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A Significant Risk In Being A Director

March 2021

A recent Court of Appeal decision highlights a significant risk of being a Director of a Company.

The Case

 

LC was the sole Director of the Company, that was a residential property developer.  LC had decided after taking accounting advice, to wind down the Company’s operations.  Existing developments would be completed but no new developments would be undertaken.  

At the time that this decision was made, it was forecasted that there would be a deficit of over $300,000.00 in GST once the wind down was completed.  Shortly after that decision was made LC’s Trust agreed to lend $380,000.00 to the Company as working capital, with security being given over the Company’s assets to the Trust. 

Some eighteen months after LC’s decision not to carry on, the Company was placed into liquidation on Inland Revenue’s application.  On the liquidation date the Company was owing almost $1 million (including $450,000 for GST).

Solvency Test

 

The Companies Act has a solvency test for companies with such test having two limbs:

  1. The liquidity limb focusses on the Company being able to pay its debts as they fall due in the normal course of business; and
  2. The balance sheet limb focusses on ensuring that the value of the company’s assets is greater than the value of its liabilities, including contingent liabilities.

The Court said, “solvency is a key value in the Act… At all times, including when a company is insolvent, directors must comply with their duties under the Act”.

Reckless Trading

 

Section 135 of the Act states that:

 “A director of a company must not – 

  1. Agree to the business of the Company being carried on in a manner likely to create a substantial risk of serious loss to the Company’s creditors; or
  2. Cause or allow the business of the Company to be carried on in a manner likely to create a substantial risk of serious loss to the Company’s creditors.

 

The Court held that, “if a Company reaches the point where continued trading will result in a short fall to creditors and the Company is not salvageable, then continued trading will be in breach of Section 135 of the Act…this applies whether or not continued trading is projected to result in higher returns to some of the creditors than would be the case had the Company had been immediately placed into liquidation and whether or not any overall deficit was projected to be reduced”.

The Court further held “there is nothing in the wording of Section 135 that envisages a comparative exercise between immediate liquidation and continued trading, where continued trading would still result in a deficit.  This is particularly the case where continued trading us undertaken in a manner that means creditors will not be paid in accordance with the statutory priorities that would arise in liquidation.”  

The Court found that in this case, “there was a deliberate strategy to put the whole risk of loss on Inland Revenue. This was despite the fact that GST on sales made by [the Company] would have, if [the Company] had been liquidated, ranked above unsecured trade debts”.

Directors to Act in Good Faith

 

Section 131(1) of the Act provides that is the duty of Directors, when exercising powers and performing duties, to act in good faith and in what the Director believes to be in the best interests of the Company. 

The Court held that with regard to Section 131(1) of the Act “it does not detract from the subjective nature of the test that Directors will probably have a hard task persuading the Court that they honestly believe that an Act or omission that resulted in substantial and foreseeable detriment of the Company was in the Company’s best interests.”

However, “there will be no breach of Section 131(1) if a Director honestly believed they were acting in the best interests of the Company.  There will, however, be a breach of Section 131 if Directors, in an insolvency or near insolvency situation, fail to consider the interests of all creditors”.

The Court continued “where there are no prospects of a Company returning to solvency, it makes no difference that a Director honestly thought some of the creditors would be better off by continuing trading”.

The Result

 

In this case the Court determined that LC “failed to consider the interests of all creditors, despite [the Company] being insolvent.  As this means he did not subjectively believe he was acting in the Company’s best interests, he was thus in breach of Section 131” (Reckless Trading).

LC was ordered to pay $280,000.00 to the liquidator and was unable to have his Trust recover the $380,000.00 advanced by the Trust to the Company.

This decision highlights the risks that Directors can face when making decisions for a Company.  The shareholders of the Company may have limited liability but the Directors do not have such limited liability and may be held personally responsible for Company debts.