The recent Supreme Court decision of Debut Homes Limited (in liquidation) v Cooper [2020] NZSC 100 has significant implications for directors of companies facing solvency challenges. These implications are particularly heightened in the current COVID-19 economic environment.

In response to the COVID-19 health crisis, the Government recognised that the economic uncertainty associated with the health crisis could lead to excessively conservative decision making, which could itself stifle New Zealand’s economic recovery. This led the Government to introduce, from 3 April 2020, a “safe harbour” regime which provided limited protection for directors of companies who continued to trade, from potential claims under sections 135 (“Reckless Trading”)

and 136 (“Duty in Relation to Obligations”) of the Companies Act. Further commentary on the “safe harbour” regime can be found here.

With the expiry of the COVID-19 “safe harbour” exemptions on 30 September 2020 and the implications of the Debut Homes decision, more than ever directors will need to turn their minds to the application and scope of their duties.

Reckless trading and the expiry of COVID-19 safe harbour provisions – Directors beware

Reckless trading and the expiry of COVID-19 safe harbour provisions – Directors beware

October 2020

Debut Homes – Summary

• Debut Homes Limited (Debut) was a residential property developer, of which Mr Cooper was the sole director, and he and his wife owned all the shares in Debut.

• Debut had been balance sheet insolvent since March 2009 (broadly, more liabilities than assets), but had been supported by shareholder advances so that, up until the end of October 2012, Debut had paid all its debts as they fell due.

• In November 2012 Mr Cooper decided that Debut should cease trading after completing its four remaining projects. At that time, Mr Cooper estimated that Debut would have a surplus of almost $170,000 from the remaining projects, but with no provision for interest costs or GST. Debut’s accountant advised that the GST deficit would be over $300,000.

• Advances from Mr Cooper’s family trust (on a secured basis) provided cash flow to ensure that the remaining properties were completed and sold. The decision to continue trading over this period meant that Debut had incurred new trade debt and, additionally, owed the trust over $200,000.

Throughout this period of trading, Mr Cooper worked in the business without pay.

• By March 2014, Debut owed GST of $450,000, and was placed into liquidation on Inland Revenue’s application. Secured debt (other than the debt owing to the trust) had been repaid.

• The liquidators brought proceedings against Mr Cooper for breach of director duties under sections 131 (“Duty of directors to act in good faith and in best interests of company”), 135 and 136 and sought compensation.

• In the first instance in the High Court, Mr Cooper was found to have breached his director duties and ordered to pay compensation. This decision was appealed and the Court of Appeal allowed Mr Cooper’s appeal against the findings of the High Court. This Court of Appeal decision was then further appealed to the Supreme Court.

• The Supreme Court reversed the Court of Appeal’s decision and reinstated the order of the High Court which found Mr Cooper to be in breach of director duties, and ordered Mr Cooper to pay compensation of $280,000 to Debut.

Insights and key takeaways

Debut Homes highlights the challenges for directors in balancing the decision to (i) continue to trade to obtain better prospects for their business and creditors overall, and (ii) acting prudently in their assessment of the trading prospects of the business. In the case of Debut Homes, by carrying on trading Mr Cooper had effectively placed the lion’s share of the loss from the business on Inland Revenue. What is clear from the Debut Homes decision is that the Court has no tolerance for the actions of directors who continue to trade-on, in near or actual insolvent circumstances, where there is no hope of salvage. In these circumstances, the Court is willing to find directors personally liable for new debts which the company incurs from the point of insolvency onwards.

Other key takeaways include:

• If a company reaches a point of insolvency which is not salvageable, any trading after that point will be considered “reckless” for the purpose of section 135 of the Companies Act. This will apply whether or not any shortfall in funds owing to creditors was projected to be reduced.

• There are options available to directors other than simply trading on in the hope things will improve. These include:

- engaging with creditors to reach informal compromises;

- pursuing more formal compromises via parts 14, 15 and 15A of the Companies Act; or

- handing control of the company to an independent third party, such as licensed insolvency practitioner, to act as liquidator or receiver.

