SMEs make up a large part of the insolvency work that we at McDonald Vague handle and the reasons for those insolvencies range from events beyond the control of the company officers to a complete lack of knowledge and understanding by the company officers of what is required of them.
• What led to those companies failing?
• What were some of the red flags that might have been seen along the way?
The causes of company failures, as reported to us by the directors, are many and varied and the real reason is not always identified correctly by the directors.
There are, however, common themes that come through in the reasons for company failures.
It is not uncommon in insolvencies to find that the failure of the company has come about because they have all, or at least most, of their eggs in one basket. The sudden failure of their major client or the decision by that client to go elsewhere leaves a yawning gap in their cash flow.
In tight economic times there is not always the ability to find new business in a short period of time to enable the business to continue to operate. They can also be left holding stock that is particular to that client and have no ability to move it on.
Company directors don’t always have the marketing skills to get out and promote their business nor the financial understanding to see ways to restructure their business to take account of the sudden loss of a major client.
The unexpected loss of a vital staff member can have the same effect, leaving the business unable to operate to its potential while another suitable employee is hired or trained up.
Often directors will point to a particular period and claim that this was when orders dried up.
A sudden down turn can sometimes lead to the company cutting its prices in an endeavour to obtain work but without giving enough thought to what it actually costs them to do that work. So they continue to operate but have no margin or insufficient margin to enable them to meet their costs and catch up on old debt.
A number of the small companies that we manage the liquidation of are companies incorporated by a tradesman to charge out their services. Many of these are tradesmen who have moved from employee status to company director and employer because they have been advised that they will be better off working for themselves through a company structure.
While they may all be very capable plumbers, builders, electricians etc many know next to nothing about the requirements of running a company and managing the finances.
They often start with a few tools and a vehicle, no operating capital and no administration systems in place.
They fall behind in filing their PAYE and GST returns, they fall behind in invoicing out the work that they have done. They fail to differentiate between what is the company’s and what are their own personal assets and the company bank account is used for everything, including buying the groceries.
They do not keep accurate records of the income and expenses and fail to carry out even basic functions like checking off bank statements. They have no prepared budgets or cash flow forecasts and, essentially, exist day to day. If there is money in the bank account they can spend it without giving any thought to things like GST & PAYE that may be falling due in the next month.
The cumulative effect of these failings is the downward spiral of the business until a creditor, generally the Inland Revenue Department, puts the brakes on them by threatening to wind them up unless payment is made.
This can include loans to shareholders, family and friends, as well as related companies. The temptation is there, if one company is flush with cash at any stage, to lend the funds to related parties.
Problems arise when there is no clear documentation of the loans and no specific requirement on the related party to make repayments.
While the related entities are still in existence and the loan sits on the company’s statement of financial position as an asset – giving a semblance of solvency – the truth of the matter is that there is no substance to the asset with no likelihood of the loan being repaid.
Allied to this is the giving by the company of guarantees for related entities leading to claims made on the company in the event of default by the related party.
What are the red flags, or danger signs, that the company’s directors or professional advisors might note along the way that indicate all is not well with the business?
• Notifications that PAYE or GST returns haven’t been filed
• GST refunds for 2 or 3 periods in a row. If the company is consistently spending more than it earns, what are the reasons.
• Failure to pay PAYE and GST. PAYE, in particular, is “trust” money deducted from employees’ wages. It should not be available for operational purposes.
• A steady increase in the outstanding creditors and increased age of the debt.
• A constant need for the shareholders to support the company with funds without any light at the end of the tunnel. How long can the shareholders continue to fund the company?
• A sudden change by creditors to expecting COD for supplies rather than place the amount on credit.
The vast majority of company directors and shareholders don’t deliberately set up their company to fail but sometimes, through a combination of matters beyond their control and a lack of skills and understanding of the requirements, that is what happens.
Good advice at the outset and continued support and assistance during the operation of the business from accounting and legal professionals could go a long way to reducing the likelihood of failure.
If you would like more information about the causes and symptoms of company insolvency, please contact one of the team at McDonald Vague.
You wouldn’t pick a tradie on price alone so why would you pick an insolvency practitioner solely on this basis?
You expect your tradie to work to industry standards when working on your house or car so why wouldn’t you take the same care before you hand over control of a business to an insolvency practitioner, who will be dealing with your company, its assets, its creditors, and its stakeholders?
Not all insolvency practitioners are created equal. They have different levels of experience and qualifications, work in different size firms, and may or may not be accredited. If you appoint the wrong insolvency practitioners, it can be difficult to remove them. If it’s shortly after appointment, the company’s creditors may be able to appoint replacement insolvency practitioners at the initial creditors’ meeting. If not, it will likely involve a trip to the High Court. If the insolvency practitioner is not accredited, they will not have to answer to a disciplinary board.
