Be warned about trading on if your company is nearly insolvent

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Timothy Bates of Auckland law firm Legal Vision.

Timothy Bates of Auckland law firm Legal Vision reviews a Supreme Court decision focusing on company directors’ responsibility under the Companies Act 1993.

This article focuses on directors’ responsibility under the Companies Act 1993 and, specifically, sections 135 (Reckless trading), 136 (Duty in relation to company obligations) and 301 (Power of court to require directors to repay money or return property).

Facts

Debut Homes Ltd (Debut) was a property developer, and Mr Cooper was Debut’s sole director.

In November 2012, Mr Cooper decided to wind down Debut’s operations, completing a four-house development then underway, at which time the company would cease trading.

This required his trust to advance further working capital that was subsequently repaid.

Mr Cooper calculated in November 2012 that even if he was to complete the four houses, there would remain an unpaid GST liability of more than $300,000 when the properties were sold.

Debut completed and sold these four houses, and in that way was able to repay his trust, plus other creditors.

On March 7, 2014, Debut went into liquidation by application of the IRD. At that point in time it owed the IRD $450,099, including unpaid GST, penalties and interest.

The Liquidators of Debut started proceedings against Mr Cooper, based upon the above sections of the Companies Act 1993.

At High Court level, Mr Cooper was held to have breached his duties under sections 131 (Directors’ duties), 135 (Reckless trading) and section 136 of the Companies Act 1993.

His defence pursuant to section 138 (Relied upon professional advice) was rejected.

He was held liable under the Compensatory section, namely 301 of the Companies Act 1993, and personally required to contribute the sum of $280,000 towards the assets of Debut.

This figure was arrived at by the High Court using as a starting point the debts incurred and not paid between breach date and the liquidation, and then for providing discount for work Mr Cooper completed for the company without getting paid.

In the Court of Appeal though, Mr Cooper had some success. It ruled that Mr Cooper’s decision to complete the houses and sell them was a defensible business decision, as opposed to the alternative of ceasing work in November 2012 when the houses were partially completed.

Therefore, it found that Mr Cooper had not breached sections 131, 135, and 136 of the Companies Act 1993.

However, the Supreme Court restored the High Court decision ordering Mr Cooper to pay $280,000. It ruled that whilst section 301 was not supposed to be punitive it could have a deterrent element.

The appropriate starting point in terms of compensation for a breach of section 135 (Reckless trading) is the deterioration in the company’s financial position between when the trading ought to have ceased and the date of actual liquidation.

But for breaches of section 136, the same measure of compensation may not apply.

The breach of duty in section 136 is the incurring of obligations without a reasonable belief that they will be met. The starting point for setting the compensatory award was to take account of all new debt incurred after the beginning of the breach.

The following caution to directors was made:

“Where directors allow a clearly insolvent company to continue trading without using one of the available formal or informal mechanisms, this will be in breach of their duties as directors, and will lead to relief being ordered under section 301.

Where there have been breaches of duties, any relief ordered under section 301 must respond to, and provide redress for, the particular duty of combination of duties breached.

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.”

Overall, the Supreme Court has clarified what compensation under section 301 can be awarded for breaches of sections 135 and 136 of the Companies Act 1993.

Whilst the Supreme Court differentiated between the award of compensation that may be made under sections 135 and 136, invariably, both sections of the Act are typically breached at the same time.

Essentially, the plaintiff liquidator can elect between the two measures of compensation for breaches of these two sections.

If you find yourself the director of a company which is struggling to pay its debts as they fall due, you need to be careful not to expose yourself personally to personal liability for the company’s debt.

It is best to take accounting advice to assess solvency, followed by legal advice in terms of potential exposure under the Companies Act 1993 as a director.

Note: This article is not intended to be legal advice (nor a substitute for legal advice). No responsibility or liability is accepted by Legal Vision or Building Today to anyone who relies on the information contained in this article.