It is important to provide a review of this decision as it shows the way in which the Companies Act 1993 and certain sections within it, will make directors personally accountable for the mismanagement of companies to the detriment of the companies itself and ultimately the creditors’.
The facts are complicated and it is not sensible to outline these in full for the purposes of this review. In broad terms though, ultimately Richard Yan through a collection of companies broadly known as Richina, gained control of Mainzeal and its subsidiaries. Mr Yan then ensured vast sums of cash/capital was taken out of the Mainzeal group of companies in order for Richina to purchase significant assets overseas, in particular land and leather businesses at or around Shanghai. The advances made were structured in such a way that it made it near on impossible for Mainzeal to ensure these obligations were met by Richina. Instead Richina through Mr Yan, provided both verbal and written assurances/letters of comfort that Richina would make available funds to Mainzeal on a need basis, and in this way, it enabled Mainzeal to meet its solvency requirements on an annual basis.
The crux of the directors defence to allegations that they were liable for reckless trading pursuant to section 135 of the Companies Act 1993, was that the reckless trading charge could only be considered in respect of the entire group rather than just Mainzeal per se, and in this way the written assurances/understanding of the Richina Group to always provide cash to Mainzeal when and it needed it, was sufficient assurance for the directors that it was safe for the company/companies to continue trading.
The Plaintiff/Liquidators said Mainzeal’s failure was predictable and a consequence of Mainzeal trading while insolvent in the manner described above. They also said that the manner in which the directors agreed to engage in business, exposed the creditors to a substantial risk of serious loss meeting the requirements of section 135.
The Court held that the letters of comfort, particularly when provided in connection with an annual audit, were not legally enforceable. That was because they did not exhibit an intention to create legally binding relations or provide an enforceable undertaking or guarantee.
The Court also noted the difficulty of extraction of funds from China. The important point made was that once funds had been extracted from Mainzeal, and used to make investments in China, it was difficult to get the monies back.
There was evidence given from PWC, who were the original auditors of Mainzeal, to the effect that key personnel there were concerned about Mainzeal and the ability of the board of directors to apply any kind of constraint to Mr Yan.
It was apparent that from 2009 Dame Jenny Shipley (JS), was more concerned about the solvency of Mainzeal. She was aware of the concerns identified by PWC as auditors and began to look at matters more rigorously.
However the Court concluded at paragraph 75
“In summary, following the 2008 delisting of Richina Pacific and the restructuring completed by the end of 2009, including separation out of the Chinese and New Zealand divisions, Mainzeal remained balance sheet insolvent. It had very significant loans to entities that were now part of the New Zealand division. These loans were not backed up in a legally enforceable way by Richina Pacific, which was now in a more separate Chinese division. The initially promised redeemable preference share capital was not provided. The shareholder letter of support and guarantee formerly provided by Richina Pacific was no longer provided by that entity. Such letters of support were now only provided by holding companies in the New Zealand division.”
Notwithstanding these factors, at the end of 2009 it was shown that Mainzeal was in a vulnerable position and was reliant on informal expressions of support for its solvency. The evidence of JS was that she remained confident of solvency because of the verbal expressions of support that had been given by Mr Yan.
Mr Yan brought about the liquidation of Mainzeal by writing an email on 29 January 2013 seeking an urgent directors meeting, and recording that Mainzeal was no longer a going concern, and he further suggested that a resolution be passed to invite BNZ to appoint receivers. Ultimately this email triggered a series of events that resulted in the liquidation of Mainzeal on 28 February 2013.
The initial enquiry of the High Court was in respect of section 135 of the Companies Act 1993 which provides:-
135 Reckless Trading
A director of a company must not-
(a) Agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors; or
(b) Cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.
In terms of the meaning of “substantial risk”, this first phrase “requires a sober assessment by the directors as to the company’s likely future income stream. Given current economic conditions, are there reasonable assumptions underpinning the director’s forecast of future trading revenue? If future liquidity is dependent upon one large construction contract or a large forward order for the supply of goods or services, how reasonable are the director’s assumptions regarding the likelihood of the company winning the contract? Even if the company wins the contract, how reasonable are the prospects of performing the contract at a profit?”
The Court also identified the distinction between a company taking legitimate and illegitimate risks.
In determining whether conduct is illegitimate under section 135, the NZ Courts will take an objective approach. Where a company has little or no equity, directors will need to consider very carefully whether continuing to trade has realistic prospects of generating cash that will service pre-existing debt and meet the commitments that such trading inevitably attracts.