You should expect your insolvency practitioner be law abiding and to deal with the company’s directors, shareholders, and creditors fairly and ethically. We have put together a handy list of what to look for, what to ask, and what to consider before engaging an insolvency practitioner.
Your insolvency practitioner should:
1. Have experience in the industry the business operates in
2. Have relevant insolvency experience, including in relation to the type of appointment you are considering and any steps you expect them to take after their appointment
3. Be an Accredited Insolvency Practitioner, either through RITANZ or CAANZ
4. Have sufficient resources behind them to properly carry out the appointment
5. Have a history of making distributions to creditors
Ask questions, and lots of them. The more information you are able to get up front the better position you will be in when it comes time to make the decision on who you should go with.
(a) Are they members of RITANZ and Accredited Insolvency Practitioners (AIPs)? Until regulation come into force in June 2020, we recommend that you only use AIPs. AIPs are required to comply with a code of conduct that dictates the professional and ethical standards they are expected to meet. The code is enforced by Chartered Accountants Australia and New Zealand. There is a public register of AIPs on both the CAANZ and RITANZ website.
(b) What previous relevant experience do they have? There are different types of insolvency appointments (advisory, compromises, voluntary administrations, receiverships, and liquidations). If you are looking at appointing voluntary administrators, you probably do not want to appoint someone who has never done one before.
(c) What kind of qualifications and experience do they have within the firm? Depending on the type of post-appointment work that will be required, you may want to appoint AIPs that are chartered accounts, have legal knowledge, or are experienced in forensic accounting.
(d) Are they Chartered Accountants, do they have a legal background, or forensic accounting skills? The appointment may determine what kind of background you should be looking for.
(e) Do they have the resources necessary to deal with the appointment? If the business operates multiple stores across the city or the country, does the AIPs’ firm have enough staff to take on the appointment?
(f) Do they have a history of making distributions to creditors? What level of overall fees would the AIP expect to charge on the job?
It is important that the AIPs you appoint understand your personal situation and your business’ needs so they can help achieve the best result for all parties. It is important that you take your time with this decision because you will be trusting them with the business.
McDonald Vague’s directors are AIPS and Chartered Accountants. We also have three non-director AIPs and our professional staff are members of RITANZ. McDonald Vague is also a Chartered Accounting Practice and is subject to practice review.
All companies must keep company records, minutes, resolutions and a share register. This article discusses what is required and what can happen when there is a failure to maintain company, statutory and financial records.
Failure to keep accounting records and to comply with Section 194 Companies Act 1993 can render director(s) liable to conviction for an offence.
Failing to maintain books and records may cause a presumption of insolvency and directors could be held personally liable.
Companies have an obligation to keep company records under S189 of the Companies Act 1993. Minutes, resolutions and financial statements must be maintained for the last 7 years. S190 of the Act requires that the records must be kept in a written form or in form or manner that allows the documents and information that comprise the records to be easily accessible and convertible into written form.
Best practice dictates that an annual shareholder resolution recording that the shareholders have received special purpose financial statements, prepared by the directors for compliance purposes, and believe these adequately meet their needs for information is recommended.
The purpose of such a resolution is to record that shareholders have received the taxation statements and to record that these adequately inform them of the progress of their company. These resolutions overcome any dispute at a later date, particularly where the directors and shareholders are not all the same people.
Shareholders also should approve the remuneration paid to the directors (even or often the same) when they record they have received the special purpose financial statements. Shareholders should also approve any major transactions as defined, by special resolution.
Directors Certificates of fairness are required for Director/shareholder remuneration and for interest on loans to/from shareholders.
If you are a registered office, you are required to maintain an Interests Register in the statutory records for each company.
The Register is required to disclose the directors:
• interests in company transactions, including those where the relationship is indirect, which may include other directorships or trusteeships (includes the initial issue of shares on formation (S. 140)
• use of company information (S. 145)
• share dealings, including the directors’ own holdings or holdings by trusts of which he/she is a beneficiary (S. 148)
• remuneration and other benefits (S. 161)
• indemnity and insurance (S. 162)
The Companies Act 1993 envisages an annual disclosure by way of entry to the register.
If the company has a constitution this must be kept at the registered office.
A company must maintain a share register that records shares issued, shareholders names and addresses’ and the number of shares held. The details of all shareholders and movements in shareholdings must be maintained for the last 10year period.
Good records help business management. Financial records must record and explain company transactions and comply with generally accepted accounting practice. Companies have different reporting requirements depending on annual revenue and assets.
Large New Zealand and large overseas companies must file annual audited financial statements under the Companies Act 1993. Smaller businesses must maintain financial statements unless it is not part of a group and has not derived income of more than $30,000 and not incurred expenditure of more then $30,000.
A company falling below these thresholds must still keep tax records and employer records.
