Directors take note thinking you are acting in good faith and in the best interests of the company may not be enough

Two recent High Court decisions provide guidance on the statutory duty of directors to act in good faith and in the best interests of the company, including consideration of whether that duty should extend to contingent creditors.

The statutory duty is set out in the Companies Act 1993 (the Act) and provides that:

"...a director of a company, when exercising powers or performing duties, must act in good faith and in what the director believes to be the best interests of the company."

The cases indicate that when exercising this duty a director's subjective belief that he or she has done what they think to be right will not in itself be sufficient to avoid liability for this duty. In particular, it should be noted that the courts have indicated:

• the duty will not be discharged if a director has "an inappropriate appreciation "of the interests of the company;
  
  
• in situations of doubt as to the solvency of a company, a director will not have discharged this duty if he or she has not taken into account the interests of a company's creditors (both current and contingent);
  
  
• a director can not by disclosing a conflict of interest assume that he or she will avoid liability in the exercise of this duty. It must be shown that at all times the director had the best interests of the company in mind. Where there is a conflict of interest, it will be difficult to establish that the duty has been discharged.

The first case

In Sojourner and Anor v Robb 1 two creditors brought an action against the directors of a company (in liquidation) seeking an order from the court to pay the liquidator of the company sufficient funds to repay the debts owed to them.

What makes this different from recent cases seeking contributions from directors in insolvency situations, is that this was not a case of reckless trading or fraud on the part of the directors. In this case, the creditors contended that the directors had breached their duties of loyalty to the company (under section 131) and, in doing so, breached the duty they owed to them as contingent creditors.

The facts

The defendants, Mr and Mrs Robb, were the sole owners and directors of a boat building and general engineering company. The company was part of a group of companies also owned by the defendants together with a farming partnership which operated under one financing facility.

The company was doing well until it decided to enter the luxury boat market which turned out to be a loss making venture for the company. The plaintiffs, Mr Sojourner and Sailing Cat Cruises Limited, had entered into contracts with the company to build two large luxury catamarans in 2000 and 2001 respectively. Work was carried out on both boats (and progress payments were received) but by the last quarter of 2002 Mr Robb realised that any further work carried out on the boats would be at a substantial loss to the company and would need to be heavily subsidised by the group. The progress payments had been in advance of actual progress made on the boats.

The company did complete work on Sailing Cats' catamaran which was launched in December 2002 but, unfortunately, the boat leaked and suffered a number of other deficiencies. Little work was carried out on the second boat and having lost confidence in the company, Mr Sojourner asked the company to stop working on it.

By February 2003 Mr Robb had become concerned over the company's potential liabilities for both boats. He also was concerned that the company might be in a situation where it was trading as an insolvent company (although on the facts this was a "technical insolvency" rather than a satisfaction of the solvency test in the Act).

In March 2003, on the advice of the company's accountant, the company sold its business to a new company (with a similar name) owned by the defendants. The new company acquired the stock and plant and also took over its staff and old customers. The defendants contended that the sale was a "hiving down action as an alternative to liquidation". The plaintiffs contended that the sale was to avoid the company's contingent liabilities to them and further that the sale was not at arm's length and sold at an undervalue (having failed to value its goodwill).

The decision

The court noted that although previous case law is relevant in determining whether the duty in section 131 has been exercised by a director, the duty is substantially to be decided on the facts.

Justice Fogarty noted that section 131 was an amalgam of objective standards as to how people of business might be expected to act, coupled with a subjective criteria as to whether the directors have done what they honestly believe to be right. However, in his opinion, the subjective aspect of the standard does not allow a director to discharge the duty by acting with a belief that what he is doing is in the best interest of the company, if that belief rests on "a wholly inappropriate appreciation as to the interests of the company".

On the facts the court found that the directors were in breach of section 131. They had misunderstood their duties as directors and for that reason were not acting in good faith. In reaching the decision to sell the company's business to the new company, the court concluded that the directors:

• failed to take account of the company's intangible assets when considering the solvency of the company; and
  
  
• did not give due regard to the interests of the company's contingent creditors.

As a result of these errors of law the court noted that the directors had failed to recognise that their duty to the company included doing their best to ensure the company met all its obligations, current and contingent.

The remedy

A breach of the statutory duty under section 131 gives rise to a remedy under section 301 of the Act whereby in the course of a liquidation of a company, the court can require a person to contribute to the assets of the company such sum as the court thinks just.

As to the test to be applied for "what the court thinks just" in these circumstances, Justice Fogarty considered the correct approach to be to look for guidance from the common law and equity. In this case the focus was placed on the fact that the directors had sold the assets of the company to a new company owned by themselves which had continued to trade profitably. The judge noted that it was well settled that the trust principle prohibiting "a trustee from making any profit by his management, directly or indirectly" equally applied to directors" 2.

On the facts the plaintiffs were able to show that there was a good prospect of the company trading on and meeting its liabilities to them or selling the business for a sufficient sum to discharge those liabilities. The plaintiffs also showed that the defendants (through their shareholding in the new company) acquired the goodwill of the business for no consideration. Accordingly at equity the plaintiffs would be entitled to damages for the full amount of their proofs of debt accepted by the liquidator.

The Court went on to apply these same equitable principles to the remedies available to it under section 301 granting Mr Sojouner and Sailing Cat full recovery of their proofs of debt together with interest. The court also extended the order to cover other unsecured creditors.

