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Debut Homes – all change from the Supreme Court

by Stephen on September 25th, 2020

I wrote about the Debut Homes case, after the Court of Appeal decision in early 2019. 

In particular, I wrote that the Court of Appeal decision (again) underlined the point, from an earlier judgment of the Court, that the decision-making processes of distressed businesses are not to be assessed with the benefit of hindsight.  Instead, those decisions are to be measured against the information available at the time – and the decisions made (in good faith) in reliance on that information.

This week, the Supreme Court has dramatically and rather emphatically overturned the Court of Appeal. 

While it can be said that a decision from the highest court of the land (clearly) provides clarity – it probably also serves to highlight an unwanted or un-needed gulf between the position faced by a company director in New Zealand when compared with their counterparts in Australia.  There are no votes in (commercial) law reform but the temporary safe harbour for company directors for duties relating to insolvent trading made as a result of COVID-19 expires on 30 September.  The Australians have extended their temporary relief until the end of the year.  I am left wondering if the Supreme Court’s clarification is what was needed to make the case for better alignment with Australia.

Key issues – complete the houses or fold

To recap, Mr Cooper was the sole director of Debut Homes Ltd, a spec house builder, which continued to trade by completing and selling four unfinished houses while the company was in financial difficulties.  The High Court found that he had breached his director’s duties because, by doing so, he had favoured Debut Homes’ secured creditors at the expense of the IRD (for Debut Homes’ GST obligations).  In essence, facing balance sheet insolvency in 2012, Mr Cooper had elected to complete the four remaining houses in order to get a better return for Debut Homes than would have been the case had a liquidator been appointed with the result that the amount of GST owing to the IRD had been increased.

The Court of Appeal determined that Mr Cooper’s decision to continue trading, by completing and selling the four houses, was for the benefit of all Debut Homes’ creditors.  Although that decision did result in Debut Homes incurring a greater GST obligation (approx. $300,000) – it also generated greater returns for Debut Homes, with the result that the company’s creditors, as a whole, were better off.

It should be noted that the secured creditors, who were better off as a result of completion of the houses, had their debts personally guaranteed by Mr Cooper.

The Court of Appeal concluded that completing the building work was a reasonable commercial course.  Mr Cooper would get incidental benefits in that the secured debt would be more reduced, but he put in significant new funds, and provided one and a half year’s work without pay.  But it could be said that everyone, including the IRD, stood to get more money because of his actions.

Supreme Court reversal

In reversing the Court of Appeal, the Supreme Court laid out a summary of conclusions on directors’ duties in rather emphatic terms.  Specifically:

  • If a company reaches the point where continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading will amount to reckless trading (i.e. a breach by the directors of section 135 of the Companies Act). 
  • Subject to the use of the formal or informal creditors’ compromise or scheme, this applies whether or not continued trading is projected to result in higher returns to some of the creditors than immediate liquidation – and whether or not any overall deficit was projected to be reduced.
  • If directors agree to debts being incurred where they do not believe on reasonable grounds that the company will be able to perform the obligations when they fall due, then there will be a breach of their duty in respect of obligations under section 136.
  • There will be no breach of the (primary) duty to act in good faith and in the best interests of the company under section 131 if a director honestly believed they were acting in the best interests of the company – but there will be a breach of section 131 if directors, in an insolvency or near-insolvency situation, fail to consider the interests of all creditors.  Such a breach may be exacerbated by a conflict of interest.
  • Where there are no prospects of a company returning to solvency, it makes no difference that a director honestly thought some of the creditors would be better off by continuing trading.  There are alternatives other than liquidation open to directors where continued trading is projected to result in a shortfall.  There are both formal and informal mechanisms available – but where informal mechanism are used they must accord with directors’ duties, the scheme of the Companies Act and the salient features of the available formal mechanisms, such as ensuring all affected creditors are consulted and agree with the course of action proposed.
  • The directors do not always have to consult all creditors if wishing to implement an informal arrangement (e.g. an arrangement with secured creditors for continued trading in order to increase the amount available for them).  But, if unsecured creditors are not to be consulted, any such arrangement would have to be on the basis that all existing debts and future debts arising from continued trading, including any GST, would be met.
  • Where directors allow a clearly insolvent company to continue trading without using one of the available formal or informal mechanisms, this will be in breach of their duties as directors and will lead to relief being ordered under section 301 (power of court to require persons to repay money or return property).

The Court also said it is not legitimate to “rob Peter to pay Paul” by following a course of action that ensures some creditors have a higher return where this is at the expense of incurring new liabilities (to other creditors) which will not be paid.

Interestingly, the Court also rejected a passage from Sojourner v Robb (a 2006 Hugh Court decision) about the standard to be applied to section 131 as wrong.  Instead, it stated that the duty to act in good faith in the best interests of the company is subjective (i.e. a director must act in what they believe to be in the best interests of the company).  And that:

  • Courts are not well equipped, even with the benefit of expert evidence, to second-guess the business decisions made by directors in what they honestly believed to be in the best interests of the company.  The courts would also be judging directors’ decisions with all the dangers of judging with the benefit of hindsight.
  • However, there are a number of exceptions and qualifications to the subjective test:
  • where there is no evidence of actual consideration of the best interests of the company;
  • where, in an insolvency or near-insolvency situation, there is a failure to consider the interests of [all] creditors;
  • where there is a conflict of interest (such as preferring those creditors whose debts had bene personally guaranteed by a director) or where the action was one no director with any understanding of fiduciary duties could have taken (which might be a breach of the duty of good faith – or the requirement that powers must be exercised for a proper purpose); or
    • where a director’s decisions are irrational.

Central to finding breaches of director’s duties was Mr Cooper’s knowledge that completing the 4 houses would mean the company would not be able to meet its (expanding) GST liability.  As a result, any decision to continue trading should have been the subject of a formal or informal insolvency process – so that all creditors had the ability to participate in the decision (to trade – complete the houses).

Where to from here?

As noted in the introduction, there is benefit in the Supreme Court decision being so emphatic.  But it is still a dramatic reversal from the decision of the Court of Appeal.

The Court placed great emphasis on Mr Cooper’s certainty that completing the houses would certainly result in the GST liability being un-met.  There were, it said, no deviations by him from his plan of action despite Debut’s continued (and worsening) difficulties.  As a result, it is likely to be arguable that there was some leeway while the position was less certain or while a formal or informal creditors’ compromise or scheme is being assessed.  That leeway is likely to only be an issue of a reasonable timeframe in which to take stock and take advice.  For example, blundering on without doing that stocktake or taking advice would be taking an unreasonable risk. 

In light of the emphatic nature of the Supreme Court decision, it seems unlikely that trading on for any length of time (without informed creditor approval) would be seen as a reasonable risk – without at the very least regular health checks.

Across the ditch

Since September 2017, Australian company directors have been able to rely on safe harbours that protect against liability for insolvent trading if:

  • at a particular time after the director starts to suspect a company may become or already be insolvent, he or she starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company; and
  • the debt is incurred directly or indirectly in connection with that course of action and during a specified time period.

Those safe harbours are designed to:

  • drive cultural change in the boardroom by encouraging directors to keep control of their company (instead of appointing an insolvency practitioner);
  • encourage directors to engage with stakeholders early when possible insolvency is suspected; and
  • encourage directors to focus on reasonable rescue and turnaround efforts, rather than taking a traditionally conservative approach and placing the company in the hands of an insolvency practitioner.

Perhaps the Supreme Court decision will be the catalyst for law reform that prevents a growing gap with Australia.

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