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.

A recent case in the Hamilton High Court looked at the requirements on a liquidator to accept the claims of creditors and to call a meeting of creditors to decide if a replacement liquidator should be appointed.

The Law on Calling a Meeting with Creditors

Where a liquidator is appointed by shareholder resolution they are required to call a meeting of creditors within 10 working days of their appointment pursuant to section 243 (1)(a) of the Companies Act 1993 (“the Act).

This requirement can be dispensed with, pursuant to section 245 of the Act, if the liquidator considers, having regard to the assets and liabilities of the company, the likely result of the liquidation and any other relevant matters, that no such meeting be held.

In those circumstances, the liquidator must give notice in writing to creditors of the decision not to call a meeting and the reasons for doing so. The notice must also include the advice that creditors have 10 working days from receipt of the notice to require a meeting to be called.

The Background

The background to the case, Nayacakalou v Minister of Education [2017] NZHC 792, is that Ms Nayacakalou was appointed liquidator of a building company by shareholder resolution. At the time of her appointment, the Minister of Education (MoE) had filed proceedings against the building company in relation to weather tightness issues.

The MoE filed a claim in the liquidation and gave written notice, within the required time period, requiring the liquidator to call a meeting of creditors.

After reviewing various reports provided by the MoE and other claimants, the liquidator decided that their claims were unenforceable against the company and, therefore, they had no standing to call a creditors meeting nor any entitlement to vote at any creditors meeting. This position was not accepted by the MoE and other claimants.

The liquidator subsequently applied to the Court for directions in relation to the discharge of her duties. The MoE filed a notice of opposition and a cross-claim

The Findings

The liquidator’s position was that the MoE’s claim was not enforceable as it was a claim in tort and no Court had issued judgement against the company. It was argued that it was a contingent claim and that only contractual claims qualify as a contingent debt.

The Court did not accept this submission and made orders that the liquidator must –
• Accept or reject the MoE’s claim as required by s 304(3) of the Act;
• Make an estimate of the amount of the claim or refer the matter to the Court for a decision on the value pursuant to s 307 of the Act; and
• Call a meeting of creditors.

Conclusion

It is common practice that liquidators do not call a meeting of creditors for the reasons set out in s 245 of the Act and give notice in writing of that decision.

Creditors of the company, including contingent creditors and creditors whose claim is for an unascertained amount, have the right to call for a meeting and to decide, by a majority in number and value of votes cast in the meeting, either in person, by proxy or by postal vote, if the liquidator should be replaced.

If a meeting is requested within the time specified by the Act then this case reinforces the requirement that the liquidator is obliged to call a meeting.

A formal meeting is called for the specific purpose of validating the appointment of the liquidators or seeking a replacement and to consider the appointment of a liquidation committee. These meetings can add an extra level of cost in a liquidation, they require public notice and formal notice of meeting.

If the larger creditors in value or a significant majority in number are not concerned by the party appointed then the other alternative is to request an informal meeting to raise concerns and provide background.

Liquidators have a duty to consider the views of creditors.

If you would like more information about creditors meetings you can read this article or contact the team at McDonald Vague.

Global Textiles Limited (In Liquidation)

We were appointed liquidators of Global Textiles Limited (“Global Textiles”) on 13 March 2015 and are now in the final stages of the liquidation. Prior to our appointment, Global Textiles had been in business for nearly 20 years.  It supplied textiles to a number of brands in New Zealand and Australia from Jean Jones to small businesses.  It was also the designer and wholesaler of a popular clothing brand.

With the emergence of globalisation and technology allowing easy access to markets outside of New Zealand, the local textiles industry has moved into the sunset phase of its life cycle. With cheaper imports from overseas coming into the market, Global Textiles’ traditional customers were increasingly demanding prices that resulted in increasingly tighter margins for the company and resulted in the business becoming unsustainable.

