We are often asked ‘how do liquidators’ work’ and what are their rights regarding access to company records and information. To clarify we have put together this article.

When a liquidator is appointed over a company, either by the shareholders or by order of the High Court, one of the first steps taken will be to locate and uplift the books and records of the company and to seek information about the business, accounts or affairs of the company to enable a full review to be undertaken.

The purpose of the review is to –

• Establish the financial position of the company at liquidation;
• Ensure that all assets have been properly accounted for;
• Identify any other avenues of recovery for the benefit of the company’s creditors; and
• Examine the actions of the company’s officers to see if they have properly carried out their duties and take the appropriate steps where necessary.

Books & Records

The books and records are generally in the possession or control of the director or are held by the company’s professional advisors, such as accountants and lawyers.

When we are appointed as liquidators, our first approach in relation to obtaining company records, is by way of a letter to the relevant person or entity requesting details of the records held and seeking arrangements to uplift those records.

In most cases that initial letter is sufficient but, on occasion, the request is either ignored or refused.

When the records requested are not provided in a timely manner, the liquidator has powers under section 261 of the Companies Act 1993 (“the Act”) to issue a written notice demanding the records and it is an offence to fail to comply with a notice.

Pursuant to section 263 of the Act, a person is not entitled to claim or enforce a lien, over the books and records of the company, against the liquidator, that arises in relation to a debt for the provision of services to the company prior to the liquidation commencing.  However, the debt is a preferential claim in the liquidation to the extent of 10% of the total debt up to a maximum of $2,000.

Information

When it comes to obtaining information about the company’s affairs, again our initial approach is to ask the people concerned to provide it.

But, if that doesn’t happen, section 261 of the Act also gives the liquidator the power to issue a notice in writing to various categories of people who have knowledge of the company’s affairs, to attend on the liquidator in person to provide the information that they have.

The people who can be required to attend are –

• a director or former director of the company; or
• a shareholder of the company; or
• a person who was involved in the promotion or formation of the company; or
• a person who is, or has been, an employee of the company; or
• a receiver, accountant, auditor, bank officer, or other person having knowledge of the affairs of the company; or
• a person who is acting or who has at any time acted as a solicitor for the company.

The person to whom the Notice is issued may be required –

• to attend on the liquidator at such reasonable time or times and at such place as may be specified in the notice:
• to provide the liquidator with such information about the business, accounts, or affairs of the company as the liquidator requests:
• to be examined on oath or affirmation by the liquidator or by a barrister or solicitor acting on behalf of the liquidator on any matter relating to the business, accounts, or affairs of the company:
• to assist in the liquidation to the best of the person’s ability.

A person who fails to comply with a notice given under this section commits an offence and, if convicted, is liable to a fine not exceeding $50,000 or imprisonment for up to 2 years.

Conclusion

When appointed over a company, the liquidator doesn’t know what they don’t know so they have been given statutory powers to uplift company records and to obtain information from those people who do know to ensure that any potential avenue of recovery for creditors is identified.

If you would like to find about more about the different insolvency services available you can read more here. If you would like more information about the powers of the liquidators to obtain information and records or how liquidators work, please contact one of the team at McDonald Vague.

It is common in New Zealand for the directors and shareholders of small companies to be the same people and many are also employees of the company – executive directors.  Whether this is in the form of a family owned business or a just a small to medium sized enterprise made up of unrelated individuals this involvement on all levels can create difficulties.

The advantage of such a set up is that the individuals are motivated to make the business work and be profitable.

The downside is that the closed nature of the board can leave gaps in the knowledge and experience held by the directors and their closeness to the business can lead to subjective decision making.

Depending on the numbers on the board, this can also lead to a stalemate position if there is a difference of opinion on matters requiring board approval.

There are two other types of directors that can be brought into the board to help address these issues, non-executive directors and independent directors.

Non-executive directors vs Independent directors

Whilst both can address the lack of knowledge and experience, a non-executive director may be representing a shareholder and, therefore, may not act without some bias.

An independent director will generally have no links with the company, other than sitting on the board, and have no affiliation to any of the other directors or shareholders.

Case Study

A liquidation that we have been conducting involves a company with two directors with the shares held by entities associated with each of the directors.  One director was an executive director, employed by the company. Two further non-executive directors were appointed to the board – one nominated by each of the other directors.

The board functioned properly, and in unity, until the company faced financial issues. 

When the issues were identified, one director made a proposal to restructure the company’s business in an effort to remedy the problems. The restructure proposal was not accepted by the other executive director and, when it went to a vote, the non-executive directors voted with their appointer so there were two in favour and two against – stalemate.

As a consequence, the company continued to trade for a period and left all four directors with a potential liability for breaches of their duties as director.

The closely aligned shareholder interests did not want to change the boardroom dynamic by resigning as directors, or voting against their appointors interests and/or personal views.  In the end the directors settled with the liquidator. 

A truly independent director, with no affiliation to the other directors or the shareholding parties, could have looked at the restructure proposal in an objective way.

Conclusion

There is no way to know what decision an independent director might have made in the liquidation referred to above but at least a decision would have been made, and action taken accordingly, rather than having the company in limbo.

If you would like more information on appointment of directors and directors’ duties, please contact one of the team at McDonald Vague.

The Solvency Test

The Companies Act 1993 requires directors to focus on the financial state of the company and to consider whether the company meets the solvency test before permitting distributions and certain other actions by the company.

The statutory Solvency Test is set out at section 4 of the Companies Act 1993.  The Solvency Test requires that both the liquidity limb and the balance sheet limb of the test are satisfied immediately after a distribution or other action.  Distributions are widely defined and include the direct or indirect transfer of money or property and incurring a debt for the benefit of shareholders.

In making a distribution, directors who vote in favour of the distribution must sign a solvency certificate confirming that, in their opinion, the company satisfies the Solvency Test immediately after the distribution is made. The relevant date for assessing solvency is the date of the resolution and not the transfer date of funds.

Liquidity Limb

The company must be able to pay its debts as they become due in the normal course of business.

The nature of the business of the company must be taken into account. A liberal interpretation is to achieve the liquidity limb, debts are paid before creditors become threatening.

Balance Sheet Limb

There is a requirement that the value of the company’s assets is greater than the value of its liabilities, including contingent liabilities.

