Mainzeal: Round 2 of 3

The Court of Appeal’s recent judgment in Yan v Mainzeal Property & Construction Limited (in Liquidation) [2021] NZCA 99 provides further guidance about the circumstances in which directors in office during a period of balance sheet insolvency will be held liable for breach of directors’ duties under the Companies Act 1993.

The facts

Mainzeal was a significant construction company with a long history of trading while balance sheet insolvent (liabilities greater than assets). From January 2011 onwards, the company entered into four new major construction projects (Wigram Museum, Manukau Institute of Technology, ANZ Tory Street & MoJ Manukau Precinct) involving obligations to principals and bond providers, along with subcontractors and suppliers.

For much of its trading life, Mainzeal had been a wholly-owned subsidiary of Richina Pacific Limited (“Richina”), a company listed on the New Zealand stock exchange and controlled by interests associated with Mr Richard Yan. Richina held extensive (and valuable) land use rights in China. Richina and another of its wholly-owned subsidiaries, had a habit of sweeping funds out of Mainzeal.

Mainzeal had been through a number of significant restructures since its incorporation. The effect of these was that other companies under the control of Mr Yan were substituted for Richina as its immediate and ultimate parent company. Unlike Richina, these entities had no substantial assets available to repay any inter-company debt.

A further (and final) restructure occurred later, arising from concerns from some of the directors about Mainzeal’s ability to recover intercompany advances. Debt of $47m, owed by Richina and its related companies, would be deferred for a period of 10 years and the obligation to repay Mainzeal replaced with an arrangement under which the debt obligation would be discharged by a company within the Richina group supplying building materials to Mainzeal under a forward purchase agreement.

Unfortunately, the directors didn’t appreciate (and did not obtain any accounting or legal advice at the relevant time) that this arrangement had several shortcomings, including the fact that under Chinese law the arrangement was likely to be unlawful due to foreign exchange controls in place restricting extraction of funds from China (along with schemes or arrangements having the purpose or effect of circumventing those controls). Both the plaintiffs and defendants led expert evidence on this point at trial.

Mainzeal went into receivership during December 2012 and was placed into liquidation during February 2013. The liquidators sued the directors for breach of directors’ duties alleging that from January 2011, at the very latest, the directors had failed to exercise their duties by continuing to trade on in a “business as usual” manner and by committing Mainzeal to the obligations to principals under the 4 construction contracts.

Breach of both sections 135 (reckless trading) and 136 (duty in relation to obligations)…

Following trial in the High Court, the directors were found liable under s 135 (but not under s 136) of the Companies Act for the entire deficiency to creditors of $110m on liquidation (reduced to $36m in exercise of the Court’s discretion under s 301).

The directors appealed (and the liquidators cross-appealed in relation to the finding of lack of liability under s 136). The liquidators also cross-appealed in relation to the reduction in quantum under s 301.

The Court of Appeal has dismissed the directors’ appeal in relation to liability (and upheld the liquidator’s cross-appeals), confirming that the directors were in breach of their obligations as directors under both ss 135 and 136 of the Act from January 2011 onwards.

Trading on in a business as usual manner involved a large measure of wishful thinking and failed to squarely address matters that had been raised, most recently, by one of the Big Four accounting firms in relation to the inter-company advances.

In addition, it was not reasonable for the directors to rely on certain assurances of support provided by the ultimate holding company in China given:

• the large deficit in Mainzeal’s balance sheet;

• the fact that the entity providing that support was only distantly related to Mainzeal; and

• the risk of significant cashflow issues inherent in a construction company with  high turnover, low margins and project risk.

The choices available to the directors as at January 2011 were essentially to seek repayment of the inter-company advances, or binding assurances of support, failing which the options were to resign from the board, or begin to wind down the company without committing Mainzeal to any further projects.

…But no loss to creditors as a result of breach of s 135…

The Court of Appeal has confirmed that it was wrong in principle for the directors to be held liable, in relation to the manner in which they had operated Mainzeal, for the full extent of the loss to creditors on liquidation in circumstances where all or part of the loss to creditors was likely to be suffered in any event, the $110m figure being higher than the total amount owing at January 2011.

…But loss to creditors under s 136…

The Court of Appeal has taken a novel approach to s 136.

The directors should not have committed Mainzeal to obligations under the 4 construction contracts and were liable for “new debt” incurred from January 2011 onwards.

There was some evidence that from July 2012 the company was not even in a position to be trading in a business as usual manner as it was failing to meet new short term obligations.

…And insufficient evidence available to determine the extent of the loss under s 136.

As far as compensation for breach of s 136 was concerned, the Court of Appeal held that there simply wasn’t enough evidence to determine the issue. The position taken by the liquidators from the outset (and after being provided with an opportunity in the High Court to amend their pleadings but choosing not to) was based on the entire deficiency in the liquidation, rather than new debt incurred from January 2011 onwards, which the Court of Appeal held is the correct approach in cases such as this.

The Court of Appeal has remitted the matter back to the High Court to determine this issue.

Our view

The conclusion that the directors were in breach of their obligations under ss 135 and 136 was, in our view, hardly surprising here, given the unusual facts, in particular the assurances of support provided (usually in an audit context) by other companies within the group that the inter-company advances would be repaid. As the Court of Appeal noted, Mr Yan’s evidence at trial was that those assurances were only ever reasonably able to be relied upon whilst Mainzeal was a going concern (although the other directors appear to have had a different view on this). Irrespective of the actual positon, failure to even consider the position of creditors and commit the company to the 4 construction contracts and seek advice in relation to the inter-company advances was a significant failure of corporate governance.

We like the concept of the “new debt” approach to s 301 compensation claims under s 136 (which is novel). However, as the Court of Appeal has noted, this approach is not entirely consistent with the statutory wording and, in our view, it would be desirable for the Government to commission further policy work in this area if this approach is to be regarded as the new norm. In our view, this is interlinked with the tricky question of what is to happen when new debts are incurred and used to pay other debts (i.e. “robbing Peter to pay Paul”), a matter which the Court of Appeal has deliberately left open. Theoretically, a s 135 claim may be brought in these circumstances in relation to a subset of creditors. However, the Court of Appeal noted that the case for the liquidators had not been run that way and that s 136 was a more promising vehicle for claims of that nature.

It is good to have judicial recognition that, generally, directors will not be liable for any immediate obligations incurred from the point where it first becomes apparent that intervention is required in the face of balance sheet insolvency.

The High Court accepted Mr Yan’s evidence that, notwithstanding the substantial “legacy claims” against Mainzeal in respect of certain leaky building claims, there was still a window of opportunity following the “breach date” for Mainzeal’s affairs to be salvaged. Unfortunately, the approach to compensation had the practical effect of putting the directors in a position where they had effectively provided a warrant of solvency from the point of breach; an approach providing no incentive for a director to continue in office where there are some reasonable prospects that a company’s financial position can be turned around. Accordingly, the Court of Appeal has, quite rightly in our view, confirmed that the “entire deficiency” approach to compensation claims now has limited scope.

The liquidators have sought leave to appeal to the Supreme Court. Watch this space.

If you have any questions about the impacts of the Court of Appeal’s decision or company and insolvency law in general, please get in touch with Jaesen, Jono, Dave or Sean.