Double jeopardy for directors of insolvent companies?

Practical Law ANZ Legal Update w-033-4179 (Approx. 6 pages)

Double jeopardy for directors of insolvent companies?

by David Friar and Tim Fitzgerald, Partners, Sam Hiebendaal, Senior Associate and Tim Shiels, Solicitor, Bell Gully

Double jeopardy for directors of insolvent companies?

The courts have recently considered a number of claims against directors of (near) insolvent companies, and ordered directors to pay compensation for breaches of duties owed under the Companies Act 1993 (CA 1993).

Dempsey Wood Civil Ltd v Gapes [2021] NZHC 2362 illustrates that claims can also be brought against the director of an insolvent company under the Fair Trading Act 1986 (FTA 1986) relating to much the same conduct; that is, falsely representing that the company can and will pay its debts. The case is notable because the director was only required to pay $100,000 for breach of duty as a director, but liable for a much greater sum through a separate claim under the FTA 1986 about a similar conduct.

This month, in a second judgment (Dempsey Wood Civil Ltd v Gapes [2021] NZHC 2933), the High Court concluded that the payment under the FTA 1986 should be reduced to the extent that the creditor recovers amounts paid as a result of the CA 1993 liability. The High Court also indicated that, in general, amounts awarded for the different claims can be cumulative because they respond to different wrongs and that the FTA 1986 award is to be paid directly to the relevant creditor.

What are a director's duties if a company is close to insolvency?

The case highlights a number of key points about the duties and potential liabilities of directors of companies nearing insolvency, including:

Directors of insolvent companies must make a "sober assessment" about the prospects of the company and whether it can continue to trade. In this case, although the company was "at least near insolvent" in mid-October 2015, the High Court said that it was not a breach for the director to allow the company to continue to trade, because there was a "realistic prospect" of new financing. In fact, to stop trading at that point may have resulted in more serious losses to creditors.
However, when that new financing fell through, the fact that the director did not perform a sober assessment of the company's financial position or seek insolvency-related advice was a significant factor in the High Court finding him liable for breach of duty from that point.
When assessing the company's position, in some cases it may be permissible to rely on informal assurances of financial support, but this is "fact specific and context dependant". The short point is: the more reliable and concrete the offered support, the more the director can rely on it.
The director would normally have been liable to pay compensation in the amount of the debts incurred by the company after it should have stopped trading (almost $300,000). However, the amount he was ordered to pay was reduced by two-thirds to account for mitigating factors, including:
- the period of breach was short (just under three weeks);
- he believed genuinely (albeit wrongly) that the company was in a better position than it was; and
- the company failed to meet only four to six weeks' worth of debts (while meeting previous debts).
Directors need to be careful about what they say to creditors about the company's position when the company is in financial difficulty. The High Court found the director liable under the FTA 1986 for misleading a creditor by saying that funds were held for payment of its invoices when they were actually earmarked to pay another creditor. The director was liable to pay for the work carried out as a result of that representation, which amounted to more than $300,000.

Background

The case involved a housing development in Mount Wellington. The defendant was the sole director of the development company, PRDL. Dempsey Wood was the civil works contractor, and the development was backed by a lender called Koi.

There were delays in the development, which caused cost overruns. These overruns put PRDL into a difficult financial position. It needed funding to continue to operate, but the development facility provided by Koi was due to expire. PRDL worked to find alternative finance and options to return to profitability.

On 15 October 2015, the Koi facility expired. On the same day, PRDL entered into an agreement to refinance the development with another financier. Koi continued to fund the development while the other financier worked through due diligence. Dempsey Wood expressed its concerns with the alternative arrangement and the fact that, on the face it, PRDL would not be able to pay Dempsey Wood for further works.

On 5 November 2015, the alternative funding fell through. PRDL then tried to look elsewhere, without success. There was a new offer from the financier on 8 November 2015, but no agreement was reached. Dempsey Wood sought comfort from PRDL that it would be paid if it continued to work. In response, PRDL's director told Dempsey Wood that an amount was held and "was earmarked for civils and consultants". This was confirmed by PRDL's solicitors. Dempsey Wood continued to work. PRDL did not obtain funding.

In the end, PRDL failed to repay the Koi facility and, on 2 December 2015, Koi appointed receivers. There was a shortfall of $2 million for Koi and $1.6 million for unsecured creditors, approximately half of which was owing to Dempsey Wood. PRDL was put into liquidation in April 2016.

A breach of the Companies Act 1993?

Dempsey Wood sued PRDL's director alleging that he breached his duties under the CA 1993 to:

Act in the best interests of the company (section 131, CA 1993).
Not to carry on business in a manner likely to create a substantial risk of serious loss to the company's creditors (section 135, CA 1993).
Not to allow the company to incur obligations when he did not have reasonable grounds to believe they could be met when due (section 136, CA 1993).

