Director’s Duties: Three Things To Take From The Debut Homes Ltd Decision

Background

Mr Cooper was the sole director of Debut Homes Limited (“Debut”), a residential development company placed into liquidation in 2014.

Prior to its liquidation, in 2012, Mr Cooper sought advice from the company’s accountant. At that time, Mr Cooper was aware that money would be due to be paid to the IRD for output tax on the sale of two properties. His forecast for the development and sale of properties still owned by Debut showed a surplus of $170,000, but this did not account for interest costs or for GST payable on the sales.The accountant at that meeting told Mr Cooper that the GST deficit would be over $300,000.Despite this Mr Cooper allowed the completion of four properties on the basis that, as a whole, the creditors would be better off than if the company ceased trading prior to developing the remaining properties. Repayments were made to secured creditors which were personally guaranteed by Mr Cooper and his trust. However, none were paid to the IRD for the GST liability.

At the liquidation date, there was GST owing of $450,099 (including interest and penalties of $84,000), money owed to trade creditors and a debt to Mr and Mrs Cooper.The liquidators and the company in liquidation made a claim against Mr Cooper and his trust.

The High Court held that Mr Cooper breached his duties and ordered him to pay $280,000 to the company’s liquidators and creditors to cover some of the shortfall. The Court of Appeal reversed this decision and, in doing so, said Mr Cooper made a “perfectly sensible business decision” that had the potential to benefit some of its creditors because, whether or not they completed the properties, there would still have been a shortfall. 

Issues

The Supreme Court looked at whether Mr Cooper breached his duties as a director under the Act namely to:

• not cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors (s 135 – Reckless trading).

• not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so (s 136).

• act in good faith and in what the director believes to be in the best interests of the company (s 131).

Outcome

1. Continuing to trade when a shortfall is inevitable and the company is not salvageable is reckless trading, even if it will provide higher returns to some creditors than immediate liquidation. 

The Supreme Court concluded that:

• Completing the properties would not benefit the IRD because, despite the increase in GST payable, Mr Cooper showed no intention or ability to ever pay the GST on the sales of properties.

• It was not an answer to say that completing the properties was a sensible business decision as it would benefit some creditors because it is not appropriate to compartmentalise creditors in this way.

• There is nothing in the wording of s 135 that envisages a comparative exercise between immediate liquidation and continued trading where continued trading would still result in a deficit.

• Loss to creditors in this case was not merely a “substantial risk”, it was a certainty.

2. If the only way to ensure higher returns to some creditors is by incurring new liabilities to other creditors that will not be paid this will likely result in a breach of s 136.

The Supreme Court concluded that:

• It was inappropriate to put a gloss over s 136, rather a literal interpretation should be taken.  

• It is not legitimate to enter into a course of action to ensure some creditors have a higher return where this is at the expense of incurring new liabilities which will not be paid; in other words, it is not legitimate to “rob Peter to pay Paul”.

• There was no evidence to suggest Mr Cooper’s knowledge there would be a GST shortfall was inaccurate, as nothing occurred after the point in which he obtained this knowledge.  Mr Cooper breached his s 136 duty by entering into a sale and purchase agreement, knowing that it would incur a further GST obligation with this knowledge.

3. In an insolvency situation, you need to consider the interests of all creditors and put the company’s interests before your own.

The Supreme Court concluded that:

• Mr Cooper believed that completing the properties would provide higher returns to some creditors.  However, he failed to consider the interests of all creditors in an insolvency situation and incurred debt knowing it would not be paid, which was a breach of the duty under s 131(1).

• This was exacerbated by the fact he acted in his own interest and in direct conflict with Debut’s best interests when he sought to pay off the secured debt, ultimately reducing his own guaranteed liability and that of the trust instead of satisfying the company’s GST and incurred obligations.

Conclusion

This decision is significant as it demonstrates how directors can be liable for the choices they make for a company in financial difficulty and emphasises the importance of considering other options provided for in the Act for insolvent or near-insolvent companies rather than continuing to trade. 

Disclaimer

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.