Supreme Court raises the stakes for directors of distressed businesses

The Supreme Court last Thursday released its long awaited decision on directors duties engaged on a company’s insolvency – Debut Homes Limited (in liquidation) v Cooper [2020] NZSC 100. The decision has profound implications for directors confronted with a business experiencing material financial distress and more broadly, for creditors, lenders and the insolvency profession.

This is the first time these issues have come before our highest court, and its decision is significant. In a year in which directors have grappled with existential challenges to their businesses, and with the decision of the Court of Appeal pending in Mainzeal, the Supreme Court has raised the stakes for directors operating financially distressed companies. Increased recourse to formal insolvency and restructuring processes seems inevitable.

The issue

Debut Homes concerned the application of the provisions of the Companies Act 1993 (Act) primarily engaged when a director continues trading a company which is insolvent, or nearly so. The relevant provisions are sections 131, 135 and 136 setting out the applicable directors duties, and section 301 which governs the consequences of a breach of those duties.

The relevant directors duties are:

  • Section 131: the duty to act in what the director considers to be the best interests of the company;
  • Section 135: the duty not to agree to, 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 (ie, to avoid “reckless trading”); and
  • Section 136: the duty not to agree to the company incurring an obligation unless the director believes on reasonable grounds that the company will be able to perform the obligation when due.

Where a director breaches any of these duties and the company is placed in liquidation, section 301 of the Act empowers a court to order that director to contribute such sum to the assets of the company by way of compensation as the court thinks fit.

Our comments

Debut Homes has raised the stakes for directors who seek to trade on a business which is insolvent, or nearly so. Their risk profile has increased. There remains scope for greater tolerance in circumstances of short term illiquidity where there are good prospects for a return to solvency within a reasonable period. Otherwise, continuing to trade will be a big call for directors. The fact that trading on is likely to improve the position of some creditors will not be enough, in the absence of endorsement of that approach by creditors through a formal or informal restructuring process (and if the latter, requiring unanimous creditors support).

Debut Homes has implications for secured creditors also. It is not unusual for secured creditors to financially support continued trading to enhance the realised value of secured assets. It is generally understood that these arrangements would require the business to effectively “tread water” through ensuring payment of future debts arising from ongoing trading. However, comments by the Supreme Court indicate that all existing debts must also be met.

The beneficiaries of Debut Homes are likely insolvency practitioners. It seems inevitable that more formal insolvency or restructuring processes will result as the raised stakes become too rich for many directors. Those who nevertheless elect to stay the course (for instance, because the issue is one of short term illiquidity and there are reasonable prospects of a solution in the near future) should ensure that their decision is informed by appropriate legal and accounting advice.

Background

Debut Homes was a residential property developer. Mr Cooper was the sole director and he and his wife owned all the shares. Mr Cooper guaranteed lending facilities and the Coopers and their trust themselves subsequently advanced money to the company.

The company had been balance sheet insolvent since March 2009 but had been supported by shareholder advances and, up until the end of October 2012, had paid all its debts as they fell due. It had, however, been experiencing cost overruns and increasing debt and, by the end of October 2012, was in real financial difficulty.

By early November 2012, Mr Cooper was faced with a bleak decision – whether to cease trading or to complete and sell existing projects. He decided on the latter course, based on projections indicating that doing so would yield a surplus of around $170,000. However, no provision was made for interest costs or for GST owing on a recently completed sale and that which would accrue on the completion and sale of the remaining projects.

By February 2014, the last remaining project had been completed and the property sold. The ongoing trading required to complete the projects necessitated the incurring of new trade debt of approximately $28,000 and was largely funded by advances by the Cooper’s trust, on a secured basis. Throughout the period of trading, Mr Cooper worked in the business without pay.

In March 2014, Debut Homes was placed in liquidation on application by Inland Revenue. By then, secured debt (other than that owing to the trust) had been repaid and the company’s overall indebtedness as at November 2012 had been reduced through completion and sale of the remaining projects. However, this was at the expense of new trade debt incurred in the process and GST obligations generated by the sales. As at the date of liquidation, GST of around $450,000 was owing.

The liquidators brought proceedings against Mr Cooper for (among other things) breach of sections 131,135 and 136, and sought compensation under section 301.

The High Court found Mr Cooper to be in breach of sections 131, 135 and 136 and ordered that he pay compensation of $280,000 to the company. The Court of Appeal overturned that decision, finding that Mr Cooper’s decision to trade the business on in the circumstances 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 Supreme Court reversed the Court of Appeal’s decision and reinstated that of the High Court.

Raised stakes

The Supreme Court’s decision in Debut Homes gives clear direction on how courts are to scrutinise the actions of directors who trade on in circumstances of near or actual insolvency, where the company has no prospect of fixing that. However, the Court has left for another day whether it is legitimate for a business suffering temporary liquidity issues to continue trading in the hope of salvage and if so, for how long.

