When the music stops: what directors owe creditors in an insolvency

One of the most common questions I am asked - and one of the most persistently misunderstood areas of company law - is what directors actually owe to creditors when things start going wrong. As a Licensed Insolvency Practitioner, I see the consequences of these questions playing out in real companies on a regular basis. I thought it was worth setting out where the law has landed, following the landmark Mainzeal decision of the Supreme Court.

Let me start with the basics and work through to where things stand today.

First: What Does 'Insolvent' Actually Mean?

New Zealand law applies a two-fold test. A company is insolvent if it fails either limb:

• Balance sheet insolvency - liabilities exceed assets.
• Liquidity insolvency - inability to pay debts as they fall due.

Both matter, and directors need to keep a close eye on both. A company can hold substantial assets on paper and still be unable to meet its day-to-day obligations - that is a liquidity problem. Equally, a company generating positive cashflow may be technically balance-sheet insolvent. The tests are not interchangeable.

What Are Directors' Duties, and Where Do They Come From?

Directors' duties are largely statutory in New Zealand, though they have deep roots in English equity law. The leading historical exposition came from Romer J in Re City Equitable Fire Insurance Company Ltd [1925] Ch 407, which established that directors' duties are fiduciary in nature - though directors are not trustees. For our purposes, the key provisions of the Companies Act 1993 are:

• s131 - duty to act in good faith and in the best interests of the company.
• s133 - proper purpose.
• s135 - reckless trading (substantial risk of serious loss to creditors).
• s136 - belief on reasonable grounds that the company can perform obligations it enters into.
• s137 - duty of care.
• s145 - use of company information.

An important starting point: all of those duties are owed to the company, not to shareholders. Section 169(3) makes that clear. And critically - the Companies Act does not specify any directors' duties owed directly to creditors. So when, if ever, do creditors enter the picture?

When Do Directors Start Owing Duties to Creditors?

The short answer is: when the company is in financial difficulty. But it took years of case law development to arrive at a settled position.

Pre-Mainzeal: The Permakraft Foundation

The foundational New Zealand case was Nicholson v Permakraft [1985] 1 NZLR 242. A capital dividend paid to shareholders as part of a restructuring was held not to be recoverable against directors when the company later became insolvent - the directors had acted honestly.

But Cooke J (as he then was) made a notable observation in obiter: while duties are owed to the company, there may be circumstances that require directors to 'consider the interests of creditors' - particularly when the company is insolvent, near-insolvent, or where a contemplated payment would jeopardise solvency. He also noted that balance sheet solvency alone is not enough: directors must consider whether the company can promptly discharge debts to current and likely future creditors.

It is worth noting that Cooke J did not express this as a formal legal duty owed to creditors. He was describing a dimension of the directors' duty to the company that becomes relevant in financial difficulty.

The Mainzeal and Debut Homes decisions

The Supreme Court's decisions in Debut Homes Ltd (in liq) v Cooper [2020] NZSC 100 and, more recently, Yan v Mainzeal Property and Construction Ltd (in liq) [2023] NZSC 113 - the Mainzeal case - are the most significant developments in this area in recent New Zealand legal history, and they are worth understanding in some detail.

In Debut Homes, the sole director was found to have breached his duties under s131 because, at a time when the company was insolvent, he embarked on a course of action that had the effect of repaying only some present creditors when he knew other creditors (including GST owing to IRD) would not be paid.

The Supreme Court ruled that it is primarily for a director to decide what is in the best interests of the company. The test was held to be subjective, because courts are not well-equipped to second-guess honest business decisions made by directors - and it would be dangerous to judge those decisions with the benefit of hindsight.

However, the Court importantly qualified that ruling in four ways. The directors had to:

• give actual consideration to what was in the company's best interests;
• in an insolvency or near-insolvency situation, consider the interests of creditors (citing Cooke J in Permakraft);
• address any conflict of interest; and
• avoid decisions that were irrational.