The director and his advisors wisely chose to have the company placed into liquidation when it became apparent that the business would be unable to compete in the new industry norm. The company’s creditors were owed $1,189,700. Following our appointment and meeting with the director, we attended the Kingsland premise to meet with the company’s 10 to15 staff and to advise them of our plan to realise the company’s assets.

There was a considerable amount of stock onsite so flooding the market by way of auction would not maximise the return for creditors. With the assistance of the director and some of the staff, we traded the business down over 3 months and moved the stock for the best price. We performed a cost benefit analysis on a regular basis to monitor and ensure that we ceased trading the business when it was no longer cost efficient to operate.  When the business stopped trading, the remaining assets were sold at auction and the premise was handed back to the landlord.

By trading on the business for a short period, we were able to:

- Get the maximum realisable value for the company’s current assets

- Pay dividends totalling $870,400

The intangible impacts were:

- Offer some of the business’ staff continued employment while we traded on (and they looked for new jobs)

- Provide the landlord with some time to look for a new tenant for the site while we traded on the business

- Reduce the directors’ personal liability under their guarantees

By trading on the business, the liquidators made a full distribution to the employees, the Inland Revenue Department, and NZ Customs on their preferential claims in the liquidation. Once the business stopped trading, the liquidators collected the company’s outstanding debtors, with the assistance of debt collectors, and returned 84 cents in the dollar to the secured creditor on its secured claim. This amounted to a total distribution to creditors in excess of $870,000.  Put another way, the return to creditors was more than 8 times the costs of administering the liquidation.

The return to Global Textile’s creditors far exceeded that originally anticipated at the start of the liquidation by both the director and his advisors. By taking a practical approach, we were able to obtain positive results for a number of the stakeholders.

This is one of the many examples we are starting to see of a director acting responsibly and in a timely manner, assisting the liquidators during the liquidation process and understanding their duties to creditors. As a result, significant amounts were returned to the company’s creditors.

A statutory demand can threaten your company’s very existence. Used to collect debt, they’re the most common form of evidence used in the High Court to support liquidating a company. Given how serious receiving a statutory demand is, it’s important to act fast and seek professional advice. If you do nothing, liquidation proceedings are virtually guaranteed.

Pay Up

A statutory demand requires payment of debts owing more than $1000 within 15 days. Time is not your friend. If you can settle the debt within that time period then you should be fine. It may still be worth seeking professional advice to see whether your creditor is abusing the statutory demand process, as there could be legal repercussions for them.

Dispute Payment

If there is an issue with the debt or invoice, then statutory demands cannot be served. If you have a genuine dispute over payment you can apply to the High Court to have your statutory demand set aside, but it must be done within 10 working days!

The Court can take into account any counter-claim, cross-demand or other relevant issues and set aside the statutory demand.

Out of Court Resolution

There are a number of formal and informal compromises available to help you reach a settlement with the creditor who served you notice. Any offer needs to show your creditor that for you to continue trading is in their best interests. You can offer assets as a form of security while you negotiate a payment arrangement.

Statutory demands can be costly

In a real life example, a debtor company was late paying an invoice but paid the total amount in full. While the payment was being processed, the creditor company passed the debt over to their debt collection agency. The debt collectors contacted the debtor for the full amount of the invoice plus their debt collection fee which was over $1000.

At this point, lawyers for the debtor company disputed the collection fee and advised the debt collectors the original invoice had been paid in full. The debt collectors issued a statutory demand to recover their fee, but lawyers for the debtor company successfully argued in court to have the demand set aside.

The court felt the debt collectors had abused the statutory demand process, so they failed to recover their $1000 fee and were ordered to pay costs of over $4000.

Statutory demands are complex proceedings involving the High Court and the Companies Act (1993). Your best course of action is to always seek professional legal advice, and from there figure out how to proceed. Ignoring a statutory demand or acting too late will almost certainly mean liquidating a company, so get professional advice before it's too late.

For more information, download our free Guide for NZ Companies in Financial Difficulty.

