Stephen Layburn

The last 10 days has seen the publication of several important updates on the topic of continuous disclosure.

These updates came in the form of the FMA’s report on the findings of its investigation into Wynyard Group Limited’s compliance with continuous disclosure obligations and then a new case study and updated guidance note from NZX.

FMA report on Wynyard investigation

Following the collapse of Wynyard in October 2016, the FMA and NZX undertook an investigation into the conduct of Wynyard and its directors.

On 30 September, the FMA reported that based on its investigation:

• the FMA does not consider that any individuals contravened the FMC Act;

• the FMA has concerns regarding the quality of some of Wynyard’s announcements, but it is not clear to us that we could establish a breach of the fair dealing provisions in the FMC Act; and

• the FMA does continue to have concerns that Wynyard may have contravened its continuous disclosure obligation in late September 2016.

Despite the FMA’s views on the potential contravention of disclosure obligations, the FMA has decided not to pursue enforcement action against Wynyard. Wynyard is now in liquidation and its shares no longer trade therefore there is no reasonable prospect of recovery for investors.

In the press statement that accompanied the release of the FMA report, it was noted that:

• the FMA is not confident the Wynyard board rigorously tested whether they were in possession of material information that required disclosure; and

• disclosure is a priority area for the FMA – which is why we supported the extension of the continuous disclosure obligation [in the new NZX Listing Rules which come into effect on 1 January 2019 – subject to a 6-month transition period] to cover information that a director or manager ought to have known.

Whilst the FMA report contains specific findings about the materiality of Wynyard’s worsening cash position, the report also makes a number of key points that are of wider application. These include:

• Board minutes should reflect discussion of the issuer’s continuous disclosure obligations in an “upfront, detailed and considered way” – and not just observance of routine / formal process. In short, the Board must (and must be shown to have) turned its mind as to whether a particularly piece of information is price sensitive.

• Individual directors (and senior managers) face the risk of personal liability for a breach of an issuer’s continuous disclosure obligations – if they had actual knowledge the information was material (price sensitive) information.

The FMA also made some recommendations for early stage issuers and their advisers. These are:

• The Board must remain conscious at all times of the need to apply an enquiring mind to information received from management. The FMA expect the Boards of all issuers to seek both appropriate breadth of management views and independent advice. This is particularly relevant for early stage issuers, who often have limited track records and high-growth aspirations. The Board may not have had time to establish a cohesive culture or the opportunity to observe the issuer through multiple reporting cycles.

• The Board should ensure that the Board minutes accurately and adequately reflect the discussion and debate that has occurred.

• Early stage issuers should provide appropriate context around any guidance they release. There are typically a range of potential scenarios that sit behind any guidance – and it is important to ensure proper emphasis is given to this range of outcomes (see also NZX guidance on this issue).

• Loss-making issuers need to manage their cash resources proactively (not reactively) – and last minute decisions to raise capital or change strategy add material risk. If an early-stage issuer’s cash resources narrow – the information needs of the market are likely to change. This heightens the need to engage with the views of investors and proactively manage expectations – to avoid market surprises.

NZX case study

NZX published a continuous disclosure case study to coincide with the release of the Wynyard report. The case study makes the following key points:

• Where issuers select non-financial metrics for their forecasts (such as sales of particular product lines), the obligations relating to disclosure of material deviations from those forecasts will still apply, where that information is material information.

• Issuers must keep sufficient internal documentation in relation to continuous disclosure discussions and decisions made by the issuer’s Board and executive team.

• Issuers should not attempt to highlight positive information in market announcements as a means to redirect or lessen attention from negative information which is relevant to investors.

NZX updated guidance on continuous disclosure

Finally, NZX has published an updated guidance note on continuous disclosure – to address the introduction of constructive knowledge element to the obligation in the updated NZX Listing Rules. As noted above, the new threshold test will focus on the disclosure of price sensitive information to the market when a director or senior manager

“has, or ought reasonably to have, come into possession of the information in the course of performance of their duties”.

The updated guidance underlines the need for issuers to have processes in place to identify and escalate material information in order to meet the new deemed awareness test.

Further information

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

I first wrote about earn-outs in 2012 – and the use of an earn-out to bridge the gap between the parties’ value expectations (and risks) in a business sale.

At its simplest, an earn-out is a mechanism whereby the seller is paid an additional amount (over and above a base price for the business) based on its actual future performance.  Whilst there are a variety of shapes and sizes of earn-out, depending on the nature of the business and the pattern of the negotiations between seller and buyer.  An earn-out is more common where there will be a period of assistance by the seller after the business has been sold.  In the typical SME example, the owners will have built the business that they have also managed and a key part of the earn-out is often that they are retained for a period after the sale to continue in a management capacity.

An earn-out is typically linked to a measure of post-sale profitability (typically EBIT – Earnings Before Interest and Tax).  It is also often said that earn-outs will be used where the value of the business is only partly attributable to the physical assets.  As such it can be said to act as a sort of dividend on the business achieving some or all of the goodwill component of the valuation.

Back in 2012, I wrote about the benefits (for vendor and purchaser of an earn-out) but also mentioned the pitfalls.  Two High Court decisions this year flesh out those pitfalls.

Two (actually three) recent High Court decisions involving acceleration mechanisms linked to an earn-out (one holding that liability to pay the earn-out had not been triggered – and the other finding that the acceleration mechanism did apply) underline the risks issues that need to be considered when negotiating and drafting earn-outs.  In keeping with a string of recent cases, the High Court applied an approach to interpretation which factored in the commercial rationale and background to the negotiations in order to interpret the disputed (and arguably flawed) terms of the relevant contracts.  Both cases underline the point that New Zealand courts will seek to apply a commercial (and not a “strict” or “literal”) approach to contracts interpretation – especially where the strict approach would yield a commercially absurd outcome to the interpretation of the disputed subject matter.

A case of Tuatara

There have been two important hearings involving the investment by the McKenzie family’s well-known investment vehicle (Rangatira) in the craft brewer Tuatara.

The existence of a dispute came about after Rangatira agreed, in 2013, to acquire some of the founders’ shares and invest new equity which (in aggregate) would give it a 35% stake in Tuatara.

The vehicle for the investment was a document labelled an ‘Investment Agreement’.

In dispute was a provision in the Investment Agreement under which Rangatira would be required to pay to the vendors and to Tuatara additional sums (the ‘Contingent Purchase Price’ and the ‘Contingent Subscription Price’ — collectively the ‘Contingent Payments’) if either of two “trigger” events occurred.  Specifically, the litigation focused on the trigger for an ‘Exit Event’ – being the sale of all the sale of all (or substantially all) of the assets of Tuatara or the shares of Tuatara which actually or by implication valued the business of Tuatara (or Tuatara itself) at greater than $12million.

The parties disputed whether an Exit Event had occurred as a result of the sale of all of the shares in Tuatara to DB at a price in excess of $12m – which was completed in January 2017 (almost 3 ½ years after the Investment Agreement had been signed).

