The Debut of clarity for director’s duties, or further uncertainty?

Mr Cooper was the sole director of Debut Homes Ltd (Debut), a residential property developer. By the end of October 2012 Debut was in real financial difficulty. The IRD put the company into liquidation in March 2014. Debut’s liquidators issued proceedings against Mr Cooper for breaches of ss 131, 135 & 136 Companies Act 1993 (CA).

At first instance, the High Court determined Mr Cooper breached all three statutory provisions. Key to this decision was the finding that Mr Cooper had elected to continue trading and complete four projects with knowledge that Debut’s financial position was not salvageable and there would be a GST liability of at least $300,000, which the company could never pay.

The Court of Appeal disagreed. This was principally on the basis that Mr Cooper made a sensible and reasonable business decision to continue trading, which was likely to improve the overall return to Debut’s creditors. It found he sincerely believed there would be significant surpluses by doing so, and the GST issues could be resolved with the IRD.

The Supreme Court reversed that finding and largely reinstated the High Court’s determination. In particular:

• There was a certainty, not merely a substantial risk, of loss to at least one creditor, the IRD. It was no answer that the decision meant some creditors might benefit given Mr Cooper had a deliberate strategy to put the whole risk of loss on the IRD. In those circumstances, there was a breach of s 135 CA (reckless trading).
• Mr Cooper breached s 136 CA (duty in relation to obligations) when he agreed to Debut incurring a GST obligation when he entered into various sale and purchase agreements. He knew there would be a GST shortfall which could not be paid. The breach did not need to be linked to a direct contractual obligation.
• As to s 131 CA (to act in good faith and in the best interests of the company), directors cannot subjectively believe they are acting in the company’s best interests if, in an insolvency or near-insolvency situation, they fail to consider the interests of the company or, where required, those of all creditors. Mr Cooper failed to do this by incurring debts to IRD and some trade creditors that he knew would not be paid. In an insolvency situation where the interests of all creditors have not been considered, a conflict of interest may exacerbate the breach. Again, that is what occurred here when Mr Cooper sought to pay off secured debts which he and his wife had guaranteed.
• Usefully it was recognised that the subjective nature of the belief was appropriate as the Court was not well equipped to second-guess business decisions directors make in what they honestly believe to be in the company’s best interests, even with the benefit of expert evidence. Any other test would involve the courts judging directors’ decisions with the dangers of judging those decisions with the benefit of hindsight.

As to relief under s 301 CA, the Court must take into account all relevant circumstances, including the nature of the breach, the level of culpability and what is required to hold a director to account. Where there are multiple breaches, any redress must be tailored to the combination of those breaches.

In terms of s 135, which looks at creditors and the business as a whole, the Supreme Court confirmed that in most cases the appropriate starting point is the deterioration in the company’s financial position between the counterfactual (when the company should have ceased trading) and the actual liquidation. However, it found that this approach might not respond adequately to a breach of s 136 as it concentrates on individual creditors and the incurring of obligations without a reasonable belief they will be met. So the net deficiency approach for a breach of s 136 in cases where new obligations are incurred and used to pay other debts may be inappropriate.

As Mr Cooper knew from 6 November 2012 that Debut was insolvent and continued trading would result in a GST deficit, the appropriate comparison point was with the position if Debut had been liquidated at that date. So, the High Court’s starting point of all new debt incurred since the beginning of November was appropriate. Mr Cooper was required to restore the sum of $280,000 to the company.

While some guidance can be taken from the judgment, it highlights that every case will be considered on its facts. The decision directors face when determining whether to continue trading is one which must not be made lightly. Unfortunately, the Supreme Court considered that, because they did not arise on the facts, it did not need to engage with the concern that s 135 may inhibit taking ordinary business risks, particularly where the business might be high risk but have the potential for high return commensurate with the risk. Neither did it deal with the situation where companies might be having temporary financial difficulties, and in such circumstances, legitimately continue trading (and if so, for how long). It is these considerations (amongst others) which will be the subject of consideration in the Mainzeal decision which is due from the Court of Appeal. Hopefully that will provide more guidance, including as to the nature of relief in circumstances where the High Court found that the company should have continued trading, but with corrective measures taken.

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