The days of sleeping directors are long gone: a wake-up call

Two recent cases involving insolvency matters highlight the fact that directors can not escape liability for inaction. In a High Court case, the court indicated that if a person is listed as a director of a company they will be deemed to be managing the company whether or not in practice they are carrying out this role. In another case, the Court of Appeal notes that "directors must take reasonable steps to put themselves in a position not only to guide but to monitor the management of a company."

Are you deemed to manage a company simply by being named a director?

The High Court recently had to consider: "Whether a director, solely by virtue of that appointment and designation, "manages a company" within the means of s.62 (1) (b) of the Insolvency Act" 1

Facts

The director in question was the son of an undischarged bankrupt, Mr Carroll. Mr Carroll had been a director of the same company prior to his bankruptcy and his son had been appointed to the position of director after his resignation. Mr Carroll remained as an employee of the company in the role of purchasing officer.

The Insolvency Act does not prohibit a bankrupt from being employed in a business but, where the business is operated by a company which is managed or controlled by a relative of the bankrupt, the employment of the bankrupt must be consented to by the Official Assignee.

As noted in the case, this is to prevent "window-dressing" where the business is effectively operated by the bankrupt and to ensure that the bankrupt is not in a position to exert influence over the relative who occupies a management role.

In this case, Mr Carroll had not sought the consent of the Official Assignee to remain as an employee and argued that he did not need to do so because his son's directorship did not, of itself, show that he managed the company. The District Court judge found in favour of Mr Carroll.

The Official Assignee appealed, arguing that the decision of the District Court judge was wrong because it failed to recognise that under the Companies Act 1993 it is the duty of directors individually to manage a company.

The court's decision

The High Court judge agreed with the Official Assignee noting that it was clear from the Companies Act and the company's constitution that the company could not operate except through the decisions of the board. The company's constitution provided a quorum of two directors for a meeting. Whether the son was actively participating in management or not, the company was still being managed.

Therefore, in the court's opinion, there was no need to determine the extent of the son's involvement in the company to determine whether as a director the son was "managing the company" for the purposes of s.62 of the Insolvency Act.

In reaching this decision, the court noted the following on the roles of directors:

Does being unsophisticated and nave assist a director to escape from the full force of the law?

In the second case2 , the Court of Appeal had to determine whether two directors were in breach of their obligations not to allow a company to trade recklessly (s.135 of the Companies Act 1993) and to keep proper books of account (s.300 Companies Act 1993).

Facts

Mr and Mrs Lewis were directors of a company set up to run a print brokering business in November 1999. The business was the brainchild of a Mr Grant whom Mr Lewis had met in a business context. Mr Grant had persuaded the Lewises to invest in the company.

Mr Grant's official role in the company was as manager. He had told the Lewises that he could not be a director due to an unresolved legal dispute. Instead, his wife, Mrs Grant, was appointed as a director.

When the business began, three additional directors (who were also investors) were involved in the company but they resigned in April 2000 and sold their shares to Mrs Grant. At the time proceedings were brought, Mrs Grant owned 80% of the shares and the Lewises owned the remaining 20%.

The company lost its main client in February 2000 and was in serious financial trouble from the end of March 2000. However, it wasn't placed into voluntary liquidation until February 2002. Mr Grant, the manager, was charged and convicted on five charges of fraud for creating false invoices made out by the company to third parties.

The liquidator had commenced proceedings on the basis that the Lewises had allowed the business of the company to be carried on in a manner likely to create substantial risk of serious loss to the company's creditors since the company's insolvency dated back to at least 31 March 2000.

The Lewises, who were never actively involved in the day-to-day management of the business, contended that they had done their best to ascertain the state of the company as:

• no directors' meetings were called other than at the commencement of the company;
• all their enquiries to both the manager, Mr Grant, and an accountant (employed to do the company's books and some specific calculations from time to time) were met with assurances that everything was under control and that the company's business was increasing; and
• they had taken action immediately they became aware that Mr Grant's assurances could no longer be believed (in December 2001).

On the evidence presented, the trial judge had concluded that the Lewises had "acted honestly and in good faith throughout the life of the company, and that they had acted as reasonable directors in the circumstances in which they found themselves".

He was also of the view that "so far as [the Lewises] were concerned a competent reliable person ...was responsible for seeing that appropriate accounting records were kept."

The court's decision

A paradigm case of reckless trading

On appeal, the liquidator argued that the judge's "obvious sympathies" for the Lewises had caused him to take the wrong approach by "focusing on their subjective belief and experience". The Court of Appeal agreed. Taking into consideration academic and judicial authorities on s.135, the court concluded the following:

On the facts of this case, the court was of the view that any reasonable and prudent director would have known that the cessation of trading had to be contemplated at least 15 months before steps were actually taken by the Lewises. This was in the courts view "a paradigm case of reckless trading".

The court went on to note:

"Directors must take reasonable steps to put themselves in a position not only to guide but to monitor the management of a company. The days of sleeping directors with merely an investment interest are long gone: the limitation of liability given by incorporation is conditional on proper compliance with a statute."

Failure to keep proper accounts

The court also held that the Lewises were in breach of s.300 of the Companies Act for failing to keep proper accounts. On s.300 the court noted:

"A director cannot be heard to say "I did not realise we were in such a pickle, because we did not have any, or adequate, books of account." It is fundamental that such books must be kept, and directors must see to it that they are kept."

The reliance the Lewises had placed on both Mr Grant and the accountant did not, in the court's view, amount to a defence under s 300(2) of the Act. The court acknowledged that the Lewises had been taken in by Mr Grant who in their opinion was a "thoroughly devious and dishonest man". But there was enough evidence to show the Lewises actually knew that there was no adequate system in place especially given they were not themselves getting any accounts.

What does this mean for the Lewises?

The court's finding that the Lewises were in breach of both s.135 and s.300 of the Companies Act means that the court, in its discretion, can grant an order requiring the Lewises to contribute towards the assets of the company and, for breach of s. 300, require them to repay all or any part of the debts and other liabilities of the company.

In determining the total amount of the Lewises' liability, there are three factors which are relevant to the exercise of the court's discretion:

• causation (in so far as there is a clear link between the Lewises allowing the company to continue to trade beyond August 2000 and the indebtedness to creditors that subsequently arose);
• the duration of the trading; and
• the extent of the Lewises' culpability.

On the facts of this case the court considers that the "culpability" factor will be key in determining how much the Lewises have to contribute to the liabilities over the relevant period. In its opinion, this is likely to be significant as it considered the neglect of their duties to be "reckless" on the facts.

However, the final amount payable by the Lewises is still to be determined by a further round of litigation. The court was not able to determine this quantum matter because it considered that additional evidence was required to resolve the relevance and status of some of the debts listed in the liquidator's statement of claim.

1 Official Assignee v Carroll (Unreported, 16 December 2005, High Court, Auckland, CRN 400-450-2376)

2 Mason & Anor v Lewis (Unreported, 30 March 2006, Court of Appeal, Hammond, Chambers and Robertson JJ, CA 267/04)

Enquiries and information

For more information on any of the cases, articles and features in Commercial Quarterly, please email Diane Graham or call her on 64 9 916 8849.