The focus of the dispute was a construction issue under the Investment Agreement – as to whether such an Exit Event was subject to a sunset period which expired on 31 December 2015.

The amount is dispute (if a Contingent Payment was due) was approx. $921k – and because the vendors considered that Rangatira had no defence to the claim, they applied for summary judgment.

In the first decision, the High Court declined to give summary judgment to the Tuatara founders against Rangatira.

As a result, the matter went to a substantive hearing (also in the High Court).

By applying the usual parameters for contractual interpretation (looking at the plain and unambiguous meaning of the relevant clause – and then testing whether that lead to a result that flouted common sense), the Court declined the claim against Rangatira and found that the Contingent Payment was not triggered for an Exit Event that occurred after the sunset date.

On this basis, the judge concluded that it was likely that the absence of specific reference to the sunset date in the definition of an Exit Event was an oversight and that both parties understood that an Exit Event had to happen prior to the sunset date to result in the obligation to pay.

In reaching this conclusion, the judge examined evidence of the negotiations between the parties and the background information that would have been available to them.  Amongst other things, included a drafting note by the founders’ lawyer in a draft of the Investment Agreement that the Exit Event was “not anticipated” against submissions and evidence on behalf of the founders that it was highly likely (on the basis of previous negotiations before the Rangatira took its stake) that Tuatara would be sold to a major industry brand – and that they were concerned that the obligation to pay the earn-out would not be defeated should this occur.

The judge also considered the commercial objective which underpinned the earn-out, namely that of facilitating the sale of the shares to Rangatira at a price that reflected the actual value of those shares.  Importantly, it was the value of the shares at the time the Investment Agreement was entered into that was of critical importance – not the value of the shares potentially at some distant time in the future.

As a result, he concluded that an interpretation that the exposure to pay the earn-out, triggered by an Exit Event, must expire at the sunset date – as being commercially sensible.  In doing so he rejected the submission of the alternative interpretation, which would require the Contingent Payments to be made potentially many years after the agreement, as not being commercially sensible.  It is also inconsistent with the principal objective of the relevant provisions in the Investment Agreement was to establish a fair value for Tuatara as at the date Rangatira acquired its stake rather than at some unspecified date potentially in the distant future.

The commercial approach to the interpretation was needed to avoid what was labelled a commercially absurd outcome that might have otherwise been yielded by a “strict” interpretation of the relevant wording.  In this regard, the analysis of the judge in the summary judgment application was more detailed and (if anything) more compelling.

The Hi-Tech case

In 2015, Hi-Tech agreed to sell its effluent management business to Waikato Milking Systems for a total of $6.25m – but under the Sale and Purchase Agreement (SPA) payment of two separate tranches of an aggregate of $1.5m (the Contingent Sums) was conditional on certain trigger events.

Those trigger events were an earn out mechanism based on the business achieving a threshold level or EBITDA (or the final farm milk gate price announced by Fonterra for the relevant season (excluding dividends) being above a specified threshold).

Hi-Tech did not suggest that either of the trigger events occurred – indeed as the judge noted, it appears to be most unlikely that any trigger event will occur.  Instead, What Hi-Tech sought summary judgment on the basis that Waikato Milking Systems had become liable to pay the Contingent Sums under an acceleration clause in the SPA.

The acceleration clause provided that liability to pay the Contingent Sums in the event of a change of control of the purchaser, or a sale, transfer, assignment or disposal of the business (or a part of it) by the purchaser.

Hi-Tech alleged that in mid-2017 Waikato Milking Systems made some significant changes to the business, including the closure of the servicing and parts operations previously carried out from the business’ premises in Morrinsville.  It considered that this constituted a transfer or disposal of part of the business – triggering the acceleration.

In the High Court, the same Associate Judge who heard the Tuatara summary judgment application found that the servicing work carried on from the Morrinsville premises constituted part of the business.  As a result, he concluded that there was no reasonably arguable defence to Hi-Tech’s claim that there has been a disposal of part of the business – and that the Contingent Sums were therefore due and payable (and awarded summary judgment accordingly).

The judge referred to the earn-out as reflect a not unusual commercial situation where parties cannot agree on the value of a company being sold, and so provide for the payment by the purchaser of an additional sum which will be conditional on meeting stated financial performance targets within a stated period.  In such cases he said the intention is to “put to the test” the vendor’s contention that the business being sold is worth the full amount (including the contingent sum or sums), and the purchaser’s contention that it is only worth the “base sum”, that it is prepared to pay up front.  He continued by noting that the purpose of the earn-out would obviously be defeated if the size of the business being sold were significantly reduced during the earn-out period by the transfer or loss of part of the business.  (In this case the servicing work carried out from the Morrinsville premises accounted for approx. 12% of the revenue of the business at the time of the SPA).

As an interpretation matter, the Judge followed a similar process to that which he used in the Tuatara summary judgment hearing (and which was also followed in the substantive Tuatara hearing) by noting that the earn-out and acceleration clauses were to be read in the relevant context – which included the commercial objectives of the earn-out.

In the Hi-Tech case, the judge accepted Hi-Tech’s submissions that the acceleration clause did not necessarily require the sale of some asset, or legal right, by the purchaser, for liability to pay the Contingent Sums to be triggered.  Consistent with that interpretation, the acceleration clause provided that a cessation of the business would be sufficient to trigger liability to pay the Contingent Sums – cessation of the business could clearly occur without any sale or transfer of any asset or legal right of the business.

Concluding comments

Both Tuatara judgments and then the Hi-Tech case build on the understanding about the approach of the New Zealand courts towards the interpretation of commercial contracts.

In turn, the judgments also highlight the practical difficulties that must be addressed mean negotiating and drafting an earn-out.  Regardless of whether a business sale is a standalone acquisition or a bolt-on acquisition undertaken by a larger business – it is almost inevitable that the purchaser will make changes to the business.

Earn-outs and any accompanying acceleration protection need to be considered carefully.  It is not always possible to predict or legislate for future developments.  And business is, by its nature, dynamic.

Further information

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

Introduction

The explanatory note accompanying the (private member’s) Bill states that:

• there is currently doubt about the ability of a company constitution to provide for ‘dry shares’ (shares which do not carry dividend rights in prescribed circumstances); and
• the classic example is shares in a co-operative where the holder ceases supplying the co-operative.

However, the explanatory note continues by stating that the issue is broader than this – and that the uncertainty arises because of the interplay between sections 36 and 53 of the Companies Act.

As a fix, the Bill proposes to add a “for the avoidance of doubt doubt” tag-on to section 53(2) that nothing in that subsection prevents the constitution of a company providing that shares in a class do not confer a right to receive dividends in the circumstances specified in the constitution.

Divergence of views?

I noted that there appear to be two schools of thought:

1. constitution can provide: that a company constitution can provide for different entitlements – but section 53 of the Companies Act makes it clear that the Board must not authorise a dividend in respect of some shares only in a class / at a different value per share for some shares in a class (i.e. the directors do not have a discretion to “stream” dividends by paying different entitlements – but can do so if it is prescribed by the constitution); or
2. constitution cannot override section 53: that the effect of section 53 is that it is not possible to provide for different entitlements – even by specifying for them in the constitution.