The obligation to keep accounting records is codified under section 194 of the Companies Act 1993. A breach of accounting requirements under Section 194 and 189 may constitute a default or breach of duties under Section 301. The potential liability for failing to keep books and records can be significant and is avoidable. Directors may face court action from the company, shareholders or creditors for failing to keep proper records. The Court can order compensation and hold the director personally liable.
A director can be held personally liable (s300(1)) if a company is unable to pay all its debts and has failed to comply with its duty to keep accounting records (s194) or (if applicable) to keep financial statements (s201 or 202) and the Court considers the failure to comply has contributed to an inability to pay all its debts or has resulted in substantial uncertainty as to the assets and liabilities.
Poor records hinder a liquidators’ ability to investigate company affairs. The lack of records can mean there is no way for a company of determining the likelihood of an impending insolvency. This breach can support a reckless trading action.
In the liquidation of Global Print Strategies Ltd (in liq) v Lewis (2006) the directors knew there was no adequate accounting system. The Court said that a director cannot be heard to say “I did not realise we were in such a pickle, because we did not have any or adequate books of account.” The Court held it was fundamental that books must be kept and directors must see to it that they are kept.
One way of dealing with difficult shareholder disputes is to have an independent party control and sometimes deal with the company assets, while the dispute is worked through.
This allows the parties to focus on the dispute without further issues arising from current trading. Such a reliable independent party is a liquidator (solvent liquidation).
We were appointed by the High Court as liquidators of a solvent company to resolve a shareholder impasse. Two shareholders owned 70% and 30% respectively of the company shares. The companies only asset was its ownership of all the shares in a trading subsidiary company. The directors were in dispute on the management of this company.
The liquidators needed to control the subsidiary trading company. The liquidators consented to becoming directors of the trading subsidiary company for an interim period.
The High Court Order was to realise the assets of the holding company by whatever method the liquidators deemed to be practical and, after the realisation costs, the distribution of excess funds from the sale were to be distributed 70%/30% to the respective shareholders.
The court appointed solvent liquidation was due to a protracted disagreement and dispute between the 2 directors over a period of about 3 years over how a wholly owned subsidiary company was to be run and that the business profitability was declining rapidly.
The main issues centred around:
1. The sales price that the subsidiary on sold its product to one of the directors own private businesses. One director who was not involved in the separate private business, believed the price that the product was on sold for was too low and did not reflect the true value of the product.
2. A disagreement as to how and when a large capital expenditure for a factory upgrade would occur to meet Food Safety Authority regulations. The upgrade required a significant capital injection and the patience of the Food Safety Authority was near an end. Potentially the factory may have been forced to shut down.
3. On closing the business a significant redundancy liability would arise as many employees had worked for the company for a long time. In addition, the Union collective pay agreements were well overdue for settlement.
4. The directors were in a deadlock and could not agree on a correct sale price of the product to a related party and the upgrade development to the factory.
The plan was to sell the shares in the trading subsidiary. After discussion with the shareholders, agreement was settled on tendering these shares on the open market as the preferred method to obtain the best price.
The sale of shares in the trading subsidiary would also require continuity of supply agreements of raw material product for the factory to be agreed.
The trading business was profiled along with financial information, advertised in local and national newspapers and also directly marketed to interested parties that were identified. The sale process was by way of a tender of shares.
34 expressions of interest were received, and 20 confidentiality documents were signed and, after discussions with the highest tenderer, a sale was concluded with the 70% majority shareholder.
Of considerable concern to the liquidators throughout this process was to ensure that the return back to the shareholders was maximized, and that tax implications were properly addressed.
The liquidators sought tax advice and two options were available:
1. A bonus issue of retained earnings in the trading subsidiary then sale of that company.
2. Or the preferred proposal was that 30% of the shares that the successful tender did not own of the shares in the company in liquidation be sold direct to the successful tenderer.
Thereby the 70% majority shareholder would acquire the 30% of the shares it did not own in the company in liquidation that owned all the shares in the trading subsidiary.
Option 2 avoided a significant funding arrangement being organised as the successful tenderer only had to fund 30% of the tender price. The payment would be a tax free capital gain for the vendor of the shares and have no downside for the successful tenderer.
The shareholder/directors and their advisors agreed to this proposal, and the liquidators applied to the High Court to have the share transfer endorsed as required by section 248 of the Companies Act along with an application to take the company out of liquidation. The court approved this.
The shareholder dispute was resolved, the 70% majority shareholder now owns 100% of the holding company who in turn owns 100% of the trading company and the minority shareholder received the best price for their shares on an open tender.
The application to the High Court to place the company into liquidation to resolve the director impasse resulted in a good conclusion to the matter for both parties.
Effective cashflow management is critical to any businesses survival and growth. Understanding your businesses underlying cashflows will help identify potential changes to your business processes that will improve cashflow, profitability and business value
A firm's ability to reliably spin-off positive cashflows from the firm's routine business operations is one of the key factors business owners and potential investors look for.
