Directors duties: proper accounting records and director remuneration

Amongst the director duties imposed by the Companies Act 1993 ("the Act") directors must keep proper accounting records (section 194), and their remuneration must be properly authorised by the board and recorded in the company's interests register (section 161).

Without proper accounting records directors' ability to perform their other duties can also be affected. If directors fail to perform their duties they may face fines, personal liability for company debts, or orders to compensate the companies concerned for losses caused.

The case of Madsen-Ries and Vance v Petera [2015] NZHC 538 dealt with various breaches and remedies in respect of directors' duties, and the judgment is well worth further study for both directors and insolvency professionals.

Madsen-Ries and Vance v Petera [2015] NZHC 538

Mr and Mrs Petera were the sole directors and shareholders of Petranz Limited, which carried on business between 2002 and 2009 as a cartage contractor. Mr Petera drove one of the company's trucks, whilst Mrs Petera worked on administrative tasks. From as early as 2003 the company failed to pay various taxes, and was eventually placed in liquidation on 30 January 2009 on application by the Commissioner of Inland Revenue.

Through most of the company's lifespan the directors failed to keep proper accounting records and ignored the company's growing tax burden, instead paying the company's trade creditors and themselves. They also continued in the unfounded belief that the company would one day be able to pay its outstanding taxes.

The liquidators sued for recoveries from the Peteras in their personal capacities as shareholders for repayment of overdrawn current accounts, and as directors for breaches of fiduciary duties they owed to the company.

Read more: Signs a business is suffering from bad financial decision making

Had they kept proper accounting records the directors could have realised sooner the full extent of the company's tax liabilities and the need to:

  • reduce their personal expenditure;
  • negotiate a settlement plan with the Commissioner of Inland Revenue;
  • introduce personal funds to settle or reduce the debt; and/or
  • cease trading and place the company in liquidation.

Without proper accounting records the liquidators were obliged to reconstruct the company's financial history using its bank statements. This was time consuming and costly. The liquidators proved that the company was insolvent from at least 30 September 2005, and they presented a list of disbursements they wished to recover from the directors.

Overdrawn shareholder current accounts

The court classified the disbursements under the following headings:

  • Funds taken for miscellaneous personal expenses;
  • Funds withdrawn via teller or cheque withdrawals;
  • Funds taken via ATM withdrawals;
  • Funds transferred to pay the shareholders' mortgage;
  • Transfers of funds to Mrs Petera's personal bank account;
  • Transfers of funds to Mr and Mrs Petera's joint personal account.

The first category included payments to such entities as restaurants and fast food outlets. The court noted that the onus was on the directors to prove that these payments related to business expenses which, without proper records, they could not.

Regarding withdrawals and payments to the directors' personal accounts (which the Peteras argued were for directors' remuneration), Justice Lang stated:

"There is no pattern ... to the timing or amounts of the payments ... they are suggestive of funds drawn to pay personal accounts and to fund living expenses". [35]

In paragraphs [18] and [19] of his judgment, Justice Lang stated:

"In the absence of any contemporaneous records regarding the purpose of these payments, the liquidators have treated the payments as drawings that must be debited to the shareholder's current account" ... "and are payable on demand".

Failure to comply with the requirements of section 161 of the Act

The court found no evidence that the company's board had:

  • properly authorised the payments to the directors as remuneration; or
  • entered the payments in the company's interest register; or
  • had signed a certificate stating that the payments were fair to the company.

The only defence available to the directors under section 161 would have been for them to prove that the payments were fair to the company at the time they were made. This they could not do, and were therefore held personally liable to the company for the amounts received.

Breaches of directors' duties under sections 131, 135, 136 and 137 of the Act

Broadly speaking, other core directors' duties under the Act require them to:

  • act in good faith and in the best interests of the company (section 131);
  • not allow the company to be operated in a matter likely to create a risk of serious loss to the company's creditors (section 135);
  • not permit the company to incur debts unless they objectively believe the company will be able to pay those debts when due (section 136); and
  • exercise the care, diligence and skill that a reasonable director would in the same circumstances (section 137).

The Court found that the Peteras had breached all of the above duties

  • The fact that the Peteras continued to draw significant funds for themselves whilst ignoring the debt owed to the Commissioner meant they had not acted in good faith, nor in the best interests of the company (section 131);
  • Their continuation of trade whilst ignoring the above circumstances also created a risk of serious loss to a major creditor, namely the Commissioner (section 135);
  • The Court found that from at least early 2006 the Peteras "could not have believed on reasonable grounds that Petranz would be able to meet the GST obligations that it thereafter incurred (section 136);
  • Finally, their decision to stop paying income tax and GST whilst continuing to draw funds for their own use revealed a strategy which fell below the standard required of reasonable directors in the same position (section 137).

Section 194 - duty to keep proper accounting records

Due to their failure to keep proper accounting records the Peteras were found to have breached the requirements of section 194(1)(a) of the Act.

When the liquidators asked Mrs Petera to produce the company's records she provided "such a small number of records that they would fit within a shoe box" [76]. There were no management accounts or cashflow forecasts, and the only financial statements produced (two out of seven years of trading) were regarded as unreliable.

The court commented that:

"The directors were effectively flying blind so far as the company's true financial position was concerned. This may have contributed ... to the company's inability to pay its debts, because the directors did not know with any certainty how large the tax debt was or whether they had any reasonable prospect of meeting it" [82]

In her defence, Mrs Petera claimed that the directors had relied on their tax advisers to tell them what to do, but because this claim was both unsupported by evidence and lacked probability, the court brushed the defence aside.

Conclusion

Justice Lang concluded that Mr and Mrs Petera had breached their directors' duties under sections 131, 135, 136 and 138, enabling the Court to make an order under section 301 that the Peteras compensate the company for and in relation to the losses caused. Justice Lang determined that by 31 July 2006 the directors should have completed financials and forecasts enabling them "to accurately judge whether the company remained viable ..." [102]. The Peteras were accordingly ordered to pay compensation "... reflecting the losses to the Commissioner after that date". [104].

The Judge also determined that the directors' failure to keep proper records justified an order under section 300 of the Act declaring the Peteras personally liable for all or part of the company's debts. However, as orders had already been made under other headings, the court limited the Peteras' personal liability for failure to keep proper accounting records to the approximate cost the liquidators incurred trying to reconstruct the company's financial history.

The liquidators argued for extensive further orders relating to their other costs; however the court declined to do so and set out various reasons why. Although it is outside the scope and purpose of this article to discuss this part of the court's decision, it is noted that this case was set down for hearing before the Appeal Court in late 2015, so further judicial comment on this case may follow.

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