My view, and I think the view which is shared by a number of experienced lawyers practising in this area, is that the first school of thought is the correct one.

Whilst the use of co-operatives is not confined to the rural economy, the first approach is at the heart of the wet share / dry share dichotomy that is commonly found in co-operative companies. And this approach also underpins the approach taken in the drafting of constitutions of companies that are not co-operatives – to provide for the automatic reclassification of shares into those in a different class if the shareholder’s circumstances change.

Typically a change of circumstances will be those where the shareholder ceases/resumes trading with the company. But, conceptually, the shareholders should be free to contract for other trigger events (for example where a working shareholder becomes a passive investor).  Amongst other things, the process of providing (hard-wiring) the knock-on impact of such changes into the constitution promotes transparency about the circumstances in which a shareholder’s entitlements will change.

From this, it is logical that only if section 53 is an irrevocable rule which cannot be overridden by the constitution – that there is a problem that needs fixing.

However, there does not appear to be an impediment in the Companies Act that prevents a constitution from specifying that shares of a certain class have reduced or enhanced rights – based on a trigger event.

Concluding comments

The effect of a constitution is that of a contract between the company and each shareholder (and the shareholders amongst themselves). Accordingly, if shareholders can contract to subscribe or purchase shares in different classes with different entitlements, then there does not seem to be any good reason why they should they not be able to contract for shares of the same class with different entitlements.

Only if my view and (anecdotally) that of a number of other experienced lawyers is wrong (and the second school of thought is shown to be correct) then the thinking which appears to underpin the Bill becomes relevant.

That is the ability to “stream” dividends is consistent with enabling shareholders to have the necessary freedom to contract for such arrangements as between themselves.  In short, if shareholders can agree to take up shares in different classes with different earnings entitlements – why should they not be able to agree to take up shares of the same class with differing entitlements?

 

Introduction

At the end of last month the Supreme Court gave an important decision (Baker v Hodder [2018] NZSC 78) on the relief available to majority shareholders where the minority withheld to a major transaction.

Sadly, the case involved a family farm in which the parents held 70% of the shares and the daughter and her husband the remaining 30%. The proposed sale of the farm was a major transaction for the company (and required a special resolution of the shareholders under section 129 of the Companies Act). In this case, the minority shareholders agreed to sign a written resolution approving the sale, but only on conditions that were unacceptable to majority.

Consequently, the majority commenced proceedings against the minority under section 174 of the Companies Act (for relief where the affairs of a company are being conducted in a way that is oppressive, unfairly discriminatory or unfairly prejudicial to the applicant) alleging that the refusal to approve the proposed sale was oppressive and/or unduly prejudicial to the majority and to the company.

At first instance, the High Court judge accepted a submission from the majority that the matter was urgent and truncated the timetable for the conduct of the proceeding – granting an application under section 174 and ordering the minority to sign a special resolution under section 129 to authorise the sale of the farm forthwith. The judge also refused to stay her decision to allow the minority to appeal to the Court of Appeal. As a result, the farm was sold.

The Court of Appeal then declined to determine an appeal by the minority, on the basis that it was now a moot point – given the farm had been sold.

However, the Supreme Court decided that the Court of Appeal should have heard the minority’s appeal – and decided that it should deal with the merits of the minority’s appeal rather than remit the case back to the Court of Appeal.

The Supreme Court decision

The Supreme Court recited the legislative history of section 129 – specifically noting that it operates as a restriction on the general management powers of directors and (where there is a major transaction), the relevant powers are specifically reserved for special resolution of shareholders. There is also the safeguard of dissenting shareholders’ (appraisal) rights.

Importantly, shareholders exercising their voting rights in relation to a major transaction are, in usual circumstances, not subject to any obligations to each other or to the company ruling out any such duty was not carried forward into the Companies Act.

In the Supreme Court, the minority argued that the use of section 174 in the context of the facts of this case undermined their rights as shareholders under section 129, and that the High Court had no jurisdiction to make the order. The Supreme Court noted that:

“Although this language [i.e. the language of section 174 – which applies where the affairs of the company have been, are being or are likely to be, conducted in a manner that is oppressive, unfairly discriminatory or unfairly prejudicial to the claimant] is not obviously apt where the oppression complained of consists of a shareholder invoking the right to decline to approve a major transaction under section 129”.

it then noted that section 174(3) contemplates that a section 174 order may be made against a person other than the company, including a shareholder and that:

“[this] could be taken as suggesting that section 174 could apply where a shareholder or group of shareholders refuses to approve a major transaction under section 129”.

But the Court also cautioned that, even if section 174 did apply in such a situation – the power to make an order under that section would need to be exercised with great caution.

Unfortunately, the Supreme Court concluded that it did not need to be definitive on the circumstances in which the exercise of minority rights under the Companies Act might itself constitute oppression under section 174 – because the Court found that the High Court hearing had been miscarried. This was because the truncated process followed in the High Court meant that the Judge was not in a position to determine a number of factual disputes. As a result, it quashed the order made by the High Court made under section 174.

The Supreme Court also noted that, by requiring the minority to sign a special resolution was that the Court was, in effect, usurping their position as shareholders. The High Court Judge justified this on the basis that there was no rational basis for the minority not to sign the resolution, given that the company was effectively insolvent and its shares were valueless. This left only the ‘bargaining chip’ in relation to the minority and their indebtedness to the majority. However, that presupposes that the minority were not able to act out of self-interest.

Importantly however, the Supreme Court did indicate that one situation in which it may be appropriate to make an order under section 174 against a minority shareholder who refuses to approve a major transaction is:

“where there are particular circumstances that mean the minority shareholder is breaching a duty owed to the company or to another shareholder or an understanding among shareholders as to the ongoing conduct of the affairs of the company”.

As an example, it said that if, on the facts of the case before it, the High Court did have the power to make an order under section 174 and such an order was justified, the form of the order made, requiring the Bakers to sign a special resolution approving the transaction, was inappropriate. It usurped their position as shareholders and “presupposes that the Bakers were not able to act out of self-interest”.

Concluding comments

The outcome of this case is that the types of case that might provide a majority shareholder with scope to obtain relief against the minority under section 174, where consent to a major transaction as being withheld, appears to be narrower than a previous High Court decision (Fairway – 2014) would indicate.

When exercising their voting rights in relation to a major transaction, shareholders are typically able to act in a self-interested manner. Consequently, in order to sustain an oppression-type claim under section 174, something more is required – to show that a minority shareholder is subject to obligations to the other shareholder/s or to the company itself. Perhaps the circumstances of a family business, such as a family-farming operation, might add that extra dimension.

It should also be noted that the Supreme Court has also indicated that even if a Court did have jurisdiction to make an order under section 174, then rather than making an order requiring the minority to approve a major transaction, the appropriate remedy would be to appoint a receiver to carry out the transaction or, alternatively, for the majority to apply to the Court for a winding-up order on the just and equitable grounds. Regrettably, the Court did not shed any further light on whether this reasoning would hold in the face of a mortgagee sale (as in Fairway) or the loss of a good deal (as in the present case).