Cashflow is typically defined as the net change in your firm’s cash position from one accounting period to the next. If you generate more cash than you consume, you have a positive cashflow. If you have greater cash outflows than inflow, you have a negative cashflow. Thus, your cashflow is a key indicator of a firm’s financial health.
Operating cashflows illuminate a company's true profitability. It's one of the purest measures of cash sources and the use of cash within a business and is the launching pad for complementary financial statements and reports.
Operating cashflow is a fundamental part of your cashflow statement. Your cashflow statement illustrates the fluctuations in cash compared to less volatile equivalents such as shareholders' equity and the balance sheet.
Your cashflow statement details both where cash is being generated and consumed in the business over a set period of time.
By taking the net income figure from the firm’s income statement and adjusting it to display variations in the firm’s working capital defined as payables, receivables and inventories as reflected on the balance sheet, the firm’s operating cashflow line item illustrates the sources of cash spun off during the reporting period.
A business’ sources and uses of cash are typically split into categories covering operations, investments and financing activities.
1. Operations: Reflects a firm's operational cash inflows and outflows, the net effect of these defines a firm’s operating cashflow position
2. Investments: Shows changes in the businesses’ cash position from the divestment or acquisition of property, plant and equipment or other typically longer-term investments
3. Finance: Captures changes in cash levels from the share buyback schemes or bond issues, together with interest payments and dividend distributions to shareholders.
A firm’s operating activities comprise its routine core commercial activities within the business that generates cash inflows and outflows. These operating activities typically include:
1. Sale of goods and services recorded during an accounting period
2. Supplier payments covering goods and services consumed during the production of outputs recorded during an accounting period
3. Employee payments or other expenses incurred during an accounting period.
To establish the significance of underlying material changes in a firm’s operating cashflows, it is useful to be familiar with just how a firm’s cashflow is estimated. Two models are generally used to tally cashflow generated by operating activities. These are the Indirect and Direct models.
Direct Method: Uses information derived from the income statement based on cash receipts and cash outgoings generated by the businesses’ operations.
Indirect Method: Adopts the firm’s net income and derives its OCF by incorporating those line items used to determine the firm’s net income but which did not affect the firm’s actual cash position.
Your operating cashflow is a very useful assessment tool as it assists business owners to understand the firm’s fundamentals. For many owners, the OCF position is considered to be the cash component of net income, as it purges the firm’s income statement of non-cash related items and non-cash based expenditure such as amortization and depreciation and changes to the firm’s current assets and liabilities position.
Operating cashflows is a more accurate indicator of underlying profitability than measures of net income, as it is less open to massaging the operating cashflows to window dress profitability.
A cashflow statement is much more than simply a snapshot of your business’ financial health. They can also be used as a powerful management tool to affect positive change within your organisation.
Business owners can use a cashflow statement to evaluate their firm’s strengths and weaknesses, helping them to chart a savvy and more efficient path forward. Used the right way, a cashflow statement can show an owner how efficiently the business is harnessing its cash while identifying which areas are absorbing more cash than they generate.
This information can be critical to ensuring the firm’s survival while providing a point of focus for growth initiatives. Cashflow is also a useful indicator of how efficient an internal business process is and how dynamic a firm’s products or services are.
By identifying changes to a firm’s internal business processes that will improve the firm’s underlying cashflow, profit, and business value, a business owner can drive innovation, lift productivity and effectiveness levels and cull under-performing products.
When a firm enjoys robust operating cashflows with more cashflowing in than flowing out, the owners know they have a healthy business. Companies with solid operating cashflow growth are more likely to enjoy predictable net income levels, together with an enhanced ability to pay suppliers and reinvest in the business.
Robust operating cashflow also provides more opportunities to expand the business and to cope with fluctuating economic conditions, turbulence in their industry or adverse weather events.
A firm’s operating cashflow is simply one aspect of a firm's cashflow position. Cashflow is also one of the most insightful measures of a firm’s financial viability, underlying profitability and its long-term prospective outlook. Cashflow measures a company’s incoming and outgoing cashflows over a nominated accounting period. Cashflow is also a useful tool for identifying inefficient processes and under-performing products or services. If you truly identify with the "Cash is King," mantra, then robust operating cashflow is one of the most reliable key indicators to look for when assessing a firm.
We are often asked ‘how do liquidators’ work’ and what are their rights regarding access to company records and information. To clarify we have put together this article.
When a liquidator is appointed over a company, either by the shareholders or by order of the High Court, one of the first steps taken will be to locate and uplift the books and records of the company and to seek information about the business, accounts or affairs of the company to enable a full review to be undertaken.
The purpose of the review is to –
The books and records are generally in the possession or control of the director or are held by the company’s professional advisors, such as accountants and lawyers.
When we are appointed as liquidators, our first approach in relation to obtaining company records, is by way of a letter to the relevant person or entity requesting details of the records held and seeking arrangements to uplift those records.
