As we find ourselves well past the midway point of 2023, the second half of the calendar year promises to bring further economic challenges and potential volatility for some businesses. This outlook may be influenced by uncertainty surrounding the impact of recession in New Zealand, global geopolitical instability, and the fast-approaching election. In situations where businesses are at increased risk of trading close to insolvency, it is natural for directors to seek a heightened understanding of the actions they can take to safeguard themselves from potential personal liability should things go wrong.
As directors will be aware, they are subject to a number of duties under New Zealand’s Companies Act. These include (among others):
Section 131: to act in the best interests of the company (and where near insolvency, this is taken to include the interests of creditors).
Sections 135 and 136: not to carry on business in a manner that is likely to create a substantial risk of serious loss to creditors, and not to agree to obligations without reasonable grounds for believing the company will be able to perform those obligations when due.
Fortunately, recent case law is useful in alleviating some anxiety felt within the director community, particularly when it comes to understanding a director’s obligations in situations where businesses may be on the brink of insolvency. Additionally, there is anticipation surrounding the pending appeal outcome regarding the Mainzeal case, which may provide further clarity on related matters.
Debut Homes
This decision has been the subject of much reporting, however the key takeaway is that when a company reaches the point where it is clearly not salvageable and continuing to trade will result in a shortfall to creditors, then directors will be in breach of their duties if they keep the business trading. This applies even if continued trading could result in higher returns to some creditors than if the company was immediately placed in liquidation.
In this situation, the statutory priorities for creditors apply, and an independent insolvency practitioner is most likely best placed to address the issues.
Sequana
Recently, the UK Supreme Court issued a significant ruling in relation to the duty of directors to act in the best interest of the company (similar to that of section 131 in New Zealand). The Court clarified that as the company approaches insolvency, directors must also consider the interests of the company’s creditors.
While the exact point at which the consideration becomes relevant remains uncertain, the Sequana case provides some guidance by indicating that when directors know, or ought to know, that the company is insolvent or approaching insolvency, they need to have regard to creditors’ interests (while still balancing those of the shareholders). As the company’s position deteriorates, the balance shifts in favour of the company’s creditors. Eventually, when there is no light at the end of the tunnel, the creditors’ interests become paramount. In New Zealand this “trigger point” currently ranges from “no possibility of salvage” in Debut Homes, and “in a vulnerable state” in Mainzeal, but may be further clarified when the decision on the appeal is released.
Mainzeal
Up to this point, the Mainzeal case, which has been extensively covered, is consistent with the above. The Court of Appeal found that a decision to continue to trade is likely to breach the insolvent trading duties unless the manner in which the directors choose to trade has realistic prospects of enabling the company both to service pre-existing debt, and to meet new commitments arising from ongoing trading - essentially leading to a return to solvency.
However, the Supreme Court is due to shortly release its decision in relation to the appeal by the directors of Mainzeal that was heard in March 2022. The directors appealed on the basis that they should only be liable, if found to have acted irrationally, and should be given a wide range of discretion to manage the company as they see fit where the company is faced with threats of insolvency. Conversely, the liquidators argued that to avoid liability, the directors would need to show they reasonably believed they could return the company to solvency when entering into further transactions.
This decision is expected to provide clearer guidance to directors in terms of what is expected of them in insolvency situations. This will be particularly important in the challenging economic environment ahead. It should also further clarify how to approach compensation for breach of the director duty provisions in the Companies Act.
Key Takeaways
Pending any clarification from the Mainzeal decision, what should directors do to protect themselves if they are concerned as to a company’s solvency? Our key recommendations are:
If you are a director of a company that is struggling financially, you must face up to the company’s financial position quickly and seek professional advice. Do not just optimistically trade on without undertaking a proper assessment.
When you are incurring obligations as a company, you must ensure there is a reasonable basis and expectation that the company will be able to satisfy those obligations.
Where the company’s financial position may be precarious, you should consider the risk of any loss to creditors and whether the insolvency mechanisms in the legislation are appropriate.
A decision to continue to trade should be made only where supported by a thorough assessment of the potential consequences of doing so, and a fair assessment that the company has reasonable prospects of servicing both its existing and future debts.
If there is no hope of returning to solvency, then you must cease trading.
At PwC Legal, we provide governance advice to both directors and companies. We also have access to a range of professionals within PwC who are able to provide financial advice to businesses when they are facing difficulty.
If you would like to discuss any of the matters outlined in this article, please get in touch.
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