From time to time we are approached by persons or companies pursued by liquidators of other insolvency firms. We are also asked to provide guidance or opinions on how a liquidator should act, what is reasonable and how to respond to demands/requests.

Insolvency specialists take different approaches and some Insolvency Practitioners ("IP") do not always act in the best interests of the company creditors. There have been several reported instances in recent years.

At McDonald Vague our objective is to maximise the return for creditors. We do not always achieve a return for unsecured creditors but have a good reputation for taking a firm and fair approach and getting returns. Cost/benefit is always a consideration.

This blog post discusses the skills and competence required of an IP, the differing approaches of liquidators, reasons why applicant creditors or shareholders should appoint an accredited IP, or a member of CAANZ or NZLSA and what should be considered in taking an action.

Competent liquidator and principal duty

A reasonable and competent liquidator should take into account the amount owed to creditors, the prospects of recovery and consider the cost versus benefit of advancing claims and legal actions. It is a liquidator's obligation to maximise the return to creditors and to act in a reasonable and efficient manner.

Underlying principles to regard

Every liquidation is different but the underlying principals are the same. In all liquidations, the liquidators should have regard to:

1. Duties imposed on liquidators by the Companies Act 1993;
2. Schedule 6 of the Companies Act 1993;
3. Companies Act 1993 Liquidation Regulations 1994;
4. Insolvency Engagement Standards issued by NZICA;
5. Court decisions (eg. Peace and Glory Society (in liq) v Samsa [2010] 2 NZLR 57);
6. The value of the assets available to be realised (if possible);
7. The probable claims and creditors to pay from asset realisations.

Benefits of governing bodies and regulation

Liquidators who are members of the CAANZ or the New Zealand Law Society have a governing body they need to report to. The Insolvency Engagement Standards ("IES") issued by the Board of the CAANZ apply to a firm's conduct on any insolvency engagement. IES provides the required standards of a CAANZ insolvency professional.

These standards should be required of all liquidators. IES is not binding on non-Institute members. A member of the Institute acting as a liquidator is required to comply with Rule 10 of the Code of Ethics 2003 which relates to timeliness and to the Insolvency Engagement Standards SES-1 and paragraph 22 of IES. The New Zealand Law Society have their own high standards for conduct. Many IP's are now CAANZ accredited insolvency practitioners.

Key standards for CAANZ members

Key standards include:

1. An Insolvency Practitioner has a duty to apply the degrees of specialised skill, knowledge, judgment and competence required to perform a job in a timely manner. A liquidator has a professional responsibility to carefully plan the liquidation and perform in an efficient and effective manner and assure quality of work performed.
2. A liquidator is required to ensure that all personnel engaged in insolvency work adhere to the principles of objectivity and integrity.

Companies Act 1993 - obligations and duties

The duties, rights and powers of liquidators are set out in Sections 253 to 279 of the Companies Act.  The principal duty of a liquidator is recorded in Section 253 as follows:

Section 253 - Principal duty of liquidator

Subject to Section 254 of this Act, the principal duty of a liquidator of a company is - 

1. To take possession of, protect, realise and distribute the assets, or the proceeds of the realisation of the assets, of the company to its creditors in accordance with this Act; and
2. If there are surplus assets remaining, to distribute them, or the proceeds of the realisation of the surplus assets, in accordance with Section 313(4) of this Act - in a reasonable and efficient manner.

In undertaking an investigation, a liquidator must bear in mind a duty to act in a reasonable and efficient manner.

Liquidators have different approaches to recovery actions often driven by creditor attitude/requirements. Some liquidators will be compelled to bankrupt directors. In the absence of other recoveries, the net costs of these actions should be borne by the liquidators or a particular creditor if that creditor has agreed to fund the cost.

A liquidator also has a duty to have regard to the views of creditors and shareholders under Section 258 of the Companies Act 1993.

Considerations for liquidators when taking actions

These are always judgment calls and a balancing of the various interests.

A liquidator should consider the financial position, the likely prospects of recovery, and public interest (if pursuing bankruptcy) and the costs in advancing an investigation and legal action.

