Implications of the Supreme Court’s “new debt” approach in Mainzeal

The Supreme Court of New Zealand has just released its decision in Yan v Mainzeal Property & Construction Limited, the latest in a suite of recent cases on the duties owed by directors to their companies. The decision is important for directors (or prospective directors) of start-ups and innovative businesses, which may start their life with little capital but have the potential for huge success.

In this Insight, we set out some of the key findings in Mainzeal, as well as important considerations for directors of emerging businesses.

Background: limited companies and directors’ duties

Limited liability companies are often used as the primary corporate vehicle to undertake new ventures. There are many good reasons why inventors and innovators (in particular) use companies to do business. First and foremost is separate legal personality: a company is a separate legal entity, distinct from its directors and shareholders. If something goes wrong and the directors were not at fault, then (generally speaking) the directors of a limited company are not liable for the company’s failure.

This does not mean directors are free to act without consequences. All directors owe duties to their company, for instance:

? to act in good faith and in the company’s best interests (s 131 of the Companies Act 1993 (Act));

? not to incur an obligation unless there are reasonable grounds to believe that the company will be able to perform the obligation (s 136 of the Act); and

? not to agree to the business of the company being carried on in a way that risks serious loss to the company’s creditors (s 135 of the Act).

A breach of these duties can expose directors to personal liability for any losses suffered by the company.

The Act also prescribes a number of steps that cannot be taken by a company without satisfying the solvency test (including payment of a dividend). The solvency test requires that: (a) the company is able to pay its debts as they become due in the normal course of business; and (b) the value of the company’s assets is greater than the value of its liabilities, including contingent liabilities.

“Solvency” (particularly in the context of start-ups)

Innovative companies and start-ups may not begin with much capital or significant assets. A director with a brilliant idea (or, in accounting terms, a significant potential future asset) may need to use borrowed funds for working capital to propel the company to success. The potential for success is the reason the shareholders back the company, hoping for a large return. But if the company were to take on loans or debts, where there is a risk those cannot be repaid, it exposes creditors of the company to potential losses. Ultimately, it can mean the directors become personally liable for breaching their duties.

These issues are by no means new or unique to start-ups. They are just particularly pronounced. As it was put by Lord Briggs of the UK Supreme Court (BTI 2014 LLC v Sequana SA [2022] UKSC 25 at [120]):

“Many start-up companies are balance sheet insolvent before a new invention or business product is sufficiently developed to be brought to market so as to generate revenue or goodwill value, and yet the company later becomes spectacularly successful, and its shareholders become millionaires. In both cases the directors may perceive that there is a reasonable prospect that the company will be able to trade out of insolvency, for the benefit of both creditors and shareholders, a perception often labelled as seeing light at the end of the tunnel.”

So, what should directors do in this situation? Is their faith that the company will eventually succeed (through the creation of valuable income-earning assets) enough to protect them?

The “shifting scale” of responsibility

Senior courts in New Zealand and abroad regularly consider this particular problem. Some important principles include:

? So long as a company is financially stable, and therefore both balance sheet solvent and able to pay creditors on time, the interests of its shareholders as a whole can be treated as the company’s interests. Directors’ duties (such as those set out above) are owed to the company, and directors must act in the company’s best interests. Generally speaking, the “interests of the company” are the interests of the shareholders as a whole. However, in certain circumstances, the interests of creditors can become a relevant consideration when making decisions about how a company operates. The key consideration is the company’s solvency.

? If a company is insolvent or bordering on insolvency, the company’s creditors as a whole have an interest in the company which is distinct from its shareholders. This does not mean the interests of the shareholders vanish, but they will have no remaining interest in the company where an insolvent liquidation or administration is unavoidable or inevitable. As the UK Supreme Court has said, “The more parlous the state of the company, the more the interests of the creditors will predominate”. Imagine a sliding scale: who is at greater risk of loss? Creditors have the most at stake (or “skin in the game”) in an insolvency situation and therefore more regard must be given to their interests. (However, importantly, the Supreme Court in Mainzeal noted that directors’ liability in New Zealand may occur earlier than it would in an analogous situation in the UK, which has a higher threshold for liability: see Mainzeal, [182].)

? In some circumstances, directors will be faced with a difficult decision: commence liquidation or conduct a “rescue”, and attempt to salvage the company? There will be situations where the company and its body of creditors are better off attempting to rescue the company than commencing liquidation. The Supreme Court in Mainzeal has arguably steered any such decision towards liquidation, but has also provided useful guidance (see below).

Facts of Mainzeal

Mainzeal Property and Construction Ltd was a large and well-known construction company in New Zealand, part of the worldwide Richina Pacific group. Mainzeal was reliant on (among other things) letters of support from related companies (which were not strictly legally enforceable) and had intra-group assets which were not recoverable.

In 2008 and 2009, a restructuring had taken place which had the effect of minimising the parent company’s assets. Mainzeal continued to rely on non-binding and legally unenforceable letters and representations of support from its related companies, including oral expressions of support.??

Mainzeal’s difficult financial situation was evident to its directors, who regularly sought assurances from the group (including Mr Yan, its principal). In 2011, the board of Mainzeal received a draft accounting report highlighting the fact that Mainzeal was balance sheet insolvent. However, Mainzeal largely continued to pay its short-term debts as they fell due.