Summarised as follows, the essential pillars of this section are:-
• The duty imposed by section 135 is one owed by directors to the company (rather than to any creditors);
• The test is an objective one;
• It focuses not on a director’s belief but rather on the manner in which a company’s business is carried on, and whether that modus operandi creates a substantial risk of serious loss;
• What is required by the directors when a company enters into troubled waters is a sober assessment by the directors, of an ongoing character, as to the company’s likely future income and prospects;
• Directors are not automatically liable because they trade a company whilst insolvent, but it is at that point a sober assessment needs to be made. The cases referred to note that once a company is in troubled waters, the directors must act very cautiously if they continue to trade. In addition, just because a company becomes balance sheet insolvent does not require it to immediately cease trading, as this may result in serious loss on creditors, especially where there remains a possibility of salvage. But the cases make it clear that there are limits to the extent to which directors can trade companies while they are insolvent in the hope that things will improve.
The Court reached the following conclusions:-
• Mainzeal was trading while balance sheet insolvent as the inter-company debt was not in reality recoverable;
• There was no assurance of group support that the directors could reasonably rely upon if adverse circumstances arose;
• Mainzeal’s financial trading performance was generally poor and prone to significant one off losses (Botany Town Centre (leaky building claim)), which meant it had to rely on a strong capital base or equivalent backing to avoid collapse.
Each of these elements needed to be established to find each of the directors liable pursuant to section 135 of the Companies Act 1993.
There is a harrowing revelation as to the enviable position a head contractor finds itself in whereby it can use significant down payments from principals, as its working capital to the ultimate prejudice of the subcontractors in this instance. The sub-contractors were left with $45.4 million owed to them in the liquidation.
The Court analysed the expressions of comfort, concluding as follows:-
• The verbal expressions of support were not set out in clear terms or in writing. These were important assurances in terms of the solvency of Mainzeal, and ran counter to what had been recorded in writing (the Charter) as between Richina and Mainzeal.
• Whilst there were letters of comfort, these had been provided only in respect of the annual audit. It was not reasonable for the directors to rely upon these. They were not legally binding. After the restructure, they came from Richina NZ which was an entity that did not have significant assets. From 2010 Richina Pacific (RP) (the asset rich company) made a conscious decision not to provide the written expressions of support.
• The limitations of Chinese law meant the ability of RP to support Mainzeal was severely limited.
• Whilst support had been provided over the years by RP, on close analysis most funds had gone from Mainzeal to Richina. Furthermore, the support from Richina was never of an unlimited kind. It was always conditional.
• The support became unreliable after the restructuring and separation at the end of 2008 and 2009, and at this point the Court ruled it was unreasonable for the directors to rely upon this support.
• The point behind the restructuring was to separate NZ and Chinese divisions and delist RP. Whilst the complete restructure never took place it did mean that Mainzeal was no longer a subsidiary of a publicly listed RP. As a result of this restructure, the letters of comfort no longer came from RP and the companies that owed the intercompany receivables were no longer subsidiaries of RP, therefore they had no ability to repay these amounts.
The Court ruled that from this point, 1 January 2010, Mainzeal was trading while insolvent in a highly material way. This was the point when sober assessment was required by the Directors. The Court ruled that Mainzeal had a reasonable period of time from this point, to force the issue of solvency, but it was not indefinite and did not spread to years. JS made some initial attempts especially when there was a further attempt by RP to extract further capital from the ailing Mainzeal.
The Court also held that the financial trading position of Mainzeal was poor. In concluding this, the Court relied upon the EBIT figures from the years 2005 through to 2012, excluding the intercompany loans and interest payments which it deemed as meaningless.
In addition it relied upon the nature of the construction industry and the significant one off negative financial events that further worsened the position such as the Siemens contract, Vector arena and the leaky building disaster which impacted upon Mainzeal as the supplier of construction services. The Court also relied upon the changed business strategies as an open acknowledgement by the Board/Management team, that the current business model was not working, and change was required. It also made the important point that in the precarious financial position that Mainzeal was operating, it involved significant risk.
Mr Hodder QC for the Independent Directors argued that section 135 did not apply unless the insolvency of the company was imminent or unavoidable. The core of this argument was that the reckless trading charge only applied to circumstances where a director should cease trading a company due to imminent insolvency but continued to trade causing further loss. However, the Court held those are not the only circumstances to which the section will apply.
