Director personal liability more acute as tough times bite business

Tuesday 14 February, 2023

In the current economic environment, many companies are going to be facing situations where solvency is at risk or where there is a need to incur obligations to stay alive. Company directors must be ultra-vigilant when it comes to their directors’ duties.

Incurring obligations on behalf of the company, failing to act in the company’s best interests or failing to spot financial trouble in an organisation early and being slow to mitigate risks can all increase a director’s personal risk.

This is the key message from Wayne Hofer and Andrew Grenfell on a recent episode of the Tompkins Wake podcast.  Each share their deep understanding of directors’ responsibilities and liabilities under the Companies Act and how to minimise personal risk.

Hofer is a partner and commercial litigation and insolvency lawyer at Tompkins Wake, while Grenfell has over 17 years of corporate turnaround, restructuring and insolvency experience with McGrathNicol.

Freedom vs Responsibility

The very structure of companies in New Zealand gives directors the freedom to take business risks, not only for the benefit of their company but for the economy as a whole.

That freedom is offset with the obligation to act with integrity. Risks must be taken within the framework of a full knowledge of the situation in which the company is trading. As Grenfell explains, there is a degree of nuance in assigning responsibility.

“The courts are clear that it's not about bad business judgment per se. Directors can act with integrity and still get things wrong. Directors come under scrutiny when they ignore red flags and continue trading recklessly.

“I've been involved in cases where board reports clearly showed that the directors were fully cognizant of the financial trouble the company was in but continued to incur obligations on behalf of the company.

“When you've chewed through your own equity and are putting creditors’ capital at risk, that's when a liquidator will be very interested at looking into the actions of the directors,” Grenfell said.

Ignorance doesn’t wash

In tough economic times, the obligations and duties of a director are more acute. The onus is on directors to actively seek out relevant information and courts no longer accept claims of ignorance as an acceptable defence. Hofer outlines the new landscape.

“So far as insolvency is concerned, the days of a director saying ‘I didn't know the company was in such a bad situation’ are gone. Courts assess situations based on what directors could reasonably have known and should have known."

“Directors are obliged to be fully aware of the company’s situation, perhaps not on a daily basis, but frequently enough to know how the business is doing. If cashflow is becoming an issue, it is the job of directors to dive deeper into their obligations,” Hofer said.

Act sooner than later

The sooner directors spot red flags and act, the greater the options available to them to find effective solutions.  Andrew cites a case that came across his desk during the Covid pandemic.

“I was brought into a situation which was the result of the vaccine mandates. When the mandates hit, the company was faced with an overnight reduction in workforce. As a result, they didn't have staff to do the work, which resulted in a sudden drop in income.

“When the directors realised the company wouldn’t have money to meet its debts, they immediately came to speak to us. Because they consulted with us early in the piece, there were options we could employ to help them trade through,” he explains.

Incurring obligations

Certain companies will also look to trade out of a rough patch which may include incurring liabilities.

“In the simplest terms, directors must ensure they don't illegitimately incur an obligation that the company can't achieve in the future. The role of a director is not to avoid risks, but it’s making sure the risks they take are reasonable in the circumstances,” Hofer said.

Mechanisms and options

When turnaround experts are called upon for help, they have a responsibility to ask: Is there a path out of this that can be reasonably relied upon? In Andrew’s experience, the answer is often yes.

“There are mechanisms we can use to help businesses come back from the brink. We can help them make compromises with landlords and suppliers. We might use structuring techniques to allow a company to continue to trade if the underlying business is viable.

“There are situations whereby you can continue to trade at the behest of your creditors. In that situation, it is critical creditors become part of the decision-making process, to agree or disagree to a proposed plan of action. With creditors onboard, a company can work its way through the risk.

“If directors want to keep themselves safe and build resilience into their business, they should consult advisors as soon as things look shaky. Expert counsel at the appropriate time will assist them in determining the best way through,” Grenfell said.