A liquidator should consider the likely return to creditors against the costs, and if spending money that could or should otherwise be distributed to creditors the likely increased return for creditors by advancing the action.

Along with the economic factors above, there is also sometimes a feeling that other enforcement action is required, such as bankruptcy, which affects all of the creditors of the individual who owes money. A bankruptcy option should recognise that this will stop any chance of future recoveries being made.

A liquidator should therefore question whether it is reasonable to issue proceedings against an individual when there is a good prospect of bankruptcy but no likelihood of a return from bankruptcy, particularly where there are competing claims likely in the bankruptcy estate, and where the party is clearly insolvent, or where another creditor could, with minimal cost, advance bankruptcy proceedings.

Certain actions require funding. Creditors can be approached and litigation funders are an option.

Estimating costs when litigation is involved is a difficult exercise as some legal costs are reactive to positions taken by the defendants. Settlement can avoid legal costs associated with discovery, interlocutory matters and trial preparation.

While we recognise that insolvent individuals and companies are a risk to their creditors there are recovery avenues available for the insolvent. They are referred to in our articles on our website, but include:

1. Part 5 subpart 2 proposals;
2. No asset procedure;
3. Summary instalment orders;
4. Settlements.

The McDonald Vague approach to debt collection and legal action

Our approach in collecting debts is some money is better than none.  

To that end, our aim is to:

1. Assess the likely ability to collect;
2. Set a game plan and budget;
3. Write claiming as quickly as possible;
4. React/report any dispute;
5. Consider legal action if the benefit has more than reasonable prospects of exceeding the costs of pursuit and will more than likely provide a return to creditors;
6. If appropriate, appoint a professional debt collection agent; and
7. Consider settlement and repayment options.

We do not typically bankrupt individuals for overdrawn current accounts, particularly when they can show in sworn statements of position that there would be no benefit to creditors in doing so. Each case is considered on its merits and we often agree to repayment plans.

For those directors/shareholders who have acted with a clear intent to defraud creditors, we take the appropriate action. In any action, a liquidator needs to consider the cost and benefit and the public interest and risk.

To find out more about how McDonald Vague can help, or for confidential advice please contact This email address is being protected from spambots. You need JavaScript enabled to view it..

One of the first tasks facing liquidators after their appointment is to ascertain and communicate with those people and entities who can rightly register a claim in the liquidation as a creditor.

Generally, this information will be provided by the directors of the company, along with copies of unpaid invoices or statements on the individual accounts, but not all eligible creditors are that easily identified.

Section 303 of the Companies Act 1993 ("the Act") sets out the admissible claims in a liquidation -

1. Claims admitted - Subject to subsection (2) of this section, a debt or liability, present or future, certain or contingent, whether it is an ascertained debt or a liability for damages, may be admitted as a claim against a company in liquidation.
2. Claims not admitted - Fines, monetary penalties, and costs to which section 308 of this Act applies are not claims that may be admitted against a company in liquidation.

As you can see from the definition in section 303(1), claims can be filed in relation to contingent matters and this could include things like potential costs and awards made against a company in legal proceedings and guarantees provided by the company for the debts and liabilities of other companies or individuals.

Consideration also has to be given to debts that are disputed by the company. The fact that the directors don't think a creditor is entitled to claim does not always mean that they aren't.

We are currently working on a liquidation where the company directors were of the belief that all external creditors would be paid in full in the liquidation. This was based on their belief that funding provided to the company by a third party could not be clawed back under the terms of the agreement under which the funding was provided.

Legal advice obtained by the liquidators after the commencement of the liquidation established that the third party was entitled to claim in the liquidation for some of the funding.

In this case, the decision had been made to proceed with the liquidation on the basis that the company was insolvent but the claim received from the third party means that all creditors will not be paid in full.

When a decision is being made by the directors and shareholders about liquidating a company, and whether or not the company is solvent, these potential contingent and disputed claims have to be taken into account.

