Directors do not need to consider creditors’ interests when determining the fairness of their own remuneration, even after the company has become insolvent, the Court of Appeal has found.
The Companies Act 1993 requires that directors who vote to authorise director remuneration must sign a certificate stating that, in their opinion, the payment is fair to the company and setting out the grounds for that opinion.
Liquidators of Petranz Limited, and the company itself, sued the company’s directors for authorising remuneration which they alleged was unfair to the company.
The company became insolvent but continued trading. During this period the directors continued receiving salaries. Upon liquidation, the company’s largest debt was owed to Inland Revenue.
The High Court found the directors breached their duties (including by reckless trading), failed to keep proper accounting records, and failed to follow the correct procedures when authorising directors’ remuneration.
When directors fail to follow those procedures, they can be required to repay to the company any remuneration which they cannot establish was fair to the company, as in the Bridgecorp litigation.
But that issue did not arise in this case as the High Court found that the remuneration was fair because the company continued to derive value from the directors’ work after it had become insolvent.
The liquidators appealed the decision.
The Court of Appeal
In Madsen-Ries v Petera the Court of Appeal rejected the liquidators’ arguments that:
- any remuneration paid to directors when a company is insolvent is unfair to the creditors, unless it is for work done to stop the company trading and to preserve the position of the creditors, and
- the duty to certify fairness of payments to directors is a reflection of a director’s fiduciary duties – which, when the company is insolvent, require the interests of the company’s creditors to be considered.
Instead the Court found that, under the Companies Act, the creditors are protected against the risk of improper distribution of company assets to shareholders (for example, by the payment of dividends) by the solvency test and by directors’ duties not to trade recklessly.
In contrast, the concept of “fairness” in the Companies Act calls for a consideration of the potentially competing interests of:
- the company and its directors
- the company and its shareholders, or
- the shareholders themselves
but not the interests of creditors.
Interestingly, the Court of Appeal accepted that director remuneration:
- could have been (though was not) approved by shareholders via the “unanimous entitled person consent” provisions of the Companies Act; in which case
- the directors would have been required to certify that the company will satisfy the solvency test after the payment - and would have been liable to repay that remuneration if the company did not do so.
The Court of Appeal did not consider that this outcome was inconsistent with its conclusions on the different roles which the solvency test and considerations of “fairness” play in the scheme of the Companies Act.
This conclusion is not completely convincing: it remains an odd outcome that the test for the legitimacy of director remuneration should be:
- fairness (to the company, not creditors) where the remuneration is approved by directors, but
- solvency (which protects creditors) where the remuneration is approved by shareholders.
But that outcome is not of the Court of Appeal’s making, and we agree that it was right not to let that one oddity distract it from its overall analysis.
When certifying that director remuneration is fair to the company, directors need not consider creditor interests, even if the company’s solvency is in question.
- the decision to “purchase” director services is no different to any other trading decision directors make - so they should not take it if it would breach their duty not to trade recklessly
- creditor interests will still be relevant to assessments of personal liability for breaches of directors’ duties, and
- to minimise the prospect of future claims, directors should ensure they follow correct processes to authorise director payments and to certify solvency and/or fairness to the company.
Our thanks to Moria Brengauz for writing this Brief Counsel. For further information, please contact the lawyers featured.