This limb causes some concern because of the complexity with assessing what the company’s assets and liabilities are and the basis they should be valued. It is necessary to look ahead to after the distribution has been made, to ensure that the assets will still exceed the liabilities.

This is often complicated when companies have kept poor financial records.

What Directors must consider when determining value

Directors should have regard to;

(i) the most recent financial statements of the company.

(ii) all other circumstances which the directors know or ought to know affect the value.

Directors may rely on valuations of assets or estimates of liabilities that are reasonable in the circumstances. When assessing contingent liabilities, the likelihood of occurrence of the contingency and opportunity for the company to offset the contingent liability by way of a counter claim, may be taken into account.
 

The Solvency Certificate

Directors who vote in favour of a distribution must sign a solvency certificate. The certificate and procedure should address:

- the appropriateness of the latest accounts
- the existence of contingent liabilities and the likelihood of any contingency occurring
- whether any claims exist to offset the contingent liability
- any special trade factors or circumstances which “ought to be known” by the directors
- assessment of what valuations or estimates are necessary or appropriate

The certificate and procedure is a formal record to show that the directors have acted properly and considered all the appropriate matters in making their assessment.

Directors need to act in good faith and make proper enquiry and may rely on reports, statements and financial information prepared by staff, professionals, experts, and advisors who the directors believe to be competent so long as they have no knowledge that such reliance is unwarranted.

A company cannot issue a solvency certificate while it remains insolvent.

Application of Solvency Test

The Companies Act requires the Solvency Test to be considered for;

- dividends
- buyback of shares or reduction of equity
- financial assistance in connection with the purchase of the company’s own shares
- minority buyouts
- shareholder discounts / shareholder forgiveness of debt
- the unfair prejudice remedy
- amalgamations
- payment or guarantee of shareholders’ outside debt

Recovery of Distributions

If a distribution is made to a shareholder and the Solvency Test is not satisfied after the distribution is made, then the moneys may be recovered from the shareholder except where the shareholder receives the distribution in good faith without knowledge that the Solvency Test is not satisfied.

A director is personally liable for the repayment of the distribution if the director unreasonably fails to follow the statutory procedures S56(2)(a) and (c) or if the director signs the solvency certificate authorising a distribution when there were no reasonable grounds to believe the solvency test was satisfied S56(2)(b) and (d), or did not take reasonable steps to prevent a distribution once becoming aware, S56(3) and S56(4).

A director is only however liable to repay the company to the extent that the distribution is not able to be recovered from the shareholders. The Court may relieve a director from full liability under S56(5) if the Court is satisfied that the company could have by making a distribution of a lesser amount, satisfied the solvency test. Case Law has not established a strict arithmetical approach to this.

This reiterates the need for appropriate procedures to be established by a company and its directors to ensure distributions are not clawed back or that directors face personal liability.

Directors may be fined where they act in a false or misleading way and can be held liable and face up to 5 years imprisonment, or to a fine not exceeding $200,000.

In our capacity as liquidators of insolvent companies we are often required to consider if shareholder distributions should be clawed back, and/or if directors are liable for repayment of distributions. These potential director actions are good reason to understand the importance of the Solvency Test and procedures under the Companies Act 1993.

If you are an advisor to a company that is insolvent or fails the solvency test, then it is important to make your client aware of the following provisions of the Companies Act 1993 and the possible consequences.

Section 135: A director must not allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.

Section 136: A director must not agree to the company incurring obligations unless the director believes at that time, on reasonable grounds, that the company will be able to perform the obligations.

If you require assistance in establishing the appropriate compliance procedures for the Solvency Test or have any general questions on the Solvency Test or other aspects of the Companies Act 1993, please do not hesitate in contacting the directors or senior staff at McDonald Vague.

In our article published in April 2017, Internal Fraud – The Threat from Within, we discussed the issue of fraud committed on an organisation by its own officers and staff, the types of offending and some basic steps that can be undertaken to reduce the risk of internal fraud.

These steps included the need to have robust and durable systems and procedures in place to lessen the opportunities for fraud to be committed or, if they are committed, increase the chances that they will be discovered before they can cause irreparable damage to the business.

A case that our firm was involved in highlights what fraud can cost a director of a company personally if another member of the business, in this case a fellow director, defrauds clients of the company through the company’s business and the director has not been vigilant in exercising their duty to ensure that the company’s activities are being properly conducted and managed.

Another case mentioned later in this article discusses the reliance on advice from certain persons including professional advisers and other directors and further enforces the liability of non-executive directors with knowledge.

FXHT Fund Managers Limited (In Liquidation) v Dirk Oberholster

FXHT was incorporated in June 2005.  Peter Justin Hitchinson was one of three directors on incorporation.

In December 2005, Dirk Oberholster became a director of FXHT and invested some funds in the business. FXHT’s business was the management of clients’ investments in foreign exchange markets. Mr Oberholster was a medical doctor and, although he had other company interests, he had no expertise in fund management.

The other two original directors ceased in July 2005 and March 2006 leaving Mr Hitchinson and Mr Oberholster as directors.

About 1 year after accepting appointment as director, Mr Oberholster discovered that Mr Hitchinson had been defrauding clients of the company.  Mr Hitchinson resigned and the matter was reported to the Police.  Mr Hitchinson was subsequently convicted of criminal fraud and sentenced to imprisonment.

The company was subsequently liquidated and Peri Finnigan and Boris van Delden were appointed as liquidators. The liquidators’ investigations confirmed that Mr Hitchinson had misapplied client funds to pay out other prior investors and to keep the business operating.

The liquidators took proceedings, through the High Court, seeking orders that Mr Oberholster contribute funds to the liquidation so that the clients could be reimbursed for the losses caused by Mr Hitchinson. The claim was on the basis that Mr Oberholster had failed in his duties as a director and thereby contributed to the losses suffered by the clients.

The High Court found that Mr Oberholster breached section 135 of the Companies Act 1993 (“the Act”) in that he allowed the business of FXHT to be carried on in a manner likely to cause a substantial risk of serious loss to the company’s creditors by allowing Mr Hitchinson free rein to run the company without requiring any formal reporting. 

The Court also found Mr Oberholster was in breach of his duty of care under section 137 for failing to put in place adequate systems of control and reporting.

Mr Oberholster was ordered to contribute funds to the liquidation to reimburse clients.

This case highlights the problems that can be caused to a company, and its officers, by fraud committed by someone within its organisation.

