specific funds or property. This was not the case in this case so there could be no relief ordered to Mr Banks. In this case, the directors were found in breach of directors’ duties, but not misappropriation.
Section 301(1)(b) allows for relief where there has been a breach of director duties (as was the case here), however, this section provides for such relief to be paid to the company (as opposed to directly to the creditor) and then liquidators could make distributions to creditors. Section 301(1)(b) allows for the pool of assets in a liquidation to increase as the Court can order a person to repay or restore money or property with interest, or to contribute a sum to the assets of the company by way of compensation. However, at the time of the trial, Mako was no longer in liquidation and had been struck off the companies register. As such, Mr Banks was not able to utilise s 301 as a creditor as there was no company in existence that could receive the payment.
This decision highlights the importance of having security over your investments in a company. In this case, Mr Banks was left without any proper avenue for recourse under s 301.
Brent is the Director of Norling Law. He has a wealth of experience in the District Court, High Court, Court of Appeal and Supreme Court. Brent is passionate about negotiating favourable outcomes for his clients and able to implement this in his daily negotiations.
Anna practices in the area of commercial litigation and has appeared as Counsel in the District Court, High Court and the Court of Appeal, having successes in all Courts. Anna has a special interest in corporate, insolvency and relationship property law.
Lucia Krajancic
Lucia graduated from Victoria University of Wellington with a Bachelor of Laws and Bachelor of Arts majoring in Criminology and was admitted to the bar in October 2022.