Directors’ Liability for Reckless Trading

All directors need to be aware of the statutory duty they owe to the company not to trade recklessly and of their potential personal liability for the debts of the company if they do so. There are now several recent cases where the Courts have taken a hard line against directors. The Court of Appeal has recently upheld a High Court decision which found a director liable for reckless trading and personally responsible for the debts and liabilities of the company to the tune of $8,400,000 plus interest from the date of liquidation of the company, not including his liability to related party creditors.

The relevant provision is section 135 of the Companies Act 1993:

A director of a company must not –

1. 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
2. Cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.

Exactly what types of actions on the part of a director constitute the taking of “a substantial risk of serious loss to the company’s creditors” depends on the particular facts of each case. However, the recent cases draw a distinction between legitimate and illegitimate risks in business, and confirm that only the taking of illegitimate business risks warrants a finding of reckless trading.

There are some peripheral points to note:

• The company does not need to be in liquidation for a director to be liable for reckless trading.
• Reckless trading can relate to any business of the company – even an isolated transaction unrelated to the usual business of the company.
• A “sleeping director” (one who has abdicated responsibilities to the other directors and who has no actual knowledge of the business in question) may be held liable for reckless trading.
• The Court of Appeal case referred to is Löwer v Traveller & Another (2005) 9NZCLC 263,889. In that case, the Court of Appeal dismissed the director’s appeal against the factual finding by the High Court that the director had taken illegitimate business risks in conducting the business of South Pacific Shipping Limited. The Court of Appeal concluded that the company’s circumstances, considered objectively, warranted the shutting down of business, and not the taking of further extensive risks. It was reckless of the director to exercise his controlling position to ensure the company carried on business in the way it did, and he was therefore personally liable for the company’s debts.

The best guidelines for determining whether or not the actions taken by the director were legitimate or illegitimate business risks were set down by the High Court (in South Pacific Shipping Limited (in Liquidation), Re; Traveller & Anor v Löwer (2004) 9 NZCLC 263,570).

The Court said the following factors were relevant:

• Whether there were collateral personal benefits to the director of continuing to trade an insolvent company and whether the director was motivated by these collateral benefits.
• Whether the company continued to trade while insolvent. While there is no obligation on directors to immediately cease trading as soon as the company becomes insolvent (on the balance sheet), there are limits to the extent directors can allow a company to trade while insolvent in the hope that the situation will improve – usually a matter of months. Directors of a company facing insolvency are expected to address the reasons for the insolvency and put strategies in place to salvage the position should they elect to continue trading. Directors who allow an insolvent company to trade for an extended period take the risk of being found personally liable for reckless trading.
• Whether the creditors had notice of and fully understood the risks being taken with their funds.
• Whether the director’s conduct was in accordance with orthodox commercial practice? As part of this, whether the company had in place an orthodox governance structure? Liability for reckless trading is likely where directors have acted otherwise than in accordance with orthodox commercial practice.
• How serious were the risks in the context of the particular business environment (i.e. was there a hostile business environment?).

These factors were considered by the High Court in Cellar House Limited (in Liquidation), Re; Walker v Allen (Nelson CP13-00, 18 March 2004) in finding the director liable for reckless trading (among other breaches of duty) and therefore personally responsible for the debts of the company. Judgment was entered against the director for $1,750,000.

The “legitimacy” test, used to determine director’s culpability, was also supported by the High Court in Mountford v Tasman Pacific Airlines of NZ Limited (2005) 9 NZCLC 263,864.

These decisions have no doubt given liquidators and creditors confidence that where directors are reckless the courts will hold them personally liable for the company’s debts.

However, directors can take some comfort in the finding that the taking of legitimate business risks is not reckless. Although, it is a fine distinction. In the two cases decided after South Pacific Shipping and Walker v Allen the Courts have found in favour of the director.

In Global Print Strategies (in Liquidation); Re Mason & Anor v Lewis & Anor (High Court Auckland) the Court found that recklessness requires more than mere negligence. The director must make a conscious decision to allow the business to be conducted in such a way as to pose a substantial risk of serious loss to the company’s creditors, or must be wilfully or grossly negligent in turning a blind eye. This introduces a degree of subjectivity to the otherwise objective test of whether a director’s conduct was reckless.

In Petros Developments Limited (in Liquidation); Re Advanced Plastics Limited v Harnett & Anor (High Court Auckland) the Court found that the director’s conduct was not reckless as the director had the full support of the creditors and the creditors were fully aware of the risks which incidentally were substantial. There was a common strategy between the director and the creditors. The Court made the observation that all business is inherently risky.

The question will always be whether the director’s conduct can fairly be regarded as reckless but it is important for directors to bear in mind the principles or guidelines in the South Pacific Shipping case. It is still open for directors to authorise their companies to take risks in business (this is often necessary to promote the company’s best interests) but all care should be given to those decisions to ensure the risk taking is legitimate.