Australia: NZ Insolvency Bulletin

• Directors of a 'phoenix company' ordered to compensate creditors

• Official Assignee obtains share of director's home for creditors

• Court of appeal sends warning to 'sleeping' directors

• Working with Voluntary Administration - Administrators potential liability for legal costs

On 4 July 2006, the High Court at Christchurch found that two directors failed to act in good faith and in the best interests of their company contrary to the Companies Act 1993. The two directors sold the business of their old company Aeromarine Limited at an under value to a new company they created, Aeromarine Industries Limited and subsequently changed the old company name. Ultimately, the directors were ordered to pay a sufficient sum to meet the debts of unsecured creditors of the old company plus interest and costs.

Mr & Mrs Robb were directors of a company, Aeromarine Limited. Aeromarine predominantly undertook light industrial work through fabricating fibreglass for a number of small customers.

The plaintiffs, Mr Sojourner and Mr Hiscock each contracted with Aeromarine in 2000 and 2001 respectively for Aeromarine to build luxury catamarans.

As the contracts progressed, it became apparent to the directors that Aeromarine would incur a loss of at least $300,000 if it completed the contracts. At that time the plaintiffs were only contingent creditors.

As a solution, the directors decided to form the new company, Aeromarine Industries Limited.

In February 2003, the new company purchased the business of the old company but placed only a nominal value on the goodwill (it was later conceded that no real value was placed on the goodwill). Most of the actual creditors of the old company were paid out. But there were no assets in the old company to meet the plaintiffs’ contingent liabilities.

After the business of the old company was sold to the new company, the old company changed its name to Kut Price Yachts. The old company was placed in liquidation later in 2003 and the plaintiffs proved as unsecured creditors in the winding up for about $300,000. Although their proofs of debt were admitted they received nothing.

The plaintiffs commenced proceedings against the directors alleging a breach of the directors duty to act in good faith and in the best interests of the company contrary to section 131(1) of the Companies Act 1993. The plaintiffs’ principal allegations were that the transfer of the business was for the purpose of avoiding the contingent liabilities under the boat contracts and the sale of the business of the old company was not at arms length and was at an under value.

The directors said that the sale of the business to the new company was:

• To clean up the business vehicle for a possible sale to a third party;

• To avoid the possibility of trading whilst insolvent;

• To try and preserve the viable aspects of the business for building up to its former state.

• To 'ring-fence' (ie, to put a fence around the core business of the company to protect the present structure) the issues with the plaintiffs.

The Court found that the directors were not acting in good faith when the business was sold to the new company. The fact that the directors thought they were acting in the best interests of the company by ‘ring-fencing’ the loss making contracts was irrelevant.

The directors were ordered to pay the liquidator of the old company a sum sufficient to meet the plaintiffs claims and that of other disappointed unsecured creditors plus interest and costs.

This decision casts a high burden upon directors to consider the interests of contingent creditors. It also sounds a warning to directors considering starting fresh with a new company using the old business that the Courts will not tolerate the use of phoenix companies to defeat the interests of creditors (in this case contingent creditors).

To comply with their duty, directors starting a new company with the ‘old business’ will need to ensure that the new company purchases the business of the old company at ‘arms length’. That means a proper valuation process needs to be undertaken.

The decision is also of interest because under the new insolvency law regime the directors actions would have exposed them to criminal penalties.

In the Insolvency Law Reform Bill, there are restrictions on the use of phoenix companies by directors to defeat the legitimate interest of creditors. Clause 386A of the Bill provides that the director of a failed company cannot be the director of a company, or take part in the business activities of a company, that has the same or a similar name as the failed company for a period of five years after liquidation of the old company. A breach of this provision will be an offence carrying a penalty of up to 5 years imprisonment or $200,000 fine. Directors can also be personally liable for the debts of the phoenix company.
Article by Craig Edwards, Lawyer, Auckland office

The recent High Court decision of Crawford v Eades & Anor shows that the family home is by no means a castle. The Official Assignee successfully set aside a director’s transfer of the family property to a trust two years before his bankruptcy.