If you would like more information about liquidations and who can file claims please contact one of the team at McDonald Vague.

An increasing number of building firms "went bust" in 2014 despite the building boom in Christchurch and Auckland, leaving homeowners, contractors, and the taxman out of pocket.  As the construction boom in Auckland gathers pace the situation is going to get worse.

Nearly 100 rebuild-related companies have gone into liquidation or receivership in Christchurch alone since the February 2011 earthquake. We see the same trend occurring in Auckland.

People often ask us why so many building firms are going under as they should be making a fortune.  The simple answer is that the good ones are, but there are many that have been caught out by over trading (transacting more business than the firm's working capital can normally sustain), thus placing serious strain on cashflow and risking collapse or insolvency.  Some of these companies shouldn't be in business in the first place.

This trend could worsen as mismanagement woes continue and big ticket construction projects open new avenues for white collar crime. 

More than half of the failures came in 2014

Construction-related liquidations more than tripled between 2013 and 2014 (mainly in Christchurch). Subcontractors were heavily represented in the liquidation numbers and the Serious Fraud Office ("SFO") received 29 complaints about suspect dealings in the rebuild and has launched six investigations.  As a result, the Government introduced new laws in 2015 to protect consumers, including mandatory written contracts, and builder requirements for residential building work costing $30,000 or more.

With an increasing number of small operators who were previously working as employees deciding to go out there and do it themselves there is increasing concern that many don't have the skills needed to run a business.  Many are good tradesmen, but not good businessmen.  Some don't manage their cashflow well and don't file PAYE returns, GST returns, or get their invoices out on time.  We often see overdrawn current accounts where the tradesman has operated the business account as their own personal bank account.

As the building boom gathers pace, tradespeople with varying levels of skills have poured into the industry as they see it as a cash cow. They often have little or no capital.  Many of them "gear up" with the latest tools and ute all purchased on HP.

New Zealand is an extremely expensive country in which to build houses.  McDonald Vague has recently been appointed over two large building companies (eHome NZ Limited and Shears and Mac Limited), both employing over 100 people and both manufacturing in a factory and then installing onsite.  eHome NZ Limited built houses in a factory and Shears and Mac Limited did commercial and shop fit-outs in New Zealand and Australia.  They operated in different sectors of the building industry but failed for similar reasons including:

• High overheads and slim margins;
• Missed deadlines;
• Contract disputes;
• Cost overruns;
• Unhelpful bureaucracy and compliance costs.

High costs driving failures

We provide consultancy and turn-around advice to a number of building firms and often the problems are the same.  Fixed price contracts stay constant but the cost of labour and materials constantly increases in a construction boom.  The costs of labour and materials will continue to increase until there is a slowdown in demand. 

Why so many fail

• Out of control pricing;
• Characterised by small businesses (a ute and a dog);
• Aggressive tendering trying to increase market share at the expense of margin;
• Poor estimates/pricing - running a project at a loss;
• Poor variation analysis;
• Undercapitalised balance sheet;
• Lack of building knowledge, the level of education in the industry is poor;
• Leaky buildings (warranties and guarantees) ongoing issue without provision;
• Desperate to climb the ladder - egos prevail in a testosterone dominated industry;
• Poor documentation/record keeping leads to failure (PAYE, GST, creditors);
• Variation sign-offs not formally completed leading to further costs borne by contractor;
• Low margins;
• Businesses are easy to establish and easy to close, with no capital requirements.

What can your clients do to protect themselves?

There are a number of things they can do, including:

• Register on the PPSR;
• Stop work when they don't get paid;
• Be familiar with remedies under the CCA;
• Do due diligence on developers or head contractors before doing work;
• Take personal guarantees;
• Enforce credit limits;
• Look at liquidated companies on the Companies Office;
• Be aware of phoenix companies;
• Make credit checks;
• Do directors' checks for liquidations;
• Get money held in trust where possible.

