Companies Act 1993 – ss 135, 136 and 301 – directors’ duties – protection of creditors’ interests – trading while insolvent – reckless trading – substantial risk of serious loss to creditors – duty in relation to obligations – breach of directors’ duties – approaches to quantify loss – proper relief – orders for compensation

Yan & Ors v Mainzeal Property and Construction Limited (In Liq) [2023] NZSC 113.

The collapse of one of New Zealand’s largest construction companies more than a decade ago and the ensuing legal wrangling has culminated in the Supreme Court’s long-awaited decision on directors’ duties.

Mainzeal Property and Construction, known for constructing several landmark buildings throughout New Zealand, including the Supreme Court building in Wellington, was placed in receivership and liquidation in February 2013.

Mainzeal at best generated limited operating profits in the five preceding years. More usually, it ran at a loss. Significantly, the company’s liabilities exceeded its assets from 2005, preventing it from paying its debts as they fell due. This balance sheet insolvency occurred largely because Mainzeal made substantial yet irrecoverable advances to members of a group of companies associated with Richard Yan, one of its directors and the controlling shareholder of the parent company.

From 2009 to 2012, Yan and directors Peter Gomm, Clive Tilby and former Prime Minister Dame Jenny Shipley, allowed Mainzeal to keep trading despite its insolvency because they relied on assurances of support from Yan’s associated companies. While not legally binding, the assurances often came orally from him.

On 29 January 2013, financial support dried up. Yan advised that his associated group of companies would not support Mainzeal. Eight days later, the Bank of New Zealand (BNZ), a secured creditor, appointed receivers. By the end of February that year, Mainzeal was in liquidation. BNZ and preferential creditors were paid fully from the receivership. Unsecured creditors, however, were owed a shortfall of about $110 million.

The liquidators, Andrew Bethell and Brian Mayo-Smith, sued the directors, alleging from January 2011 they had agreed:

• to keep operating in a manner likely to create a substantial risk of serious loss of creditors, in breach of s 135 of the Companies Act 1993 (reckless trading); and
• to the company incurring obligations to creditors when they did not believe on reasonable grounds that Mainzeal could met those obligations when they fell due, in breach of s 136.

Procedural history

Cooke J dismissed the liquidators’ s 136 claim but found the directors traded recklessly by no later than 31 January 2011 (breach date). Compensation of $36m, representing about one-third of the amount owed to unsecured creditors, was awarded.

The directors appealed to the Court of Appeal, as did the liquidators who sought a larger award of compensation for the reckless trading breach and a finding that the directors did breach s 136.

The court agreed with Cooke J. The directors breached s 135 as they had exposed creditors to a substantial risk of serious loss by no later than the end of January 2011. However, that risk did not materialise as there was no “net deterioration” in the company’s position between the breach date and the liquidation date. As the liquidators had failed to establish any loss, compensation could not be awarded.

On the s 136 claim, the court differed from Cooke J: the directors did breach their duty not to incur obligations which they could not reasonably believe Mainzeal would meet. The breach occurred in respect of two sets of obligations and the relevant loss suffered was the amount of the new debts incurred that remained unpaid at liquidation. The Court of Appeal sent the case back to the High Court to determine quantum.

The directors appealed to the Supreme Court, seeking to reverse the findings of liability under both sections or succeed in arguing that the liquidators had failed to establish loss for which the court could award compensation.

The liquidators sought to uphold the findings of liability, cross-appealed the Court of Appeal’s finding on the approach to assessing s 135 losses and asked for compensation to be fixed rather than having this aspect remitted to the High Court.

Supreme Court

The judges were unanimous: the directors breached the Act and were liable for nearly $40m, plus interest.

The court upheld the lower courts’ findings that the directors had, by no later than 31 January 2011, breached s 135 in adopting “a trading policy that was ‘likely to create a substantial risk of serious loss to the company’s creditors’”.

This was because:

• Mainzeal had been trading for many years while balance sheet insolvent;
• external advice was given that additional capital was required, yet such capital was not provided;
• Mainzeal generated little, if any, operating profit from 2008;
• the directors were aware of the company’s precarious financial position; and
• they could not have reasonably relied on assurances of support as sufficiently mitigating the risk to creditors to ensure compliance with s 135.

