Fordyce Road Development Limited (in liquidation) v Khan

[2019] NZHC 2288

IN THE HIGH COURT OF NEW ZEALAND AUCKLAND REGISTRY

I TE KŌTI MATUA O AOTEAROA TĀMAKI MAKAURAU ROHE

CIV-2019-404-1099

[2019] NZHC 2288

BETWEEN

FORDYCE ROAD DEVELOPMENT LIMITED (IN LIQUIDATION)

First Applicant

BRYAN EDWARD WILLIAMS
Second Applicant

AND

FEROZ KHAN

First Respondent

CAROL LEON KHAN

Second Respondent

Hearing:	11 September 2019
Appearances:	M D Arthur and M Brengauz for Applicants No appearance for Respondents
Judgment:	12 September 2019

JUDGMENT OF LANG J

This judgment was delivered by me on 12 September 2019 at 4 pm, pursuant to Rule 11.5 of the High Court Rules.

Registrar/Deputy Registrar Date……………

FORDYCE ROAD DEVELOPMENT LTD (IN LIQ) v KHAN [2019] NZHC 2288 [12 September 2019]

[1]    This proceeding concerns a company called Fordyce Road Development Limited (Fordyce). Fordyce was placed in liquidation by resolution of its shareholders on 6 May 2016. The second plaintiff, Mr Williams, is Fordyce’s liquidator.

[2]    The defendants, Mr and Mrs Khan, were at various times Fordyce’s directors and shareholders. Mr Khan incorporated Fordyce on 5 September 2013 as the entity through which he proposed to carry out a subdivision project on land situated in Parakai, to the north of Auckland City (the Parakai land).

[3]    Mr Khan remained the sole director and shareholder of the company until September 2015. In that month his wife and brother Fazloor Khan became the joint owners of the all of the shares in the company. That remained the position until the company was placed in liquidation. In September 2015 Mr Khan also resigned as director and was replaced by his wife and Fazloor Khan. They resigned as directors on 31 March 2016 and Mr Khan again became the company’s sole director. That remained the position until the company was placed in liquidation.

[4]    On or about 27 November 2014 Mr Khan nominated Fordyce as purchaser under an existing agreement for the sale and purchase of the Parakai land. Fordyce was unable to complete the purchase of the land and the vendors ultimately cancelled the contract. On 6 May 2016 Mr Khan’s wife and brother passed a shareholders’ resolution placing the company in liquidation.

[5]    In this proceeding Mr Williams, in his capacity as Fordyce’s liquidator, contends that Mr Khan breached statutory duties he owed to the company under the Companies Act 1993 (the Act). He seeks orders under ss 300 and 301 of the Act requiring Mr Khan to pay compensation to the company for breaching these duties. In addition, the liquidator seeks recovery from Mr and Mrs Khan of funds that he says they received but which belonged to the company.

[6]    The proceeding has been served on both Mr and Mrs Khan but they have taken no steps to defend the liquidator’s claims. The trial has therefore proceeded on an uncontested or formal proof basis.

Background

[7]    Mr Khan entered into the agreement to purchase the Parakai land on 10 April 2013. The purchase price was initially $2.8 million. The agreement required the purchaser to pay a deposit of $280,000 when the agreement became unconditional. In addition, the purchaser was required to make an additional payment of $650,000 on  2 December 2013.

[8]    The agreement was conditional on the purchaser carrying out a due diligence investigation to satisfy himself that the property was suitable for the proposed development. Mr Khan proceeded on the basis that he would not confirm satisfaction of this condition until he had obtained a resource consent permitting him to develop the Parakai land on terms acceptable to him.

[9]    Not surprisingly, the application for resource consent required the outlay of considerable funds. Fordyce borrowed money to meet these costs from third parties, including Mr Khan’s adult children. It appears to have begun doing so even before Mr Khan formally nominated Fordyce as purchaser under the agreement for sale and purchase.

[10]   On or about 10 September 2013 Fordyce entered into a term loan agreement with a company called Qian DuoDuo Ltd under which it borrowed the sum of

$110,000. This loan was to be repaid in September 2014 and required Fordyce to pay interest at the rate of 27 per cent per annum. Between 5 and 25 March 2014 Fordyce borrowed the sum of $30,000 from Mr Khan’s son Faizal. In October 2014 Fordyce also entered into a loan agreement with another son, Riaz Khan, for the sum of

$10,000. Interest was to run at ten per cent per annum on that advance. Fordyce used these funds to pay various creditors for the services they provided in relation to the application for resource consent.