It also highlights the risks faced by a director by becoming involved in a company whose business is outside their expertise and who fails to comply with the statutory requirements of being a director.

Mr Oberholster was not involved in any way with the fraud committed against clients by his fellow director but, because the Court held that he had not properly carried out his duties as a director, he became personally liable to reimburse, at least in part, the clients who had suffered losses.

We have included the link to the High Court decision.   The High Court's decision was appealed to the Court of Appeal who upheld the findings of the High Court.

Use of Information and Advice – A defence?

Section 138 of the Act can provide some relief from personal liability to directors who rely on advice given to them by certain classes of people, including professional advisers and other directors. 

This is dependent on the individual director's situation, knowledge and responses, and may be particularly relevant where the director concerned is a non-executive director and not involved in the day to day operation of the business, who makes reasonable enquiries and receives misleading information from the other director.

However, once the non-executive director is in possession of information or could be reasonably expected to have acquired sufficient knowledge of the company’s business and how that business is being managed, they may be found liable from that point onwards. 

This is set out in the High Court and Court of Appeal decisions in the case Grant & Ors v Johnston & Ors. We have included the link to the High Court decision in this case.

In this case it was decided that a non executive director who was mislead for a period of time, and who took affirmative action to identify and correct company deficiencies including lending the company significant sums of money to fund trading losses was not required to pay a contribution to creditors despite having been found negligent as a director from the time that the Court determined he should reasonably have paid attention to the mounting evidence of his fellow director’s ill disciplined and incompetent management and the adverse results that followed.

These cases remind us that directors in any role must be active and vigilant, and that while a non-executive director may be given some time to learn and then remedy poor company trading, there comes a time when continuing a company trading will not be considered to be a reasonable course of action.

If you are a director and are concerned about your company's financial performance, you have reservations about the information you are being provided, you would like more information about your duties as a director, or you want advice on restructuring,  business systems and procedures, please contact McDonald Vague.

With financial year end, one of the considerations fresh in the minds of business owners and their advisors is the decision regarding appropriate directors’ remuneration.

In a previous article we reviewed the case of Madsen-Ries and Vance v Petera [2015] NZHC 538. In this article, we consider an issue on appeal by the liquidators of Petranz Limited (“the company”) as to whether salaries paid by the company to the directors were fair to the company when they were paid (Madsen-Ries v Petera [2016] NZCA 103). This article will also cover where creditor considerations fit in with such decision making, and the appropriate remedies for creditors if things go wrong.

Background

Mr and Mrs Petera were the sole directors and shareholders of the company, which carried on business between 2002 and 2009 as a cartage contractor. Mr Petera drove one of the company’s trucks, and Mrs Petera worked on administrative tasks.

During this time, the company made various non-business related payments that the Court deemed shareholder drawings, which caused their shareholder current accounts to be overdrawn. However, regarding salaries, in contrast to journalising director salaries at year end, the company paid the Peteras regular fixed amounts between October 2007 and May 2008. During this period the salaries were declared and PAYE paid to the IRD.

In the High Court, the liquidators of the company sued the Peteras for:

- Compensation for breaches of various directors’ duties,

- Repayment of overdrawn shareholder current accounts,

- Repayment of directors’ salaries they argued were unfair to the company at the time they were paid.

In addition to the repayment of the Peteras’ shareholder current accounts, the liquidators claimed a total of $453,003.33 for breach of director’s duties, including $132,255.09 for creditor claims and $321,647.64 for liquidators’ costs up to and including the trial. At the time of liquidation, the company owed creditors $132,555.33.

The High Court, considered the extent of the liquidators’ claim, and stated that their approach to this type of litigation was “[93] …neither cost effective nor proportionate” to the claim involved, and went against the intentions of the Companies Act 1993 (“the Act”).

Justice Lang found that the language and intent of sections 300 and 301 of the Act narrowed the issues to:
- The amount of compensation to the company that should be paid by the Peteras for reckless trading for actual loss, and
- the amount of personal liability for failure to keep proper accounting records.

Breach of Directors’ Duties

Justice Lang found the Peteras had breached various director’s duties under the Act: s 131 (to act in good faith and in the best interest of the company), s 135 (not to allow the company to be operated in a manner likely to create a risk of serious loss to creditors), s 136 (not to permit the company to incur debts unless they objectively believe the company will be able to repay those debts), and s 137 (to exercise the reasonable care, diligence and skill that a reasonable director would in the same circumstances).

For their breach of directors’ duties, Justice Lang ordered the Peteras to repay the company $64,708, being the losses suffered by the Commissioner of Inland Revenue from the time he determined that they should have stopped trading (31 July 2006).

The Court of Appeal approved of the decision by Justice Lang, to order payment of $64,708 as appropriate compensation to the company for breach of duty not to trade recklessly (s 135 of the Act). The amount determined as compensation also effectively limited the liquidators’ further claims under this cause of action.

Directors’ Salaries: S 161 of the Companies Act

The parties agreed that the directors had failed to comply with the procedures in s 161 of the Companies Act 1993 (“the Act”). The payments were not authorised by the board of directors (s 161(1), not recorded in the company’s interests register (s 161(2)), and finally the directors had not produced a certificate that the payments were fair to the company at the time they were made (s 161(4)).

Under s 161(5) the directors would be personally liable to repay their salaries unless they could show the payments were fair to the company at the time they were made.

In the High Court Justice Lang determined the salary payments were fair to the company at the times they were made, and allowed the Peteras to retain their salaries on the basis that:
- “(the liquidators’ concerns) are answered to some extent by the fact that the company paid PAYE in respect of those payments. To that extent the debt owing to the Commissioner did not become larger during the period in which the payments were made” [50], and
- “the company gained full value from the work carried out” [51], and
- “the company was able to derive profit from Mr Petera’s work because it was able to charge customers for the driving duties he undertook on the company’s behalf” and “the company’s administrative needs were handled by Mrs Petera” [51].

Directors’ Salaries and Fairness

In the Court of Appeal, the liquidators argued that the requirements that the salary payments be fair to the company, reflected the directors’ fiduciary duty of good faith (s 131 of the Act), and that they owed a duty to consider the fairness of the payments in relation to their effect on creditors’ interests, especially given the poor financial situation of the company at the time. The liquidators argued that, from the date of insolvency, the directors should have stopped trading and stopped paying themselves a salary (which would have protected creditor interests by preserving the company’s assets such as they were at the time).