We can help

Please contact the team at McDonald Vague Limited if you would like to learn more about how your client can protect/mitigate the risk of a customer going into liquidation.

Creditors of companies that fail are often shocked and angered by the ability of directors of the failed company to start up a new business and carry on as though nothing happened.

They cannot accept that they are suffering because of the losses they are facing whilst the people they see as being responsible for the losses appear to suffer no ill effects.

Who is at fault?

It is important to note that the debt owed to the creditor is owed by the company, not the directors personally.  A limited liability company has its own separate legal identity and it is generally only when the directors have given personal guarantees in favour of particular creditors that they become personally liable for the debts concerned.

Furthermore, company failures are not always attributable to actions of the directors.  Failures come about for a variety of reasons including economic downturn, natural disasters, default in payments from customers and major clients changing supplier.

Starting over

There is no automatic bar to a director of a failed company starting up a new business on the failure of the old one.

There are provisions within the Companies Act 1993 in respect to starting and operating phoenix companies within five years of the commencement of the liquidation of the failed company.

Section 386B(1) of the Companies Act 1993 defines a phoenix company as follows:

A phoenix company means, in relation to a failed company, a company that, at any time before, or within five years after, the commencement of the liquidation of the failed company, is known by a name that is also -

1. a pre-liquidation name of the failed company; or
2. a similar name

A pre-liquidation name means any name (including any trading name) of a failed company in the 12 months before the commencement of that company's liquidation.

A similar name means a name that is so similar to a pre-liquidation name of a failed company as to suggest an association with that company.

There are some exceptions to the rules regarding phoenix companies, for instance Court approval can be obtained (Section 386A(1)) or a Successor Company Notice can be issued (Section 386D).

You can see more detail regarding phoenix companies in the article on our website written by Peri Finnigan, Phoenix companies:  what exactly are the rules here?

What can be done to stop them?

Directors don't always just walk away unscathed by the failure of their company.

There is a personal toll in the stress that they have been under leading up to the failure, the personal loss they may have suffered through funds they had put into the company or through personal guarantees provided to financiers or suppliers, and the sense of failure that most feel when their company is liquidated.

Their actions will also be subject to scrutiny by the liquidator of their company.

Liquidators will investigate, among other things, the activities of the directors to establish if the directors have breached their duties.  This can lead to legal proceedings being taken against the directors if they are considered to have acted in breach of those duties and caused loss to creditors by doing so.

If found to have been in breach of their duties or reckless in their actions the Court can impose monetary penalties on the directors to the level it thinks is appropriate to the circumstances.

One of the statutory duties imposed on liquidators is to report to the Registrar of Companies where they suspect the company or any director of the company has committed an offence that is material to the liquidation against the Companies Act 1993, the Crimes Act 1961, the Financial Markets Conduct Act 2013, the Takeovers Act 1993 and the Insurance (Prudential Supervision) Act 2010.

The liquidators will also report to the Registrar of Companies on any director who they believe should be banned from being director because of the belief that their actions were wholly or partly responsible for the failure of the company or because they have had two or more failed companies in the previous five years.

Breaches of the banning orders and operating a phoenix company can, on conviction, lead to penalties of up to five years' imprisonment or a $200,000 fine.

In conclusion, whilst it may seem unfair that the directors of a failed company can just carry on with business as usual after the failure, there are provisions available to have them brought to task and penalised where appropriate.

The solvency test is not required to be met each day a company trades.  It is required for certain transactions including distributions and dividends and requires the company to demonstrate it can meet two tests.  These tests are the trading solvency/liquidity test and the balance sheet solvency test.  

To satisfy the solvency tests, a company must be able to pay its debts as they become due in the normal course of business; and the value of its assets must be greater than the value of its liabilities (including contingent liabilities).

One objective of the solvency test is to control all transactions that transfer wealth from a company.  In a liquidation context, where transactions have occurred when the company did not satisfy the solvency test, creditors may be able to recover from directors personally.

