Debut homes: a warning for directors of financially distressed businesses

The very recent and eagerly waited Supreme Court decision of Debut Homes Limited (in liquidation) v Cooper¹ has provided a sharp focus on directors’ duties – how far do they extend where a company is looking as though it is on the road to failure?

The Companies Act 1993 provides the statutory basis of the duties a director owes to the company of which he or she is a director, specifically sections 131, 135 and 136:

1. A director must act in good faith and in what the director believes to be the best interest of the company – section 131(1)² ;
2. A director must not agree to, cause or allow the company’s business to be carried on in a manner that is likely to create a substantial risk of serious loss to the company’s creditors – section 135; and
3. A director must not agree to the company incurring an obligation unless the director believes at that time, on reasonable grounds, that the company will be able to perform the obligation when it is required to do so – section 136.

In coming to a conclusion that he or she has acted “in good faith” and “in the best interests of the company”, or that his or her decision will not “create a substantial risk of serious loss to the company’s creditors” or that he or she has “reasonable grounds” on which to believe that the company can and will perform all future obligations that it incurs, a director can rely on professional advice provided the director acts in good faith, makes proper inquiry, and does not believe that reliance on such advice is unwarranted – section 138.

If a director does make a poor choice, but has relied on robust professional advice, section 138 will generally provide a defence to an allegation of failure to perform a statutory duty. But, as Mr Cooper found out³, a director who forms his own interpretation of “good faith” and “best interests” may still be held to account even after having taken advice.

Mr and Mrs Cooper owned a residential property development company, Debut Homes Limited, of which Mr Cooper was the sole director. At 31 October 2012 the company was balance sheet insolvent (albeit supported by shareholder loans) but it was paying all its debts as they fell due, including GST, but it was clear that, if existing developments were to be completed and sold, the company would quickly be in financial difficulty. Mr Cooper met with his accountant on 6 November 2012 who advised him that completing and then selling a number of partially finished houses would likely leave a shortfall of GST payable to Inland Revenue of something over $300,000. Following the meeting Mr Cooper decided to wind down the operations of the company but only once existing developments were completed and sold – he reasonably believed that this would generate more money to repay secured creditors.

For the purposes of this article we have considered only the aspects of the case that relate to directors’ duties. The courts also considered aspects relating to secured debts and repayment (including conflicts of interest where the director/shareholder is a secured creditor) which are outside our present focus.

Inland Revenue appointed liquidators to the company in March 2014, and the liquidators sued Mr Cooper for the shortfall on the basis that (amongst other things), as the company’s director, he had not properly performed his statutory duties which had thus resulted in a loss to creditors, principally Inland Revenue.

The High Court determined that Mr Cooper had indeed breached his duties as a director under each of section 131(1), 135(b) and 136 and made appropriate awards for damages. The High Court rejected his section 138 defence that he was entitled to rely on professional advice he had taken at the time.

The Court of Appeal⁴ overturned all of these findings on the basis that directors are not expected to have perfect business judgement, and that commercial good practice (in this case, that continuing to develop and sell the otherwise unfinished houses would result in more money being available for secured creditors) is relevant in assessing good faith. It considered that Mr Cooper’s choice to complete the houses was a “perfectly sensible business decision” and was likely “to improve the return rather than cause loss to the company’s creditors”. The court found that Mr Cooper’s sincere belief that continuing with the unfinished developments would result in significant surpluses and that in due course the GST issues would be resolvable with Inland Revenue.

But the Supreme Court was having none of it and, in a move that reinstates the courts’ insistence that directors act in accordance with the gold standards of duties enshrined in the Companies Act, it overturned the decision of the Court of Appeal and restored the judgment of the High Court.

So, where did Mr Cooper go wrong?

The Supreme Court stressed the need for a company to remain solvent at all times. The solvency test is described in section 4 of the Companies Act and comprises two parts – the liquidity limb (section 4(1)(a)) and the balance sheet limb (section 4(1)(b)). The Court was keen to state the importance of solvency:

Solvency is a key value in the Act. Where a company becomes insolvent, there are statutory priorities for the distribution of funds to creditors and mechanisms to ensure these are not circumvented. There are also a number of formal mechanisms in the Act, apart from liquidation, for companies experiencing financial difficulties. All of the formal mechanisms have carefully worked out processes for decision-making and involve either an independent person or consultation with all affected creditors. None of these formal regimes involve continued unfettered decision-making by directors. Directors can choose to employ informal mechanisms but these must align with formal mechanisms. At all times, including where a company is insolvent, directors must comply with their duties under the Act (our emphasis).

