Seal 'N' Secure (1998) Limited (in liquidation) v Hartnell
[2014] NZHC 3375
•19 December 2014
IN THE HIGH COURT OF NEW ZEALAND AUCKLAND REGISTRY
CIV-2013-404-005068 [2014] NZHC 3375
BETWEEN SEAL 'N' SECURE (1998) LIMITED (In
liquidation) First Plaintiff
VIVIEN JUDITH MADSEN-RIES and
HENRY DAVID LEVIN Second Plaintiffs
AND
DAVID LESLIE HARTNELL First Defendant
DONALD MATHEW LEONARD Second Defendant
Hearing: 8 December 2014 Appearances:
R Thompson/K Kuang for the Plaintiffs
No appearance by or on behalf of Second DefendantJudgment:
19 December 2014
JUDGMENT OF WOOLFORD J
This judgment was delivered by me on Friday, 19 December 2014 at 4.00 pm pursuant to r 11.5 of the High Court Rules.
Registrar/Deputy Registrar
Solicitors: Meredith Connell, Barristers and Solicitors, Auckland
Chancery Street Chambers, Auckland
Solv Law Limited, Penrose, Auckland
SEAL 'N' SECURE (1998) LIMITED (In liquidation) v DAVID LESLIE HARTNELL [2014] NZHC 3375 [19
December 2014]
Introduction
[1] This is a claim by Seal ‘N’ Secure (1998) Limited (in liquidation) (“the company”) and its liquidators, as the first and second plaintiffs, against the second defendant, Donald Mathew Leonard, a director and shareholder of the company, to recover distributions received from the company. The plaintiffs also claim for breach of directors’ duties and seek orders that the second defendant pay compensation to the company for such sum that the Court considers just, calculated with reference to the liabilities of the company at the date of liquidation.
[2] The plaintiffs’ claim was initially brought against both the first and second defendants as directors and shareholders of the company. The first defendant took steps to defend the proceeding, but eventually settled the claim with the plaintiffs by paying a substantial sum of money to the plaintiffs without any admission of liability. The second defendant was served with the statement of claim, notice of proceeding and the plaintiffs’ initial disclosure on 17 December 2013. He has not filed a statement of defence and has chosen not to defend the proceeding. The
plaintiffs are therefore able to proceed by way of formal proof.1
[3] In preparation for the formal proof hearing on 8 December 2014, the plaintiffs filed affidavits sworn by one of the second plaintiffs, Henry David Levin, as liquidator of the company and Dennis Clifford Parsons, an independent expert, together with a synopsis of submissions, two volumes of documents and a bundle of authorities. On 8 December 2014, I heard from Ms R Thompson and Ms K Kuang on behalf of the plaintiffs. There was no appearance by or on behalf of the second defendant. The plaintiffs’ claim was therefore uncontradicted.
Company history
[4] The company was incorporated on 3 April 1998. It traded as a retail shop at Auckland International Airport. It ceased trading when the business was sold by an agreement for sale and purchase of a business dated 20 July 2011. On 7 December
2011, the company was placed in liquidation and the second plaintiffs were
appointed joint and several liquidators. Three creditors have filed claims in the
1 High Court Rules, r 15.9(1).
liquidation. The total amount of the claims is $256,909.86, of which $38,202.16 is preferential. The major claim is by the Commissioner of Inland Revenue (‘the Commissioner”) who has filed a claim totalling $255,912.34 relating to unpaid core income tax, unpaid core PAYE and GST as well as interest and penalties, together with Court costs as the petitioning creditor.
Discussion
[5] The second plaintiffs have undertaken an objective analysis of the solvency of the company which was approached by considering the whole of the company’s financial position, including the nature of its debts and obligations, the nature of its business and whether it had any realisable assets. The overall commercial reality of the company’s situation was also taken into consideration.
[6] On the basis of the uncontradicted affidavit evidence of Messrs Levin and
Parsons, I accept that the company was probably cash flow insolvent from at least 31
March 2006. By 31 March 2007, cash flow insolvency was almost indisputable. The company remained insolvent through to 23 May 2011 when the second defendant received his last distribution from the company, by which time it was balance sheet insolvent as well as cash flow insolvent.