Further information

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

Introduction

A recent High Court decision concerning an unsuccessful prejudiced shareholder claim under section 174(2) of the Companies Act highlights the need for SMEs (and especially family businesses) to think carefully about (and plan for) the changing needs of stakeholders over time.

The case concerned a well-known retail business started by two brothers in 1983. Because the business also owned the premises – two companies were formed (one to operate the business and the second to own the premises). The shareholdings in both companies reflected the brothers’ initial capital contributions – with the older brother holding just over 50% and the younger brother just under 50%.

More than three decades after the business was started, the younger brother brought a claim, under section 174 of the Companies Act, that his older brother is conducting the companies’ affairs in a manner unfairly prejudicial to him as a shareholder. Consequently, he sought relief under section 174(2) by way of acquisition of his shares, or payment of compensation, or the companies’ liquidation.

Background

Both brothers were directors and initial both worked fulltime in the business. For many years their respective families also worked in the business (the older brother’s family mostly full-time – and the younger mostly worked as casual employees when required).

The brothers were paid at agreed hourly rates in a manner designed to reflect their input into the business – with their hourly earnings being topped (paid as a bonus) up from operating surpluses, plus a profit share which were paid in proportion to the shareholdings. Both wives initially were paid salaries, but that reverted to hourly rates in later years as the business became less profitable.

In 2003, as a result of ill health, the younger brother substantially reduced his day-to-day input into the business (and his remuneration dropped accordingly). The older brother’s remuneration increased – because of his extra hours in his brother’s absence.

In keeping with many retail businesses, the combined impact of increased competition (traditional and online) meant that the business suffered a decline in turnover and profitability – and had largely declared losses in the first half of the present decade. In 2012 additional capital was required to be injected into the business. At this stage, the older brother contributed in proportion to his shareholding (and the younger brother contributed a much lower proportion because he was earning les from the business). The brothers also agreed to halve their hourly rates. At this stage the business was no longer paying rent to the property-owning company.

By March 2013, the brothers were at loggerheads and the rift continued until late 2015, when the younger brother resigned as a director.

Prejudiced shareholders

Section 174 of the Companies Act enables a shareholder (or former shareholder) or any other ‘entitled person’, who considers that the affairs of a company have been, or are being, or are likely to be, conducted in a manner that is oppressive, unfairly discriminatory, or unfairly prejudicial to them – to apply to the Court for a range of orders.

Although failure to comply with specified sections of the Companies Act constitutes “unfairly prejudicial conduct” for the purposes of section 174, the Courts have held qualifying conduct does not need to be unlawful or exercised in bad faith. Instead, section 174 is described as a remedial provision designed to allow the Court to intervene where there is a clear departure from the standards of fair dealing and, in the light of the history and structure of the particular company and the reasonable expectations of the shareholders, to determine whether the detriment caused to the complaining shareholder’s interests is justifiable.

Section 174 is said to be directed to respond to “an unjust detriment to the interests of a [shareholder]”, where it is just and equitable to do so. It is designed to provide a remedy (not punishment) and because the Court must undertake a sort of balancing act. And (because the remedies available are drastic) the Courts have held that:

• errors of judgment, inefficiencies, and poor business management without (clear evidence) of bad faith or self-interest cannot amount to oppression;

• judges are ill-equipped to evaluate business strategies – but do have training and expertise in dealing, for instance, with fraud, illegality, or conflicts of interest; and

• section 174 is not a(n easy) means of providing an exit – where there are straight-out disagreements over company strategy. This point was reinforced by the High Court in Yovich (2001).

Complaints

A brief summary of the manner in which the Court dealt with the younger brother’s complaints is:

• Refusal to buy him out
  • In late 2003 (after younger brother’s ill health), older brother commissioned an informal valuation of the business – for the purposes of its sale, or sale of younger brother’s shareholding.
  • Younger brother said the older refused to sell the business but had offered a price that was unacceptable. The judge did not see anything in the (skeletal) evidence of the proposed transaction to point to any unjust detriment under this heading alone.
  • The judge also found nothing in the company’s history or structure, or in the brothers’ reasonable expectations as to its operation, to suggest one shareholder could require the other to buy them out.
  • Given younger brother’s resignation as director, the judge did not see the cases on ‘irretrievable breakdowns’ to be particularly relevant. There was no inability to operate effectively – despite difficult trading circumstances the business continued to operate effectively and the relationship breakdown did not stymie its operation.
• Management of the business
  • The judge found no evidence that the brothers’ joint expectations (for remuneration in proportion to the level of participation – plus a top from surpluses in proportion to shareholdings) were not readdressed when younger brother reduced active participation, or (more significantly) when the business suffered a downturn.
  • The judge noted that, in seeking something as significant as the forced liquidation of a functioning business – the ‘unjust detriment’ must be something in the nature of fraud, illegality, or conflicts of interest. Evidence is required of diversion from the company’s reasonable and accepted remuneration practices, and/or of a sham to divert shareholder entitlements elsewhere. Here, the level of remuneration was not seen by the judge as disproportionate in management of a 7-day a week retail business.
  • The judge could see nothing unjustly detrimental in older brother’s management of the business. In particular, younger brother’s concerns about the business’ efficiency, statutory compliance, premises and other prospects (even if proven) – simply arose from his and the business’ changed circumstances. And the continuing conduct of the business in accordance with the shareholders’ original expectations – was not (of itself) unjustly detrimental to him.
  • By contrast with Yovich, there is nothing in the companies’ present circumstances to make the original expectations now unjustly detrimental to younger brother’s interests. Instead, the business’ present circumstances reinforce the shareholders’ original expectations, to reward participants’ (based on input) over any determined return on shareholders’ investment.
• Access to company records
  • The complaints about lack of access to business’ records were unclear (and in any event the judge was satisfied that the records were made available at the business’ premises and during the proceedings).
• The property company
  • The younger brother argued that his interests in the property-owning company should be addressed on a standalone basis.
  • The judge did not agree – noting that the companies’ history and structure pointed to the brothers’ reasonable expectations that both companies were to be operated jointly for the good of the overall business. He found that there is nothing in that original intention that makes it now unjustly detrimental to the younger brother.

Concluding comments

One of the difficulties evident in this case was that, not only did the operating company not have a constitution (having been compulsorily re-registered under the Companies Act) but also there was no Shareholders’ Agreement in place between the brothers. Sadly, the evidence in this case points to a number of inflexion points where the brothers might have considered their changing needs and those of the business – including the period of ill health and the need for a capital injection. These were opportunities missed.

A Shareholders’ Agreement is a common means of bridging the gap between the Companies Act 1993 and a company’s constitution (if it has one) and the key arrangements between shareholders governing the birth, life and orderly burial of a company that is the vehicle for their joint business.

A Shareholders’ Agreement should provide a series of clear rules governing the major events in the lifecycle of the business and its stakeholders, including the introduction of new investors, and the exit or death of a shareholder (particularly a working shareholder).