CONCERNED ABOUT YOUR PERSONAL LIABILITY?
TALK TO US IN CONFIDENCE

• If you are concerned you have authorised distributions while not able to meet the solvency test;
• or are worried about your personal liabilities as a director if your company goes into liquidation,
• contact us now for free, confidential, expert advice.
• The sooner you contact us the more options are open to you.

This email address is being protected from spambots. You need JavaScript enabled to view it.

Peri Finnigan

Director

Phone: (09) 303 9519

Mobile: 021 900 657

Email: This email address is being protected from spambots. You need JavaScript enabled to view it.

The solvency test 

The solvency test consists of two parts:

1. Trading solvency/liquidity - the company is able to pay its debts as they become due in the normal course of business; and
2. Balance sheet solvency - the value of the company's assets is greater than the value of its liabilities, including contingent liabilities.

The Companies Act 1993 requires that in some situations directors sign a solvency certificate.  Sometimes this considers only the ability to pay debts as they fall due.  

The situations requiring a signed solvency certificate are: 

• Distributions by the company for the benefit of a shareholder, including a dividend, and incurring a debt to or for a shareholder's benefit, solvency to apply before and after distribution ;
• Share purchases;
• Share redemption options being exercised;
• Financial assistance to acquire share is offered by the company;
• An amalgamation; and
• 20 days prior to a Solvent liquidation.

The considerations

Directors need to consider all circumstances that the directors know or ought to know that affect the value of the company's assets and liabilities.  In the case of contingent liabilities consideration is required to be made on the likelihood of the contingency occurring and any claims the company may reasonably be expected to meet to reduce or extinguish the contingent liability.

Contingent liabilities to be factored in

Contingent liabilities can impact a solvency certificate and impact the validity of a distribution.  If directors are aware of a contingency, action must be taken to determine projected costs and probable outcomes.  Directors must be realistic when assessing solvency and take reasonable steps to obtain all information relevant to forming an opinion.  The Courts have confirmed the solvency test should be applied with a sense of commercial reality.

Contingent liabilities can include obligations under guarantees, letters of credit, bills of exchange, current or pending litigation, eg. leaky building claims, performance bonds, leases, tax assessments, deferred purchase agreements and underwriting adjustments.

Section 4(4) of the Companies Act 1993 - Meaning of Solvency Test - says:

"In determining, for the purposes of this section, the value of a contingent liability, account may be taken of -

1. The likelihood of the contingency occurring; and
2. Any claim the company is entitled to make and can reasonably expect to be met to reduce or extinguish the contingent liability". 

Risk of personal liability

Directors who do not fulfil their obligations under the Companies Act 1993 are subject to penalties and personal liability. The liability of a director will be determined by his or her involvement in the decision.  Failing to vote on a board matter should be carefully considered as directors are collectively responsible for any decision made by the board.

Directors should ensure all workings support solvency certificates and contain all necessary information and support for decisions made.  This detail can provide vital defence when a liquidator challenges a distribution made.

Directors should be aware that they should not sign a certificate as to solvency if there is doubt as to the existence of reasonable grounds for such belief.  If they do not take reasonable steps, they can risk being held personally liable for any non-recovery of the distribution made to the shareholders.

Directors can rely on information and professional or expert advice, but only if they act in good faith, make proper inquiry or have no knowledge such reliance is unwarranted (Section 138 of the Companies Act 1993).

Section 56(3) of the Companies Act 1993 - Recovery of distributions - says:

"If by virtue of section 52(3) or section 70(3) or section 77(3), as the case may be, a distribution is deemed not to have been authorised, a director who -

1. Ceased after authorisation but before the making of the distribution to be satisfied on reasonable grounds for believing that the company would satisfy the solvency test immediately after the distribution is made; and
2. Failed to take reasonable steps to prevent the distribution being made, - 
   is personally liable to the  company to repay to the company so much of the distribution as is not able to be recovered from shareholders".

