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Section 135 of the Companies Act - Reckless Trading:

Tuesday, July 18, 2017

Non-Executive or Passive Directors and Directors' Duties: The Courts Take no Excuses for a "Hands Off" Approach

There are many "non-executive" directors in New Zealand who are not involved in the day-to-day running of the business, but do sit on the board of a company and involve themselves in high level management and governance decisions.  Many 'mum and dad' investors become involved through business or personal dealings with an exciting new business venture, and after being encouraged by the leader of this business venture, decide to become a director of the associated company.  Sometimes inexperienced shareholders become directors, trusting in their more experienced colleagues to "steer the ship".  However, it is very important to realise that there are particular risks with becoming a director in any of these circumstances and for a director who isn't involved with the day-to-day running of a company.     Following the enactment of the Companies Act 1993 ("Act"), Sections 131-138A of the Act (relating to directors' duties) mean that such 'non-executive' directors cannot claim that another director or person was responsible for decisions made.  In various Court decisions, it has become very clear that directors need to be pro-active in performing their duties to the company and ensure that they have their hands "on the pulse" rather than be "hands off" in their approach.

Reckless Trading

The key section so-called 'hands-off' directors need to be aware of is Section 135 of the Act, which deals with reckless trading.  Section 135 provides that a director of a company must not -

  1. 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
  2. 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.

There is no requirement that the director must have acted (or failed to act) knowingly, even directors who may have no intention of acting otherwise than in good faith may be in breach of their directors' duties for simply being too passive.  Section 301 of the Act does provide that a director's knowledge – or lack thereof – will be relevant when it comes to granting relief once a director is found to be in breach of duty. However, this is unlikely to be of much assistance when taking into account the stigma and stress of being found culpable under the Act of breaching your duties and having more than likely incurred large legal fees in defending such an action.

Reckless Trading in Practice – Case Examples

Recent decisions have outlined the strength of this section, and have outlined that honest and well-meaning directors can be in breach of their duties even if another person more directly caused loss (through fraud, for example).  It is enough that - through inaction - they allowed or caused the business to be carried on in such a manner.

Mason v Lewis

Mr and Mrs Lewis became investors and then subsequently directors of a company whose business was print brokering, influenced by the manager of the business, Mr Grant.  Mr Grant's wife was another director.  Following the loss of its key client, Mr and Mrs Lewis were made aware after a meeting with an accountant that the company was in a situation of trading insolvency.  Soon after, they were made aware that the company owed outstanding tax of over $163,000.00 to the IRD.  It was not until Mr Lewis discovered that Mr Grant had been providing false invoices that the directors resolved to put the company into liquidation, more than a year later.  Mr Grant was subsequently convicted of fraud.

The Court of Appeal, overturning an earlier decision of the High Court, concluded that even though the Lewises had not made a conscious decision to recklessly trade, this did not mean that they were absolved from responsibility. The Court found that the Lewises had not paid proper attention to the financial affairs of the company, which had been trading on an insolvent basis for quite some time.  It was held that a reasonable director would have recognised this "urgent need" some 15 months before the company was eventually put into liquidation.

Mason v Lewis, set out that the essential elements of Section 135 are as follows:

  1. The duty imposed by Section 135 is owed by the directors to the company (rather than to any particular creditors);
  2. The test for liability is an objective test (rather than a subjective one);
  3. The focus is on the manner in which a company's business is carried on and whether there is a substantial risk of serious loss; and
  4. Directors must be prepared to perform a "sober assessment" on an ongoing basis as to the company's likely future income and prospects when a company enters troubled financial waters.

In terms of penalty, the Court of Appeal declined to determine the amount that the Lewises were liable for, and sent the matter back to the High Court for determination.  In a later decision, the Court of Appeal required the Lewises to contribute $506,000.00 to the assets of the company by way of compensation, using its discretion under Section 301(1)(b)(ii).

Grant v Johnston

Mr Johnston became a director and shareholder of NZNet, an Internet Service Provider, of which his friend for over 30 years, Mr Andrews, was the sole director.  Mr Johnston sought legal advice before doing so, and completed significant due diligence on the company, including obtaining a significant volume of NZNet's financial information.  Initially Mr Johnston had no involvement in the management of the company including no access to the office, bank accounts or a company credit card.  However, it soon became apparent that NZNet had substantial and unsustainable debts (including to the IRD).  As a result, Mr Johnston gradually became more involved in the business over the course of nearly two years, seeking legal advice where necessary so as to form a plan to pay creditors and employees' wages, and gradually injecting money into the business to the tune of $460,000.00.  When Mr Johnston eventually stopped contributing and it emerged that employer deductions had not been paid (or were short-paid) to the IRD to the tune of $250,000.00, Mr Johnston resigned as a director.  Shortly after, NZNet was placed into liquidation leaving in excess of 25 creditors (including Mr Johnston) owing slightly above $1,000,000.00.

