Home > Insight > 02 July 2017
02 July 2017
by Patrick Learmonth

Company directors cannot assume that they have no risk for their company’s business activities. The Companies Act 1993 imposes on all directors, including non-executive directors and “sleeping directors”, a duty to ensure that the company does not trade recklessly.

 If a director fails in this duty then he or she can be personally liable for company debts. Section 135 Companies Act 1993 provides a director of a company must not: 

  • Agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors; or 
  • Cause or allow the business of the company to be carried on and a manner likely create a substantial risk of serious loss to the company’s creditors.

A company does not need to be insolvent or in liquidation for a director to be liable for reckless trading. And reckless trading covers all business activities including single transactions of an unusual or irregular nature. All directors are at risk – including those who do not participate in company board matters.

Section 135 does not require proof that the trading concerned lead to a substantial risk of causing loss to creditors – only that the trading be likely to cause such a substantial risk.

Exactly which business decisions create a risk of a breach of the duty imposed by section 135. Directors need to objectively consider the company’s circumstances – do these warrant that the company business be closed rather than continuing to operate with extended risk. The High Court in Re South Pacific Shipping Limited; Traveller v. Lower (2004) 9 NZCLC held that there was a distinction between taking legitimate and illegitimate business risks. What might be illegitimate? Factors to be taken into account in determining whether a director is in breach of section 135 were: 

  • The existence of any collateral personal benefits accruing to the director by continuing to trade the company whilst insolvent and whether that director was motivated by such personal benefits. 
  • Did the company continue to trade whilst insolvent? Directors do not necessarily need to cease trading as soon as they become aware that the company is insolvent – on the basis of the balance sheet – but there are limits as to how far a director should permit the company trade as insolvent solely in hope that conditions will improve (as a rule of thumb any such continued training extending past six months would be risky). 
  • Did the company’s creditors have notice of and understand the risks the company was taking. 
  • Were the directors acting in accordance with orthodox – usual – commercial practice? 
  • How serious were the risks taking into account then current business conditions. 

The taking of legitimate business risks will not necessarily be considered reckless. It has been held that to be considered reckless directors behaviour needs more than simple negligence. A director would have had to have made a conscious decision to allow the trading concerned to be undertaken knowing that it would raise the risk of a substantial loss to creditors – or the directors acted wilfully or with gross negligence in undertaking or allowing such trading without consideration of the risk to creditors.

It is accepted that business activities often require risk to be taken and that it is legitimate for such risks to be taken. But directors need to consider – fairly and objectively – whether the risk is legitimate and not reckless. Otherwise directors may find themselves at risk of being liable for loss to creditors of a company.