The judgment delivered by the Court of Appeal in the ongoing proceedings between the liquidators of Mainzeal and its directors is significant. In a bizarre twist of courtroom drama, the Court found that the directors of Mainzeal had breached sections 135 and 136 of the Companies Act 1993 (Act), while also striking out the controversial method employed by the High Court to assess damages. This leaves the parties in a complicated position. The directors succeeded in having the $36 million dollar award of damages overturned, while also becoming exposed to a possibly much larger sum – one which their directors’ liability insurance may not entirely cover.
This article will largely focus on the Court of Appeal’s interpretation of sections 135 and 136 of the Act, what this means for the liability of directors going forward.
Section 135 – Reckless trading
The Court of Appeal dismissed the directors’ appeal against the High Court finding of a breach of s.135 of the Act. The Court found the directors of Mainzeal were suffering from “wishful thinking” when they continued to trade as usual after the directors were warned in early 2011 of the company’s significant balance sheet problems.
The Court stated that although s.135 of the Act is not intended to undermine a company which is attempting to trade its way out of troubles, a sober assessment must be had of the significance of the company’s troubles before a decision to continue can be made. The Court found the directors’ assessment in early 2011 that the company was solvent, although careful, was flawed. The directors did not take into account countervailing circumstances, including the fact they could not recover large sums of money from related companies, which it had lent to. The Court considered that the directors had also placed too much faith in assurances from the ultimate owner, which were not legally binding and could not be enforced.
The Court did accept the directors were in a difficult position with few options available to them. The Court believed that the directors of Mainzeal should have sought more concrete assurances and been frank that without repayments from related entities, the company would become insolvent. Continuing to trade as usual and hope that the company would recover was not an option.
The Court was clear with regards to the directors’ responsibilities. The Court did not allow the directors to escape liability because they received assurances of repayments, placing responsibility of the failure squarely at the feet of the directors.
Although the Court was very clear the directors had breached s.135 of the Act, this cause of action failed because the liquidators argued Mainzeal was already insolvent in early 2011. The Court’s analysis revealed that from early 2011 the finances of the company improved slightly and so the decision to trade on while insolvent and in breach of s.135 did not result in any material loss.
This judgment provides very useful guidance to directors responding to troubling trading circumstances. There is clear guidance on what directors legally must do when trading becomes difficult. Directors cannot continue on with “business as usual” when a company is experiencing difficulties and their planning must take in to account the situation they are in. Directors must ensure special consideration is given to the risk of serious loss to creditors when the possibly of financial trouble becomes apparent. A company should only continue to trade when a sober analysis of the situation has revealed that there is a realistic prospect of the company being able to continue servicing its debt. Understanding that if a return to solvency is unlikely, it is not appropriate for a company to continue trading to save all or part of a company – in such case, any rescue attempt must come from an administrator.
A good faith attempt by directors to trade out difficult circumstances is not sufficient to alleviate the need for a sober assessment of the realities of a company’s financial position. The Court said that directors may be able to trade on without being reckless if the manner in which they did so had a realistic chance of enabling the company to service pre-existing debt and to meet new obligations.
The Court of Appeal’s judgment confirmed that s.135 requires an objective assessment of the directors’ conduct and that directors of a company entering troubled waters must conduct a sober assessment of the company’s future prospects. A decision to trade on in circumstances like those experienced by Mainzeal will likely be a breach of s.135 unless the directors adopt a new strategy with a realistic chance of servicing debt and meeting new commitments, without using credit as a vehicle to service debt.
Section 136 – Duty in relation to obligations
The Court of Appeal’s judgment also provided guidance on the scope of s.136 of the Act, rejecting the High Court’s assessment that the obligations arising out of s.136 were confined to one or more specific, identifiable events. The Court stated there is no good reason to read down the section in this way. It saw obligations in a more general context, covering all the obligations arising out of various contracts, ancillaries and requirements entered into by the company either through director level resolutions or delegated authority.
The Court ruled that the directors should be liable for all debt incurred from the date they breached s.136, the date it was not reasonable to believe the company could pay its obligations as they came due.
The Court once again noted that Mainzeal could continue to trade, but only if it could first address the company’s serious balance sheet insolvency. The evidence showed that by June 2012, the company was in a dire financial position. Overdue accounts represented half the accounts payable and it was obvious the company’s modest cashflow was slowly dwindling. The Chief Financial Officer informed the directors that the company was not paying its debts as they came due on 27 June and the matter was tabled on 5 July 2012.
Despite this, the directors continued to trade on as usual, putting faith in the assurances of Mr Yan that money would be available from various entities within the group but without legally enforceable mechanisms for this.
For current and future directors, obvious lessons from Mainzeal might surround an overreliance on comfort notes, ensuing there are appropriate mechanisms and security to recover debt or a clear example of where trading should have ceased. However, the most important lesson is likely that directors can be held liable for the entirety of new debt incurred by a company from the date s.136 was breached.
Where to from here?
While it remains to be seen if a potential appeal to the Supreme Court will alter the Court of Appeal’s judgment or how lower courts will apply this judgment, we are confident that this case will change how directors consider trading in marginal solvency situations.
If you want to read more about recent case law regarding director duties in near insolvency cases, see also our article on Debut Homes.
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