In most cases that initial letter is sufficient but, on occasion, the request is either ignored or refused.
When the records requested are not provided in a timely manner, the liquidator has powers under section 261 of the Companies Act 1993 (“the Act”) to issue a written notice demanding the records and it is an offence to fail to comply with a notice.
Pursuant to section 263 of the Act, a person is not entitled to claim or enforce a lien, over the books and records of the company, against the liquidator, that arises in relation to a debt for the provision of services to the company prior to the liquidation commencing. However, the debt is a preferential claim in the liquidation to the extent of 10% of the total debt up to a maximum of $2,000.
When it comes to obtaining information about the company’s affairs, again our initial approach is to ask the people concerned to provide it.
But, if that doesn’t happen, section 261 of the Act also gives the liquidator the power to issue a notice in writing to various categories of people who have knowledge of the company’s affairs, to attend on the liquidator in person to provide the information that they have.
The people who can be required to attend are –
The person to whom the Notice is issued may be required –
A person who fails to comply with a notice given under this section commits an offence and, if convicted, is liable to a fine not exceeding $50,000 or imprisonment for up to 2 years.
When appointed over a company, the liquidator doesn’t know what they don’t know so they have been given statutory powers to uplift company records and to obtain information from those people who do know to ensure that any potential avenue of recovery for creditors is identified.
If you would like to find about more about the different insolvency services available you can read more here. If you would like more information about the powers of the liquidators to obtain information and records or how liquidators work, please contact one of the team at McDonald Vague.
It is common in New Zealand for the directors and shareholders of small companies to be the same people and many are also employees of the company – executive directors. Whether this is in the form of a family owned business or a just a small to medium sized enterprise made up of unrelated individuals this involvement on all levels can create difficulties.
The advantage of such a set up is that the individuals are motivated to make the business work and be profitable.
The downside is that the closed nature of the board can leave gaps in the knowledge and experience held by the directors and their closeness to the business can lead to subjective decision making.
Depending on the numbers on the board, this can also lead to a stalemate position if there is a difference of opinion on matters requiring board approval.
There are two other types of directors that can be brought into the board to help address these issues, non-executive directors and independent directors.
Whilst both can address the lack of knowledge and experience, a non-executive director may be representing a shareholder and, therefore, may not act without some bias.
An independent director will generally have no links with the company, other than sitting on the board, and have no affiliation to any of the other directors or shareholders.
A liquidation that we have been conducting involves a company with two directors with the shares held by entities associated with each of the directors. One director was an executive director, employed by the company. Two further non-executive directors were appointed to the board – one nominated by each of the other directors.
The board functioned properly, and in unity, until the company faced financial issues.
When the issues were identified, one director made a proposal to restructure the company’s business in an effort to remedy the problems. The restructure proposal was not accepted by the other executive director and, when it went to a vote, the non-executive directors voted with their appointer so there were two in favour and two against – stalemate.
As a consequence, the company continued to trade for a period and left all four directors with a potential liability for breaches of their duties as director.
The closely aligned shareholder interests did not want to change the boardroom dynamic by resigning as directors, or voting against their appointors interests and/or personal views. In the end the directors settled with the liquidator.
A truly independent director, with no affiliation to the other directors or the shareholding parties, could have looked at the restructure proposal in an objective way.
There is no way to know what decision an independent director might have made in the liquidation referred to above but at least a decision would have been made, and action taken accordingly, rather than having the company in limbo.
If you would like more information on appointment of directors and directors’ duties, please contact one of the team at McDonald Vague.
The Companies Act 1993 requires directors to focus on the financial state of the company and to consider whether the company meets the solvency test before permitting distributions and certain other actions by the company.
The statutory Solvency Test is set out at section 4 of the Companies Act 1993. The Solvency Test requires that both the liquidity limb and the balance sheet limb of the test are satisfied immediately after a distribution or other action. Distributions are widely defined and include the direct or indirect transfer of money or property and incurring a debt for the benefit of shareholders.
In making a distribution, directors who vote in favour of the distribution must sign a solvency certificate confirming that, in their opinion, the company satisfies the Solvency Test immediately after the distribution is made. The relevant date for assessing solvency is the date of the resolution and not the transfer date of funds.
The company must be able to pay its debts as they become due in the normal course of business.
The nature of the business of the company must be taken into account. A liberal interpretation is to achieve the liquidity limb, debts are paid before creditors become threatening.
There is a requirement that the value of the company’s assets is greater than the value of its liabilities, including contingent liabilities.
This limb causes some concern because of the complexity with assessing what the company’s assets and liabilities are and the basis they should be valued. It is necessary to look ahead to after the distribution has been made, to ensure that the assets will still exceed the liabilities.
This is often complicated when companies have kept poor financial records.
Directors should have regard to;
(i) the most recent financial statements of the company.