The Court of Appeal however disagreed, and stated:

“[16] The scheme of the Act is that creditors’ interests are a relevant consideration for directors where the directors authorise distributions and other transfers of benefit by a company to its shareholders. In those circumstances the Act uses the solvency test, not the concept of fairness, to protect creditor interests. Where directors are called upon to authorise transactions in which the interests of the company on the one hand, and its directors or shareholders on the other, may diverge (including the payment of their remuneration), the Act uses the concept of fairness. The issue for the directors in those circumstances is fairness as between directors and the company. When certifying fairness, including where required by s 161, directors do not need to consider creditor interests. Directors may nevertheless be liable to contribute to an insolvent company’s assets to reflect losses attributable to the payment of director remuneration and, in turn, a company’s failure to meet its obligations to creditors. Such liability could arise under s 301, by reference to a breach of the s 135 duty not to trade recklessly.”

Liquidators’ Application for Leave to Appeal

The liquidators then sought leave to appeal to the Supreme Court, which although it accepted “[4] that the interpretation of the phrase “fair to the company” in s 161 raises an arguable issue of general importance”, declined to hear the appeal.

The Supreme Court found that such an appeal would require the Court to consider both a legal argument and conduct its own assessment of whether the payments were fair to the company, which it would not normally do, being a matter of “[5] application rather than principle”.

The Supreme Court also noted its concern over proportionality, given the amount already awarded in the High Court, the low level of company debt and the large claim of the liquidators.

Lastly, given the poor financial situation of the Peteras, who were facing bankruptcy, a further award against them would likely have no practical effect.

Conclusion

Regarding director remuneration, there is a distinction between fairness to creditors and fairness to the company. The duty of fairness is owed by directors to the company and indirectly to creditors, whose interests are directly addressed through solvency provisions and the enforcement of directors’ duties such as the duty not to trade recklessly.

The intent of sections 300 and 301 of the Act is to compensate the company and creditors for actual losses, and any further amounts claimed, such as liquidation costs, must be reasonable and proportional to the debts owed by the company.

Although s 161 contains a means of clawback of directors’ salaries, to claim both under this heading and the reckless trading provisions would involve a duplication of claim, and such approach has been rejected by the Court.

Nevertheless, directors must still take care to follow the procedures set out in s 161, and ensure their salaries are fair to the company at the time the salaries are paid.

Finally, if salaries are being paid to directors whilst ordinary creditors are not being paid, the company’s future viability should be reviewed. McDonald Vague can assist with that process.

It is apparent from Court decisions in recent years that there are risks involved for directors who become involved in a company whose business is outside their areas of expertise or knowledge and who rely on the advice of others.

Directors will be held to account if they breach their duties irrespective of whether they are a director involved in the day to day operation of the company or a passive non-executive director. 

The case of FXHT Fund Managers Limited (In Liquidation) and Anor v Dirk Oberholster was heard in the High Court in December 2008 and involved Peri Finnigan and Boris van Delden of McDonald Vague as the liquidators of FXHT.

The proceedings, taken by the liquidators, alleged breaches of director’s duties by Mr Oberholster, one of two directors of the company, and the Court had to decide, if it found there were breaches, whether or not Mr Oberholster was entitled to the defence which is set out in section 138 of the Companies Act 1993 (“the Act”).

Section 138 Use of information and advice

1. Subject to subsection (2), a director of a company, when exercising powers or performing duties as a director, may rely on reports, statements, and financial data and other information prepared or supplied, and on professional or expert advice given, by any of the following persons:
   
   (a) an employee of the company whom the director believes on reasonable grounds to be reliable and competent in relation to the matters concerned:
   
   (b) a professional adviser or expert in relation to matters which the director believes on reasonable grounds to be within the person’s professional or expert competence:
   
   (c) any other director or committee of directors upon which the director did not serve in relation to matters within the director’s or committee’s designated authority.
   
   
2. Subsection (1) applies to a director only if the director—
   
   (a) acts in good faith; and
   
   (b) makes proper inquiry where the need for inquiry is indicated by the circumstances; 
   
   (c) has no knowledge that such reliance is unwarranted.

In this case it was found that Mr Oberholster could not rely on the defence for two reasons.

The first issues was that the person whose advice he relied on, the 2nd director of the company who ran the day to day operations, was the very person he was supposed to monitor the actions of.

The second issue was the general nature of the advice provided and the informal undocumented manner in which it was provided.

This case highlights the need for ALL directors to ensure that they know what is happening within their company - 

• by asking the appropriate questions of the people who are managing the business on a dayto day basis – including other directors; and
• by seeking the relevant financial reports, information and data.

They must also ensure that what they receive is relevant, sufficiently detailed and properly documented.

If you would like more information about the requirements on directors and the types of advice you should be seeking please contact our offices.

There is a lot of confusion amongst business owners on the best sale option – assets or shares. Getting it wrong can incur unexpected liabilities and loss.

There are two types of business sales:

1. An asset sale (plant, property, machinery, equipment, goodwill, etc)
2. A share sale (being shares, either all or part).

However, understanding the risks and benefits will help business owners make an informed decision. 

The sale/purchase decision should consider debt structures, securities held and required, the level of transparency sought, risk profile of the parties, the tax impacts, how the business operates, who is required, and whether the business will attract investors. It also depends on consents being achieved, transferability or gaining of regulatory licenses, warranties, contingent liabilities, and shareholder support in a share sale. 

The choice is usually dependent upon the respective objectives and bargaining powers of the vendor and purchaser. The logical option is one that optimises the economic benefit of both buyer and seller.

OPTION 1 - ASSET SALE

The large majority of purchasers favour asset sales. This option leaves the vendor with a company that is either held for tax purposes, or for future use, or that can be liquidated. The liquidation of a solvent company enables capital profit to be distributed tax free. The liquidation of an insolvent entity tidies up loose ends and provides for an independent party to ensure creditors are paid in the right priority and order.

A business asset sale involves the sale of some or all of the company’s assets. The assets may include fixed assets such as machines, land and buildings, trading stock, and intangible assets such as, intellectual property, patents, trademarks, and goodwill. 

