Supreme Court reviews directors' duties

The Supreme Court has recently released a decision on directors' duties, which should serve as a timely reminder to all directors of their duties under the Companies Act in circumstances of insolvency. Continuing to trade while insolvent will be a breach of your duties, even if you believe that overall creditors may be better off or the extent of losses will be reduced. It is however welcome confirmation for liquidators that the Courts will enforce the provisions of the Companies Act based on the clear wording of these sections.

With the Covid-19 safe harbours expiring on 30 September 2020 directors need to be more mindful of their duties, particularly if the company is insolvent or near-insolvent.

On 24 September 2020, the Supreme Court released its decision in in the case of Debut Homes Ltd (In Liquidation) v Cooper [2020] NZSC 100.^[1] 

The facts of the case are simple: Debut Homes Ltd was a residential property developer and Mr Cooper was its sole director. Mr Cooper decided to wind down the company at the end of 2012 - completing existing developments but not undertaking any new developments. At the time the decision was made Mr Cooper knew that Debut Homes would have a GST deficit of over NZD300,000 once the wind-down was complete. Debut Homes was placed into liquidation on 7 March 2014 following application by the IRD. The liquidators commenced proceedings against Mr Cooper.

The courts considered whether Mr Cooper breached any of the following duties set out in the Companies Act 1993:

• section 131 (duty to act in good faith and in best interests of company);
• section 135 (duty not to (i) 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 (ii) 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); and
• section 136 (duty not to agree to incur 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),

and, if so, what relief was appropriate.

The High Court found that Mr Cooper had breached all three duties, and he was ordered to pay NZD280,000 to the company. The Court of Appeal however overturned the High Court judgment, on the basis that Mr Cooper's decision in November 2012 was a "sensible business decision". The Supreme Court overturned the decision of the Court of Appeal and reinstated the decision of the High Court.

The Supreme Court judgment carefully considered the nature and extent of the directors' duties in sections 131, 135 and 136 with a focus on the clear words of each section. The key points arising from (or reaffirmed by) the decision are:

• Interests of creditors have to be considered where the company is insolvent or near insolvent. This includes prospective creditors.
• Section 135 is necessarily forward-looking and it was not relevant that the GST on future obligations was not a current obligation at the end of 2012.
• If a company reaches the point where continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading will be in breach of s 135 of the Act. This applies whether or not continued trading is projected to result in higher returns to some of the creditors than would be the case if the company had been immediately placed into liquidation, and whether or not any overall deficit was projected to be reduced.
• There is nothing in the wording of s 135 that envisages a comparative exercise between immediate liquidation and continued trading, where continued trading would still result in a deficit.
• If directors agree to debts being incurred where they do not believe on reasonable grounds that the company will be able to perform the obligations when they fall due, then there will be a breach of s 136 of the Act. It is not legitimate to "rob Peter to pay Paul".
• Such obligations do not need to arise from direct contractual arrangements between the company and the creditor.
• The test in s131 is subjective. There will be no breach of s 131 if a director honestly believed they were acting in the best interests of the company. However, if the belief is unreasonable it will be hard to persuade the Court that it was honestly held.
• In an insolvency or near-insolvency situation, directors will breach s131 if they fail to consider the interests of all creditors. Such a breach may be exacerbated by a conflict of interest.
• Where there are no prospects of a company returning to solvency, it makes no difference that a director honestly thought some of the creditors would be better off by continuing trading.
• The relief available for breaches of directors' duties must respond to the duty or duties actually breached and it is not designed to be punitive.It must take into account all of the circumstances, including the nature of the breach, the level of culpability and what is required to hold a director to account.
• For breaches of s135, the net deficiency test is appropriate (i.e. a starting point of an amount equal to the deterioration in the company's financial position between the date when trading should have ceased and the date of actual liquidation).