The bankrupt operated a small photographic retail and film processing shop. In 1998 the company began struggling with difficult trading conditions caused by the advent of a cut price photographic developing centre introduced by The Warehouse. The final blow came in mid 2001 when a supplier withdrew extended trade credit support, and the business was left with little choice but to cease trading.

The company was subsequently placed into liquidation in September 2001 with the OA appointed as liquidator. It transpired that the company was unable to pay a dividend to unsecured creditors. On that advice, the lessor of the company’s premises sought to enforce a personal guarantee that the director had given to recover its outstanding monies. Unfortunately for the lessor the director couldn’t meet the debts owing and he was adjudged bankrupt in May 2003.

Normally this would have been the end of the story. However, the OA delved into a transaction that the bankrupt and his wife had entered into in late 2000 in which the bankrupt’s share in the family home was transferred to a family trust via an accelerated gifting programme, known as the ‘lease for life’ technique. The transaction comprised two parts, namely a lease and a sale and purchase agreement where the bankrupt and his wife leased their family home to themselves for the duration of their lives, and then sold it to a family trust at a zero value thereby circumventing the normal gifting obligations. The transfers were undertaken on the advice of a business consultant when the bankrupt’s company was experiencing the difficult trading conditions mentioned above.

As a result of their inquiries, the OA issued two notices in 2005. The first to set aside the transfer of the bankrupt’s share of his family home to the trustees of a family trust, and the second to set aside a lease from the bankrupt and his wife as the owners of the property to themselves as lessees.

The bankrupt and his wife applied to the High Court for orders reversing the OA’s notices but were unsuccessful.

The Court held that both the sale and purchase agreement and lease were void for want of consideration. The sale and purchase agreement was void because the trustees had paid nothing for the House. As for the lease, although the bankrupt and his wife had undertaken to pay all outgoings (which would normally be treated as consideration), in the context of this transaction, the Court found that these were obligations which already rested with the bankrupt and his wife prior to the lease and it was not possible to give themselves, as valuable consideration, obligations that they already had.

The Court had little trouble finding that the bankrupt’s reason for transferring his house to the trust had been motivated, in part, by a need to protect it from the circling creditors, and therefore fell short of the requirement that a gift be made in good faith.

Interestingly, the bankrupt’s financial advisor who gave evidence in support of the transactions said that he had advised a number of clients on the ‘lease for life’ technique and that he was aware that some legal firms ‘particularly in the city of Auckland regularly use the lease for life technique’ for the same purpose as the bankrupt.

This case shows that creditors should not always be put off in pursuing debtors who have arranged their financial affairs in complicated trust structures.
Article by Matthew Hayes, Lawyer, Auckland office

The Court of Appeal judgment in Mason v Lewis, demonstrates that sleeping directors who ignore their duties will get little sympathy from the Court.

This case came on appeal by the liquidator after the High Court found that Mr and Mrs Lewis had not contravened sections 135 or 300 of the Companies Act for failing to maintain proper accounting records. Global Print ran up millions of dollars in debt in the short trading period of the company and was never solvent. The High Court’s sympathy stemmed from Mr and Mrs Lewis’ reliance upon the Manager of Global Print, Mr Grant, who had initially convinced Mr and Mrs Lewis to invest money in the company, and continually assured them that the company was on the verge of profitability. As the company fell into further debt, Mr Grant fabricated accounts to a factoring company and was later found guilty on criminal fraud charges.

The sympathy of the High Court Judge was not shared by the Court of Appeal. The Court reiterated that the duty under section 135 is an objective one, and the focus is not on the directors belief, but rather on the manner in which the company’s business is carried out.

The Court listed numerous factors which should have alerted Mr and Mrs Lewis to the company’s perilous financial condition, including:

• The company's only significant contract was terminated in February 2000 after two months of trading.

• Resignation of other directors who had day to day knowledge of the company's activities.

• Unpaid PAYE tax from March 2000.

• No proper Board meetings being held and very limited financial information being available to Mr and Mrs Lewis.

• Mr and Mrs Lewis having been advised on various occasions that the company could not meet its debts.

• The decision of Mr Grant to factor debts without the consent of Mr and Mrs Lewis in October 2000.

• Letters of demand to Mr and Mrs Lewis from the IRD in March or April 2001 regarding a tax debt of $163,000.

