Spark Arena in Auckland. The ASB Sports Centre and The Supreme Court building in Wellington. These are landmark buildings that were constructed by Mainzeal Property and Construction Limited, which was for a time the third largest commercial construction company in New Zealand. But in a shock to the construction industry, Mainzeal collapsed in 2013 and was put into liquidation.

How did it all go wrong? As it turns out, and is canvassed in detail in a decision in Mainzeal v Yan1; released by the High Court on 26 February 2019, things were not so rosy behind the scenes. In fact, Mainzeal's trading had been unpredictable for a number of years, and the company's arrangements with parent and holding companies - in which significant funds were transferred out of the company - inevitably led to the demise of this once reputable company. The directors of Mainzeal, the Court has found, allowed that trading and funding position to continue for some time, and therefore had some responsibility for the significant losses that were ultimately incurred by creditors.

In this article, we focus on the actions of Mainzeal's directors, the High Court's analysis of their actions in the context of their duties, and the losses for which the Court found they were liable.

Background

Mainzeal was first established in 1968. By 2004, it was wholly owned by Richina Pacific, an overseas company registered in Bermuda. A majority of the shares in Richina were held by an investment consortium that was primarily interested in investing in China, particularly in the leather industry. That investment group was represented by Richard Yan. From 2004, Dame Jenny Shipley became chairperson of Mainzeal's board. She was joined by Clive Tilby and Mr Yan. Sir Paul Collins joined as a director several years later.

A series of documents established the relationship between the parent company Richina and Mainzeal. The parent company had ultimate power as the owning shareholder, particularly in relation to equity and loans to and from Mainzeal. But there was no promise of any new equity, and Mainzeal had to compete with a wider group of companies for that.

Over the course of subsequent years, the parent company and wider group undertook major acquisitions in mainland China. Funds of approximately $40 million were transferred from Mainzeal for that purpose. That is, Mainzeal assisted the parent company to acquire substantial assets in China. These funds from Mainzeal were treated as loans, and appeared in Mainzeal's accounts as an asset. If the loans could not be recovered, however, Mainzeal's liabilities significantly exceeded its assets.

The parent company, mostly through Mr Yan, promised underlying assistance in support for Mainzeal to continue as a going concern. But these assurances were non-binding and there were no formal legal documents recording the loans. Further, there were very tight controls on removing money from China, so the parent company would have considerable difficulty providing funds back to Mainzeal.

Restructuring of the group occurred during 2008 and 2009 in which the group was separated into New Zealand and Chinese divisions. This impacted on Mainzeal's ability to recover the loans, as the significant assets acquired in China were held by the Chinese division.

By 2012, Mainzeal was experiencing significant cash flow difficulties. Mainzeal also experienced difficulties with a significant construction contract with Siemens. Mr Yan ultimately confirmed there was no capacity to bring cash equity from China to assist, and it became clear that prior assurances and undertakings could not be relied on. Mainzeal went into liquidation in early 2013. Unsecured creditors were ultimately owed approximately $110 million.

The liquidators commenced a High Court proceeding against the former directors, effectively for the benefit of creditors. Their principal allegation was that the directors breached their duties under section 135 of the Companies Act 1993 by engaging in reckless trading. In particular, the liquidators said that the directors acted improperly by continuing to trade Mainzeal from the time it was balance sheet insolvent, and relied purely on verbal assurances of support that were clearly not able to be met.

The Court agreed.

Breach of Director Duties

The High Court conducted a thorough analysis of the duty on directors in section 135. Given the importance of that duty to the liquidators' allegations and the Court's decision, we have copied the full section here:

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.

The Court provided guidance regarding the type of behaviour that section 135 intends to prevent and the corresponding threshold that must be met for a director to be found to have traded recklessly:

  1. The section involves a reasonably high threshold that must be established before liability arises. The manner of trading must give rise to a substantial risk of company failure causing a deficiency in liquidation resulting in serious loss to creditors.
  2. Section 135 is not therefore intended to apply to the normal business risks taken by companies. The Companies Act recognises that companies are risk taking entities, and have limited liability for this reason.
  3. Instead, the "substantial risk of serious loss" referred to in section 135 is concerned with an abnormal or unreasonable risk. In other words, the section is concerned with "illegitimate" risk taking.
  4. When a company is technically insolvent, or near to that point, it is not really the shareholders' capital that is being risked any longer. In such a situation, the directors are risking creditors' money. To then treat the creditors' money as the capital of the business is not appropriate, and liability may follow if there is a substantial risk of serious loss to the creditors.
  5. Any promises made by shareholders, including by a holding company or by a parent or associated company in a wider company group, to provide support when necessary need to be assessed carefully in light of the obligations arising under section 135 and in the particular facts and circumstances presenting.