The Court has provided the following guidance:

  • under the Companies Act, maintaining solvency is “vital” and “a key value”, this is reflected in the scheme of the Act, and the nature, extent and content of directors duties must be interpreted in that context;
  • If a company reaches the point where continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading will be a breach of section 135, whether or not continued trading is projected to result in higher returns to some of the creditors than would be the case if the company had been immediately placed into liquidation, and whether or not any overall deficit was projected to be reduced;
  • If directors agree to debts being incurred where they do not believe on reasonable grounds that the company will be able to perform the obligations when they fall due, then there will be a breach of section 136;
  • In an insolvency or near insolvency situation, there will be a breach of section 131 if directors fail to consider the interests of all creditors, and that breach may be exacerbated by a conflict of interest;
  • Where there are no prospects of a company returning to solvency, it makes no difference that a director honestly thought some of the creditors would be better off by continued trading. In those circumstances, the appropriate alternative to liquidation is to use the formal mechanisms under Parts 14 and 15A of the Act, or potentially informal mechanisms;
  • The benefit of these formal mechanisms is the involvement of creditors in any decision about the company’s future, the protection provided to debts incurred in undertaking the process and involvement of an external insolvency practitioner: “Removal of the decision making powers from directors under formal insolvency mechanisms under the Act is a recognition that directors are not the appropriate decision makers in times of insolvency or near insolvency”, as they might be compromised by conflicting interests or are too close to the company and its business to take a realistic and impartial view of the way forward.
  • If informal mechanisms are used, then either:
    • all affected creditors would need to be consulted and agree with the course of action proposed; or
    • if not (for instance, where an arrangement is made with secured creditors for continued trading in order to increase the amount available for the secured creditors), then “any… arrangement would have to be on the basis that all existing debts and future debts arising from continued trading… would be met”;
  • Where directors allow a clearly insolvent company to continue trading without using one of the available formal or informal mechanisms, this will be in breach of their duties as directors and will lead to relief being ordered under section 301;
  • Where there have been breaches of duties, any relief ordered under section 301 must respond to and provide redress for the particular duty or combination of duties breached. Within this context, there are nuances in approach to relief for breaches of specific duties:
    • Section 131: Here, the choice of relief would depend on the nature of the breach;
    • Section 135: In most cases, the appropriate starting point (before application of discretionary factors) is the “net deficiency approach”: 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. This is because the section looks at the creditors and business as a whole.
    • Section 136: As this section concentrates on individual creditors and the obligation the company incurs to them, the relief should be restitutionary in nature (ie, operate to reverse the harm to the company of having incurred that obligation) as best deterring directors incurring new debt to pay old (ie, “robbing Peter to pay Paul”). The net deficiency approach to relief for breach of section 135 would not respond to breach of section 136.
  • Relief under Section 301 can be compensatory or restitutionary in nature and must take account of all the circumstances, including the nature of the breach or breaches, the level of culpability of the director, causation, duration of the breach, holding the director to account and reversing the harm to the company.

Application to Debut Homes

Section 135

In the case of Debut Homes, Mr Cooper’s decision in November 2012 was to trade the business on. The Court found that in electing that course, Mr Cooper did not consider that the company’s financial position was salvageable, and he knew that by so doing, a sizeable GST shortfall would be produced: “[t]o continue trading in such circumstances must be a breach of s 135”. This was so despite the fact that the GST obligation was yet to accrue (“[s]ection 135 is necessarily forward-looking”), whether or not some creditors would be better off, and whether or not any overall deficit was projected to be reduced, particularly if it meant that creditors would not be paid in accordance with the statutory priorities that would arise in liquidation.

Section 136

Mr Cooper’s knowledge that a substantial GST shortfall would be produced also meant that he was in breach of section 136; he did not have reason to believe the obligation would be paid when due. Despite the suggestion in previous cases that section 136 applied only to debts on capital account and not on revenue account, the Court observed that this did not seem to have any basis in the statutory wording.

Section 131

The Court also considered Mr Cooper to have breached section 131. The Court reinforced that the test is subjective: whether the director honestly believed the action taken was in the best interests of the company. Directors cannot subjectively believe they are acting in the best interests of the company if, in an insolvency or near-insolvency situation, they have failed to consider the interests of all of the creditors, including prospective creditors, not just whether some of the company’s creditors benefit.

Mr Cooper failed to have regard to the interests of Inland Revenue and the creditors to whom new trade debts were incurred, which debts remained outstanding on liquidation. This was exacerbated by the fact that his own interests were promoted through payment of secured debts for which he and his trust were liable as guarantors.

Section 301 relief

Given Mr Cooper had been found to be in breach of sections 131, 135 and 136, the Court considered that a restutitionary measure of relief would appropriately respond to the nature and combination of the breaches, and that a starting point of all new debt incurred after the beginning of November 2012 was appropriate (being the position taken by the High Court). Three factors influenced that view:

  • Mr Cooper was knowingly “robbing Peter to pay Paul”;
  • Mr Cooper did not take the interests of all creditors into account (exacerbated by his conflict of interest); and
  • Mr Cooper had a deliberate strategy to place all the loss on Inland Revenue, contrary to statutory priorities.

The Court agreed with the High Court that a discount was warranted to reflect the fact that Mr Cooper had worked for a year and a half without pay, but that full allowance for this would not have been appropriate.

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