When to make an asset sale

An asset sale will depend upon the objectives of the parties. A purchaser may only be interested in certain assets for a particular purpose. For example, specialised machinery, or maybe only the retail arm. In the sale of part of a business, GST will be charged on the part sale if the part sold cannot be operated independently as a separate business.  

What happens after an asset sale

Under an asset sale, the sale proceeds are paid to the vendor company and are extracted from the company by the company’s shareholder(s) after payment of creditors. The shareholder(s) are usually left with a company that requires a liquidation process to settle disputes and liabilities (if funds are insufficient to clear all debts) or a solvent liquidation to extract the capital gain tax free. 

For an asset sale, the apportionment of the sale value is important and can be a contentious area of negotiation with the purchaser. If individual assets have been depreciated or amortised below market value there may be tax claw-back. The purchaser will have a different view on the value attached to assets and goodwill. 

An asset sale is usually preferred in the following cases:-

1. Smaller and simpler businesses are more likely to be sold by way of an asset sale for various reasons (e.g. fewer assets to transfer, accounts are often unaudited and less reliable).
2. An asset sale is preferred if the buyer does not want all the assets, only part, or does not want to take all of the employees, or wishes to merge the business it is acquiring with its own business under its own branding.
   
   

OPTION 2 - SHARE SALE

Vendors commonly prefer a share sale. Under a share sale, the proceeds are paid directly to the company shareholder(s). The buyer assumes full responsibility and risk for the company going forward. 

When to make a share sale

Businesses where a substantial portion of the asset value is attributable to goodwill and Intellectual property are more likely to be transferred by way of a company share sale.

A share sale minimises tax issues for the vendor. The share sale proceeds are usually tax free (unless the company shares were acquired for the principal purpose of sale in the short term). 

What happens after a share sale

With a sale and purchase of shares, the business does not change hands. Continuity of the business continues. The relationship with employees is not affected. Ownership of the business remains with the company. On settlement, the purchaser(s) becomes the shareholder(s) of the company.

The legal impact is that on settlement the full benefit of the business (and also the liabilities) lies with the company. In many cases, the contracts between the company and its customers and suppliers continues unaffected, subject to consent being gained or termination clauses being dealt with upfront.

A share sale requires due diligence as risks are high.

ADVANTAGES AND DISADVANTAGES OF SHARES SALE VERSUS BUSINESS ASSET SALES

The advantages for a share sale for a vendor are:- 

1. the vendor can exit the business cleanly;
2. the purchaser acquires ownership of all of the company’s assets and liabilities (the complete package);
3. the purchaser effectively assumes all of the liabilities of the on-going company (subject to any specifically excluded under the Sale and Purchase Agreement); and
4. the transaction is between the shareholder(s) of the company and the purchaser so the purchase funds go directly to the shareholder(s).

The advantages of an asset purchase for a purchaser are:-

1. it eliminates risks associated with unknown liabilities;
2. flexibility - the purchaser specifies the assets to purchase and the liabilities (if any) it is prepared to take over;
3. tailored due diligence investigation can focus on the assets being purchased;
4. valuation - usually assets are relatively simple to value;
5. tax advantages - for a purchaser, the cost of assets are valued at market value at the time of purchase (for a vendor, tax losses can be used to eliminate any tax liability on the sale); and
6. the purchaser does not necessarily have to take on all employees. They are likely terminated following sale by the vendor.

The disadvantages for the purchaser of a share sale are:-

1. unforeseen liabilities are often assumed, such as tax and contingent liabilities. The vendor may not even know about these liabilities. They can include leaky building issues, lease issues such as reinstatement of premises on exit, or even prior anti competitive behaviour claims;
2. the risk of assuming all liabilities can be potentially significant. It is however possible to minimise the risks with carefully drafted Sale and Purchase terms, but contingent liabilities can be forgotten or missed;
3. complicated valuation - more costly; and
4. minority shareholder approval - complications arise if they refuse to sell.

The disadvantages to the vendor of an asset sale are:-

1.  the vendor will be left with the company liabilities to pay. Liquidation is an option for both the remaining solvent or insolvent company.

SUMMARY

An asset sale can be used to sell any type of business; a share sale can only be used to sell an incorporated business.

1. In an asset sale, you can choose what you’re selling to a degree. For instance, you may want to keep the name of the business, or a particular asset.  In a share sale, the entire business passes to the new owner, including things such as the business name.
2. In a share sale, the liabilities are sold along with the rest of the business; in an asset sale, only assets are sold, meaning that the original owner may still be responsible for the business’s liabilities.
3. Tax wise, in a share sale there is a possibility that the entire price you pay for the business may be tax free.

Care should be taken by both parties in the decision to buy and sell. Proper due diligence should be undertaken. 

An asset sale provides greater protection for a purchaser. An asset sale is also best for an insolvent vendor company. If the company business for sale is insolvent then a sale of assets option is the recommended course. This will likely lead to a liquidation of the vendor company. There are options for insolvent companies to hive down and for directors to start up again in the right circumstances. This is the topic for another article.

There is risk and responsibility that comes with being a director.  Sections 131 to 145 of the Companies Act 1993 (the Act) set out directors’ responsibilities and duties owed to both the company and third parties.  In the event of business failure by liquidation or other means, if any action is taken for breach of these sections of the Act, it generally falls to insolvency practitioners to act. Whether the insolvency practitioner decides to take any action for breach of directors’ duties is commonly assessed on a case-by-case basis, taking into consideration the likely recovery weighed against the cost of the action and the evidence available to support the action.

The ability to pursue a director, however, is not limited to just insolvency practitioners.  The purpose of this article is to address actions other than those available under Sections 131 to 145 of the Act, as these have been covered in our articles Setting the Records Straight and Directors’ Duties: Proper Accounting Records and Director Remuneration.  The organisations and actions reviewed in this article cover a number of other actions available to insolvency practitioners as well as creditors and third parties who may (or may not) have a relationship to the company.

The High Court

The Act allows liquidators, creditors, and shareholders of a company in liquidation to apply to the High Court seeking that the Court look at the conduct of directors (and other persons specified in the section) and, if appropriate, order that the directors return money or property to the company or pay compensation to the company.  Creditors may also seek orders that the money to be paid or property to be transferred be paid or transferred to them rather than to the company in liquidation.

Under sections 382 and 383 of the Act, the Court can prohibit certain persons who have been convicted of specified offences against the company or convicted of a crime involving dishonesty from managing companies and/or being directors of companies without the High Court’s prior consent.