The High Court concluded that the directors acted in breach of their duties under section 135. The Court particularly focused on events following restructuring in 2008/09, when the New Zealand operations were separated from the Chinese operations to ensure greater independence and the Mainzeal directors were instructed to "act more independently". From this point, and at least from mid-2010, the directors allowed the company to trade in a manner likely to create a substantial risk of serious loss to the company's creditors.

There were three key considerations, which cumulatively led to this conclusion:

  1. Mainzeal was trading while it was balance sheet insolvent, because the inter-company debt was not, in reality, recoverable. This was because the related party debts were owed by companies within the wider group that were not in a position to repay them to Mainzeal, and the absence of a legally binding commitments meant that the loans were not recoverable. As a result, Mainzeal's liabilities well exceeded its assets. This insolvency was not a transient or temporary state, and the Court considered that the directors adopted a policy of trading while the company was insolvent on a balance sheet basis from as early as 2005.
  2. There was no assurance of group support on which the directors could reasonably rely if adverse circumstances arose. In particular, the expressions of support were not sufficiently clear and reliable, and given the importance of such assurances for the legitimacy of Mainzeal's continued trading, the reliance on verbal assurances was unreasonable. Further, after the restructuring, the companies that owed Mainzeal money were no longer directly part of the group structure. The support was also subject to the constraints of Chinese law.
  3. There may have been no substantial risk of failure if the company's trading performance was particularly good and dependable. However, Mainzeal's financial trading performance was unpredictable, generally poor and prone to significant one-off loses, which meant it had to rely on a strong capital base or equivalent backing to avoid collapse. By 2010, the company was facing significant leaky building claims from projects in which it had been a main constructing party, and one significant contract with Siemens did indeed then lead to problems in late 2012 that then significantly contributed to Mainzeal's collapse.

The Losses

The manner in which the Court then assessed compensation, however, was novel.

A reckless trading case typically involves a court identifying the further losses that have been created by the directors allowing a company to trade beyond a nominal date that the company should have been put into liquidation.

However, the Mainzeal directors' breach of duties did not arise because the directors failed to cease trading and put Mainzeal into liquidation or receivership in January 2011. In particular, ceasing to trade would have been foolhardy have would have likely created huge losses arising from a failure to continue with significant construction contracts obligations it had underway. Instead, the breach arose because the directors allowed Mainzeal to engage in trade in a vulnerable state: the company only collapsed and caused serious loss to creditors because of the manner in which the company traded, which the directors agreed to.

The Court held that all of the creditors' $110 million losses was directly attributable to the directors' breach of section 135. However, in exercising its discretion, it considered that $36 million was an appropriate and just contribution by the directors to the creditors on liquidation.

The Court then distinguished between Mr Yan and the other directors. It said he was in a conflict of interest, he was communicating the expressions of support that the other directors relied upon, which were misleading, and he and the shareholders in the wider group substantially benefitted by using Mainzeal funds to acquire interests in China. In contrast, Dame Jenny, Mr Gomm and Mr Tilby acted in good faith and with honesty, and obtained no personal advantage.

Mr Yan was therefore held to have liability for all of the $36 million, with each of Dame Jenny, Mr Gomm and Mr Tilby being liable for $6 million each, jointly with Mr Yan.

What the Directors Could Have Done

On one view, the findings against Dame Jenny, Mr Gomm and Mr Tilby seem harsh, as their ability to properly govern seems to have been hampered at all stages by the actions of the parent company, the wider group and Mr Yan. The Court also seems to have taken the view that the directors could have caused the parent company and the wider group to change its approach. Whether that is realistic, is debatable.

However, the constant theme in the Court's decision is that the group's behaviour was constant over a number of years and the directors continued to make decisions in that environment, resulting in significant trading decisions, which gave rise to serious loss to creditors.

The Court also provided some helpful examples throughout the judgment of some of the steps the directors could have taken:

  1. Asked for regular updates by the parent company, and insisted on hard evidence of strong connections in China that would lead to the ability to receive funds.
  2. Taken legal advice at an early point, including regarding the commitments that the directors were relying on were sufficient or needed to be documented in a binding way.
  3. Stopped their faith in assurances provided by Mr Yan, and insisted upon the inter-company arrangements substantially changing so that Mainzeal was no longer required to continue operating in the manner it was.
  4. Insisted on these inter-company issues being resolved, if necessary to the point of resignation if matters remained unresolved.

Footnote

1. Mainzeal Property and Construction Group Limited v Yan [2019] NZHC 255.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.