Performance Of Directors Duties When Under Financial Stress

By Alicia Hill, Principal, MST Lawyers

Directors of companies owe duties to the company, its shareholders and creditors which, if they fail to perform them, can make them liable for claims of compensation for loss and damage.

Directors of financially struggling companies, in particular, need to be conscious of:

  • the financial viability of the business and continually assess this against performance;
  • the accuracy of what they say to financiers, investors or other people about the business; and
  • the need to ensure decision making is for proper purposes, in good faith and in the best interests of the company and not themselves personally.

The following cases put a spotlight on some of the traps faced by directors.

Insolvent Trading

The question of what is ‘insolvent’ trading is often answered by reference to the less than helpful definition in the Corporations Act 2010 (Cth) (Act) being, ‘a person is solvent if they are able to pay debts as and when they fall due. If a person is not solvent, then they are insolvent’.

ASIC has also published Regulator Guide 217 listing factors to be considered when attempting to determine whether a company is trading while insolvent.

In Treloar Constructions Pty Ltd v McMillan [2017] NSWCA 72, the Court was asked to make findings that the director of McMillan, be personally liable pursuant to section 588M of the Act for debts incurred by the company while trading although insolvent.

Treloar entered into a contract with McMillan Prestige Pty Ltd, of which McMillan was a director, to supply construction and project management services. Treloar issued 11 invoices during this time that went unpaid. Receivers were appointed to McMillan Prestige, and the company was wound up.

Treloar brought an action in the District Court seeking to recover the unpaid invoices from the director, McMillan, for allowing the invoice debts to be incurred when the company was trading while insolvent. The action was initially unsuccessful. However, the Court of Appeal overturned the District Court decision and granted judgement in the amount of $418,991.77 (the total value of the invoices) to Treloar against the McMillan.

In proving its case, Treloar sought to rely on an expert report prepared by an insolvency practitioner as to the insolvency of McMillan Prestige addressing matters including:

  • non-payment of tax debts;
  • access to investment funding;
  • the company’s aged creditors;
  • the company’s cash at bank;
  • debtor information of the company.

Arguments were raised as to whether the court could rely on the insolvency practitioner’s report. Ultimately, the Court found that the assessment of the insolvency claim was soundly based on the facts at the time.

Access to short-term or ‘on demand’ funding was not supportive of a finding that a company was solvent. The Court of Appeal determined that McMillan Prestige was insolvent after it considered:

  • the company group accounts at the time;
  • the working capital available to the company at the time;
  • whether invoices were paid outside their terms;
  • whether the company had particular funding available to it;
  • whether an overdraft facility could assist in the assessment of solvency;
  • whether any unpaid tax debt existed; and
  • what effect debtors of the company had on the assessment of solvency.

McMillan sought to raise as a defence to liability that he had reasonable grounds to expect that the company was solvent at the time and would be solvent even after incurring the debt.

The Court, in considering the full circumstances determined there were no reasonable grounds to expect that the company was solvent during the period it incurred the liability to Treloar. McMillan, as director, and for allowing these debts to arise, was judged to be personally liable to pay $418,991.77 to Treloar.

Not engaging in misleading and deceptive conduct

In Ward v Xiang [2017] NSWCA 39, Mr Xiang brought proceedings against Mr Ward for nine alleged misleading and deceptive representations resulting in Mr Xiang paying $500,000 to acquire shares in a company called Alternative Fuel Solutions Pty Ltd (AFS).

These representations included:

  • that AFS operated a genuine business (and investing in AFS would lead to Mr Ward sponsoring Mr Xiang to assist him in obtaining permanent residency within Australia); and
  • that Mr Xiang would receive a return of $450,000 of his investment in two years.

Two of the nine alleged representations were considered to be misleading by the judge.

Mr Ward claimed that he had not made any direct representations to Mr Xiang.

All conversations between Mr Ward and Mr Xiang had been translated or provided through a third party, Mr Knight, or Mr Knight’s company, to procure Asian investors for AFS.

The Court found that Mr Ward had no doubt made the representations to Mr Knight with the intention that they be passed on to Asian investor prospects. The court found that Mr Ward was in full control of the AFS business at the relevant time and had authorised Mr Knight to locate Asian investors for the AFS business.  Thus, he had a knowing involvement in the making of those representations.

Consequently, the Court of Appeal confirmed the judgement against Mr Ward for making misleading and deceptive representations about the AFS business to Mr Xiang.

Exercising powers in good faith for a proper purpose

In ASIC v Drake (No.2) [2016] FCA 1552, the Australian Securities and Investments Commission (ASIC) commenced proceedings against the directors of a company (the responsible entity of a listed managed investment scheme) for the alleged breach of fiduciary and statutory duties to act in good faith and for a proper purpose.

This was a long and detailed case, but the relevant portion, for this discussion, pertains to ASIC submitting to the Court that approval of a decision to increase management fees for the entity was made for an improper purpose and not in good faith.

The claim stated that the higher management fees would benefit one of the directors, Drake, who owed the company (via a loan account recorded in its financial statements) more than $20 million and ultimately, would not be in the best interests of shareholders.

The court reconfirmed that impropriety of a director would arise where there was:

“a breach of the standards of conduct that would be expected of a person in his position be reasonable persons with knowledge of the duties, powers and authority of his position as director, and the circumstances of the case, including the commercial context. Such standards, expressed according to objective criteria, are ultimately stated, as necessary, by the courts.”

Based on the evidence provided, Edelman J found that the directors had acted honestly and in good faith for a proper purpose. When considering the proposal to increase the management fees of a responsible entity of a managed investment scheme, the judge determined that based on the information available to Drake, the decision was rational and believed to be in the best interests of the company at the time.

If you would like to discuss any aspect of this article further, please contact Alicia Hill, Accredited Specialist in Commercial Litigation, a member of the Australian Restructuring and Insolvency Turnaround Association (ARITA) and a graded Arbitrator with the Resolution Institute on (03) 8540 0200 or email.