[11]   The Auckland Council declined the application for resource consent, but on 20 August 2015 the Environment Court allowed an appeal by Fordyce against that decision. The Environment Court granted Fordyce a resource consent to subdivide the Parakai land into 65 residential lots and to carry out associated earthworks.

[12]   The delay that occurred in obtaining the resource consent required Fordyce and the vendors to vary the agreement for sale and purchase on several occasions. By December 2013 the agreed purchase price had increased to $3.25 million plus GST. In addition, the date for satisfying the due diligence condition had been extended to 31 July 2014, and the date of settlement was to be 20 October 2014. Fordyce was also required to pay a deposit of $700,000 no later than 20 August 2014.

[13]   In December 2014 the date for satisfaction of the due diligence condition was further extended to 27 February 2015 and the amount of the deposit was amended to 20 per cent of the purchase price. The date of settlement was amended to 20 April 2015 and the date of possession was to be 1 October 2015.

[14]   In October 2015 the vendors granted an extension until 31 October 2015 for that purchaser to declare the agreement unconditional but all other conditions were stated to remain the same. It is difficult to discern the agreed date of possession at that point because the agreement reached in December 2014 provided for the date of possession to be 1 October 2015.

[15]   Fordyce failed to obtain the necessary finance to either pay the required deposit or settle the purchase of the property. As a result, the vendors purported to cancel the agreement on 5 November 2015.

[16]   A dispute then arose as to whether the vendors were within their rights to cancel the agreement. This was ultimately settled in late April 2016, when the vendors paid Fordyce the sum of $100,000 to settle all claims it may have had against them arising out of the purported cancellation of the agreement. Fordyce then went into liquidation on 6 May 2016. Three of the five causes of action in this proceeding relate to the manner in which Mr Khan dealt with the settlement funds.

[17]   The liquidator’s investigations revealed that Mr and Mrs Khan held an account with Kiwibank having a credit balance of $125,359.55 as at 30 June 2019. That account is currently the subject of a freezing order made by this Court on 19 June 2019 and subsequently extended to 11 October 2019.

First and second causes of action: Breach of duties under ss 135, 136 and 137 of the Companies Act 1993

[18]   The liquidator contends that Mr Khan breached his statutory duties under ss 135, 136 and 137 of the Act. Section 135 prohibits directors from permitting 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. Section 136 prohibits directors from permitting the company to incur an obligation unless they believe on reasonable grounds the company will be able to perform the obligation when it is required to do so. Section 137 requires directors to exercise the care, diligence and skill that a reasonable director would exercise in the same circumstances.

The tests to be applied

Section 135

[19]   In Mason v Lewis the Court of Appeal confirmed that the duty under s 135 is owed by directors to the company rather than to creditors.1 Furthermore, the test under s 135 is objective and focuses not on the director’s belief but rather on the manner in which the company’s business was carried on and whether this created a substantial risk of serious loss. In some cases a director may take risks and, viewed objectively, these may be either legitimate or illegitimate. Section 135 is concerned only with risks that are objectively illegitimate.

[20]   In short, the section requires a director to make a “sober assessment” as to the company’s likely future income and prospects once it encounters financial difficulty or approaches insolvency. Furthermore, where a company has little or no equity, the directors will need to carefully consider whether the company has realistic prospects of generating future cash income sufficient to service both pre-existing debt and the inevitable commitments that such trading attracts.2

1      Mason v Lewis [2006] 3 NZLR 225 (CA) at [51].

2      Fatupaito v Bates [2001] 3 NZLR 386 (HC) at [67].

Section 136

[21]   Section 136 prohibits a director from incurring an obligation unless he or she believes on reasonable grounds the company will be able to perform the obligation when required to do so. The test under this section includes both subjective and objective elements.3 A director will breach the duty unless he or she subjectively believes, at the time the company incurs an obligation, that the company will be able to meet the obligation when it is required to do so. The director’s subjective belief must, however, be based on objectively reasonable grounds. In this context the words “will be able” suggest the need for a degree of certainty in the director’s mind that the company will be able to perform the obligation in question when it is required to do so.4

[22]   In Jordan v O’Sullivan, Clifford J observed that when breaches of both sections 135 and 136 are alleged, there is likely to be a common enquiry as to whether the director engaged in illegitimate trading in the form of taking illegitimate risks.5 This should not, however, disregard the distinct tests under the two sections and the differing requirements imposed by each.

