Insolvency law meets the moment

  • Publications and reports

    09 February 2023

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Changes in the macroeconomic climate are likely to strain balance sheets and cash flows in 2023. This will heighten existing anxiety within the director community over potential personal liability for breach of the directors’ duties when businesses trade on the cusp of insolvency.

Recent consideration of statutory insolvent trading duties by appellate courts provides fresh guidance for managing these risks. Three decisions stand out: two recent, one anticipated. Collectively, they provide (or will provide) a critical roadmap for directors operating businesses in precarious financial positions.

The appetiser: Debut Homes

In Madsen-Ries v Cooper [2020] NZSC 100 (“Debut Homes”), the Supreme Court considered, for the first time, ss 135 and 136 of the Companies Act 1993 (Companies Act). Debut Homes concerned a director’s operation of an insolvent property development company whose financial predicament was unsalvageable. Commonly paired as the “insolvent trading duties”, ss 135 and 136 respectively require directors not to carry on business in a manner likely to create a substantial risk of serious loss to creditors, and not to agree to obligations without reasonable grounds for believing that the company will be able to perform those obligations when due.

In a September 2020 decision, the Supreme Court offered the following guidance for directors:

  • If continued trading will result in a shortfall to creditors of a company, and the company is not salvageable, continued trading will breach the directors’ insolvent trading duties regardless of whether or not:
    • continued trading is projected to improve returns to some of the creditors compared with outcomes in an immediate liquidation; and
    • any overall deficit was projected to be reduced.
  • Where there are no prospects of a return to solvency, it makes no difference that a director honestly thought some of the creditors would be better off by continued trading. Instead, the appropriate alternatives to liquidation are creditors compromises or voluntary administration under Parts 14 and 15A of the Companies Act, or potentially informal mechanisms.
  • If informal mechanisms are used, all affected creditors must be consulted and agree with the proposed course of action, or any arrangement must ensure that all existing debts and future debts arising from continued trading are met.
  • The amount of compensation payable will depend on the particular duty breached. The usual approach under s 135 will be to start with the extent of deterioration (if any) in the company’s financial position between the date when trading should have ceased, and the date of actual liquidation. By contrast, the starting point under s 136 should be the amount of the new obligations incurred in breach of that section. Various discretionary considerations are then applied.
An English entrée: Sequana

In October 2022, the United Kingdom Supreme Court issued its own significant insolvency decision in BTI 2014 LLC v Sequana SA [2022] UKSC 25 (“Sequana”). The key issue in Sequana was defining the circumstances in which directors must have regard to the interest of creditors when exercising duties owed to the company, and what obligations that imposes on directors. The common law has long recognised that the directors of a company which is insolvent or bordering on insolvency are obliged to consider and have proper regard to the interests of its creditors and prospective creditors (described as “the creditor duty”). However, there remained uncertainty as to whether this was preserved following the statutory codification of directors’ duties in the UK and, if so, as to its scope and application.

Sequana concerned a payment by a company which was solvent but had an uncertain amount of contingent liabilities. These were recorded in company accounts at a fraction of their potential value but ended up being significantly greater than estimated. On the company being placed in insolvent administration, a claim was made against the directors that they owed (and breached) a duty to consider the interests of creditors when deciding to make the payment because there existed a real risk of the company becoming insolvent.

Whilst rejecting the proposition that a “real risk” of insolvency was sufficient to require directors to consider creditors’ interests, the UK Supreme Court found that:

  • The creditor duty exists; directors of a company which is insolvent or bordering on insolvency are obliged to consider, and have proper regard to, the interests of its creditors and prospective creditors.
  • The duty is triggered when insolvency is imminent or when the directors know or ought to know that an insolvent liquidation is probable.
  • The extent to which directors must take into account creditors’ interests is a sliding scale. Where a company is insolvent or bordering on insolvency, the interests of creditors, including prospective creditors, must be balanced with those of the shareholders, with creditors’ interests becoming paramount as the company’s fortunes further decline and liquidation approaches.

These findings align with the approach taken by New Zealand courts in relation to s 131 of the Companies Act. That section requires directors to act in what they consider to be in the best interests of the company. Courts here recognise that in cases of insolvency or near- insolvency, consideration of the interests of the company requires consideration of the interests of its creditors, including prospective creditors.

The Main(zeal) course

Debut Homes and Sequana have heightened anticipation in New Zealand for our Supreme Court’s forthcoming decision on the appeal of Yan v Mainzeal Property & Construction Ltd (in liq) (“Mainzeal”). Mainzeal was one of New Zealand’s largest construction companies. It collapsed in 2013 leaving around $110m owing to unsecured creditors. Its liquidators brought proceedings against the former directors under ss 135 and 136, alleging that they had allowed the company to continue trading, and incur significant obligations, while insolvent and without taking appropriate precautionary steps (particularly regarding related party support).

The High Court found the directors had not breached s 136 but had traded recklessly in breach of s 135. Mainzeal was balance sheet insolvent, trading poorly, prone to significant one-off losses and reliant on assurances of support from its shareholders that were informal, conditional, and non-binding. Despite this, the directors permitted Mainzeal to continue trading, exploiting the lag between the time Mainzeal was paid by principals and when it had to pay its sub-contractors. Starting with the net deficiency on liquidation and then discounting for discretionary factors, the Court ordered the directors to contribute $36 million to Mainzeal: the highest award ever made in an insolvent trading case in New Zealand.

The Court of Appeal agreed that the directors had breached s 135, and found they had breached s 136 too. Differing from the High Court, the Court of Appeal held that the appropriate measure of compensation for breach of s 135 was the extent of deterioration in the company’s financial position over the relevant period. However, no loss was found to have arisen from this breach, as the High Court had found that Mainzeal’s financial position did not deteriorate over the relevant period. As for s 136, the Court considered the directors were liable for the amount of all new obligations Mainzeal assumed without a reasonable basis, with some adjustments to be determined by the High Court. The Court was split as to the existence and extent of a discretion to reduce the compensation payable.

The Court of Appeal offered the following guidance where a business was in a precarious financial position:

  • Directors must face up to that financial situation and assess the risk of serious loss to creditors.
  • A decision to trade on should be made only after a sober assessment of the likely consequences based on the company’s likely future income and prospects.Unfounded optimism is not enough.
  • A decision to trade on will likely breach the insolvent trading duties unless the manner in which the directors choose to trade has realistic prospects of enabling the company both to service pre-existing debt, and to meet new commitments arising from ongoing trading.

The Supreme Court heard an appeal by the directors in March 2022, with a decision expected in early 2023. The Court has good reason to take its time. It will need to grapple with a number of complex issues regarding the interpretation and interaction of ss 135 and 136, and how to approach compensation for breach of these provisions. Some of that work was frontloaded in Debut Homes, but Mainzeal involves more complicated facts and a business of much larger scale. The Court will also need to reflect on the extent to which Sequana represents, or ought to be incorporated into, New Zealand law, albeit that Sequana was primarily argued under the UK’s equivalent to s 131; not ss 135 and 136 at issue in Mainzeal.

The Supreme Court’s position in Mainzeal will be consequential. The Court has an opportunity to reinforce, further develop, walk back, or to provide nuance to the principles it previously expressed on the more straightforward facts presented in Debut Homes. Regardless, much needed clarity should be provided to the interpretation and application of statutory provisions which have received a good deal of criticism and calls for legislative redrafting. In the absence of an overhaul of the statutory insolvent trading duties anytime soon, the Supreme Court’s decision is expected to provide clearer guidance for directors operating businesses in an increasingly challenging economic environment.