Risky business

What happens when your building company goes down the slippery slope?

If you’re doing anything more complex than home handyman jobs, then construction is a risky business. If you have to commit to a fixed price on bigger new builds, renovations, or infrastructure projects, then you run the risk of having under-priced the job. If you are doing it on a cost reimbursement basis then you run the risk of major budget blowouts. Either of these can result in tensions with your client and ultimately unpaid invoices and expensive disputes. Sometimes these make such a big hole in your cash flow that you can’t pay your bills as they fall due. And when you get to that stage, technically you are insolvent. When you become insolvent, several things typically happen. Your subbies withdraw their labour, your suppliers put you on stop credit, and both of them hound you for payment. Your bank and landlord get twitchy. You can’t progress the build as promptly as you need to, which causes your client to stop paying. You use deposits and progress payments from newer projects to pay the suppliers and subcontractors on the problematic ones. And your more aggressive creditors serve statutory demands on you.

What is a Statutory Demand? It is a form that your creditors can give you under the Companies Act that gives you 15 working days to pay their debt, otherwise your company is deemed to be insolvent. Failure to pay in time enables the creditor to apply to the court to put your company into liquidation. That takes a few months to achieve, and there are various defences you can raise, but the application to liquidate your company becomes public knowledge at a very early stage. You can take comfort in the fact that statutory demands can only be used for undisputed debts, so unless you have conceded that the debt is payable, then you can always dispute it. But in the meantime, if you want to stop the word getting out then you only get 10 working days to apply to the court to shut the whole thing down, and that costs a lot.

What else can happen to you when you become insolvent? When your bank learns of your difficulties it can put your company in receivership. That means that all your company’s income is syphoned off until the bank’s debt is paid, and usually liquidation follows after that. Your bank, your landlord and some suppliers will hold personal guarantees from you, and they will call those up if your company defaults in payment. You might be comforted by the fact that you have your personal assets in trust, but they can still bankrupt you, in which case you lose a lot of freedom and most of your non-trust assets.

The consequences of liquidation

Well for a start, you lose control of it. The bank and any other secured creditors take most of the assets, and the liquidators convert the rest into cash. The liquidators distribute the cash to the preferential creditors (themselves, the employees, the IRD, etc.) and any surplus to the unsecured creditors. The company then ceases to exist. What else can the liquidators do? They can terminate any unprofitable contracts, and they can bring to an end any claim against the company and prevent anyone from suing it. In certain circumstances they can group all your companies together and combine their assets. They can call up your shareholder loan account, and if you have looked after yourself or any particular creditors at the expense of the other creditors, they can reverse those transactions and claw back any payments made in the six months prior to liquidation while the company was insolvent. What’s more, they can take action against you if you have breached any of your director’s duties under the Companies Act. That is exactly what happened in two construction company collapses in New Zealand, one of which was massive (Mainzeal Property and Construction Ltd) and the other relatively minor (Debut Homes Ltd). They illustrate that directors can be held to account no matter how large or small the company is. The Debut Homes case went all the way up to our Supreme Court, and Mainzeal was the subject of a recent judgment from our Court of Appeal. This is what we can learn from them.

Debut Homes v Cooper

Debut Homes was a residential developer, and Mr. Cooper was a shareholder and the sole director. By October 2012 he knew it was in trouble, and the shortfall to the IRD was likely to be $300,000.

Notwithstanding this he elected to complete all current projects that the company was engaged in. To be fair to him, he tried very hard to salvage the company, but it was all to no avail. seventeen months later the IRD got the company placed into liquidation, and by that time it was owed $450,000 in GST.

Debut had completed and sold various homes, but Mr. Cooper decided where the proceeds went. He favoured the secured creditors who were holding personal guarantees from him, as well as his family trust, at the expense of the IRD. As a result, and because he had breached three of the directors’ duties under the Companies Act, he was ordered to pay $280,000 into the company, and $280,000 of the secured debt owed to the family trustees became unsecured instead. This was on top of the court costs and legal fees he had already incurred. The Court said that once he knew Debut had no hope of returning to solvency and there would inevitably be a shortfall to one or more

creditors, Mr. Cooper should not have decided to continue to complete the developments. He could have put the company into liquidation. He could have invited the BNZ to put it into receivership. Or he could have gone for a creditors’ compromise, a scheme of arrangement, or a voluntary administration.

The Mainzeal litigation

The Mainzeal case was a little different from Debut Homes, in that the company could have been salvaged if the directors had acted decisively. The Court of Appeal acknowledged that directors could allow their company to continue trading while technically insolvent for a limited time, but they had to take meaningful and realistic steps to turn it around.

They could take some time to explore all realistic alternative courses of action to try to avoid an insolvent liquidation. If they were actively engaged in seeking advice and attempting to address the company’s problems, they could not be criticised and would not be exposed to liability. But the time to throw in the towel was when all reasonable options had been exhausted and it was obvious that there was no reasonable prospect of the company pulling through. I expect both of these cases will serve as a wake-up call to directors of large building companies, particularly professional directors who don’t have a fortune tied up in the company and who have plenty of opportunities to earn a good living elsewhere. Those directors are likely to pull the pin earlier than smaller owner/operators. But for the smaller owner/operators, I can’t help thinking that these are unrealistic expectations of human beings who are desperate to salvage their only source of income and everoptimistic that their fortunes will change given enough time.

Geoff Hardy Auckland commercial lawyer

Geoff Hardy has 46 years’ experience as a commercial lawyer and is a partner in the Auckland firm Martelli McKegg. He guarantees personal attention to new clients at competitive rates. His phone number is (09) 379 0700, fax (09) 309 4112, and e-mail geoff@martellimckegg.co.nz.

This article is not intended to be relied upon as legal advice.

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