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Will we allow stay and fight to become cut and run?

22 June 2022

The worst may be yet to come in terms of the damage to the New Zealand economy from COVID-19 as businesses battle high inflation, rising interest rates, and continuing supply chain disruption while also withdrawing from the protection of the Government’s business assistance package.

This has helped to contain the number of insolvencies over each of the last two years at half the rate recorded in 2019, but for some recipients it will be disaster delayed rather than disaster avoided. 

The catalyst may be Inland Revenue which has entered into 140,000 payment arrangements engaging over $3.7b in debt. When those amounts come due, they will force at least some of those borrowers to the wall. 

Similarly with the Business Finance Guarantee Scheme under which the government accepted up to 80% of the default risk to encourage lenders to take on loans they might otherwise regard as too risky. This has now been wound up but, as at 30 June 2021, had 4,035 borrowers with a combined exposure of $2.86b – many with a tenor of 10 years. How many of them will be able to renew their loan on normal commercial terms?

Damage may be aggravated by poor law

Unfortunately the impact of these risks may be aggravated by a legislative and regulatory framework which is now wired to encourage directors to cut and run rather than stay and fight. 

The preferred option for distressed companies over the last decade has been the company-led sale. It has a lot to recommend it: higher recovery, lower transaction costs, better outcomes for stakeholders, reputation preservation, and capital adequacy benefits.

But the fall-out from the Debut Homes and Mainzeal judgments may change the calculus from trading through to insolvency.

The key part of the Debut decision was:

If a company reaches the point where continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading will be in breach of section 135 of the (Companies) Act.

“[T]his applies whether or not continued trading is projected to result in higher returns to some of the creditors than would be the case if the company had been immediately placed into liquidation, and whether or not any overall deficit was projected to be reduced.”

The Supreme Court found the director, who had traded on an “unsalvageable” company, liable to pay compensation on a “restitutionary” “new debt” basis – i.e. total gross debts incurred after the point at which the company ought to have ceased trading.

The Court of Appeal’s judgment in Mainzeal appears to have expanded the circumstances in which directors may be liable on a “new debt” basis. The Court of Appeal made no express finding that Mainzeal was unsalvageable. And it was not disputed that the Mainzeal directors believed that the company could meet those obligations when required.   

In Mainzeal, it was accepted that the directors had believed that the necessary financial support would be provided as and when required. But the Court of Appeal (the Supreme Court has yet to deliver its ruling) found that the assurances on which they were relying were insufficiently clear and definite, were not in writing, and were informal with unclear parameters, and that the board had failed to take “urgent corrective action”. 

It was “not acceptable for directors to continue to trade with their creditors’ money unless they have put in place carefully thought-through strategies, with a good prospect of success, to restore the company’s solvency”.

Against the objectives of the Companies Act?

It is worth reminding ourselves of the objectives of the Companies Act 1993, including:

  • to reaffirm the value of the company as a means of achieving economic and social benefits through the aggregation of capital for productive purposes, the spreading of economic risk, and the taking of business risks
  • to encourage efficient and responsible management of companies by allowing directors a wide discretion in matters of business judgement while at the same time providing protection for shareholders and creditors against the abuse of management power, and
  • to provide straightforward and fair procedures for realising and distributing the assets of insolvent companies.
someone signing a document

Law change anyone?

Chapman Tripp considers that the deficiencies in the current law relating to directors’ duties are sufficiently serious to require a deep dive review by the Law Commission followed by thoroughgoing reform.

Sections 135, 136 and 301, in particular, should be revisited as there are fundamental policy and technical issues to be addressed. The Court of Appeal in Mainzeal explicitly called for a review of these provisions, and the Supreme Court described them as “scrambled” during its hearing of the Mainzeal appeals.

The essential policy issue is how to balance the taking of business risks objective and the creditor protection objective in relation to directors’ conduct. How much risk should the honest, unconflicted director bear in a situation of uncertain solvency who decides to continue trading in good faith but is unable to forestall liquidation and losses to creditors?

Cautious directors will realise that the consequence of the Debut Homes and Mainzeal decisions to date is that, where solvency is uncertain, ongoing trading renders them liable for all gross debts incurred from that point (not including those ultimately met). In large turnover companies, those figures could be substantial.

Some specific and more technical questions any review ought to consider are:

  • whether errors of judgement made in good faith ought to be treated as distinct from dishonest and self-interested performance of directors’ duties, and if so, how
  • when and to what extent directors must consider the interests of creditors, and whether in doing so they must consider the creditors as a body or individually
  • whether sections 135 and 136 apply to distinct forms of trading and transactions and, if not, how to deal with any overlap
  • whether and to what extent the Court should have any discretion in ordering directors to pay compensation or contribute to the assets of the company
  • whether directors ought to be ordered to pay compensation based on losses suffered by specific creditors and, if so, how that aligns with mechanisms for distribution to creditors (i.e. if compensation is to be calculated by reference to “new” creditors, then the regime ought to allow for the compensation to go to those creditors directly)
  • the relevance of the solvency test under section 4 outside of the context of distributions, and whether meeting that test ought to be a requirement of continued trading, and
  • the standard of review the Courts ought to apply to directors’ decisions given the reference to “allowing directors a wide discretion in matters of business judgement”.

Safe harbour?

We also suggest a permanent “safe harbour” building on the temporary COVID provision and modelled on the Australian policy which has been in place for five years and provides a helpful template for consideration. 

The Australian legislation allows directors relief from personal liability for company debts incurred in order that the company can continue trading under distressed circumstances, provided they are taking a course of action reasonably likely to lead to a better outcome. 

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Factors in determining this are:

  • obtaining appropriate professional advice
  • developing or implementing a restructuring plan to improve the company’s financial position
  • maintaining proper financial records
  • keeping informed of the company’s financial position, and
  • taking steps to prevent misconduct by officers and employees of the company.

The protection ceases when it becomes evident that the rescue plan is unlikely to succeed.

Directors should be encouraged to engage early with possible insolvency risk and to explore options that best improve outcomes for all stakeholders. 

SME-specific restructuring processes?

Other areas of potential reform would be to:

  • encourage more use of voluntary administration, potentially by streamlining aspects of it and reducing costs, and
  • consider implementing some SME-specific restructuring processes.

Australia introduced a streamlined SME rescue process as part of its COVID response and has kept it in force. It enables boards of companies with outstanding debts of less than AU$1m to appoint a small business restructuring professional to develop a restructuring plan. 

This appointment triggers a moratorium on the enforcement of debts and claims by the company’s creditors. The directors remain in office and can exercise their usual functions while the plan is developed. A timeframe of 20 working days is allowed for this, with a further 15 days for a creditor vote. A 50% vote is required for acceptance, although dissenting secured creditors will not be bound except by court order.

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This article is part of our regular publication Restructuring & Insolvency: Rescue & Recovery. Read the other articles in this series below.  

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