The Court of Appeal has delivered the highly anticipated Mainzeal judgment after hearings in July 2020. The Court held that the directors breached both of the two core duties which protect creditors from the risks of insolvent trading, but overturned the controversial measure of damages for reckless trading adopted by the High Court. The High Court is now required to reconsider the quantum of loss but on a "new debt" measure. On the figures mentioned in the judgment, it seems at least possible that liability will increase from the original award of $36 million, but with apportionment between the directors to be reconsidered. This long running saga appears to have significantly further to run.
There is also the prospect that the decision will provoke change in our insolvent trading laws. The Court called for such a review to ensure that these laws provide a coherent and practically workable regime to protect creditors when directors decide to keep trading when a company is insolvent or near insolvent. In the meantime, the decision is critical of the directors' performance and provides guidance on what is expected of directors in the "twilight zone" near insolvency.
Reckless trading – section 135 of the Companies Act
The High Court had found that Mainzeal traded while balance sheet insolvent or near-insolvent, had no enforceable assurances of group support on which the directors could reasonably rely, and had a poor trading record.
The Court of Appeal dismissed the directors' appeal against that finding, essentially accepting the Judge's reasoning. It was "wishful thinking" for the directors to continue to trade on as usual where Mainzeal was in a very vulnerable state. In particular, the Court held that it was not reasonably open for the directors to assume that certain related company debts were recoverable or that assurances of support could be relied upon.
In those circumstances, the directors ought to have been cautious before deciding to continue to trade. They were not. They failed to take urgent corrective action to address the "profoundly unsatisfactory financial position of the company and the risks this created for current and future creditors".
If they had taken urgent action and still not received adequate assurances from Mainzeal's shareholders as to financial support, then that would have been the occasion to undertake a formal review of the appropriateness of continued trading, and the potential for continuing to trade in a way that did not disadvantage existing creditors and ensured that new creditors were paid. Even then, the Court considered that if the directors had taken the steps available to them it would have become clear that Mainzeal could not continue to trade without creating substantial risk of serious loss to creditors.
The Court's finding came against the backdrop of a summary and restatement of reckless trading law. The Court confirmed existing authority that, among other things:
- s 135 requires an objective assessment of the directors' conduct;
- directors of a company entering troubled financial waters must carry out a "sober assessment" of the company's likely future income and prospects before deciding to continue to trade;
- a decision to trade on instead of ceasing to trade is likely to breach s 135 unless the manner in which the directors choose to trade on has realistic prospects of enabling the company to service existing debt and meet new commitments, without just using new creditors' money to service debts to existing creditors.
The Court also reiterated the Supreme Court's decision in Debut Homes that formal insolvency procedures are there for a reason, and it is not open to directors of an insolvent company effectively to conduct their own informal administration or liquidation without the consent of creditors or ensuring those who have not consented are paid in full. That creates the risk that the company's assets are not distributed in accordance with lawful priorities and that the company "robs Peter to pay Paul".
The decision also helpfully deals with good faith attempts to trade out of a difficult financial position to restore the company's solvency, which had not been addressed by the Supreme Court in Debut Homes. The Court expressed the view that directors might still be able to trade on without trading recklessly if the manner in which they do so has realistic prospects of enabling the company both to service pre-existing debt and to meet the new commitments which such trading will attract.
Reckless trading – remedy
Despite finding the directors liable for reckless trading, the Court held those breaches caused no loss in the circumstances in this case. That was because the company's position in fact improved between the date on which the liquidators asserted the company ought to have ceased trading and the date when it in fact went into liquidation. This result was partly a consequence of the way in which the liquidators' case was framed. By early 2011 when the alleged breach occurred, the company was, according to the liquidators, already "hopelessly insolvent". The cause of the insolvency therefore pre-dated the alleged breach of duties, so that there was no causal link between the alleged breaches and the claimed losses.
The Court of Appeal overturned the High Court's novel approach that the entire shortfall (or "deficiency") to creditors in the liquidation was the appropriate starting point for measuring the directors' liability to compensate the company for their breaches. It also did not accept the liquidators' arguments that liability for reckless trading can be measured by reference to new debt incurred which remains unpaid.
Duty in relation to obligations – section 136 of the Companies Act
Departing from the High Court, the Court of Appeal found that the directors had breached their duty not to incur obligations unless the director believes on reasonable grounds that the company will be able to perform the obligation when it is required to do so. That duty was breached both in relation to long-term obligations which the company incurred from 2011 on and later in relation to short-term obligations incurred in the last six months of trading which were ultimately unpaid. The company's ability to meet the long-term obligations depended on the company receiving shareholder support as and when financial difficulties arose. It was not reasonable for the directors to believe that shareholder support would be forthcoming.
The quantum of liability for breach of the duty in relation to obligations is to be measured in this case by the long-term and short-term debt incurred in breach of duty and which remained unpaid at liquidation. The Court of Appeal sent that quantification task back to the High Court to be determined, together with the question of whether the liability of any directors ought to be reduced in the exercise of the court's discretion. On the figures mentioned in the decision, it seems that the liability for the breach of the duty in relation to obligations will be at least as significant as the original decision, and potentially significantly more, including once interest and costs are considered. The High Court had found Richard Yan liable for 100% of the $36 million liability, with the other three directors jointly liable for 50%. That outcome will also be under review.
Conclusion
The decision restores orthodoxy in terms of the measure of loss for reckless trading and directors' duties in relation to the manner in which they cause the company to assume obligations. It reinforces the High Court's significant warning for directors of companies to maintain effective risk management structures, particularly when facing financial difficulties. The decision, again, demonstrates the critical importance of financial and legal advice for directors during uncertain trading conditions. The Court of Appeal stated that it was reasonable for the directors to take some time to explore all realistic alternative courses of action and endeavour to avoid an insolvent liquidation. However, the directors here did not actively seek advice or address these issues until it was too late. They could have resigned if their efforts to obtain support were not effective – a final option noted in earlier directors' duties cases.
The outcome in this case will remain uncertain for some time given both the possibility of further appeal and the need for the High Court to re-consider the level of damages. Our legislative framework may also be reviewed as a result of this case. This review ought to focus on what safe harbours should be available to directors and the conditions under which these protections could be engaged. Directors ought to be able to take reasonable, informed steps to trade out of difficulty and avoid an unsatisfactory outcome of an insolvent liquidation (where that is in the interests of creditors and future creditors are protected). Bearing in mind the impact on directors of the potential for long-running court cases and personal liability, clearer guidance on safe harbours should bring about better outcomes for all concerned.
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