Risky business - Mainzeal and directors' duties
August 2023
An important decision
The Supreme Court’s recent decision in Yan v Mainzeal Property and Construction Limited (in liq)[1] begins with the statement:
The issues in this appeal are of fundamental importance to the business community. They involve the scope and application of duties under ss 135 and 136 of the Companies Act 1993 (the 1993 Act) — provisions that address the interests of creditors — and how compensation for breach of these duties should be assessed.
A fair assessment.
The scene is set
The litigation arose from the ashes of the 2013 failure of a large construction company. The liquidators pursued the directors for a shortfall of about $110m owed to unsecured creditors. With a former Prime Minister (Dame Jennifer Shipley) in the cross hairs as one of the directors, the case has attracted more than its fair share of publicity.
Section 135 / Reckless trading
Section 135 prohibits reckless trading by a director in the following terms:
A director of a company must not—
(a) agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors; or
(b) 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.
Eschewing both a fully subjective and a fully objective interpretation, the Supreme Court opted for a negligence based interpretation sitting in the middle of the continuum[2]:
(a) An objective approach is to be taken in determining whether the business of the company was carried on in the prohibited manner (so that subjective awareness of the likelihood of substantial risk or serious loss is not necessary).
(b) However, when assessing whether the actions of the directors in agreeing to, or causing or allowing that trading were in breach of s 135, the courts will proceed on the basis of those facts and circumstances of which the directors were aware, or should have been aware, if exercising appropriate care, skill and diligence. The reference to “business judgment” in the long title of the 1993 Act is consistent with a focus on the reasonableness of the directors’ actions on the basis of the material they had, or should have had, if exercising the required standard of skill, care and diligence.
(c) As to the levels of care, skill and diligence required, the more complex the company the higher the level of skill and diligence expected of a director. …
The directors were in breach of s 135 given the perilous finances of Mainzeal from at least 31 January 2011 onwards and the lack of “a substantial injection of capital or assurances of support on which reliance could reasonably be placed” which in turn posed “a likelihood of substantial risk of serious loss to creditors”[3].
Section 136 / Duty not to incur obligation unless director has reasonable grounds to believe it can be performed
Section 136 states:
A director of a company must 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.
When construing “believes at that time on reasonable grounds”, the Supreme Court opined that something less than conviction and something more than “hopes” was required[4]:
Looked at in this way, we consider that s 136 is premised on the basis that directors ought not to commit a company to obligations unless confident on reasonable grounds that they will be honoured.
The Court also clarified that s 136 is not to be confined to obligations of a particular kind and may be invoked in relation to a course of trading to which the director has agreed[5].
Having crafted its club, the Court set about beating the directors with it[6]:
We have already made findings that as at 31 January 2011 the manner in which the directors allowed Mainzeal to trade exposed creditors to a substantial risk of serious loss. We do not rehearse all of the factual findings, but what is clear from the narrative set out above is that after 31 January 2011 the directors did not have reasonable grounds to believe that Mainzeal would, in the medium to long term, be able to pay its debts. Each of the four major projects involved Mainzeal incurring medium to long-term obligations. It follows that when the directors agreed, as they did, to Mainzeal entering into the obligations associated with the four major projects they did not have reasonable grounds to believe that those obligations would be honoured. Therefore, the liquidators’ claims in relation to the four major projects and associated obligations are made out.
Quantifying a claim under ss 135 & 136
Three possible measures were discussed:
(a) Entire deficiency – the total amount of the unpaid debt;
(b) Net deterioration – the extent, if any, that the financial position of the company deteriorated between breach and actual liquidation dates; and
(c) New debt – gross debt taken out in breach of ss 135 / 136 which remains unpaid at date of liquidation.
Section 135
Agreeing with the Court of Appeal’s assessment, the Supreme Court endorsed a net deterioration approach, provided the applicable counterfactual is liquidation / cessation of trading at the breach date[7]. It outlined possible alternatives in different scenarios[8]:
Measures of loss other than net deterioration may be necessary, or appropriate, where:
(a) the breach of s 135 is itself the cause of the company’s failure, in which case the entire deficiency may be the basis of the award;
(b) the records of the company do not enable its affairs as at the breach date to be adequately reconstructed, in which again entire deficiency may be the measure of loss; or
(c) the director has acted in breach of s 135 and derived a benefit from having done so, in which case compensation can be calculated by reference to the value of benefit illegitimately obtained (disgorgement)
The net deterioration approach will require complicated forensic assessment (really expensive and uncertain calculations, in simple terms) when dealing with the failure of complex and substantial companies – a consequence squarely acknowledged by the Supreme Court[9]:
We accept that insistence on a net deterioration approach can lead to practical difficulties. This is especially so in litigation concerning the failure of substantial and complex companies. In the case of such companies, it will often be difficult, to the point sometimes of being impracticable, to establish with any confidence the financial position of the company at breach date. There may be, as here, a number of possible breach dates. On a net deterioration approach, there will have to be a complex notional liquidation assessment in respect of each breach date. There will also always be the possibility that the court will pick another breach date (as the Court of Appeal did here in relation to s 136). Each calculation will involve an extremely difficult, uncertain and expensive exercise. The practical requirement for a number of such exercises means that there will be much wasted expenditure. The alternative of split trials as to liability and quantum (with a first trial to determine breach date and a second to assess quantum) is likely to prove problematic (and expensive) in practice.
