The recent Supreme Court judgment in Mainzeal[1] has confirmed that compensation can be calculated differently for breaches by directors of their duties under ss 135 and 136 of the Companies Act 1993. This article provides a more detailed review of the methodologies available post-Mainzeal.

Our initial summary of the decision and its implications is here. We have also published a review of the state of directors’ obligations to creditors post-Mainzeal, which can be accessed here.

Significant developments

The Mainzeal decision is significant for a number of reasons:

• until recently, compensation under both ss 135 and 136 was usually calculated based on a “net deterioration” methodology. The Mainzeal decision has confirmed that compensation can be calculated by different methods, with potentially very different outcomes (discussed further below);
• it represents a change in approach to the discretionary aspect of awarding compensation under s 301 of the Companies Act. Culpability is the critical factor in the exercise of the Court’s discretion. The focus will likely be on reducing the level of liability where a director’s culpability is “limited”, rather than reserving full compensation for only the most egregious cases. Full compensation is the norm;
• it has brought to an end the long-standing uncertainty surrounding the ability of individual creditors to seek direct compensation under s 301 of the Companies Act for a breach of directors’ duties. The Supreme Court has confirmed that compensation can be awarded directly to creditors who bring claims against directors under s 301.

Relief for breach of s 135 - reckless trading

Compensation (or damages) for a breach of s 135 will frequently (but not always) be determined by the “net deterioration” approach. The “net deterioration” is the extent to which the company’s financial position deteriorated between the breach date and the date of liquidation.

That approach reflects that s 135 is concerned with the position of the creditors and business as a whole. It is premised on a complaint that the company continued to trade after the date on which the liquidation ought to have occurred and, as a result, the company (and its creditors) are worse off than they otherwise would have been.

However, as the “net deterioration” approach is concerned with the decline of the company during the breach period, it is possible for the compensation payable to be nil, despite the Court determining that the duty has been breached. That was the outcome in Mainzeal - although the directors breached s 135, they were not liable for any damages as the overall position of the company improved from the breach date until the date of actual liquidation. There was no “net deterioration”.

But “net deterioration” is not the only methodology applicable. The Supreme Court confirmed that other measures of loss might be necessary, or appropriate, on any particular facts. Other options (which weren’t applicable on the Mainzeal case) include:

• “new debt” - this is the measurement typically, but not exclusively, applicable to a breach of s 136 (see below). The Supreme Court confirmed that, in the right circumstances, it might be applicable to a breach of s 135;
• “entire deficiency” - a director could be held liable for all losses suffered by a company where the breach of s 135 is itself the cause of the company’s failure, or the company’s records are inadequate, thereby preventing an adequate reconstruction;
• “disgorgement” - a breach of s 135 which resulted in a director deriving a benefit from the breach, could result in the compensation being calculated by reference to the improperly obtained benefit.

Relief for breach of s 136 - incurring an obligation

Conventionally, calculating compensation for a breach of s 136 followed the same “net deterioration” approach applicable to a breach of s 135. In recent cases, the Supreme Court has adopted a different approach, which more appropriately reflects the nature of the breach and the section, being focused on the loss to individual creditors by the incurring of a particular obligation, rather than on the business of the company and the body of creditors as a whole.

The Mainzeal judgment confirms that compensation (or damages) under s 136 will usually (but not always) be based on a “new debt” measurement of the loss. The “new debt” is the gross amount of the new debt or obligations taken on after the breach date and which remain unpaid in the course of the liquidation (ie excluding any distributions made to creditors during the liquidation in respect of the particular loss). In Mainzeal, that comprised of four significant long-term projects entered into after 31 January 2011 and all obligations incurred after 5 July 2012 (less certain concessions made by the liquidators).

This means that, unlike liability under s 135, directors who trade on when the company is insolvent may still be liable to compensate the company if there is a shortfall owing to creditors on liquidation, even if the overall financial position of the company has improved.

“Practicalities must be respected”

The Supreme Court recognised that calculating damages can be a very complicated exercise - different compensation methodologies, complex facts, competing counter-factuals and hypotheticals, and numerous possible breach dates, all have the potential to cause disproportionate cost and delays when calculating damages. The Court recognised that it would be unrealistic to expect precise calculations of loss. Rather, it proceeded on the basis that it could enter judgment if satisfied on the balance of probabilities that the amount sought by the liquidators was less than the losses actually suffered.

Exercise of discretion

The Court retains a discretion under s 301 of the Companies Act when determining the level of compensation payable by directors for breaches of their duties. Without any clear judicial guidance, different Judges have applied this discretion very differently, making it difficult to predict what level of compensation may be ordered. The Supreme Court has now provided some clearer guidance.

First, the Court’s discretion should be exercised cautiously. Importantly, the Supreme Court held that compensation for the full extent of the losses should be the norm.

Secondly, whereas previously factors of “causation, duration, and culpability” were all relevant to the exercise of the discretion, the Supreme Court has confirmed that causation is more appropriately considered in determining the existence of the breach and extent of the loss, and duration is a component of culpability. Culpability is, therefore, the critical factor and will likely be used to apportion liability as between directors. In Mainzeal, Mr Yan was described as being “far more culpable than the other directors” and was liable for the full amount of the loss ($39.8 million plus interest). The other directors, being less culpable, each had their liability capped at one sixth of the total loss ($6.6 million plus interest).

Claims for compensation by creditors - an end to historical uncertainty

Mainzeal has also provided much needed certainty on the relief available to creditors under s 301 of the Companies Act. The Supreme Court has held that, notwithstanding a legislative drafting error in s 301, creditors are entitled to bring direct claims against directors for breaches of directors’ duties, and can seek payment of compensation under that section for the harm caused directly to them.

There are still unanswered questions and potential difficulties as to how direct compensation to creditors should operate in the context of a liquidation. However, the Supreme Court has given a clear direction that compensation can be paid directly to a plaintiff creditor.

Get in touch

If you would like advice on anything discussed in this article or what the implications of the Mainzeal decision could mean to your business, please get in touch with one of our experts.

Special thanks to Lucy Harrison for her assistance in writing this article.