The Court held that Mr Andrews actively misled Mr Johnston over a substantial period of time.  However, in noting that the days of "sleeping directors with merely an investment interest are long gone", Mr Johnston was unable to avoid the responsibilities of directorship.  It was accepted that Mr Johnston's advances kept the Company afloat.  It was held that Mr Johnston acted recklessly in breach of Section 135, but only from the point that a newer third director resigned (only two months before Mr Johnston resigned), for reasons that NZNet was insolvent. The Court held that it was at that stage that Mr Johnston should have taken steps to stop NZNet from trading.  Instead he continued to liaise with Mr Andrews as to a strategy for continuing to run the business.  For similar reasons, Mr Johnston was also found to have breached his duty of care to NZNet under Section 137 of the Act, but from an earlier date when he continued to provide 'lifeline' funding despite learning about the dire nature of the financial position of NZNet.

In terms of penalty, the Court used its discretionary power under Section 301 of the Act and decided that as the amount that Mr Johnston owed during his tenure as director was less than the debt NZNet owed to Mr Johnston, he was not required to repay NZNet.  Mr Andrews on the other hand was ordered to contribute to the full extent of the outstanding creditor debt as at the date of the liquidation, namely $1,098,591.29.  The third director, who became a director for little under three months shortly before the company was placed into liquidation (following his tenure as Managing Director of NZNet) was found to be in breach of Section 137 and was ordered to contribute a sum of $83,814.82 to the assets of NZNet by way of compensation, using the same calculation.

FXHT Fund Managers Limited (In Liquidation)

A doctor became a director of a company whose business was the management of private clients' investments in foreign exchange markets, after being introduced to the business by an acquaintance, Mr Hitchinson, who was the only other director.  The doctor guaranteed the premises and equipment leases, and did not have a day-to-day role in managing the business, and inquired weekly as to the state of affairs, relying on information provided to him by Mr Hitchinson.  Mr Hitchinson began to take money from some investors to pay other investors' returns and when the doctor became aware that certain investors' funds were unaccounted for, required Mr Hitchinson to resign as a director.  The company was subsequently put into liquidation, and Mr Hitchinson was subsequently charged with fraud, as it was alleged he defrauded investors of sums totalling US$297,751.00, including apparently spending company money on a series of "questionable expenses" including on personal items such as on his own pet.

The Court examined the way in which the company was run and found that the doctor had breached Section 135, even though he had no knowledge of Mr Hitchinson's fraud. The Court found he essentially allowed Mr Hitchinson, as an executive director, "free rein" over the control of the company.  The appropriate question here was what would a reasonably prudent director in the doctor's shoes have done?   While the doctor may have asked "all the right questions" the Court held that there was no basis upon which the doctor could test these answers.  By not testing Mr Hitchinson's verbal assurances, it was held that this was a "failure to control" him which created the environment that allowed Mr Hitchinson's dishonesty to thrive.  The Court also held that the doctor had breached Section 137 – and therefore his duty of care to the company - due to his negligence in failing to control the company generally and in the "latitude" he provided to Mr Hitchinson.

The Court ordered the doctor to contribute a sum of NZ$17,492.50 and US$148,875.75 to the company, which was one-half of the amount identified as being misappropriated by Mr Hutchinson.

Conclusion

If you are offered a position as a non-executive director of a company, and especially a small company with few directors, or you are offered a directorship, but are unversed in business management, it is important to evaluate your options before agreeing.  Then, once you become a director, it is important to continue to check that you have appropriate mechanisms in place so you are very aware of the financial status and performance of the company, the risks it faces, and you can test the answers to the questions that you ask about the company. You can get business, legal and accounting advisers to assist you and provide advice, and the importance of this advice cannot be overstated, it will be especially useful if you are either new to being a director, or if you are a non-executive director of a small company.

Please kindly direct any enquiries to:

Andrew Knight on (09) 306 6730 (aknight@mcveaghfleming.co.nz) or

Harry Forsythe on (09) 306 6727 (hforsythe@mcveaghfleming.co.nz)

 

This article is published for general information purposes only.  Legal content in this article is necessarily of a general nature and should not be relied upon as legal advice.  If you require specific legal advice in respect of any legal issue, you should always engage a lawyer to provide that advice.   

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