A serious warning from the New Zealand courts for directors of subsidiaries of foreign-owned parents

gavel on a desk with some legal reference books in the background

A recent judgment of the High Court in New Zealand in which company directors were held jointly and severally liable for damages of NZ$36 million is a timely reminder of the risks run by board members even in jurisdictions not renown for hostile litigation environments. The case, which concerned one of New Zealand’s largest property and construction companies, is especially interesting because it throws light on the particular challenges faced by directors of a subsidiary of a foreign-owned holding company on which the company relies for financial support.

As the Court reviewed the history of dealings over many years between the company and its Chinese parent, it found that by 2008, the parent (through related entities) had extracted loans of approximately NZ$40 million to purchase assets in China, leaving the New Zealand subsidiary with negative equity of nearly NZ$45 million.

Dependence on holding company for support

The Court also found that as a result of these loans and unfavourable trading conditions, the company had, in effect, traded while insolvent for many years prior to its ultimate collapse in 2013. In and of itself, this finding would not necessarily have been fatal to the directors’ defense that they acted reasonably and should not be found liable under New Zealand’s reckless trading laws. As the judge put it:

Directors of a balance sheet insolvent subsidiary may continue to trade without breaching (the reckless trading laws) in circumstances where they have a reasonable basis to conclude that a solvent related company, such as a holding company, will protect the interests of the creditors notwithstanding that the subsidiary is trading whilst insolvent. That may well be the case when the subsidiary is part of a wider group, and the subsidiary is simply treated as a division of an overall group enterprise, and where the directors have a reasonable basis for concluding that necessary support is available from the wider group….. continuing to trade in those circumstances may not, by itself, give rise to liability. It depends on the circumstances.

That is similar to the position that would apply in other common law jurisdictions such as the U.K. and perhaps elsewhere. The problem for the directors here was that the subsidiary had not secured legally binding commitments from the holding company to guarantee its indebtedness. The judge ruled that letters of support were simply inadequate for this purpose, saying: “Only a legally binding commitment could protect the creditors in an insolvency.” The judge went on to consider the implications of the fact that any commitments from the holding company, even assuming they were legally binding, would still have been subject to Chinese law.

The impact of foreign law

Under a heading in his judgment “The limitations of Chinese law,” the judge summarised expert evidence given at trial by an experienced Chinese trade negotiator, who gave evidence that the ability to remove funds from China was heavily controlled by the Chinese authorities. The witness said that such authorities were unlikely to be impressed by applications to transfer funds to loss making subsidiaries, and that this would have been one of the highest risks facing a company such as this one.

The judge recorded that the expert had said: “…., had he been a Mainzeal director, he would have been asking for regular updates and insisting on hard evidence of strong connections in China that would lead to the ability to receive funds.” The judge agreed, and found that the directors had not taken such steps.

Conclusion

In an increasingly globalized economy, the number of foreign-owned companies is very likely to grow. This case highlights the need for directors of foreign-owned subsidiaries to consider the impact on any commitments of financial support (even if expressed in legally binding language) of foreign law, regulation and practice governing the ultimate parent. As the judge put it: “In my view, the directors needed to ensure that the expressions of support, even if provided in legally binding form, would be effective given the limitations of Chinese law.” The need for expert input in the decision making process has perhaps never been greater.

Impact of D&O insurance

In deciding on the figure of NZ$36 million worth of damages, given that the overall loss to shareholders exceeded NZ$110 million, the judge had access to information concerning the relevant D&O insurance limits, which were apparently NZ$20 million. About that he said:

In the end, however, I have decided it is not appropriate to alter what I would otherwise consider to be an appropriate amount to award simply on the basis of the extent of the insurance cover. For the avoidance of doubt, I make no findings on the insurance cover, and how it applies between defendants. I am mindful, however, that the amounts sought by the plaintiffs, and the extent of the deficiency at liquidation, potentially involve very significant sums of money that individuals such as the second to fourth defendants would normally find considerable difficulty in meeting in the absence of support, such as insurance cover.

This conclusion makes a chilling (but perhaps not surprising) reading for directors in the sense that the judge showed no inclination to limit the extent of the award to the available insurance limits. It seems likely that there will be an appeal against the judgment so we will keep a careful eye on developments.

About Francis Kean

Francis is an Executive Director in Willis Towers Watson's FINEX Global, where he specializes in insurance for Dir…
Categories: Asia, Australasia, Construction, Directors & Officers | Tags: , , , , ,

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