Court of Appeal ruling shows directors should err on the side of caution when trading through financial difficulties
The director community in New Zealand will not have been surprised to see that the Mainzeal saga reached another milestone – but without fully resolving the key issues. In March, the Court of Appeal confirmed liability of both the executive and non-executive directors, but the directors have already applied to appeal the decision to the Supreme Court. This means that the issues resolved by the Court of Appeal may be revisited yet again, leaving open the possibility that the directors will ultimately be relieved of liability.
What was the decision?
The Court of Appeal held that the directors breached the two core duties which protect creditors from the risks of insolvent trading, not to recklessly trade and the duty in relation to obligations, but overturned the controversial measure of damages for reckless trading.
It was "wishful thinking" for the directors to continue to trade on as usual when Mainzeal was in a very vulnerable state. In particular, the Court attacked the assumptions on which the directors had relied, particularly by assuming that related company debts were recoverable and that assurances of support could be counted on.
Ultimately, however, the directors were "saved" by a finding that, despite the reckless trading, the financial position of the company was not proved to have worsened and therefore creditors as a whole did not suffer any loss. In this part of the case, the directors were successful and overturned the liquidators' original success. This should be of some comfort for directors generally, if they can manage to restore value to the balance sheet when facing insolvency.
The Court of Appeal upheld the Liquidator's appeal regarding the duty in relation to obligations. The Court considered the manner of trading presented such precarious conditions that directors could not reasonably have been able to have any confidence that it could meet its obligations. The company's ability to meet those obligations depended on them receiving shareholder support as and when financial difficulties arose. It was not reasonable in the circumstances for the directors to believe that shareholder support would be forthcoming.
The High Court must now reconsider the quantum of loss. It seems at least possible that liability will increase from the original award of $36 million, although how that will be allocated amongst the directors remains to be seen.
The Court also criticised the current laws governing insolvent trading. It called for a review of these laws, to ensure that they provide a coherent and practical regime to protect creditors when directors decide to keep trading in precarious financial circumstances. Directors equally will consider that they should be able to take reasonable, informed steps to trade out of difficulty and avoid the unsatisfactory outcome of an insolvent liquidation, without overwhelming concerns about liability. Directors currently face significant financial and reputational exposure, so clearer guidance in this area would be welcomed.
Lessons for directors
Don't make assumptions when it comes to the company's financial position
The directors ought to have been cautious before deciding to continue to trade. In this case, they were not. They failed to take urgent corrective action to address the "profoundly unsatisfactory financial position of the company and the risks this created for current and future creditors", for example, by obtaining better shareholder support. They should have given the shareholders an ultimatum requiring their support.
Properly consider the company's financial position and trading strategy
A decision to trade on is likely to breach the reckless trading provision unless the manner in which the directors choose to do so has realistic prospects of success. Directors cannot simply use new creditors' money to service debts to existing creditors: they must be able to pay any new debts incurred. Any decision to continue to trade in a precarious financial situation must be made after a sober assessment of the company's position. Evidence of financial and legal advice received will usually be necessary to demonstrate that directors have properly considered the company's financial position.
Formal insolvency processes cannot be avoided when necessary
Directors of an insolvent company should not conduct their own informal administration or liquidation without the consent of creditors or after ensuring non-consenting creditors are paid in full. That creates the risk that the company's assets are not distributed in accordance with lawful priorities.
Professional advice is recommended
One enduring lesson for directors observing this case is the complexity of significant litigation and therefore the time often needed to resolve liability claims in corporate collapses of this scale. Directors should be looking carefully at the financial and legal advice they obtain, the quality of information produced within their organisations, and whether they are adequately insured to protect against the significant exposure which may lie down the path of insolvency.
This opinion piece was first published in the NZ Herald's Capital Markets Report.