The Registrar of Companies (the Registrar) and the Financial Markets Authority (FMA).

The Registrar and the FMA have powers granted under Section 385 of the Act to prohibit persons who, within the preceding five years, have been involved in the management of one or more companies that have failed due to mismanagement.

The Registrar and FMA are responsible for supervising different markets/industries. The FMA is responsible for companies that operate inside the financial markets and the Registrar deals with companies operating in all other markets. A banning order against a director will not result in any recovery for the creditors of the failed companies but it will stop the director from being a director or promoter of a company, or taking part in the management of a company for up to ten years.

Any person can make a complaint to the Registrar or the FMA to investigate a directors’ actions and/or a failed company and to ask the Registrar or the FMA to determine whether a banning order is appropriate.  Both the Registrar and the FMA have online complaint forms available on their websites.

When considering whether to make a banning order, the Registrar will look at a number of aspects surrounding the failure of the company together with any supporting evidence that is attached to the complaint.  The Registrar will also conduct his own investigations, which will  typically include looking at the number of failed companies the person has been a director of and how the director’s involvement may have resulted in the failure of the company.

The Registries Integrity and Enforcement Team (RIET)

In addition to facilitating the banning order process, the Registrar also utilises the RIET to deal with matters of non-compliance of a serious and/or prolific nature under the Act. Where the director may have caused the company or its creditors serious financial loss or where there are persistent failures to comply with the Act, the RIET will investigate.

The RIET has the power to issue formal warnings, infringement notices, and/or the suspension or cancellation of the registration of an entity or individual.  The RIET also has the power to prosecute. These powers can be used at any time – the REIT does not have to wait for a business failure to take action.

Police

While civil actions against a director are usually brought by an insolvency practitioner following a company’s collapse, the Police can be involved at any time over the course of the company’s life, if the matter is of a criminal nature.  Any party can refer any criminal matter to the Police.  As with any Police complaint, the Police undertake their own, independent investigation into any claims that are made and take appropriate action, based on the evidence available to them and level of the offending.

Serious Fraud Office (SFO)

The SFO primarily deal with matters of public interest on a large scale.  It primarily deals with cases that involve multi-victim investment fraud, fraud involving those in positions of trusts and matters of bribery and corruption.

The SFO is responsible for investigating and prosecuting complex fraud cases that are not handled by the Police.  The SFO’s powers are wide reaching – their powers are not limited to investigating directors’ actions and the SFO can investigate matters at any time.

Fair Trading Act 1986 (FTA) and False Statements

If a director has reassured creditors that the company is able to pay its debts and has made promises for payment but has not made the payments promised, that director could face proceedings brought by a creditor under Section 9 of the FTA for misleading and deceptive conduct and/or Sections 13, 43 and 45 of the FTA.

Directors making untrue statements can also face claims for negligent misstatement or deceit, where creditors have been told by a company’s director that payments will be made but those payments are never received. 

There have been a number of successful cases brought by creditor against directors that have been found to be in breach of the FTA and/or have made misrepresentations.  In order to succeed on these types of claims, the creditor bringing the claim will need to prove (amongst other things) that the director (or other staff) were making the statement in his/their personal capacity, not on behalf of the failed company.  Because these types of actions against directors are taken through the Courts, which means they can be costly and uncertain in outcome.

Professional Bodies

If a company’s director is a member of a professional body, such as a director who is a Chartered Accountant or Lawyer, it is important to understand how and to what extent the professional body’s rules will apply to the director’s conduct, particularly in relation to disciplinary matters for conduct that occurs other than while acting as a member of their profession.

Conclusion

It is important to understand that, as a director or an individual acting through or on behalf of a company, you could be held personally liable for your actions.

If you wish to discuss directors’ actions and responsibilities further, please contact one of the team at McDonald Vague Limited.

Amongst the director duties imposed by the Companies Act 1993 ("the Act") directors must keep proper accounting records (section 194), and their remuneration must be properly authorised by the board and recorded in the company's interests register (section 161).

Without proper accounting records directors' ability to perform their other duties can also be affected. If directors fail to perform their duties they may face fines, personal liability for company debts, or orders to compensate the companies concerned for losses caused.

The case of Madsen-Ries and Vance v Petera [2015] NZHC 538 dealt with various breaches and remedies in respect of directors' duties, and the judgment is well worth further study for both directors and insolvency professionals.

Madsen-Ries and Vance v Petera [2015] NZHC 538

Mr and Mrs Petera were the sole directors and shareholders of Petranz Limited, which carried on business between 2002 and 2009 as a cartage contractor. Mr Petera drove one of the company's trucks, whilst Mrs Petera worked on administrative tasks. From as early as 2003 the company failed to pay various taxes, and was eventually placed in liquidation on 30 January 2009 on application by the Commissioner of Inland Revenue.

Through most of the company's lifespan the directors failed to keep proper accounting records and ignored the company's growing tax burden, instead paying the company's trade creditors and themselves. They also continued in the unfounded belief that the company would one day be able to pay its outstanding taxes.

The liquidators sued for recoveries from the Peteras in their personal capacities as shareholders for repayment of overdrawn current accounts, and as directors for breaches of fiduciary duties they owed to the company.

Read more: Signs a business is suffering from bad financial decision making

Had they kept proper accounting records the directors could have realised sooner the full extent of the company's tax liabilities and the need to:

• reduce their personal expenditure;
• negotiate a settlement plan with the Commissioner of Inland Revenue;
• introduce personal funds to settle or reduce the debt; and/or
• cease trading and place the company in liquidation.

Without proper accounting records the liquidators were obliged to reconstruct the company's financial history using its bank statements. This was time consuming and costly. The liquidators proved that the company was insolvent from at least 30 September 2005, and they presented a list of disbursements they wished to recover from the directors.

Overdrawn shareholder current accounts

The court classified the disbursements under the following headings:

• Funds taken for miscellaneous personal expenses;
• Funds withdrawn via teller or cheque withdrawals;
• Funds taken via ATM withdrawals;
• Funds transferred to pay the shareholders' mortgage;
• Transfers of funds to Mrs Petera's personal bank account;
• Transfers of funds to Mr and Mrs Petera's joint personal account.

The first category included payments to such entities as restaurants and fast food outlets. The court noted that the onus was on the directors to prove that these payments related to business expenses which, without proper records, they could not.

