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Tightening credit conditions and finance company failures

01 October 2007

The recent "credit crunch" in global financial markets and the flurry of local finance company failures give cause to remind directors of the need to bear in mind their specific duties in insolvency or near-insolvency situations.

Although the New Zealand focus is presently on finance companies, a sensible observer might suspect their uneasy predicament will have flow-on effects to the rest of the economy.

Particularly important is the obligation of directors to ensure that their companies do not engage in "reckless trading". In this article we refresh you on the key aspects of the law in this respect, and suggest steps which can be taken by directors to reduce the likelihood of falling foul of the reckless trading prohibition.1

Reckless trading – the statutory prohibition

The obligation on directors to avoid reckless trading has existed in one form or another for many years. The current statutory prohibition is set out at section 135 of the Companies Act 1993. Briefly, that section provides that a director must not agree to a company’s business being carried on, or cause or allow the business of a company to be carried on, in a manner likely to create a substantial risk of serious loss to the company’s creditors.

Balancing legitimate and illegitimate business risks

The current statutory formulation of this duty has been widely criticised. The chief complaint is that no legislative guidance is given as to what actions on the part of company directors will constitute legitimate risk-taking and what actions will cross the line into reckless trading.

The concern is that in the absence of such guidance, company directors may be encouraged to act in an overly cautious manner, thereby potentially frustrating the ambitions of shareholders and creditors who may well possess a healthy appetite for risk (and its sought-after handmaiden, profit). The fine line between entrepreneurial daring and reckless activity is alluded to in the long title to the Companies Act itself, which provides that one of the purposes of the Act is to encourage efficient and responsible management of companies by allowing directors a wide discretion in matters of business judgement while at the same time protecting shareholders and creditors against the abuse of management power.

In the absence of statutory guidance as to what constitutes acceptable business risk-taking for these purposes, it is necessary to look to case law. By and large, however, the cases in this area do not offer full or unambiguous guidance on this point, judges having (understandably) restricted themselves in most occasions to offering a decision on the particular facts before them without developing a quasi-legislative map for directors navigating troubled business waters. Nonetheless, it is possible to identify certain considerations which ought to be taken into account by a court when determining whether a business risk was legitimate. Directors may wish to bear these points in mind, particularly so if liquidity issues are increasingly pressing upon their companies.

Considerations to note

The duty in section 135 of the Companies Act is not owed to a company’s creditors or its shareholders but, rather, to the company itself. However, this distinction is of little practical significance, as a director who is found to have breached this duty may be ordered by a court to contribute to the assets of the company which are available to its creditors upon its liquidation or, where an application is made by a creditor, to make payment directly to that creditor. Moreover, Court of Appeal authority exists to the effect that the obligations owed by directors to a company require those directors to have regard to the interests of the company’s creditors.2 The need to have regard to the interests of a company’s creditors clearly requires directors to attempt to understand those interests, including if necessary, by engaging in dialogue with those creditors.

Whether the risk of a proposed business activity was fully understood by a company’s creditors and shareholders is a factor a court will likely take into account in determining whether that activity constituted reckless trading. Directors proposing to undertake a potentially risky course of action, particularly if their company is already trading under the constraint of diminishing liquidity, should consider whether the company’s creditors and shareholders have been or should be fully briefed as to the proposed action. This will especially be the case if there is a risk that the creditors and shareholders will be adversely affected by the proposal. All creditors are obviously not created equal. Many will be larger and more sophisticated enterprises than the company in question. Trading banks, for example, may be quite prepared to accept an increase in risk where that has a reasonable prospect of translating into a healthier company going forward. Keeping the persons whose capital is at risk informed of a key business decision is an obvious means of reducing the likelihood of those persons subsequently claiming that decision was reckless.

Judges can also be expected to have regard to whether the actions in question are in accordance with orthodox commercial practice. This is not an easy matter to determine, of course, and will depend on the facts of each case. The key here will be whether standard features of good corporate governance have been followed in determining whether to enter into, or continue, that course of action. Holding regular board meetings, ensuring board members are fully briefed (including as to effects on the various investors, including creditors), developing detailed business plans and projections, reviewing the performance of the company against those plans and projections and adapting the chosen course of action as and when needed in light of this review, maintaining accurate accounting records, considering restructuring options and consulting internal and external experts where necessary, are all features of prudent corporate governance.

Another consideration which is apparent in the case law in this area is the time for which a company may have been trading while in balance sheet insolvency. Companies do not need to cease trading immediately that they become balance sheet insolvent, and indeed, doing so when there was reasonable prospect of trading out of difficulties may itself cause significant and unnecessary loss to investors. Nonetheless, it is clear that a company should not trade indefinitely while insolvent.

The key factor in this determination will be the point at which it becomes apparent that the company cannot trade its way out of difficulties. Although the cases do not suggest a hard and fast rule as to the period of time which will be allowed before the plug should be pulled on the company, the suggestion is that a period of weeks or some months, rather than a longer period, may be appropriate. As the length of time increases, so too does the inference that a company may not be able to trade its way out of difficulties, and also therefore the risk that a director may be found to have breached the duty to not trade recklessly.

The present environment of increasing corporate collapse affords a timely reminder to all of the need for alertness to, and compliance with, the reckless trading prohibition. A very regular review of the company’s position, and reporting on it to the board, is important.3

Footnotes

  1. This article follows up on an earlier Boardroom article by Jane Parker and Brigid McArthur of Chapman Tripp in June 2004.
  2. Nicholson v Permakraft (NZ) Ltd [1985] 1 NZLR 242 at 249, 254 and 255.
  3. For a description of how the New Zealand Court of Appeal recently approached, on the facts, a case of reckless trading, see Mason v Lewis [2006] 3 NZLR 225. In that case the Court, in finding the director liable for breach of the reckless trading prohibition, noted that a reasonable and prudent director would have seen that the company in question was in financial trouble and would have taken steps to remedy the situation or, ultimately, to stop trading. The Court stressed that directors must take reasonable steps to guide and monitor the management of their company and in particular pay proper attention to their company's financial affairs.

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