The Supreme Court recently released its decision in relation to the long-running directors’ duty case, Yan v Mainzeal Property and Construction Limited (in liquidation) [2023] NZSC 113 (Mainzeal).

In the wake of the release, there have been a flurry of articles and hot-takes from journalists and legal commentators that canvass the main factual and legal findings, assisted in large measure by the Court’s decision to include a quasi-guidance section at paragraphs [359] – [370] of the judgment. If you are looking for a general overview of the case and do not have the appetite to review 142 pages of legal prose, there are good summaries by RNZ, the NZ Herald (paywalled), Stuff, BusinessDesk (paywalled) and NBR (paywalled).

In this article, we explore one of the findings in Mainzeal that has received comparatively little attention – that breaches of sections 135 and 136 of the Companies Act 1993 can be pursued by individual creditors and, critically, that any losses that the Court determines they have suffered will be directly paid to them. This ruling has the potential to drastically change New Zealand’s insolvency landscape.

s135 and s136 of the Companies Act 1993

Overview of s135

Section 135 of the Companies Act prohibits a director from agreeing, causing, or allowing a company being carried on in a manner that is likely to create a substantial risk of serious loss to its creditors.

The test is objective – it asks first whether the company was trading in such a manner and second whether the director knew or ought to have known that it was in said state and opted to proceed nonetheless.

The Supreme Court held that the standard to be applied to the second limb of the test is akin to negligence (i.e., what would a reasonable director have done in the circumstances).

Overview of s136

Section 136 of the Companies Act prohibits a director from agreeing to the company incurring an obligation unless she or he 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 test is mixed objective/subjective. This means that the director must actually believe that performance will be possible and the grounds on which they rely to form that belief must be objectively reasonable.

The Supreme Court has now confirmed that “agree” in this context does not require the directors to agree to the specific undertaking(s) at issue. It is sufficient that the obligation is one that is an “inevitable corollary of [the] continuation of trading”.

Historical difficulties with s301

In the context of a liquidation, claims for breaching sections 135 and 136 conventionally travel through section 301. This provision does not create a separate cause of action. It merely provides a procedural mechanism for the conduct of these claims and a handful of others.

On its face, the Supreme Court acknowledged that the wording of section 301 does not allow creditors to obtain direct relief for breaches of sections 135 or 136. That effectively limited the class of potential plaintiffs to liquidators only.[1]

The New Age

Problem solved

The Supreme Court took a purposive approach to interpreting section 301(1)(c) and determined that there had been a “drafting slip” by Parliament. Properly construed, section 301 did allow for a direct claim by creditors for breaches of sections 135 and 136 for losses that they have suffered as a result of those breaches.

Practical implications

The Supreme Court’s recognition of two “new” causes of action for creditors against directors is consequential. Most of these can be marshalled under two headings:

1. Creditors now have significantly more control over repayment of their debt post-liquidation.

No longer are creditors confined to waiting for liquidators to advance claims against directors. Liquidators can be bypassed (though perhaps not altogether).[2]

This has both positive and negative second and third order effects. On the positive side:

1. Plaintiff-creditors can bring and conduct proceedings based on their own risk appetite and budget.
2. Plaintiff-creditors stand to improve their chances of:[3]
   1. recovering their debt; and
   2. getting their debt repaid sooner.
3. Plaintiff-creditors can band together to consolidate resources and share information as they see fit.
4. Pioneering plaintiff-creditors that are successful may inadvertently enable other creditors to obtain their own settlements or, failing agreement, judgment.
5. Directors will not escape liability by hiding behind a general security granted over all the company’s assets (as the “new” causes of action are not assets of the company and therefore cannot be stymied by a security-holder).[4]

Collectively, these effects could be seen as advancing the policy goal of improving access to justice.

On the negative side:

1. There may be a “bank run” to get to directors first, while they remain solvent and/or have a fund available under their D&O policy (a point to which we will return).
2. To the extent a plaintiff-creditor is successful and obtains a recovery, it will reduce the pool of assets available for the balance of creditors in the liquidation. This is on the basis that the loss will no longer be claimable by a liquidator in relation to a claim advanced by her or him in respect of breaches of sections 135 and 136.
3. A successful plaintiff-creditor will obtain a much larger share, relatively speaking, than their counterparts who do not litigate and may diminish the ability of the director-defendant to service any subsequent judgment (or settle claims), whether advanced by a liquidator or by other plaintiff-creditors. There is an obvious tension here with the parri passu / equal treatment policy goal of the insolvency regime.
4. It may create a cluttered and unwieldy litigation environment, with multiple proceedings against the director-defendant on foot simultaneously. On the two occasions where the High Court in New Zealand has awarded compensation directly to plaintiff-creditors under section 301, it has been justified, in part, because the liquidator elected not to bring proceedings. The Supreme Court has not limited access to the claims in this way.
5. There is uncertainty as to how claims advanced by creditors will interface with those made by the liquidator. It is unclear, for instance, to what extent a full and final settlement reached between a defendant-director and the liquidator will impact a plaintiff-creditor that is not a party to the agreement. At minimum, one would expect the plaintiff-creditor’s claimable loss to reduce by an amount equivalent to their dividend in the liquidation, but it remains to be seen whether it would bar their claim altogether.

At this early stage, it appears that the change in dynamic will disproportionately favour wealthier creditors and, in some cases, may lead to worse outcomes for poorer creditors.[5]

2. Directors now face significantly greater risks in the event of an insolvent liquidation.

The pool of potential plaintiffs has been increased by several orders of magnitude. Directors will therefore need to carefully consider the motivations and appetites of individual creditors in the twilight period before liquidation. The Court has long advocated for directors to have regard to the interests of creditors when the company is in distress, but these developments are likely to make that recommendation take on additional salience.

Insurers will need to take this increased risk to its insureds into account. We are likely to see increases in the premiums charged under these policies and potential variations to the nature and scope of the coverage.

Eventually, we may also see the development of a new cottage-industry for creditor-led litigation.  Given it will no longer be necessary to engage with the rather restrictive liquidation process to get repaid, there will be opportunities for insolvency practitioners and professional advisors to work directly with creditors to achieve a recovery.

If you have any questions or would like more information about the points discussed in this article, please get in touch.

[1] High Court authority had been divided on this issue but the proof is ultimately in the pudding – there have been very few cases where creditors have advanced claims for breaches of directors’ duties in New Zealand, and only two successfully. The circumstances of those claims made them fairly unique.

[2] It remains to be seen how plaintiff-creditors will obtain sufficient information to initiate these claims that are by their nature very complex evidentially. Liquidators have a significant advantage in this regard. Invocation of the section 256 CA93 pathway, liquidation committees, and pre-commencement discovery orders may become the norm.

[3] Of course, the cash-value of that improvement will be highly fact specific.

[4] This was one of the proposals in the recent Insolvency Law Reform Cabinet Paper dated 4 November 2019 prepared by MBIE.

[5] Two counterpoints to this are worth recognising: 1. A plaintiff-creditor assumes a risk in pursuing these claims along with an associated financial burden and, if successful, should be suitably rewarded; and 2. A plaintiff-creditor may actually help other creditors get payment e.g. by establishing a “breach date” (under s135 or 136 or both), after which all losses are recoverable.