In Mainzeal, the liquidators did not challenge the Court of Appeal’s finding that a net deterioration had not been proved on the facts. So they recovered no damages under s 135.
Section 136
Reasoning that s 136 is more directed towards the incurring of obligations to creditors rather than the risk posed by the general conduct of the business, the Supreme Court endorsed a “new debt” method of quantifying breaches of s 136[10]:
As will be apparent, we accept that the duty under s 136 is owed by the directors to the company. However, for the reasons we have explained, we are satisfied that relief calculated by reference to the losses to creditors is available. This can be rationalised on the bases either that in this instance, the loss to the creditors is to be treated as a loss to the company or, more generally, because a new debt approach accords with the purpose of the legislature and in particular, is consistent with s 301. It is also consistent with our adoption in this case of a net deterioration approach in relation to s 135, loss so calculated corresponds to the loss to the creditors as whole. Accordingly, we conclude that the Court of Appeal was correct to direct compensation in relation to s 136 on a new debt basis as such an approach best responds to the harm caused by the breaches of s 136.
Divining a robust “loss” under s 136
The liquidators’ evidence provided a starting point of $75.2m:
(a) liabilities in relation to four major projects: $31.5 million
(b) additional subcontractor claims: $34.2 million
(c) trade creditors: $9.5 million
TOTAL: $75.2 million
Third party advances which were not claimed in the liquidation reduced this total by $11.7m, to $63.5m, the amount claimed in the Court of Appeal. That Court identified several issues precluding its ability to quantify a recoverable figure[11]:
[535] It seems likely that a substantial proportion of this figure is represented by obligations in respect of which we have found the directors liable under s 136: claims by principals (or bond providers who have indemnified those principals) in respect of the four significant construction contracts entered into after 31 January 2011, subcontractor retention claims in respect of those contracts, and claims in respect of obligations incurred from 5 July 2012 onwards. But we do not have sufficient information to determine that issue.
[536] The liquidators’ figures also do not appear … to include any allowance for dividends paid or payable to the relevant creditors from other recoveries in the liquidation. We consider that only the net deficit to relevant creditors after 31 January 2011, after making an allowance for all payments received by them before liquidation or during the liquidation (other than, of course, as a result of these proceedings), can be recovered for breach of s 136.
[537] The liquidators’ figures also do not, as we understand the position, make any allowance for interest since the date of liquidation, and may not make any allowance for interest at all.
[538] We are not in a position to determine the figure that is potentially recoverable for breach of s 136, in light of the outstanding issues identified above … The determination of that figure will need to be referred back to the High Court.
After a clearly signalled reluctance to have the matter referred back, the liquidators made several concessions to the amounts claimed. By building in this “safety buffer”, they were able to convince the Supreme Court to carry out the quantification exercise. It landed on a figure of $39.8m[12]:
For the reasons just given, we are satisfied that we can calculate compensation on the basis proposed by the liquidators — we are satisfied that it is more likely than not that the losses for which compensation can be awarded exceed the amount now claimed. Indeed, we are of the view that this figure provides a considerable margin of comfort. The allowance proposed by the liquidators for dividends to be received (approximately $5.6 million) is generous. More significantly, the deduction from the amount claimed of the retentions figure of $18.1 million resolves, by a comfortable margin, not only all uncertainties in relation to retentions in favour of the directors but also any remote possibility of injustice to the directors in relation to other aspects of the calculation (for instance, the possibility that some trade or subcontractor debts included in the new debt calculation were incurred before 5 July 2012).
[318] To put all of this in figures, we reduce the figure claimed in the Court of Appeal of $63.5 million by $18.1 million for retentions and $5.6 million for likely dividends producing a final figure of $39.8 million.
Section 301
The preceding analysis set the highwater mark of $39.8m for any award to the liquidators. The task
of the Supreme Court was to determine under s 301, whether any such award should be for less
than $39.8m and how any award was to be apportioned between the directors.
Section 301 reads:
301 Power of court to require persons to repay money or return property
(1) If, in the course of the liquidation of a company, it appears to the court that a person who has taken part in the formation or promotion of the company, or a past or present director, manager, administrator, liquidator, or receiver of the company, has misapplied, or retained, or become liable or accountable for, money or property of the company, or been guilty of negligence, default, or breach of duty or trust in relation to the company, the court may, on the application of the liquidator or a creditor or shareholder,—
…
(b) order that person—
(i) to repay or restore the money or property or any part of it with interest at a rate the court thinks just; or
(ii) to contribute such sum to the assets of the company by way of compensation as the court thinks just; or
(c) where the application is made by a creditor, order that person to pay or transfer the money or property or any part of it with interest at a rate the court thinks just to the creditor.
