Paper presented for the Auckland District Law Society, April 2006
Directors are under a duty not to cause or allow the business of a company to be conducted recklessly. Section 135 provides (under the heading “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.
Where s135 is breached there will usually have been a breach of s136 as well. Section 136 provides:
A director of a company 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.
The usual manner in which a director is brought to account for breaching ss135 and 136 is during a liquidation by virtue of s301 which is as follows:
(1) If, in the course of the liquidation of a company, it appears to the Court that a person who has taken part in the formation or promotion of the company, or a past or present director, manager, liquidator, or receiver of the company, has misapplied, or retained, or become liable or accountable for, money or property of the company, the Court may, on the application of the liquidator or a creditor or shareholder, -
(a) Inquire into the conduct of the promoter, director, manager, liquidator, or receiver; and
(b) Order that person –
(i) To repay or restore the money or property or any part of it with interest at a rate the Court thinks just; or
(ii) To contribute such sum to the assets of the company by way of compensation as the Court thinks just; or
(c) Where the application is made by a creditor, order that person to pay or transfer the money or any property or any part of it with interest at a rate the Court thinks just to the creditor.
New Zealand’s largest award against a director for reckless trading, $8.4 million, was made in Löwer v Traveller a case that made its way through the High Court and Court of Appeal in 2004 and 2005, and will have been to the Supreme Court between the date of writing this paper and 4 April when it is delivered. Löwer was in fact decided under corresponding provisions of the 1955 Act, but the case is worth looking at in some detail for its discussion of what amounts to reckless trading, and the approach taken by the Court to the issue of striking the correct balance between protecting creditors and encouraging entrepreneurial activity and the taking of legitimate business risks.
Mr Klaus Löwer was the dominant shareholder and director of South Pacific Shipping Co Ltd (“SPS”), which was incorporated in January 1992 and was placed in liquidation in February 1998 owing $44 million.
The ships operated by SPS were used by it under charter arrangements and Löwer had an ownership interest in the majority of these ships. Mr Löwer was a German national and German tax law provided certain incentives which encouraged ship ownership and ship building. He took fees for arranging loans from a German bank, Bremer Landesbank, to finance the purchase of the ships which were chartered by his interests to SPS, and a company he controlled was paid fees for managing each vessel.
Löwer had several co-directors throughout the period SPS was in operation. The main ones who remained as directors throughout were the chief executive, Captain Fast, and an Australian based director, Mr McAllum. Löwer had 85 per cent of the shares in SPS.
At all times the company traded at a loss and at all times there was a deficit in shareholders funds. The company was able to keep going for so long because its customers paid it within 14 days, whereas SPS was able to obtain credit on 30 to 90 day terms. The practical effect was that SPS derived its working capital from its creditors. There was also flexibility in charter payment arrangements. Enough had to be paid to cover the commitments to Bremer Landesbank, but beyond that Mr Löwer could control what was paid to his interests in respect of the margins they were to make on chartering the ships to SPS. Much of the company’s related party debt of about $23.5 million as at the time of liquidation was charter debt.
The trans-Tasman shipping market that SPS entered in 1992 was in a state of flux. As the anti-price fixing provisions (and other anti-trust provisions) of the Commerce Act 1986 do not apply to international shipping , there had previously been various arrangements between trans-Tasman operators aimed at ensuring that only New Zealand and Australian operators could ply the trans-Tasman trade. One of these arrangements was known as the “Accord”, under which New Zealand and Australian maritime unions banned the loading of cargo onto foreign manned ships on international voyages that included a leg between New Zealand and Australia. However, the Accord was being eroded by the early 1990s and by 1996 it broke down altogether, as did other anti-competitive arrangements between the shipping companies.
Despite these difficulties, and despite the scale of its business, board meetings between the directors of SPS were few and far between, record keeping was poor, projections were overly optimistic year after year, with no real analysis of why that was or measures put in place to improve, and SPS kept chartering more ships.
