Recent decisions mean stakes rise in director liability

By Kerry Fulton

Friday 20th February 2004

The Companies Act 1993 was heralded as a clear message to directors to exercise their powers and duties responsibly. The consequence of failure could be significant civil and/or criminal liability.

Two cases in the last three weeks are a timely reminder of the potential civil consequences: the multimillion dollar payment to settle the claims by the liquidators of DML Resources against Murray Bolton, Stuart Walbridge, Laurie Margrain and Wayne McCarthy and the successful judgment for $7 million obtained by the liquidators of South Pacific Shipping (SPS) against Klaus Loewer (see page 6).

The claims decided by the High Court have not all been for large amounts. But the strike rate of the decided cases is very much against the director. In summary the awards over the past six years are: 2001 Sanderson $35,000 ($90,000 claimed); 2001 Bates: $30,000 ($60,000 claimed); 2001 Jackson $387,746 plus some $228,000 owed to family trusts (the full amount claimed); 2001 Hilltop $590,000 (the full amount claimed); 1998 Nippon Express $250,000 against each of two directors (total unpaid debts claimed of $1.12 million). Interest and costs are additional.

At issue in most cases are the directors' obligations under sections 135 and 136. S135 says a director must not allow the company to trade where there is a substantial risk of serious loss to the creditors.

What that means has been left to the courts to say and this uncertainty has attracted a degree of criticism.

S136 says a director must not agree to the incurring of obligations unless they have reasonable grounds to believe the obligation incurred can be met when called on. That is more straightforward.

The cases have thrown up several issues. Some of these are: the use of professional advisers; the way creditors are dealt with; the absence of directors' meetings; and the discretionary nature of relief.

The act does enable directors to rely on professionals and also to delegate some obligations so long as adequate and justified supervision is in place.

But that has not always been translated into a satisfactory outcome for the director.

In one case the court said, "I do not wish to be unduly harsh about the company's accountant. But, having seen him in the witness box, I do not think he was capable of advising the directors to take the hard but irresistible decision to liquidate. It was a case of the blind leading the blind."

It is clear directors need to be prepared to seek and receive the sort of advice they may not want to hear. It will often be better for a director to go outside the company's usual advisers to seek that advice.

It will invariably be safer to do that sooner rather than later, as the court will ask, "was there something in the financial position of the company that would have alerted an ordinary prudent director to the real possibility that continuing to trade would cause serious loss to creditors?"

The way creditors are dealt with by directors is another significant feature of the cases. The courts have looked closely at what the directors knew about the company's financial plight when it incurred credit, assessed against what the creditors knew or were told by the company.

Buying goods and services on credit is exposing creditors to the risk of loss and when the company is facing liquidity problems that risk is increased.

The deeper the problem, the greater the risk the creditor does not get paid.

Two of the cases have found directors liable for the entire unpaid trade debts incurred. McDonald & Vague's DML claim was also based on the $7.4 million of unpaid trade creditors' debts at liquidation. Some of that debt dated back to February 1997 (DML went into receivership on November 3, 1997).

It settled days before trial.

What will be important is that all creditors are dealt with equally.

This is not easy due to the tension between the commercial and legal aspects of the trading situation.

Inevitably, advising creditors of financial pressures adds to that pressure, with changes in credit terms often being imposed or arrears cleared.

Openly explaining the financial woes might win some creditor support but this is typically only entertained for the select few creditors deemed essential.

But directors and creditors in that situation have to watch out for that other problem; the voidable transaction.

The more the creditor knows of the problems the company is facing, the greater the risk the creditor may have to repay any sums they receive. Special deals arising from these deep-seated liquidity problems can lead to a greater problem later for both the creditor and the director.

Directors must therefore take care not to mislead any creditors about the credit risk they are entering.

That message applies as much to staff of the company as it does the directors, because there is also the attendant risk of liability under the Fair Trading Act for credit incurred on the basis of misleading statements made by staff about the state of the company.

The SPS case is notable in this context because the court reduced the possible award against the director 30% on the basis that creditors trading with the company had to have assumed some risk and that this would have been (without any evidence to determine this) reflected in the prices they charged.

Without doubt, this will be the most controversial aspect of the decision and I would expect most commentators to argue against this type of reduction as a matter of principle and commercial reality. This reduction was also made notwithstanding an earlier finding by the court that the creditors did not know the specific risks.

The majority of businesses that fail tend to be of a smaller scale and where the whole concept of a "board" is perhaps a bit foreign to the directors. There remains, though, a clear need for discipline in company management and regular, formal directors' meetings are a must: small or large company.

Planning for those meetings is important. Obtaining up-to-date financial information of actual and forecast performance is important.

Where the company faces financial problems this formality will assist the analysis of the problems and help with their earlier identification of possible solutions. Failure to hold regular, productive directors' meetings will result in judicial criticism and increase the prospects of a liability finding.

Finally, one point has emerged clearly from the decided cases: the sum which a court might award for a breach of duty is a matter of judicial discretion. It has been described as awarding only the "just desserts."

The courts usually have regard to three factors as guidelines to the exercise of this discretion: culpability of the director(s) (how they behaved in a business sense); duration (of the breach); and causation (of ultimate losses to the company/creditors).

This is not altogether satisfactory for creditors or directors, but does allow a balancing exercise that recognises company failure does not automatically translate through to a director's liability. It is in this way that the factors noted above will have their financial impact in a directors' claim.

Despite the strike rate, unpaid creditors have to remember the act does not impose liability just because a company fails.

Kerry Fulton is a barrister specialising in commercial litigation and insolvency. He was counsel for the plaintiffs in the successful DML and Jackson directors' cases, and for the directors in settling the Nautilus litigation.

In the SPS case the court reduced the possible award against the director 30% on the basis that creditors trading with the company had to have assumed some risk and that this would have been (without any evidence to determine this) reflected in the prices they charged

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