Trade Better

One of the major risks of being a director is the liability you face if the company fails. Thanks to a new decision from the High Court, this risk has just become a lot higher.

When a company fails, directors often face a risk that they will be sued for having breached their director duties. Traditionally this has meant a claim by liquidators saying that the directors should have liquidated the company more quickly when problems arose. While directors are entitled to make a reasonable attempt to trade out of difficulty, Courts have repeatedly required directors in difficult circumstances to exercise “sober judgement” in deciding whether a company has any prospect of returning to solvency. Fundamentally, this approach has meant that directors must compare the impact of immediate liquidation with what will happen if they delay. Where directors are confident that they can improve a company’s financial outlook, they have been justified in continuing to trade even if the company does not ultimately return to the black.

The decision of the High Court in Mainzeal Property and Construction Limited (In Liq) v Yan challenges this approach and creates a new risk for directors that they will be exposed to claims that they could have traded their company better even if liquidation was not a realistic option.

Under the Companies Act 1993, directors owe a range of duties to the companies that they lead. These include duties to act in good faith and in the best interests of the company, and duties not to trade recklessly or to take on any obligations that the company cannot reasonably expect to meet. Underlying each of these different duties is a fundamental expectation that directors will act reasonably in carrying out their role. In practice, what this means is that Courts considering challenges against directors have not applied a strict level of scrutiny to their actions but instead have asked whether their actions can be justified in commercial terms. Directors are not expected to make the right decision every time but only to make decisions that are reasonable when measured against the circumstances in which they find themselves.

This is of real importance to directors in carrying out their role. Directors need to be able to understand and assess what their duties mean and to ensure that they stay within them. The vast majority of directors who face legal claims have attempted to act appropriately and the law should assist directors in being able to carry out this task well. For this reason, an objective standard for measuring directors’ compliance with their duties is an important part of the law of companies in New Zealand. At least since 1993 when the present Companies Act was implemented, this objective standard has been provided by a direct comparison to a hypothetical earlier liquidation. By considering whether a director should have liquidated his or her company sooner, the Courts have given directors a standard against which to measure their own conduct. Directors have been entitled to ask: can I reasonably make the situation better for myself by continuing onwards?

The decision in Mainzeal has thrown this objective standard into doubt. In that decision Justice Cooke of the High Court held that Mainzeal would have been worse off if its directors had liquidated the company sooner. From the period of time where financial trouble became obvious, to the actual date of liquidation, the directors significantly improved the company’s financial circumstances, probably saving the company’s creditors millions of dollars in the process. Nevertheless the Court was not satisfied that this meant that the directors had acted appropriately and instead asked the question whether there was a different course of action the directors could have taken to better protect the company.

Justice Cooke considered that if the directors of Mainzeal had threatened to resign their roles then its Chinese parent company would have been much more likely to provide additional funding. His Honour considered that this could have averted the ultimate liquidity crisis that toppled the company. Accordingly he found that the directors had traded recklessly and were, at least partly, responsible for the company’s ultimate failure. It was for this reason that the Judge ordered the directors to pay a combined total of $36m of damages to the company’s liquidators.

The Mainzeal decision introduces new risks for directors. This is not limited only to major companies with foreign parents, but to directors to all sorts of companies. The Court’s decision indicates that Judges may now look at how the directors have traded their company and assess whether there were better alternatives available. If the Court, in a hindsight exercise, considers that a better road existed, then the directors may be required to pay the difference between what the Court considers could have been achieved and what was ultimately the creditors’ loss in the liquidation.

It has long been the case that directors of companies in difficult circumstances are required to take a sober judgement about whether to continue trading. This duty has now intensified. It is no longer enough for directors to consider whether liquidating a company is the best way out of trouble and reasonable directors may need to show that they have taken legal and accounting advice about their alternatives before making any decisions about how they try to trade out of trouble. This places directors in a more difficult position and may mean that some directors choose not to take on roles in more risky industries or that they expect a greater level of compensation for the roles that they do take on. Fundamentally, it will mean that in order to protect themselves, directors need to engage more with expert advisors and to take advantage of the protections that directors enjoy when they are acting on the basis of expert advice.

The decision in Mainzeal is now going to the Court of Appeal and no doubt, that Court will have a lot to say about the new approach which the High Court has created. In the meantime, however, directors are now on notice that the standard they will be held to may be higher than what they had expected.

Holland Beckett Law has a wide team of commercial and company law experts who are well equipped to advise companies in a range of industries who are encountering financial difficulties. Our team is able to give clear and pragmatic advice to directors about their own risks and about the pathways that are open to them to avoid personal liability in the event of a company failure.

This Article is based off an article by David Fraundorfer and Tim Conder that was published in the New Zealand Law Journal in June 2019

David is a Partner of Holland Beckett Law’s litigation team.