The Supreme Court returned to basics in its analysis of Mr Cooper’s actions, stating that (in its view) he was aware on 6 November 2012 that completing and selling the unfinished houses would result in a GST shortfall of something in the order of $300,000 – if he continued trading after 6 November, loss to creditors was not merely a “substantial risk”, it was a certainty. Unlike the Court of Appeal before it, the Supreme Court took the view that even though GST on future sales was not owed to Inland Revenue at 6 November, section 135 is necessarily forward-looking in its operation. It also rejected the argument that completion of the properties was potentially beneficial to some creditors on the basis that creditors cannot be compartmentalised, and that Mr Cooper knew that continued trading would generate an overall deficit.

In regards to section 136, the High Court had determined that, after the 6 November meeting with his accountant, Mr Cooper could not reasonably have believed that the company would be able to meet its obligations incurred after 31 October when they fell due. He had, therefore, breached his duty under section 136. The Court of Appeal considered that incurring a GST liability was incidental to a future transaction, and such incidental liabilities are not the object of section 136. The Supreme Court did not accept that the application of section 136 was limited to direct contractual obligations and agreed with the High Court’s assessment. Of particular interest is its view that:

… it is clear from the existence of section 136 that it is not legitimate to enter into a course of action to ensure some creditors have a higher return where this is at the expense of incurring new liabilities which will not be paid. In other words, it is not legitimate to “rob Peter to pay Paul”.

Finally, the Supreme Court turned its attention to section 131 – had Mr Cooper breached his duty to act in good faith and in the best interests of the company? The High Court said ‘yes’ (he was not acting in good faith by preferring the position of secured creditors instead of all creditors), the Court of Appeal said ‘no’ (it was a sensible business decision to complete the unfinished houses as the selling price would more than recover costs and free up more funds for creditors), and the Supreme Court agreed with the High Court (Mr Cooper failed to consider the interests of all creditors in an insolvency situation).

And what of section 138? If a director has taken professional or expert advice, to what extent can he or she rely on that advice?

The Judge in the High Court cast doubt on whether section 138 actually provided a defence as reliance on such advice appeared to be contrary to a finding of a breach of duty. If it is a defence, the Judge said, then that advice needs to be of a type contemplated by the wording of section 138, and cannot be reliance on “generalised and loose statements” even if those statements have been made by a professional adviser or expert. The Court of Appeal, although not finding that section 138 had been triggered (as it had not found Mr Cooper to be in breach of the sections 131, 135 or 136), agreed with the High Court’s analysis of section 138. The Supreme Court concurred with both lower courts, and found that (as a matter of fact) the accountant’s views expressed at the meeting on 6 November were generalised and not the type of advice contemplated by section 138.

The High Court, now ratified by the Supreme Court, took the view that the company should have been liquidated on or about 6 November 2012 when it was clear to Mr Cooper that any future trading was putting existing and future creditors’ interests at risk, and it calculated restitution from that base.

The Supreme Court concluded its written decision with a summary of directors’ duties as it sees them:

1. 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 section 135 of the Companies Act, whether or not continued trading is projected to result in higher returns to some of the creditors than would be the case if the company had been immediately placed into liquidation, and whether or not any overall deficit was projected to be reduced.
2. If directors agree to debts being incurred where they do not believe on reasonable grounds that the company will be able to perform the obligations when they fall due, then there will be a breach of section 136 of the Companies Act.
3. There will be no breach of section 131 if a director honestly believes he or she is acting in the best interests of the company. There will, however, be a breach of section 131 if a director, in an insolvency or near-insolvency situation, fails to consider the interests of all creditors.
4. Where there are no prospects of a company returning to solvency, it makes no difference that a director honestly thought that some of the creditors would be better off by continuing to trade. In such situations, alternatives to liquidation are described in the Companies Act.

How we can help

If you are the director of a company that is either financially stretched, or is possibly going to be financially stretched in the future, please talk with us. There are formal and informal mechanisms in the Companies Act that we may be able to apply to your situation, and liquidation is not an inevitable result if a company is ‘on the ropes’. If the company’s situation is a result of the Covid-19 pandemic and/or the application of the various Alert Levels, there are specific mechanisms in place that may be available to you.

Above all, focus on your company’s solvency. As a director you must certify solvency before a company makes a distribution to its shareholders, please contact us if you need assistance with understanding your obligations in this regard.

Please also bear in mind the comment made above about the nature of our advice if you wish to rely on it. A quick, informal telephone call or email is unlikely to satisfy the test for professional advice under section 138.

¹ [2020] NZSC 100

² There are exceptions in the case of subsidiary companies and certain joint ventures, but only if it is permitted in the constitution and/or with the agreement of the shareholders – see sections 131(2) to (4)

³ Debut Homes Limited (in liq) v Cooper [2018] NZHC 453

⁴ Cooper v Debut Homes Limited (in liq) [2019] NZCA 39, [2019] 3 NZLR 57