IntroductionRecent high profile events including the Hartner Construction and Ansett Australia collapses have again highlighted a director's individual liability for allowing companies to continue to trade whilst insolvent. Coincidentally, there have been a number of recent Court decisions dealing with this issue, in which the Courts imposed personal liability on directors for amounts incurred after directors should have been aware the company was unable to meet those debts.
The cases demonstrate a willingness by the Courts to lift the corporate veil by holding directors personally liable for company debts, and a lack of distinction between the liability of individual directors with varying degrees of involvement in the business. Accordingly, it is not possible for directors to remain aloof from a company's operations and still seek to avoid liability by arguing they did not have knowledge of the company's true financial position. Responsibility for the financial obligations of the company will apply equally among all directors.
This article reviews these recent decisions. It illustrates the need for all directors to take reasonable steps to remain informed about a company's trading position, to seek and act on professional advice, and to take steps to address an insolvent position at an early stage. This requires the ability to know when "enough is enough" and demonstrates the classic tension between attempting to trade out of difficulty, and making the decision to appoint a liquidator.
Relevant LegislationClaims against directors result from an alleged breach of a director's statutory duties under the Companies Act 1993 ("Act"). In particular, Section 135 requires a director not to cause, allow, or agree to the carrying on of the business of the company in a manner likely to create a substantial risk of serious loss to creditors. Section 136 requires directors not to agree to the company incurring any obligation unless, at the time, the director believes on reasonable grounds the company will be able to perform the obligation when required.
Breach of duty does not impose direct liability on directors to creditors, as the statutory rights for a remedy rest with shareholders. However, if a company is placed in liquidation, a creditor may be able to apply to the Court for orders that a director pay the company compensation for such a breach. The Court also has power to order payment directly to the creditor.
The CasesIn Re BM & CB Jackson Limited (in liq); Benchmark Building Supplies Limited v Jackson, Mr and Mrs Jackson were the directors of a family building company. The company's financial position had deteriorated significantly over a number of years until eventually in March 1997 Benchmark placed a stop credit on the company's account forcing Mr Jackson to put the company into voluntary liquidation. Benchmark claimed the directors were in breach of the duties they owed the company under the 1955 Act equivalents of Sections 135 and 136.
Whilst the directors argued that they could reasonably conclude the company had a good chance of trading through the downturn (it had good forward work opportunities and the limited support of its bank and principal supplier), the Court held that by 30 June 1996 reasonable directors would have recognised that continuing to trade would create a substantial risk of serious loss to unsecured creditors. Accordingly the directors were held liable to pay the liquidator trade debts from that date until the date of judgment.
The Court confirmed that an objective test based on the reasonable director is to be applied, and provided the following
useful summary of the tests to be used in assessing a director's liability:
Section 135: Was there anything in the company's financial position that would have alerted an "ordinarily prudent director" to the real possibility that continuing to trade would cause the kind of serious loss to the company's creditors the section was intended to prevent; and Section 136: The director's belief must be "reasonable on objective grounds" so that a reasonable director of the company in the circumstances could believe that the company would pay the debts it was incurring.A further interesting aspect of this case was the manner in which the Court assessed the respective culpability of the two directors. Mrs Jackson was much less involved in the day-to-day running of the company and was probably not at all involved in the critical decisions to continue trading or liquidate. However, the Court did not consider this absolved her from full responsibility as "[d]irectorship of any company involves acceptance of all the directorial duties imposed by law. There is no halfway house." In discussing the culpability of Mr Jackson the Court touched on the emotional difficulties that often need to be confronted in making a decision to liquidate when noting that "...[the] position was simply that the Company represented his livelihood and he wanted it to continue in business by any means ...".
In a second case, Re Hilltop Group Limited (in liq); Lawrence v Jacobson, Mr Jacobson and Ms Cowley transferred the business of their partnership to Hilltop Group Limited ("Hilltop") under the sole directorship of Mr Jacobson in April 1996, a year after the business had lost its major customer. The business continued to trade. The purchase price for the business transferred to Hilltop included "grossly overstated" goodwill calculated on previous years profits. Evidently Hilltop was insolvent from the time it began trading and subsequently went into liquidation in June 1997. Hilltop's liquidator sued the director for contribution to the company's assets alleging breaches under the 1955 Act equivalents of (among others) Sections 135 and 136.
Applying a similar test to that in the Benchmark case the Court found that Mr Jacobson agreed to and facilitated the company continuing to incur obligations to creditors when he knew, or ought to have known, the company would not be able to meet those obligations in a timely manner. As no reasonable prudent director faced with the situation could justifiably have done so, Mr Jacobson was held liable to contribute $589,336.88 (plus interest) to the assets of the company.
The Court rejected Mr Jacobson's attempt to avoid liability under Section 138(1)(b) which allows a director when performing his duties to rely on reports, advice and information supplied by professional advisors or experts. The Court found that this only applies where the director acts in good faith, makes proper enquiries, and has no knowledge that such reliance is unwarranted. Here the Court held that Mr Jacobson could not show the specific reliance on that advice that was necessary to exclude liability. Again this illustrates the need for directors to be pro-active and to seek specific advice on the actual situation if liability is to be avoided.
CommentThe Court in the Benchmark decision assessed Mr Jackson's culpability for knowingly and unreasonably risking the money of unsecured creditors as unrealistically and unreasonably optimistic. In doing so he was acting to save his family's building company - his financial lifeline. Whilst we may have sympathy for a person placed in this situation, Mr Jackson's liability stemmed from his continuing to trade having been squarely confronted with the reality of the company's financial position.
Decisions for continuing to trade range widely, and often emotion and ego overtake good business sense. In recognising this, the Benchmark decision refers to a spectrum that encompasses "reckless directors" ranging from "the crooked to the honest, but hopelessly and unreasonably optimistic". There are stark contrasts between the parties and circumstances to these cases. Mrs Jackson's actions seem reasonably innocent to the seemingly pre-meditated actions of Mr Jacobson.
Nonetheless the Courts are consistent in their treatment of directors imposing the same level of personal liability despite their place on the spectrum.
The Courts do not look subjectively at directors when deciding personal liability. They apply an objective standard of what the reasonable, prudent director would have done in the same circumstances. Accordingly, subsequent to the point that a "reasonable, prudent" director would liquidate a struggling company, a "reckless" trader may be held personally liable for the company's debts.
These decisions are a reminder to all directors that they must take their obligations and duties seriously, and retain a suitable degree of involvement in the affairs of the company. In addition directors must continue to seek and act on professional advice, and to take steps to address an insolvent position at an early stage if liability under these provisions is to be avoided.
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