Usually, entrepreneurs choose the vehicle of a limited liability company to trade a business for the benefit of its shareholders. However, this is not the only option available. From the 1970s onwards, a popular choice was for a limited liability company to trade a business through a corporate trustee. In that structure, the corporate trustee is the legal owner of the business but trades it for the benefit of its beneficiaries of a trust.
There are inherent risks with an essentially asset-less trustee company trading a business. In particular, there is a real risk that the model can be used to defeat genuine creditors of the company where the business and its profits are treated as trust assets. Where a business is operated in this way, there is a risk that the directors of the corporate trustee open themselves up for liability for breaches of their duties as the directors of the company.
That said, the Courts will look closely at the actions and knowledge of the directors when determining whether a breach of duty has occurred.
Liability can be mitigated by director’s actions
This situation came before the Courts in the late 2000s in the case Levin v Ikiua, where the liquidators of the corporate trustee brought proceedings against the directors for (in their view) operating the company in a manner that gave rise to a substantial risk of serious loss to the company’s creditors.
In summary:
- The Company, OPC Managed Rehab Limited, settled a trust (the OPC Managed Rehab Trust) and transferred its business to the OPC Trust.
- The Company had a contract with ACC to provide rehabilitation case management services, which was the Company’s sole source of income.
- From late 2000, the Company traded this rehabilitation case management service business for the benefit of the OPC Trust.
- Each month, following the payment of the company’s creditors, any residual funds were transferred from the Company to the beneficiaries of the OPC Trust.
- At the beginning of 2001, ACC raised the concern that it was overpaying for the Company’s services. One of the directors, Mr Ikiua, accepted that the Company had “inadvertently” overcharged during that period. As a result, the Company withdraw the invoices/claims that it had already submitted to ACC and reissued corrected invoices/claims.
- Both Mr Ikiua and Mr Sio (the Entitlements Manager of the Company) gave evidence that measures were put in place after the 2001 allegations of overpayments to avoid a re-occurrence of the problem.
- In or around August 2022, ACC conducted an audit of the invoices/claims and formed the view that $695,190 (excluding GST) had been overpaid to the Company. As part of the investigation procedures, Mr Ikiua was interviewed.
- On 26 January 2006, the Company was placed into liquidation, and the liquidators brought proceedings against the directors of the Company for breaching their duties to the Company.
- A gross sum of $3,434,074.40 was claimed to have been paid by ACC to the Company for services rendered. Out of the $3,434,074.40, a total of $1,604,424.01 was distributed to the OPC Trust.
Putting aside the issue of whether the OPC Trust was properly settled, the liquidators’ view was that the “empty shell policy” of the corporate trustee, coupled with the ACC contract being its only source of income, was a method of operation that gave rise to a substantial risk of serious loss to the Company’s creditors, as the business was conducted in a manner that did not provision for any contingent or unexpected debt.
The High Court and the Court of Appeal did not agree with the liquidators.
The Courts held that if the directors had knowingly made distributions to the beneficiaries in priority to creditors of the Company, then they may have been in breach of their duties. However, the evidence showed that:
- the directors ensured creditors were paid before any distributions were made; and
- the directors had no knowledge of any debts owing to ACC at the relevant time.
The fact that there was the emergence of a disputed liability of which they could not have reasonably anticipated, was not held to be caused by the manner of operation.
As a result, no breach of duty arose for the period prior to October 2002, the date that the Courts believed knowledge of debt was gained by the directors.
However, a small amount of distributions was made following the directors being made aware of ACC’s claim. The Court held that only these distributions (totalling circa $8,000) were made in a manner that gave rise to a substantial risk of serious loss to the Company’s creditors.
Many readers may ask: why did the Court conclude that the directors had no knowledge of the debt to ACC?
It seems that the Court took the view that the directors reasonably believed the problem had been resolved in 2001, following the issue first arising. When it occurred again, the directors did not know a debt to ACC existed when they distributed trust funds. As such, the Judge found that the directors first became aware of the overpayment issue leading to liquidation when Mr Ikiua was interviewed in October 2002 by ACC.
Breaches can be caused by inaction taken to notification of issues:
A recent High Court case illustrates the other side of the coin: where directors do know about a risk but fail to act, liability can follow.
In this case, the director operated Company A which began winding down its business in the mid-2010s following the loss of some key customers. The director began incorporating Companies B and C and employed staff to work in the other businesses. Since Company A already operated a payroll system and had an account with the IRD, the director decided it would be administratively easier to utilise this existing system, and Company A employed the staff working in the businesses operated by Companies B and C.
Companies B and C reimbursed Company A for wage payments for the staff, but did not account for the employer tax that was being accrued by Company A for their benefit.
In the late 2010s, the IRD issued a statutory demand on Company A for the unpaid tax, for around $125,000. No changes were made by the director to the method of Company A’s operation, despite later acknowledging that Company A was “borderline insolvent” at this point.
Two years later, IRD issued a second statutory demand to Company A for around $480,000 in unpaid tax and penalties. Shortly after, Company A was placed into liquidation.
The liquidators brought proceedings against the director for the loss suffered by the Inland Revenue, on the basis that the manner in which the director traded Company A created substantial risk of serious loss to Company A’s creditors.
The Court agreed that the director had breached section 131, 135, 136 and 137 of the Companies Act 1993, and awarded full liability for the Inland Revenue debt.
Conclusion
These cases demonstrate that operating a business through a corporate trustee structure is not, in itself, improper. However, directors must exercise particular care where their duties to the company may come into tension with the interests of trust beneficiaries.
Levin v Ikiua provides a useful example of a situation in which the directors took reasonable steps to ensure that their duties to the company were not subordinated to the interests of the trust beneficiaries.
The key takeaway is that where warning signs emerge, burying one’s head in the sand is rarely a practical, or legally defensible solution, and can give rise to the piercing of the corporate veil, and personal liability for debts being imposed on a director.
