Directors of insolvent companies who fail in their duties, may be held personally liable for losses caused by their actions or injurious omissions.
Insolvent companies
Firstly, when is a company insolvent?
The Companies Act 1993 (the Act) defines a solvent company, using two limbs as when:
- The company is able to pay its due debts; and
- The company’s balance sheet reflects positive equity
However, some cases indicate that the primary consideration is cashflow:
“… not concerned with the state of a company’s balance sheet, but rather with whether it has funds available to it with which to pay its debts as they fall due in the ordinary course of business”.
Re Gladding King Real Estate Ltd (in liq) (1993) 6 NZCLC 68,261 (HC) at 68,275.
Directors’ duties
The Act lists several duties owed by company directors. These include:
- S 135 – the duty to not trade recklessly
- S 136 – the duty to not incur obligations which can’t be fulfilled
- S 131 – the duty to act in good faith
- S 137 – the duty to exercise care
Case law shapes how these duties are enforced by the courts when claims are made by liquidators or creditors of insolvent companies.
Yan v Mainzeal Property and Construction Limited (in liquidation) (2023)
Background
Mainzeal was a well-known major construction company. Leaky building claims and poor trading conditions were the issues that led to the company’s failure. The directors (including ex-prime-minister Jenny Shipley) prolonged their decision to liquidate. Creditors were owed $110 million dollars.
S 135 – Reckless Trading
The Supreme Court found the directors were liable under s 135 for reckless trading. They carried on in a manner “likely to create substantial risk of serious loss to the company’s creditors”.
The balance sheet was effectively negative. It reflected advances to related parties that were non-recoverable, and which should have been written off to the P&L.
Cashflow was poor. Assurances of ‘last resort’ support from one director (Mr Yan), and the parent company (which had no substantial assets in any case), weren’t enforceable.
In Mainzeal’s twilight, it used new unsecured creditors for its working capital.
S 136 – Duty in relation to obligations
The directors were also found by the Supreme Court to be liable under s 136 for failing in their duties in relation to obligations.
They entered the company into four major construction projects no reasonable director would have believed feasible, and then incurred further short-term liabilities.
Director liability
All directors of the company were held liable in joint for $39.8 million, plus interest.
Mr. Yan was held as “fundamentally [at] fault”. His losses weren’t limited.
Other directors let Mr Yan trade the company in this manner without applying enough pressure to resolve the issues. They ought to have resigned or possibly wound the company down earlier.
The other director’s liabilities were only limited to $6.6 million each, plus interest.
Lessons for directors
- Address issues of insolvency immediately.
- Do not trade for an extended period whilst balance sheet insolvent, unless external cashflow support can really be relied upon.
- If deciding to trade-on through uncertainty, ensure you have a sound understanding of how new obligations will be met.
Sojourner v Robb (2006)
Background
Contracts to build luxury yachts were entered into. Losses exceeding $300,000 became inevitable, caused by enormous labour needs. To avoid the losses the director stripped the company. The business was sold to a new entity he controlled. Assets, goodwill, staff and customers were transferred, but goodwill was significantly undervalued. The company was left as a shell with few assets remaining.
S 131 – A director must act in good faith and in the best interests of the company
The High Court found the director to be liable under s 131 for their failure to sell the business at “fair value”, leaving the creditors with little means to be repaid.
“Creditors are persons to whom the company has ongoing obligations. The best interests of the company include the obligation to discharge those obligations before rewarding the shareholders.”
Director liability
The director was held liable for approximately $500,000.
Lessons for directors
- Ensure proper care is taken to assess profitability of opportunities.
- You cannot transfer between companies unless at market value.
- Creditors must be paid before shareholders.
FXHT Fund Managers Limited (in liquidation) v Oberholster (2010)
Background
Dr Oberholster, A South African GP who’d emigrated to Northland, supported an acquaintance (Mr Hitchinson, also a South African emigrant) by agreeing to appointment as a non-active director of their company. He also purchased 50% of the shares. The company operated an unprofitable foreign exchange business, which shifted into a Ponzi scheme. Mr Hitchinson regularly misled Dr Oberholster regarding the company’s performance during casual discussions.
S 137 – Director’s duty of care
The liquidators initially pursued Mr Hitchinson for defrauding investors US$297,751 and NZ$44,095. No funds were recovered by the liquidator.
Dr Oberholster was then confronted for his failure to care to the company, and was found to have breached s 137. The Court held that he did not exercise the skill a reasonable director would have, as he did not have the basic expertise needed to direct an investment fund, and he allowed to company to be run without adequate financial oversight.
Director liability
Dr Oberholster, as a 50% shareholder, was held liable for 50% of the damages; NZ$17,493 and US$148,876.
Lessons for directors
- Do not accept a directorship role if you don’t understand the business.
- Ensure you have sound oversight of the financials.
- Be wary opportunities which require little commitment whilst providing a disproportionate benefit or remuneration.
Madsen-Ries v Cooper
Background
Mr Cooper was the director of a property construction firm, which became financially distressed. He decided to complete existing developments before winding up the company, whilst prioritising other creditors ahead of IRD. He anticipated before doing this, IRD would be owed over $300,000 in GST come liquidation.
S 131 – A director must act in good faith and in the best interests of the company
It was found by the Supreme Court the director had breached s 131. When a company is near insolvency, it must consider the interests of its creditors. The director sought to pay some creditors, whilst not paying others, including the IRD.
S 135 – Reckless Trading
The Supreme Court ruled that s 135 had been breached when the director allowed the company to continue trading in circumstances where it risked serious losses to creditors. Throughout the period leading to liquidation, IRD was a significant creditor, however the director chose to complete developments instead of winding the company up immediately.
S 136 – Duty in relation to obligations
The director could not have reasonably believed the company would meet its GST obligations and other debts when they fell due, and was therefore liable under s 136.
Mr Cooper indeed planned ahead of time that IRD would be left owed an increasingly substantial sum, however had decided to continue trading.
Director liability
The High Court ordered Mr Cooper to make a contribution of $280,000, and set aside a GSA between a Family Trust and the company to ensure the funds were paid to IRD.
Lessons for directors
- You cannot choose to ignore some creditors, whilst favouring others.
- If you know the company will be unable to pay a creditor, you must cease trading.
Announced in 2024, the Minister of Justice has asked the Law Commission to undertake a review of director duties and liabilities. This work is about to commence in 2025. It’s aim is to look at clarifying duties and consequences for s 135 and s 136. It may recommend changes that lead to amendments of the Act and hopefully clarify the lines that directors ought to play in.
In each of the cases summarised above, directors failed to meet their duties, and most were ultimately held personally accountable. In the increasingly turbulent business environment, these failures are becoming more common. To best understand the risks, we recommend seeking expert advice from an advisor.