(ii) all other circumstances which the directors know or ought to know affect the value.
Directors may rely on valuations of assets or estimates of liabilities that are reasonable in the circumstances. When assessing contingent liabilities, the likelihood of occurrence of the contingency and opportunity for the company to offset the contingent liability by way of a counter claim, may be taken into account.
Directors who vote in favour of a distribution must sign a solvency certificate. The certificate and procedure should address:
- the appropriateness of the latest accounts
- the existence of contingent liabilities and the likelihood of any contingency occurring
- whether any claims exist to offset the contingent liability
- any special trade factors or circumstances which “ought to be known” by the directors
- assessment of what valuations or estimates are necessary or appropriate
The certificate and procedure is a formal record to show that the directors have acted properly and considered all the appropriate matters in making their assessment.
Directors need to act in good faith and make proper enquiry and may rely on reports, statements and financial information prepared by staff, professionals, experts, and advisors who the directors believe to be competent so long as they have no knowledge that such reliance is unwarranted.
A company cannot issue a solvency certificate while it remains insolvent.
The Companies Act requires the Solvency Test to be considered for;
- buyback of shares or reduction of equity
- financial assistance in connection with the purchase of the company’s own shares
- minority buyouts
- shareholder discounts / shareholder forgiveness of debt
- the unfair prejudice remedy
- payment or guarantee of shareholders’ outside debt
If a distribution is made to a shareholder and the Solvency Test is not satisfied after the distribution is made, then the moneys may be recovered from the shareholder except where the shareholder receives the distribution in good faith without knowledge that the Solvency Test is not satisfied.
A director is personally liable for the repayment of the distribution if the director unreasonably fails to follow the statutory procedures S56(2)(a) and (c) or if the director signs the solvency certificate authorising a distribution when there were no reasonable grounds to believe the solvency test was satisfied S56(2)(b) and (d), or did not take reasonable steps to prevent a distribution once becoming aware, S56(3) and S56(4).
A director is only however liable to repay the company to the extent that the distribution is not able to be recovered from the shareholders. The Court may relieve a director from full liability under S56(5) if the Court is satisfied that the company could have by making a distribution of a lesser amount, satisfied the solvency test. Case Law has not established a strict arithmetical approach to this.
This reiterates the need for appropriate procedures to be established by a company and its directors to ensure distributions are not clawed back or that directors face personal liability.
Directors may be fined where they act in a false or misleading way and can be held liable and face up to 5 years imprisonment, or to a fine not exceeding $200,000.
In our capacity as liquidators of insolvent companies we are often required to consider if shareholder distributions should be clawed back, and/or if directors are liable for repayment of distributions. These potential director actions are good reason to understand the importance of the Solvency Test and procedures under the Companies Act 1993.
If you are an advisor to a company that is insolvent or fails the solvency test, then it is important to make your client aware of the following provisions of the Companies Act 1993 and the possible consequences.
Section 135: A director must not 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.
Section 136: A director must not agree to the company incurring obligations unless the director believes at that time, on reasonable grounds, that the company will be able to perform the obligations.
If you require assistance in establishing the appropriate compliance procedures for the Solvency Test or have any general questions on the Solvency Test or other aspects of the Companies Act 1993, please do not hesitate in contacting the directors or senior staff at McDonald Vague.
In our article published in April 2017, Internal Fraud – The Threat from Within, we discussed the issue of fraud committed on an organisation by its own officers and staff, the types of offending and some basic steps that can be undertaken to reduce the risk of internal fraud.
These steps included the need to have robust and durable systems and procedures in place to lessen the opportunities for fraud to be committed or, if they are committed, increase the chances that they will be discovered before they can cause irreparable damage to the business.
A case that our firm was involved in highlights what fraud can cost a director of a company personally if another member of the business, in this case a fellow director, defrauds clients of the company through the company’s business and the director has not been vigilant in exercising their duty to ensure that the company’s activities are being properly conducted and managed.
Another case mentioned later in this article discusses the reliance on advice from certain persons including professional advisers and other directors and further enforces the liability of non-executive directors with knowledge.
FXHT was incorporated in June 2005. Peter Justin Hitchinson was one of three directors on incorporation.
In December 2005, Dirk Oberholster became a director of FXHT and invested some funds in the business. FXHT’s business was the management of clients’ investments in foreign exchange markets. Mr Oberholster was a medical doctor and, although he had other company interests, he had no expertise in fund management.
The other two original directors ceased in July 2005 and March 2006 leaving Mr Hitchinson and Mr Oberholster as directors.
About 1 year after accepting appointment as director, Mr Oberholster discovered that Mr Hitchinson had been defrauding clients of the company. Mr Hitchinson resigned and the matter was reported to the Police. Mr Hitchinson was subsequently convicted of criminal fraud and sentenced to imprisonment.
