On 24 September 2020, the Supreme Court delivered its judgment on a case taken by the liquidators of Debut Homes Limited (In Liquidation) (Debut) against its director, Leonard Wayne Cooper.
In this case, the liquidators alleged that the director had been in breach of duties as director under the Companies Act 1993 (the Act) and were seeking orders against the director.
The liquidators were successful in the High Court, but that decision was overturned by the Court of Appeal. The liquidators were then granted leave to appeal to the Supreme Court, where they were successful, and the orders made in the High Court were restored.
The background to the case was that Debut was a property developer and Mr Cooper was its sole director. At the end of 2012 Mr Cooper decided to wind down Debut’s operations. It would complete existing projects but would not take on any new ones. At the time the decision was made, it was predicted there would be a deficit of over $300,000 in GST once the wind-down was completed.
Section 135 of the Act relates to reckless trading and contains duties of particular relevance to insolvency situations. Section 135 states –
135 Reckless Trading
A director of a company must not-
(a) Agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors; or
(b) 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.
Mr Cooper submitted that continuing to trade in circumstances of insolvency can be a legitimate business risk, not a breach of duty, if there is a probability of improving the position of most of the creditors, as was the case in this matter. He submitted that the reasonableness of such actions must be assessed in terms of the benefit to the company as a whole and not by reference to any detriment to individual creditors.
The Supreme Court found that there was a breach of section 135. It was known by Mr Cooper that there would be a GST shortfall of at least $300,000, which is a serious loss. It also said that it was not possible to compartmentalise creditors and held that it was a breach whether or not some creditors were better off and whether or not any overall deficit was projected to be reduced.
Section 136 of the Act also relates to insolvency situations and provides as follows-
136 Duty in relation to obligations
A director of a company must not 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.
The liquidators accepted that by continuing to trade, Mr Cooper may have reduced the company’s obligations to secured creditors. However, continuing to trade caused the company to incur new debt to the IRD and 10 new unsecured creditors who had supplied goods and services to complete the properties.
They submit that Mr Cooper knew, when signing the sale and purchase agreements, that the GST obligation at least would not be met and that therefore he had breached the duty under section 136.
The Supreme Court decided that it is clear from the existence of section 136 that it is not legitimate to enter into a course of action to ensure some creditors receive a higher return where this is at the expense of incurring new liabilities which will not be paid.
Section 131 of the Act requires the directors to act in good faith and in the best interests of the company and provides –
131 Duty of directors to act in good faith and in best interests of company
(1) Subject to this section, a director of a company, when exercising powers or performing duties, must act in good faith and in what the director believes to be the best interests of the company.
The High Court held that Mr Cooper breached this duty in two respects. First, when he applied the funds realised from the sale of properties to fund further work and to satisfy secured debts which he had personally guaranteed. In doing so, the High Court said, he was not acting in good faith as he was not considering the obligations Debut owed to all its creditors. Secondly, Mr Cooper was acting in his own interests above those of Debut as, by failing to pay GST to the IRD, Mr Cooper was creating a new debt for Debut which would be subject to penalties and interest, while limiting his own liability for debts guaranteed by himself.
The Supreme Court held that Mr Cooper had breached his duties under section 131 because he failed to consider the interests of all creditors and acted in his own interests in direct conflict with Debut’s best interests.
The Judgment also includes decisions in relation to a possible defence for Mr Cooper under section 138 of the Act, whether or not a security in favour of a related trust should be set aside in part or in full, and the level of compensation to be ordered under section 301 of the Act, which we have not summarised.
As can be seen from the Judgment of the Supreme Court, which resulted in the restoration of the High Court orders against Mr Cooper to pay $280,000, there is a strong requirement on the directors of insolvent companies to consider the interests of the company, and all of its creditors, ahead of their own best interests.
It is also clear, when considering the interests of creditors, that a director has to consider them individually – not lump them together and say that while some creditors have lost more than they would have if trading hadn’t continued, overall the creditors are better off.
The practice of “robbing Peter to pay Paul” is not legitimate and can lead to directors facing allegations of breach of duty and, potentially, substantial orders to compensate the company and its creditors.
If you would like more information on the duties of directors, please contact one of the team at McDonald Vague.
Link to the Judgment Of The Court
One of the obligations on the liquidators of insolvent companies, whether appointed by the shareholders or the Court, is to review the books, records and affairs of the company to identify any potential causes of action that could lead to a benefit for creditors.
