Hefty consequences for getting it wrong when company was in financial distress
In September 2020, the Supreme Court released its keenly anticipated decision in the Debut Homes case (1). This decision illustrates the risks for directors where a company is experiencing irrecoverable financial distress.
In the Debut Homes decision, the court clearly spelt out that in insolvency, or near-insolvency situations, it is not acceptable to simply try to ‘trade through’ in the belief that this will
improve the company’s financial position. Instead, directors must ensure they use the formal (or informal) mechanisms provided in the Companies Act 1993 to address the company’s financial predicament.
If directors fail to meet their duties, they face a very real risk of incurring personal liability — as occurred in the Debut Homes case.
Before we look at the implications of the Debut Homes case, it is helpful to summarise the legal duties of company directors. Directors have a range of specific legal duties, including to:
• Act in good faith and in what they believe to be the best interests of the company (which includes an obligation to consider the interests of creditors in near-insolvency situations)
• Use their powers for a proper purpose
• Follow the Companies Act 1993 and the company’s constitution
• Only allow the company to make commitments that they believe, on reasonable grounds, that the company can perform when required to do so
• Trade in a manner that is not likely to put creditors at a substantial risk of serious loss, i.e. trading recklessly, and
• Use company information appropriately.
As these duties are active, rather than passive, it is impossible to be a ‘silent’ or ‘sleeping’ director. All directors are responsible for fulfilling these duties, which means that you cannot simply default your duties to your fellow directors.
Why is it important to fulfil your director duties? If you breach your duties as a director and the company is placed into liquidation, you risk being held personally liable to repay or restore funds, or to contribute a sum of money to the assets of the company (as the court thinks just).
Setting the scene
Debut Homes Limited operated a residential property development business; Mr Cooper was its sole director. In October 2012, the company was in financial difficulty and, in November 2012, Mr Cooper decided to wind down Debut’s operations. Mr Cooper made the decision to not take on any further work, but to complete and sell the company’s existing projects. At the time of this decision, it was forecast the company would be unable to meet its GST obligations of over $300,000 once the winddown was complete.
The company was not salvageable in the sense that even after continued trading it would still be insolvent. Mr Cooper, however, believed that completing the company’s existing projects, rather than selling them half-finished, would provide a higher overall return to creditors. Mr Cooper did not, however, consider the interests of all creditors, namely Inland Revenue.
Mr Cooper ran the company (without drawing any salary) until February 2014, when the company’s last project was completed and sold. In finalising these projects, Debut Homes had incurred further debt of approximately $28,000. In March 2014, Debut Homes was placed into liquidation by the IRD. At this point, the company owed more than $450,000 to the IRD. The liquidators brought proceedings against Mr Cooper for (amongst other things) breach of his director duties under the Companies Act, and sought an order under s 301 for compensation against him personally.
The High Court and Court of Appeal decisions
The key issue was whether Mr Cooper had breached his director duties by continuing to trade when the company was insolvent (or nearly insolvent). The particular director duties in question were the duties to:
• Act in good faith and in the best interests of the company (s 131 of the Act)
• Not allow the company to be carried on in a manner likely to create a substantial risk of
• serious loss to the company’s creditors, commonly known as ‘reckless trading’ (s 135), and
• Not agree to the company incurring an obligation unless the director believes at that time, on reasonable grounds, that the company will be able to perform the obligation when due (s 136).
The High Court found that Mr Cooper had breached his director duties and he was ordered to pay $280,000 to the liquidators. Mr Cooper appealed.
The Court of Appeal overturned the High Court’s decision, on the basis that Mr Cooper’s decision to complete the existing developments was a sensible business decision. The court noted that if Debut Homes had sold its projects while incomplete, then the losses to creditors would have been even greater. The liquidators appealed.
To the Supreme Court
The Supreme Court considered whether it was a defence for Mr Cooper to assert that completing the company’s existing projects was a justifiable decision, given this would provide higher returns than immediate liquidation would have.
The court held that 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 reckless and a breach of director duties.
It was not a defence for Debut Homes to assert that completing the properties was a sensible business decision. Mr Cooper knew that continued trading would still result in a shortfall, and accordingly he had breached s 135 of the Act, regardless of the fact some creditors would be better off and despite the overall deficit to all creditors being reduced.
Where there are no prospects of a company returning to solvency, it makes no difference that a director honestly thinks some of the creditors will be better off by continuing trading. Directors should not enter into a course of action that may result in some creditors receiving a higher return at the expense of incurring new liabilities which will not be paid. In this case, by continuing to trade, some creditors received more at the expense of the IRD. As the court put it, it is not legitimate ‘to rob Peter to pay Paul.’
The Supreme Court reinstated the decision of the High Court and Mr Cooper was ordered to personally pay compensation of $280,000 to the company. The compensation sum could have been more, but the Supreme Court agreed with the High Court that a discount was warranted on the basis that Mr Cooper had worked for 18 months without pay to complete Debut Home’s projects. Mr Cooper was also ordered to pay the liquidators’ legal costs.
Options for directors
The Debut Homes case highlights that directors must be aware of the various mechanisms that are available if a company is facing insolvency or near-insolvency. The key mechanisms are:
• Liquidation: winding up the company
• Creditors’ compromise: this usually involves part of a company’s debts being forgiven. It must be approved by a majority of creditors, representing at least 75% of the debt owed to each class of creditor
• Court-approved creditors’ compromise: where the court agrees that a compromise is fair and reasonable to creditors, and
• Voluntary administration: an administrator is appointed to increase the prospects of a company surviving. This must be approved by a majority of creditors, representing at least 75% of the debt owed to each class of creditor.
Directors must take care
The decision in the Debut Homes case is relevant to directors of all New Zealand companies. The case highlights the risks for directors who continue trading when the company faces actual, or near, insolvency. If, as a director, you allow your insolvent company to continue trading without using one of the available formal or informal mechanisms, then you will breach your director duties and you are likely to incur personal liability.
A critical decision for directors is whether or not to continue trading. If you are a director of a company in financial distress, it is essential that you deal promptly with the situation and seek both legal and accounting advice as to your options. This should include considering the mechanisms available through the Companies Act 1993, such as liquidation, voluntary
administration or a creditors’ compromise.
(1) Vivien Judith Madsen-Ries and Henry David Levin as Liquidators of Debut Homes Limited (In Liquidation) v Leonard Wayne Cooper  NZSC 100.