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The Supreme Court judgment on directors’ duties in Debut Homes v Cooper is unhelpful in the general guidance it seeks to deliver to boards where a business is under pressure in deciding whether and how to trade on.
This is because the case before the Court was closer to fraud than to reckless trading. Factor that in and the decision should not cause undue alarm to the thoughtful and prudent director who has good reason to believe that the company can trade through its difficulties.
Debut Homes was a residential property developer. Mr Cooper was its sole director. From November 2012, Mr Cooper knew that Debut Homes was not salvageable and decided to wind down its operations. He was subject to a complex set of conflicting interests: as sole director of a company he jointly owned with his wife; a guarantor of the company’s bank debts; and with his family trust being a lender to the company.
Consequently he put in place a “strategy to put the whole risk of loss on Inland Revenue”. He did so by completing projects in order to repay debt which he had guaranteed. In winding down Debut Homes, he incurred GST of at least $300,000 knowing that it could not be repaid. Had a liquidator sold the properties, the GST debt would effectively have been preferential (as a personal liability of the liquidator).
The Supreme Court found Mr Cooper liable under each of sections 131, 135 and 136 of the Companies Act 1993.
The judgment contains a series of broad statements (particularly on sections 135 and 136) that do little to help directors understand their duties.
The Supreme Court found that:
- a director will breach section 135 by continuing to trade where the director knows that continued trading will result in a shortfall and that the company is not salvageable
- if the company is “unsalvageable”, directors must look to insolvency mechanisms under the Act, and
- continued trading may result in a breach even where such trading reduces the company’s overall deficit.
The Supreme Court found that Courts can take a broad approach to awarding relief in cases of a breach. Relief can be compensatory or restitutionary in nature and must take account of all of the circumstances, including the nature of the breach or breaches, the level of culpability of the director, causation, duration of the breach, holding the director to account and reversing the harm to the company.
On a section 135 claim, the Supreme Court confirmed that (in most cases) a ‘net deterioration’ calculation is the appropriate starting point. The net deterioration approach calculates loss by reference to any deterioration in the company’s financial position from the date that the trading should have ceased to the date of actual liquidation. That approach looks at the creditors and the business as a whole.
On section 136, in Debut Homes’ specific circumstances, it also found that restitutionary relief could be granted, using a starting point of all debts incurred after the company became unsalvageable. But the personal benefit obtained by the director appears to have been the driving factor in granting such restitutionary relief.
Other points of note
The Supreme Court also:
- sought to apply the section 4 solvency test as part of the statutory scheme applying to directors and liquidations. But the application of that test is properly targeted at distributions to shareholders rather than directors’ duties
- reinforced the subjective aspect of the section 131 test (although that is well understood in practice), and
- commented on the competing shareholder primacy and stakeholder models, but concluded that it did not need to decide which of those models is correct.
The Supreme Court’s approach reflects a concern about conduct that prejudices certain individual creditors, even where the body of creditors as a whole benefits. That complicates matters for directors in difficult trading situations and workouts.
But the Court also made some effort to limit the scope of the judgment to “unsalvageable” companies and expressly excluded companies with temporary liquidity issues from that definition. The Court’s focus is clearly on companies facing inevitable liquidation.
Importantly, the judgment does not address attempts to trade out a difficult position in good faith. Accordingly, we consider that the judgment should be confined to its facts in the future so that director-driven workouts can take place without always needing to resort to insolvency mechanisms under the Companies Act.
Debut Homes shows again that reform of sections 135 and 136 is needed. The current drafting, along with judicial interpretations of it, has led to ever-increasing uncertainty for directors.
Greater clarity on sections 135 and 136 would be well received, particularly after the directors’ temporary COVID-19 safe harbour expired at the end of September. Directors should be given confidence to pursue director-driven workouts, which often lead to a better result for creditors (including employees) than formal insolvency processes. That is consistent with the Government’s aims to limit the damage to the economy from COVID-19.
We have raised our concerns about sections 135 and 136 with officials from the Ministry of Business, Innovation and Employment, and consider urgent reform is needed in light of Debut Homes.
The Court of Appeal’s judgment in Mainzeal is expected later this year or early next. The Court of Appeal sought submissions on how Debut Homes impacts that case. We will be keeping a close eye on whether the Court of Appeal limits Debut Homes to its facts.
Mainzeal will of course also deal with a series of other important issues for directors. Those include:
- to what extent directors are responsible for ensuring that shareholders properly capitalise a company
- directors’ ability to rely on parent company or group support, and
- how loss is calculated in a reckless trading case: net deterioration (as the Supreme Court suggests, and as described above), or much larger figures based on losses suffered either by particular creditors, or even all debts incurred after a particular point in the company’s trading?
We will keep you updated about that judgment.
Our thanks to Janko Marcetic for writing this note.