Increasingly, the exit mechanisms in a Shareholders’ Agreement are being paired with key person insurance cover and ‘Buy-Sell’ arrangements which ensure that there is both a compulsory sale upon the occurrence of a trigger event (typically death or disability) and a pool of money with which to fund the buy-out.

Particularly in the context of a family business, with arrangements for future generations to take over the reins, a failure to plan for the consequences of developments such as ill health can risk the shareholders becoming embroiled in time-consuming, stressful and expensive arguments. As this most recent case has demonstrated, the Courts will be reluctant to force a buyout or even a liquidation where the stakeholders had not planned for this eventuality and there was no unjust detriment by continuing to operate the business in the manner the founders’ planned.

Further information

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

Introduction

At the end of last month, the Court of Appeal released a decision overturning the High Court on the question of whether purchasers were entitled to escape their purchases of units in the Monaco Hotel and Resort development near Nelson on the basis that the purchase agreements constituted void allotments of securities under the Securities Act 1978. The result of the earlier High Court decision was that the sole director of the developer was ordered to repay the subscriptions (i.e. the purchase price plus interest).

The key issue on appeal was whether the offers to sell the units in the Monaco development amounted to offers of (participatory) securities. There were five subsidiary issues addressed by the Court of Appeal including whether the default in repayment of subscriptions was due to any misconduct or negligence on the part of the director – thereby blocking the relief available to the director in terms of the proviso in section 37(6) of the Securities Act.

Background

The back story and the legacy of Securities Act issues affecting the Monaco development is a long one. A potted history of the relevant parts of that back story for the purposes of this note is:

• In 2003, the hotel component of the development was marketed using a standard form “hotel lease” – providing for a rental based on the gross unit revenue pooled from all hotel units. After deduction of costs and a management fee, the pooled revenue would be allocated based on the purchase price paid for a particular hotel unit expressed as a percentage of the total purchase price for all hotel units.

• Income pooling was then identified as a Securities Act issue and, in 2005, the Securities Commission granted an exemption for participatory securities for the proportionate ownership scheme offered under the hotel lease. The exemption was supported by an enforceable undertaking – requiring the re-offer of the hotel units to those who had applied for them. (The Court of Appeal judgment notes that all parties, including the Securities Commission, regarded the income pooling arrangements under the hotel lease as giving rise to the Securities Act issue and that there would be no such issue if the income for each unit was accounted for separately).

• The Monaco development had run into financial problems and further funding was needed. Westpac Bank (and subsequently Lombard Finance) agreed to provide this funding on the condition that the question of the income pooling under the hotel leases was addressed – and an individual accounting structure was adopted for the leases offered in connection with the sale of all further units. This led to the “cottage lease” being developed in 2005 – which was used for all subsequent sales.

• The purchasers only acquired their individual units for which separate certificates of title were issued. They did not acquire any estate or interest in the associated amenities.

• The cottage lease provided for a rental stream calculated by:

o aggregating the revenue actually received for letting the particular unit; and
o deducting outgoings relating to the unit and outgoings relating to the conduct of the business from the unit (which included a 20% management fee).

• Because the hotel manager as lessee managed all of the units and guest allocation, the cottage lease contained a provision requiring it to use reasonable endeavours to ensure that the allocation is fair and equitable. This was relied on by the investors to support their argument that individual unit owners had rights to participate in the earnings of other unit owners in the same complex and the offers therefore amounted to securities for the purposes of the Securities Act.

• In 2013, five years after settling the purchase of their units, the investors issued proceedings against Monaco and its sole director. They did not claim that there had been any pre-contractual misrepresentation in the forecast returns or any breach of the leases. Instead, their sole claim was that the offer inviting them to purchase units subject to the cottage lease was an offer of a ‘participatory security’ to the public in breach of the Securities Act because there was no authorised advertisement or registered prospectus and no statutory supervisor was appointed. They sought a declaration that the purchase agreements and the leases were invalid and of no effect and an order requiring Monaco (as the issuer) and Mr Sanders (as director) to repay the subscriptions being the purchase price paid by them.

• In 2016, the High Court found that the offers to purchase units in the resort subject to a cottage lease constituted offers of participatory securities – and that Mr Sanders had not proved that there was no negligence or misconduct on his part in failing to repay the subscriptions. Accordingly, the Judge found that Mr Sanders was liable to repay the subscriptions plus interest calculated in accordance with the Securities Act. In a separate judgment – the High Court declined to make a relief order under s 37AH of the Securities Act.

Key issue – did the offers to purchase units subject to the cottage lease constitute offers of participatory securities under the Securities Act?

The definition of ‘security’ includes the right to participate in any earnings of any other person. In its judgment, the Court of Appeal referred to the critical issue as being whether the guest allocation clause (in the cottage lease) confers a right on individual unit owners to participate in the earnings derived not only from their own unit but also from guests occupying other units in the same complex. In concluding that the answer is “no”, the Court of Appeal noted that:

• The only earnings to which a unit owner was entitled is the rent payable under the cottage lease for their particular unit. The initial base rent, if one is payable (which was optional – at the request of the investor) was limited to a return of 8% on the purchase price of the specific unit for 2 years after settlement. Thereafter, the rent payable for each unit was limited by the revenue derived from letting that unit. The earnings achieved from letting other units in the same complex do not form part of the rent calculation and were irrelevant to the rental assessment.

• The Court continued by saying that the revenue component of the rent calculation is restricted to the revenue actually received from letting the particular unit. The guest allocation clause does not alter this. It expresses what would otherwise be an implied obligation on the part of the manager to allocate guests to units on a fair and equitable basis, subject to guest preference and selection.

• This provision goes some way to ensuring that each unit owner has an equal opportunity to earn revenue from their unit. However, the revenue achieved from letting a particular unit depended on a range of factors including its location, whether it is on the ground floor or an upper level, whether it has one or two bedrooms and the nature of the facilities provided.

• Also, while the rent for each unit will inevitably depend on the success of the resort as a whole, this does not mean that an individual unit owner has a “right” to participate in any earnings other than those generated from his or her particular unit. If the cottage lease conferred a right to participate in the earnings of another then this “right” would be enforceable – but there was no such enforceable right. For example, a breach of the guest allocation clause could result in a damages claim against the manager – but it would not result in a claim against other unit owners for a share of the earnings achieved from letting their units (and it did not permit earnings to be re-allocated among unit owners).

• The fact that some costs were shared was irrelevant. The definition of “security” relevantly focuses on earnings, not outgoings.

Could the director prove that the default in repayment of the subscriptions was not due to any misconduct or negligence on his part in terms of the proviso to section 37(6) of the Securities Act?

The Securities Act provides that allotments of a security offered to the public for subscription without a registered prospectus are invalid – and the issuer is obliged to return any subscriptions received for such securities as soon as reasonably practicable. If any subscriptions are not repaid within two months of receipt, the issuer and all directors of the issuer are jointly and severally liable to repay them together with interest. Whilst the liability of the issuer is absolute (subject to any relief order made under sections 37AC or 37AH) individual directors are not liable if they can prove that the default in repayment was not due to any misconduct or negligence on their part.

