A recent decision of the High Court, Delegat v Norman [2012] NZHC 2358 provides a useful illustration of the application of the following Companies Act 1993 provisions:

  • when a person will be deemed to be the director of a company as either a 'shadow director' or a 'de facto director' under section 126 of the Act; and
  • when a director will be in breach of the duties relating to reckless trading and incurring obligations under sections 135 and 136 of the Act, or be in breach of the duty to act in good faith and in the best interests of the company (under section 131) or the duty to exercise the care, diligence and skill of a reasonable director (under section 137), particularly where a company is of doubtful solvency.

Background

This case involved the failed luxury yacht maker, Salthouse Marine Limited (SML). The Jim Delegat Business Trust had contracted with a boat building subsidiary of SML (Boat 93) to construct a luxury yacht for the Trust in November 2009. The construction of the yacht was guaranteed by SML. However, prior to the completion of the Trust's yacht, SML was placed into receivership in February 2010 and then into liquidation in May 2010. Boat 93 was also liquidated. This left the Trust with an incomplete hull (worth between $150,000 and $455,461) and a substantial loss on the payments of $1.23 million it had made to Boat 93 to build the yacht.

The Trust has not pursued claims in contract against either Boat 93 (for breach of contract) or SML (as guarantor) because of their insolvency. Instead, the Trust brought proceedings against one of the two directors of SML, Mr Norman, under section 301 of the Companies Act. This section allows a creditor of a company in liquidation to apply to the court for an inquiry into the conduct of a director of the company. Following the inquiry, if the director is found to be in breach of duty to the company, the court may order the director to contribute such sum by way of compensation to the assets of the company as the court thinks just.

Mr Norman had become a non-executive director of SML in 2008 after being approached by Ms Salthouse to become an investor in SML. At the time SML was in financial difficulties, but Mr Norman agreed to fund SML because he admired the yachts built by SML and had a genuine belief that SML's financial difficulties could be turned around. Although Mr Norman was not appointed as a director of Boat 93 or of any of SML's other boat building subsidiaries, the Trust alleged that he was a 'shadow' or 'de facto' director of Boat 93 in addition to being a director of SML. The Trust also alleged that Mr Norman was in breach of his directorial duties (under sections 131, 135, 136 and 137 of the Companies Act) by allowing both Boat 93 and SML to trade recklessly.

Ms Salthouse, the managing director of SML, was the sole director of Boat 93 and the other boat building subsidiaries.

The court's comments on shadow and de facto directors

The court noted that section 126 of the Companies Act distinguishes shadow directors from de facto directors. A shadow director does not purport to act as a director, but instructs or has the power to instruct the actions of an appointed director. In contrast, a de facto director occupies the position of director notwithstanding that he or she has not been validly appointed as such. A de facto director is held out by the company and purports to act as a director.

Discussing the principles relating to de facto directors, Justice Woolford made the following points:

  • The concept of de facto director is confined to those who willingly or voluntarily take upon themselves the role, either by usurping the office or by continuing to act once their formal role has ceased. It does not extend to a person who does not willingly adopt the role of director.
  • In order to establish that a person is a de facto director of a company, it is necessary to plead and prove that he or she undertook functions in relation to the company that could properly be discharged only by a director.
  • There needs to be clear evidence that the person was either the sole person directing the affairs of the company or if there were others who were true directors that he or she was acting on an equal footing with the others in directing the affairs of the company.
  • If it is unclear whether the acts of the person are referable to an assumed directorship or to some other capacity, such as shareholder or consultant, the person must be entitled to the benefit of the doubt.

Was Mr Norman a shadow or defacto director?

The Trust alleged that Mr Norman was a shadow or de facto director of Boat 93 because he made or participated in various governance decisions relating to Boat 93. This included:

  • locating and negotiating with customers of Boat 93;
  • incorporating Boat 93;
  • specifying the commercial purpose of Boat 93;
  • entering into build contracts with Boat 93;
  • determining where Boat 93 and other subsidiaries' customers' yachts would be constructed;
  • employing or continuing to employ Ms Salthouse as the General Manager of Boat 93 and other subsidiaries; and
  • delegating authority to Ms Salthouse, in her capacity as General Manager, to make operational decisions on behalf of Boat 93 and other subsidiaries.

The court disagreed with both these claims.

For Mr Norman to be a shadow director of Boat 93, the Trust had to prove that Ms Salthouse had been accustomed to acting in accordance with Mr Norman's instructions. The court said this test required some sort of “on-going control or influence in a company's affairs”. However, there was no evidence provided of Mr Norman giving Ms Salthouse directions or instructions in relation to the operation of Boat 93 or the other boat building subsidiaries, so the Trust failed on that ground.

The judge also found on the evidence that Mr Norman did not assume the status and functions of a de facto director of Boat 93. In relation to the governance decisions raised by the Trust, the court found that Mr Norman carried these out as a director and funder of SML, not Boat 93 or the other boat building subsidiaries. Further, the judge held that if there was any doubt about the capacities in which Mr Norman was acting, the benefit of that doubt was to go to Mr Norman.