In a previous decision, the Supreme Court observed that relief under s 301 can be “compensatory or restitutionary in nature and must take account of all the circumstances, including the nature of the breach or breaches, the level of culpability of the director, causation, duration of the breach, holding the director to account and reversing the harm to the company”[13].
In Mainzeal, the Supreme Court rejected a strict tort approach to awarding damages without the possibility of substantial adjustment as “a blunt instrument capable of producing injustice”[14]. Instead, discretionary remedialism comes to the fore:
Further, there may conceivably have been something equivalent to contributory negligence or conscious risk taking on the part of creditors (insufficient to exclude liability altogether) or some other factor that might warrant allowance that is most conveniently provided by the exercise of a discretion;[15]
It will be recalled that the discretion under s 320 of the 1955 Act was said to involve an assessment of causation, culpability and duration. On our approach, causation is assessed separately, with the losses attributable to the breach setting a cap on the compensation that can be awarded. Duration might be thought to be a component of culpability. We accept that “limited” culpability may be a basis for awarding less by way of compensation than the losses caused by the breach. However, the starting point for assessing compensation will be those losses. As well, compensation for the full extent of such losses is not reserved for cases in which the breach of duty was egregious. Rather it should be regarded as the norm; this on the basis that the relevant culpability standard is that provided for by the legislature. Culpability assessment is likely to be most relevant when it comes to fixing the incidence of liability between directors;[16]
For the reasons just outlined, we consider that flexibility in remedial response for breach of ss 135 and 136 is appropriate to respond to facts of particular cases, making it appropriate for the courts to be free to tailor relief in ways that respond to the particular breach or wrong, to the harm that flows from that and, at least to some extent, the culpability (particularly amongst themselves) of the directors[17].
Apportionment
The final result saw an order that the directors contribute $39.8m to the assets of Mainzeal, with the liabilities of Dame Shipley and Messrs Tilby and Gomm limited to $6.6m plus interest each. Director Yan fared much worse, being liable for the entire amount.
Whilst accepting that all the directors had acted honestly[18], the Supreme Court exercised its discretion based on the assessments of relative culpability made in the High Court[19]:
We see Mr Yan as far more culpable than the other directors. From the time when the directors’ obligations to Mainzeal required them to have at least substantial regard for the interests of creditors, his interest as the representative of the shareholder of Mainzeal created a potential conflict. Furthermore, in a practical sense, the assurances the other directors relied on came from him. If he was not in a position to ensure that the assurances were honoured by the parties who formally gave them, they should not have been given. If he was in a position to ensure that assurances were honoured, then they should have been honoured. As well, his actions in the events that immediately precipitated the collapse of Mainzeal were in stark contradiction to the spirit of the assurances. That Mainzeal continued to trade while insolvent and in this way caused the losses to the creditors at the time of its collapse is fundamentally his fault. We see no reason why his liability should be for less than the assessed loss.
As to the relative culpability of the other directors, counsel for the liquidators may be right that Dame Jenny lent her reputation to the company and that, therefore, there might be some basis for treating her as more culpable than Messrs Tilby and Gomm. Nevertheless, on what is ultimately a matter of impression, Cooke J, who saw and heard all the directors, was better placed than we are to assess relative culpability. We are not prepared to depart from his conclusions, effectively, that they were equally culpable but far less so than Mr Yan.
Concluding remarks
After grabbing the headlines with a large damages award against several directors including an ex-Prime Minister, Mainzeal may well be a cause of consternation for those around the boardroom table. The final outcome has served to weaponise ss 135 and 136 of the Companies Act and they become useful additions to a liquidators’ armamentarium in conjunction with s 301.
A director overseeing the business of a company will need to engage with risk all the time. Superficially, the Supreme Court’s judgment may be seen as stifling the risk taking behaviour required to be successful in the business world. However, on closer analysis it is clear that liability will not attach:
under s 135 if, on an objective assessment, a director brings the levels of care, skill and diligence required; and
under s 136 if a director is confident on objectively reasonable grounds that a company’s obligations will be met.
It seems appropriate to end on a quote cited by the Supreme Court from Clarke and Sheller JJ in Daniels v Anderson in the context of the common law duty of care:
A person who accepts the office of director of a particular company undertakes the responsibility of ensuring that he or she understands the nature of the duty a director is called upon to perform. That duty will vary according to the size and business of the particular company and the experience or skills that the director held himself or herself out to have in support of appointment to the office. None of this is novel. It turns upon the natural expectations and reliance placed by shareholders on the experience and skill of a particular director.
[1] [2023] NZSC 113; [2] At [211]; [3] At [234]; [4] At [244]; [5] At [249]; [6] At [256] [7] At [282]; [8] Ibid; [9] At [284]; [10] At [296]; [11] [2021] NZCA 99; [12] SC decision at [317] – [318]; [13] Madsen-Ries (as liquidators of Debut Homes Ltd (in liq)) v Cooper [2020] NZSC 100 at [182]; [14] SC at [348]; [15] At [349]; [16] At [350]; [17] At [351]; [18] At [352]; [19] At [357]