As a remedy for creditors who have lost money in a liquidation, pursuing a director under Section 135 or 136 of the companies act is economically fruitless. Section 135 specifies a director must not agree, or cause:
“…the business being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.”
Section 136 states a director 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.”
There is a wealth of legal writing on the above short sections, and the more lawyers write on the subject and pour over the handful of decisions handed down the more areas there are for protracted legal disputes and avenues for defence.
Few pieces of New Zealand company law have been so analysed as the snippets of legislation relating to the personal liability of company directors of insolvent companies.
What constitutes create a substantial risk? What constitutes unreasonable?
All business is risky, and all businesses face different levels of risks. An objective assessment of the risks facing a company is very difficult to do at the time, enormously complex after the fact.
There has been renewed interest in this area after the success of the liquidator in the case of Meltzer vs. Lewis, where non-executive directors were held to account for some of the losses of their company. However, it is important to understand that the courts only held them partially liable, limiting their liability by both the duration of their directorship and the value of their shares in the operation. There was no punitive element in the award won by the liquidator.
It is important to remember that liquidators do not use these provisions because these prosecutions are expensive, difficult to win, and easy to defend.
Help from the Institute…
If the company’s accounts had been prepared by a member of the institute of Chartered Accountants, then the accountant has an obligation to advise their client of possible breaches of section 135 and 136.
Going through the files, we find such advice more than you would imagine. This is a powerful tool in compelling directors to own up to their obligations to their creditors, but it is not necessarily proof of reckless trading or a breach of Sections 135 or 136. The directors may have access to personal capital, access to information not available to the accountant, and so on. There are more effective remedies, and Section 301 is perhaps the most powerful.
Section 301 – What’s that?
This is a nice little piece of legislation that rips the corporate veil into little pieces. Much more effective than the more difficult remedy available under section 135 & 136. Section 301 allows a creditor (especially useful in the face of a passive liquidator), shareholder or liquidator, to take action against a director if that director has:
“misapplies, or retained, or become liable or accountable for, money or property of the company.”
If the action is taken by a creditor, and the result is that the director is ordered to return the property, the court can compel the director to return the property direct to the creditor.
This section also applies to others involved in the business. Specifically, a 301 action can also be taken against a liquidator, director, promoter or a manager of the company.
The case law reveals that the sorts of things a director can be held liable for include:
- Retention of secret profits
- Paying dividends out of capital
- Misallocation of money or property belonging to the company
- Granting preference to creditors (especially where personal guarantees are concerned)
- Failing to use proper skill and take proper care in the performance of their duties
This section can be used to recover funds that have been misallocated by the director, where there is some breach of trust, or possible malfeasance. It cannot be used, however, to recover a debt owed by the director (such as a current account) where this has been properly done and accounted for. It would apply where a director has taken funds, and accounted for it, but given the financial state of the company should not have.
This section cannot, typically, be used by secured creditors. It is reserved for the use by unsecured creditors, although a secured creditor can (using Section 305) elect to waive some or all of their security.
The importance of this section is that it allows the court to reward the creditor who takes the action, and gets around the debenture holder & preferred creditors (mostly the IRD). This can be important if, in liquidation, there is a GSA holder whose claim would rank ahead of all other creditors.
This is a useful section that covers situations where the company does not maintain accounting records.
If a company does not maintain proper accounting records, and subsequently goes into liquidation, the court can hold that director personally liable. The guidelines are this:
- Lack of proper accounting records kept
- Lack of proper accounting records contributed to the failure of the business
- The director does not have a defence to
- Taking all reasonable steps to keep proper accounting records
- Having reason to believe a competent person was handling the accounts
- The court thinks it is proper to hold the director personally liable for all or part of the company’s debts.
This action can only be taken by the liquidator.