Supreme Court clarifies duties of directors to protect creditors from insolvency risks
28 Nov 2023
In Yan v Mainzeal Property and Construction Limited (in liquidation),(1) the Supreme Court drew to a close the long-running proceedings that arose out of the liquidation of Mainzeal Property and Construction Limited (in liquidation) (Mainzeal). In doing so, the Court provided clarity on the extent of director's duties under sections 135 and 136 Companies Act 1993 (the Act), when those duties will be owed to creditors and how losses for breaches of those duties will be compensated.
In the early 2000s, Mainzeal was one of New Zealand's largest construction companies. Its name adorned construction sites across New Zealand. Yet its apparent success belied the fact that transactions with related companies had left it financially exposed. It was operating on fine margins and, from 2005, was balance sheet insolvent – a fact that was not apparent from its financial statements. Its situation was compounded from 2009 onwards by mounting leaky building claims.
By early 2013, promises of support from Mainzeal's wider group were proven to be illusory. In February of that year, Mainzeal was placed into receivership with liquidation following shortly thereafter. After payments to secured and preferential creditors, unsecured creditors were faced with a shortfall of $110 million. In 2015, Mainzeal's liquidators brought proceedings under section 301 of the Act against Mainzeal's directors. The claims included the following:
- In breach of section 135 of the Act, the directors(2) had agreed to, caused or allowed Mainzeal's business to be carried on in a manner likely to create a substantial risk of serious loss to its creditors.
- In breach of section 136 of the Act, the directors had allowed the company to incur obligations when they did not believe on reasonable grounds that the company would be able to perform those obligations when it was required to do so.
At first instance,(3) Cooke J dismissed the section 136 claim because, in part, the pleadings did not set out the specific obligations that were the subject of that alleged breach. The directors were, however, found to be in breach of the duty in section 135 and ordered to pay $136 million in compensation.
Court of Appeal
The Court of Appeal held that the directors had breached the duties in sections 135 and 136.(4) However, it did not consider that the loss under section 135 had been established on the evidence and found that it did not have sufficient information to determine the compensation payable under section 136. It referred the issue of compensation for the section 136 breach back to the High Court.
The Supreme Court considered legislative history of, and case law authority on, the provisions at issue in detail. From that analysis, the Court found that the approach to both duties is coloured by the following considerations:
- The legislature had favoured protection of creditors over the competing policy consideration of leaving judgements regarding business risk to directors.
- Directors of companies of doubtful (or worse) solvency must consider the interests of creditors – who will, at that point, have a greater economic interest in the affairs of the company.
- In contrast to the position in the United Kingdom, liability under sections 135 and 136 can arise well before liquidation becomes an inevitability. A long-term strategy of trading while balance sheet insolvent will generally not be acceptable.
The Court held that the proper approach to determining whether section 135 had been breached required a court to engage with two distinct questions:
- Had the business of the company been carried on in a manner likely to create a substantial risk of serious loss to its creditors? This had to be approached objectively, so the director's subjective awareness of the risk was irrelevant.
- Were the directors, in agreeing to, causing or allowing that course of trading, in breach of section 135? This had to be determined by referring to the facts and circumstances that the directors were or should have been aware of.
The touchstone is reasonableness. Ultimately, the question is not whether the directors appreciated the risk, but whether they should have appreciated the risk.
As to the second question, Court said that the level of care, skill and diligence that the law requires should be considered in context. It will vary according to the complexity of the company. In addition, the identification by directors of a potentially substantial risk does not necessitate an immediate cessation in trading. Rather, directors are entitled to take stock and seek advice as to whether there is a way forward. The amount of time appropriate to do this is determined by what is reasonable in the circumstances.
Applying those tests, the Court found that the directors of Mainzeal had not acted reasonably and were liable under section 135:
- They had not pursued issues regarding Mainzeal's solvency to their conclusion.
- At a governance level, the board had not focused on the broad strategic issues faced by the company, which was compounded by a lack of external advice.
- Their reliance on unenforceable assurances of support from the wider group was unreasonable.
The Court held that section 136 should be construed in accordance with its ordinary meaning. That meaning, the Court said, did not require a plaintiff to identify a particular obligation, it can apply to a course of trading.
The Court agreed with the Court of Appeal that, from July 2012, the directors had allowed Mainzeal to incur obligations that they did not have reasonable grounds to believe it would be able to meet.
Turning to compensation, the Court held that, generally, the proper approach to determining recoverable losses under section 135 was the net deterioration in the financial position of the company between the dates the duty was breached and liquidation. The Court said this approach was consistent with previous authority and the focus in section 135 on creditors as a class. The Court cautioned that there will be circumstances where another measure of loss will be more appropriate.
In this instance, the Court said that the liquidators could not prove the loss on a net deterioration basis and, accordingly, no relief would follow.
Under section 136, however, the position is different. The Court said that as the provision is focussed on obligations to creditors, quantifying loss on new debt basis was justified. This means that the loss should be quantified by determining the gross amount of debt that was taken on in breach of section 136 and that remained unpaid at the date of liquidation.
Due to concessions made by the liquidators, the Court was able to quantify that loss at $36 million. The Court found that it was more likely than not that the losses for which compensation can be awarded exceeded the amount claimed.
The Court addressed the scope of its discretion to award compensation.(5) The Court confirmed that, in awarding compensation, it was proper to consider the breach, the harm caused by the breach and, at least to some extent, the culpability of the director. However, the Court held that, generally, directors in breach should carry the full weight of the losses and that the discretion will likely be reserved for apportioning liability between directors.
In exercise of the discretion, the Court found one director, Richard Yan, liable for the entire $36 million. The other directors each had their liability capped at $6 million.
At the heart of the Court's decision was the tension between creditor protection and allowing directors freedom to take business risk. The Court held that the legislature, in enacting sections 135 and 136, had resolved that tension in favour of creditor protection.
On one view, this could result in the risks identified by the Court playing out in New Zealand's economy – that the imposition of stricter duties could result in an increase in unnecessary liquidations and a reduction in the pool of people willing to become directors. That rigour is, however, moderated by:
- The certainty provided by the clear practical guidance provided by the Court.
- The contextualisation of the reasonableness test under section 135 – the obligations lessen as the size and complexity of a company decreases.
- If a company is experiencing acute financial distress, directors are entitled to take stock of their position before they will be considered to have breached their duties.
- The ability of a court to consider culpability and other more proximate causes of a company's failure in exercising the discretion under section 301.
In any event, the knowledge that directors are obliged to consider creditor interests, may increase the likelihood of prospective creditors trading with firms experiencing financial difficulty.
Either way, it is an area ripe for legislative reform. The Supreme Court joined with the Court of Appeal in expressing its view that a review of the provisions addressed in the judgment would be appropriate.
(1)  NZSC 113.
(2) Sir Paul Collins, one of the directors, was not named in either the section 135 or 136 claims by the time of the first instance hearing.
(3) Mainzeal Property and Construction Ltd (in liq) v Yan  NZHC 255.
(4) Yan v Mainzeal Property and Construction Ltd (in liq)  NZCA 99,  3 NZLR 598.
(5) The Act, section 301: the Court can award compensation that it "thinks just".