This could include identifying potentially voidable transactions, where an individual creditor has received a payment, giving it preference ahead of the body of creditors, or the transfer of assets or property to other parties for no, or insufficient, consideration.
It could also include identifying breaches of duties by the directors which has caused creditors of the company to suffer increased losses.
While many such causes of action are identified and settled by agreement between the liquidators and the parties concerned there are also cases where there is no agreement and the liquidator is left with the options of either initiating legal proceedings or dropping the matter.
In making that decision, the liquidator will consider the strength of the case, the likely costs to be incurred in proceeding and how these could be funded, and the level of return to creditors that could eventuate from such action.
The funding of the proceedings is the major obstacle the liquidators need to overcome and many good cases are not actioned because of the inability to raise the funds.
Broadly speaking, a liquidator has 5 potential avenues of funding available –
If the liquidators have realised sufficient funds from the liquidation of the company’s unencumbered assets, they are entitled to use those funds to cover the costs of their investigation and any legal proceedings.
In those circumstances, the liquidators have to give careful consideration to the likelihood of success in the legal proceedings and, if those proceedings are successful, the likelihood that any amounts ordered are collectable and will result in a distribution to creditors.
It could leave a liquidator open to criticism if they use up funds, that could have been distributed to creditors, on a risky action against a director and ended up with no recovery or only sufficient recovery to cover the costs of the liquidator’s investigations and the legal costs incurred in running the case.
The Liquidators can decide to fund the proceedings from their own resources. This will be done by allowing their time to accumulate as unpaid Work in Progress (WIP) and by paying any legal costs from their own funds and recording those payments as a disbursement to be recovered when, or if, funds are available.
This is a reasonably common practice amongst insolvency practitioners, but the same things will be considered when making the decision. The bottom line is, will the actions lead to a return to creditors?
It is not the liquidator’s job to take proceedings that will lead to a penalty being imposed on the defendant that only pays the liquidators costs. If legal actions are not likely to lead to a benefit for the creditors, but the director’s actions warrant it, the Liquidators can, and should, report the breaches committed by the director to the Registrar of Companies, with a view to having them banned.
Creditors of a company in liquidation can be approached by the liquidators to see if they are prepared to provide funding to allow legal action to be undertaken. Those creditors that do agree to provide funding receive a priority ahead of other unsecured creditors pursuant to clause 1 (1) (e) of the Schedule 7 of the Companies Act 1993.
This allows payment of the unsecured debt of that creditor, and the amount of the costs incurred by that creditor in helping to recover the funds, ahead of some other preferential creditors and the rest of the unsecured creditors.
The use of 3rd party litigation funders is increasing in New Zealand but is generally limited to the larger cases, such as the Mainzeal Property & Construction Limited (in Liquidation) claim against its directors.
There have been questions raised about the ethics of this form of funding but, whilst there is no specific legislation about the use of 3rd party funding, it has been approved in various proceedings. The Law Commission is currently undertaking a review of class actions and litigation funding
The 3rd party funders provide the funding for proceedings, which would otherwise be unaffordable, in exchange for a percentage of any recoveries. If there are no recoveries, the 3rd party funder carries the cost, so there is no downside for the creditors.
Section 316 of the Companies Act 1993 establishes, and regulates the use of, the Liquidation Surplus Account (“the account”).
Funds that represent unclaimed assets from a liquidation must be paid to the Public Trust and will, if they remain unclaimed for a period of 12 months, become part of the account.
Liquidators can apply to the Official Assignee for New Zealand for a payment from these funds to cover the cost of proceedings, advice, or expert witnesses.
To be eligible for the funds, the liquidator must prove that it is fair and reasonable for the costs to be met out of the account. There should be a public interest element in the proceedings and the application must relate to the claims of the creditors in the liquidation.
It is understandable that the creditors of a failed company want to see errant directors held to account and forced to cover the losses they have incurred because of that director’s actions and they expect liquidators to do that.
The options outlined above all include one party or another taking on the often substantial risks and costs involved in taking legal proceedings, so, while the main objective is always to recover funds for the benefit of the creditors, any actions taken have to be carefully considered and reviewed objectively.
Throwing good money after bad, or spending money, that could have provided some return to creditors, without any recovery, is not in the best interests of either the creditors or the liquidators.
The directors of a company have all the powers to decide what will be done, when it will be done and how – but with that power goes the responsibility to the company and its shareholders, to the company’s creditors and last, but not least, to themselves.