With the company making substantial losses in its first 2 and a half years of trading, the directors sought legal advice as to their exposure for reckless trading. The first opinion, in October 1994, recommended more frequent board meetings at which the directors would (among other things) discuss comparison of the company’s trading performance against company budgets, and recommended having an independent third party examine the reasonableness of the assumptions upon which the budgets and cashflow forecasts were prepared. The frequency of board meetings did not increase. Some outside assistance was obtained in relation to budgets and forecasts, but they did not improve.
When trading worsened further in 1995, another legal opinion was sought. This time, the legal advice was that if there was a liquidation the directors would almost certainly be liable for reckless trading. Since the company was being propped up by its major shareholder at his complete discretion, it was strongly recommended that a commitment be obtained from Mr Löwer to give backing to the company in the event it became unable to meet its obligations to its creditors. It was also recommended that he provide a statement of assets and liabilities, demonstrating reasonable grounds for a belief on the part of the directors that support from Mr Löwer would in fact be provided when it was most needed.
This commitment was not obtained, and when the Accord broke down completely in 1996 SPS’ position became hopeless. However, it traded on until Mr Löwer terminated the charter arrangements and resigned as a director on 18 February 1998, and SPS was placed in liquidation on 19 February 1998.
The liquidator asserted that the company should have stopped trading at the end of April 1994, that trading beyond that date was reckless, and that Mr Löwer should have to repay to the company the losses the company sustained from May 1994 until trading ceased, a figure of approximately $9.5 million. Orders were sought against Mr Löwer only, the claims against the other directors either having been settled or in some cases not pursued due to their impecuniosity.
Discussion of the reckless trading provisions
William Young J discussed in detail the nature of the reckless trading provisions. His Honour was critical of the test of what amounts to reckless trading from “the most influential of the s320 cases”, Thompson v Innes , per Bisson J:
“Was there something in the financial position of this company which would have drawn the attention of an ordinary prudent director to the real possibility not so slight as to be a negligible risk, that his continuing to carry on the business of the company would cause the kind of serious loss to creditors of the company which sec 320(1)(b) was intended to prevent?”
Despite the above test having been cited with approval in numerous subsequent decisions, William Young J was sure it was not intended by Bisson J in Thompson v Innes to suggest that it would be reckless whenever directors took more than negligible risks and those risks led to business failure and serious loss to creditors, noting that:
“Risk is implicit in business and the chance of business failure is seldom “so slight as to be a negligible risk”.
His Honour considered that, despite the above passage, implicit in Thompson and cases following it was a distinction between the taking of legitimate and illegitimate risks, with only the latter amounting to reckless trading, and cited with approval academic writing to this effect. The following guidelines could be used to determine whether a business risk is legitimate:
(a) Was the risk fully understood by the creditors whose funds were in peril? It would be contrary to the principles of limited liability (which, among other things, promote the taking of risks) to find directors liable when risks which were recognised by creditors have crystallised.
(b) When a company is insolvent or near insolvent, the directors are under a duty to have regard to the interests of the creditors.
(c) Of course, it is not necessary to cease trading as soon as the company is insolvent (in the balance sheet sense). To cease trading immediately might inflict serious loss on creditors. However, it would be unusual to trade on while insolvent (in the balance sheet sense) for more than a matter of months.
(d) Did the directors act otherwise than in accordance with orthodox commercial practice?
As an overall consideration, it was necessary to assess whether the conduct can fairly be regarded as reckless. Reference to what reasonable directors would have done or foreseen should not lead to liability for mere negligence.
Were Mr Löwer’s actions reckless?
Applying the above guidelines to Mr Löwer, William Young J found that:
(a) A “significant driver” of the decisions to trade on and expand the business, was the availability of fees for putting together the financing arrangements for the ships, management fees and margins. These collateral benefits provided an unusual incentive for Löwer to take risks with the money of trade creditors.
(b) Taking risks with the money of trade creditors is exactly what he did. It was highly unorthodox to trade on for years while insolvent.
(c) Trade creditors were not on notice of the risks they faced. No accounts were filed with the Companies Office prior to May 1994, and there was evidence of a statement in the media by Captain Fast in 1996 indicating that the company was financially strong when clearly it was not. However, there was no evidence of creditors actually being misled.