The court also upheld the Court of Appeal’s finding that the directors were in breach of s 136 in relation to both sets of obligations. While the directors had argued the breaches in respect of the first lot had not been specifically argued or pleaded, the Supreme Court considered they were squarely on the table at trial.

Liability principles

Conscious of the impact of its decision on directors and good governance practice, the Supreme Court outlined the implications of its judgment.

Where a company is insolvent or bordering on insolvency, ss 135-136 are geared at protecting creditors who have an economic interest in the company, which the directors must consider.

Directors have a continuing obligation to monitor their company’s performance and prospects, for failure will breach their duty to exercise the care, diligence and skill of a reasonable director. They should “squarely address” the future of the company if monitoring reveals the potential for substantial risk of serious loss to creditors or doubt as to whether there is a continuing reasonable basis for believing the company can honour obligations it has incurred.

If the potential of either risk is revealed, the directors must decide how best to avoid breaching their obligations. Professional or expert advice from independent sources will help, and directors will be afforded a reasonable amount of time to decide the course of action they should take, whether that is eliminating the risks or managing and mitigating them.

The courts must assess directors’ decisions against a standard of reasonableness, and will recognise that such decisions will involve the exercise of business judgment often in complex, time-pressured situations, on incomplete information and where more than one reasonable course of action is open.

Loss

On the proper approach to quantifying loss under s 135, the court agreed with the directors: “net deterioration”, or how much a company’s financial position has deteriorated between breach and liquidation dates should be used. The measure fell in line with the language of the provision, the court said – the substantial risk of serious loss is directed at creditors generally, not individual creditors. On the facts of Mainzeal, however, the liquidators were not entitled to compensation because no net deterioration, as a result of reckless trading, had been proved.

For s 136 losses, the liquidators’ “new debt” approach was preferred. The provision focused on categories of obligations and losses to particular creditors, the court said. The most logical basis for quantification was the loss those creditors suffered. The court concluded it had adequate information to quantify the s 136 losses, assessing them at nearly $40m.

Relief and culpability

On the issue of relief, the liquidators had applied under s 301 of the Act, which empowers the court to require certain persons repay money or return property as it “thinks just”. The court said the language of the provision meant it was free to tailor relief in ways that responded to particular breaches or wrongs, to the harm that flowed as a result and to the culpability of the directors as between them.

An order imposing on the directors joint and several liability for $39.8m was the “obvious” starting point, the court said. However, said such an award would not be “just”, given the differing levels of culpability between the directors. The court exercised its discretion under s 301 by reference to Cooke J’s assessment of their respective culpabilities.

While the court accepted that Yan had acted honestly, he was “far more culpable” than the other directors. That Mainzeal kept trading while insolvent, which caused the losses to the creditors upon its collapse, was “fundamentally his fault. We see no reason why his liability should be for less than the assessed loss.”

While the former prime minister lent her reputation to Mainzeal, which could form the basis for treating her as more blameworthy than Tilby and Gomm, the court was not prepared to depart from Cooke J’s informed conclusion that the trio were “equally culpable but far less so than Mr Yan”.

The Supreme Court endorsed the Court of Appeal’s view that a review of ss 135, 136 and 301 would be appropriate. The purpose and text of s 301, for instance, were at odds with one another.

While the court had resolved the tension, it said “there remains a more general incoherence in relation to ss 135, 136 and 301 as to distribution of the proceeds of a successful claim…The problems just highlighted are not the only ones that have emerged from our consideration of the present case.”

Applicable principles: likelihood of a substantial risk of serious loss to creditors – whether it was reasonable for directors to continue trading while balance sheet insolvent – whether relying on assurances of support from sister companies was reasonable – whether the directors squarely addressed the company’s financial position – whether directors incurred obligations on reasonable grounds that the company could honour them – quantifying loss – net deterioration or new debt – scope of s 301 discretion – culpability.

Held: The directors’ appeal failed; the liquidators’ cross-appeal is allowed to the extent the directors must contribute $39.8m, plus interest, to Mainzeal’s assets.

Yan must pay the full amount and Dame Jenny, Tilby and Gomm are each directed to pay one-sixth of the total, rounded down to $6.6m. More than 10 years’ interest was added and $65,000 in costs was awarded.

Yan & Ors v Mainzeal Property and Construction Limited (In Liq) [2023] NZSC 113.