Section 137

[23]   Section 137 requires a director to exercise the care, diligence and skill that a reasonable director would exercise in the same circumstances. In undertaking that enquiry the section requires the Court to take into account, without in any way limiting or restricting the enquiry, matters such as the nature of the company, the nature of any decisions made and the role and responsibilities assumed by the director. The section requires an objective standard to be applied in relation to relevant decisions made by a director.6 The standard to be applied is that of a reasonably competent director.7

[24]   I consider it convenient to deal with the claims under all three sections together, because the allegations underpinning each claim are essentially the same.

3      Jordan v O’Sullivan HC Wellington CIV 2004-485-2611, 13 May 2008, at [55].

4      Goatlands Ltd (in liq) v Borrell (2006) 3 NZCCLR 726 (HC) at [114].

5      Jordan v O’Sullivan, above n 3, at [62].

6      Grant v Johnson [2016] NZCA 157.

7      Richard Geewiz Gee Consultants Ltd(in liq) v Gee [2014] NZHC 1483 at [105].

Analysis

[25]   As will already be evident, Fordyce was incorporated solely for the purpose of completing the subdivision development. This required it first to meet the costs associated with obtaining resource consent and then to meet its obligations under the agreement for sale and purchase. These required it to pay a substantial deposit and then to pay the balance of the purchase price on settlement.

[26]   Significantly, Mr Khan did not provide Fordyce with any working capital by way of either paid up share capital or shareholders’ advances. It appears inherently improbable in any event that Mr Khan would have been able to provide it with the necessary funding himself. He had been adjudicated bankrupt on two occasions prior to entering into the agreement to purchase the property. He was first adjudicated bankrupt on 22 July 1998 and was discharged automatically from that bankruptcy on 22 July 2001. He was then adjudicated bankrupt again on 11 February 2010 and was automatically discharged from that bankruptcy on 11 February 2013. This was just two months before he entered into the agreement for sale and purchase.

[27]   Furthermore, this was not the first occasion on which Mr Khan had attempted to develop land in the Parakai area. On 2 November 2006 Mr Khan had incorporated another company of which he was the sole director. That company was also involved in the attempted development of land in the Parakai area. It was placed in liquidation on 12 January 2010 and Mr Khan’s second bankruptcy followed just one month later. This history of business failure meant that Mr Khan and Fordyce were unlikely to be attractive lending propositions for most financial institutions. It is therefore not surprising that such funding as Mr Khan was able to procure came from associates and family members.

[28]   The liquidator conducted an examination of Mr Khan under s 261 of the Act on 23 August 2018. During the examination the liquidator asked Mr Khan how he intended to fund the application for resource consent and the obligations imposed on Fordyce under the agreement for sale and purchase. Mr Khan’s answers to these questions were extremely vague. In summary, he appeared to be of the view that once resource consent was obtained the value of the land would rise significantly. This

would provide him with the necessary equity to approach a financier and obtain sufficient funding to meet all costs, including the purchase of the land. He referred in very vague terms to discussions he had held with a financier, and also talked about obtaining funding through a nominee company operated by his then solicitors. It is clear from Mr Khan’s evidence given at the examination, however, that he never formulated any realistic or workable strategy for the funding of the project.

[29]   Given its lack of funding from the outset I accept the liquidator’s submission that Fordyce became insolvent as soon as it began to incur significant costs relating to the application for resource consent. It had no means to pay these debts because it derived no income from trading activities and had little prospect of obtaining funding from either its sole shareholder or from financial institutions. Once the limited assistance provided by Mr Khan’s associates and family members ended it had no means of financial survival.

Decision: liability

[30]   The starting point in the present case is the fact that Mr Khan was the sole director of the company during the period when Fordyce incurred virtually all of its indebtedness. He was therefore the person who assumed day to day responsibility for decisions made and actions taken by the company. He was also the person responsible for deciding how Fordyce would fund the costs that would inevitably be incurred in the subdivision project.

