A clear warning for directors of financially distressed businesses
The recent and significant Supreme Court decision of Debut Homes Limited (in liquidation) v Cooper  NZSC 100 has brought a clear and renewed focus on the duties of directors in situations where a company may be insolvent or near insolvent. The strict approach taken by the Supreme Court overturns the decision of the Court of Appeal and held the director to be financially liable for a breach of his duties. This comes at a time when there are undoubtedly a number of companies treading close to the line of solvency given the impact of the Covid-19 pandemic.
Directors need to be cautious and diligent if their company is at risk of insolvency, and where appropriate, should take advice and consider turning to formal or informal insolvency mechanisms to guide the company through difficult times.
You can find a full description of the case and our analysis here, however we summarise the key findings and takeaways for directors below.
- Under the Companies Act, directors have statutory duties including to act in what they consider to be the best interests of the company, not to allow business to be carried on in a manner likely to create serious risk of loss to creditors and not to enable the company to incur obligations unless the director believes on reasonable grounds that the company will be able to perform them. If a director is found to be in breach of these duties and the company is liquidated, then the court can order a director to personally contribute funds to the assets of the company by way of compensation. In Debut Homes, the director was ordered to pay $280,000 towards the liquidation for creditors.
- The Court took the view that once a company is in a position where continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading is a breach of director duties. In Debut Homes, continued trading improved the outcome for some creditors, however this did not matter, as the interests of all creditors needed to be taken into account (in this case, being a GST liability to the IRD).
- The Court highlighted that directors are not the best decision makers in these difficult situations as often they are conflicted and too close to the action to be impartial. In these circumstances, companies should adopt formal or informal insolvency mechanisms, as are available under the Companies Act, such that an independent person can assist in the recovery (or wind up) and creditors can have a say (if applicable).
We suspect that these findings will inevitably increase the willingness of directors to turn to processes such as voluntary administration (VA) to guide companies which may be near insolvency, so to reduce any exposure to personal liability. It is important to remember that liquidation is only one potential outcome of a VA process, and another outcome is to return the company to its directors once the creditor meetings have been held. A purpose of VA is to provide breathing room to allow time to assess whether the company can be saved. Other insolvency mechanisms can also involve arrangements with creditors and ultimate company survival. We have previously provided a summary of options available (refer here – although note the safe harbours are no longer available, unless re-instated at a later date).
The Court put emphasis on the fact that the company was not salvageable, and in that case continued trading by the company was still expected to end in a shortfall to creditors. This means that where there are prospects for corporate turnaround, it may still be appropriate for directors to take legitimate and informed risk in continuing to trade for a relatively short time. In doing so, directors should ensure that they:
- take action early in facing the key question of whether the company can be salvaged;
- take into account the interests of all creditors in making any decisions (including prospective creditors);
- fully document decision making in board minutes; and
- obtain expert financial and legal advice to guide their decision making (bearing in mind that a defence may be available to directors if reliance is made on such advice).
We note that this decision was released right at the time that availability of the Covid-19 safe harbour provisions for director duties expired (on 30 September 2020). However, similar to the line of reasoning in the Supreme Court case, the safe harbour provisions were never there to protect companies with no real prospect of recovery. A key criteria for access to the safe harbour was a real prospect of the company returning to solvency by September 2021.
Given the safe harbours are no longer available and the view taken by the Court, we strongly encourage directors to take advice early, as entering into a formal or informal arrangement with creditors is an effective way to protect directors, and can still leave available the opportunity to salvage the company.
As above, further details of the case and findings can be found here .
If you need any assistance in considering your options or would like to discuss these matters, then please do not hesitate to get in touch.