The Supreme Court’s long awaited decision in Yan v Mainzeal Property and Construction Ltd (In Liq) offers some much needed clarity on directors’ duties in New Zealand. Our initial summary of the decision and its implications is here. This article provides a more detailed review of the state of directors’ obligations post-Mainzeal.

Mainzeal focuses on ss 135 and 136 of the Companies Act 1993. As with all directors’ duties, these obligations are primarily owed to the company, rather than to creditors or shareholders individually. However, both ss 135 and 136 are creditor focused and govern how a director should act when a company is facing solvency concerns.

Section 135 - Reckless trading

“A director of a company must not cause, allow or 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.”

Despite being titled “reckless trading”, s 135 imposes a negligence standard on directors, with the heading being merely an “artefact of legislative history”. It’s not only “illegitimate” risk taking by directors that will be captured by s 135. The Mainzeal judgment sets out a two-stage approach to assessing liability under s 135:

1. first, the Court must objectively determine whether the business of the company was carried on in a way that was likely to create a substantial risk of serious loss to the company’s creditors; and
2. secondly, the Court must assess whether the actions of the directors were “reasonable” - whether they were consistent with the care, skill and diligence expected of director with the information the directors had, or should have had. The larger and more complex the company, the higher the level of skill and diligence expected of a director.

Mainzeal also affirms the Supreme Court’s finding in Debut Homes that it will be a breach of s 135 for directors to continue trading a company where there is a substantial risk of loss to creditors, even where trading on for a period could improve the position for some of the existing creditors.

Having found a breach of s 135, the Supreme Court applied the conventional “net deterioration” approach to calculating damages. The Mainzeal directors were not liable for any losses under s 135 because the overall creditor position of the company had, in fact, improved from the point where Mainzeal should have ceased trading (the “breach date”) until the date when receivers were actually appointed (see our article on what Mainzeal means for compensation for breaches of directors’ duties here).

The Court does acknowledge that some companies carry a recognised heightened risk (for example, start-ups) and some creditors may recognise this when they do business with those companies. However, it has left open the question of how section 135 will operate in such cases.

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.”

Mainzeal has resolved the uncertainty as to whether claims under s 136 are limited to substantial or one-off new obligations, or whether liabilities incurred by ongoing trading are “obligations”. The Court declined to read down the statutory provision and found that obligations incurred in the course of ordinary trading can also amount to a breach, if the directors are not confident on reasonable grounds that they will be honoured.

There may, therefore, be a substantial overlap between ss 135 and 136 - if an obligation cannot be met, there will almost always be a substantial risk of loss to a creditor. However, the Supreme Court took a different approach to calculating damages under s 136, resulting in a significant liability being owed by the directors. See our article on compensation here, which outlines the difference between the “net deterioration” approach applied to breaches of s 135 and the “new debt” approach applied to s 136.

The law on s 136 does recognise that a near insolvent company may be capable of meeting its short-term obligations, but not medium to long-term obligations. In those circumstances, it may not be a breach of s 136 for directors to allow a company to continue trading, but they should not be committing the company to mid or long-term obligations, such as large new projects or significant expenditure.

What is the purpose of directors’ duties?

Underpinning the Court’s decision was an acknowledgement of competing policy concerns in relation to directors’ duties:

1. on one hand, the desirability of companies taking business risks and allowing directors a wide discretion in matters of business judgment; and
2. on the other, the need to protect those who extend credit to companies from the risk of loss (particularly because of the information asymmetry between companies and creditors).

Overall, the Supreme Court considered that the wording of ss 135 and 136 reflected a decision by the legislature to place greater weight on creditor protection.

The judgment also recognised that this imposes stricter, “more exacting”, obligations on directors than the equivalent law in the UK.

What does this mean for directors?

The Supreme Court recognised and commented that it was important that the principles established by this judgment are accessible enough to provide guidance to directors.

Some key takeaways for directors include findings that:

1. Directors have a continuing obligation to monitor the performance and prospects of their company, and will be in breach of their duties if they fail to do so;
2. A long-term strategy of trading while balance sheet insolvent is generally unacceptable unless there are exceptional circumstances (for example, where support is provided from a related company or a third party that can reasonably be relied on);
3. Where there is uncertainty about the solvency of a company, or its ability to meet obligations, directors should be taking expert advice from sources independent of the company;
4. Directors of an insolvent, or nearly insolvent, company can take a reasonable time to “take stock” and decide on an appropriate course of action. What is a “reasonable time” will depend on the circumstances, including the complexity of the company’s affairs and the urgency of the presenting situation;
5. A company can only trade while insolvent while its directors identify whether or not there is a path forward that does not create a substantial risk of loss to creditors. If losses to creditors are unavoidable, it cannot continue trading in an attempt to mitigate those losses;
6. At the point where directors have concerns about the solvency of a company, directors should be paying substantial regard to the interests of creditors;
7. Both Mainzeal and Debut Homes emphasise the alternative mechanisms available under the Companies Act to companies and directors facing financial difficulties. These include creditor compromises and arrangements, under Part 14 and Part 15, and voluntary administrations under Part 15A of the Companies Act.

The Supreme Court also confirmed that the directors’ duties under ss 135 and 136 apply to each company within a group of companies. While the inter-group position may well be relevant to assessing a company’s future prospects, the directors owe separate duties to each company within the group (which are not obviated by s 131(2) of the Companies Act).

Conclusions

The Supreme Court has emphasised that the creditor protection rationale of ss 135 and 136 trumps undue deference to the business judgment rule. Directors need to be aware that this creditor focus kicks in not just when an insolvent liquidation is certain (as in the UK), but earlier, when the company is insolvent, or approaching insolvency, and it’s not clear that the company can trade its way through without any creditors suffering loss.

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.