Recouping Liquidation Costs through Litigation against Directors—a Dubious Practice

In the last few years there had sprung up in New Zealand a series of first instance cases where judges had acceded to pleas by liquidators that the damages for which company directors could be found liable as a result of having, without fraud, breached their directors’ duties could extend to the costs of running the ensuing liquidation. No special statutory fiat was invoked, just ordinary compensatory principles. The cases were decided under the summary remedy procedure that dates to the 19^th century and is still common to the statute books of the United Kingdom (see Insolvency Act 1986 (UK), s 212) and New Zealand (Companies Act 1993 (NZ), s 301). The Court of Appeal has now knocked back these cases: Re Aluminium Plus Wellington Ltd, Shaw v Owens [2017] NZCA 315, [2018] NZAR 606 (Aluminium Plus case). The Court could see that this new development was becoming a gravy train for liquidators.

In Aluminium Plus, the underlying debts of the company at liquidation were only $61,000, but with interest a default judgment had been entered for $87,600. The judge at first instance found that the debts had arisen as a result of the poor way in which the company had been run, and for that reason the director should be liable for them. The judge then added to that $26,900 to cover the liquidators’ expenses. The liquidators had initially claimed expenses of $43,000, but conceded that they had to deduct the costs incurred in actually suing the director. Those costs were properly only the subject of a costs award in the litigation. On appeal, the Court of Appeal reduced the additional liability awarded against the director to $7,500.

It follows that the Court of Appeal did not see that it was wrong in principle to make directors liable for the costs of the liquidation. But the Court expressly sent a signal that liquidators should run a liquidation bearing firmly in mind the scale of the insolvency.

The issue of principle is, however, a difficult one. Does the liquidation of the company draw a line under the damages for which a director can be accountable for his or her fault in running the company? One can put aside for these purposes the fact that insolvency legislation does often provide for the imposition of liability on directors for costs caused by failing to keep proper financial records for the company in a way which makes a liquidator’s task more difficult: in New Zealand, see Companies Act 1993, s 300.

One way to test the issue might be to ask what would have happened if no insolvency had occurred but the company had sued a former director for breach of his or her duty of care and skill in running the company. Can one claim the costs of bringing in outside expertise to put the company’s business back on the rails? Probably yes. But the costs incurred in a liquidation are not necessarily linked to breach of duty. It is perfectly legitimate to put a company into liquidation, whether it is solvent or not. There is no duty on shareholders to sell their shares in a company that owns a viable business rather than resolve to liquidate the company. The basic costs of winding up a company will still be incurred, whether or not there have been breaches of duty. This is an argument that often there will not be a sufficient causative connection between the breach of duty and liquidation costs.

Another argument against imposing liability for liquidation costs rests on the convenience of crystallising liabilities at the commencement of liquidation. This already happens with claims. It is true that in relation to claims, post-liquidation interest is usually subordinated to repayment of the capital of debts as they stood at the commencement of liquidation, whereas this is not usually the case with liabilities; they continue to accrue interest until paid. But it is one thing to accrue interest on losses caused by a director’s breaches of duty, and another thing to add to that base liability post-liquidation costs. Even directors should be entitled to know where they stand, and not be exposed to the way in which a liquidator conducts the liquidation.

Can guidance be obtained from other jurisdictions? Making directors liable for the costs of a liquidation was a live issue in Re Ralls Builders Ltd (No 2) [2016] EWHC 1812 (Ch), [2016] 1 WLR 5190 (Ralls Builders case). This decision involved proceedings for ‘wrongful trading’ under s 214 of the Insolvency Act 1986. This provision confers a broad discretion on the court to require defaulting directors to make such contribution to the company’s assets as the court thinks proper. As in Aluminium Plus, the liquidators initially sought to make the directors liable for all the costs of the liquidation, but at trial they accepted that they could not claim for the legal costs of bringing the wrongful trading claim. They also ceased to claim for liquidation costs that would have been incurred without any wrongful trading. On the facts, this left only the costs of their own time, and related expenses, in pursuing the wrongful trading claims.

In Ralls Builders, Snowden J rejected the liquidators’ claims. He held that the liquidators’ own expenses in the litigation were no more recoverable than the costs spent on lawyers. They were all sunk costs in bringing the cause. There was, therefore, no need in Ralls Builders to focus on whether, for example, the sheer number of extra debts had made the liquidation more expensive than a standard liquidation, if there is such a thing. At the same time, there is nothing in Snowden J’s judgment to encourage the idea that there might be a window for recovery of liquidation costs, outside awards of legal costs in the action.

The judgment of Snowden J in Re Ralls Builders has been the subject of trenchant criticism by Gabriel Moss QC ((2017) 30 Insolvency Intelligence 49) on the basis that the judge made the errant director liable only for the net worsening of the company’s debts through wrongful trading rather than liable for the new debts that would not have been incurred had he stopped the company trading, as he should have. Even if Snowden J were wrong on his basic approach, it would not answer the question whether the new liabilities for which a director should be made liable ought to extend to the liquidator’s costs.

For what it is worth, I think Snowden J’s general approach is defensible. Mr Moss may have the legislative history on his side, but if he is right the section (s 214 of the Insolvency Act) is incoherent. If the intention of the section is to protect only providers of new credit, then why does the section give the remedy to old and new creditors? If one is concerned with first principles, it is not at all obvious that the law should concern itself with continued, but honest, trading that simply results in the company treading water. Certainly, creditors should be individually protected against fraud. But the case for protecting each of them against negligently caused economic loss is far from clear, in the face of the fact that other creditors have benefited from the continued trading.

The Australian insolvent trading regime does not rely on the common law. It is bespoke in its substance and in its remedies. As to remedies, the regime can certainly operate punitively. There is a civil penalty regime for some types of breach (Corporations Act 2001 (Cth), Part 5.7B, Division 4) but even without that defaulting directors can be made liable for the company’s debts without regard to causation (s 588M). There appears to be a difference of judicial view as to whether in imposing liability account should be taken of the likely dividend that creditors will receive in the liquidation: see the discussion of the cases in Re Swan Services Pty Ltd [2016] NSWSC 1724 at [208]ff. It seems that no direct order to pay the costs of liquidation can be made, but to the extent that any liquidation dividend has been reduced by the liquidator’s costs, the director would be effectively carrying those costs when made liable for the outstanding debts. In the writer’s view it is not a regime to be emulated.

Peter Watts QC is a Senior Research Fellow at Harris Manchester College, University of Oxford.