The Court of Appeal has released its decision on the claim against the former directors of Mainzeal Property and Construction Limited.
Mainzeal directors traded recklessly and incurred obligations which they did not reasonably believe could be met when they fell due. The Court of Appeal has referred the decision back to the High Court to determine the quantum of damages and has recommended the insolvency provisions in the Companies Act be reviewed.
Mainzeal was one of New Zealand’s largest construction companies, building several landmark buildings including the Supreme Court in Wellington and Spark Arena in Auckland. In 2013 Mainzeal collapsed owing approximately $110 million to unsecured creditors. A claim was brought by the liquidators against Mainzeal’s directors alleging the directors had traded recklessly (breaching section 135 of the Companies Act 1993) (1) and that the directors committed to obligations without having a reasonable basis for believing those obligations could be met when they fell due (breaching section 136).
High Court Decision
Section 135 states that a director must not cause, allow, or agree to the business of a company being carried out in a manner likely to create a substantial risk of serious loss to the company’s creditors. The High Court decided there had been a breach of section 135, in that Mainzeal was trading while balance sheet insolvent, receiving no guarantee of group support (which could be reasonably relied upon), trading in a generally poor manner, and prone to one-off losses.
Section 301(a) gives the Court power to investigate a potential breach. If a breach is found, a remedy can then be determined under section 301(b). The High Court rejected the “net deterioration” approach set out in Mason v Lewis (2) and took an “entire deficiency” approach, resulting in the Court assessing the total shortfall in the liquidation.
The Court began at a starting point of $110 million, which was reduced to $36 million after considering relevant factors such as culpability, causation, and duration. Of this $36 million, Richard Yan was ordered to pay $18 million, and the other three directors were ordered to pay $6 million each.
The High Court found there was no breach of section 136 as there was insufficient evidence.
Court of Appeal Decision
Breach of section 135
The Court of Appeal upheld the High Court’s decision that there was a breach of section 135. Where a company trades while balance sheet insolvent, they must take urgent remedial action. Mainzeal had numerous options available including pressing for repayment of debt from companies who owed Mainzeal money, obtaining legally binding guarantees of group support, or at a minimum, conducting a review into the appropriateness of continuing to trade. While it is acceptable for directors to take some time to explore all realistic courses of action to avoid insolvency, they must attempt to seek advice and address the issues, not simply carry on trading as normal.
The Court of Appeal overturned the High Court’s approach to section 301. The Court of Appeal held that Justice Cooke’s “entire deficiency” approach was not the correct approach as, in this case, the total shortfall was not caused by the directors reckless trading. Rather, they held that the “net deterioration” approach should have been applied. Therefore, as Mainzeal was already insolvent at the time the breaches occurred and due to the fact Mainzeal’s financial position actually improved from the date of breach until the date of liquidation, there could be no “net deterioration”, or rather, no loss to the creditors as a whole which was caused by the directors reckless trading.
New Debt Approach
The Court of Appeal considered whether the “new debt” approach could apply to section 135. This approach considers any new debt incurred following the date of the breach and aims to protect new creditors who engage with already insolvent companies (where the decision to stop trading should have been made). Here, this was not available under section 135 because the duty is owed to the company as a whole, not to individual creditors (section 169(3)(f)). Therefore, any repayments to creditors would need to be made equally to each creditor; as opposed to the new creditors being prioritised.
Breach of section 136
The Court of Appeal found the directors had breached section 136. Although the High Court decided there was a lack of specific evidence, the Court of Appeal stated the directors should not have entered into the four new substantial construction contracts from 31 January 2011. Mainzeal’s financial position made it unreasonable for the directors to believe that the obligations under these contracts could be performed when required. The Court did not consider specific evidence for each of these contracts was necessary. The short term obligations were more complicated. But the Court concluded the short term obligations entered into from 5 July 2012 were also in breach of section 136.
The key take away here is that specific evidence will not be required for each specific obligation for the Court to conclude the directors did not reasonably believe an obligation could be performed when it fell due.
Section 169(3) provides that the duty in section 136 is owed to the company, however, the Court of Appeal held that the “new debt” approach could apply to section 136, as a breach must be treated as “a form of harm to the company.” Therefore, the directors should be liable for new obligations (which are in breach of section 136) from the date of insolvency until the date of liquidation.
The Court of Appeal has referred the amount of damages back to the High Court. The amount claimed by the liquidators is approximately $63.551 million and relies on the “new debt” approach.
Implications of the Decision
1. While directors may take time to consider all realistic courses of action to avoid insolvency, they must do so with caution, seek advice, and address their insolvency issues. They must not simply carry on trading.
2. The “new debt” approach now applies to section 136, but not to section 135.
3. Specific evidence is not required in relation to each obligation for a breach of section 136 to be found.
4. Even if a company is not required to stop trading, if they enter into new obligations which the directors do not reasonably believe will be able to be met by the company when they fall due, the directors may be liable for these.
It should be noted that the Court of Appeal labelled the Company’s Act as unsatisfactory in a number of respects regarding its application to insolvent trading. As such, the Court of Appeal has recommended that the Act be reviewed to ensure that it provides a more “coherent and workable regime for the protection of creditors where directors decide to keep trading when either insolvent or near insolvency.”
If you have any questions in relation to your own business after reading this article, please do not hesitate to get in touch with Anna Fox, Nick Strettell or Melissa Borcoski from the Saunders Robinson Brown team.
The above information is of a general nature only. The information in this article does in no way constitute legal advice and all readers should contact a law firm for advice relating to your specific circumstances.
1. *All references are to the Companies Act 1993.
2. Mason v Lewis 
3. NZLR 225 (CA).