As a director, whether that be as the sole director of a small company or one of many in a large company, you have duties imposed on you under legislation, such as the Companies Act 1993 (“the Act”), and the company’s constitution.
In any circumstances, you must firstly comply with the duties imposed by legislation, which are set out in sections 131 to 138A of the Act. Your first duty is to act in good faith and in what you believe to be the best interests of the company – not your own.
In tough times, if the company is insolvent, then the focus changes and you must act in the best interests of the company’s creditors by ensuring the company doesn’t incur debts and liabilities that it cannot pay.
If you do not fulfil your duties as a director, you could be held personally liable for those breaches and face monetary penalties or imprisonment and you could be ordered to contribute funds to the company to pay creditors.
Where you are the sole director, the thought process is simple.
Where you are not the sole director, and your company is insolvent, then the thought process is the same but (and it’s a big but) being able to put into effect any actions you think are the correct and proper thing to do is dependent on the majority of directors agreeing with you.
If you do not get that agreement, you need to start making decisions about what is best for you personally.
"Should I Stay or Should I Go" is a song by English punk rock band the Clash and one of the verses is as follows -
Should I stay or should I go now?
Should I stay or should I go now?
If I go, there will be trouble
And if I stay it will be double
So come on and let me know
The 3rd and 4th lines of the verse highlight the issue for you, as the director holding the minority view, of what you should do.
Do you remain as a director to try and bring about the changes you think are required to get the best results for the creditors of the company or do you accept the other directors will not change their point of view.
That is a decision for you to make, based on the circumstances of your company and on any professional advice you may take but, if you do not see any way that you can stop the company failing because the other directors won’t take the course you are proposing, there is no obligation on you to “go down with the ship”.
To protect yourself, you should keep good records of the events that occurred, the proposals you put to the Board and responses you received and seek independent professional advice.
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.
Companies cease trading for many reasons including technological change, competition, ill health, directors’ retirement, ongoing financial problems, or simply because the company has sold its business or assets and serves no further purpose.
When a business is profitable, a business can cease to trade following sale of its business or sale of its business assets and can resolve to wind up via a section 318(1)(d) procedure (known as the “short form removal”) or follow a formal solvent liquidation. In current New Zealand law, solvent liquidations are advanced to distribute capital gains and capital reserves tax free and to provide more certainty of finality.
In insolvency, directors have a legal obligation to cease trading in accordance with insolvency laws and to ensure they do not breach directors’ duties. Failing to do so, can have significant consequences for the directors personally.
When a company ceases to trade, business stops, trading accounts are closed, employees are terminated and assets are realised and distributed. There can be a surplus or a deficit arising.
If trading has ceased voluntarily in a solvent company, directors and shareholders resolve to wind up the company. Surplus funds from the sale of assets are distributed among shareholders after all creditors have been repaid. A final tax return is filed and then following tax clearance, an application can be filed with the Registrar of Companies for company strike off. This is a short form removal. In larger companies or where large capital gains have been realised, a solvent liquidation is advanced.
If a deficit is anticipated on windup and where the directors/shareholders do not plan to top up the shortfall, an insolvent voluntary liquidation should be advanced so that an independent practitioner appropriately deals with the distribution of assets taking into account priorities established by legislation. This adds some independence and avoids directors inadvertently preferring certain creditors who then face claw back later when liquidation is advanced by a creditor.
The Shareholders should look to appoint a liquidator, or the board to appoint an Administrator (if the company is worth rescuing). The practitioner appointed then deals with the company’s affairs and assesses whether it can be rescued or sold as a going concern or wound up. Under a rescue/restructure some staff may be maintained and the business may continue often under a new structure. Sometimes a director or manager has the opportunity to buy back the assets from the liquidator or administrator or receiver in a new entity. This is often called a “hive down”.
If business rescue isn’t an option, assets are sold to repay the company’s creditors as far as possible, following a strict order of priority set out in the Companies Act 1993.
If you are a creditor of a company that has ceased trading, you need to find out the circumstances in which the business has ceased to trade. If it’s solvent and being wound up, you should be contacted by the director(s) and you should make a claim by providing evidence of your debt to be paid. If trading has ceased due to insolvency and an insolvency practitioner has been appointed, you should contact the liquidator or Administrator to register as a creditor and file a formal claim (if the practitioner has not contacted you). The liquidator will assess your claim and arrange to pay creditors from available funds in the order of priority set by the seventh schedule of the Act.
