Establishing directors' personal liability in liquidation cases

When a company is close to insolvency (or insolvent), decisions taken, or not taken, by the company's directors at the time can result in the directors being personally liable for contributions to the company's debts in liquidation. Two recent cases provide guidance on the courts' approach to findings of liability and the determination of the amount of a director's liability in such situations.

The law

In the course of a company's liquidation, the court is empowered to make orders (under section 301 of the Companies Act 1993) where directors have been found to be in breach of certain duties (or other matters referred to in section 301) in relation to the company. The orders include providing for the director (or directors) to:

• contribute such sum to the assets of the company by way of compensation as the court thinks just; or, where the application is made by a creditor,

• pay or transfer money or property or any part of it with interest at a rate the court thinks just to the creditor.

In most cases claims for contribution under section 301 are based on the breach of one or more of a director's statutory duties under the Companies Act (the Act). In addition to the general duties which require that a director act in good faith and in the best interests of the company (section 131), and exercise the care, diligence and skill that a reasonable director would exercise (section 137), there are two duties which are often the focus of section 301 claims. These are the reckless trading and obligation provisions in sections 135 and 136 of the Act which require a director:

• not to agree to, cause or allow the business of the company to operate in a manner likely to create a substantial risk of serious loss to the company's creditors (section 135); and

• not to 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 when it is required to do so (section 136).

Peace and Glory Society Limited (in Liquidation) and anor v Stefano Samsa

In a recent case, Peace and Glory Society Limited (in Liquidation) and anor v Stefano Samsa¹, the Court of Appeal affirmed that the appropriate approach to a claim under section 301 should be in two stages. First the court should consider whether the director was in breach of any of the duties he owed to the company and second, the court should, in its discretion, determine whether and to what extent a director should be required to contribute to the assets of the company. The second stage allows the court to inquire into the overall justice of an order under section 301 relative to the breach (or breaches), consequent losses and the director's level of culpability.

The facts

The case involved a claim by the liquidators of Peace and Glory Society Limited (the company) against the company's sole director (who was also the only shareholder of the company). The company had been established by the director for use as a vehicle to carry out a small property development business. In 2000, the company acquired a residential property which was on land capable of being subdivided. The purchase of the property was financed by a bank loan (secured by a first mortgage) and a series of loans from the director's mother (which were eventually secured by a second mortgage). The mother's loans were also used to develop the property.

The plan was to develop the property in two stages. The first stage involved the renovation of the existing property on the land for resale and the second stage was to subdivide the section and build on the subdivided site for resale. Since the property had been acquired for development the company was entitled to and had received a GST refund for the GST paid on the purchase of the property which was repayable on the resale of the property.

Unfortunately for the director, the first stage of the development took longer and was more expensive than expected. By late 2003 he could not source the required funding to complete the project and the valuation of the property showed that it was worth far less than the monies owing on it. He moved into the property in order to help complete the renovations (paying market rent to the company). At about this time, the IRD began investigating the company in relation to its GST returns and placed pressure on the director to list the property for sale in order for the company to meet its GST liabilities. This was despite being told that there would be a GST shortfall on any sale under the current market conditions once the debts to the secured creditors had been paid. Eventually, after seeking advice from his solicitor and a financial adviser, the director decided that his best course of action would be to purchase the property in his personal capacity.

On completion of the sale of the property in May 2004 the company was left with no assets and a GST bill to pay. It was placed into liquidation on the application of the Commissioner of Inland Revenue in October 2005.

The claim

In the High Court² the liquidators had claimed that the director had been in breach of his duties under sections 131, 135, 136 and 137 of the Companies Act in relation to his management of the company and the sale of the property to himself and had sought orders requiring the director to compensate the company under section 301. The High Court however rejected all of the liquidators' claims.

