Debut Homes in the Supreme Court — a product of the vicarage?

In UBS AG (London Branch) v Kommunale Wasserwerke Leipzig GmbH Gloster LJ, dissenting, characterised the conclusion of her majority colleagues as involving the “morals of the vicarage”: “In my view it is impracticable and unreal to introduce into commercial transactions the moral standards of the vicarage”.¹ She might just as well have said “the morals of the judge”. In my respectful view, the same thing can be said of a considerable part of the reasoning of the Supreme Court in Madsen-Ries (as liquidators of Debut Homes Ltd (in liq)) v Cooper (Debut Homes).²

While I have serious misgivings about aspects of the remedy awarded in this case, that the defendant director was found liable on the facts of the case for causing the company to be unable to pay its GST causes no surprise. This is so, even if one puts aside for the moment the findings of bad faith made by Hinton J at first instance.³ This is because the drafting of ss 135 and 136 of the Companies Act 1993 is also totally uncommercial. The relaxation of these provisions for the COVID-19 crisis (see s 138B and sch 12 of the 1993 Act, added by the COVID-19 Response (Further Management Measures) Legislation Act 2020) would not have been needed at all had our base company law confined itself to fraudulent trading (a concept that embraces true recklessness).

One does not need to be a political conservative to hold the view that “creditors” are not one of society’s vulnerable groups. One can certainly make a strong case for vulnerability in respect of sub-categories of creditor, in particular employees (while knowing that some employees are rich and sophisticated). Consumers can be another, although most consumer transactions involve simultaneous exchange of consideration (trust law can also protect their payments). Class-action systems may also be needed to recognise cases where there are bulk claims that are uneconomic to pursue individually. These groups can be attended to. But creditors as a whole are not more vulnerable than their debtors. Most are themselves running businesses, know when they have not been paid, and our commercial law has long provided an extremely powerful remedy to each and every one of them, namely the statutory demand as a harbinger of a liquidation process that stops any debtor’s business in its tracks. It is not a remedy available to individual shareholders.

The Inland Revenue is certainly not one of society’s vulnerable and is fully cognisant of the statutory demand process. The fact is that GST is in substance a type of commission on trading, and now that the Supreme Court has handed the Revenue strong prospects of a personal guarantee of it from directors, the Revenue may often find it convenient to be passive. The Revenue’s priority status for GST over other creditors also encourages lethargy in debt collection.⁴

As for the efficacy of the statutory demand process, it may be that the process could be even cheaper if that part of the liquidation jurisdiction was transferred from Associate Judges in the High Court to the District Court. But that’s speculation. We can note, however, that early New Zealand company law, in the form of the Companies Act 1882, did provide for a role for District Courts in liquidations where that would be more efficacious than using the resources of the High Court (then “Supreme Court”).⁵

The empowerment that the statutory demand process gives to individual creditors needs to be tempered when the interests of creditors as a class (and arguably the interests of a business’s employees) suggest that liquidation is not the optimal solution. It is in this context that company law, and almost from time immemorial insolvency law more generally, has long adopted the process of judicially sanctioned compromises with creditors. For examples one can look to s 196 of the old 1882 Act in respect of voluntary windings up and to s 213 for compulsory liquidations. Of course, the 1993 Act now has a panoply of schemes designed to forestall the liquidation process, including voluntary administration.

Until the Supreme Court in Debut Homes suggested otherwise,⁶ it has not been widely argued that a primary purpose of such schemes is to discourage directors from trading a company whilst insolvent. The idea of anything other than fraudulent trading being a problem would not have occurred to company lawyers under earlier generations of our companies statutes. Under the 1882 Act, the compromises provisions could not be triggered without someone commencing the winding up process, and the plain purpose of the provisions was to rein in the power of individual creditors. Even then, the rights of individual creditors were seen as so important that no individual creditor could be forced to accept a compromise unless three-quarters by value of other creditors preferred a com- promise over a liquidation. It is true that the 1993 Act provisions do allow the company (and in the case of s 288, the directors) to initiate these processes, but there is nothing to suggest that there is a duty to do so. Creditors and liquidators remain prime movers of them.