If you are owed funds, and the company that owes you is facing strike off by the Registrar (often for failing to file an annual return), you can object to the strike off by objecting on the Companies Office website:
If you suspect the company has or had assets, or there has been some untoward dealings, as a creditor you can apply to the Court for the appointment of a liquidator after following a proper process. The liquidator can investigate and take recovery action. As the applicant creditor, your applicant Court costs are preferential and rank in priority to the distributions to unsecured creditors.
To take action to recover against a struck off company, you must apply for the company to be restored to the Register first. This involves a formal application to the Registrar of Companies and you will need to provide evidence of the debt due. Once reinstated follow a formal demand process.
The two most common ways of restoring a company are as follows:
1. An application made to the Registrar under section 328 of the Companies Act 1993 by a:
o liquidator/receiver, or
o creditor of the company.
Note | This process can take up to six to eight weeks to complete.
2. An application made to the High Court under section 329 of the Act. This option could be considered if there is some urgency to your application such as a property settlement. This is also the only option available if the Registrar received an objection to your section 328 application.
For more information on the implications of a company ceasing to trade, call one of the team at McDonald Vague Limited. We offer no obligation up to one hour free same-day consultations and can quickly assess your best options.
The Tax Working Group at recommendation 61 have said for closely held companies, that IRD should be granted the ability to require shareholders to provide security to IRD if debt is owed by the shareholders to the company and the company owes debt to IRD. This enhances the position of IRD in insolvency and essentially breaks the corporate veil.
Accountants need to monitor the current account positions of their clients and ensure that dividends and salaries are being declared to ensure current accounts are not overdrawn.
Recommendation 61 provides:
61. that, for closely held companies, Inland Revenue have the ability to require a shareholder to provide security to Inland Revenue if:
(a) the company owes a debt to Inland Revenue.
(b) the company is owed a debt by the shareholder.
(c) there is doubt as to the ability/and or the intention of the shareholder to repay the debt.
The impact on companies will vary. For many it will make no difference – for example, public companies, those whose directors/shareholders only receive tax paid salaries, those who annually declare a return and pay tax and where salaries equate to the amount of drawings taken, and those who pay tax and make distributions to shareholders fully imputed.
For closely held companies that routinely have a low taxable profit and material non cash tax deductible expenses resulting in cash surpluses that are paid to shareholders without the shareholders declaring income, issues will arise.
Accountants need to be more proactive for their clients and ensure current accounts are managed.
Tax Working Group Interim Report
A question that will often arise in discussions with the directors and shareholders of companies facing financial difficulties is what their personal liabilities are.
The initial response to the question is, if the company is a limited liability company, you are not personally liable for the debts of the company BUT… and it is a reasonably big “BUT” because there are a number of ways in which an individual can become personally liable in relation to an insolvent company.
The purpose of this article is to identify some of the ways in which you can become personally liable and the steps you can take to avoid or mitigate that liability.
It is common for trade suppliers to require the directors of a company seeking to open a credit account with them to provide a personal guarantee (PG). To be enforceable, the terms of the guarantee must be in writing, must be brought to the guarantor’s attention and must be signed by the guarantor as accepted. The terms of the PG are often incorporated in the trading terms and conditions for the account so be careful to read ALL the small print before you sign the acceptance at the bottom of the page.
Generally, the guarantee will require the guarantor to settle the debts of the company to the supplier from personal resources if the company fails to do so.
If the company is placed into liquidation, the creditor can make a call on the guarantor to meet their obligations under the guarantee without having to wait for the liquidation process to be completed.
You can try to avoid providing guarantees however you may have to if you want a credit account with that particular supplier. You could also seek to limit the guarantee to a specified maximum amount.
A shareholder’s current account records the advances made to the company by the shareholder as credits and the drawings taken out of the company by the shareholder for personal expenses as debits.
It is common for directors and shareholders who work in a company business to take drawings rather than paying themselves a wage or salary with PAYE and other payroll deductions taken out and declared to the Inland Revenue Department.
Providing the accounting process is followed properly, there is nothing wrong with doing this.
The problem arises if the company is insolvent and the shareholders have taken out more than they have put into the company. An overdrawn shareholder’s current account is a debt owed to the company and is payable on demand. As it is an asset of the company, a liquidator would seek payment of the overdrawn amount from the shareholder concerned.
