The long-awaited Supreme Court decision in the Mainzeal case has arrived—and while it is good news for creditors, the decision will not provide much comfort for directors facing uncomfortable choices around distressed companies.

The Supreme Court agreed that the Mainzeal directors breached their duties and must contribute NZ$39.8 million plus interest to Mainzeal’s assets. Mr Yan is liable for the entire amount plus interest, while the other directors are liable for NZ$6.6 million each, also with interest. The Court’s decision largely supports the findings made by the High Court and Court of Appeal. 

While Mainzeal’s liquidators and creditors will no doubt be pleased with the result, the Court’s judgment offers little relief—or new guidance—for directors.

Background

Before its collapse, Mainzeal was one of New Zealand’s largest construction companies. In 2013, Mainzeal went into receivership and liquidation owing around NZ$110 million to unsecured creditors. The liquidators of Mainzeal brought proceedings against the directors, alleging (among other things) that the directors had breached sections 135 (reckless trading) and 136 (duty in relation to obligations) of the Companies Act.

The High Court concluded that the directors were in breach of section 135 and were potentially liable for the full loss of the company on insolvency. In exercising its discretion under section 301, the Court awarded compensation of NZ$36 million, which was the largest award for reckless trading in New Zealand history at the time. Both parties appealed.

The Court of Appeal found the directors breached both sections 135 and 136 by trading on as usual despite Mainzeal’s unstable financial position. The Court expanded the interpretation of section 136 to apply to classes of obligations or to all obligations entered into after a particular date. The Court concluded there was no loss from the directors’ breach of section 135 as there was no net deterioration in Mainzeal’s position, but that compensation should be awarded under section 136 under the new debt approach.

The Mainzeal directors applied for leave to appeal to the Supreme Court, challenging the finding of liability under sections 135 and 136, and arguing that the liquidators had not established loss. The liquidators cross-appealed the decision to refer the assessment of quantum of damages back to the High Court and challenged the finding that no loss stemmed from the breach of section 135.

Supreme Court decision

The key issues addressed by the Court were:

1. Did the directors breach section 135?

2. Did the directors breach section 136?

3. If the directors did breach either of these sections, how should loss be calculated?

4. What orders for compensation should be made?

The Court decided that:

• The directors did breach section 135. Mainzeal was balance sheet insolvent from 2005, its financial position was precarious, and the directors could not have reasonably relied on the assurances of support given. The directors should have stopped trading Mainzeal by 31 January 2011. In continuing to trade after this date, the directors adopted a policy that was likely to create substantial risk of serious loss to creditors. 

• The directors did breach section 136 in respect of four major projects from 31 January 2011 and for all obligations entered into after 5 July 2012. Section 136 can apply to a course of trading, and the section is not limited to specific kinds of obligations or particular obligations as opposed to groups of obligations. 

• Following a breach of section 135, in most cases, loss should be calculated on a net deterioration basis. This approach looks at the extent (if any) that the financial position of the company worsened between when the directors should have stopped trading and liquidation. Because the liquidators did not prove that there was a net deterioration, they were not entitled to compensation for the directors’ breach of section 135.

• Following a breach of section 136, loss should be calculated on a new debt basis. In this case, the relevant loss was the gross amount of debt incurred after 31 January 2011 and unpaid at the time of liquidation.

• Courts have flexibility while determining relief, but compensation for the full extent of losses should be regarded as the norm, with culpability more likely to be relevant when apportioning liability between directors. The Court decided that the directors should be liable for about a third (NZ$39.8 million) of the total amount owed to creditors (NZ$110 million), with Mr Yan liable for the entire $39.8 million plus interest, and the other each directors having their liability capped at NZ$6.6 million plus interest.

Lessons for directors

There is little comfort for directors in the judgment: the main theme is creditor protection. Key practical takeaways for directors of distressed companies include:

• Carefully monitor the performance and prospects of your company.
• Seek professional advice about your options.
• Make a plan that addresses the issues causing concern and restores the company’s solvency.
• Monitor progress with the plan.

If you are in charge of a company that is insolvent and can’t be salvaged, don’t trade on, even if doing so would reduce the debt owed to creditors. Take advice and consider the appointment of administrators or liquidators. Courts will allow a reasonable time for directors to take stock and decide what course of action they should take, and directors will not normally be liable for trading during this period (but that may not always be the case).

As the Court recognised, the issues dealt with in the case “are of fundamental importance to the business community.” The case once again highlights the need for law reform about director duties. Striking the balance between director accountability and allowing directors to make commercial decisions that involve risk is not easy, but the business community deserves more certainty.

Thanks to Sonali Singh, Solicitor and Eve Gamet, Solicitor for their assistance with this article.