Directors’ duties and working capital lessons from Mainzeal

THE High Court decision in the Mainzeal Construction case was released last week and has resulted in considerable media attention, given the amount of money and personalities involved. It may be that the directors will appeal the decision, however, in the meantime, there are some useful takeaways from the High Court judgement of Justice Cooke.

The Mainzeal case arose out of the collapse of Mainzeal Property and Construction Ltd in February 2013, leaving about $110 million owing to unsecured creditors of the company (many being unpaid subcontractors and construction contract claimants). Mainzeal (and two related companies) were placed into liquidation and the liquidators subsequently brought legal proceedings against the former directors.

The liquidators claimed various causes of action but their main claim was that the Mainzeal directors had breached their duties under section 135 of the Companies

Act commonly known as the duty to avoid ‘‘reckless trading’’.

The director duty in section 135 states that a director must not agree to (or cause or allow) the business of a company to be carried on ‘‘in a manner likely to create a substantial risk of serious loss to the company’s creditors’’. The liquidators essentially alleged that Mainzeal collapsed because the directors allowed the company to continue trading in an insolvent state for several years, using creditors’ funds as working capital and relying on promises of financial support from the Mainzeal shareholder group but in circumstances where those promises of support were not formalised into legally binding documents.

The background to the case is obviously complex and cant be summarised sufficiently here, but in the end Justice Cooke decided there were three key considerations that led him to find that the directors had breached the section 135 duty.

They were (a) Mainzeal was trading while ‘‘balance sheet insolvent’’ because a significant debt owed to Mainzeal by another company in the wider Mainzeal group was not, in reality, recoverable; (b) there was no legally binding assurance of group financial support for Mainzeal on which the directors could reasonably rely; and (c) Mainzeal’s financial trading performance was generally poor and prone to significant oneoff losses, which meant it had to rely on a strong capital base or equivalent backing (which it had not secured) to avoid collapse.

The fact that Mainzeal did not have any legally binding documents in place with its shareholder group for financial support (if adverse circumstances arose) was a critical factor for the judge. Letters of comfort had been provided by group companies in connection with Mainzeal’s annual audit, but the judge decided it was not reasonable for the directors to rely on those letters, as they were provided only for the purpose of the audit and were not legally binding. Various verbal assurances of financial support had been given however the judge said that ‘‘given the importance of the assurances for the legitimacy of Mainzeal’s continued trading in an insolvent state, the reliance on purely verbal assurances was unreasonable’’. Only legally binding commitments could protect creditors in the event of insolvency.

Related to that, even if the support had been legally binding, another significant issue was that the directors would need to have taken steps to ensure that funding was able to be extracted from the wider group companies in China, given that the ability to remove funds from China is heavily controlled by Chinese authorities. It was noted that the directors had not done that.

In relation to Mainzeal being ‘‘balance sheet insolvent’’, the judge also noted that its a feature of the construction industry that companies are able to obtain substantial payment from clients/principals in advance of paying their own subcontractors. That very significant cashflow existed for Mainzeal and gave it what was essentially the business working capital but it meant Mainzeal was trading with the subcontractors’ money and it was that money which was at risk, instead of share capital from shareholders. The amount owed by Mainzeal to its unpaid subcontractors was

$43.8 million. We suggest this is a particularly important point for directors of all construction companies to note.

Justice Cooke noted that three of the four directors (including former Prime Minister Dame Jenny Shipley) had acted in good faith, and with honesty, throughout the events involving Mainzeal and he noted that they breached their duty because they had failed to fully appreciate and address the risks they were exposing the creditors to, and because of unreasonable reliance on assurances of financial support expressed in loose terms that had been given to them.

That resulted in an order against the four directors for a total of $36 million, the three less culpable directors being liable for $6 million each. It will be very interesting to see if the decision is appealed.

David Smillie is a partner at Gallaway Cook Allan in Dunedin.