A recent decision by the Supreme Court highlights the consequences of breaching directors duties, even if the director believes they are acting in the best interests of their creditors.
The case of Debut Homes Limited v Cooper has big implications for directors involved in a business that is struggling financially and is a timely reminder that directors need to take their duties extremely seriously. It also provides some really good guidance on what to do and more importantly, what not to do, if you’re a director of a company in financial difficulty.
Debut Homes Ltd was a residential property development company owned by Mr. Leonard Cooper, who was also the sole director. The company was incorporated in 2005 but by the end of 2012 Mr. Cooper, on advice from his accountant, decided to wind down Debut’s operations.
Debut’s assets had been less than its liabilities (balance sheet insolvency) since March 2009 but it had been supported by shareholder advances from Mr. Cooper, up until the end of October 2012, and had paid all its debts as they fell due. It had, however, been experiencing cost overruns and increasing debt and by the end of October 2012, was in real financial difficulty.
Mr. Cooper decided that four existing developments would be completed and sold in order to pay some of its creditors but no new developments would be undertaken. Mr. Cooper would have owed the Inland Revenue over $300,000 in GST once the wind-down was completed but he didn't engage with the IRD in any way at all.
Debut Homes was finally placed into liquidation in 2014 by the IRD with an unpaid GST bill of $450,000 (including penalties and interest).
The High Court initially found Mr Cooper had breached his duties as a director and ordered him to pay the liquidators $280,000. The Court of Appeal overruled that decision and found Mr Cooper’s decision to continue trading was for the benefit of all of the company’s creditors.
However, the Supreme Court overturned the Court of Appeal’s decision and found Mr Cooper to be in breach of the key duties of the Companies Act.
The Companies Act states:
- a director must act in good faith and in what the director believes to be the best interest of the company; and
- a director must not agree to, cause or allow the company’s business to be carried on in a manner that is likely to create a substantial risk of serious loss to the company’s creditors.
Maintaining solvency is a key value of the Companies Act according to the Supreme Court decision:
“Where a company becomes insolvent, there are statutory priorities for the distribution of funds to creditors and mechanisms to ensure these are not circumvented. There are also a number of formal mechanisms in the Act, apart from liquidation, for companies experiencing financial difficulties.
All of the formal mechanisms have carefully worked out processes for decision-making and involve either an independent person or consultation with all affected creditors. None of these formal regimes involve continued unfettered decision-making by directors.
Directors can choose to employ informal mechanisms but these must align with formal mechanisms. At all times, including where a company is insolvent, directors must comply with their duties under the Act (our emphasis).”
Debut Homes failed the solvency test as outlined in the Companies Act. The solvency test has two limbs that both must be satisfied: the liquidity limb (the company is able to pay its debts as they fall due) and the balance sheet limb which is satisfied if the value of a company’s assets is greater than the value of its liabilities.
If a company reaches the point where the company is clearly not salvageable and continuing to trade will result in a shortfall to creditors, directors are in breach of their duties under the Companies Act if they decide to keep trading.
In addition to the solvency test, the Companies Act has other provisions dealing with insolvency and near-insolvency situations. These include formal and informal mechanisms such as proposing a “compromise” to creditors, voluntary administration, liquidation and receivership.
The Supreme Court found that all formal mechanisms “require persons independent of the directors to run the processes...The removal of decision-making powers from directors in such circumstances is a recognition that directors are not the appropriate decision-makers in times of insolvency or near-insolvency.
This is because their decisions may be compromised by conflicting interests and, even where that is not the case, they may be too close to the company and its business to be able to take a realistic and impartial view of the company’s situation.”
Another feature of formal mechanisms is they require the involvement of all creditors. Mr. Cooper should have looked at putting some of those formal mechanisms in place and reaching a compromise with creditors. All creditors, including the IRD needed to be engaged with. The order of priority when it comes to creditors should have had the IRD at the top of the list, even though that isn't stated anywhere. In this case the IRD wasn't part of Mr. Cooper’s decision making process at all.
Mr. Cooper tried to do the right thing by his creditors but he made a big mistake by not paying the IRD first. People have got to be really, really careful here, because the duties of the Act will be enforced and that means directors may be personally liable.
Of the options available to him, Mr. Cooper decided to carry on trading. One of his defenses was his decision was based on professional advice but the Supreme Court was very clear that by not availing of formal or informal mechanisms in the Companies Act he was personally liable, despite the fact he acted on professional advice.
So Mr. Cooper did a lot of things wrong to be frank. His intentions were good but he didn't do things the right way and he didn't consider all of the people he ought to have considered.
In these uncertain times when things can change really quick it shows the importance of directors being very aware of what's going on in the company and being mindful of their obligations. It also means considering the solvency of the company regularly and robustly.
Janice Hughes is a Director of, and senior legal adviser at, Aspiring Law. Please remember, this information is designed as a general guide, and should not replace specific legal advice on a particular issue.