The company was subsequently liquidated and Peri Finnigan and Boris van Delden were appointed as liquidators. The liquidators’ investigations confirmed that Mr Hitchinson had misapplied client funds to pay out other prior investors and to keep the business operating.
The liquidators took proceedings, through the High Court, seeking orders that Mr Oberholster contribute funds to the liquidation so that the clients could be reimbursed for the losses caused by Mr Hitchinson. The claim was on the basis that Mr Oberholster had failed in his duties as a director and thereby contributed to the losses suffered by the clients.
The High Court found that Mr Oberholster breached section 135 of the Companies Act 1993 (“the Act”) in that he allowed the business of FXHT to be carried on in a manner likely to cause a substantial risk of serious loss to the company’s creditors by allowing Mr Hitchinson free rein to run the company without requiring any formal reporting.
The Court also found Mr Oberholster was in breach of his duty of care under section 137 for failing to put in place adequate systems of control and reporting.
Mr Oberholster was ordered to contribute funds to the liquidation to reimburse clients.
This case highlights the problems that can be caused to a company, and its officers, by fraud committed by someone within its organisation.
It also highlights the risks faced by a director by becoming involved in a company whose business is outside their expertise and who fails to comply with the statutory requirements of being a director.
Mr Oberholster was not involved in any way with the fraud committed against clients by his fellow director but, because the Court held that he had not properly carried out his duties as a director, he became personally liable to reimburse, at least in part, the clients who had suffered losses.
We have included the link to the High Court decision. The High Court's decision was appealed to the Court of Appeal who upheld the findings of the High Court.
Section 138 of the Act can provide some relief from personal liability to directors who rely on advice given to them by certain classes of people, including professional advisers and other directors.
This is dependent on the individual director's situation, knowledge and responses, and may be particularly relevant where the director concerned is a non-executive director and not involved in the day to day operation of the business, who makes reasonable enquiries and receives misleading information from the other director.
However, once the non-executive director is in possession of information or could be reasonably expected to have acquired sufficient knowledge of the company’s business and how that business is being managed, they may be found liable from that point onwards.
This is set out in the High Court and Court of Appeal decisions in the case Grant & Ors v Johnston & Ors. We have included the link to the High Court decision in this case.
In this case it was decided that a non executive director who was mislead for a period of time, and who took affirmative action to identify and correct company deficiencies including lending the company significant sums of money to fund trading losses was not required to pay a contribution to creditors despite having been found negligent as a director from the time that the Court determined he should reasonably have paid attention to the mounting evidence of his fellow director’s ill disciplined and incompetent management and the adverse results that followed.
These cases remind us that directors in any role must be active and vigilant, and that while a non-executive director may be given some time to learn and then remedy poor company trading, there comes a time when continuing a company trading will not be considered to be a reasonable course of action.
If you are a director and are concerned about your company's financial performance, you have reservations about the information you are being provided, you would like more information about your duties as a director, or you want advice on restructuring, business systems and procedures, please contact McDonald Vague.
With financial year end, one of the considerations fresh in the minds of business owners and their advisors is the decision regarding appropriate directors’ remuneration.
In a previous article we reviewed the case of Madsen-Ries and Vance v Petera  NZHC 538. In this article, we consider an issue on appeal by the liquidators of Petranz Limited (“the company”) as to whether salaries paid by the company to the directors were fair to the company when they were paid (Madsen-Ries v Petera  NZCA 103). This article will also cover where creditor considerations fit in with such decision making, and the appropriate remedies for creditors if things go wrong.
Mr and Mrs Petera were the sole directors and shareholders of the company, which carried on business between 2002 and 2009 as a cartage contractor. Mr Petera drove one of the company’s trucks, and Mrs Petera worked on administrative tasks.
During this time, the company made various non-business related payments that the Court deemed shareholder drawings, which caused their shareholder current accounts to be overdrawn. However, regarding salaries, in contrast to journalising director salaries at year end, the company paid the Peteras regular fixed amounts between October 2007 and May 2008. During this period the salaries were declared and PAYE paid to the IRD.
In the High Court, the liquidators of the company sued the Peteras for:
- Compensation for breaches of various directors’ duties,
- Repayment of overdrawn shareholder current accounts,
- Repayment of directors’ salaries they argued were unfair to the company at the time they were paid.
In addition to the repayment of the Peteras’ shareholder current accounts, the liquidators claimed a total of $453,003.33 for breach of director’s duties, including $132,255.09 for creditor claims and $321,647.64 for liquidators’ costs up to and including the trial. At the time of liquidation, the company owed creditors $132,555.33.
The High Court, considered the extent of the liquidators’ claim, and stated that their approach to this type of litigation was “ …neither cost effective nor proportionate” to the claim involved, and went against the intentions of the Companies Act 1993 (“the Act”).