Under Section 56, a distribution may be clawed back from the shareholders unless the shareholders received the distribution in good faith, without knowledge of the company's failure to satisfy the solvency test, and the shareholder has altered their position in reliance on the validity of the distribution and it would be unfair to require repayment in full or at all.  As the tests are cumulative, failure to satisfy any of the above will likely result in clawback of distributions. 

When can directors be held personally liable?

Directors can be held personally liable in the following circumstances:

• They fail to complete a solvency certificate when it is required;
• The procedure for authorising the relevant transaction has not been followed;
• Reasonable grounds for believing that the company would satisfy the solvency test did not exist at the time the solvency certificate was signed; or
• Between the date of approving the transaction and its date of execution, there has been a change in circumstances in relation to the company's ability to meet the solvency test but the distribution occurs anyway.

Apart from the obvious consequences of clawback, any director who signs a certificate knowing that it is false or misleading commits an offence and is liable on conviction to a fine not exceeding $200,000 or imprisonment not exceeding five years.  A director who votes in favour of a distribution, but fails to sign a certificate to the satisfaction of the solvency test also commits an offence and is liable on conviction to a fine not exceeding $5,000.  The risks are too high to not take reasonable care. 

Conclusion

If a company is marginally solvent, directors need to take particular care to satisfy themselves, for certain transactions, that the transaction is properly authorised and that the company will meet the solvency test immediately after the transaction is implemented.

It seems like a typically Kiwi thing to do - a couple of mates decide to go into business together and start up a company to operate the business.  Everything is split down the middle - each director owning 50% of the shares and all agreed on a handshake.

What could go wrong?

The recent liquidation of a small business shows just what can happen.  Things went well for the first couple of years.  Business was going okay and making a small profit but then things started to go wrong.

The relationship broke down between the shareholders and got to the stage where they couldn't agree on anything to do with the business including staff management and business direction.

Legal advisors became involved and an attempt was made to resolve the issues by one of the shareholders buying out the other's interest.  Unfortunately, they couldn't agree on the value of the business.

As a result, the decision was made and agreed to by both shareholders to liquidate the company.  The liquidation process was made more protracted and costly by the sniping between the shareholders leading to higher liquidation fees and therefore a reduced payment to creditors.

There are no guarantees of course but this situation may have been avoided, or at least the damage mitigated to a certain extent, if there had been a shareholders' agreement put in place at the time the company was incorporated.

Shareholder agreements usually include

A shareholder agreement is like a business pre-nuptial agreement.  It sets out the basis of the relationship between the shareholders and can include matters such as:

• Defining the type of business the company will engage in;
• How the business will be managed and who will be responsible for particular areas of management such as staff employment etc;
• What types of decisions can be made by individuals alone and what types need majority or unanimous agreement;
• How any of the parties leaving the business will be handled - what happens to their shares etc;
• How any disagreements or disputes that arise will be handled.

It can contain confidential information as, unlike a company's constitution, it does not have to be filed with the Registrar of Companies and be available for public viewing.

Shareholder agreements may also include

They may also cover:

• Non-competition restrictions;
• Appointment and retirement of directors;
• Professional indemnity insurance;
• Transfer of shares and pre-emptive rights;
• Disability and insurance - what happens in the case of a trauma or death to insurance proceeds - does it pay company debts or does it go to the estate?  Who is the policy owner?
• Shareholder approvals, consent and voting.

The complexity and size of the shareholders' agreement will depend to a certain extent on the size of the business, the number of shareholders involved and the areas to be covered.

It will be different for every company and shareholders should seek proper legal advice when putting together any such agreement and before signing one.

How McDonald Vague can help

We regularly see the result of fallouts between company directors and shareholders.  We would advise all company directors and shareholders to put together a Shareholder Agreement at the time the company is incorporated to avoid prolonged and unnecessary expense to shareholders and their creditors.

If your relationship with fellow director(s) and/or shareholder(s) is breaking down contact us for free and confidential advice to find out how we can help.

Alternatively, download our Free Guide to Avoiding Business Failure