Mainzeal: Reckless Trading

In Mainzeal1 the former directors were held liable for a breach of section 135 of the Act. Richard Yan, (who was the founder and main shareholder of Mainzeal's parent company, Richina Pacific) was ordered to pay compensation of $36M.  Each of the other directors (Shipley, Tilby and Gomm) were held liable to contribute $6M each towards that $36M.

Section 135 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 general, the Act contemplates two ways a company could be insolvent (known as the "Solvency Trust"). It either cannot meet its debts as they fall due or its liabilities exceed its assets.

In the Mainzeal case, the balance sheet deficit was very significant and was for a period of many years.  The directors had relied on non-enforceable assurances from group members and verbal assurances of support from Mainzeal's parent company, Richina Pacific ("Richina"). The board members argued that as the parent company had provided substantial support to Mainzeal over the years reliance on the expressions of support was reasonable. Richina had also supplied construction bonds or guarantees of the bonds in Mainzeal's favour - which meant that if Mainzeal failed, Richina itself would have a large contingent liability.  However, the Court (quite rightly in our view) found it was entirely unreasonable to rely on unenforceable promises, particularly given the extent of the liability and the period of time for which Mainzeal had been balance sheet insolvent – any support Richina gave was purely at its option and it was not reasonable for the directors to rely on that support (which of course was not in fact forthcoming, leading to Mainzeal's failure).

In summary, the Court found:

   
1. Mainzeal had a policy of trading while balance sheet insolvent and intercompany debt was not in reality recoverable.  It was in this position since 2005 – but it was only from May 2009 that it was separated out from Richina (which previously was responsible for it) and became financially self-sufficient to the extent this created a large risk to its creditors.
   
2. Although the Court only considered the problem became significant later, from 2009, there was no assurance of group support on which the directors could reasonably rely if adverse circumstances arose – while letters of comfort were provided by members of the company group during audits, there were no legally binding terms between the companies Mainzeal could rely on.
   
3. Mainzeal's financial trading performance was generally poor and prone to significant one-off losses, which meant it had to rely on a strong capital base or equivalent backing to avoid collapse – and it had no such backing.

It is notable that the Court found it significant that the board seldom took any formal legal advice in respect of the significant issues it faced and found that was reflective of their failure to comply with their duties.  In 2012, when legal advice was taken, that advice was that the board needed to ensure the commitments from Richina were documented in a legally binding way.  The Court considered that was sound advice and not acted on.

The case highlights:

   
1. When directing a company, a director must make decisions based on reasonable facts and which are reasonable in the circumstances.
   
2. If a company is balance sheet insolvent, then directors have to make every effort to scrutinise the situation very carefully to decide whether there are other factors that would ensure the company could remain solvent if all its liabilities were called upon – they need to look at this from the position of creditors.
   
3. Getting appropriate professional advice (legal and accounting advice) will assist to take the right course and thereby avoid liability – and will demonstrate the board has acted reasonably – but only to the extent the advice is followed.

All of the directors have appealed the judgment, the liquidators have counter appealed on the basis that the Court erred in applying a discount to the starting point of a loss of $110M.  The liquidators have also claimed Shipley – who was chairperson of Mainzeal, as well as being a director of other companies in the group and having interests in the parent company had a higher level of culpability than Gomm and Tilby.

The appeal is yet to be heard, although other cases of breach of section 135 have generally found directors fully liable for the debts the company from the date the breach has been found (setting aside losses that were entirely unforeseeable).  We, and other company lawyers are waiting for the appeal impatiently as the outcome will likely have a very significant effect on this area of the law.

If your company has potential solvency issues or you have other serious company issues you need help with, or you wish to understand your duties in more detail and get advice, please contact:    

Steve Graham on (09) 306 6727 (sgraham@mcveaghfleming.co.nz)

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