[7] The company first defaulted on its tax obligations by failing to pay income tax for the financial year ending 31 March 2005 when it became due. It also defaulted on its tax obligations by failing to pay income tax for the financial years ending 31 March 2006, 31 March 2007 and 31 March 2008 when it became due. While the company was failing to pay income tax, the second defendant received the benefit of distributions from the company of $101,515.62, $25,378.75 and
$59,640.00 in the financial years ending 31 March 2006, 31 March 2007 and
31 March 2008 respectively.
[8] The plaintiffs’ position that the company was probably cash flow insolvent by 31 March 2006 was based on the fact that if the defendants had repaid their respective current account debts, the company may have been able to meet its due debts. However, the plaintiffs submit that there are no reasonable grounds to conclude that the defendants intended to do so. In fact, not only did the defendants
not repay their current account debts, they drew further cash that the company generated through trading by taking drawings for their personal use.
[9] The distributions to the second defendant were not authorised until directors’ resolutions in relation to the financial years ending 31 March 2006, 31 March 2007 and 31 March 2008 were signed on or about 16 March of 2009. At the same time, the second defendant also signed a solvency certificate stating that the company would, immediately after making the distributions, satisfy the solvency test. The uncontradicted affidavit evidence of Messrs Levin and Parsons is that, contrary to the solvency certificate signed by the second defendant, the company was clearly insolvent at that time.
[10] Shortly after the directors’ resolutions authorising distributions totalling
$186,534.37 to him were signed by the second defendant on or about 16 March
2009, the company reached an arrangement with the Commissioner in relation to its accrued income tax debt, which is recorded in a letter from the Commissioner to the company’s accountants dated 30 June 2009. The company’s debt to the Commissioner was calculated to be $265,160.32, which was to be paid by way of 24 monthly instalments of $4,000, with a final payment of $169,160.32 on 14 July
2011.
[11] The following year, the company defaulted on its arrangement with the Commissioner. It failed to make monthly payments of $4,000 to the Commissioner for the months of June and October 2010. Of the agreed debt of $265,160.32, only
$85,000 was paid up until 31 March 2011. Moreover, when the company ceased trading in July 2011, having sold its business for $90,000, none of the sale price was paid to the Commissioner in reduction of the accrued income tax debt.
[12] The company also fell behind on its current tax obligations soon after the arrangement had been made with the Commissioner on 30 June 2009 in relation to its accrued income tax debt. The company failed to pay PAYE to the Commissioner for the months ending 30 September 2009 and 31 November 2009 on the due dates. Accordingly, the company accumulated new penalties as at 11 January 2010. The company also defaulted on its PAYE and GST obligations in 2011. The company
defaulted on its PAYE obligations for the months ending 31 March 2011, 30 April
2011 and 31 May 2011. Similarly, the company defaulted on its GST obligations for the two month periods ending 31 January 2011, 31 March 2011, 31 May 2011, 31
July 2011 and 30 September 2011. As a result, the company also incurred penalties and interest on these core PAYE and GST debts.
[13] While the company was unable to pay its core income tax debt and failing to pay PAYE on the due dates, the second defendant received the benefit of distributions from the company of $28,160 and $80,160 in the financial years ending
31 March 2009 and 31 March 2010 respectively. The distribution of $28,160 to the second defendant in the financial year ending 31 March 2009 was not authorised by a directors’ resolution nor did the second defendant sign a solvency certificate when the distribution was made on or about 10 May 2009. The distribution was also made less than two months before the arrangement was reached with the Commissioner in relation to the company’s accrued income tax debt on 30 June 2009.
[14] The distribution of $80,160 to the second defendant in the financial year
ending 31 March 2010 was authorised by a directors’ resolution on or about 23 May
2011. A solvency certificate was also signed by the second defendant at the same time. The uncontradicted affidavit evidence of Mr Levin and Mr Parsons is that, contrary to the solvency certificate signed by second defendant, the company was clearly insolvent at that time. In fact, it was then defaulting on its PAYE and GST obligations. It was also due to pay $169,160.32 to the Commissioner in less than two months to clear its accrued income tax debt. Instead, it ceased trading in July
2011.
[15] The company’s most recent financial statements are for the financial year ending 31 March 2011. They record the balance owing on the second defendant’s current account as being $46,421. It is a well settled principle that advances made by a company to its shareholders are debts owed by the shareholder to the company
which are repayable on demand.2 On 21 February 2013 the company made demand
for this amount on the second defendant. No payment has been received from him and the amount outstanding under his current account remains due and owing.