The Court of Appeal noted that there are two issues to the director’s defence:

• First, whether there was misconduct or negligence on the part of the director; and

• Secondly (if so) whether there was a sufficient causative link between that misconduct or negligence and the default in repayment — was the default in repayment due to that misconduct or negligence?

Finding that the High Court only considered the first of these questions, the Court of Appeal noted that it was clear from the evidence that the director genuinely believed that offers of units subject to the cottage lease would not pose any issue under the Securities Act. He had good grounds for that view – as the whole purpose of replacing the hotel lease with the cottage lease was to avoid any issue arising under the Securities Act. Mr Sanders was entitled to have confidence that this had been achieved. Lawyers for other interested parties, including those for one of the investors, Westpac Bank and Lombard Finance plainly all thought so. The financiers would not have been prepared to advance further funding if they had been concerned that ongoing sales and leases would be void with all purchase moneys being repayable with interest. And the Securities Commission clearly thought that the problem arose because of the pooling arrangements under the hotel lease and would not arise if earnings for each unit were accounted for separately.

As a result, the Court of Appeal did not accept that the director was negligent in holding the belief that unit sales subject to the cottage lease were not securities and there was no obligation to refund the purchase prices paid. The Court also noted its view that, even if the director ought to have followed up on a suggestion in his own legal advice that a staff solicitor investigate further, there was no reason to suppose that such investigation would have reached a different view – so any claim of negligence, by not making further enquiry, cannot be regarded as causative of the default in repayment.

Concluding comments

The concept of a ‘participatory’ security, as a sort of catchall for investment offerings that are not equity or debt securities, has been replaced (largely by managed investment products) as a result of the transition from the Securities to the FMC Act. However, the concept of participating in the capital, assets, earnings, royalties, or other property of another person is still relevant to determining what is a ‘security’ and therefore an ‘investment product’ for the new regime under the FMC Act.

As a result, there may still be occasions where developments are funded by means of offering an interest in an asset that involves the sharing of overhead (costs). Various forms of property or infrastructure development are the most likely candidates for such an offer. Consequently, where the structure confines the entitlement of an investor to an identifiable (silo’d) income stream that is restricted to the earnings from their asset – then the Court of Appeal judgment indicates a navigable pathway to ensuring that the rights on offer are not a ‘scheme’ that is subject to the disclosure and other compliance obligations imposed by the FMC Act.

In addition, the Court of Appeal’s findings on a director’s entitlement to relief, where they can point to an absence of misconduct or negligence, when a director of an issuer had good grounds to believe (based on both professional advice and the absence of a causative link between the director’s conduct and the specific default complained of) continues to be relevant to a number of the defence provisions that have been carried over to the FMC Act.

Further information

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

Introduction

A recent High Court decision (D4 Cash Investors Limited v Advanced Creative Technologies Limited [2017] NZNC 3280 [21 December 2017]) that made headlines more, I suspect, because the names of some of the investors than the underlying fundamentals provides another lesson for those considering some form of shareholder loan with which to prop up an SME.

The case involved Advanced Creative Technologies Ltd (“Creative Technologies”), a company which had been promoted as the owner of computer software known as the ‘Matariki Codex’ – with a numbering of eye-watering claims (none of which had eventuated). In 2005, a number of investors ploughed in approx. $300,000 through a vehicle called D4 Cash Investors Ltd (“D4”). D4 claimed that the initial investment was later converted to a loan – and that it was owed $3.2m (which included penalty interest at 30%).

The background to the repayment claim was detailed. In simple terms, High Court was told Creative Technologies was struggling for further financing in 2005 and decided to spin off potential commercial benefits from a data compression capability derived from its primary software development. The funds were initially raised on the basis that the investors would receive a minority shareholding in Creative Technologies. With investors complaining about a lack of commercial progress, this equity investment was later re-structured as a debt investment with the loan backdated. No repayments were ever made.

The reason for the restructuring and its effect were disputed. Creative Technologies said it was a joint venture – and nothing was payable until revenues were received.

The use to which the funds were applied was also in dispute – with claims that the money was used for research that was wider than what was agreed – and was therefore unauthorised spending.

Was the Loan Agreement a sham?

In seeking to defend a demand for repayment plus interest, Creative Technologies argued the Loan Agreement was a sham because no funds were advanced after the parties signed it – and there was never any intention to do so. However, the judge:

• Accepted that, at the time the Loan Agreement was signed, the directors of both lender and borrowed realised additional funding was required for the project – and that the Loan Agreement provided an avenue for doing so. The wording of the Loan Agreement expressly provided for an extension of the amount of the loan and the time for repayment.

• Found that, at the time the Loan Agreement was signed, there was a genuine common intention that funds would be advanced under the Loan Agreement. And the fact that there were no advances following the date of signing cannot serve to extinguish this intention.

• Noted that the sham argument also pointed to a lack of intention to repay. But this was inconsistent with the language of the Loan Agreement. And the directors of both lender and borrower said they were acting in the best interests of those companies.

• Noted that the Loan Agreement was said to fix the irregularity affecting the use of the funds – which also strongly suggested that there was a genuine intention on the part of Creative Technologies to repay those funds.
Accounting treatment

The accounting treatment of the Loan Agreement both by borrower and lender was at odds with the assertion the loan was never intended to be repaid. This is countered by the point that it is hard to see why it would feature as an asset in D4’s balance sheet and a liability for Creative Technologies.

Adequate consideration?

Backdating the Loan Agreement created a legal issue. No funds were advanced after signing, and the advances made beforehand could not constitute consideration. Some other consideration is required if the loan is to be enforceable.

Here, the judge was satisfied that, if D4’s funds were used in an unauthorised way that benefitted Creative Technologies and was of no benefit to D4, then D4 would have legal remedies against Creative Technologies. Remedying this situation by converting the funds that were irregularly applied into a loan from D4 would put any such argument at an end. Removal of potential risk while such argument remained alive could constitute (valuable) consideration. In return for D4’s disavowal of interest in Creative Technologies’ intellectual property in the Matariki Codex, Creative Technologies promised to pay the sum stipulated in the Loan Agreement.

The judge found this explanation consistent with the evidence – and rejected Creative Technologies’ argument that the consideration on which D4 relied (to enforce the Loan Agreement) was illusory.

The judge was also satisfied that those benefits were present at the time the Loan Agreement was executed – and, therefore, they provide sufficient consideration to support the Loan Agreement.

Collateral contract/estoppel argument

It was not clear who drafted the Loan Agreement although the judge noted that the terms of the Agreement were something the directors of Creative Technologies and D4 seemingly reached agreement upon amongst themselves. However, the judge:

• Rejected a claim by Creative Technologies that there were additional conditions that were not recorded in the Loan Agreement.

• Rejected a similar claim that the parties concluded a collateral oral contract that the Loan Agreement would not take effect until Creative Technologies had the funds to repay the loan – because there was nothing or no-one to obstruct the inclusion of such a term. And because such a provision would be the mainstay of the Agreement – its absence cannot be explained as a mere oversight.