(d) The risk to creditors was very serious. SPS faced a hostile business environment with increased competition, excess capacity and depressed freight rates. High standards of governance were called for.
(e) The governance style adopted by the directors was “lamentable”. Directors meetings were few and far between. Despite the scale of the business, there was not much in the way of orthodox practices such as preparing agendas and board papers, ensuring that appropriate planning took place, matching performance against forecasts, ensuring that decisions of the directors were implemented, or even recording proceedings of directors in minutes.
(f) Of particular significance were the decisions made at a crucial board meeting on 18 April 1994 (one of only 3 board meetings in that year). Although projections of profits for previous years had turned into substantial losses, some informal profit projections were produced for the board meeting and on that basis the decision was made to charter 3 more ships. This extensive expansion of the business provided collateral benefits to Mr Löwer.
In summary, His Honour found that in the circumstances:
“…Mr Löwer can fairly be regarded as having forfeited the protection of limited liability…Given his wish to permit SPS to continue to trade despite insolvency, the hostile business environment, his unwillingness or inability to implement orthodox governance practices, and the proven unreliability of management reporting, he ought to have been prepared to put his own money up by capitalising the company to an extent that was appropriate given the risks he was taking with creditor’s money. His behaviour departed so markedly from orthodox business practice and involved such extensive and unusual risks to the creditors that it can fairly be stigmatised as reckless.”
It was held that the directors should have ceased trading in April 1994 at the latest, as by that stage they were trading with their creditors’ money in circumstances where the prospects of success did not warrant the taking of further risks.
William Young J approached the question of quantum on the basis that an award should be aimed at compensating for damage done through reckless trading, as opposed to punishing. The starting point was, therefore, the difference between what creditors would have lost had trading ceased as it should have in April 1994, a figure of approximately $9 million, and what creditors were going to lose in the liquidation, a figure of approximately $27 million, i.e. $18 million.
From the figure of $18 million, various deductions were made for:
(a) The fact that some of the $27 million was made up of creditors’ claims which were weak;
(b) The fact that trade creditors must have appreciated “general industry risks”, although His Honour was at pains to point out that this did not amount to contributory negligence on their part. There was a round 30 per cent deduction from the award for this factor.
After these deductions, the final award was $8.4 million.
His Honour was not prepared to make any deduction for the losses Mr Löwer had suffered because he put up no detailed evidence as to all of the losses and gains he had made out of SPS, and:
“The potential for him to derive substantial collateral advantages from his involvement with SPS encouraged him to gamble with the funds of his creditors and I see nothing unjust in requiring him to make a significant albeit only partial contribution to their losses”.
Appeal to Court of Appeal
Mr Löwer appealed to the Court of Appeal on a number of grounds including:
(a) In finding that trading was reckless from April 1994, insufficient weight was given to the fact that the company was in fact able to pay its creditors until 1998;
(b) Insufficient weight was placed on Mr Löwer’s reliance on his fellow directors and on legal advice in 1994;
(c) Insufficient weight was placed on the fact that in 1994 Mr Löwer did intend to provide substantial financial support;
(d) As the winding up of SPS did not take place until 19 February 1998, some three and a half years after the 1955 Act was repealed, there could be no liability under s320 of that Act. Further, there could be no liability under s135 of the 1993 Act because all of the acts found by the High Court to amount to reckless trading took place before the 1993 Act came into force on 1 July 1994.
The liquidators cross-appealed against the deduction made by the High Court for creditors’ appreciation of risk, which was said to be arbitrary and without precedent.
The appeal and cross-appeal were rejected. The Court of Appeal was generally in agreement with the approach taken by William Young J to liability and quantum. Some specific points from the Court of Appeal judgment will be dealt with in the discussion that follows.
Appeal to Supreme Court
Mr Löwer has appealed to the Supreme Court, only on ground (d) above. The appeal will be heard on 30 and 31 March 2006.
Löwer v Traveller involved a large award against the director in that case, but in the writer’s view this need not be cause for alarm among those concerned that the reckless trading provisions are likely to stifle the sort of risk taking which limited liability companies are there to encourage. Löwer was an extreme case in terms of the way the business was operated and the level of losses. The approach taken to the assessment of liability and damages shows that the Courts are hesitant to second guess the decisions of directors, with the benefit of hindsight, but that they will intervene in appropriate cases.
