Sarah Martin Solicitor and Andrew Hazelton - Partner Hazelton Law
The recent judgment in Mainzeal Property and Construction Ltd (in liq) v Yan  NZHC 255 involved 12 causes of action and a complex factual background. This article focuses on just the first cause of action: the allegation that the directors breached their duty under s 135 of the Companies Act 1993 not to trade recklessly. This was the only cause of action where the Court made comments about the construction industry in general.
Mainzeal was a part of the Richina Pacific Group and allowed companies in the Group to extract funds from it on a number of occasions to acquire lucrative assets overseas. Mainzeal was therefore owed significant amounts of money by other companies in the Group. It continued to trade in this state, using the funds paid to it by principals before paying its subcontractors.
Mainzeal relied on assurances from the Group that financial support would be provided if needed. However, these assurances were vague, infrequent and not legally enforceable. The Group also went through two restructures, one in 2008-09 and one in 2012. These restructures separated the New Zealand and Chinese divisions of the Group and meant that the loans given by Mainzeal were owed by New Zealand entities that did not have the means to pay them back. The Group still did not provide a legally enforceable assurance that the loans would be paid. Furthermore, stringent Chinese regulations meant it was unlikely that the Chinese entities could have provided financial support to Mainzeal.
In 2012, Mainzeal began to experience significant cash flow issues due to disputes over a large construction contract with Siemens. Around this time, it was also involved in several leaky building claims. Mainzeal continued to trade until BNZ suspended any further advances on its facilities. It was placed into liquidation on 28 February 2013.
The Liquidator claimed that the directors were in breach of their duty under s 135 of the Companies Act 1993 not to trade recklessly. The Act requires a director not to agree to carry out business in a manner likely to create a substantial risk of serious loss to the company’s creditors or cause or allow the business to be carried out in this way.
The Court emphasized the following features of s 135:
Merely trading while the company is insolvent does not breach s 135. Nor is it concerned with normal business risks taken by a company. There must have been substantial risk of serious loss to its creditors.
A “substantial risk” to the creditors means a major or large risk of the company going into liquidation with a deficiency. Furthermore “serious loss” requires there to be a serious deficiency in liquidation rather than a minor or modest loss. This is a reasonably high threshold.
Section 135 is concerned with the risk to creditors, not the company. A substantial risk of serious loss to creditors will arise when potential insolvency is in issue. When this occurs, any risks the directors take risk the creditors’ funds rather than the shareholders’ capital.
When the company enters a difficult period, the directors must make ongoing sober assessments of the company’s likely future income and prospects.
There must be a causal link between the manner of trade and the substantial risk of serious loss to the creditors.
Section 135 is assessed objectively.
The Court summarized this section by stating:
The manner of trade must give rise to a substantial risk of company failure causing a deficiency in liquidation resulting in serious loss to creditors. Alternatively, the section can also apply if failure is already likely, but the manner of trade creates a substantial risk of additional serious losses to creditors on the liquidation.
There were three key factors which led the Court to decide the directors had breached their duty not to trade recklessly:
Mainzeal was trading while balance sheet insolvent as it was owed significant amounts of money and was unlikely to be able to recover these debts;
The directors could not reasonably rely on the assurances of Group support; and
Mainzeal’s financial trading performance was generally poor and, as it was a construction company, prone to significant one-off losses. This meant that, to avoid collapse, it had to rely on a strong capital base or equivalent backing. It had neither.
The Court noted that while the directors’ decision to trade while insolvent is the source of their breach, this would not have been as problematic if Mainzeal had reliable Group support or a strong financial trading position. However, it had neither.
The first key factor was the directors’ policy of trading while insolvent. The Court accepted that Mainzeal was balance sheet insolvent from as early as 2005. Balance sheet insolvency is when a company’s liabilities are greater than its assets. Mainzeal was owed substantial amounts of money by other companies in the Group. However, the Group had been re-structured so that the companies that owed the debts were unable to re-pay them. Furthermore, the Group had never given any legally-enforceable commitments to repay the loans.
The Court emphasized that continuing to trade while balance sheet insolvent does not necessarily establish a breach of this duty. The directors could be satisfied that the creditors were properly protected by other means while the company was trading in this position.
However, Mainzeal traded using their creditors’ funds. The Court stated that it is a:
“recognized feature of the construction industry that companies are able to obtain payment from contractual principals in advance of paying sub-contractors. This very significant cash flow advantage existed for Mainzeal and gave it what was effectively working capital. But this working capital comprised creditors’ funds – Mainzeal was literally trading with the sub-contractors’ money. This money was at risk in place of share capital.”
The second factor which led the Court to find a breach of s 135 is the reliance that Mainzeal placed on the Group for support. The Court stated that a company may place reliance on the support of the wider Group. However, whether this constitutes a breach of s 135 depends on the circumstances. In the present case, Mainzeal’s reliance on the Group was inappropriate. The expressions of support were unclear, conditional, not legally binding and limited by stringent Chinese regulations.
The third factor which established a breach of s 135 was Mainzeal’s trading performance. The Court described this as “unpredictable and generally very poor”. In assessing this, the Court focused on Mainzeal as a construction company. It noted that “construction was a difficult business” and that companies operate on very small margins. They are also susceptible to large one-off losses. When a problem arises with one contract it can put significant financial pressure on the whole company. Also, by 2010, there were a number of significant leaky building claims made against Mainzeal. Significant liability can arise for companies involved in these claims and Mainzeal had not adequately provided for the potential associated costs.
The Court also touched on a few additional factors that were relevant to a breach of s 135. While directors may rely on their auditors’ advice, there are limits on how much they may do so. The directors did not take external legal advice even though they were facing a number of legal issues. They were also too focused on how the company’s business operations were progressing and did not give the same attention to its structural and governance risks. Lastly, Mainzeal’s creditors would not have understood the vulnerable position the company was in. It was a well-established company, chaired by a former New Zealand Prime Minister and part of the Richina Pacific Group. The creditors would have viewed that it was at low risk of failure.
In summary, directors of construction companies should be aware of the following points coming out of the Mainzeal judgment:
In considering whether a director has breached its duty not to trade recklessly, a court will objectively assess whether there has been a substantial risk of serious loss to creditors.
Trading while insolvent does not necessarily constitute a breach of this duty. A company could do so while also providing adequate protection to its creditors. However, the Court decided that Mainzeal had not done this as it was trading using the funds it owed its subcontractors.
The Court also noted that construction companies operate on very small margins and are susceptible to large one-off losses. These factors contributed to the Court’s finding that Mainzeal’s trading performance was poor and unpredictable, thus causing a substantial risk of serious loss to creditors.
The directors have stated they are appealing the judgment, so the Court of Appeal will revisit the matter next year.
*this article is not intended to be legal advice nor is it a substitute for taking your own legal advice, no liability is accepted by the authors or RMBA for anyone relying upon the information in this article.