General observations on status of Loan Agreement

At the time the Loan Agreement was executed, Creative Technologies directors were also directors of D4. The judge noted that those directors were hardly likely to call up a loan if there were no funds to pay the loan. They may also have believed that once the “monetising event” occurred the loan could readily be repaid. Nonetheless, the judge accepted that each company simply assumed no demand for repayment would be made until Creative Technologies could make it – so that the inclusion of a clause deferring payment obligations until a “monetising event” was unnecessary.

However, she added that such assumption and conduct cannot constitute an enforceable oral collateral contract capable of obstructing the demand for payment. Nor can it amount to an enforceable representation by way of estoppel.

The judge also noted that, at no time in the communications between D4 and Creative Technologies in the years between 2006 and 2012 did Creative Technologies act in a way that suggested it disputed the loan was legally valid. Indeed, in 2010 Creative Technologies wrote to D4 proposing that the loan, which it recognised to be comprised of the original money investment in D4, be capitalised in return for shares in Creative Technologies. This conduct was not consistent with how Creative Technologies sought to portray the Loan Agreement.

This decision provides another example of a situation where arrangements between what were often closely-related entities, including conduit lenders, were:

• not adequately documented; and/or

• did not adequately address the possibility that any departures from arm’s-length terms that were not adequately signposted – could later be “back-filled” (particularly where the parties later ceased to be closely-related).

Specifically, even if it might seem obvious that a conduit lender would be unlikely to call up a loan if there were no funds to repay it (or would not call for repayment until there was a “monetising event”) these conditions should be adequately documented.

Further information

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

Yesterday the FMA released a draft of an updated version of its Corporate Governance handbook and announced that it was seeking feedback on the handbook’s intent, content and presentation.

The revised version updates the 2014 edition of the handbook and includes developments in corporate governance since then – including non-financial reporting, director and executive remuneration, and auditors.

The press statement that launched the new round of consultation noted that the NZX had recently published an updated corporate governance code (NZX Code) for listed companies – which is based closely on the principles of the FMA’s 2014 handbook 2014, and that the FMA sees the NZX Code as the primary guidance on corporate governance practices for NZX-listed companies.

As a result, the FMA says that the focus in the revised handbook shifts away from listed companies, but remains a practical guide for directors and executives of New Zealand-based companies and entities of various types and size, to help them apply corporate governance principles effectively.

Key changes

The FMA has updated the following subject matter under the principles from the 2014 guide:

• Principle 3 (Board Committees): External audit firms and association with the chairperson.

• Principle 4 (Reporting and disclosure): Non-financial reporting.

• Principle 5 (Remuneration): Transparency of long and short-term incentives.

• Principle 6 (Risk Management): Risk management and environmental, social and governance (ESG) matters.

• Principle 7 (Auditors): Standards of best practice for appointing auditors, non-audit work and independence.

• Principle 9 (Stakeholder interests): To maintain alignment with the NZX Code, the FMA has removed Principle 9 (Stakeholder interests). Stakeholder considerations are important, so they have been incorporated into all 8 principles (in particular Principle 4 on reporting and disclosure, and Principle 8 on shareholder relations). The commentary has also been updated.

The FMA is seeking feedback on whether the updated handbook helps directors, executives and advisers to think about how to apply corporate governance principles. Specifically, the consultation process seeks feedback on 6 questions:

1. Do you agree with the overall approach to move their focus away from listed issuers?

2. Is more guidance needed for companies seeking to grow and possibly raise capital and/or list in the future – if yes, in what areas would guidance be useful (giving examples of the additional guidance that should be added)?
3. Do you have any feedback on the structure or presentation of the document? Is there anything the FMA could improve about the way it has been written, or communicated, to better assist directors and executives to apply the corporate governance principles?

4. In most areas the FMA has made very few changes to the substantive guidance. Are there any specific areas where the FMA should include more guidance or commentary?

5. Are there any areas where the FMA is out of step with guidelines that your company/Board follows, or any other areas of ambiguity in the handbook?

6. Are there any cost implications or other barriers to adopting the revised guidelines?

Relevance

The FMA’s thoughts on corporate governance add to the publications on this topic by NZX, the IoD and the NZ Corporate Governance Forum. There are points of overlap and some points of difference between each of the publications.

As other commentators have noted, good governance practice expects a level of compliance (and reporting) that goes beyond a checklist approach. Consequently, Boards should carefully consider issues such as relevance to their company.

Ultimately, the FMA’s thoughts are guidance and do not create new legal obligations. However, for those who come within the FMA’s regulatory umbrella, the benchmarks established by the FMA are likely to be highly relevant. It is also highly likely that the Courts will have regard to the FMA’s thoughts.

In an economy with a very high proportion of output generated by SMEs, across a range of industries and representing an often very diverse range of interests, the shift in the FMA’s focus away from the big end of town (whilst much-needed) is likely to present a few challenges.

My personal experience indicates that the FMA still has some way to go to understand the challenges (particularly for non-executive directors) faced by many SMEs. Equally, a range of those involved at a governance level find the exercise of putting theory into practice a challenge. As a result, the latest round of consultation provides lessons and opportunities for both the FMA and its target audience/s.

Deadline for feedback

Feedback is sought by Friday, 8 December 2017.

Further information

A link to the FMA consultation paper is attached.

If you would like more information about the FMA’s revised handbook, please contact me.

A recent Supreme Court decision about a liquidator’s challenge of voidable transactions highlights an issue about the need to consider contingent liabilities when assessing the question of solvency. To some readers, this signals the problems faced by a dynamic business and the risk that decision-making will be brought into question by a liquidator and ultimately the Courts – with the benefit of hindsight.

The test applied by the Supreme Court was that contingent liabilities should be taken into account where there is sufficient certainty that the liability will crystallise into an actual debt within a reasonable timeframe.

Background

Mr & Mrs Browne operated a group of 20 companies, including David Browne Contractors Ltd (“Contractors”), David Browne Mechanical Ltd (“Mechanical”) and Polyethylene Pipe Systems Ltd (“Polyethylene”). The issue on appeal was whether payments by Polyethylene to Contractors and Mechanical should have been repaid – because they were voidable.

In March 2007, Polyethylene entered into a subcontract with McConnell Dowell to weld polyethylene pipes to be laid on the seabed in Lyttelton Harbour. Two of the welds failed during the installation process and a third was identified as defective.

McConnell Dowell informed Polyethylene in May 2008 that it intended to seek recovery of its costs due to the failures in accordance with the indemnity provisions of the subcontract.

In June 2008 Polyethylene’s directors resolved to repay unsecured advances from Contractors and Mechanical of over $900,000 and also to repay a further debt owed to Mr Browne. It was also resolved that Polyethylene would enter into a general security agreement (“GSA”) with Mr Browne to secure $450,000 to fund its ongoing operations. The directors’ resolution was supported by a solvency certificate dated 1 July 2008. In doing so, the contingent liability to McConnell Dowell was addressed by stating that the claim was disputed, would be offset by counterclaims for extras and variations and, in any event, would be covered by McConnell Dowell’s insurers.