2 Thom Contractors Ltd (in liq) v Thom HC Auckland CIV-2008-404-6829, 28 April 2009 at [16].
[16] In addition, the plaintiffs seek recovery of the distributions made to the second defendant under s 56(1) of the Companies Act 1993. It provides:
56 Recovery of distributions
(1) A distribution made to a shareholder at a time when the company did not, immediately after the distribution, satisfy the solvency test may be recovered by the company from the shareholder unless—
(a) The shareholder received the distribution in good faith and without knowledge of the company's failure to satisfy the solvency test; and
(b) The shareholder has altered the shareholder's position in reliance on the validity of the distribution; and
(c) It would be unfair to require repayment in full or at all.
[17] A distribution is in turn defined in s 2 as follows:
(2) distribution, in relation to a distribution by a company to a shareholder, means—
(a) The direct or indirect transfer of money or property, other than the company's own shares, to or for the benefit of the shareholder; or
(b) The incurring of a debt to or for the benefit of the shareholder—
in relation to shares held by that shareholder, and whether by means of a purchase of property, the redemption or other acquisition of shares, a distribution of indebtedness, or by some other means.
[18] Section 56(5) of the Companies Act gives a discretion to the Court to permit a shareholder to retain part of a distribution. It provides:
(5) If, in an action brought against a director or shareholder under this section, the Court is satisfied that the company could, by making a distribution of a lesser amount, have satisfied the solvency test, the Court may—
(a) Permit the shareholder to retain; or
(b) Relieve the director from liability in respect of—
an amount equal to the value of any distribution that could properly have been made.
[19] In this case, where the amount of the distributions sought to be recovered from the second defendant exceeds the total amount of the creditors’ claims, s 56(5) may be seen to be of some relevance. In National Trade Manuals Limited (In liquidation) v Watson,3 Venning J considered the application of s 56(5) in the context of a summary judgment application. The distribution at issue in that case was the sum of $204,741.88. It was established that immediately after the resolution
authorising the distribution, the company would have failed the insolvency test because the company’s liabilities exceeded its assets by $73,557. The defendant in that case, pursuant to s 56(5), sought to retain or be relieved of liability in respect of an amount equal to the value of the distribution that could properly have been made on the date in question.
[20] Venning J rejected his application and gave judgment to the plaintiff in the sum of $204,741.88. His Honour held that the defendant could not be said to have received the distribution in good faith as the Commissioner of Inland Revenue had already filed proceedings to liquidate the company based on a demand for $160,000.
[21] A company is therefore able to recover a distribution from a shareholder if immediately after the distribution was made the company was insolvent unless the Court is satisfied of all three of the requirements set out in s 56(1), bearing in mind the ability of the Court to grant some relief to a shareholder under s 56(5). The date for assessing the solvency of the company is the date of the directors’ resolution authorising the distribution as opposed to any earlier date on which the physical payment was made. Those dates were 16 March 2009, when the 2006 to 2008 distributions were made, 10 May 2009, when the 2009 distribution was made and 23
May 2011, when the 2010 distribution was made. The company was almost indisputably insolvent by 31 March 2007.
[22] As to the three requirements of which a Court needs to be satisfied in order to refuse an application by the company to recover distributions made when the company did not satisfy the solvency test, the second defendant has chosen not to
file a defence and provide evidence that he had no knowledge of the company’s
3 National Trade Manuals Limited (in liq) v Watson HC Auckland CIV-2005-404-007335, 20
September 2006
failure to satisfy the solvency test. On the other hand, the evidence filed by the plaintiffs discloses that the second defendant was often in contact with the Inland Revenue Department and was well aware of the company’s failure to file returns and its inability to meet its accrued income tax debt.
[23] Furthermore, without any input from the second defendant, there is no evidence that he has altered his position in reliance on the validity of the distributions. Nor have any issues of unfairness of requiring repayment in full or at all been raised by him. These are matters particularly within his knowledge and his choice not to defend the proceeding counts against him.
