Timely reminder about directors' duties to creditors

Thursday 1 October, 2020

In the current economic climate, company directors should always be conscious of their company’s financial position and be ready to make hard decisions if it looks unable to pay its debts. Directors owe duties to the company’s creditors not to continue to trade if the company is insolvent and can be made to pay compensation if they breach this duty. The latest Supreme Court decision examines in more detail the limits of this duty.

Background

The case, Madsen-Ries v Cooper[1], related to the liquidation of Debut Homes, a residential property development company. By late October 2012, Debut had serious financial issues, so its sole director, Mr Cooper, decided Debut would complete its existing developments and then be wound down. Mr Cooper considered that completing Debut’s existing developments would improve the overall return to Debut’s creditors prior to the eventual liquidation, but was aware that this strategy would result in incurring GST obligations of at least $300,000, which it would be unable to meet.

The properties were completed and sold, and the proceeds went mostly towards reducing Debut’s debts to its secured creditors, to whom Mr Cooper and his family trust had given guarantees. Debut was put into liquidation on the application of the IRD. The liquidators sought compensation from Mr Cooper for breach of directors’ duties. The High Court held that Mr Cooper had breached his duties because he chose to complete the developments, despite knowing that it would result in a significant shortfall to the IRD. The Court of Appeal considered that Mr Cooper’s decision to complete the development was a sensible business decision which was likely to increase the overall return to creditors. The Supreme Court disagreed.

As part of its decision, the Court has provided some valuable guidance around how directors can avoid breaching their duties.

If continued trading will result in a shortfall, stop trading

If a company isn’t salvageable, it must stop trading when it reaches the stage that continued trading will result in a shortfall to creditors. This applies even if continued trading would result in higher returns to creditors than immediate liquidation. If the directors believe that continuing to trade is in creditors’ best interests, they can try to reach an informal agreement with all creditors or use the formal mechanisms in the Companies Act, such as voluntary administration, receivership or liquidation. If directors continue to trade in this situation, they risk breaching the reckless trading provision in s 135 of the Act.

You can agree to incur debts without actually agreeing to anything

Directors have a duty not to agree to the company incurring debts unless the director has a reasonable belief that the company can pay those debts when they fall due (s 136). Directors may think that they can avoid breaching this duty if the company doesn’t enter into direct contractual arrangements with anyone, but the duty covers involuntary obligations as well, such as the obligation to pay GST which arises when a company enters into a contract. Director can’t take steps to provide a higher return to some creditors, for example by selling a property, by incurring new liabilities that the company can’t pay.

Won’t someone think of the creditors?

Directors have to act in good faith and in the best interests of the company. If the company is insolvent, or nearly insolvent, this duty includes considering creditors’ interests too. Directors have to consider the interests of all creditors; they can’t favour certain creditors because it will benefit the director personally. Directors won’t breach their duty if they honestly believe that they’re acting in the best interests of the company, but there needs to be evidence that they actually considered what the company’s best interests are.

Breaching duties can be expensive

If directors breach their duties, the court can order the director to compensate the company. Compensation won’t be limited to the change in the company’s bottom line if the director has breached s 136 (incurring debts without reasonable belief that the company can pay). Directors might have to compensate the company for any debts incurred in breach of s 136. This is to discourage directors from incurring new debts just to pay existing debts. In this case, the Supreme Court ordered Mr Cooper to pay Debut compensation of $280,000 and partially set aside a general security agreement securing an advance by his trust to Debut.

Keeping yourself safe

Making the decision whether a struggling company should continue trading is both challenging and risky for directors. The different conclusions reached by the Court of Appeal and Supreme Court demonstrate that the law in this area is far from straightforward. In this case, it came down to Mr Cooper’s knowledge that, in completing the properties, Debut would be incurring GST liabilities that it couldn’t pay. Mr Cooper should have involved all creditors in the process, formally or informally, of deciding whether Debut should continue to trade, rather than using the IRD as a bank that he didn’t intend to repay. The result may have been different if the ultimate outcome had been less certain.

Unfortunately, more directors may find themselves having to make difficult decisions about whether to continue trading, and the wrong decision can leave them personally liable. Seeking professional advice early and proactively consulting with creditors can help reduce the risk.

If you have questions about reducing your risk, we can help. Get in touch with one of our experts below.