The GSA was executed on 28 July 2008 and the loans were repaid on 2 September 2008 – less than a week after McConnell Dowell had written to Polyethylene with a detailed breakdown of the losses it claimed as a result of first weld failure (which were over $2.5m).

McConnell Dowell took further procedural steps in early 2009 and succeeded in its claim against Polyethylene in July 2009 (for $2.9m).

Mr Browne responded by putting Polyethylene into receivership under the GSA – and Polyethylene was then put into liquidation in October 2009 on the application of McConnell Dowell.

The liquidator issued High Court proceedings against Contractors, Mechanical and Mr Browne for an order requiring repayment. He also applied to have the GSA set aside. These applications were declined in the High Court. The Court of Appeal overturned that decision – and ordered that the GSA be set aside and that Contractors and Mechanical repay the amounts paid to them.

The Supreme Court unanimously dismissed the appeal in relation to the decision ordering repayment by Contractors and Mechanical. It held that, if a reasonable and prudent business person would be satisfied that there is sufficient certainty that a claim will become a legally due debt at a temporally proximate point, then it will be a due debt for the purposes of section 292(2)(a) of the Companies Act. It concluded that there was such sufficient certainty in the case of the McConnell Dowell claim.

Key issue

The key issue for the Supreme Court was whether the payments to Contractors and Mechanical were made at a time when Polyethylene was insolvent (unable to pay its due debts). Such insolvent transactions are voidable by a liquidator under section 292 of the Companies Act. To do so, the ‘insolvent transaction’ must:

• be entered into with 2 years prior to liquidation; and
• enable a creditor to receive more than it would receive, or would be likely to receive, in the company’s liquidation.

The directors had signed a solvency certificate at the time the payments were made – giving three reasons to support their view that Polyethylene was solvent. The Supreme Court found that, assessed objectively, none of these reasons was valid, either at the time of the solvency certificate (July 2008) or at the time of the impugned transactions (September 2008). Specifically:

• The debt was disputed – there were no proper reasons for the directors to dispute the debt. Indeed, the reports and other material available to the directors in September 2008 clearly showed that Polyethylene was responsible for the pipe failures.
• That McConnell Dowell owed money for extras and variations – no details of were provided of amounts allegedly owing.
• That McConnell Dowell’s insurance would cover the claim – the Court noted that Mr Browne’s view on this issue was subject to a number of uncertainties, with the result that a prudent business person would have sought advice promptly on the insurance position (or not relied on such cover – which seemed the likely outcome because of the wording of the subcontract).

As a result, the directors’ focus on “due debts” for the purposes of cashflow solvency at the time of the transactions should have included debts that were present and contingent debts.

The Court accepted the liquidator’s submissions that a contingent debt can be a due debt if it is “reasonably temporally proximate” (which must be considered in light of the facts of the case) to the transactions being considered.

The Court found cashflow solvency must be assessed objectively, taking a “practical business perspective” (rather than one which is unduly technical). And that “If a reasonable and prudent business person would be satisfied that there is sufficient certainty that a contingent debt will, within the relevant period, become legally due then it must be taken into account”.

Whilst the Court accepted that there is a difference between debts and damages but noted that, once liability and quantum have been established in any claim for damages, the resulting judgment sum will be a debt owing. This means that the question is the same if
there is sufficient certainty that a claim will crystallize in the relevant period, then it must be taken into account.

The Court also noted that it was significant that the directors put in place a scheme to strip Polyethylene of its assets (through payments to related parties) which showed that they considered there was, at least a real and substantial risk that the McConnell Dowell claim would succeed.

Concluding comments

Overall, the Supreme Court’s approach appears to be consistent with that taken by the courts in Australia.

The direction to take a practical business approach (armed with the relevant facts and, where appropriate, advice) when considering the question of solvency – does not lend itself to criticism that the Courts have had the benefit of 20/20 hindsight. Instead, the conclusion was that contingent liabilities must be factored into any assessment of solvency when (viewed objectively) from the perspective of a reasonable and prudent business person, there is sufficient certainty as to both liability and quantum to indicate that they will crystallise within a reasonable timeframe.

In the present climate, with traditional retail models under some stress, the key contingency is the liability for future lease payments. A fact-specific assessment here is relatively simple – is there a ready market to take the premises off your hands? But what about other contingent liabilities such as unused gift cards. Here, there are industry models and trading history available to provide the directors with the data needed to make the necessary fact-specific assessment to determine whether the company is cash flow solvent.

And finally, the Courts will also view negatively any transaction, particularly one moments before detonation, which has the effect of stripping the company of assets – for the benefit of related parties.

It seems that issues relating to building products that are not what they are claimed to be have become a regular news item. This trend is a matter of concern to the Commerce Commission – and its latest Fair Trading Act case has resulted in a company director being fined $151,875 for misrepresenting imported (generic) cladding as a premium brand.

Christchurch Lightweight

Darryl Campbell, a former director and owner of the now-defunct Christchurch Lightweight Concrete Limited (“Christchurch Lightweight”) pleaded guilty to 9 charges under the Fair Trading Act for his misrepresentations to Christchurch Lightweight staff and customers between 2007 and 2010 that Chinese-made autoclaved aerated concrete cladding panels (“AAC panels”) were the Australian-made ‘Hebel’ brand.

During this period Christchurch Lightweight supplied exterior AAC panels for at least 83 properties.

In sentencing Mr Campbell at the Auckland District Court, Judge Gibson accepted the Comcom’s submission that Mr Campbell’s conduct was deliberate:

“He clearly knew the panels were not Hebel panels and he also knew, I am satisfied, of their reputation in the market.”

The case is part of the Comcom’s prosecution of four individuals associated with the former Cavan Forde group of companies – alleging the four misrepresented their AAC products as Hebel products. One individual has pleaded guilty to the charges against him and is awaiting sentencing and the remaining two defendants have entered not guilty pleas. All four held ownership or management positions in the now-defunct companies that supplied AAC panels during the relevant period.

Piercing the corporate veil

One of the main reasons for choosing a company as the vehicle to carry on a business is the protection of limited liability. However, a combination of the approach of the Courts and the developing trend of the offence provisions of public good statutes being backstopped by personal liability for those in control of the company means that there is a growing list of circumstances in which directors can be held personally liable for the acts of omissions of the company. This “piercing” of the corporate veil is increasingly being used where the Courts consider that the offending took place with the knowledge or encouragement of the director.

The Court of Appeal has invoked personal liability where the misleading or deceptive claims made by a company brochure relied on a director’s personal expertise and experience and therefore contained an element of “personal endorsement”. As a result, it said that in these circumstances, the consumer was best served by a broad approach to the Fair Trading Act and that directors should face (strict) liability.

In an economy where many sectors are dominated by SMEs, it is likely that regulators such as Comcom will take the view that it is highly likely that the directors will have a high level of personal involvement in, and knowledge of, the company’s activities – and therefore should be personal liable for the misleading or deceptive conduct of the company.

Further information

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