The Court noted that the obligation to consider the interests of creditors was consistent with the 'stakeholder model of corporate governance', but clarified that this did not amount to a formal 'duty' to creditors. In this respect, New Zealand law aligned with Australian case law (Spies v The Queen (2000) 201 CLR 603), though the Court did not expressly reference it.

What did all that mean in practice? In Mainzeal, the Supreme Court assessed compensation payable to the company by the directors at NZ$39.8 million plus interest, with the liability of each director other than Mr Yan limited to NZ$6.6 million plus interest. That outcome should be sobering for any director who is inclined to treat financial difficulty as something to be managed quietly and quietly hoped away.

Two further decisions

Two further decisions are worth noting.

The first is the Court of Appeal's decision in Arnerich v DHC Assets [2021] NZCA 224. A builder-creditor (the sole creditor) brought its own proceeding under s301 against the director of a corporate trustee which owned land being developed - in circumstances where the trustee had made distributions to beneficiaries (primarily the director and his family) without first making provision for the contingent indebtedness of the builder. Both the High Court and the Court of Appeal found the director liable under s131, on the basis that he had been in a position of conflict of duty and interest when authorising the distributions. Both courts confirmed that the duty under s131 is owed to the company - not directly to creditors.

Directors who make honest and considered (if ultimately wrong) decisions are treated differently from those who simply close their eyes to the problem.

The second is Dempsey Wood Civil Ltd v Gapes [2021] NZHC 2362, a judgment of Fitzgerald J. This case also concerned a development company unable to pay its builder, who sued the director for breaches under ss131, 135 and 136. The judge found that the director had breached ss135 and 136 but not s131 - holding on the facts that he had subjectively believed the company's assets were sufficient. The case is a useful illustration that the subjective element genuinely matters: directors who make honest and considered (if ultimately wrong) decisions are treated differently from those who simply close their eyes to the problem.

So Where Does This Leave Us?

Mainzeal does not establish any fundamentally new legal principle. But its practical consequences are significant, and the other decisions above point the same way.

What emerges is this: when a company is insolvent or approaching insolvency, directors cannot simply focus on preserving value for shareholders and hope for the best. They must actively consider the interests of creditors as part of the company's best interests. The further the company moves into insolvency, the more dominant that creditor-focused consideration becomes.

Practical Lessons for Directors

The key practical lessons are not complicated:

• Take both solvency tests seriously. Monitor both the balance sheet and cashflow on an ongoing basis, particularly when trading conditions are difficult.
• Seek advice promptly. The Court in Mainzeal specifically noted that directors are entitled to seek advice before making decisions about continued trading. This is not a sign of weakness - it is exactly what a responsible director should do.
• Document your reasoning. If you decide to continue trading through difficulty, keep a clear record of what you considered and why you concluded that it was in the company's best interests to do so.
• Consider all creditors, not just the loudest ones. A decision that advantages some creditors at the expense of others - particularly when insolvency is known - is precisely the kind of conduct that attracted personal liability in Debut Homes.
• Do not trade on simply because you cannot face the alternative. Once solvency is unresolved and the numbers do not support continued trading, inaction is not a neutral position - it is itself a decision, and in Mainzeal it was found to have been taken essentially by default.

A Final Word

As an insolvency practitioner, I see the consequences of these failures regularly. Directors who engage early with professional advice, whether from their accountant, lawyer, or an insolvency practitioner, are far better placed than those who delay. The law gives directors genuine room to make commercial decisions and take reasonable risks. What it does not permit is continuing to trade in the knowledge that creditors will suffer, while nothing is done to address the underlying problem.

If you are a director of a company that is struggling and you are uncertain of your position, please do not wait. Contact me promptly. Getting the right advice at the right time is almost always considerably less costly, financially and personally, than dealing with the consequences later.

Kevin Davies is a Licensed Insolvency Practitioner and a member of RITANZ, licensed by Chartered Accountants Australia and New Zealand. He practises at Principle Insolvency Limited Partnership. This article is intended as general commentary only and does not constitute legal or professional advice in respect of any particular situation.

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