The Court of Appeal’s decision in the Mainzeal proceedings helps to clarify what directors’ duties look like in an insolvency (or near insolvency) situation.

It also helps to clarify what a director who breaches those duties will be up for. But that clarity may be fleeting: the court saga seems far from over, and there may be a law change coming up too.

We outline below what happened in the Court of Appeal, and where things now seem to stand for directors generally. For a recap on how one of NZ’s major construction companies collapsed, the allegations facing Mainzeal’s directors and our assessment of the High Court’s approach.

Outcome of the appeal

The Mainzeal directors didn’t get what they hoped for. In appealing the HC’s decision as to both liability for breach of directors’ duties and quantum of loss, the directors ended up with potentially much greater liability for damages than were assessed in the HC, but for different reasons.

• The CA agreed with the HC that Mainzeal’s directors breached their ‘reckless trading’ duties to the company.[1] However, it took a different (more orthodox) approach to assessing liability for that breach - essentially coming to a “zero damages” position, on the basis that (to cut a long story short) the directors’ breach of this duty caused no loss to Mainzeal or its creditors.
  
  
• However, any celebration by the directors was short-lived as the CA also found the directors had caused Mainzeal to incur obligations they could not reasonably have believed Mainzeal could meet, breaching s 136 of the Companies Act 1993. The extent of the directors’ liability for that breach is the debt incurred in breach of the duty which remained unpaid at liquidation. This amount could well be significantly more than the amount initially stated by the HC. The CA has sent the matter back to the HC to determine the quantum.

More detail on how the CA got to this position, as to both liability and quantum of damages, is set out further below. But first, we look at the recurring lessons for directors arising from this and other recent decisions.  

Recurring lessons in corporate governance

After a few recent decisions from NZ’s highest courts (including Mainzeal in the CA and Debut Homes in the Supreme Court) there are some recurring lessons that directors of companies in the ‘twilight zone’ need to be aware of:

1. Where possible, get support agreements formalised and in writing - In some circumstances it will be reasonable for directors to rely on informal agreements or assurances of financial support. However, directors should do so cautiously. Both Courts found it unreasonable for Mainzeal’s directors to rely on informal (unenforceable) assurances of financial support, largely due to the size of deficit, the likelihood that the support would be relied on, and the dubious nature that the support would or could be supplied.
   
   
2. In times of financial trouble, carrying on “BAU” is not enough - Directors need to tread very carefully whenever there is any question of insolvency. The CA made it clear that Mainzeal’s directors should have done anything but continue to trade on a “business as usual” basis; they should have pushed for repayment of group debts owed to Mainzeal or for formalised assurances of support, and failing that, they should have conducted a sober assessment of Mainzeal’s future. While it’s never a desirable outcome, sometimes the best thing a director can do is resign or wind up operations -

“Sometimes it is necessary to bite the bullet and take steps that will trigger an administration or an insolvent liquidation, and failure to do so will result in liability under section 135 [prohibition against reckless trading].”

3. Where concerned, seek professional advice - All three courts (the HC and CA in Mainzeal and the SC in Debut Homes) have now emphasised the need for directors to take professional advice in times of financial trouble to see what options are available. Under s 138 of the Act relying on professional advice can also be a defence for a breach of a director duty, while ignorance is not.
   
   
4. There is no duty to avoid insolvency - The CA in Mainzeal stressed that a director’s duty to avoid ‘reckless trading’ is not a duty to avoid insolvency. Insolvency is a reasonable and legitimate risk of conducting business, and can happen without directors breaching any duties. The duty in s 135 is, instead, a duty to avoid an unreasonable risk of serious loss to the company’s creditors.

Detail from Mainzeal on liability and quantum of damages

Section 135 - reckless trading

The HC had, somewhat unusually, found the Mainzeal directors (in breach of s 135, reckless trading) to be liable for the entire deficiency in the liquidation ($110 million), minus discretionary discounts for factors like culpability.

However, the CA did not agree that the starting point should be liability for the entire deficiency. The liquidation was not caused by the directors’ breach - the duty does not require directors to avoid insolvency, but to avoid substantial risk of serious loss to creditors in an insolvency or near insolvency situation. The directors could not therefore be held accountable for the entire shortfall, as Mainzeal was already hopelessly insolvent by 2011 (assessed as being the start of the directors’ breach).

The liquidators also pleaded, as an alternative measure of damages, that the directors should be liable for the difference between the value of creditors’ claims in the actual liquidation and a notional liquidation in early 2011 (the start of the directors’ breach). However, the CA rejected this method due to difficulties in assessing the likely value of claims in a notional liquidation. Instead the CA held that the correct method of calculation was the net deterioration in the company’s financial position from the start of the breach until the date of liquidation. No such deterioration had been proved by the liquidators.

Section 136 - duty in relation to obligations

The CA found the directors had caused Mainzeal to incur obligations they could not reasonably have believed Mainzeal could meet, breaching s 136 of the Act.

The HC had dismissed liability under this section, finding that the liquidators needed to establish a breach in relation to each individual obligation incurred (which the liquidators had not done).

The CA took a different approach, finding that specific obligations did not need to be identified and pleaded. Rather the liquidators only needed to show that the directors had caused or allowed Mainzeal to enter into an obligation or a class of obligations without a reasonable belief those obligations could be met. Consequently, the CA found the directors breached
s 136 in respect of:

• long-term obligations entered into from 31 January 2011, as by then it was clear that Mainzeal was balance-sheet insolvent and dependent on informal shareholder assurances of support in order to meet those obligations. By trading on as ‘business as usual’ and not addressing these issues, the directors did not have reasonable grounds to believe they could meet these obligations; and
• all obligations (including short-term obligations) entered into by mid-2012, as by then Mainzeal was in such a precarious position it was vulnerable to failure at any time.

Following in the footsteps of Debut Homes, the CA found that as a result of this breach the directors were liable for all new debt that was incurred in breach of that duty which remained unpaid at liquidation (ie February 2013). While the directors’ damages have yet to be quantified, it is likely that the liability may be higher than the amount initially quantified by the HC for the breach of s 135 ($36 million). As a starting point, the amount of debt incurred in breach of s 136 was calculated as almost $64 million.

Still not the last word

By no means does this appeal spell the end of the discussion on directors’ duties in insolvency or near insolvency situations. The case has now been sent back to the HC so the directors’ damages under s 136 can be quantified, and with even more of the directors’ personal funds on the line, it’s likely that the directors will appeal again.

The CA has also made its dissatisfaction with the insolvency-related directors’ duties in sections 135 and 136 of the Act clear, calling for their review.

Watch this space.