Directors’ duties – in the case of distressed companies

A recent Court of Appeal decision has again underlined the point (made by the Court of Appeal in an earlier judgment) that the decision-making processes of distressed businesses are not to be assessed with the benefit of hindsight (i.e. that whether the decision-making process was the right one is based solely on an examination of the outcomes).  Instead, they are to be measured against the information available at the time – and the decisions made (in good faith) in reliance on that information

Background

The sole director of Debut Homes Limited [Cooper v Debut Homes Limited (in liq) [2019] NZCA 39, 8 March 2019] , a spec house builder, appealed against findings by the High Court that, by continuing to trade by completing and selling four unfinished houses while the company was in financial difficulties, he had breached his director’s duties.

The cornerstone of the High Court decision that Mr Cooper had breached his duties under sections 131, 135, and 136 of the Companies Act 1993 by continuing to trade – was that, in 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.

Court of Appeal decision

In upholding Mr Cooper’s appeal, 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 – it also generated greater returns for Debut Homes, with the result that the company’s creditors, as a whole, were better off.

Amongst the factors that contributed to the Court of Appeal decision were:

• (Relying on the earlier Court of Appeal decision in Peace and Glory Society Ltd (2009)), the Court’s overview of the evidence was that Mr Cooper was acting in good faith and in what he believed was the best interests of the company when he decided to complete the building work and sell the remaining properties.  The prospect of a surplus not including GST, and advice from his accountant confirms that Mr Cooper was not manipulating events to defeat the IRD’s interests.

• 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.

• Mr Cooper proceeded upon a reasonable belief that there would be a surplus after the sale of the unfinished properties, and it was only unexpected extra costs that meant that surplus was far smaller than expected.

• The IRD was at serious risk of getting no GST before the decision to complete the properties.  On the basis of the evidence, the Court concluded that the risk taken was legitimate.  Whilst a developer needs to trade bearing in mind its GST obligations and must act with reasonable belief that the IRD will be paid (and if tax debt is in effect being used as the company’s bank, that can be reckless trading).  But here, the IRD was going to be in a bad position if there had been an immediate liquidation before the houses had been completed.

• As a result the Court concluded that Mr Cooper did not act in bad faith and was not reckless.  Instead, as a reasonably astute and attentive person who had a reasonable understanding of his business, its financial position and the interests of creditors – he took stock of the company’s position, put the brakes on further projects, and focussed on completion of the developments to best serve the interests of creditors.  He incurred further debt in order to complete, but he considered whether those creditors could ultimately be paid, and did his costings with that in mind.  By and large they were paid with the exception of the IRD and Mr Cooper’s family trust.

• The GST situation was complex and the IRD was not necessarily going to be worse off, and could be better off, after completion and sales.  The walk away option, leaving the houses unfinished, was the less sensible commercial option.

Reasonable reliance defence

The Court of Appeal, in upholding part of the High Court judgment, concluded that there was no affirmative defence available to Mr Cooper under section 138 of the Companies Act for the reliance he placed on his accountant, despite his being a credible accountant who Mr Cooper was entitled to rely on, and he generally encouraged Mr Cooper to embark on the course that he did.

Whilst the accountant did provide general support in favour of completion and this was a significant factor in the general assessment of the reasonableness of Mr Cooper’s actions, and whether there was any element of recklessness – there was nothing in the category of “reports, statements, and financial data and other information prepared or supplied” required by section 138 to establish the defence.

Voidable transactions

Whilst the Court of Appeal declined to set aside the security granted to Mr Cooper’s family trust (which had part-funded the completion of the houses) it did set aside $35k of payments to Mr Cooper as voidable on the basis that there was no ‘running account’ and nothing to suggest that the payments were for the purposes of inducing further supply.  Mr Cooper had good reason to support the company in completing and selling the properties irrespective of whether he got some payments along the way.

Concluding comments

In keeping with the introduction, it is interesting to note the Court of Appeal’s comments (in the context of dismissing the allegations of reckless trading) that risk must be considered with the potential advantage of the proposed action to the company and an assessment of how likely it is that the advantage will be enjoyed.  Potential downside must be considered with potential upside, otherwise the purpose of encouraging efficient and responsible management of companies and leaving directors a wide discretion in matters of business judgment will be defeated.  

As a result, section 135 must be interpreted in the light of its purpose.  Consistent with the long title to the Companies Act, caution must be exercised to avoid bringing hindsight judgment to bear in circumstances which do not fully and realistically comprehend the difficult commercial choices facing the directors.

Further information

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