Solvency the key
/Supreme Court decision a warning to directors trading near-insolvent companies
Madsen-Ries v Cooper [2020] NZSC 100
Background
Debut Homes Limited (Debut) was a property developer. Mr Cooper is Debut’s sole director. In November 2012, Mr Cooper decided to wind down Debut’s operations. Existing developments would be completed but no new developments undertaken. At the time this decision was made, it was forecast that there would be a deficit of over $300,000 in GST once the wind-down was completed.
The liquidators of Debut sued Mr Cooper. They claimed that he incurred debts on behalf of Debut without a reasonable belief that Debut would be able to meet them when they fell due, in breach of ss 135 & 136 of the Companies Act 1993 (the Act),. The liquidators claimed the full amount of unsecured creditor claims, being $449,507.
The High Court found that Mr Cooper had breached the above provisions. This decision was reversed in the Court of Appeal but was later reinstated by the Supreme Court.
Solvency is key
The Supreme Court decision emphasised that solvency is a “key value” in the Act. Where a company becomes insolvent there are statutory priorities for the distribution of funds to creditors and mechanisms to ensure that these are not circumvented. These formal mechanisms have carefully worked-out processes for decision-making and involve either an independent person or consultation with all affected creditors. The Court warned that where directors choose to employ informal mechanisms “these must align with formal mechanisms.”
Substantial risk of loss to creditors
Section 135 provides:
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.
The High Court held that Mr Cooper had breached s 135 by allowing Debut to be carried on after 1 November 2012 as this caused or allowed a substantial risk of serious loss to the company’s creditors, and in particular to Inland Revenue.
The Court of Appeal, in contrast, found that there was no breach of s 135 and said that Mr Cooper’s decision to complete the houses was a “perfectly sensible business decision” and one that was “[o]verall … likely to improve the return rather than cause loss to [Debut’s] creditors”. The Court considered that the High Court had erred by placing too great a focus on the risk of non-payment of GST and by failing to account for the benefit to other creditors from obtaining higher prices for the properties.
The Supreme Court, on the other hand, agreed with the High Court. It held that Mr Cooper’s decision to carry on Debut post-November 2012 created the certainty of a GST shortfall of $300,000, which it regarded as a “serious loss”.
The Court said further that it is not an answer to s 135 that “completing the properties was a sensible business decision in that it had the potential to benefit some of the creditors by providing higher returns than immediate liquidation would have done”.[1] If continuing trading meant a certain shortfall, this was a breach of s 135 regardless of whether some creditors would be better off.
Incurring an obligation
Section 136 provides:
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.
As with the claim of a breach of s 135, the High Court found that Mr Cooper had breached s 136, whilst the Court of Appeal held that he had not. The Court of Appeal noted that s 136 focusses on the incurring of a particular obligation rather than on the carrying on of the business as a whole. It considered that the fact that an incidental GST liability would arise on particular sales did not make the agreements the kind of transactions that are the object of s 136.
At the Supreme Court, Mr Cooper argued that the provision is directed towards a contractual obligation incurred with the agreement of the director, rather than a tax debt. The liquidators argued to the contrary, and said that to require a direct agreement to incur an obligation between a company and a creditor places an unnecessary gloss on the plain wording of the provision.
The Supreme Court again found in favour of the liquidators and held that the provision is not limited to direct contractual obligations. It agreed with the liquidators that there is no policy for placing such a gloss on the section. The Court said that Mr Cooper knew that by entering into the sale and purchase agreements Debut would incur the GST obligation on the sale prices charged. As such, he was agreeing to Debut incurring the GST obligation.
The arguments of the liquidators and the Attorney-General were accepted by the Court that it is not legitimate for a director to enter into a course of action to ensure some creditors have a higher return where this is at the expense of incurring new liabilities which will not be paid.
Relief
A significant issue in the decision was what level of relief is appropriate, and on what basis.
Section 301 affords to a court a broad discretion to inquire into the conduct of the director and order the director to repay or restore money or property, or contribute such sum to the assets of the company by way of compensation as the court thinks just.
The Supreme Court held that, in terms of a breach of s 135, in most cases the appropriate starting point would be an amount equal to the deterioration in the company’s financial position between the date when trading should have ceased and the date of the actual liquidation (the net deficiency approach). This is because s 135 looks at the creditors and business as a whole.[2]
In contrast, for breaches of s 136, the focus should be on individual creditors. The relief ordered should “operate to reverse [the] harm and thus be restitutionary in nature.” So, where the director carries on trading, ‘robbing Peter to pay Paul’, the correct test is not the net increase in the amount owing to creditors, since that would create the “perverse incentive to continue to trade in breach of s 136 as long as they are careful to make sure that the net deficit remains constant.”[3]
The starting point for compensation for Mr Cooper’s breach of s 136 was based on all new debt incurred after November 2012 (i.e. when Mr Cooper decided to wind down Debut yet continued to trade).
The High Court’s compensation order, which was based on the additional GST liability Debut incurred (less an allowance for the director working for the company without charging for his time) was reinstated. Mr Cooper was ordered to make a contribution of $280,000 towards the assets of Debut.
Comment (Tom Pasley)
The Supreme Court decision in Debut Homes continues the modern trend of ratcheting up the ambit of directors’ duties and potential liability to creditors. In particular, the decision highlights the risks and difficulties that directors face when considering whether to continue to trade, where the company is insolvent or near-insolvent. This area of corporate governance was already challenging – especially in the current poor economic environment due to COVID-19. The challenges for directors have now increased.
Ultimately, the Supreme Court makes it clear that directors of insolvent or near-insolvent companies, who can see that there will be a shortfall to creditors, are required to take proactive steps to address that risk as soon as they can. This must include some form of insolvency or restructuring mechanism, such as creditors’ compromises, voluntary administration, or liquidation. If directors make the wrong decision, the Supreme Court makes it clear that they are at risk of personal liability.
The very challenging predicament faced by directors is demonstrated by the fact that the Supreme Court took a completely different approach to that taken by the Court of Appeal, whose decision it overturned.
The natural consequence of this decision is an increase in companies being put into liquidation at an early stage, and a decrease in companies attempting to trade out of difficult circumstances. The bottom line is likely to be an ‛up-tick’ in claims against directors.
Tom Pasley is a Special Counsel at Fee Langstone