By mid-2012, Mainzeal was under considerable financial pressure, and was eventually placed into receivership and liquidation in February 2013. On completion of liquidation, approximately $110 million of unsecured creditors’ claims were left outstanding. However, Mainzeal’s ‘net’ liabilities had actually improved over the relevant period, which conventionally, would suggest the directors had little prospect of personal liability.

The main issues in Mainzeal were: (i) the directors’ liability under sections 135 and 136 of the Act; and (ii) if the directors were liable, the calculation of any compensation for breach.

Mainzeal decision: directors must carefully exercise their judgment to “take stock” of possible insolvency

The Supreme Court upheld the Court of Appeal decision, in summary that:

? Directors have a continuing obligation to monitor the performance and prospects of their company. If monitoring reveals the potential for substantial risk of serious loss to creditors, or doubt as to whether the company can honour its obligations, directors must squarely address the future of the company.

? In the short term, trading while insolvent may be legitimate. Directors will be allowed a reasonable time to assess risk, review the options and decide what course of action they should take. But they must deal directly with the issues that have given rise to concern.

? During this “taking stock” period, directors will not normally be liable for continuing to trade. But this may not be the case if substantial new obligations are taken on, without measures in place to allow for them to be met.

? A long-term strategy of trading while insolvent is generally unacceptable. In rare circumstances, it may be legitimate (for instance, where there are assurances of support from a parent or sister company, or third parties, that can be reasonably relied on). However, it is possible the Court may use hindsight to determine whether such reliance was reasonable, so any assurance should (at least) be legally enforceable.

? Directors should take professional advice, and that will be taken into account by the Court when considering the reasonableness of any decisions.

? The Court also rightly recognised that directors have to exercise business judgement, and the Court will attempt to “adjust for the danger of hindsight bias” (although that may not be of much practical assistance for directors).

Mainzeal decision: no compensation for breach of s 135

The Supreme Court found that the directors had breached s 135 of the Act (in addition to s 136), among other reasons because Mainzeal had been trading while balance sheet insolvent for several years, and had made a sequence of unreasonable decisions (including ignoring advice from external advisors and relying on unenforceable assurances of support) (see Mainzeal, [211] and [234]). However, as there had been no net deterioration in the company’s creditors’ overall financial position, no damages were awarded for breach of s 135.

Mainzeal decision: s 136 compensation measured by “new” debt

The most important point to come out of Mainzeal was its decision on the compensation payable by the directors for breach of s 136. The Supreme Court had previously considered in Debut Homes Ltd (in liq) v Cooper [2020] NZSC 100 that compensation could be ordered for breach of s 136 of the Act on a ‘restitutionary’ basis in an amount based on the value of a particular new debt (in that case a GST shortfall). The idiom “robbing Peter to pay Paul” was used by the Court, and appears to have arisen from submissions by Inland Revenue (which appeared as an Intervener in Debut Homes). However, the moralistic element of that idiom does not sit well with the orthodox approach to directors’ duties (absent fraud). It is normal and expected for some company liabilities to replace others in the ordinary course of business (without any ‘robbery’ occurring).

The Supreme Court in Mainzeal has now confirmed that the starting measure of compensation under s 136 is not net deterioration, but the amount of the new debt taken on by the company in breach of section 136. (Compensation for breaches of s 135 should generally be ordered on the basis of “net deterioration”, which did not occur in this case.)

In other words, breaches of ss 135 and 136 will give rise to materially different outcomes for directors.??

The Court has also confirmed that section 301 of the Act involves the exercise of discretion, which may allow a Court to reduce or allocate compensation for overall ‘culpability’ (among other things). However, that discretion may be of little comfort to directors in a near-insolvency who essentially need to consider both: (i) the company’s creditors as a whole; but (ii) be mindful of their potential liability to compensate for specific new debts.??

As a practical matter, it is difficult to say exactly how serious the impact of this decision will be for directors (and their insurers), other than that it moves the bar considerably towards risk aversion.

Takeaways for startups (in particular tech/IP-heavy start ups)

? A “sober assessment” of a company’s financial situation is always required, but particularly so now. This will include giving proper consideration to whether the company is sufficiently capitalised, the credit-worthiness of the company’s debtors, including intra-group debts, and the legal enforceability of any assurances of support.

? Contingent liabilities are within the scope of the test for balance sheet solvency, but not contingent assets. There is therefore a difficult imbalance when a business is focused on the development of such assets. They may wish to consider taking out guarantees, especially around the time of refinancing. This will put a burden on guarantors (such as shareholders), but may be more equitable than the directors shouldering personal responsibility.

? The level of a company’s D&O insurance cover may need to be reconsidered, to reflect the increased liability for directors.

? Finally, it is notable that this decision comes as the Government is trying to incentivise ESG-related decision-making (Companies (Directors’ Duties) Amendment Act, s 4). Mainzeal will no doubt give directors pause for thought regarding the incurrence of immediate financial obligations for perceived long term social benefits. Mainzeal does not directly address that issue, but given how far it ‘shifts the bar’ towards increased liability, that may well be the inevitable effect.