Dempsey Wood also claimed that the director had misled them, in breach of the FTA 1986, when (among other things) he told them that there were sufficient funds remaining in the Koi facility for Dempsey Wood to be paid for work carried out after that time.

Decision on directors' duties

The High Court conducted a detailed analysis of PRDL's financial position and the director's conduct, with a focus on the events of November and December 2015, and decided that PRDL was at least near insolvent from 15 October 2015 (when the Koi facility expired).

However, the High Court said that it was permissible for the director to allow PRDL to continue to trade beyond that point. That was because Koi continued to fund monthly drawdowns and the alternative deal was at that stage "a realistic possibility". There was therefore not a substantial risk of serious loss to creditors at that time (for the purposes of section 135, CA 1993) and to cease trading at that point "could have resulted in more serious losses to creditors".

However, that position changed by mid-November 2015 when the alternative deal was "off the table". Given the development was not viable at that point and the "only realistic refinancing transaction in play had just fallen over", the company was in a "very vulnerable position". In those circumstances, the High Court found that:

The director breached his duty under section 135 of the CA 1993. He should have carried out a "sober assessment" of PRDL's financial position and what options were available (for example, seeking more definite assurances of support from Koi), rather than carrying on in a "business as usual" way. That was likely to give rise to a substantial risk of serious loss to PRDL's creditors. The High Court rejected the director's argument that such a risk was inherent in trading with a limited liability company on a monthly in arrears basis; that inherent risk is premised on a company's directors fulfilling their statutory duties.
The director also breached section 136 of the CA 1993 by allowing Dempsey Wood to continue works between mid-November and early December 2015, even though there were no longer reasonable grounds to believe that Dempsey Wood would be paid (given that alternative funding had fallen over). Following the Court of Appeal decision in Yan v Mainzeal Property and Construction Ltd (in liq) [2021] NZCA 99, the High Court found the director liable under section 136 of the CA 1993 for "trade debts" in that period and noted that, for ongoing work, the payment obligation is incurred when the work is performed, not when the contract is signed. It was not a defence that the contract had been signed at a time when the director believed PRDL would be able to pay.
The director did not breach his duty to act in the best interests of the company, under section 131 of the CA 1993, because he genuinely believed that creditors would be paid through his continued pursuit of refinance. While he "misjudged matters" in late November 2015, that was not enough to conclude he did not subjectively believe he was acting in PRDL's best interests.

The High Court held the director was liable to pay compensation based on the "new debt approach" (that is, quantified by reference to the value of debts taken on by the company after the date it should have stopped trading), which the courts have said is more appropriate for breaches of section 136 of the CA 1993. The High Court took a broad brush approach in concluding that PRDL undertook almost $300,000 of payment obligations to Dempsey Wood that it should not have. That was the sum that the director would usually be required to pay.

However, the High Court made "a reasonably significant allowance" (a reduction) and said that the director was only required to pay $100,000, because of the short period of breach (under three weeks) and because the director was not "significantly at fault, from a culpability perspective" as he believed that obtaining refinance and terminating the pre-sale agreements would improve the position. The High Court also noted that the director had caused the company to carry on business in a manner that largely resulted in all but the last four to six weeks of creditors' claims being met.

After calling for further submissions from the parties, the High Court ordered that the $100,000 be paid to PRDL and left open the question whether it could actually have been paid directly to Dempsey Wood (which had argued it should be paid to PRDL).

Decision on Fair Trading Act 1986 claim

The High Court said that the director misled Dempsey Wood and breached the FTA 1986 by saying funds were available to pay for further work when that money had been earmarked to repay Koi.

This did not require nearly as much analysis as the directors' duties claims, though the evidence on those claims was relevant. Dempsey Wood was aware of PRDL's financial difficulties, and specifically asked for assurance that it would be paid. In response, the director said that there were specific funds that would be available to pay Dempsey Wood. Dempsey Wood relied on that assurance when it decided to continue work, and suffered loss as a result from not getting paid.

The High Court estimated that loss at approximately $285,000 and, importantly, decided that the FTA 1986 and CA 1993 liabilities are in theory cumulative. That is, because the CA 1993 and FTA 1986 liability stems from "different 'wrongs'" there is no "double punishment" by holding a director liable to pay both amounts. A creditor successful in bringing such a claim will receive an award made under the FTA 1986 directly, without it needing to go into the general pot for distribution in the liquidation.

However, in this case, Dempsey Wood sought payment for the same unpaid costs and invoices under both claims. Given that, the High Court said that any money Dempsey Wood receives on account of the breach of the directors' duties claim should be offset against the amount owed for misleading and deceptive conduct.

Conclusion

The case highlights real risks of personal liability for directors of insolvent companies, not just for breach of duty as a director, but also for potential liability under the FTA 1986.

Double jeopardy for directors of insolvent companies? | Practical Law