For these reasons, this author does not buy the reasoning of the Supreme Court that the scheme provisions signal that “directors are not the appropriate decision-makers in times of insolvency or near-insolvency”.⁷

Nor does the presence of scheme provisions signal that, before their invocation, directors in running a company, even an insolvent one, are required to give equal weight to the interests of every single unsecured creditor, as also suggested by the Court.⁸ Virtually from the beginning of modern company law, those running insolvent companies have been forbidden from preferring themselves or share- holders (and their close relatives) in their capacity as unsecured creditors, but nothing has said that there need be equal treatment, or even equal consideration of the interests of other creditors. Nor has consultation with all creditors been a requirement.⁹ It is true that all formal insolvency mechanisms start from a premise of pari passu treatment, but that is not the case before those mechanisms are triggered.

Before divining a duty of equal payment of creditors from the tea-leaves of the scheme provisions, it is regrettable that the Court did not notice that earlier this year the Legislature reduced the standard voidable preference period from two years to six months before liquidation.¹⁰ It is odd that the circumstances in which inequality of treatment triggers restitutionary remedies have been greatly confined by Parliament, while in the courts delictual ones against directors have been fomented, potentially with retrospecive effect and a six-year limitation period applied to them.

As for the existing case law, a long line of cases had expressly recognised that equality of treatment was not required.¹¹ None of the relevant case law is referred to by the Supreme Court. So, for instance, in Re Sarflax Ltd,¹² counsel put to Oliver J the very principle that the Court propounds in Debut Homes, namely that upon insolvency a director must treat all creditors with equal respect or face a charge of fraudulent trading. The Judge strongly rejected it, stating that general principle has long held that, before formal insolvency, a debtor is prima facie entitled to discharge external debts in any order it pleases. Voidable preference law may ultimately reverse some of those decisions, but no delictual claim has been available against directors.

This reasoning was accepted as still sound in Morphitis v Bernasconi,¹³ in a jurisdiction that has long had voluntary administration and other compromise systems. It was applied by Stevens J in Krtolica v Westpac Banking Corporation,¹⁴ and by the Western Australian Court of Appeal in Westpac Banking Corp v Bell Group Ltd (No 3).¹⁵ In the latter case, Drummond AJA stated:

[2635] There is in my opinion no foundation for the proposition that, prior to winding up, the creditors of an insolvent company have any claim to equal treatment by the company for any purpose, whether or not a financial restructure is contemplated by the company and a particular creditor

…

[2636] Far from being obliged to treat all creditors equally prior to winding up, an insolvent company can prefer one creditor over another.

In particular, those creditors whose support is most needed to keep the company trading can be paid and others left to their right to bring a peremptory statutory demand. In many cases equality of treatment is in fact incompatible with the survival of marginal businesses. Creditors, in general, know this.

The mere fact that the director has guaranteed the debts of such creditors does not detract from the privilege as to order of payment, since the guarantee may only reflect how critical the creditor’s co-operation is to the continued operation of the business. A narrower test of necessity might have been developed instead of the one that gives a debtor prima facie freedom to choose the order of payment, but the broader test has the advantage of simplicity. Whether directors are permitted at common law to be perversely hostile to a creditor remains something of an undecided issue. ¹⁶ The tort of interference with contractual relations may be a better mechanism for dealing with that problem.

There is, then, an element of the vicarage about the Supreme Court’s notion that directors of every insolvent company have to contemplate the cost of initiating voluntary administration or a creditors’ scheme, or at least be very careful to mimic one, in order to avoid personal liability being imposed by a judge. To again borrow Dame Elizabeth Gloster’s words, this notion is “impracticable and unreal”. With so many of New Zealand’s companies being very small, the practicality of making these regimes ubiquitous is most doubtful. Certainly, the cost-benefit equation of clogging up (to use a pejorative term) the courts with the schemes is, it is suggested, unproven. Those who run these processes do not come cheap. These limitations were recognised by the Law Commission.¹⁷ The processes should remain creditor-driven rather than director driven. Nor should directors’ conduct be combed over by a court to compare it with what might have happened under a fully-developed scheme or a liquidation.