• When a company is in financial difficulty, the directors must consider all creditors when deciding a course of action.

• The duty to not incur obligations without reasonable belief that the company will be able to perform the obligations as they fall due, is not limited to contractual obligations (and can, for example, include GST).

• Directors need to think very carefully before taking on new debt to repay old debt.

• Directors actions will not be viewed favorably where, as the Court commented, they are “robbing Peter to pay Paul.”

• In addition to the Companies Act, both the Income Tax Act 2007 and the GST Act 1985 contain mechanisms that allow Inland Revenue to seek redress. The action Inland Revenue takes will depend on the particular facts and activities of the company in question, and the priority rules for GST.

• Inland Revenue has played its part during COVID-19 by agreeing to various tax instalment arrangements. However, in general, Inland Revenue is becoming more vigilant in pursuing directors and shareholders of distressed companies, where a company cannot meet its tax liabilities.

So what should directors do?

Debut Homes is not an isolated case; rather it is another case in a line of decisions that have been heard and are pending in the Courts that grapple with the same issue of companies experiencing material financial distress (see, Mainzeal Property and Construction Ltd (in liq) v Yan [2020] NZHC 1659; Alala International Ltd (In Liq) v Chen [2020] NZHC 2212). In the current economic climate, questions of solvency and whether to continue trading will be an ongoing focus for all businesses.

Directors also need to think very carefully when deciding which creditors to pay. It may be tempting to focus on paying those creditors who are related, or where directors have given personal guarantees. The Courts may see this as an indication that the director is preferring their own interests over those of creditors as a whole and hold the director personally liable for any shortfall.

Directors should obtain advice if they are concerned as to the solvency of their company. To ensure that directors are able to rely on any advice it must be directed to the specific risk / issue in question and not be simply generic in nature. If directors are seeking legal advice on the scope of their personal duties and they wish to retain legal privilege in that advice, then it should be obtained separately from advice provided to the Company and should be addressed solely to the directors.

In relation to tax obligations, professional advice should be sought as to when a taxable activity ceases for GST purposes, the tax treatment of transaction costs and whether any clearances are required from Inland Revenue.

Reckless trading and the expiry of COVID-19 safe harbour provisions – Directors beware

This content is accurate as at 5 October 2020. This content is for general information purposes only, and should not be used as a substitute for consultation with our professional advisors. If you wish to understand the potential implications of COVID-19 for your business, please get in touch. To find an advisor and to see more of our general guidance for businesses, please visit our COVID-19 webpage at www.pwc.co.nz/covid-19

© 2020 PricewaterhouseCoopers and PwC Legal New Zealand. All rights reserved. ‘PwC’ and ‘PricewaterhouseCoopers’ refer to the New Zealand member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

How PwC can help?

PwC can help companies and directors by providing specific advice to assist with determining a company’s financial position, directors’ duties and obligations and what steps/actions directors should be taking when approaching a position of insolvency. Our service offering includes:

Business Restructuring Services:

Providing advice on what steps directors should be taking when faced with insolvency or near insolvency, and can also take formal insolvency appointments where a company cannot meet its obligations;

PwC Legal:

Advising on the legal aspects of directors’ duties, including advising on the implications and consequences of taking certain actions, and corporate governance considerations; and

PwC Tax and Private Business:

Advising directors of the tax implications and consequences of taking certain actions, as well as working with Inland Revenue where resolution of tax issues is required.

John FiskPartner, Advisory+64 21 492 052john.fisk@pwc.com

Marcus McMillanDirector, Advisory+64 27 511 6608marcus.j.mcmillan@pwc.com

Keegan ToftDirector, PwC Legal+64 21 0866 0612keegan.x.toft@pwc.com

Matt KeenanPartner, PwC Legal+64 21 834 216matt.p.keenan@pwc.com

Eugen TrombitasPartner, Tax+64 21 493 903eugen.x.trombitas@pwc.com

Catherine FrancisDirector, Tax+64 20 4067 6744catherine.d.francis@pwc.com

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