Legitimate v illegitimate risk
One of the criticisms of s135 is that it does not allow for risky business activity even where the prospect of large profits might be the outcome. Higher risk often means higher rewards, but the words “substantial risk of serious loss to the company’s creditors” do not seem to allow such a balancing of risks.
In Fatupaito v Bates, O’Regan J expressed the view (obiter) that such a balancing exercise was not open on the wording of s135, and that to enable such an approach would require that the reference to risk in s135 be qualified with wording such as “except where the potential for substantial gain justifies the taking of such risk”. His Honour noted that his view was contrary to that of Tompkins J in his article “Directing the Directors: The duties of directors under the Companies Act 1993” (1994) 2 Waikato Law Review 13, who was prepared to imply an ability to balance risk and reward under s135. William Young J was of the same view in Löwer. The Court of Appeal was not required to address the point and did not refer to it.
Voluntary assumption of risk
The main thrust of the liquidator’s cross-appeal in the Court of Appeal was that the reduction by 30 per cent of the damages award for the fact that trade creditors generally knew the risks associated with the shipping industry was “unnecessary, arbitrary and unreasonable and without precedent”. The Court of Appeal agreed with the general approach of William Young J to damages, describing it as a principled approach which was open to him and which was just, without specifically addressing the issue of the level of knowledge of the creditors. In the writer’s view, there is a certain arbitrariness about the reduction for assumption of general risk (in keeping with His Honour’s caution that “some element of rough justice may be called for”), and the reduction is hard to reconcile with His Honour’s findings to the effect that the directors were less than open in terms of the financial information which was filed.
There is no guidance in s135 or s301 as to whether or not the individual circumstances of creditors, or the circumstances of categories of creditors, can be taken into account. However, not doing so could have strange results. In Löwer, (under ss 320 and 321 of the 1955 Act) had there been no distinction made between categories of creditors the related party debt owed to Mr Löwer’s interests would have watered down what was available to trade creditors through any award. In Re B M & C B Jackson (in liq) (a case under ss189, 190 and 275 of the 1995 Act in its post 1 July 1994 form, which are identical to ss135, 136 and 301 of the 1993 Act), Wild J distinguished between trade creditors, who he ordered be paid in full, and creditors controlled by the defendants, who he ordered be paid an amount deemed appropriate by the liquidator.
For Mr Löwer it was argued that insufficient weight had been given to his reliance on the two directors who were based in New Zealand and Australia, and who were more involved in the day to day operations of the company. Mr Löwer did not attend the crucial board meeting of 18 April 1994 and did not attend many others. The Court of Appeal was not prepared to upset the High Court’s finding of fact that Mr Löwer did in fact exercise control over the company, albeit from Germany. It was he who had the incentive to continue trading and expand the business and there was plenty of circumstantial evidence indicating that Mr Löwer had primary responsibility for the decisions that the directors made.
Whereas s320 of the 1955 Act prohibits “knowingly” being a party to reckless trading, s135 of the 1993 Act refers to causing or allowing the business of a company to be carried on in a manner likely to create a substantial risk of serious loss. Passive directors are caught, as Wild J found in Jackson :
“Mrs Jackson was much less involved in the running of the Company than was her husband, and was probably not at all involved in the critical decision as to whether to continue trading or liquidate. But I do not regard that as absolving her from full responsibility. Directorship of any company involves acceptance of all the directorial duties imposed by the law. There is no halfway house.”
There is extensive discussion in the High Court and Court of Appeal decisions in Löwer of the legal advice provided to the directors. For Mr Löwer it was argued that because the legal opinion provided by Buddle Findlay on 20 October 1994 did not recommend ceasing to trade he could not have been expected to do so. It could not be argued that the opinion was relied upon at the critical time, April 1994, as it was provided 6 months later, but it was pointed to in support of the proposition that the High Court decision was based on hindsight rather than on objective factors apparent as at April 1994.