There is nothing intrinsically wrong with directors consulting with all the company’s creditors, but it will often be pointless and inefficient to do so, and it should not there- fore be made mandatory, let alone sanctioned with an open-ended fine in the form of liability for all the company’s debts.

Equally unconvincing, is the Supreme Court’s use of the “solvency test” in the 1993 Act as a lever for assuming that insolvent trading is by itself a bad thing.¹⁸ The 1993 Act provisions that turn on the solvency test are aimed at pre- venting the return of capital to shareholders after insolvency, nothing more. This too has been an age-old concern of company law.

After engaging in some rather unhelpful speculation on stakeholder theory in company law, which may signal more non-accountable law making from the Supreme Court to come (governance is one thing, judicial review of directors’ decisions is another), the Court then sermonised on the vice of insolvency in the following way:

[32] Further, no matter which view is taken on the best interests of the company, maintaining solvency is vital. It cannot be in the best interests of the shareholders as a whole for a company to become insolvent as they would not only lose possible future income from the company, but also their investment in it. Equally, it cannot be in the best interests of the company itself to become insolvent, given it would cease to exist in the event of liquidation. Similar considerations apply to other stakeholders.

The concept of limited liability, and of incorporation insofar as that is the reason directors are not personally liable for debts, have little point if companies are meant to remain solvent at all times. To make an analogy, there is not much point to freedom of speech if one is not allowed to say unpleasant things. The promoters of limited liability envisaged not just the taking of risks but the taking of high risks.

The Supreme Court in that passage also makes assumptions about the unwillingness of shareholders, and implicitly creditors, to risk the company’s insolvency that cannot be sustained. If the prospect of profits is high enough, both classes of investors will willingly wear high risks of insolvency. The Supreme Court’s approach cross-subsidises such risk-takers by giving them indirect rights against directors that they did not bargain for (recall that in Re South Pacific Shipping Ltd, William Young J discounted damages for reckless trading under the Companies Act 1955 to take account of the risk-taking that he saw creditors as having willingly taken).¹⁹ As for the company itself, it has no interest in whether it lives or dies.

In a footnote much later in its judgment the Court indicates that its real target is insolvent trading where there is “no possibility of salvage”. This, in fact, may be the ratio decidendi of the judgment, but the wide-ranging dicta in the opening part of the Court’s judgment have the potential to do much damage to traditional corporate law. If, for example, we want small players challenging monopolists and oligopolists, we must not personalise corporate insolvency (for example, pierce the corporate veil by one means or another). The construction industry also seems to be one where it is extraordinarily hard to get things right (notwithstanding Hinton J’s finding of bad faith in Mr Cooper’s treatment of the Revenue, she otherwise found him to be an “an astute and careful business person”).²⁰

Frankly, the Court should back-pedal on these dicta. Much of the Court’s reasoning is strikingly uncommercial and will encourage a new batch of life-destroying litigation. The well-resourced Revenue will be a frequent funder. Lawyers, litigation-funders, and the tricoteuses who gloat over the scalps of directors will be the main beneficiaries. With company law in this state, and in particular with incorporation and limited liability as methods of asset protection being increasingly eroded, it can be no surprise that family trusts have become a bane in New Zealand.

As indicated at the beginning of this piece, even without the reasoning and rhetoric of the Supreme Court just criticised, it was going to be difficult for Mr Cooper to avoid prima facie liability on the facts of the case under one or other of ss 135 and 136. This means that the Court’s broader dicta were unnecessary for dealing with the case. There are two reasons for this.

