Mainzeal decision – directors liable for reckless trading

Earlier this week, in a case brought by the company’s liquidators, the High Court upheld claims of reckless trading made against the former directors of Mainzeal.  The Court has ordered that the directors pay compensation of various amounts totalling $36 million.

Mainzeal went into liquidation in early 2013.  The losses suffered by unsecured creditors were approximately $110m.  The liquidators sought orders against the former directors that they contribute between $32.8m and $75.3m.

Based on the statement released by a number of the former directors after the decision was released, it seems likely that the High Court decision will be appealed.

Background

Mainzeal went into liquidation in 2013, owing creditors more than $110m.  

At the heart of the liquidators’ reckless trading claim were allegations that the directors allowed Mainzeal to continue trading whilst insolvent state for a period of several years – whilst relying on assurances from Richina Pacific, Mainzeal’s parent – whose business was in China, to provide financial support.

At one time, Mainzeal enjoyed strong cashflows from its construction projects – but these were extracted by its parent, Richina Pacific, as loans which were sued to buy valuable assets in China.  But Richina Pacific also funded some of Mainzeal’s developments and also supported Mainzeal by guaranteeing money for construction bonds.

The onset of Mainzeal’s problems began with a substantial operating loss in 2005.  It made a profit in 2006 but lost money in subsequent years due to a string of trouble-plagued construction projects.  And then in 2012 it was then “knocked for six” by a dispute with Siemens over a large contract for upgrade of the HVDC (electricity) link across Cook Strait, where payments were withheld for work under dispute.

At this time Mainzeal’s auditor was recording his “considerable concerns” about Mainzeal and how he lost confidence relying on Richina Pacific’s assurances.  The directors acknowledged that there was no question that Mainzeal was reliant on its parent in balance sheet terms.

But the judge said there was an absence of relevant (legally binding) support from any Richina entity for the benefit of Mainzeal.

It seems that the directors were less concerned about balance sheet solvency at the time, because Mainzeal always had the cash flow to pay its debts.

By January 2013, Mainzeal director and Richina Pacific founder, Richard Yan was writing to all the directors seeking an urgent meeting suggesting that Mainzeal was no longer a going concern and suggesting that a resolution be passed to invite BNZ to appoint receivers.  All the directors gave evidence of their surprise at this turn of events and the collapse of Mainzeal that followed – with receivers being appointed in early February 2013 and liquidators at the end of that month.

Having found that the directors traded recklessly, the High Court judgment made awards:

• against Richard Yan for $18m – because he induced the other directors to breach their duties”; and
• against the other three directors for $6m each.

The judge said he accepted that Richard Yan had acted honestly and he was genuinely committed to Mainzeal – nevertheless he led on the other directors in a way that contributed to their breach of duty.  And the other directors acted in good faith and with honesty and they did so throughout – but they failed to fully appreciate the risks they were exposing creditors to.

Guilty of reckless trading

Section 135 of the Companies Act provides that a director will be liable for a reckless trading if the company is insolvent – and the directors agree to / or 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.

The High Court upheld the claim and, after taking into account a range of considerations, held that there were three key matters that (cumulatively) led it to conclude that the directors had breached their duty to the company:

• The directors had adopted a policy of insolvent trading.  The parent group (of Richina Pacific and its related companies) had extracted significant funds forming part of Mainzeal’s capital base for use elsewhere by the group, particularly for investment in China, leaving the company balance sheet insolvent (i.e. with negative equity – because liabilities exceeded assets).  The directors then agreed to continue trading in this state as part of the company’s modus operandi over a number of years.  In order that it could trade it used money owed to trade creditors —particularly sub-contractors —as its working capital.

• The Court held that this approach alone would not have meant the duties were breached if the directors could reasonably have been assured that Richina Pacific group support would have been provided in the event of adverse financial circumstances.  But the Court held that no such assurance arose in the facts of the case.  The assurances relied upon were ambiguous, conditional, and subject to the constraints of Chinese law, which restricted the ability to return money to New Zealand from China.

• The Court held that the above two factors would not have led to breach if the trading performance of the company was sufficiently strong so that it did not need to rely on significant financial resources to avoid collapse.  But this was not the case.  Mainzeal’s performance was generally poor, often involving annual trading losses, and it was also prone to significant one-off losses arising from particular projects.

The directors also sought to rely on advice from Ernst & Young that Mainzeal was a going concern.  In rejecting this reliance, the Court ruled that whether a company is a going concern is a different question from whether it is balance sheet solvent (and that there is a lower threshold for going concern status).  Nonetheless, the Court also found that the Ernst & Young’s advice was subject to a key assumption that Richina Pacific would offer financial support, which was not valid.

Damages

The Court rejected the liquidators’ claim that the directors should contribute an amount representing the difference in the loss to creditors between the 2013 liquidation and what would have occurred if Mainzeal had been liquidated in 2011, when the breach of duties arose.  The Court rejected this approach because it did not reflect the way the directors had breached their duties. The directors had not breached their duty by trading on a company that was destined to fail in any event.  Instead, their breach involved trading the company in a manner that made it vulnerable to collapse.

The Court also rejected an alternative method for calculating the level of compensation described as the “new debt” approach, which had been advocated by a prominent overseas commentator.  It held that such an approach was not appropriate under the New Zealand provisions for a breach of section 135. 

The Court assessed the appropriate amount of compensation based on the total loss on liquidation ($110m) as the starting point.  This was on the basis that Mainzeal would not have failed at all were it not for the vulnerable trading approach that the directors had adopted.  The Court held that it was not necessary to find that the directors could have successfully stopped this approach had they performed their duties, but nevertheless found that it was likely that the Richina Pacific group would have taken steps to stop the vulnerable trading approach had the directors declined to agree to it, if necessary by threatening to resign.

The Court then allowed a substantial discount from the starting point of $110m given that there were many other factors that contributed to Mainzeal’s failure.  A total figure of $36m was arrived at, being approximately one-third of the total loss to creditors, and being similar to the balance of funds that the directors had allowed the shareholder group to extract from Mainzeal.

D & o insurance

The Court considered, but ultimately did not take into account, the insurance cover held collectively by the directors, which potentially involves $20m of liability cover.  The Court made no findings on the extent and operation of this insurance cover.

Lessons from the High Court judgment

The primary takeaway from the High Court decision is that, although directors will not automatically be liable for continuing to trade a company that is undercapitalised and, possibly, in a state of negative equity / balance sheet insolvency, adopting a policy of continuing to trade while in such an insolvent state (with no viable “fix”) may attract personal liability for reckless trading.

It is also apparent that reliance on assurances of financial support given by other group companies, is warranted only where those assurances are enforceable and/or viable (of real substance).  Consequently, directors of companies within a group need to carefully consider trading risks in much the same way as those of a stand-alone company.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.