Justice Lang found that the language and intent of sections 300 and 301 of the Act narrowed the issues to:
- The amount of compensation to the company that should be paid by the Peteras for reckless trading for actual loss, and
- the amount of personal liability for failure to keep proper accounting records.
Justice Lang found the Peteras had breached various director’s duties under the Act: s 131 (to act in good faith and in the best interest of the company), s 135 (not to allow the company to be operated in a manner likely to create a risk of serious loss to creditors), s 136 (not to permit the company to incur debts unless they objectively believe the company will be able to repay those debts), and s 137 (to exercise the reasonable care, diligence and skill that a reasonable director would in the same circumstances).
For their breach of directors’ duties, Justice Lang ordered the Peteras to repay the company $64,708, being the losses suffered by the Commissioner of Inland Revenue from the time he determined that they should have stopped trading (31 July 2006).
The Court of Appeal approved of the decision by Justice Lang, to order payment of $64,708 as appropriate compensation to the company for breach of duty not to trade recklessly (s 135 of the Act). The amount determined as compensation also effectively limited the liquidators’ further claims under this cause of action.
The parties agreed that the directors had failed to comply with the procedures in s 161 of the Companies Act 1993 (“the Act”). The payments were not authorised by the board of directors (s 161(1), not recorded in the company’s interests register (s 161(2)), and finally the directors had not produced a certificate that the payments were fair to the company at the time they were made (s 161(4)).
Under s 161(5) the directors would be personally liable to repay their salaries unless they could show the payments were fair to the company at the time they were made.
In the High Court Justice Lang determined the salary payments were fair to the company at the times they were made, and allowed the Peteras to retain their salaries on the basis that:
- “(the liquidators’ concerns) are answered to some extent by the fact that the company paid PAYE in respect of those payments. To that extent the debt owing to the Commissioner did not become larger during the period in which the payments were made” , and
- “the company gained full value from the work carried out” , and
- “the company was able to derive profit from Mr Petera’s work because it was able to charge customers for the driving duties he undertook on the company’s behalf” and “the company’s administrative needs were handled by Mrs Petera” .
In the Court of Appeal, the liquidators argued that the requirements that the salary payments be fair to the company, reflected the directors’ fiduciary duty of good faith (s 131 of the Act), and that they owed a duty to consider the fairness of the payments in relation to their effect on creditors’ interests, especially given the poor financial situation of the company at the time. The liquidators argued that, from the date of insolvency, the directors should have stopped trading and stopped paying themselves a salary (which would have protected creditor interests by preserving the company’s assets such as they were at the time).
The Court of Appeal however disagreed, and stated:
“ The scheme of the Act is that creditors’ interests are a relevant consideration for directors where the directors authorise distributions and other transfers of benefit by a company to its shareholders. In those circumstances the Act uses the solvency test, not the concept of fairness, to protect creditor interests. Where directors are called upon to authorise transactions in which the interests of the company on the one hand, and its directors or shareholders on the other, may diverge (including the payment of their remuneration), the Act uses the concept of fairness. The issue for the directors in those circumstances is fairness as between directors and the company. When certifying fairness, including where required by s 161, directors do not need to consider creditor interests. Directors may nevertheless be liable to contribute to an insolvent company’s assets to reflect losses attributable to the payment of director remuneration and, in turn, a company’s failure to meet its obligations to creditors. Such liability could arise under s 301, by reference to a breach of the s 135 duty not to trade recklessly.”
The liquidators then sought leave to appeal to the Supreme Court, which although it accepted “ that the interpretation of the phrase “fair to the company” in s 161 raises an arguable issue of general importance”, declined to hear the appeal.
The Supreme Court found that such an appeal would require the Court to consider both a legal argument and conduct its own assessment of whether the payments were fair to the company, which it would not normally do, being a matter of “ application rather than principle”.
The Supreme Court also noted its concern over proportionality, given the amount already awarded in the High Court, the low level of company debt and the large claim of the liquidators.
Lastly, given the poor financial situation of the Peteras, who were facing bankruptcy, a further award against them would likely have no practical effect.
Regarding director remuneration, there is a distinction between fairness to creditors and fairness to the company. The duty of fairness is owed by directors to the company and indirectly to creditors, whose interests are directly addressed through solvency provisions and the enforcement of directors’ duties such as the duty not to trade recklessly.
The intent of sections 300 and 301 of the Act is to compensate the company and creditors for actual losses, and any further amounts claimed, such as liquidation costs, must be reasonable and proportional to the debts owed by the company.
Although s 161 contains a means of clawback of directors’ salaries, to claim both under this heading and the reckless trading provisions would involve a duplication of claim, and such approach has been rejected by the Court.
Nevertheless, directors must still take care to follow the procedures set out in s 161, and ensure their salaries are fair to the company at the time the salaries are paid.
Finally, if salaries are being paid to directors whilst ordinary creditors are not being paid, the company’s future viability should be reviewed. McDonald Vague can assist with that process.