Despite these factors, the company continued trading until February 2002, when a shareholders resolution appointed liquidators to the company.

Justice Hammond, delivering the Court of Appeal judgment, stated that the matter was ‘a paragon case of reckless trading under section 135 of the Companies Act 1993. The only real issue at trial should have been as to the appropriate relief to be afforded’. The Judge found that ‘for a period of 15 months (at minimum) creditors were left at the mercy of a hopelessly insolvent company, which was in any event being run by a crooked manager’.

This case sends a sound warning to sleeping directors not to abdicate their responsibilities. It will be no answer for directors to say that they relied on their manager if they have ignored clear factors evidencing the company’s financial problems.
Article by Kevin Sullivan, Senior Associate, Wellington office

Administrators must ensure that costs incurred in the course of an administration are reasonably and honestly incurred, or the administrator can be personally responsible for the costs.

In this article we examine the circumstances in which an administrator may be personally liable for costs incurred in the course of an administration. We also examine the ways in which an administrator can minimise his or her exposure to personal liability for costs.

There are subtle differences between an administrator (a person appointed by the company, creditors or the court) and a deed administrator (a person appointed under a deed of company arrangement usually by creditors). We will not examine the differences between those roles in any detail in this article.

Under the Insolvency Law Reform Bill administrators (not deed administrators) are entitled to be indemnified out of the company’s property for personal liability incurred in the performance their duties. Deed administrators are usually entitled to be indemnified under the deed or at law.

Despite the indemnities, the Court has a general supervisory power over both administrators and deed administrators.

Clause 239ADS of the Bill provides that the Court may make an order if it is satisfied that the administrator or the deed administrator’s management of the company’s business, property or affairs is prejudicial to the interests of some or all of the company’s creditors or shareholders.

The equivalent provision in the Australian Corporations Act 2001, section 447E, has been held to support a personal costs order against an administrator or a deed administrator. This occurred in the recent case of Grosvenor Constructions (NSW) Pty Limited (subject to a deed of company arrangement) v Hunter, where the company, Grosvenor Constructions and its administrator were ordered to pay costs on an indemnity basis.

The company commenced proceedings against certain parties and subsequently agreed to pay security for costs. The company then failed to carry out the agreement, abandoned the proceedings and also failed to explain to the Court the reasons for doing so. The Court inferred that the administrators’ conduct was unreasonable. His Honour said that section 447E supports costs orders against an administrator and proceeded to make the costs orders mentioned above.

The following principles have emerged from the Australian cases:

• Costs are in the discretion of the court;

• An administrator is entitled to be indemnified for costs properly incurred, that is, costs reasonably and honestly incurred;

• In legal proceedings, a court has the power to make a personal cost order against an administrator (It is less likely that a cost order will be made against an administrator if the administrator is not joined as a party. However, the Court can still make an order against a non-party in exceptional circumstances);

• The normal costs order against an administrator who is unsuccessful in legal proceedings is an order to pay the successful party’s costs, without limitation to the company’s assets (this means that the administrator will be personally liable if the company’s assets are insufficient to meet the costs award);

• An administrator under a deed:

The voluntary administration legislation has been operating for some 14 years in Australia and with a current average of 554 administrations in Australia per month (Australian Securities Investment Commission 2005 External Administration Statistics) there has been very few occasions where administrators have been held to be personally liable for costs.

Nevertheless, there are steps that administrators can take to minimise the likelihood of disgruntled creditors or shareholders (or the Registrar of Companies) seeking personal cost orders against them, such as:

• Most importantly, carry out the duties with propriety;

• Ensure that any costs incurred are proper in the circumstances. Proper means reasonably as well as honestly incurred (for example, it would be unreasonable to pursue or defend litigation which is doomed to fail);

• The administrator should seek advice on whether it is reasonable to commence or defend legal proceedings (for example, in the absence of impropriety a deed administrator is entitled, and arguably bound to defend a challenge to a deed of company arrangement);

• Where appropriate, ensure that proceedings are commenced in the name of the company, not the administrator’s name;

• Ensure that any deed of company arrangement entered into by an administrator contains a contractual right to reimbursement of the administrator’s remuneration and expenses incurred as a result of the administration, including instituting or defending Court proceedings.

This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication.