Paul Dalkie, Barrister, discusses the Director’s Duty under ss135 and 136 of the Companies Act 1993 by taking a dive into the recent case Debut Homes Limited (in liq) and anor v Copper and annor  NZSC 100 and theories on corporate governance.
The Supreme Court decision in Debut Homes Limited (in liq) and anor v Copper and anor will significantly impact on commercial transactions in NZ as it affects the meaning and application of ss135 and 136 of the Companies Act 1993. It may well result in these provisions having to be amended.
At various times New Zealand has attempted to position as an international financial centre. That becomes a difficult aspiration to fully grasp when its highest court produces judgments lacking in analysis, and recognition of commerciality. Such judgments do little to assist the Supreme Court in trying to achieve peer recognition from other final courts around the globe. As well, corporations looking at the possibility of doing business in New Zealand become circumspect fed by a lack of confidence in the legal system. The Supreme Court has been subjected to criticism, since its inception, over decisions in a range of different areas. The recent decision in Debut Homes is another.
Peter Watts, has severely criticized the Debut Homes decision, which he compared to applying “the morals of the vicarage” to statutory duties as they operate in commercial activity. It is a turn of phrase Clive James and Oscar Wilde who, between them have produced some of the world’s most quotable quotes, would like to have owned.
This case is important because
This case is important because it considers the scope of directors’ duties particularly in the zone where a company is insolvent, or nearly so.
Debut Homes had one director, Mr Cooper. By the end of October 2012 Debut Homes was in financial difficulty. Since March 2009 it had balance sheet insolvency (assets < liabilities) but had been supported by shareholder advances. On November 6, 2012 Mr Cooper met with the company’s accountant to consider how it could fund and sell four unfinished houses. The forecast was for a profit after sales of $170,000 but excluded interest expense and GST payable on sales, including GST payable on November 30, 2012 on two prior sales. At the end of sales Mr Cooper and his accountant estimated a GST deficit of over $300,000.00. Sales took place between November 9, 2012 and January 21, 2014. Debut Homes was put into liquidation on the IRD’s application for unpaid GST on March 7, 2014. At liquidation Mr Cooper and his wife were collectively owed around $410,000, trade creditors were owed around $28,000 and the IRD debt on GST stood at around $450,000.00.
In the High Court Hinton J found there had a been breaches under ss 131(1), 135 and 136. Inter alia, Mr Cooper was ordered to pay $280,000 to the liquidator. His appeal was successful. The liquidators appealed to the Supreme Court. The main issue on appeal was whether Mr Cooper was in breach of his duties as a director, and whether he had a defence under s138.
Theories on corporate governance
(i) New Zealand – a narrow approach
Although the Court briefly looked at various theories on how corporate governance should work, it avoided the opportunity to give an opinion and provide guidance.
The Court dealt with the issue of solvency in terms of strict absolutes, saying – “maintaining solvency is vital” at one end of the spectrum, or else there is the other end of the spectrum – insolvency where shareholders would lose their investment and the company cease to exist on liquidation.
The same buttoned down approach re appears in the judgment at paragraph  suggesting the moment insolvency arrives then the company must cease trading. It also contains this sentence – “Where a company becomes insolvent, there are statutory priorities for the distribution of funds to creditors and mechanisms to ensure these are not circumvented.” The Court must be referring to when a corporation is put in liquidation; there is no statutory obligation on a company to observe statutory priorities to pay creditors when it is still trading just because it might be insolvent at some point.
One of the reasons in the first place for using a company to trade is to take advantage of its separate legal personality, distinct from its directors, to conduct the business venture. That separate personality enables the business to be conducted by the directors taking acceptable risks and making business decisions for the overall benefit of the business enterprise. To encourage business activity in an economy the law must balance between the extremes of a business environment that is too constricted and one too reckless. The stakes in the ground that define these points are found in legislation controlling corporations and their activity. The space between the stakes is corporate governance.