First, in part owing to unthinking accidents in the legislative process, neither s 135 nor s 136 is reconcilable with the risk-promoting part of the preamble to the 1993 Act and with the concepts of incorporation and limited liability otherwise provided for in the Act. Elaboration on this will not be given here,²¹ except to say that until Debut Homes we had become reliant on the goodwill of the judiciary to tone down the excesses of the drafting, and to deploy the discretion in s 301 to ameliorate the overreach of the sections. That this was a precarious situation is shown by Debut Homes.

Secondly, Hinton J’s finding that Mr Cooper intended the GST liability that the company was going to incur would never be paid because the company would cease to trade as soon as the sale of the houses that generated the GST liability had taken place,²² meant that Mr Cooper was inevitably in trouble. Had the Revenue been a contracting party, this would have been fraudulent trading. The Revenue was not, of course, a contracting party, and it was not induced in any way to change its conduct. But the Supreme Court was correct to say that the obligations for which a director can be liable under s 136 extend beyond contractual obligations, and the first instance findings of intent preclude any suggestion that there can have been reasonable grounds for thinking the obligation would be discharged.

It was much less clear that Mr Cooper should have been prima facie liable under s 131 of the Act (the duty to act in the best interests of the company), in the way the Court found. The Court’s finding under this section is premised on a general identification of a company’s interests with its creditors’ interests after the commencement of insolvency or “near insolvency”.²³ This is a half-baked premise; a hare set running in this country by Cooke J in a total obiter dictum in Nicholson v Permakraft (NZ) Ltd.²⁴ There is no doubt that in traditional company law the arrival of insolvency triggers at common law certain disabilities in both directors and shareholders in relation to dealings with the company’s assets. But a generalised change of focus in company decision-making from share- holders to creditors was an unwarranted extrapolation and not part of company orthodoxy. Cooke J, and those who have followed him, simply did not analyse the body of case law they were relying upon for their broader, amorphous proposition. This too is explained elsewhere,²⁵ to the sup- porting sources for which there is other recent material.²⁶ In BTI 2014 LLC v Sequana Sab (Sequana) David Richards LJ expressed a number of reservations as to Cooke J’s dicta in Permakraft, including in relation to the concept of “near insolvency”.²⁷ Sequana (under appeal to the UK Supreme Court) was not considered in Debut Homes.

Given the Supreme Court’s general hostility to insolvency, there was little hope of the Court re-examining the duties-to-creditors premise, even though we should be grateful that the Court upheld the view that s 131 is based on a subjective test as to where the directors see the company’s interests as lying.²⁸

This brings us to the criticisms to be made of the Court’s approach to remedy for breach of s 136, and to its over- repetition of the phrase “robbing Peter to pay Paul”. The background is that the Court endorsed the face value of the debts that the directors should not have allowed the company to incur (less any of those debts that have in fact been repaid) as a starting point to determine the remedy.29 The Court rejected the counter-argument that the duty imposed by s 136 is one owed to the company and, therefore, to the extent that in incurring the new obligations the company also discharged old ones, only the net deterioration was appropriate as a measure of compensation for the wrong done to the company. The Court saw that argument as allowing Peter to be robbed to pay Paul, and said that there was:³⁰

… much force in the liquidators’ submission that limiting compensation to the net increase in amounts owing would provide directors with the perverse incentive to continue to trade in breach of s 136 as long as they are careful to make sure that the net deficit remains constant.

The Court also seems to have thought that a “restitutionary” award could be made under s 301 that would not necessarily equate with a purely compensatory one, and would capture the face value of the new debt incurre.³¹

One can start by responding to this last point. It is respectfully suggested that the Court has misunderstood the concept of restitutionary relief both in private law and in s 301 of the 1993 Act.