However, the 20 October opinion was based on unreliable financial information provided by the company, including a profit forecast of $2.5 million to the year ending June 1995, which turned out to be a loss of $6 million. The Buddle Findlay opinion was based on the profit projection being reasonable and supportable. It was not.
Section 138 of the 1993 Act provides that a director may rely on the advice of professional advisers and employees where reasonable and provided the director acts in good faith, makes proper inquiry where the need for inquiry is indicated by the circumstances, and has no knowledge that such reliance is unwarranted. Section 138 would not have assisted Mr Löwer due to lack of reliance.
Direct claims by creditors
Section 169(3)(f) provides that the duty in s135 is a duty owed to the company, and not to the shareholders or creditors. However, creditors are specifically mentioned in s135. The section is there for their protection, and although directors owe their duties to the company, upon insolvency or near insolvency the duty includes an obligation to take the interests of creditors into account.
Normally, s135 is enforced by a liquidator bringing an action under s301. In theory, since the duty is owed to the company, shareholders could bring a derivative action prior to liquidation, but there rarely will be incentive to do so. Creditors can bring an action against directors under s301 for breach of s135, but any recovery will be paid to the company and will normally be distributed pro rata among the unsecured creditors. However, in the High Court decision in Löwer, William Young J appeared to believe that the Court could, on the application of a creditor under s301, require that payment be made by a defendant to a creditor.
Perhaps the generally held view that recovery under s301 is for the benefit of creditors generally is behind a number of cases where individual creditors have tried to obtain redress against delinquent directors by going around the Companies Act and using alternative causes of action.
Common law causes of action such as breach of fiduciary obligations, negligent misstatement and deceit are not precluded by the Companies Act and may be available in situations which could also be characterised as reckless trading. In Benton v Priore it was held that creditors could bring proceedings against directors outside s301, unless the causes of action in the proceedings were expressly forbidden by statute. In that case, the plaintiffs alleged that the first defendant director, in order to prevent the plaintiffs from recovering a debt from the company, had transferred its main assets to another of the defendant’s companies at an undervalue. There were 6 causes of action: misleading and deceptive conduct under the Fair Trading Act 1986; negligence; breach of fiduciary duty; conspiracy with unlawful object or purpose; interference with contractual relations; and interference with trade by unlawful means.
The defendants applied to strike out all causes of action on the basis that claims of this nature are dealt with by s297 (transactions at undervalue) and s298 (transactions for inadequate or excessive consideration with directors and others), and that only liquidators can bring such claims, through s301. The strike out application failed before Master Gendall, and his decision was upheld on review before Heath J, who agreed that claims under ss297 and 298 could only be brought by a liquidator, but held that ss297, 298 and 301 were not a code.
The case appears to have settled, so the causes of action were not tested at trial. The case has been criticised on the basis that insofar as the causes of action were based on duties owed to creditors in situations of insolvency or near insolvency (in particular negligence and breach of fiduciary duty), such common law duties are encapsulated by ss135 and 136 and it is specifically provided in s169(3) that these duties are owed to the company, not creditors.
The Fair Trading Act cause of action was probably the least likely to fail. There is precedent for such claims, although normally something in the facts indicating a positive assumption of personal responsibility by the director will be required. In Benton v Priore, the plaintiffs alleged that they were misled by an assurance from the defendant that the purpose of the restructuring was not to avoid paying the company’s debts. In Hill Country Beef NZ Ltd v Sharplin a director was held to be liable under the Fair Trading Act for one third of the company’s debt owed to the plaintiff creditor after the company went into liquidation. The director had given assurances in meetings with the creditor that the company’s finances were improving and that payment would be made, right up until the liquidation. It was found that the director was genuinely hopeful that business would improve and he really thought it would or might, but there was no reasonable basis for the assurances given.
In Kinsman v Cornfields Ltd the Court of Appeal held that it will be a rare case where a director who participates directly in negotiations as to his or her company’s business will be able to avoid s9 liability simply on the basis that he or she was acting only on the company’s behalf, as the Fair Trading Act is intended to cast a wider net than that.
Patrick McGrath, Auckland