In my opinion a consideration of corporate governance is fundamental to looking at trading activities and the risks a corporation takes in the course of its business enterprise. It cannot be isolated off so you simply look at solvency, or not; the ‘not’ being insolvency. That said, there is no question that the concept of solvency is critical to the existence of a company as it conducts its business. In actual business solvency of a company does not operate like a binary system of either zero or one. The Court’s approach in Debut Homes tends to assume that every business activity is vanilla. This ignores the fact that some business activities are very risky. It is very often the case that in the course of commercial activity of a company over the time of its existence it will move in and out of solvency. It could do so for a variety of reasons, such as the cyclical nature of its business, something over which directors have no control, except the ability to decide to continue trading through the down turn. In such a business shareholders and trade creditors would no doubt be aware of the trading cycle, and be prepared to indulge the company over the cycle. The agricultural industry is a very good example. Often goods are sold knowing that payment will not be made until a crop or stock is sold. Clearly the company is insolvent at the start of the cycle, it cannot pay its debts as and when they fall due, although it might be balance sheet solvent. Its existence continues because trade creditors are prepared to seek an indulgence. Shareholders “best interests” are less relevant since they must have made the investment knowing the nature of the business; so, they take the risk.
Another possibility is that the directors themselves make a business decision to engage in a course of activity, or enter into a contract that will cause the company to be immediately, or become, insolvent. The decision to do so, must be measured critically against the likely return to the company at the conclusion of the activity, or the contract – so the best interests of the company. That would definitely violate the Court’s view in Debut Homes – “maintaining solvency is vital”, and it would likely conclude there is a breach of s135 and possibly s136 for that reason alone. However, my opinion is that is wrong, and the wrong approach. A decision such as this per se does not mean:-
- there will be serious loss to the creditors if the decision has been made carefully, and an in an informed way, properly balancing the risks; and
- the directors have had the company incur an obligation it cannot perform when required.
The dynamics of the business decision along with the forward prospective outcome should be considered. That component is the element of risk. Taking a risk does not mean that there are breaches of s135 and 136 merely because the immediate outcome of the decision in accounting terms is that the company is insolvent.
The Court of Appeal in Debut Homes acknowledged this where they said risk is a part of business, and an intrinsic feature of it within which the trading activity of a company must be measured. This was said in the context of looking at s135.
These aspects must be weighed against the test for reckless trading. Any director is entitled to take account of them and weigh them. The end result may be conduct that does not fall within the test at all. A company is not bound to cease trading if it encounters insolvency problems. Stopping trading at that point might inflict serious loss to creditors when there is a probability of trading through. In Re South Pacific Shipping Ltd (in liq) William Young J indicated the Court should depart from a literal approach to s135 in favor of a text which examines whether the trading risks that have been taken are “legitimate”. Although the Court in Debut Homes referred to this decision, they avoided any consideration of the proposition on the narrow basis that the company was not salvageable.
Added to this is the view that when a corporation is insolvent, or nearly so, the interests of the creditors must be taken into account. This derives from Nicholson v Permakraft (NZ) Ltd. Although the interests of creditors must be considered in the insolvency vicinity, it is not as a high a requirement as a duty to do so which the Court in Debut Homes recognized.
(ii) A wider approach to corporate governance – Delaware
Delaware takes a much wider view of corporate governance. It is worth considering. There the position is–
“at least where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the residue risk bearers, but owes its duty to the corporate enterprise.”
On this view of corporate governance directors must consider the corporate enterprise as a whole. The directors need to be –
“… capable of conceiving of the corporation as a legal and economic entity. Such directors will recognize that in managing the affairs of a solvent corporation in the vicinity of insolvency, circumstances might arise where the right … course to follow for the corporation may diverge from the choice that the stockholders (or creditors, …) would make if given the opportunity to act.”
Under this model there is not so much emphasis on the interests of creditors. It is a broader approach that looks at commercial context and the risk, and recognizes the significance of a separate corporate existence. When it comes to corporate liability there can be a fixation on the company as an artificial entity, distinct from its members, who hide behind the veil. However, when it comes to defining the object of directors’ duties there should be no reason why the separate existence of the corporation is not a consideration.
The idea is that the concept of a company is essentially an aggregation of its members. This promotes the possibility of a view that the duties of corporate officers may be conceptualized as directed to the corporate enterprise as a separate entity rather than to discrete groups such as the shareholders or creditors, or both. Then, the theory would be that directors should be diligent and have regard for the company as a separate enterprise.