The Court is right in three respects. First, the concept of restitution does not require proof that the defendants who are subjected to restitutionary remedies have themselves received the money or other property to be restored.³² Secondly, restitutionary relief does not turn on proof that the defendant has committed a breach of fiduciary duty.³³ Thirdly, where restitutionary relief is available it might lead to a greater award than a counter-factual compensatory remedy. So, an agent who disburses a principal’s money or other property in breach of instructions (whether honestly or not, and whether in breach of fiduciary duty or not) cannot usually defend a duty to restore it by showing that if the instructions had been complied with the principal would have lost the money in other ways.³⁴

However, restitutionary remedies are concerned only with the precise reversal of inappropriate transfers of money or property received by someone, and always take into account counter-receipts of money or property. The remedy sought for breach of s 136 is not one of reversal, but one for compensation as a result of the incurring of an obligation. The underlying transaction is not sought to be reversed, and indeed is relied upon by the claimant. Moreover, the relevant dispositions are matched by actual counter- receipts by the company; this is not a case where a defendant is trying to defend a misapplication of money on the basis of a hypothesis that, in all events, the claimant would have lost the money.

The same principles are involved in s 301. Section 301 has a history dating to the 1882 Act in New Zealand and before that in the United Kingdom. It is plain beyond doubt that the concept of restitution in that section is solely addressed to cases fitting the description of restitutionary causes of action at common law. So, it is obvious that the reference in s 301(1)(b)(i) to an order requiring the defendant “to repay or restore the money or property” refers back to the phrase in the body of s 301(1) whereby the defendant “has misapplied, or retained, or become liable or accountable for, money or property of the company”.

The wrong that Mr Cooper was sought to be made liable for in Debut Homes did not involve any of the things listed in the phrase just quoted from the body of s 301(1), so the remedy in s 301(1)(b)(i) was simply unavailable. With respect, therefore, the Court was almost incontrovertibly wrong when it stated: [157]

The word “repay” implies that the person has received company money or property and can be ordered to return it to the company. The word “restore” suggests rather that a person can be ordered to return the company to the position it would have been in absent the breach, including making good a company debt that should not have been incurred, even if the person has not received company money or property.

The word “repay” is clearly referring to money, and the word “restore” is clearly referring to property. Neither word is referring to “position” in the way the Court suggests. The part, and only part, of s 301(1) that captures the wrong in s 136, and that in s 135 for that matter, is that which refers to “negligence, default, or breach of duty”. And the remedy for such wrongs is “compensation” under the other limb of s 301(1)(b), namely (ii).

The question then arises whether a court might be able to award more than the claimant’s net losses under the guise of “compensation”. This seems doubtful, although it is a more arguable proposition than the Court’s invocation of “restitution” in order to use sub-paragraph (i). Given that the Court seems to have accepted that net-loss compensation is the normal measure of compensation for breach of s 135,³⁵ one can anticipate liquidators doing their best to shoe-horn their pleadings into s 136 after Debut Homes. Even if compensation for breach of s 136 can be given an expanded meaning, on a fact pattern such as that in Debut Homes a court would surely have to ask how much GST debt would have been incurred had the company ceased trading when it should have, and then realised its assets (or what would have been the discount suffered had the liquidator sold on to another property developer and the company’s liability for GST thereby been avoided). The Court seems to have accepted that much,³⁶ but it is not clear that the relevant material was in evidence.

This brings us to the rest of the Court’s reasoning on this topic. The operative word in the expression “robbing Peter to pay Paul” is the word “rob”. Robbery is a sub-category of theft and involves dishonesty. As we have noted there were findings of bad faith made against Mr Cooper in relation to the incurring of the GST liability. But absent dishonesty, it is submitted that it is not obvious that new creditors should be treated as more worthy than old creditors. Ironically, in Permakraft Cooke J seems to have thought that new creditors warranted less protection.³⁷ Contrary again to the Supreme Court, there is also little force in the liquidators’ argument that limiting compensation under s 301 to the company’s net losses creates a perverse incentive in directors to trade on. Treading insolvent water (an oxymoron admittedly) does occur, but it is fairly hard to sustain, and is not made any easier by the fact that GST liabilities are being incurred, let alone that those liabilities are then bloated by the addition of penalties (at the expense of unsecured creditors). The wishful thinking of the generality of creditors, or their lack of due diligence, is often no less culpable than that of directors, so long as the latter are honest. There are, in fact, plenty of dishonest business people. Let’s concentrate on them.