The liquidators' appeal to the Court of Appeal sought an order for compensation under section 301 based only on a breach of section 136 of the Act. The liquidators argued that by the director selling the property to himself he had created a GST obligation which he knew the company could not meet. In the High Court the liquidators had argued that the issue of incurring the GST obligation was also tied in with allegations of the director's purchase of the property being at an undervalue and the second mortgage to the director's mother not being genuine. These allegations were rejected by the High Court and therefore were not raised on appeal.

The Court of Appeal's decision

The Court of Appeal agreed that the director was in breach of section 136:

• an obligation was incurred by the company; and

• at the time of incurring the obligation the director did not honestly believe on reasonable grounds that the company would be able to perform the obligation when it was required to do so.

The court also rejected the submission made on behalf of the director that for liability under this section to be found the obligation must be viewed in light of the purpose of section 136, namely to compensate those who suffer loss as a result of illegitimate trading. In the court's view this was an issue to be addressed in the context of assessing the director's culpability under section 301 and not for assessing liability under section 136.

However, despite finding the director to be in breach of section 136, the Court of Appeal rejected the liquidators' argument that the High Court judge had not taken into account both stages of the two stage process required for determining the extent of a director's liability under section 301. The court acknowledged that the proper two stage analysis was not explicitly addressed in the High Court's judgment, but in its view the judge had "implicitly" assessed the level of culpability involved in the director's actions having accepted that the purchase of the property by him had triggered a breach of section 136.

The Court of Appeal considered it was appropriate for the High Court in assessing the amount of the director's liability to have considered the director's dilemma: "to allow the insolvent [company] to continue to accrue the holding costs of the property (ie to incur more debt) or to bring the matter to a head by purchasing the property." In this regard the court noted the evidence suggesting that the property was unlikely to sell on the open market for a price which would have cleared the company's debts. Further, the IRD in correspondence to the director had effectively required the property to be put on the market. It was also considered relevant that the High Court's findings indicated that the director had purchased the property for fair value and that he had made some attempt to settle the GST liability out of his own funds (albeit for a smaller amount) following the sale of the property. In the court's opinion this indicated that the director had not deliberately chosen a course that was designed to disadvantage the IRD, even though if the director had opted to instead either ask the bank to place the company into receivership or had placed the company into voluntary liquidation the IRD would have recovered the GST as a priority debt.

Having found that the High Court had taken legitimate factors into account in its consideration of the director's contribution under section 301, the court dismissed the appeal.

Lewis v Mason

The Supreme Court has also had to address the issue of determining a director's contribution under section 301 in a recent case³ involving the long-running Mason v Lewis litigation.

Background

This litigation involved two directors, Mr and Mrs Lewis, who had been found by the Court of Appeal in breach of section 135 (the duty not to engage in reckless trading) in relation to the conduct of the affairs of a printing company which had been placed into voluntary liquidation in 2002. This was despite the fact that in the initial hearing the trial judge had concluded that the Lewises had "acted honestly and in good faith throughout the life of the company, and that they had acted as reasonable directors in the circumstances in which they found themselves" and accordingly had found that they were not in breach of their section 135 duty. T he directors had played a limited role in the management of the printing company and they had left the day to day operations of the company to an individual who, unbeknown to them, had conducted the company's affairs in a fraudulent manner. However, on appeal, the Court of Appeal held that the case was "a paradigm case of reckless trading" and found both directors liable to contribute under section 301 for their breach of duties under section 135. (T he Court of Appeal's decision in Mason and ors v Lewis is discussed in the Autumn 2006 issue of Commercial Quarterly.)

The recent Supreme Court decision arose out of the litigation following the Court of Appeal sending the matter back to the High Court to determine the quantum of the Lewises' liability under section 301. The Court of Appeal had not been in position to reach a decision on this issue because of insufficient evidence provided by the liquidators at the initial High Court hearing. However, the Court of Appeal stipulated that the maximum liability of the Lewises was to be capped at $560,000, being the overall amount sought by the liquidators at the initial hearing.

