The Supreme Court has brought the Mainzeal saga to an end by holding the directors liable and awarding compensation of $39.8 million (plus 10 years of interest). The outcome effectively endorses the lower courts' criticisms of the directors' conduct and awards a similar amount of compensation to that of the High Court in February 2019.
In doing so, the Supreme Court took a deep dive into the legislative framework and cases but produced a decision that provides practical guidance for directors, within the limits of the existing legislation. The Court also called for a review of our insolvent trading laws and identified issues with how the existing provisions are drafted and operate. This must be a priority now for our lawmakers.
Background
The demise of Mainzeal is well-known. The former prominent construction company went into receivership and then liquidation in 2013 owing approximately $110 million to unsecured creditors. The liquidators brought proceedings against its directors (including former Prime Minister, Rt Hon Dame Jenny Shipley) alleging that the directors had traded recklessly (in breach of s 135 of the Companies Act 1993) and allowed Mainzeal to commit to obligations without reasonable grounds for believing it could meet them (in breach of s 136 of the Act).
The High Court held that the directors of Mainzeal had breached their duties under s 135 by continuing to trade on as usual when Mainzeal was in a vulnerable state. The High Court found there was no "net deterioration" in the position of creditors but that the company had nonetheless suffered loss because its collapse and creditor losses were not inevitable if the directors had acted to protect creditor interests. The High Court awarded compensation of $36 million calculated as a proportion of total creditor losses.
The Court of Appeal agreed that the directors had breached s 135 but disagreed that the breach had resulted in any loss to the company (because there was no net deterioration over the period of trading). Instead, the Court of Appeal found that the directors had also breached s 136 and were liable for certain obligations that they had agreed to Mainzeal undertaking but that the company failed to perform. All parties appealed to the Supreme Court.
The Supreme Court decision
The Supreme Court has sewn together the reasoning of the High Court and Court of Appeal to provide a comprehensible framework for New Zealand's insolvent trading duties. The Supreme Court agreed with the courts below that the directors of Mainzeal had breached s 135 for five key reasons:
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Mainzeal had been trading while balance sheet insolvent for many years.
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Advice was given by external advisors that additional capital was required, yet such capital was not provided.
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From 2008, Mainzeal generated little, if any, operating profit.
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The directors were aware of the precariousness of Mainzeal's position.
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The directors could not reasonably have relied on assurances of support from the Richina Pacific group or Mr Yan because the assurances that had been given were neither legally nor practically enforceable.
The Supreme Court agreed with the Court of Appeal that Mainzeal did not suffer any loss from reckless trading because the position of creditors as a whole had not deteriorated. The Court rejected the liquidators' argument that a "new debt" measure of damages was available under s 135. The "net deterioration" assessment of loss is generally, but not exclusively, appropriate for s 135.
The Supreme Court also agreed that the directors of Mainzeal had breached s 136 by incurring medium-term obligations (relating to four major construction projects) that the directors could not reasonably have believed the company could fulfil in its vulnerable state, and by incurring short-term obligations after it became clear that the company could not meet its debts as they fell due.
The Supreme Court upheld the "new debt" measure of loss adopted by the Court of Appeal for s 136 breaches — reflecting the "obligation-by-obligation" and "creditor-by-creditor" focus of the provision. It quantified the loss at $39.8 million (plus interest, which could be in the order of $15 million, and costs). In support of this measure of loss, the Supreme Court also found that individual creditors are entitled to seek relief under s 301 to enforce insolvent trading duties.
The Supreme Court agreed with the High Court that courts have a discretion to reduce compensation ordered against individual director on the basis of "limited" culpability but emphasised that full compensation should be the norm. Culpability would be primarily relevant to allocating responsibility between the different directors. However, acting honestly and in good faith and without personal benefit is not enough to avoid liability: the duties imposed on directors go well beyond that standard.
For Mainzeal's directors, the Supreme Court held Mr Yan liable for the full $39.8 million (plus interest) and said the manner of trading was "fundamentally his fault". The other directors (including Dame Jenny) were each jointly liable with Mr Yan but capped at $6.6 million each (plus interest).
Key messages for directors
The Supreme Court endeavoured to reassure directors that time, complexity and matters of business judgment will all be taken into account by courts when determining reasonableness of director decisions. Courts will recognise and adjust for the danger of hindsight bias.
Directors should continue to proceed with caution when faced with uncertain economic conditions and the following key messages are reinforced by the decision:
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No assumptions: Directors can be liable even if they do not appreciate a risk, and the courts will assess the reasonableness of a director's actions based on circumstances they should have been aware of. If financial difficulties / uncertainties are apprehended, then directors must squarely face up to the company's situation, obtain expert advice on its financial position and assess the risk of loss to creditors.
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Time to take stock: Directors are entitled to take time to "take stock" of the situation and take advice, even if that means trading insolvently for a period of time while they do so. They must use that time wisely. If there is a potential for risk of loss, the directors must decide how that potential can be avoided. There needs to be a plan for managing and mitigating the issues that have given rise to the concern (eg recapitalisation or a manner of trading). Directors must thoroughly and critically consider the company's forward-looking trading strategy before deciding to continue trading and not "set off" the risks to future creditors against the advantages to existing creditors from continued trading. Independent professional advice was strongly recommended.
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Long-term balance sheet insolvency: A long-term strategy of trading while balance sheet insolvent is generally not acceptable unless there are assurances of external support that can be reasonably relied upon. There will be serious questions about the reasonableness of relying on assurances that are not legally binding or practically enforceable and are not honoured.
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On-going reflection: The Court has emphasised that principles of sound corporate governance should be adhered to if directors decide to continue trading. A decision to trade on in the face of uncertainty regarding a company's solvency should only be made after undertaking a professional assessment of the range of potential (and likely) consequences of doing so and the prospects of enabling the company to service its existing debt and meet the new commitments that ongoing trading will attract. The company's financial situation should be continually monitored and the decision to continue trading should be kept under review.
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Resignation an option: It is appropriate for directors of a distressed company, who do not exercise ultimate control, to threaten to resign or to put the company into liquidation as a method of achieving necessary changes.
Law reform?
The judgment is substantial and considers a wide range of issues relating to the operation of the Companies Act, decisions in other jurisdictions and detailed questions around what compensation is available and how it is calculated and proved. There will be many reflections on the judgment and how it applies in time to come.
The Supreme Court has nonetheless endorsed the view that the insolvent trading provisions require review by government. This was signalled by the Court of Appeal in March 2021 and has been widely called for in recent years. We hope that a law reform process can now be expedited, particularly in the current economic environment, which is highly challenging for directors and management. That review should consider (among other things) the range of differing forms of insolvent trading duties in other key jurisdictions, including the effectiveness of steps taken in Australia to provide safe harbours for directors.