1. UBS AG (London Branch) v Kommunale Wasserwerke Leipzig GmbH [2017] EWCA Civ 1567, [2017] 2 Lloyd’s Rep 621 at [347].
2. Madsen-Ries (as liquidators of Debut Homes Ltd (in liq)) v Cooper [2020] NZSC 100.
3. Debut Homes Ltd (in liq) v Cooper [2018] NZHC 453 at [39].
4. Law Commission Priority Debts in the Distribution of Insolvent Estates: An Advisory Report to the Ministry of Commerce (NZLC SP2,
   1999) at [103]–[105] and [140].
5. Companies Act 1882, ss 185 and 186.
6. Madsen-Ries (as liquidators of Debut Homes Ltd (in liq)) v Cooper, above n 2, at [36]–[46].
7. Madsen-Ries (as liquidators of Debut Homes Ltd (in liq)) v Cooper, above n 2, at [43].
8. At [44].
9. As suggested at [48].
10. See s 292(4C) of the Companies Act 1993 as inserted on 16 May 2020.
11. Peter Watts, Neil Campbell and Christopher Hare Company Law in New Zealand (2nd ed, LexisNexis, Wellington, 2016) at [17.1.2].
12. Re Sarflax Ltd [1979] Ch 592 at [602].
13. Morphitis v Bernasconi [2003] EWCA Civ 289, [2003] Ch 552 at [42].
14. Krtolica v Westpac Banking Corporation [2008] NZHC 1 at [119].
15. Westpac Banking Corp v Bell Group Ltd (No 3) [2012] WASCA 157.
16. Watts, Campbell and Hare, above n 11.
17. Law Commission Insolvency Law Reform: Promoting Trust and Confidence (NZLC SP11, 2001) at [202].
18. Madsen-Ries (as liquidators of Debut Homes Ltd (in liq)) v Cooper, above n 2, at [33]–[34].
19. Re South Pacific Shipping Ltd (in liq) (2004) 2 NZCCLR 8, (2004) 9 NZCLC 263,570 (HC).
20. Debut Homes Ltd (in liq) v Cooper, above n 3, at [14].
21. See Watts, Campbell and Hare, above n 11, at [17.2].
22. Debut Homes Ltd (in liq) v Cooper, above n 3, at [16] and [39].
23. Madsen-Ries (as liquidators of Debut Homes Ltd (in liq)) v Cooper, above n 2, at [31].
24. Nicholson v Permakraft (NZ) Ltd [1985] 1 NZLR 242 at [249]–[250].
25. Watts, Campbell and Hare, above n 11 at [17.1].
26. Kristen van Zwieten “Director Liability in Insolvency and its Vicinity” (2018) 38 OJLS 382.
27. BTI 2014 LLC v Sequana SA [2019] EWCA Civ 112, [2019] 1 BCLC 347 at [149].
28. Madsen-Ries (as liquidators of Debut Homes Ltd (in liq)) v Cooper, above n 2, at [112].
29. At [168].
30. At [166].
31. At [157] and [160]–[161].
32. At [157].
33. Madsen-Ries (as liquidators of Debut Homes Ltd (in liq)) v Cooper, above n 2, at [160].
34. Peter Watts “Agents’ Disbursal of Funds in Breach of Instructions” [2016] LMCLQ 118.
35. Madsen-Ries (as liquidators of Debut Homes Ltd (in liq)) v Cooper, above n 2, at [164].
36. At [169].
37. Nicholson v Permakraft (NZ) Ltd, above n 24, at [250].

The views expressed in this article are the author’s own and do not reflect the position of the IoD unless explicitly stated.