First impressions of Supreme Court decision in Mainzeal
The much-anticipated decision if the Supreme Court in Mainzeal[1] was released this morning. Whilst the media headlines largely focus on the impact of the damages award against the directors, there is a lot of detail to unpick.
Largely, the Supreme Court has upheld the Court of Appeal judgment (and key elements of the High Court judgment) – that the directors breached their duties under sections 135 and 136 of the Companies Act 1993.
The Supreme Court concluded that the total assessed loss of $39.8 million, provided both a starting point for, and the maximum that could be awarded by way of damages against the directors. Using that approach, the Court saw no reason to depart from the High Court’s assessment of relative culpability – holding Richard Yan liable for the full amount while the liability of the remaining directors was limited to one sixth of that amount ($6.6 million each). Interest and costs were also awarded.
Helpfully, the media release that accompanies the judgment maps out the Court’s unanimous conclusions on the key issues.
Protection of creditors
Sections 135 and 136 of the Companies Act apply the policy of the earlier law that, once a company is insolvent or bordering on insolvency, directors are required to have regard to the interests of creditors. The language of sections 135 and 136 makes it clear that their purpose is creditor protection.
Breach of section 135
Following the pathway of the decisions of the lower Courts, the Supreme Court concluded that, from 31 January 2011, the directors allowed Mainzeal to trade in a manner that was likely to, and did, create a serious risk of substantial loss to creditors. That Mainzeal was trading in such a manner would have been apparent to the directors if they had acted with reasonable skill and diligence.
And whilst section 135 does not permit directors of a company that is insolvent/teetering on the brink to continue trading at the risk of future creditors – they must have time to take stock of the situation and obtain advice.
In this case, the finding of breach included findings that the directors could not reasonably have relied on assurances of support given to them by other companies in the Richina Pacific group or Mr Yan as mitigating the risk to Mainzeal’s creditors as sufficient to ensure compliance with section 135. This is because those assurances were neither legally nor practically enforceable – and were not honoured.
Breach of section 136
The Court rejected arguments from the directors that liability under section 136:
- cannot apply to liabilities incurred in a course of trading (as opposed to incurring particular obligations); and
- depends on affirmative agreement to the incurring of particular obligations – rather than a general agreement to continued trading (and incurring the obligations that were the inevitable outcome of ‘trading on’).
Qualifying the loss – net deterioration/new debt
When quantifying the losses caused by the directors’ breach – two approaches were discussed:
- Net deterioration: the extent that the company’s financial position (and that of its creditors) deteriorated between breach and liquidation dates.
- New debt: the gross amount of debt that was taken on from the date breach – and was still unpaid at liquidation.
For the section 135 breach, the Court agreed with the directors – that the proper approach was net deterioration. This is primarily because net deterioration reflects loss to the creditors as a whole and is consistent with the language of section 135 which is directed to substantial risk of serious loss to creditors generally – and not that of individual creditors. Because no net deterioration had been proved, no award of compensation was given for the breach of section 135.
For the section 136 breach, the Court agreed with the liquidators – that the proper approach was that of new debt. By contrast to section 135, section 136 is focused on losses to particular creditors including groups of creditors. Consequently, the most logical basis for quantification is the loss suffered by those creditors. (Here – the judgment differs from the Court of Appeal and says that the Court had enough information to quantify the losses associated with the section 136 breach – assessed at $39.8 million.)
Orders for compensation
The Court referred to the language of section 301 of the Companies Act as providing flexibility (aka discretion) as to the relief awarded. This is seen as providing latitude to respond to the specific fact matrix and tailor the damages/compensation granted – so as to respond to the specific breach(es) – and the harm caused.
Discussion of recent UK decisions
Whilst they are not mentioned in the media release, the treatment of two recent UK decisions, particularly the 2022 UK Supreme Court decision in Sequana, is interesting.
Sequana was a case about ‘wrongful trading’ under section 214 of the Insolvency Act (UK) which our Supreme Court noted corresponds, but only at a very high level, to sections 135 and 136 of the Companies Act. There, the liability threshold under section 214 is crossed only if the director knew or ought to have known that there was no reasonable prospect of avoiding insolvent liquidation. On this basis, a director will not be liable for a company debt unless, at the time it was incurred, it was practically inevitable that it would not be paid. This is a much higher threshold than sections 135 and 136.
Significantly, there is the defence under section 214 which the Supreme Court commented at least suggests that proper implementation of a reasonable strategy of minimising loss to creditors will avoid liability.
Underpinning the Sequana decision is the point that, where the Company’s financial affairs deteriorate, the creditors effectively have an economic stake in the company’s residual assets – which increases in line with their exposure. As a result, there is a fundamental change to responsibilities when a company is insolvent/teetering on the brink. Where a company is “hopelessly insolvent” the company’s interests are the same as those of the creditors.
Takeaways
There is a lot of reading in the Supreme Court decision (142pp).
Noting the key theme in the decision that the language of sections 135 and 136 makes it clear that their purpose is creditor protection – there is some acknowledgement of the difficulties facing the directors of a distressed company – and the judgment notes that the courts must apply a standard of reasonableness when assessing the directors’ decision-making.
In bullet point form:
- directors must take stock and plan (and act on the plan) when their monitoring of the company’s affairs (and solvency) indicates that a risk of breach of the duties in sections 135 and 136;
- the process of forming a plan – may mean that the directors may need to take professional or expert (independent) advice;
- a decision to continue trading while balance sheet insolvent should not be taken – unless the directors can reasonably rely on assurances of external support;
- when applying a standard of reasonableness to an assessment of directors’ decision-making, the courts will recognise the need to exercise business judgment, and:
- the courts will allow a reasonable time for directors to assess risk, review the options to meet that risk and decide what course to take, including time to take advice;
- where advice has been taken, this must be factored into an assessment of the reasonableness of the directors’ actions;
- judges are alert to, and will adjust for, the danger of hindsight bias – and will acknowledge that decisions that were reasonable when made may still turn out badly and that in difficult situations there will often be scope for more than one reasonable course of action:
- directors must often make complex decisions under pressure of time and events and sometimes with incomplete knowledge – despite their best efforts; and
- although directors will not normally be liable for continuing to trade during the taking stock / planning period, that may not be the case if substantial new obligations are taken on without measures in place to allow for them to be met.
More information
For more information, please do not hesitate to contact me.
[1] Yan v Mainzeal Property Construction Ltd [2023] NZSC 113
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