[24] Because the second defendant is liable to repay his current account in contract law and the distributions he received under s 56(1) of the Companies Act, it is unnecessary for me to consider the merits of the plaintiffs’ claims that the second defendant is also in breach of a number of director’s duties under the Companies Act, but it seems to me that there is real merit in these claims as well. Mr Levin expresses the position simply:
16.3The defendants used their position as directors to withdraw significant sums and paid those sums to themselves as shareholders. They did this without keeping appropriate records for the other uses that money should have been put to, notably making provision for, and paying when due, tax liabilities.
16.4I think it is clear that by failing to organise annual financial statements and tax returns (or keep a track of accumulating tax liabilities) the defendants for many years up until March 2009 failed to keep adequate accounting records as they were obligated, and this failure was a critical factor in creating the set of circumstances which produced the creditor losses. Also, if Mr Hartnell’s defence that the financial statements prepared for the Company were not finalised and/or inaccurate, the defendants have in my view never remedied this breach.
16.5In or about March 2009, the defendants finally organised accounts and tax returns to be completed for the periods from 31 March 2005 to 31 March 2008. These disclosed large unmet liabilities. Rather than repaying the money they had borrowed from the Company, they authorised distributions of $298,455 to seek to eliminate their obligation to repay that amount. That amount would have repaid all the overdue tax debt at the time, but the defendants instead chose to leave the overdue tax debts unpaid.
16.6In May 2009, the defendants organised accounts and tax returns to be completed for the year ended 31 March 2009. This quantified the Company’s further tax debts, and of course further interest had accrued on the outstanding tax debts. Their response was to authorise a further $45,056 of distributions, bringing total distributions authorised in the 2 months (from March 2009 to May
2009) to $343,511, to the further detriment of the Company and its creditors.
16.7In May 2011, the defendants authorised a final $128,456 of distributions. This brought the total distributions for the 2006 to
2010 years to $471,767, made while they knew the Company was insolvent and had significant overdue debts to Inland Revenue. If
they had not authorised these distributions, they would have been liable to repay the Company an additional $471,767 as shareholders.
Although, by that time, it was probably too late for creditors to receive the full benefit of the current account debt, as the amount
was by then so large it may have only led to the defendants’ bankruptcy. The damage to creditors had been done when the money was withdrawn while the Company did not keep appropriate
records for, or make appropriate provision for, its liabilities arising as the result of the very same trading that had generated the cash that
the defendants paid to themselves.
16.8I do not regard the loss to creditors as having been caused by the directors taking legitimate business risks. Taking cash when no proper record is kept of a company’s liabilities, and then refusing to return it when the extent of the company’s liabilities is finally disclosed, cannot in my view be regarded as activities associated with the normal risk of running a business. In my view, the risks to, and losses borne by, creditors are much more fairly described as consequent on the defendants misusing their position as controllers of the company for their personal benefit, and not in the best interest of the company.
16.9In short, I consider the defendants failed to exercise the care, diligence and skill of a reasonable director. In addition to the failures I have summarised above, they also permitted the company to continue trading when there were no reasonable grounds to believe it was able to meet its obligations incurred through trading. By doing so, in my view, the defendants agreed to and/or caused or allowed the business of the company to be carried on in a manner likely to create a substantial risk of serious loss.
16.10Put another way, but for the self-interested actions of the defendants, the company would have had sufficient funds to pay its debts. It was the conscious and deliberate actions of the defendants in taking such extensive drawings, and then authorising the 2006 to 2010 distributions, which inflicted losses on the company’s creditors. In these circumstances, there is a clear and obvious link between the defendants’ actions as directors and the loss suffered by the company’s creditors. Notably, these losses were not caused by the risks normally associated with the company’s trading in a competitive environment.
Result
[25] Accordingly, there is judgment in favour of the plaintiffs against the second defendant in the sum of $341,275.37, which comprises the second defendant’s current account of $46,421 and the distributions made to the benefit of the second defendant of $294,854.37.
[26] I note that this is $84,365.51 in excess of the total of creditor claims. However, the costs of liquidation as at 31 August 2014 total $76,731.65 plus GST in addition to legal costs, which have been accrued but have not been billed. The liquidation of the company can again be directly linked to the actions of the second defendant in leaving the company’s significant debts unpaid for such an extensive period of time, not as a consequence of normal business risks but as a result of deliberate actions in withdrawing cash and making distributions to himself.
[27] The plaintiffs are also entitled to costs on a 2B basis for this proceeding.
……………………………….
Woolford J
0
0
1