The aim is to maximize corporate value. In Peoples Dept Stores Inc v Wise the Court said –
“Insofar as the statutory fiduciary duty is concerned, it is clear that the phrase the ‘best interests of the corporation’ should be read not simply as the ‘best interests of the shareholders’. From an economic perspective, the ‘best interests of the corporation’ means the maximization of the value of the corporation.”
This is a sound economic/business theory that enables promotion of business activity to produce corporate value.
The reception of this theory of corporate governance was not without its critics. In North American Catholic Educ. Programming Found., Inc. v. Gheewalla the Court rejected much of the reasoning in the Credit Lyonnais Bank Nederland N.V. case. However, the position reverted in Quadrant Structured Products Co. Ltd. v. Vertin. A claim that the board of directors of an insolvent corporation breached its fiduciary duties by pursuing a risky business strategy to benefit the corporation’s sole shareholder at the expense of the corporation’s creditors was dismissed. The decision means directors of insolvent corporations have considerable latitude to pursue value-maximizing strategies designed to benefit the corporate enterprise as a whole.
s135 – insolvent trading
Before I look at what the Court said about s135 I will comment on the arguments on appeal. Mr Cooper presented an attractive argument to the effect that continuing to trade in the circumstances was a legitimate business risk where there was the probability of improving the position to the creditors overall (as in fact happened). He said the reasonableness of that must be assessed by looking at the benefit to the company as a whole, and not to any detriment to individual creditors.
The liquidators asserted that by carrying on the business as he did Mr Cooper knew there was more than ‘a substantial risk’ of a GST shortfall. Simplistically, that is so. The liquidators also ran an extraordinary argument to the effect that Mr Cooper had other options he did not explore such as:-
- trying to negotiate with the IRD;
- only selling the remaining properties to GST registered entities so that the sales would have been zero rated and the GST position no worse;
- using the devices and procedures available under Parts 14, 15, or 15A of the Act.
This very peculiar argument has nothing to do with s135, and how it is to be applied and interpreted. None of its parts have anything to do with deciding where or not there has been a breach of s135. Quite apart from that, (a) and (b) lack any commercial reality. As for (a) there would have been no certainty of any agreement with the IRD, unless, likely, it was one that suited them. As for (b), trying to sell to only GST registered entities would certainly have been to the advantage of the IRD since the GST debt would not have increased past what was owed for the two prior sales. However, the time taken to find actual GST registered entities that would want to buy residential properties would have been a factor affecting the holding costs on interest in relation to the two secured creditors of Debut Homes. The IRD would have also racked up penalty interest and use of money interest onto the primary GST debt. Additionally, it would more likely than not have eroded any profit margin and returned less to the creditors overall since any GST registered entity would probably be a reseller.
As for (c), that Mr Cooper did not attempt to look at other parts of the Companies Act, I cannot see how this is even an argument. The point seems to run – because Mr Cooper did not try and avail himself of the mechanisms under any of Parts 14, 15 or 15A of the Act he therefore breached s135.
The Attorney-General intervened. Their argument was similar to the first part of the appellant’s argument. It too simplistically asserted if continued trading would result in incurring new debts where a portion of them will not be paid then there are breaches under ss131, 135, and 136 of the Act.
The Court was impressed with the argument in (c) above, and dedicated paragraphs  to  of its judgment setting out what Parts 14, 15, and 15A were all about and how they operated. Whist I do not cavil with what they wrote; it has no relevance to the point on appeal as it concerned s135.
The Court said they accepted the liquidators’ submission about these other parts of the Act that could have been considered to avoid a breach of s135. Some explanation of how this is germane to the issues about s135 on appeal in the mind of the Court appears in paragraph . There the Court says the duty under s135 must be assessed “.. in light of the scheme of the Act, and in particular Part 15A, …”. There is no authority or basis for this view. Part 15A which is a mechanism designed to be used in an insolvency has no bearing upon the duty imposed on directors under s135. That is an error. There is then the comment made in the same paragraph about how all creditors are to be consulted under Part 15A. I have no issue with that. However, it is an error to say that can be applied and overlaid to the duty under s135. I think this is the origin of the basis for arriving at the concluding error on s135 – that the duty requires all creditors to be treated equally. It does not. The line of thinking seems to be – the duty under s135 must be assessed in light of Part 15A – and since that requires all creditors to be consulted, therefore s135 requires all creditors to be treated equally.