Was Mr Norman, as a director of SML, guilty of a breach of a reckless trading duty to the company?

The court noted that both sections 135 and 136 of the Companies Act are similar in so far as they are both intended to address the same sort of conduct, namely, reckless trading which causes serious losses to creditors. However, the court pointed out that cases suggest that section 135 may be more appropriate when challenging a course of conduct over an extended period of time, whereas section 136 may be more appropriate when the challenged conduct relates to the incurring of specific liabilities.

The cases determined under section 135 differentiate between the taking of legitimate and illegitimate business risks. Courts take an objective approach in determining whether the conduct of a director breaches section 135. That is, “conduct will only breach section 135 if it is reckless, in the sense of being well outside the orthodox business practice”.

Section 136 is breached if a director agrees to the company incurring an obligation at a time when he did not believe (a subjective test) on reasonable grounds (an objective test) that the company would be able to perform that obligation when required to do so.

Based on the application of sections 135 and 136 of the Companies Act, the Trust alleged that there were four 'watershed moments' when SML should have ceased trading and that Mr Norman was, in effect, reckless in allowing SML to continue to trade.

The first occasion was in December 2008 when Mr Norman made the decision to invest in SML. The Trust argued that SML was “highly insolvent” at this time and continuing trading was not in the best interests of SML's current and prospective creditors. But the court found that the risks Mr Norman took on when he decided to invest were legitimate business risks, particularly given the level of funding to which Mr Norman had committed under a working capital facility he provided through Merchant Trust. Further, if he had not invested at that time there would have been substantial losses to the purchasers of the yachts under construction in December 2008.

The second occasion was in April 2009 when Merchant Trust made its last advance under the working capital facility established by Mr Norman. However, the court was of the view that Mr Norman was entitled at that time to continue with the directors' strategy to turn the business around while supporting it by advancing further funds in the form of short-term advances from Yachts West (a company owned by Mr Norman and which had been appointed as the sales agent for SML in Western Australia). Yachts West was in the process of selling a trade-in boat on behalf of SML which formed part of the purchase price of a SML yacht being built in New Zealand (the Summersalt).

The third occasion was in August 2009 following the sale of the trade-in boat, when there were no further funds available from the purchaser of the Summersalt and Mr Norman was not committed to providing SML with sufficient finance. The Trust contended that it suited Mr Norman to fund SML on an “at-will” basis on the chance that another customer would materialise and thereby minimise the possibility that he would ultimately have to personally fund the full cost of having his own SML yacht completed. However, the court found that there was no evidence to support the allegation of an ulterior motive on the part of Mr Norman and that the amount of the advances made by Mr Norman (through Merchant Trust) during the period from September to December 2009 clearly demonstrated Mr Norman's continued commitment to SML.

The final 'watershed moment' was in November 2009 when SML agreed that Boat 93 enter into a contract with the Trust to build a new yacht. At this time, the Trust contended that Mr Norman should have recognised that the risks to the Trust were “patently clear and clearly unreasonable”. SML had been running at a loss throughout 2009 and it had no committed funding in place. Further sale prospects were uncertain. However, the court found that Mr Norman (who had considerable financial means) was committed to continuing to fund SML at that time, as indicated by the amount of advances made in the four month's prior to SML's receivership in February 2010. The court also was of the view that despite the global financial crisis there was some basis for the opinion held by Ms Salthouse and Mr Norman that future sales were likely.

Looking at the overall circumstances, Justice Woolford concluded that Mr Norman was not in breach of either section 135 or 136 of the Companies Act. Mr Norman had taken a legitimate business risk in investing in SML and his willingness to fund SML was of considerable importance when judging his conduct. Further, Mr Norman believed on reasonable grounds that SML would be able to guarantee the completion of the Trust's boat in November 2009. The court found that the catalyst for the action taken by Mr Norman to appoint a receiver to SML in February 2010 only arose when a further sale did not eventuate.

Was Mr Norman in breach of his section 131 and 137 duties?

On the evidence, the court was in no doubt that Mr Norman had acted in good faith and in what he believed to be in the best interests of the company. The court noted that he had been motivated by his admiration for the yachts built by SML and in addition to funding SML he had attempted to improve SML's prospects of success in other ways.

The court also concluded that Mr Norman was not in breach of his duty to exercise the care, diligence and skill of a reasonable director under section 137 by allowing SML to continue to trade at the four 'watershed moments' noted above. The court found that Mr Norman made a decision to provide funding to enable SML to continue to pay its debts as they fell due. As a result, in the end, other than the losses suffered by the Trust and Mr Norman himself, creditors were better off than before Mr Norman made his initial investment in December 2008.

The court also noted that as a non-executive director resident in Perth he:

  • had received regular financial reports covering SML's financial performance throughout 2008 and 2009;
  • was involved in corporate governance to the extent of being involved in both sales strategies and cost-cutting strategies, as well as reviewing budget forecasts for SML.

For a copy of this case, click here.