If you take more funds out of the company than you put in it creates a liability. To mitigate that liability, make sure your accountant attributes an annual salary to you in your current account when completing the annual financial reports for the company. This will require you to declare that salary in your personal tax return and pay tax on it.
The Companies Act 1993 (‘the Act”) sets out the duties and obligations of a director to the company and, if the company is insolvent, to its creditors.
Those duties are set out in sections 131 to 137 of the Act and include the duty to –
If a director breaches one or more of those duties and obligations, they can be held personally liable for some, or all, of the company’s debts.
To avoid the potential liability, make sure you know what your duties and obligations are, who they are owed to and how that position can change depending on the financial state of the company.
The failure to pay GST, and PAYE, and other payroll deductions that have been taken from an employee’s wages, to the Inland Revenue Department can lead to a prosecution being undertaken by the IRD and result in the company directors being held personally liable for the debts.
The penalties imposed on conviction for failing to pay on the taxes deducted from employee’s pay can be severe, including terms of imprisonment.
To avoid this potential personal liability, keep a separate tax account into which you put all GST and payroll deductions payable to the IRD and make sure you pay it on when due.
If you have cashflow issues, then you may be eligible to apply to the IRD for hardship relief or an instalment plan. Acting early will reduce your potential personal liability.
The Phoenix Company provisions of the Act were put in place to ensure that, if a company fails, the directors cannot just set up a new company with the same name, or a similar name (a phoenix company), and carry on trading without their creditors or suppliers being aware of what has happened.
The director of a failed company is banned from operating a new company with the same or similar name for a period of 5 years unless they have the permission of the Court or one of the exceptions set out in sections 386D to 386F apply.
The 3 exceptions referred to are –
If the director of a failed company sets up a phoenix company and does not have Court approval or meet the requirements of one of the exceptions, then the director can be found personally liable for debts of the phoenix company and could also, on conviction on indictment for the breach of the Act, be liable to fine of up to $200,000 or imprisonment for 5 years.
To avoid falling foul of the phoenix company provisions, make sure that you obtain good professional advice on whether your proposed course of action will be in breach of those provisions and what needs to be done to correct that position.
You can restructure and trade with the same or similar name, if you follow the right steps.
There is the potential for liabilities of your insolvent company to become your personal problem if you have not paid attention to your duties as a director of the company or you have used funds from the company in breach of your obligations.
If you would like more information on your personal position and how you can best protect yourself from personal liability, please contact one of the team at McDonald Vague.
With power comes responsibility, and the duties imposed on company directors are extensive and onerous. Whilst business is brisk and revenues swell, breaches of directors’ duties often go unnoticed and without serious repercussions. When fortunes change, a director’s conduct, even years before, can come under close scrutiny from various quarters. As matters go from bad to worse, these parties include shareholders, creditors, receivers, liquidators and regulatory enforcement.
Section 126 of the Companies Act 1993 (“the Act”) widely defines directors; effectively including shadow and silent directors, as well as those who although not duly appointed, exercise certain powers of a director.
Calling to account
Under the Act, liquidators have extensive powers to investigate the affairs of failed companies and the conduct of its officers. They can also seek recovery of funds or property where companies’ officers have acted improperly.
It is important to note that although a director may be guilty of breach of duty or law, a liquidator will be more concerned with recovery of money or property lost as a result of that breach, than looking to have the director sanctioned.
After selling or realising company assets, liquidators turn to other avenues of recovery such as:
After the recent Supreme Court decisions in Allied Concrete Limited v Meltzer (SC 51/2013); Fences & Kerbs Limited v Farrell (SC 80/2013); Hiway Stabilisers New Zealand Limited v Meltzer (SC 81/2013)  NZSC 7, recovery actions under the insolvent transaction regime have been limited. On the other hand liquidators are increasingly focussed on potential recoveries for breach of directors’ duties.
Directors duties under the Act
The Act details various directors’ duties: some individual and some collective. Furthermore, certain decisions require higher approval from shareholders through special resolution, such as for major transactions or directors’ salaries.
Directors’ duties include but are not limited to the following:
“Section 133 Powers to be exercised for proper purpose
A director must exercise a power for a proper purpose.”
“Section 134 Directors to comply with Act and constitution
A director of a company must not act, or agree to the company acting, in a manner that contravenes this Act or the constitution of the company.”
“Section 135 Reckless trading
A director of a company must not—
(a) agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors; or
(b) 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.”