[31]   I accept that Mr Khan was not the director of the company between September 2015 and March 2016 but  by that  stage  the  die  was  already cast.  Furthermore, Mr Khan effectively acknowledged during his examination by the liquidator that he remained in control of the company’s activities during this period.

[32]   The complete failure by Mr Khan to develop any realistic financial strategy for meeting Fordyce’s contractual obligations leads to the inevitable conclusion that he breached his obligations under sections 135, 136 and 137 of the Act. In terms of s 135, he allowed Fordyce to incur significant indebtedness that it had no way of meeting without funding from either himself as sole shareholder or from third parties. Given the lack of any realistic prospect of funding from these sources his actions created a

substantial risk of serious loss to the company’s creditors, including members of his own family.

[33]   In terms of s 136, Mr Khan had no grounds for believing, let alone believing on objectively reasonable grounds, that Fordyce would be able to meet the obligations he caused it to incur. And, in terms of s 137, no reasonable director in the same circumstances would have permitted Fordyce to incur those obligations when it had no realistic hope of meeting them. Mr Khan therefore failed to exercise the care, diligence and skill that a reasonably competent director would have exercised in those circumstances.

[34]   I therefore accept the submission for the liquidator that this is a paradigm case of reckless trading and the taking of illegitimate risks. Mr Khan plainly breached his statutory obligations to the company under ss 135, 136 and 137 of the Act.

Quantum

[35]   Section 301 of the Act permits the Court to order any director who has breached the obligations imposed by the Act to pay compensation to a company that has suffered losses as a result of the breach. As Mr Arthur points out for the liquidator, in this context the courts have often compared the financial position of the company at liquidation with the position it was in when a decision ought to have been made to cease trading.8

[36]   In the present case, however, Fordyce became insolvent virtually immediately after its incorporation when it began to incur debts that it had no realistic means of paying. It should not have been trading from the outset given the lack of any source of funds to meet its obligations. Furthermore, Mr Khan is the sole cause of the company’s losses. He cannot attribute blame for the losses to any cause other than his own conduct. It is therefore appropriate and just that Mr Khan should compensate Fordyce for all of the losses it suffered whilst he was the sole director of the company.

8      Mason v Lewis, above n 1, at [109]; Sojourner v Robb [2007] NZCA 493, [2008] 1 NZLR 751 at [71]-[73].

[37]   The liquidator calculates that, as at the date the present proceeding was filed, Fordyce’s creditors had suffered losses totalling $339,778.03. Of that amount, the sum of $189,778.03 represented debts owing to trade creditors who provided it with services in support of its application for a resource consent. The remaining sum of

$150,000 represents the loans obtained from third parties, including Mr Khan’s two sons.

[38]   Mr Khan will therefore be required to pay the company compensation in the sum of $339,778.03 under the first two causes of action.

Third and fourth causes of action: breach of s 131 of the Companies Act 1993 and breach of fiduciary duty to the company

[39]   These causes of action are based on events that occurred after Fordyce received the sum of $100,000 from the vendors in settlement of any claim arising out of the vendors’ actions in purporting to cancel the agreement for sale and purchase.

[40]   On Mr Khan’s instructions the vendors’ solicitors paid the settlement funds into the trust account of Fordyce’s solicitors on 22 April 2016. This was a different firm of solicitors from those who had been acting for Fordyce in relation to the agreement for sale and purchase. On the same date, Mr Khan directed Fordyce’s solicitors to pay the sum of $97,274.50 into his personal bank account. This represented the balance of the settlement sum after deducting legal fees paid to the solicitors.

[41]   On 28 April 2016, just over a week before Fordyce went into  liquidation,  Mr Khan used these funds to pay the sum of $35,000 to Peters Property Holdings Ltd, one of Fordyce’s creditors.

[42]   On 8 July 2016, Mr and Mrs Khan met with the liquidator. Neither told him about the existence of the settlement funds. On the same day Mr Khan transferred

$20,000 of the settlement funds to his wife. He then transferred a further sum of

$9,000 to her on 28 July 2016.

[43]   The transcript of the examination conducted by Mr Williams under s 261 of the Act on 23 August 2018 reveals that Mr Khan told the liquidator he could not recall anything about the offer of settlement by the vendors following cancellation of the agreement for sale and purchase. That evidence was obviously of dubious credibility.