The subsequent High Court case resulted in the Lewises' liability being assessed at 60% of the total creditors' pool (which was over twice the amount of the Court of Appeal's $560,000 cap). The Lewises appealed the High Court's decision to determine whether the High Court had been wrong not to follow the Court of Appeal's stipulation that their liability was not to exceed $560,000. They also argued that the High Court had not taken relevant factors into consideration in exercising its discretion under section 301, particularly with regard to determining the extent of their culpability for the company's losses. The Court of Appeal agreed with the Lewises that the High Court was required to make an award subject to the sum stipulated by it, but rejected their arguments which sought to establish that the appropriate quantum of liability was less than $560,000. (This decision is discussed in the Winter 2009 issue of Commercial Quarterly.) The Lewises appealed this decision to the Supreme Court.

The Supreme Court's decision

The Supreme Court rejected the appeal and made the following points:

• The maximum liability of the Lewises was capped by the Court of Appeal at $560,000 because the liquidators originally only sought that amount. However, that did not preclude the liquidators establishing that the actual level of indebtedness was higher than $560,000;

• The Court of Appeal was correct to include the post-liquidation interest as part of the creditors' pool for the purpose of assessing the liability of the Lewises;

• The Court of Appeal was not wrong in its consideration of the extent the conduct of the directors contributed to causing the creditors' losses noting that: "if the [directors] had properly performed their directors' duties the losses very probably would not have occurred. If they had given proper attention to the affairs of the company they would surely have appreciated that it was incurring unsustainable losses." It also agreed with the Court of Appeal's suggested steps which could have been taken by the directors. (See the Winter 2009 issue of Commercial Quarterly article for details of those steps.);

• The argument that the directors' culpability was less than that of a director who committed frauds and should not have been assessed as 60% responsibility "might possibly have some substance" but the Supreme Court was not persuaded that it should make an adjustment given the "total neglect of their duties" and the fact that as a result of the cap the quantum of liability for both directors was already substantially less than 60% of the actual indebtedness.

A few recommendations

Although the outcome of the Peace and Glory case may offer some comfort to directors, both it and particularly the Mason v Lewis litigation highlight the need for directors to be vigilant in ensuring their actions are not in breach of any statutory duty in insolvency situations.

A director will inevitably have his or her own individual view as to how the company should act if it is heading towards insolvency and whether or not the company should continue trading, but a director should be mindful that his or her actions may result in personal liability if they are undertaken without giving due consideration to the duties they owe to the company and also, potentially, to creditors. The Mason v Lewis litigation also provides a clear indication that inaction by directors will not be tolerated by the courts. As the Court of Appeal noted the "days of sleeping directors with merely an investment interest are long gone: the limitation of liability given by incorporation is conditional on proper compliance with a statute."

Key points for directors to keep in mind in the current economic climate include the following:

• A director of a company should ensure they have access to accurate financial information, on a daily basis if required, so as to be always in a position to judge the company's state of health.

• If a director has any concerns as to whether his or her actions are likely to be in breach of the statutory duties, then they should seek advice.

• Where any decision is likely to prejudice the interests of creditors, the directors should seek specific advice on that issue before proceeding with the proposed action.

• When reaching a business judgment as to whether the company should continue trading and incur obligations, the directors are entitled to rely on professional accounting advice. Where that reliance on advice is reasonable (i.e. the advice is obtained from an appropriate adviser, is based on the relevant facts, and is followed), that is likely to be a defence to any allegation of breach of duty.

• A director should record his or her actions carefully, with reasons for the decisions if considered appropriate. That paper trail will be important if the company does become insolvent and the director is required to defend his or her actions.

¹ [2009] NZCA 396

² Peace and Glory Society Limited (in liq) v Samsa (Hugh Williams J, High Court, Auckland, CIV-2007-404-000700, 2 December 2008)

³ Lewis v Mason [2009] NZSC 103

Enquiries and information

For more information on any of the cases, articles and features in Commercial Quarterly, please email Diane Graham or call her on 64 9 916 8849.