Regarding withdrawals and payments to the directors' personal accounts (which the Peteras argued were for directors' remuneration), Justice Lang stated:

"There is no pattern ... to the timing or amounts of the payments ... they are suggestive of funds drawn to pay personal accounts and to fund living expenses". [35]

In paragraphs [18] and [19] of his judgment, Justice Lang stated:

"In the absence of any contemporaneous records regarding the purpose of these payments, the liquidators have treated the payments as drawings that must be debited to the shareholder's current account" ... "and are payable on demand".

Failure to comply with the requirements of section 161 of the Act

The court found no evidence that the company's board had:

• properly authorised the payments to the directors as remuneration; or
• entered the payments in the company's interest register; or
• had signed a certificate stating that the payments were fair to the company.

The only defence available to the directors under section 161 would have been for them to prove that the payments were fair to the company at the time they were made. This they could not do, and were therefore held personally liable to the company for the amounts received.

Breaches of directors' duties under sections 131, 135, 136 and 137 of the Act

Broadly speaking, other core directors' duties under the Act require them to:

• act in good faith and in the best interests of the company (section 131);
• not allow the company to be operated in a matter likely to create a risk of serious loss to the company's creditors (section 135);
• not permit the company to incur debts unless they objectively believe the company will be able to pay those debts when due (section 136); and
• exercise the care, diligence and skill that a reasonable director would in the same circumstances (section 137).

The Court found that the Peteras had breached all of the above duties

• The fact that the Peteras continued to draw significant funds for themselves whilst ignoring the debt owed to the Commissioner meant they had not acted in good faith, nor in the best interests of the company (section 131);
• Their continuation of trade whilst ignoring the above circumstances also created a risk of serious loss to a major creditor, namely the Commissioner (section 135);
• The Court found that from at least early 2006 the Peteras "could not have believed on reasonable grounds that Petranz would be able to meet the GST obligations that it thereafter incurred (section 136);
• Finally, their decision to stop paying income tax and GST whilst continuing to draw funds for their own use revealed a strategy which fell below the standard required of reasonable directors in the same position (section 137).

Section 194 - duty to keep proper accounting records

Due to their failure to keep proper accounting records the Peteras were found to have breached the requirements of section 194(1)(a) of the Act.

When the liquidators asked Mrs Petera to produce the company's records she provided "such a small number of records that they would fit within a shoe box" [76]. There were no management accounts or cashflow forecasts, and the only financial statements produced (two out of seven years of trading) were regarded as unreliable.

The court commented that:

"The directors were effectively flying blind so far as the company's true financial position was concerned. This may have contributed ... to the company's inability to pay its debts, because the directors did not know with any certainty how large the tax debt was or whether they had any reasonable prospect of meeting it" [82]

In her defence, Mrs Petera claimed that the directors had relied on their tax advisers to tell them what to do, but because this claim was both unsupported by evidence and lacked probability, the court brushed the defence aside.

Conclusion

Justice Lang concluded that Mr and Mrs Petera had breached their directors' duties under sections 131, 135, 136 and 138, enabling the Court to make an order under section 301 that the Peteras compensate the company for and in relation to the losses caused. Justice Lang determined that by 31 July 2006 the directors should have completed financials and forecasts enabling them "to accurately judge whether the company remained viable ..." [102]. The Peteras were accordingly ordered to pay compensation "... reflecting the losses to the Commissioner after that date". [104].

The Judge also determined that the directors' failure to keep proper records justified an order under section 300 of the Act declaring the Peteras personally liable for all or part of the company's debts. However, as orders had already been made under other headings, the court limited the Peteras' personal liability for failure to keep proper accounting records to the approximate cost the liquidators incurred trying to reconstruct the company's financial history.

The liquidators argued for extensive further orders relating to their other costs; however the court declined to do so and set out various reasons why. Although it is outside the scope and purpose of this article to discuss this part of the court's decision, it is noted that this case was set down for hearing before the Appeal Court in late 2015, so further judicial comment on this case may follow.

With power comes responsibility, and the duties imposed on company directors are extensive and onerous. Whilst business is brisk and revenues swell, breaches of directors’ duties often go unnoticed and without serious repercussions. When fortunes change, a director’s conduct, even years before, can come under close scrutiny from various quarters. As matters go from bad to worse, these parties include shareholders, creditors, receivers, liquidators and regulatory enforcement.

Section 126 of the Companies Act 1993 (“the Act”) widely defines directors; effectively including shadow and silent directors, as well as those who although not duly appointed, exercise certain powers of a director.

Calling to account

Under the Act, liquidators have extensive powers to investigate the affairs of failed companies and the conduct of its officers. They can also seek recovery of funds or property where companies’ officers have acted improperly.

It is important to note that although a director may be guilty of breach of duty or law, a liquidator will be more concerned with recovery of money or property lost as a result of that breach, than looking to have the director sanctioned.

After selling or realising company assets, liquidators turn to other avenues of recovery such as:

• Recovery of insolvent transactions - simply put, claw back of preferential payments to creditors which were made whilst the company was insolvent, and
• Recoveries against directors for breach of their duties.

After the recent Supreme Court decisions in Allied Concrete Limited v Meltzer (SC 51/2013); Fences & Kerbs Limited v Farrell (SC 80/2013); Hiway Stabilisers New Zealand Limited v Meltzer (SC 81/2013) [2015] NZSC 7, recovery actions under the insolvent transaction regime have been limited. On the other hand liquidators are increasingly focussed on potential recoveries for breach of directors’ duties.

Directors duties under the Act

The Act details various directors’ duties: some individual and some collective. Furthermore, certain decisions require higher approval from shareholders through special resolution, such as for major transactions or directors’ salaries.

Directors’ duties include but are not limited to the following:

• “Section 131 Duty of directors to act in good faith and in best interests of company
• (1) Subject to this section, a director of a company, when exercising powers or performing duties, must act in good faith and in what the director believes to be the best interests of the company...”

• “Section 133 Powers to be exercised for proper purpose

  A director must exercise a power for a proper purpose.”

• “Section 134 Directors to comply with Act and constitution

  A director of a company must not act, or agree to the company acting, in a manner that contravenes this Act or the constitution of the company.”

• “Section 135 Reckless trading

  A director of a company must not—

  (a) agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors; or

  (b) cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.”

