The ‘limited’ aspect of a limited liability company, or the idea that a company is a separate legal person whose liabilities do not extend beyond the company, is a foundational principle of company law.
Construction and Major Projects team.
However, it is easy to see how the protections afforded by a limited liability company can result in unfairness, particularly in instances where the directors have failed to behave to the required standard under the law.
This article briefly looks at two recent cases, in the construction context, where an insolvency has caused significant losses, and creditors have looked to recover from the directors in different ways.
The first case is a New Zealand example that will be familiar to many.
Mainzeal, formerly one of the largest main contractors in the country, went into liquidation in early 2013 owing roughly $110 million to unsecured creditors.
The liquidator, acting on behalf of the company, made a claim against the former directors of the company alleging they had breached their duty under the Companies Act 1993.
Breach of director’s duties is an established way for the court to ‘pierce the corporate veil’. The director’s duties stem from the notion the directors owe duties to the company they steward.
The Companies Act codifies director’s duties, including the duty not to trade recklessly, and more specifically, to not:
– 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
– 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 liquidator alleged that the former directors of Mainzeal had been trading recklessly. The Court upheld this claim.
In essence, it was found that Mainzeal had a practice of trading with an insolvent balance sheet, with no firm assurances in writing from the company’s Chinese funders that they would continue to fund any deficit.
This practice would not breach director’s duties if the company’s performance was sufficiently strong that it did not need to rely on funding.
However, the overall performance of the company was poor, as it was prone to annual trading losses and significant losses on projects.
Cumulatively, these factors led the Court to conclude thats 135 of the Companies Act, the prohibition on reckless trading, was breached.
The Mainzeal case received a lot of press during the trial and as a result of the judgment, due to how high profile the collapse was and the fact that the directors, including a former Prime Minister, received hefty penalties.
Breach of director’s duties is an established way for the court to ‘pierce the corporate veil’. The director’s duties stem from the notion the directors owe duties to the company they steward.
Another recent case in the United Kingdom shows how a contractor tried a different approach to recover money from directors of a development company.
Palmer Birch (A Partnership) v Lloyd [2018] EWHC 2316 (TCC) involved the approximately £5 million refurbishment of a property in Devon.
The commercial structure behind the deal was complicated. Put simply, Hillersdon House Ltd (HHL) was given a licence by the owner of the property, Seizar Holdings Limited (SHL), to refurbish the property.
HHL contracted Palmer Birch to carry out the works. The ultimate funder of the operation was Michael Lloyd and his London bank.
Two years into the project Michael Lloyd ran into financial difficulties and the bank funding was exhausted. HHL’s debt to Palmer Birch for construction work (and other debts) began to compound.
To cut a long story short, HHL was placed into liquidation.
However, this was not before Michael Lloyd diverted funds realised from another investment away from HHL. Palmer Birch sued Michael Lloyd and his brother, Christopher Lloyd (a director of HHL) in tort for:
– Conversion of materials and tools stored in secure storage at the Property;
– inducement or procurement of a breach of contract by HHL in instructing or demanding that:
• HHL not make payment of sums due to Palmer Birch;
• HHL refuse to allow Palmer Birch to complete the works;
• HHL terminate the contract; and
• The contract administrator not certify further interim payment
– Unlawful interference by failing to fund further payments by HHL to Palmer Birch.
While the Court found that Michael Lloyd’s failure to continue to fund the company did not amount to inducing a breach of contract, the Court did find that he had induced a repudiatory breach of contract by liquidating HHL and diverting funds from the other investment.
Both brothers were liable for conspiracy to bring about the repudiatory breach. Pursuing the directors in this way, was a relatively novel approach, but one that in this case resulted in some success.
Relevantly (for both cases), the Judges noted that the Palmer Birch case was an example of ‘the perils of contracting with an undercapitalized limited liability company with no guarantees from the individuals associated with it.’
In the current market, where we are seeing more insolvencies in the industry, it is important that everyone is aware of these perils. Those involved in the industry need to think carefully about:
– Who they are contracting with and their ability to pay;
– What security can be put in place to protect their position where there are doubts, e.g. bonds, personal guarantees, and parent company guarantees;
– What are the payment terms? Are extended payment terms causing excessive risk?;
– Can payment risks be alleviated by ensuring arrangements are in place directly with relevant lenders, e.g. tripartite agreements with banks;
– Their systems for putting in claims and monitoring if they are paid, to ensure claims are filed in a timely manner and payments are made when due;
– Whether to exercise the right to suspend immediately if there are payment defaults;
– Regularly asking for information about retentions to ensure they are being held on trust;
– Whether to broaden payment security mechanisms, such as project bank accounts which secure payment across the supply chain for large scale projects that can carry the cost of such arrangements.
Proactive steps may help minimise the consequences of insolvencies and avoid the need to engage in the sort of litigation that was necessary in the Mainzeal and Palmer Birch cases.
• Kensington Swan offers 15 minutes of free advice on construction issues to CCNZ members.
This article was first published in the April issue of Contractor Magazine.
Rising from the ashes