At paragraph 284 the following summary is apt:-
“It is appropriate when assessing all of the above considerations to be clear s135 is not concerned with the normal business risks that companies exist to take. It is only when illegitimate risk taking to the standards contemplated by this section are involved that a breach arises. Here I am satisfied that the risks taken by the directors cannot be regarded as normal business risk taking. On the contrary, the directors allowed Mainzeal to continue to trade in highly unorthodox circumstances, which involved a very significant risk to the creditors. The directors here were not taking the normal risks that are inherent in the operation of a company of Mainzeal’s size.”
Causing the company to continue business in the infringing manner.
The Court ruled that after the restructure, so by mid-2010, the directors having asked a number of searching questions as to solvency of the company, and their responsibility for it through JS, they ultimately left these issues unresolved and thus they allowed or agreed for the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.
I note the Court gave some insight as to what the directors ought to have done at this point, namely using the threat of resignation to drive RP into providing the necessary capitalisation.
Breach of section 136.
The Court was also required to consider whether section 136 of the Companies Act 1993 had been breached, which imposes upon the directors a statutory obligation not to agree to the company incurring obligations unless the director believes on reasonable grounds that the company will be able to perform the obligation when it is required to do so.
The Court ruled that to establish a breach of section 136, it must be established that at the time the obligation was entered into, the director did not believe that the company would be able to meet its obligations as entered, or if the director did believe that the company would be able to meet its obligations, that his or her belief was on reasonable grounds.
Ultimately the claim brought against the directors pursuant to section 136 failed, because the Plaintiffs had not adduced the requisite evidence.
Quantum and the application of section 301.
The Court held the key contravention of the Companies Act 1993 was in respect of section 135 and that section is directed to the manner in which the business of the company is carried on. However, directors must face the ultimate responsibility for the vulnerable trading given that it is their responsibility to determine the manner of trading, and that they have the duty not to trade in a manner causing a substantial risk of serious loss to creditors.
Under section 301, after conducting an inquiry, the Court is required to determine the amount of compensation that the breaching directors should contribute, that the Court thinks just. The Court did not feel confined to applying historic precedent on the method of assessing compensation under this section. The Court relied upon case authority that showed a Court had previously awarded the full amount of the deficiency on liquidation.
The Court held that the starting point for the exercise of the discretion pursuant to section 301 was the entirety of the deficiency identified on liquidation, namely $110.6m. In order to reach this point the Court concluded that there were steps that the directors could have taken that could have avoided this scenario. In particular:-
a) Recapitalise Mainzeal to allow it to operate separately from RP;
b) Turn the previous written and oral assurances into legally binding commitments;
c) Some more limited but legally binding and efficacious support to restore solvency.
The Court also believed the threat and actual use of the resignation process was a tool by which RP and Mr Chan could have been brought into line on capitalisation. The Court had previously used the example of what the threat of the ex-Prime Minister of New Zealand resigning from a publically listed company might have on her fellow director/shareholders.
The Court considered that were three discretionary factors that should apply, namely causation, culpability, and duration of trading.
Duration and culpability.
The Court ruled that the directors had exposed creditors to the risk of serious loss for a number of years. Their breach of duty was continuous. They had many opportunities to correct the manner in which Mainzeal’s business was being conducted, but they failed to do so. As a factor it counts in favour of a significant contribution.
The Court ruled that the 2nd to 4th defendants acted in good faith, with honesty, and did so throughout, but their breach arose from their failure to fully appreciate and address the risks they were exposing creditors to. In addition, it arose from the unreasonable reliance on assurances expressed in loose terms, that had been given to them.
Mr Yan, the first defendant, was ruled to have acted honestly yet in a way that led the other directors to breach section 135. He was in an inherent conflict of interest. He gave assurances to the fellow directors that were misleading.
Causation as a factor added little to the assessment because of the earlier finding that the breach of section 135 caused all of the $110.6m arrears of the liquidated company.
It was revealed as part of the section 301 exercise, that there was available $20m worth of insurance cover available to all of the directors.
The eventual findings were:-
The Directors in total were liable for $36m of which:-
Mr Yan $18m severally
Peter Gomm & Mr Yan $6m jointly
Jenny Shipley & Mr Yan $6m jointly
Clive Tilby & Mr Yan $6m jointly
The High Court decision is now subject to an appeal lodged by the Directors. A cross-appeal has been filed by the Liquidators where they seek greater awards against the directors. These will be resolved in the Court of Appeal.
There is also a significant costs and interest argument still before the High Court.