MODULE 12 OBLIGATIONS OF DIRECTORS REGARDING INSOLVENT TRADING ADB Private Sector Development Initiative Corporate and Financial Governance Training Solomon Islands Dr Ann Wardrop La Trobe University

Acknowledgement These materials were produced by the Asian Development Bank’s Pacific Private Sector Development Initiative (PSDI). PSDI is a regional technical assistance facility co-financed by the Asian Development Bank, Australian Aid and the New Zealand Aid Programme.

Module 12 Outline 3  Overview of s 70 of the Companies Act 2009  What must a director do under s 70?  Policy behind s 70  The two situations in which liability is incurred under s 70  Who are directors for the purposes of s 70?  Obligations of directors regarding a meeting called under s 70  Defences to an action by creditors

Module 12 Outline 4  When is a company unable to pay its debts when they fall due in the ordinary course of business? [insert name of trainer].  Example of matters that would put a reasonable director on inquiry about co solvency – the warning signs of insolvency [insert name of trainer]

Overview of s 70 5  Section 70 provides that a director can be liable to a creditor of the company for an obligation incurred by the company after the director fails to comply with s 70 or fails to participate in a meeting called under s 70.  S 70 places an obligation on all directors to:

What must a director do under s 70? 6  call a meeting of directors within 10 working days to consider whether the directors should appoint a liquidator if the director:  Believes that the company is unable to pay its debts as they fall due in the normal course of business; OR  Is aware of matters that would put any reasonable person on inquiry as to whether the company is unable to pay its debts as they fall due in the normal course of business

Some background matters 7  [Insert name of trainer] will discuss the meaning of the phrase ‘unable to pay its debts as they fall due in the normal course of business’ and the warning signs of insolvency such that a reasonable person would be put on inquiry.  Throughout these slides, ‘being unable to pay debts when they fall due in the normal course of business’ will be referred to as ‘cash flow insolvency’ or ‘cash flow insolvent’

Overview of s 70 8 Being aware of matters that would put a reasonable person on inquiry has two elements. First the director must be ‘aware of matters’ – that would put a reasonable person on inquiry. Second, whether or not a reasonable person would be put inquiry is an objective test, to be judged ‘according to the standards of the director of ordinary competence who is expected to be capable of reaching a reasonably informed position about the financial capacity of the company’ Credit Corp Aust Pty Ltd v Atkins (1999) 30 ACSR 727

Background: what does a liquidator do? 9 Liquidator winds up the company. He or she will find and protect the assets of the company, sell the assets, investigate the affairs of the company, distribute moneys to creditors and shareholders (if a surplus), provide reports on the company’s affairs to creditors, shareholders and the Registrar. Control of the company passes to the liquidator.

Policy behind s  Discourages irresponsibility of incurring obligations when director knows or suspects company is cash flow insolvent.  Incurring obligations in these circumstances is commercially dishonest.  Sets up an incentive for directors to hold a directors’ meeting to consider the financial situation of the company.

Liability of a director under s  Direct liability to creditors will be imposed on a director in two situations under s 70: 1. If:  the director does not call a meeting when he or she should have and that person is still a ‘director’ when the obligation is incurred; and  the company is cash flow insolvent at the time the meeting should have been called and the company is later placed into liquidation; (s 70(3)) or

Section If  a meeting is called under s 70, and the relevant director doesn’t participate in the meeting; and the directors at the meeting don’t appoint a liquidator; and there were no reasonable grounds for believing the company was cash flow solvent at the time of the meeting; and the company is later placed in liquidation. (s 70(4))

Who are directors under s 70? 13 ‘Directors’ includes ‘shadow directors’ under s 72 – that is, if the directors of a company are accustomed or required to act on the directions of another person (person X), person X is treated as a director of the company for liability purposes even though person X has not been formally appointed a director.

What happens at a meeting called under s 70? 14  S 70(2)  The directors must consider whether to appoint a liquidator or to continue to carry on the business of the company.  If the company is cash flow insolvent and the directors fail to appoint a liquidator this will be a breach of their directors’ duties.

Model rules and insolvent trading 15  The model rules require directors to call a meeting within 10 working days if insolvency is suspected or a reasonable person would be put on inquiry about cash flow insolvency. See e.g. private company model rules, Schedule 2, cl 48.  Failure to comply with a rule of the company is itself a breach of directors’ duties under s 66 of the Act.

Defence: creditor’s negligence 16  S 70(5) sets out a defence for a director who is liable to a creditor under either of the two situations described in slides 10 and 11 above.  If the director can show that the creditor:  knew or ought to have known of the circumstances that called into question the solvency of the company; or  otherwise assumed the risk of dealing with the company in those circumstances.

What is insolvency? 17  [insert name of trainer] will discuss the test for cash flow insolvency and the warning signs for directors of impending or actual insolvency.

SOEs and insolvent trading 18  Duty not to engage in reckless trading (SOE Regulations reg 20) Director of SOE must not agree, cause or allow the business of the SOE to be carried on in a manner likely to create a substantial risk of loss to the SOE creditors. At the very least this imposes on a director of a SOE a duty not to allow insolvent trading. Breach of this duty will give rise to an action by the SOE against the director for breach of statutory duty.* (compare situation under s 70 CA where creditors have a direct cause of action against the director) Peter Watts, Directors' Powers and Duties (2009, 291)

SOEs and insolvent trading 19  The Solomon Island regulation is the same wording as NZ law. Below is an example of breaches of the NZ law to give an idea of the sorts of behaviour prohibited:*  Fatupaito v Bates [2001] NZHC 401  Director knew the company was balance sheet insolvent and had said it was ‘hopelessly insolvent’ and had a prior history of poor performance, however he thought that by continuing to trade the company could complete projects it had on its books and therefore realise benefits for the company. The evidence showed that if the company had ceased to trade at the relevant time the shortfall of assets to liabilities that existed at the time of actual liquidation would have been NZ$59, lower. Peter Watts, Directors' Powers and Duties (2009, )

SOEs and insolvent trading 20  The court held that once he knew the company was balance sheet insolvent and having known of the co’s prior poor performance, he should have known that continued trading posed a substantial risk of serious loss to creditors. This was made worse by allowing the company to undertake new projects.  ‘While there may be circumstances where continued trading is justified by the prospect of collecting pre-existing debts or generating significant income from a reasonably minor expenditure (as in situations where projects are nearly completed and a small amount of work to complete them will justify payment of a full contract price) directors must be very cautious before embarking on that course’

SOEs and insolvent trading 21 On the facts of the case: the director did not assess the likelihood that existing debts would be collected and accepted an optimistic forecast of income for uncompleted projects provided by an employee even though the employee had a poor past record about forecasting income for such projects especially in light of poor workmanship. Held: breached duty not to trade recklessly.

SOEs and insolvent trading 22  Duty in relation to obligations: reg 21 Director must not agree to the SOE incurring an obligation unless the director believes at that time on reasonable grounds that the SOE will be able to perform the obligation when required to do so. In Fatupaito v Bates the director was also held to have agreed to the incurring of obligations without reasonable grounds that the company would be able to perform those obligations.