Insights on reckless trading and director liability: a recent High Court case

A recent High Court judgment has shone the light on the ability of creditors to claim against company directors accused of “reckless trading”. This ruling has considerable implications for directors, showing that creditors can make successful applications to the courts independently and directly, particularly when creditors are well-resourced or determined.

On September 26, the Court delivered a judgment against Timothy Mahoney, a director of Civil Underground Limited (“Civil Underground”). This case marks the first substantive decision holding a director liable to a creditor for breaching their duties since the Supreme Court ruling against Mainzeal directors last year.

Background on the Mainzeal case

The Mainzeal case concluded in August 2022 after eight years of litigation. The court dismissed appeals from four directors of the failed construction company, finding them liable for over $40 million in claims from creditors who lost approximately $111 million when the company collapsed in 2013. Mainzeal’s chief executive, along with its chair and directors, now face liabilities exceeding $50 million.

The recent ruling against Mr Mahoney

In the now recent decision, creditor Drew Boaden made claims against Mr Mahoney for breaching director duties under the Companies Act 1993 (the “Act”) and the Fair Trading Act 1986. Civil Underground, which had leased a property from Mr Boaden, went into liquidation in October 2020 after Mr Boaden issued a statutory demand for unpaid rent.

At a high level, the High Court evaluated the conduct of Mr. Mahoney, concluding that while his actions in March 2019 to capitalise lending and write off debts were deemed reasonable, they did not restore the company’s solvency. The Court found that Civil Underground had been insolvent since at least September 2018 and that Mr. Mahoney had a six-month period to assess the situation. Despite a significant increase in the company’s overdraft, Mr Mahoney allowed trading to continue beyond March 31, 2019. Ultimately, the Court determined that this decision saw Mr Mahoney breach his legal duty by creating a substantial risk of loss, as the company continued to operate insolvent for over a year. Accordingly, the Court stated that a “sober assessment” was required.

According to the liquidators’ report to creditors, there was a shortfall of $1.34 million owed to outstanding creditors. Justice Kiri Tahana ruled in favour of Mr Boaden, awarding claims of $131,883 for outstanding rent and other costs, citing Mr Mahoney’s breach of sections 135 and 136 of the Act, which relate to reckless trading and the reasonable belief in being able to meet obligations.

This case demonstrates Section 301 of the Companies Act 1993 in action, with creditors being able to seek compensation from directors when breaches of duty cause financial harm. The court highlighted several considerations for pursuing such claims, including proof of breach, director’s assets, and potential claims under the Fair Trading Act for any misleading conduct by the director.

The broader impact on directors

Previously, it was common for only liquidators to pursue such claims. However, this case may potentially open the floodgates of creditors directly claiming against directors if they incur obligations after failing the insolvency test.

As this judgment illustrates, directors of any company, regardless of size, must navigate their responsibilities with care including taking a sober assessment and acting promptly to ensure they are not recklessly trading or taking on obligations they cannot meet.

Avoiding similar pitfalls: Key actions for directors

To avoid similar situations, directors should consider the following actions in future:

• Sober assessment: when a company is insolvent or nearly insolvent, directors are required by the courts to take a sober assessment. This involves taking a “reasonable” amount of time to evaluate the company’s financial position, seek professional advice, and identify potential paths forward for the business. This assessment should determine whether continuing to trade is likely to create a substantial risk of loss to creditors (interests of creditors generally – s 135 of the Act), or if it is reasonable to expect the company to meet its new obligations (interests of specific creditors – s 136 of the Act); and
• Act early: the reasonable amount of time to take a sober assessment varies depending on each situation. In this particular case, it was accepted by the Court that Civil Underground had been insolvent since at least September 2018 which would have given Mr Mahoney six months to determine whether to continue trading and a reasonable amount of time to assess the company’s position. It is important to consistently assess solvency and not delay seeking advice when a risk of insolvency arises. If directors incur obligations while insolvent, they are at risk of facing personal liability, making it crucial to tread carefully when entering obligations during financial distress.

Seeking guidance

If you’re a director concerned that your company may be near insolvent and are uncertain about your legal obligations or the steps you should take, consider reaching out to our commercial team for advice on navigating these challenges and protecting your position.

Get in touch with our Commercial Team here.