Mark O'Brien: Reckless beyond just risky

COMMENT

The prospect of being held personally responsible for a company's debts, especially to the tune of $7 million, would raise concerns among even the most experienced of company directors.

On February 12 South Pacific Shipping director Klaus Loewer was found liable by the High Court for reckless trading and ordered to pay $7 million to the company's liquidators, the highest award of its kind in New Zealand.

Only a few weeks earlier, the directors of DML Resources settled a claim by the company's liquidators for another multi-million dollar sum.

Reports of these events may have left many questioning their understanding of a director's liability. Where does legitimate risk-taking end and reckless trading begin in the eyes of the court?

Legally speaking, most directors can relax. There will no doubt be closer scrutiny of directors' actions and a trend towards higher standards in the post-Enron environment, and the SPS judgment itself demonstrates that the court will be willing to award significant sums against errant directors where appropriate.

Nevertheless, reckless trading is not the norm and, even where it does occur, it can be very difficult to establish.

The SPS judgment does not lower the threshold of the existing law on reckless trading. It simply reflects the exceptional circumstances of the particular case.

The judgment endorses good business practice, and, if anything, provides reassurance for directors that if they run their companies in a proper manner then they are unlikely to face this kind of legal action.

Limited liability encourages enterprise by facilitating and promoting the taking of business risks.

There is, however, a balance that needs to be struck.

Companies legislation seeks to achieve this balance primarily by imposing two particular duties on directors. The first, and the one at issue in the SPS case, is a duty not to allow the company to carry on business "in a manner likely to create a substantial risk of serious loss to the company's creditors".

The second is a duty not to allow the company to incur an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when required.

The provisions that impose these duties (sections 135 and 136 of the Companies Act 1993) are generally known as the "reckless trading" provisions.

They have been criticised as clumsy, ill-defined and vague and therefore difficult to apply in practice. Perhaps, but the general intention is clear enough.

It is to guard against excessive risk-taking, or recklessness, with what is, in effect, creditors' money rather than company capital.

The SPS judgment casts the distinction between acceptable and unacceptable conduct in terms of "legitimate" and "illegitimate" risk-taking behaviour.

So, what is illegitimate risk-taking behaviour? While the answer will depend on the circumstances of each case, the SPS judgment helps explain the term.

First of all, the reckless trading provisions are directed at the risk of loss to the company's creditors, not its shareholders (for whom other director duties are more applicable).

Therefore they apply most readily where the company is insolvent, as was SPS, or near insolvent.

Even then, the law does not require a company immediately to cease trading just because it is balance-sheet insolvent.

Indeed, it may be better to trade on if there is a reasonable prospect of the company trading out of its difficulties.

However, directors of a company facing insolvency should address the reasons for the insolvency and ensure that there are carefully considered recovery strategies in place, and a good prospect of actual recovery before they choose to trade on.

They must also regularly monitor the position and close the business promptly if there is no improvement. The time allowed for improvement in most cases has been limited to a matter of months at most. In the SPS case, the directors traded an insolvent company for almost six years. Directors should also at least consider keeping the creditors fully informed.

In SPS, creditors were far from fully informed.

Directors should also follow proper and orthodox commercial practices. They should, for example, ensure that business plans are in place, that risks are identified and monitored, that budgets and projections are regularly assessed against actual results, that regular and formal meetings are held and that proper records are maintained. They should also take, and take heed of, professional advice where appropriate.

Conflicts of interest must be recognised, disclosed and properly managed.

Finally, directors will not necessarily be saved by their subjective assessments or intentions. Objective standards will be applied. In SPS, Loewer said he believed there was no serious risk of insolvency because he considered he himself would be able to provide sufficient funds if required to ensure continued trading.

Justice Young described this as a "flimsy basis for continuing to trade". Unlike a capital injection or contractual commitment, it left the company and its creditors completely exposed to the risk that Loewer might change his mind.

The SPS judgment was made under the former companies legislation but is nevertheless applicable to the interpretation of the current law. That law imposes a duty not to allow "a substantial risk of serious loss to the company's creditors". Some commentators and judges prefer a literal approach which some suggest provides no obvious scope for allowing for the sort of considerations which make the taking of significant business risks legitimate.

Justice Young's answer to this is to distinguish between legitimate and illegitimate risk-taking behaviour, and to view only the latter as constituting a breach of duty. This allows for the section to apply in a sensible way.

The SPS judgment provides a timely reminder of the need for directors to act in the best interests of the company. Where solvency is an issue, this means they must also have regard to the interests of creditors and ensure good standards of governance are applied.

* Mark O'Brien is a litigation partner at Bell Gully, and represented PricewaterhouseCoopers, the liquidators of SPS, in the case described in this article.