Directors’ ‘shield’ under threat

Press, 29 June 1988, Page 36

Directors’ ‘shield’ under threat

Directors beware. An overstatement, perhaps, but in certain circumstances directors may find themselves personally liable for debts of a company.

“the shield” from liability historically afforded directors and shareholders by incorporation of a company is now being increasingly pierced. This has not always been so. Commonwealth company law has traditionally been reluctant to pierce the “corporate veil” in favour of creditors, a striking contrast to American corporation laws. Fraudulent trading is one exception. Since 1929 English law has provided for directors’ personal liability under such circumstances. The scope in New Zealand has now been extended to "reckless” trading. At issue is the extent of the duty directors owe before winding up. The old view held there was a duty to the company but not to creditors. But judicial statements today show that directors owe duties to the company itself and sometimes to creditors. The Courts, in handling business failure, are more prepared to look at the earlier and possibly contributory actions of directors. For creditors it would appear that the test is: ought the directors to have known that a particular thing or action was likely to cause loss to creditors. If so, the unanimous consent of the shareholders will not be sufficient to justify the breach of duty.

Directors’ duties to the creditors may therefore arise upon an insolvency or financial difficulty bordering on insolvency. Of course, if the company is not insolvent then it is arguable that the directors are not liable. A 1985 New Zealand Court of Appeal case, Permakraft,

Ltd, v. Nicholson, reveals some interesting remarks about duties to creditors. The President of the Court, Mr Justice Cooke, remarked that directors owe duties to the company. This may then require the directors to consider the interests of creditors if the company was insolvent, or near insolvent, or of doubtful solvency, or if some action or course of action would jeopardise solvency. Here there is a hint that a duty of care (in negligence) is owed by directors to creditors, at least in cases of insolvency or near insolvency. In other words, there is a duty for a director to take reasonable care even where the company itself would not be under such a duty. As well as judge-made common law on the subject, Parliament has legislated for penalties against directors. Section 320 (1) (a) of the Companies Act, 1955 (as amended in 1980) relates to the unreasonable incurring of debts. It provides that: “If in the course of the winding up of a company it appears that — (a) any person was, while an officer of the company, knowingly a party to the contracting of a debt by the company and did not, at the time the debt was contracted, honestly believe on reasonable grounds that the company would be able to pay the debt when it fell due for payment as well as all its other debts (including future and contingent debts)” ...

“An officer” includes a director, manager, or secretary. To be “knowingly a party” the liquidator must show the officer to have had actual knowledge of the incurring of the debt and a general knowledge of the company’s affairs. The director must have also taken an active part in the prohibited act, i.e. the

The October sharemarket crash has resulted in public demand for a more informed market. One demand has been for more information and knowledge about the role and duties of directors. Howard Joseph, of Anthony Harper, the Christchurch law firm, presents this article in light of those demands.

It addresses the obligations of company directors to creditors and is an edited version of a paper given by Professor John Farrar, of the University of Canterbury Law Faculty at a seminar held by Anthony Harper recently.

contracting of the debt. The liquidator then has to prove the absence of honest belief (upon reasonable grounds) that the company could pay the debts when due. In New Zealand, however, no criminality attaches to the incurring of a debt. Under the Companies Act criminality arises only where fraudulent trading, false pretences, and fraudulent gifts are proven. Otherwise, civil liability prevails which is restricted to companies in the “course of winding up.” Only at that point will liability arise.

Section 320 (1) (b) of the Companies Act addresses reckless trading. The leading New Zealand case of Thomson v. Innes held that a company unable to pay its debts as they fell due did not of itself prove recklessness in carrying on the business. It was said many companies experience liquidity problems, but with some forbearance by creditors they were able to trade their way out of difficulty. But it was also said “there are grave responsibilities on directors who take that course with-

out reasonable prospects of sucess, as their actions may amount to a reckless disregard for the losses they impose on company creditors.”

In the 1987 case of Rex Wood Service Centre, Ltd (in liquidation) the liquidator of an insolvent company sought to make a director personally liable for the total amount claimed by proved creditors. It was held that proper company records would have explained the substantial loss of the company. As the director was responsible for the lack of records, and as that information was not available, the director had acted in a reckless manner. Accordingly the director was declared personally liable for the amount claimed, with interest at 11 per cent. Fraudulent trading is covered by Section 320 (1) (c). In order to prove an intent to defraud creditors, actual dishonesty must be shown. This section is directed at persons who deliberately and knowingly set out to cheat and defraud creditors. A genuine but unjustified hope that creditors would be paid is sufficient to prevent a successful action.

Accordingly, Section 320 is not aimed at the blameworthy, irresponsible, or even hopelessly optimistic, but against those who deliberately and knowingly set out to cheat or defraud creditors. Successful convictions under this section have been rare. One example was the 1983 case of re Casual Capers, Ltd (in liquidation). Here the director knew the company. was insolvent and was knowingly a party to the company continuing to carry on business with intent to defraud creditors. Regarding the liquidator’s other allegations, the disappearance of cash books and stock cards, while suspicious,

was held insufficient to justify fraud. Significantly, Section 320 creates a new statutory cause of action: that those guilty of participating in misleadings committed before winding up may incur personal liability. The Limitation Act, 1950, provides for an action to be brought within six years of the winding up order or from the date the liquidator was appointed. Section 320 requires the civil standard of proof on a balance of probabilities. But a high degree of probability is required because the subject matter of the inquiry involves facts which, if established, would constitute an offence.

A director can be criminally liable under Section 461 (d) of the Companies Act for fraudulently carrying on a business. In Australia there is criminal liability for reckless trading. In New Zealand, either criminal or civil liability can be decided first. A criminal conviction will incur imprisonment of up to two years or a $lOOO maximum fine (or both). Over all, economic recession has hardened the Courts and Parliament against directors of failing companies. Recent case law appears to go beyond earlier authority. At common law, the New Zealand Courts have hinted at liability in tort (negligence law) in respect of a duty of care to creditors of companies.

To pierce the “corporate veil” indirectly in this manner is unusual but not revolutionary in Commonwealth legal terms. It is certainly not revolutionary compared with the willingnesss of some United States Courts to recognise a trust relationship to creditors, and to pierce the corporate veil in cases of thin capitalisation.