“Section 136 Duty in relation to obligations
A director of a company must not 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 137 Director’s duty of care
A director of a company, when exercising powers or performing duties as a director, must exercise the care, diligence, and skill that a reasonable director would exercise in the same circumstances taking into account, but without limitation,—
(a) the nature of the company; and
(b) the nature of the decision; and
(c) the position of the director and the nature of the responsibilities undertaken by him or her.”
“Section 194 Accounting records to be kept
(1) The board of a company must cause accounting records to be kept that—
(a) correctly record and explain the transactions of the company; ...”
Penalties and consequences of breach of director’s duties
The Act imposes criminal penalties up to a maximum of five years imprisonment or $200,000 for certain serious breaches of duties by directors.
Whilst fines accrue to the Crown, a liquidator is more concerned about what can be recovered for the company, and will petition the Court for orders under sections 300 and 301 of the Act.
Section 300 of the Act allows the Court to order directors personally liable for some or all the debts of a company for failure to keep proper accounting records. That is subject to the proviso that such failure contributed to the cause of the company’s failure.
Section 301 applies to a variety of relevant people, and includes directors for breach of their duties. Under subsection 301(1)(b) the Court may order a director:
“(i) to repay or restore the money or property or any part of it with interest at a rate the court thinks just; or
(ii) to contribute such sum to the assets of the company by way of compensation as the court thinks just;”
As the focus of this article is on breaches of directors’ duties generally, we have set out the facts and findings from two recent cases where liquidators have sought orders under section 301.
Recent cases: Section 301 of the Act
Two recent cases we will consider are:
Morgenstern v Jeffreys  NZCA 449
Morgenstern was the sole director and shareholder of Morning Star Enterprises Limited (“MSE”), primarily through which he had been a successful property developer. Another of his companies was Morning Star (St Lukes Garden Apartments) Limited (MS St Lukes) which undertook a $67,000,000 development in St Lukes Auckland. The first phase of the development was successfully completed in 2005, however the second phase stalled during 2006, due to resource consent issues, which were not fully resolved until 2008. The delay ultimately caused major losses on the project.
MSE came under financial pressure in 2007, and Morgenstern, who’s shareholder current account was overdrawn by $1,776,336, sold his 99% and another’s 1% shareholding in MS St Lukes to MSE for a total consideration of $3,500,000, crediting his current account in payment.
There was no formal valuation done on the shares, and the price was determined after an informal valuation of land, building and future development, by the financial manager of the St Lukes project.
As to the value of the shares, Morgenstern admitted under cross-examination that his shares had no actual value when he sold them in 2007, but asserted that they would have the necessary value once the project was completed. MSE in fact sold the same shares in 2008 for $1.
The Court of Appeal affirmed the findings of the High Court with regard to Mr Morgenstern’s breaches of director’s duties, that:
The Court of Appeal stated the applicable legal principles as follows:
“ There is no dispute that the duties imposed on directors by ss 131, 135 and 137 are owed to the company and require directors to act in the best interests of the company. A director must not put his or her personal interests ahead of those of the company. The duties arise regardless of the size of a director’s shareholding and role in the company.”
Alpha Box Property Holdings Limited (in liquidation) v Wiekart  NZHC 1257
Alpha Box Property Holdings was part of the Circle Group of companies. Mr Wiekart was Alpha Box’s only director and shareholder. He was also a shareholder and director of the other companies in the group, along with another director, Mr Saunders.
Alpha Box traded in residential properties. Its business slowed to a point when in late 2007 it ceased operations. Over approximately six months Alpha Box’s last settlements came through, during which time the company made several payments to other group companies totalling $1,021,692.83. Mr Wiekart maintained that the payments were reimbursements of expenses paid by the other companies on Alpha Box’s behalf. The payments by Alpha Box had left the company without funds to pay $108,947.79 GST incurred in its final six months of trading, to the IRD (the company’s only creditor in the liquidation).
In her judgement Justice Peters noted the other Circle Group companies had liabilities over which Mr Wiekart and Circle Group fellow director Mark Saunders and his parents had personal guarantees. Her Honour also found the payments to those companies were not reimbursements but unsecured and undocumented loans.
