More than 600,000 Kiwi companies risk losing limited liability protection unless they are more cautious when facing financial difficulty, say the lawyers who acted in a landmark Supreme Court case.
The litigation, which focused on Debut Homes Limited (Debut) and the actions of its director Leonard Cooper, is the first time the country's top court has squarely considered directors' duties.
The Supreme Court found that if a company reaches the point where it is clearly not salvageable and continued trading will result in a shortfall to creditors, directors should immediately close or at least ensure creditors fully understand the risks.
The judgment, delivered late last month, may have implications for directors who face economic difficulties due to Covid-19.
It could also have a major impact on other proceedings, including the forthcoming Court of Appeal decision in Mainzeal v Yan, which involves former Prime Minister Jenny Shipley, the lawyers who succeeded in the Debut case said.
Nick Malarao and Phil Shackleton of Meredith Connell, who acted for Debut's liquidators, said directors for all of the country's more than 600,000 companies need to realise the implications of the judgment.
"If your business is in trouble, the judgment means you need to carefully consider whether you should keep on going, and who [this decision] may affect, including the IRD, your bank and others you owe money to," the tax and company law specialist said.
"Unless creditors know what is going on and support you, you cannot keep trading without risking being in breach of reckless trading and other provisions of the Companies Act – and if you breach these provisions, you risk losing limited liability protection."
Malarao, who was a member of the Tax Working Group, added the decision has become even more relevant for directors after the Government's Covid-19 "Safe Harbour" protections ended on September 30.
Shackleton, who acts in banking, finance, and insolvency cases, said the guidance provided by the Supreme Court will help directors and creditors navigate the challenges faced by businesses in the Covid-19 era.
"The judgment encourages collaboration with creditors, and such collaboration should result in fewer companies getting into really serious trouble," he said.
The case: 'It should have stopped trading'
In 2012, Cooper, a residential property developer, decided to wind-down Debut Homes' operations due to financial issues.
While existing developments would be completed but no new developments would be undertaken.
When this decision was made, it was forecasted there would be a deficit of more than $300,000 in goods and services tax (GST) once the wind-down was completed.
Debut was then placed in liquidation in March 2014 on the application of Inland Revenue.
When the case hit the courts, the main issue was whether Cooper had breached his directors' duties under the Companies Act 1993. There was also a debate about whether a general security agreement securing advances by Cooper's family trust should be partially set aside.
In 2018, the High Court initially found he had breached his duties and rejected a defence of reliance on professional advice.
It ordered Cooper to contribute $280,000 towards the assets of Debut and set aside the general security agreement.
However, Cooper challenged the ruling and won, with the Court of Appeal quashing the High Court's orders.
This case was then appealed by Debut's liquidators to the Supreme Court with a hearing held in October last year, before a ruling was issued on September 24 this year.
The bench of Chief Justice Helen Winkelmann, and Justices Joe Williams, Susan Glazebrook, Mark O'Regan, Ellen France unanimously restored the High Court orders.
Cooper was also ordered to pay costs of $25,000.
"Debut was insolvent by the beginning of November 2012. It was unable to pay its debts and continued trading was projected to result in a shortfall of GST of at least $300,000," the judgment reads.
"It should have stopped trading at that point unless a viable formal or informal mechanism was found."
The course of action taken by Cooper, the judges found, meant he was in breach of his
obligations under the law.
"This is because there was a certainty of a loss of at least $300,000 to Inland Revenue.
"Further, at no stage did Mr Cooper revise his strategy, even though the overall trading position was worse than the costings projected in November 2012."
Cooper failed to consider the interests of all creditors and the breach was also exacerbated by his conflict of interest, the court said.
Looking at the wider picture of directors' duties, the judges said if a company reaches the point where continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading will be in breach of s135 of the Companies Act.
"Where there are no prospects of a company returning to solvency, it makes no difference that a director honestly thought some of the creditors would be better off by continuing trading.
"There are alternatives other than liquidation open to directors where continued trading is projected to result in a shortfall."
The full Supreme Court judgment can be read below or at this link.