Australia: Why directors must consider creditor interests when company solvency is at risk

Last Updated: 3 June 2019
Article by Brent Van Staden and Joshua Waters

In brief - Federal Court finds Termite Resources' directors breached their duties by failing to conduct a proper analysis of sufficiency of cash reserves

In Termite Resources NL (In Liq) v Meadows, in the matter of Termite Resources NL (In Liq) (No 2) [2019] FCA 354, the Federal Court found against the defendant directors of Termite Resources NL (Termite) on the grounds that each had breached their duties. Following an extensive review of the duties owed, White J ordered that the directors compensate Termite in the amount of $7 million for their collective breach. The decision serves as a reminder for corporate directors to consider the interests of creditors when a company's solvency is at risk and of the very real personal consequences that can flow from getting it wrong.

Termite was established as a wholly owned subsidiary of Outback Iron Pty Ltd (Outback) to conduct mining operations at Cairn Hill in the Far North of South Australia. Outback was an incorporated joint venture between IMX Resources Ltd (IMX) and Taifeng Yuanchuang International Development Co Ltd (Taifeng).

By 30 June 2012, IMX and Taifeng had advanced $48.9 million, through Outback, to Termite. In turn, Termite, pursuant to a Distribution Policy accepted by the directors, distributed $46.1 million of its mining proceeds back up the chain before being placed into voluntary administration on 18 June 2014. The Court was required to consider whether the Distribution Policy had binding effect on the parties and whether the directors' acceptance of it was in breach of their duties owed to Termite.

Distributions clauses in Distribution Policy found by Court to be binding

White J acknowledged that the document being described as "Policy" pointed against any part of it having binding effect. However, his Honour was persuaded that two clauses of the Distribution Policy concerning the agreed character of contemplated distributions were binding while the balance was not. The reasons provided were:

  1. the relevant clauses appeared in a section of the document headed "Procedure" so as to distinguish them from other sections
  2. both the subject matter and declaratory expression of the relevant clauses were apt to indicate a binding agreement, and
  3. IMX's auditor was pressing for formal documentation to provide certainty that IMX would receive the distributions from Termite on which it relied to remain solvent before providing its opinion on IMX's ability to continue as a going concern, so that, in the context of the parties it was understandable, objectively considered, that the companies wished to be bound.

Of particular significance to the outcome of the case, was the requirement of the Distribution Policy that Termite maintain a $3 million cash reserve and distribute all surplus mining proceeds to Outback.

Directors' duties and foreseeable risks to solvency

The case examined the scope of duties owed by directors under sections 180 and 181 of the Corporations Act 2001 (Cth) and at common law. It was held that it is necessary to have regard to matters bearing on a company's solvency at the time a course of action is decided on and afterwards to determine the scope of directors' duties. White J found the following matters, amongst others, to be foreseeable risks to Termite's solvency:

  1. iron ore price volatility and fluctuations
  2. USD/AUD exchange rate fluctuations
  3. the unreliability of forecasts regarding the quantity and grade of ore available at the Cairn Hill mine, and
  4. project uncertainties.

The Court held that directors are required to consider the interests of creditors when determining a course of action when there is a real and not remote risk of the company's insolvency. It was found that the directors had knowledge of the above risks and had contemplated their potential impact on Termite's solvency.

Cash reserve in Distribution Policy was insufficient to cover Termite's contingencies and liabilities

Evidence was adduced at trial to establish that a $3 million cash reserve was insufficient to enable Termite to meet its back-ended liabilities in the event one of the foreseeable risks came to fruition and Termite was unable to continue mining operations at Cairn Hill.

It was held that directors acting with reasonable diligence in the circumstances would not have approved a Distribution Policy with a cash reserve of less than $10 million. In his Honour's words, the adoption and implementation of a cash reserve of less than $10 million could not rationally be regarded as having been taken in Termite's best interests. It was plain that the Distribution Policy was undertaken in the interests of IMX and Taifeng and the directors had not appeared to consider Termite's interests at any stage. The lack of regard for Termite's interests removed the availability of the Business Judgement Rule found in section 180(2) of the Corporations Act to excuse the directors from liability.

The $3 million figure was inserted into the Distribution Policy by the director drafting the document without any consideration of its appropriateness to cover the contingencies and liabilities of Termite, if required. Termite's Board never addressed the sufficiency of the cash reserve.

The directors were found to have breached their duties by failing to conduct a proper initial analysis of the cash reserve and by not keeping themselves informed of its ongoing adequacy. The directors were ordered to compensate Termite for the loss suffered as a result of their breach.

While ultimately successful, it appears Termite's decision to structure its claim in this way limited the quantum of compensation able to be awarded to it by the Court. By focussing on the directors' failure to maintain sufficient cash reserves rather than the imprudence of the distributions themselves, Termite's ability to recover from its former directors was limited to the difference in value between the cash reserves actually maintained and the cash reserves which would have been maintained by directors acting with requisite care and diligence.

We will examine the issues relating to causation and loss raised by White J in our next article, which will feature in the June issue of CBP Focus.

Brent Van Staden Joshua Waters
Corporate advisory
Colin Biggers & Paisley

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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