The Court concluded on s135:-
 If a company reaches the point where continued trading will result in a shortfall to creditors and the company is not salvageable, then continued trading will be in breach of s 135 of the Act. … this applies whether or not continued trading is projected to result in higher returns to some of the creditors than would be the case if the company had been immediately placed into liquidation, and whether or not any overall deficit was projected to be reduced.
 That there will be breaches of ss 135 and 136 in the above circumstances is clear from the wording of those sections but also from the scheme of the Act with its emphasis on solvency, the carefully prescribed statutory priorities on liquidation, as well as the all‑important pari passu principle, and the features of the formal mechanisms for dealing with insolvency or near-insolvency situations.
So, paragraph  gives effect to the requirement to maintain solvency at all times. In paragraph  you can see the Court’s view on equal treatment of debts even though the company is not in liquidation. Where the Court offered no view on corporate governance, this will make a very restrictive environment within which to operate. Risk is largely out of the question, business decisions must be severely curtailed, and the underlying purpose of incorporation in the first place, allowing separate personality is lost. Unless there is another appeal pending on s135, and there is not, then the only way forward is to amend the legislation to overcome the effect of this decision. And, just on decisions from final courts an American Judge once said what I decide is always right because I sit in the final court.
S136 the duty in relation to incurring obligations
The argument here again related to the question of the GST debt. The words in s136 are important, it provides:-
“A director of a company must not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so.”
The Court of Appeal thought the fact that the GST obligation was incidental to the contracts meant it was not caught by s136. Additionally, the existing GST debt (the one due for the period ended November 30, 2012) had been incurred under contracts entered into when the company was solvent.
On appeal the liquidators argued Mr Cooper had incurred an obligation because when the company entered into the new contracts he knew that at least part of the GST debt would not be paid.
Not surprisingly, the Attorney-General again closely aligned with the liquidators and argued s136 should not be confined to contracts, and that it should include statutory obligations, such as GST.
For his part, Mr Cooper supported the Court of Appeal position, and argued that s136 was confined to contractual obligations. He also added that the duty under s136 (and s135) was to the creditors as a whole and not any individual. He also sought some mileage on his argument in the fact that s135 uses the word “agree” as well.
The central issue on this aspect revolved around what was meant by the phrase – “must not agree to the company incurring an obligation”.
In my opinion reference to the word “agree” where it appears in s135 does not assist any argument on its meaning in s136. The context is different. The relevant extract of s135 provides: –
A director of a company must not—
(a) agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors; or
In s135 the word “agree” is used in the broad sense of a director making all kinds of decisions such as voting on a motion to continue to trade which will involve obligations being incurred as well as more directly agreeing on behalf of a company to enter into a contract. That is the proper sense you can give to the words – “to the business of the company being carried on” where they appear in s135.
By comparison, I think that the word “agree” in s136 does mean enter into a contract. The word is directly linked to obligation, so – “agree to the company incurring an obligation”. It is axiomatic some meaning must be placed on that phrase as a whole.
The Court declined to say whether it thought s136 applied only to contracts or had some wider meaning. So, it decided not to decide on the interpretation of s136. Even so, it agreed with the submission of the liquidators that to interpret s136 as only applying to contracts was to put a “gloss” on it. Putting a gloss on a phrase is to artificially add an overlay or meaning to it not plainly open from the literal meaning of the words themselves. Here the Court was asked to say what the phrase – “agree to the company incurring an obligation” meant. Plainly, on the literal meaning of those words in that phrase, it means contracts. A gloss would be required to include a debt that arises by reason of a statutory obligation. Entering into a conveyancing contract is one thing that gives rise to an obligation under the contract. However, the attendant GST arises only after the contract comes into existence, and assuming it is the type of contract to which GST applies, then GST is imposed by statute. The incidence of GST imposition is not something a director can agree to.
The Court then decided that Mr Cooper must have breached s136 as well since he knew from November 2012 there would be a GST shortfall. They claimed he breached s136 when the properties “were sold and the GST debts incurred.”
This is often referred to as offering a defence. The better view, I think, is that expressed by Hinton J where she said if it was reasonable to rely on advice given then it would go against there being any breach of duty.
The essential features of s138 are that a director, exercising powers, may rely on reports, statements, and financial data prepared by an expert or professional, within their areas of competence and where the director acted in good faith.
Given the way in which the Court dealt with ss135 and 136 any avoidance under s138 of a finding of a breach of duty was not open. It would not have mattered what kind, or quality, of advice was received. The Court found there was a breach of s135 because there was going to be a shortfall to creditors if trading continued. S138 could not overcome that.
The particularly narrow way in which the Court has looked at the question of insolvency has the consequence s138 has no scope and is rendered completely ineffectual. The only support for s138 in the decision of the Court in Debut Homes is it might be said it still has application where there is a prospect of the company trading through its insolvency. In Debut Homes the evidence was Mr Cooper did not intend to trade on past the last sales, and knew there would be a shortfall on at least the GST debt to the IRD. The Court disposed of s138 on the basis that the advice from the accountant was far too generalized and not of the type as would fall within s138.
- relying on information provided by a competent and reliable professional responsible for providing information about the solvency of the company;
- the company was solvent and there was a reasonable expectation it would remain so even if the debt was incurred;
- taking a course of action where there is reasonable likelihood there will be a better outcome for the company. This is a relatively new amendment which came into effect on September 19, 2017 and affects debts incurred directly or indirectly in connexion with a qualifying “safe harbour” plan under s588GA. It provides a quasi-defence for directors in answer to an insolvent trading claim.
It is an error to say directors are required to treat all creditors equally where the company is insolvent. I think it has come from assuming Parts 14, 15, and 15A apply to companies once they are insolvent. That is not so. It is only once a company is either wound up, or subjects itself willingly or otherwise to alternate arrangements from liquidation such as:- receivership, or Part 14 (a compromise with creditors), Part 15 (a scheme of arrangement) or Part 15A (voluntary administration) that a particular provision within each of those Parts will then dictate the manner and priority in which debts are paid.
The concept that “maintaining solvency is vital” – if not – the company must be put into liquidation, or consider one of the mechanisms under any of Parts, 14, 15 and 15A, is severely restrictive on commercial and business activity. It does not accord with the reality of the commercial life of a company where it may fluctuate in and out of solvency over the term of is trading life.
The ‘either’ solvent ‘or’ insolvent view taken makes no allowance for responsible corporate governance. Corporate governance is the way in which the business activity of a company is controlled by its directors in terms of the decisions, they make, the transactions they have a company enter into, and the risks taken and assessed along the way.
The broader view of corporate governance as the ‘best interests of the corporation’ meaning maximization of the value of the corporation has real merit. It can cater for all interests, shareholders, investors, trade creditors and the separate interest of the corporate enterprise. It would stimulate economic and business activity. It gives effect to the reason for using a corporation in the first place, that is, some measure of protection because of its separate legal personality. That is not hiding behind the so call corporate veil nor inviting dubious commercial activity. The real harm insolvent trading provisions need to aim at is to protect against reckless or fraudulent trading activity of directors.
The safe harbor provisions in the Corporation Act 2001 are certainly worth considering into the Companies Act 1993.
  NZSC 100, “Debut Homes”
 Generally referred to as the provision that imposes a duty on company directors not to engage in reckless trading or insolvent trading.
 This imposes a duty not to agree to incur an obligation unless the director believes in reasonable grounds the company will be able to perform when required to do so.
 Three examples in the commercial context are: F. Barlow QC Trusts & Trustees vol 17 (2011) 81 – 93 on Kain v Hutton  3 NZLR 589; J Palmer & A Geddis, ‘What was that thing you said?’ (2012) UQLJ 287 on Vector Gas  2 NZLR 444; Commerce Commission v Telecom  1 NZLR 577, the ‘0867’ case and the assertion by the NZSC that the laws in Australia and NZ on what constitutes ‘taking advantage of market power’ are now the same.
 QC; former professor in law at the University of Auckland.
 Messrs James & Wilde each would have proudly owned this phrase.
 Apt for the legal profession is – “There is no reasoning someone out of a position he has not reasoned himself into.”
 And, from Oscar Wilde – “I am so clever that sometimes I don’t understand a single word of what I am saying.”
 They had advanced money to fund the completion of the houses.
 Under s301(1)(b)(ii).
 This provides a defence, inter alia, that the director, acting in good faith, relied on professional/expert advice
 See judgment @ para 
 I am referring to the principal business activity of the corporation as a whole.
 c/f s135 Companies Act 1993
 c/f s136 Companies Act 1993
 Cooper v Debut Homes Ltd (in liq)  NZCA 39 (08/03/19)
 Re South Pacific Shipping Ltd (in liq); Traveller v Lower (2004) 9 NZCLC 263, 570.
 Supra fn 16 @ para 
 Para  and footnote 83
 Sometimes referred to as in the “vicinity of” insolvency.
  1 NZLR 242. See Cooke J @ p250; Somers J @ 255. Note, however, Richardson J expressly reserved on the point @ p254.
 See judgment @ para  and the footnotes in fn 17.
 The State of, USA.
 Credit Lyonnais Bank Nederland NV v Pathe Comm Corp 1991 Del. Ch. LEXIS 215 (Delaware USA); BCE Inc v 1976 Debentureholders 2008 SCC 69
 Supra fn 15
 2004 SCC 68;
 930 A.2d 92 (Del. 2007)
 Supreme Court of Delaware
 Fn 20 Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp. C.A. No. 12150
 C.A. No. 6990-VCL (Del. Ch. Oct. 1, 2014).
 Judgment @ para .
 To parrot the words from s135 of the Companies Act 1993
 Penalty interest and use of money interest to one side.
 The appellant was represented by Meredith Connell, a law firm which holds an instrument known as the ‘crown warrant’, and entitles the holder to prosecute cases on behalf of the crown/government. Essentially, both the appellant and the intervener were represented by government lawyers, so the crown law office squared.
 See judgment at para .
 A point Peter Watts makes in his article, and in his book: – Directors’ Powers and Duties, 2015, LexisNexis, 2nd ed, especially @ para 10.1.2.
 See judgment @ para . The Court said the case was “not the place to decide any nuances”. You have to wonder when it would be.
 See judgment @ para 
 See judgment @ para 
 See judgment @ para ;  NZHC 453, @ para 
 So, the situation in South Pacific Shipping Ltd (in liq); Traveller v Lower (2004) 9 NZCLC 263, 570
 The director’s duty to prevent insolvent trading is contained in s588G Corporations Act 2001
 There are others: see s588H Corporations Act 2001
 The solvency test under the Corporations Act 2001 is in s95A. It is the cash flow test. “A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable.”
 Companies Act 1993
 Not a new idea; … Salomon v Salomon & Co Ltd  AC 22.
 Notice the Court in Debut Homes commented Part 15A of the Companies Act 1993 had been enacted – “to bring New Zealand’s corporate insolvency scheme in line with other comparable jurisdictions, notably Australia.”
Paul Dalkie has practised as a barrister for more than 24 years in New Zealand and Australia. He appears in and has appeared in a wide range of civil and commercial cases and arbitrations. Prior to becoming a barrister he practised as a solicitor in Queensland for more than 8 years including at two global firms Blake Dawson Waldron (now Ashurst) and Cannan & Peterson, Sly & Weigall (now Norton Rose Fullbright).
He has appeared and argued cases and conducted trials and appeals at all Court’s levels, including the Privy Council.
His practice has particular emphasis on contract disputes of all kinds, and corporate law, especially insolvency and shareholders and directors disputes.
He is admitted to practice in New Zealand, Queensland and Victoria, and in the Federal Courts of Australia.
Visiting lecturer at the Beijing Jiaotong University, Beijing, China in Corporations Law and Contract Law