• “Section 136 Duty in relation to obligations

  A director of a company must not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so.”

• “Section 137 Director’s duty of care

  A director of a company, when exercising powers or performing duties as a director, must exercise the care, diligence, and skill that a reasonable director would exercise in the same circumstances taking into account, but without limitation,—

  (a) the nature of the company; and

  (b) the nature of the decision; and

  (c) the position of the director and the nature of the responsibilities undertaken by him or her.”

• “Section 194 Accounting records to be kept

  (1) The board of a company must cause accounting records to be kept that—

  (a) correctly record and explain the transactions of the company; ...”

Penalties and consequences of breach of director’s duties

The Act imposes criminal penalties up to a maximum of five years imprisonment or $200,000 for certain serious breaches of duties by directors.

Whilst fines accrue to the Crown, a liquidator is more concerned about what can be recovered for the company, and will petition the Court for orders under sections 300 and 301 of the Act.

Section 300 of the Act allows the Court to order directors personally liable for some or all the debts of a company for failure to keep proper accounting records. That is subject to the proviso that such failure contributed to the cause of the company’s failure.

Section 301 applies to a variety of relevant people, and includes directors for breach of their duties. Under subsection 301(1)(b) the Court may order a director:

“(i) to repay or restore the money or property or any part of it with interest at a rate the court thinks just; or

(ii) to contribute such sum to the assets of the company by way of compensation as the court thinks just;”

As the focus of this article is on breaches of directors’ duties generally, we have set out the facts and findings from two recent cases where liquidators have sought orders under section 301.

Recent cases: Section 301 of the Act

Two recent cases we will consider are:

• Morgenstern v Jeffreys [2014] NZCA 449, and [2014]NZSC 176, and
• Alpha Box Property Holdings Limited (in liquidation) v Wiekart [2015] NZHC 1257

Morgenstern v Jeffreys [2014] NZCA 449

Morgenstern was the sole director and shareholder of Morning Star Enterprises Limited (“MSE”), primarily through which he had been a successful property developer. Another of his companies was Morning Star (St Lukes Garden Apartments) Limited (MS St Lukes) which undertook a $67,000,000 development in St Lukes Auckland. The first phase of the development was successfully completed in 2005, however the second phase stalled during 2006, due to resource consent issues, which were not fully resolved until 2008. The delay ultimately caused major losses on the project.

MSE came under financial pressure in 2007, and Morgenstern, who’s shareholder current account was overdrawn by $1,776,336, sold his 99% and another’s 1% shareholding in MS St Lukes to MSE for a total consideration of $3,500,000, crediting his current account in payment.

There was no formal valuation done on the shares, and the price was determined after an informal valuation of land, building and future development, by the financial manager of the St Lukes project.

As to the value of the shares, Morgenstern admitted under cross-examination that his shares had no actual value when he sold them in 2007, but asserted that they would have the necessary value once the project was completed. MSE in fact sold the same shares in 2008 for $1.

The Court of Appeal affirmed the findings of the High Court with regard to Mr Morgenstern’s breaches of director’s duties, that:

• Firstly “Mr Morgenstern breached his duty under s 131(1) of the Act by failing to act in good faith and in the best interests of MSE in putting his own personal interests in satisfying his current account ahead of the interests of MSE.” Further, that he “did not honestly believe the sale to be in the best interests of MSE.”[44-46]
• Secondly “Mr Morgenstern was in breach of his duty under s 135 not to agree to or cause or allow the business of MSE to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.”[47]
• Thirdly that Mr Morgenstern breached his duty of care under section 137, in that his actions:
• “fell well short of the standard to be expected of a reasonable director. ...the company’s recordkeeping was deficient.. failure to produce timely accounts;... omission to ratify the share sale, as a major transaction, by special resolution... the most egregious omission was Mr Morgenstern’s failure to obtain an independent share valuation by a suitably qualified person.”

The Court of Appeal stated the applicable legal principles as follows:

“[55] There is no dispute that the duties imposed on directors by ss 131, 135 and 137 are owed to the company and require directors to act in the best interests of the company. A director must not put his or her personal interests ahead of those of the company. The duties arise regardless of the size of a director’s shareholding and role in the company.”

Alpha Box Property Holdings Limited (in liquidation) v Wiekart [2015] NZHC 1257

Alpha Box Property Holdings was part of the Circle Group of companies. Mr Wiekart was Alpha Box’s only director and shareholder. He was also a shareholder and director of the other companies in the group, along with another director, Mr Saunders.

Alpha Box traded in residential properties. Its business slowed to a point when in late 2007 it ceased operations. Over approximately six months Alpha Box’s last settlements came through, during which time the company made several payments to other group companies totalling $1,021,692.83. Mr Wiekart maintained that the payments were reimbursements of expenses paid by the other companies on Alpha Box’s behalf. The payments by Alpha Box had left the company without funds to pay $108,947.79 GST incurred in its final six months of trading, to the IRD (the company’s only creditor in the liquidation).

In her judgement Justice Peters noted the other Circle Group companies had liabilities over which Mr Wiekart and Circle Group fellow director Mark Saunders and his parents had personal guarantees. Her Honour also found the payments to those companies were not reimbursements but unsecured and undocumented loans.

Justice Peters found Mr Wiekart guilty of breaches of sections 131(1), 133, 135(b) and 137 of the Act. In paragraph [42] her Honour found that Mr Wiekart:

• had not acted “in good faith and in what he believed to be the best interests of Alpha Box, and Alpha Box alone”, and
• “did not exercise his power to make advances for a proper purpose”, and
• “failed to exercise the care, diligence, and skill that a reasonable director would have exercised in the same circumstances…”

Justice Peters then made an order pursuant to section 301 of the Act that Mr Wiekart repay the full amount of $1,021,692.83 which he had caused to be paid by Alpha Box. This was in spite of the debt owed to the IRD being considerably lower, and acknowledging that the net surplus after payment to the IRD, the liquidators’ fees and costs had been paid would revert to Mr Wiekart.

Conclusions

From the above case law and given the requirements of the Act, it is important for directors to know their responsibilities and duties both in terms of the Act and their company’s constitution. Sound risk management policy will have checks and balances to ensure directors’ duties are complied with; not only for the benefit of the company, its shareholders and creditors, but also to avoid subsequent personal liability for directors’ actions.