Lessons for directors from the NZ Net litigation

Last week, Rob Everett (the CEO of the FMA) gave a media briefing and opined that SMEs are struggling to attract high-quality directors to their boards, leaving a gap for firms just when they need an experienced hand on the tiller. Everett’s thesis seemed to be that the Financial Markets Conduct Act hadn’t led to a chilling effect on talented leaders accepting Board roles at the big end of town but the same might not be said about that same talent joining the boards of smaller, riskier companies.

A brief examination of the experience of the director at the centre of the NZ Net litigation (Grant & Khov v Johnston [2016] NZCA 157) might prove instructive for many.

The story so far

The liquidators of NZ Net brought proceedings against three former directors seeking compensation to satisfy debts due to the company’s creditors on the basis of claims that the directors breached various statutory duties. The High Court found against all three – however, in the case of one (Rowan Johnston), ordered that he not be liable to contribute towards NZNet’s debts because the company’s liability to him (totalling $460,000) exceeded any loss attributable to his breaches.

Mr Johnston, had injected funds into NZ Net in an effort to help it trade through a number of difficulties, but found that he had been misled about NZNet’s financial position by its founder and Managing Director (Stephen Andrews). Consequently he resigned as a director some 4 months prior to NZNet going into liquidation.

The Court of Appeal decision

On appeal by the liquidator, on claims of reckless trading and breach of the general duty of care under section 137 of the Companies Act – the Court of Appeal made a number of interesting findings that buttress the role of the director (particularly the non-executive director).

The Court opened by observing that, while the statutory tests are objective, performance of the requisite standard is to be measured by reference to the responsibilities of the particular director within the particular company structure. A director is not absolutely liable for all losses suffered while he or she holds office as a director. Instead, liability is only imposed to the extent that the director acts or fails to act in a proscribed way.

Whilst a director ha a general duty, when exercising his or her powers or in performing his or her functions, to act in good faith and in what he or she believes to be the company’s best interests. The Court of Appeal noted that it is important not to confuse the role of a non-executive director like Mr Johnston with that of a company’s management. A non-executive director is responsible for exercising a reasonable degree of skill and care in overseeing the company’s management and control and when participating in any significant decisions to which the company is a party. He or she is not responsible for managing the company’s business on a daily basis.

Consequently, the Court held that:

• The liquidators’ allegation that Mr Johnston was in breach of his statutory duties from the date of his appointment as director, and before he had an opportunity to fully familiarise himself with NZNet’s business, is unrealistic and must fail.
• After a year in the role, Mr Johnston had failed to exercise reasonable skill and care as a director, but (perhaps impeded by the way the liquidators brought their case – both obscuring the extent of recoveries from Mr Andrews and establishing the extent of the deterioration of NZNet’s finances for the final 9 months of Mr Johnston’s Board role) it declined to order that he pay compensation because he would have been entitled to an allowance for the substantial advances he made to the company during that period.
• On causation, the Court found that:
o Mr Andrews, as Managing Director, was primarily liable for NZNet’s losses – and Mr Johnston did not contribute to the mismanagement in a material way;
o Mr Andrews actively misled Mr Johnston over a sustained period of time;
o The amount incurred to one major creditor was incurred by Mr Andrews without the knowledge of Mr Johnstone; and
o Mr Johnstone’s tenure was relatively short in the context of the company.
• Also on the issue of causation, the Court was swayed by the stance of the IRD, as the company’s second-largest creditor, which would be the largest beneficiary of any compensation order – which appeared to stand by as the tax debt escalated but took no steps to recover it. As a result, the Court described the IRD as having contributed significantly to its own losses.

Interestingly also, the Court concluded by noting that the High Court trial lasted for at least a week. It described the economic benefits of pursuing such claims as questionable — when it must have been apparent to the liquidators, on a sober assessment of the case, that the maximum amount of Mr Johnston’s potential liability was very modest indeed. As a result, both parties have incurred costs which must exceed any potential benefits from this litigation.

Concluding comments

The Court of Appeal decision underscores the point that the performance of a director against the requisite standard must be measured by reference to their specific role.

Clearly also, even if a breach of duty is proven, issues of causation, responsibility for the relevant losses and fairness are relevant to any final order.

However, despite the Court’s observations about the economic benefits of pursuing the case, there must be doubts whether this decision alone will see an influx of experienced hands reaching for the tiller of SMEs – especially those experiencing difficulties.

Further information

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