[44]   The liquidator alleges that the manner in which Mr Khan dealt with the settlement funds amounted to a breach of his statutory obligations under s 131 of the Act to act in good faith and in the best interests of the company. The liquidator also contends it amounted to a breach of Mr Khan’s fiduciary duty not to profit personally from his position as a director and not to allow a conflict of interest to arise between his own interests and his duties as a director. In this context directors have a duty to ensure that company funds are not misapplied.9

[45]   The manner in which Mr Khan dealt with the settlement funds has several distinguishing features. First, it shows he took active steps to conceal the existence of the settlement and the disbursement of the settlement funds. He went to the extent of instructing new solicitors apparently for the sole purpose of receiving and disbursing the settlement funds. He was then deliberately vague about the settlement in response to questions from the liquidator even though he must have known full well what had happened.

[46]   Secondly, the steps taken by Mr Khan to conceal the transaction were successful because the liquidator was required to expend considerable time and effort to ascertain what had happened both in relation to the settlement and the disbursement of the settlement funds.

[47]   Thirdly, Mr Khan used the settlement funds for three purposes, only one of which was for the benefit of the company even though it was the beneficial owner of the funds. First, he repaid one of the company’s creditors and in doing so clearly preferred that creditor over the remaining creditors. Secondly, he paid the sum of

$29,000 to his wife even though she had no entitlement to it. Thirdly, he retained the balance in his personal bank account where it was mixed with his own funds.

9      Shannon Agricultural Consulting Ltd (In liq) v Shannon [2015] NZHC 1133 at [26]; Intext Coatings Ltd v Deo (In liq) [2016] NZHC 2754, [2017] NZAR at [53].

[48]   In the absence of any explanation for his actions I consider these events demonstrate that Mr Khan probably acted dishonestly throughout in dealing with the settlement funds. He certainly largely preferred his own best interests and those of his wife rather than the best interests of the company. The conduct amounts, in my view, to a clear breach of Mr Khan’s duty under s 131 to act in good faith and in the best interests of the company. It also amounts to a breach of Mr Khan’s fiduciary duty to the company. He put his own interests and those of his wife ahead of those of the company in what amounted to an obvious conflict of interest.

[49]   The remedy for both forms of breach is straightforward. Mr Khan should be required to restore to the company the funds he appropriated from it. The liquidator accepts that Mr Khan should not be required to repay the funds he paid to Peters Property Holdings Ltd because Fordyce benefited from that payment even though it resulted in one creditor being preferred over the others.10 Mr Khan will therefore be required to repay the sum of $62,274.50 to Fordyce under these causes of action.

Fifth cause of action: knowing receipt

[50]   This cause of action is pleaded against Mrs Khan alone. It is based on the fact that Mr Khan paid her the sum of $29,000 from the settlement funds received from the vendors. The liquidator contends Mrs Khan received the funds subject to a constructive trust in favour of the company because she knew when she received them that in making the payment to her Mr Khan was acting in breach of his fiduciary duty to the company.11

[51]   In McLennan and Van Delden as liquidators of Neil Timber Ltd (in Liquidation) v Livaja the Court of Appeal observed:12

[38]      A claim for knowing receipt, however, depends on the tainted circumstances of receipt of property. Liability will arise where it is unconscionable for the recipient to retain it because of the recipient's state of

10     The liquidator has indicated he proposes to set this transaction aside using his powers under s 292(1) of the Act.

11     Equiticorp Industries Ltd (in stat management) v The Queen (Judgment No 47) [1998] 2 NZLR 481 (HC) at 540 and 638.

12     McLennan and Van Delden as liquidators of Neil Timber Ltd (In Liquidation) v Livaja [2017] NZCA 446.

knowledge in respect of the fact that the transfer involved a breach of fiduciary obligations owed by the transferor.

[39]      Different High Court judgments have described the basis for knowing receipt as either unconscionability or unjust enrichment, a divergence possibly arising from the nature of the remedy applied in such cases. This in turn has led to differing conclusions as to the level of knowledge required to establish liability.