Justice Peters found Mr Wiekart guilty of breaches of sections 131(1), 133, 135(b) and 137 of the Act. In paragraph  her Honour found that Mr Wiekart:
Justice Peters then made an order pursuant to section 301 of the Act that Mr Wiekart repay the full amount of $1,021,692.83 which he had caused to be paid by Alpha Box. This was in spite of the debt owed to the IRD being considerably lower, and acknowledging that the net surplus after payment to the IRD, the liquidators’ fees and costs had been paid would revert to Mr Wiekart.
From the above case law and given the requirements of the Act, it is important for directors to know their responsibilities and duties both in terms of the Act and their company’s constitution. Sound risk management policy will have checks and balances to ensure directors’ duties are complied with; not only for the benefit of the company, its shareholders and creditors, but also to avoid subsequent personal liability for directors’ actions.
The solvency test is not required to be met each day a company trades. It is required for certain transactions including distributions and dividends and requires the company to demonstrate it can meet two tests. These tests are the trading solvency/liquidity test and the balance sheet solvency test.
To satisfy the solvency tests, a company must be able to pay its debts as they become due in the normal course of business; and the value of its assets must be greater than the value of its liabilities (including contingent liabilities).
One objective of the solvency test is to control all transactions that transfer wealth from a company. In a liquidation context, where transactions have occurred when the company did not satisfy the solvency test, creditors may be able to recover from directors personally.
The solvency test
The solvency test consists of two parts:
The Companies Act 1993 requires that in some situations directors sign a solvency certificate. Sometimes this considers only the ability to pay debts as they fall due.
The situations requiring a signed solvency certificate are:
Directors need to consider all circumstances that the directors know or ought to know that affect the value of the company's assets and liabilities. In the case of contingent liabilities consideration is required to be made on the likelihood of the contingency occurring and any claims the company may reasonably be expected to meet to reduce or extinguish the contingent liability.
Contingent liabilities to be factored in
Contingent liabilities can impact a solvency certificate and impact the validity of a distribution. If directors are aware of a contingency, action must be taken to determine projected costs and probable outcomes. Directors must be realistic when assessing solvency and take reasonable steps to obtain all information relevant to forming an opinion. The Courts have confirmed the solvency test should be applied with a sense of commercial reality.
Contingent liabilities can include obligations under guarantees, letters of credit, bills of exchange, current or pending litigation, eg. leaky building claims, performance bonds, leases, tax assessments, deferred purchase agreements and underwriting adjustments.
Section 4(4) of the Companies Act 1993 - Meaning of Solvency Test - says:
"In determining, for the purposes of this section, the value of a contingent liability, account may be taken of -
Risk of personal liability
Directors who do not fulfil their obligations under the Companies Act 1993 are subject to penalties and personal liability. The liability of a director will be determined by his or her involvement in the decision. Failing to vote on a board matter should be carefully considered as directors are collectively responsible for any decision made by the board.
Directors should ensure all workings support solvency certificates and contain all necessary information and support for decisions made. This detail can provide vital defence when a liquidator challenges a distribution made.
Directors should be aware that they should not sign a certificate as to solvency if there is doubt as to the existence of reasonable grounds for such belief. If they do not take reasonable steps, they can risk being held personally liable for any non-recovery of the distribution made to the shareholders.
Directors can rely on information and professional or expert advice, but only if they act in good faith, make proper inquiry or have no knowledge such reliance is unwarranted (Section 138 of the Companies Act 1993).
Section 56(3) of the Companies Act 1993 - Recovery of distributions - says:
"If by virtue of section 52(3) or section 70(3) or section 77(3), as the case may be, a distribution is deemed not to have been authorised, a director who -
Under Section 56, a distribution may be clawed back from the shareholders unless the shareholders received the distribution in good faith, without knowledge of the company's failure to satisfy the solvency test, and the shareholder has altered their position in reliance on the validity of the distribution and it would be unfair to require repayment in full or at all. As the tests are cumulative, failure to satisfy any of the above will likely result in clawback of distributions.
When can directors be held personally liable?
Directors can be held personally liable in the following circumstances:
Apart from the obvious consequences of clawback, any director who signs a certificate knowing that it is false or misleading commits an offence and is liable on conviction to a fine not exceeding $200,000 or imprisonment not exceeding five years. A director who votes in favour of a distribution, but fails to sign a certificate to the satisfaction of the solvency test also commits an offence and is liable on conviction to a fine not exceeding $5,000. The risks are too high to not take reasonable care.
If a company is marginally solvent, directors need to take particular care to satisfy themselves, for certain transactions, that the transaction is properly authorised and that the company will meet the solvency test immediately after the transaction is implemented.