The second case

In Hedley v Albany Power Centre Ltd 3 the High Court had to consider what directions should be given to the liquidators of Albany Power Centre Ltd (APC) on an issue of whether they should bring an action against APC's directors for breach of their duties under sections 131 and 137 (the director's statutory duty of care provision) of the Act.

The facts

APC was one of a number of Waltus-promoted property syndicates. The company had been set up to purchase and develop a building centre in 1997. It was marketed as a ten-year investment by Waltus Investments Ltd to investors. The centre was managed by Waltus International Property Management Ltd.

Some of the Waltus property syndicates were merged into a single company (in 2000), Urbus Properties Ltd (Urbus). But APC and six other Waltus syndicated companies (together referred to as the WSCs) were not included in the original merger.

In 2002, APC's board of directors (which was also the board for the other WSC's) proposed that Urbus acquire the properties owned by the remaining WSCs and recommended acceptance of the proposal to each of the WSCs' shareholders. APC's shareholders approved the Urbus proposal and after its assets were sold the company was placed in liquidation.

At the time of the proposal the facts suggested that APC's directors approached the sale through a consideration of the interests of the WSCs as a group. Each of APC's four directors was a director of each of the WSCs. They met as a Board of the WSCs and dealt with all APC's business at these meetings. There were no separate minutes for APC business.

After APC had been placed in liquidation, a disgruntled APC shareholder sought leave from the court (in 2004) to bring a derivative action against the directors for breach of their statutory duties including their duty under section 131 of the Act. He contended that the proposal prevented APC shareholders from receiving the benefit of future capital gains and income returns in the commercial property market. He also contended that the shareholders should be entitled to receive any profits from the sale made by the directors for such breach. However because the company was in liquidation, the application was treated as an application under section 284 of the Act for directions to the liquidator.

At the initial hearing 4 the judge sought further information before he could make a substantive ruling. Directions were given to the liquidators to supply the information and two years on, a second hearing was held before the same judge.

At this hearing the liquidators sought further directions from the court as to the course of action they should take. In their opinion, based on the further information obtained by them, although there was a clear breach of the directors' objective duty in section 137, they were unable to conclude that the directors were in breach of their section 131 duty. As a result they considered the likelihood of recovering sufficient losses for any breach by the APC directors would not justify them commencing proceedings.

Court's comments on the directors discharge of their section 131 duty

Justice Wild did not share the liquidators' concerns over establishing a cause of action based on a breach of the directors' section 131 duty. It is to be noted however that the judge's comments on this point were only to assist the liquidators to make a decision on whether to proceed with an action based on section 131 against the directors. No definitive ruling on the matter has been given.

The judge placed particular emphasis on the fact that all APC's four directors were also directors of the other WSCs. This placed the directors in a conflict of interest over the transaction.

He found that on the facts it appeared that APC's directors failed to distinguish and focus on the interests of APC, as opposed to the other WSCs. Instead they had taken the approach that what was good for the WSCs was also good for APC. He noted that the rationale behind the directors' concern and preference appeared to have been to lift the overall quality of the portfolio of properties offered to Urbus.

In his view, this was not the correct approach to have taken. He referred to his earlier comments in his 2004 judgment 5, where the judge noted that in order for APC's directors to have discharged their duties under section 131 they needed to:

1. identify the options available to APC;
   
   
2. assess each of those options: its present and prospective value to APC; its advantages and disadvantages, again both present and prospective; and
   
   
3. compare each option on the basis of (b).

That this had not been done was confirmed by the additional information obtained by the liquidators from the directors.

Justice Wild also noted that a director cannot, by disclosing his personal or other interests or conflicts, avoid liability under section 131 if he fails faithfully to consider, and act in, what is in the company's best interests (as opposed to his own, or those of another person(s)). The judge went as far to say that he doubted whether a conflicted director can discharge his section 131(1) duties.

The outcome

It is still to be seen what the liquidators' next step will be. The court gave directions for the liquidators to either:

• commence proceedings against the directors (if they considered it appropriate to do so based on his comments); or
  
  
• if still in doubt, they are to obtain an opinion from a senior counsel as to a recommended course of action.

The court also recommended that the liquidators put the matter to the shareholders to decide for themselves after being fully appraised of the likely amount recoverable, the costs of bringing the proceedings and the timeframe involved.

In terms of the likely amount recoverable, the court expressed the view that for a breach of section 131 the directors are liable for all losses which would not have occurred "but for" the breach, and all gains they have made as a result of the breach. On the facts, this would include the undervalue component (if any) of the sale of the APC centre to Urbus, management fees relating to the centre and paid to the WSCs, together with any loss of the benefit of retaining ownership of the centre. In addition if the profits made by the directors are over and above the losses incurred by APC, then the directors would be required to account for those profits.

The judge dismissed the liquidators concerns over the application of the "but for" test on the facts indicating that it was enough to show that the directors' breach was a substantial, or contributing factor, in causing the loss. In the court's view there was sufficient evidence to establish this link.

1 Sojourner and Anor v Robb (Unreported, HC Christchurch, CIV 2004-476-000568, 4 July 2006)

2 Regal(Hastings) Ltd v Gulliver and Others [1942] 1 All ER 378

3 Hedley v Albany Power Centre Ltd (In liquidation) (No.2) (HC, 2 June 2006; Wild J, Wellington, CIV 2002-485-1345)

4 Hedley v Albany Power Centre Ltd (in liq) [2005] 2 NZLR 196

5 Hedley v Albany Power Centre Ltd (in liq) [2005] 2 NZLR 196, at 210

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.