[40]      We consider that the correct basis for knowing receipt is unconscionability. We prefer to characterise the liability incurred on a finding of knowing receipt as a personal liability to account in equity to the beneficiaries by restoring the property lost by the unconscionable receipt. The core duty of that liability is to restore misapplied assets, or their equivalent, to the beneficiaries.

(Footnotes omitted)

[52]   In the present case I have no hesitation in concluding that Mrs Khan must have had actual knowledge that the funds she received came for the settlement with the vendors, and that the funds belonged to Fordyce rather than to her husband. I reach that conclusion for several reasons. First, Mrs Khan was married to Mr Khan and could reasonably be expected to be aware of her husband’s actions. More importantly, she had been a shareholder and director of the company between September 2015 and March 2016. She would therefore have known of the purchase of the property because it was still on foot during that period. I have no doubt that she also knew of the circumstances that led to the purported termination of the agreement by the vendors. Significantly, she and Mr Fazloor Khan signed a shareholders’ resolution on 8 April 2016 approving the acceptance by Fordyce of the settlement offer from the vendors.

[53]   Furthermore, the company had been in liquidation for approximately three months when Mrs Khan received the payments from her husband. She was obviously aware of that fact because she and Mr Fazloor Khan had signed the resolution placing the company in liquidation on 6 May 2016. Mrs Khan must also have known that any funds received by the company after that date were earmarked for the benefit of the company’s creditors. Finally, I have little doubt that Mrs Khan would have wanted to know the source of the two payments that her husband made to her. There is no reason to believe he would have lied about that issue.

[54]   Taken together, these factors persuade me that Mrs Khan received the funds in circumstances where she had actual knowledge that they belonged to the company and

had been wrongfully paid to her by her husband. Her actions in receiving the two payments of funds belonging to the company in these circumstances mean it would be unconscionable for her to be permitted to retain them. Grounds have therefore been established justifying intervention by the Court in its equitable jurisdiction to require Mrs Khan to repay those funds to the company.

Result

[55]   Under  the   first   and  second  causes  of  action   I  make  an  order  under    s 301(1)(b)(ii) of the Act requiring Mr Khan to contribute the sum of $339,778.03 to the assets of the company.

[56]   Under the third cause of action I make an order under s 303(1)(b)(i) of the Act requiring Mr Khan to restore the sum of $62,274.50 to the first applicant. Under the fourth cause of action I award the first applicant equitable damages against Mr Khan in the sum of $62,274.50. The judgments entered under these two causes of action may be satisfied by Mr Khan making a single payment to the first applicant in the sum of $62,274.50.

[57]   Under the fifth cause of action I enter judgment against Mrs Khan and in favour of the first applicant for the sum of $29,000. The first applicant shall not, however, be entitled to recover this sum from Mrs Khan if Mr Khan satisfies the judgments entered under the third and fourth causes of action.

Interest

[58]   Mr Khan is to pay the first applicant interest on the sums awarded under the first and second causes from the date of liquidation until that date of payment of those sums. Interest shall be calculated in accordance with the relevant provisions of the Interest on Money Claims Act 2016.

[59]   Mr Khan is to pay the first applicant interest on the sums awarded under the third and fourth causes of action from 22 April 2016 until the date of payment. Interest shall again be calculated in accordance with the relevant provisions of the Interest on Money Claims Act 2016.

[60]   Mrs Khan is to pay the first applicant interest on the sum of $20,000 from 8 July 2016 until the date of payment and on the sum of $9,000 from 28 July 2016 until the date of payment. In each case interest is to be calculated in accordance with the relevant provisions of the Interest on Money Claims Act 2016.

Costs

[61]   The first applicant has been the successful party and is entitled to costs against Mr Khan to be calculated on a category 2B basis together with disbursements as fixed by the Registrar.

[62]   The claim against Mrs Khan formed a relatively small part of the overall claim and could easily have been dealt with by a straightforward application for summary judgment. I therefore direct that the first applicant is also entitled to an award of costs against Mrs Khan calculated on a category 2B basis but this is to be reduced by 50 per cent to reflect this fact. Mrs Khan is also to be jointly liable with Mr Khan for payment of disbursements as fixed by the Registrar. Mrs Khan’s liability to pay costs and disbursements will, however, be extinguished if Mr Khan satisfies in full the award of costs and disbursements made against him.

Lang J

Solicitors:

Chapman Tripp, Auckland