CORPORATE GOVERNANCE When Pragmatism Rules – Legitimate risk or reckless trading?

Alarm bells sounded for company directors last year, when two directors were fined heavily for reckless trading and further two cases involving reckless trading were considered by the High Court.
In February 2004 the director of South Pacific Shipping, Klaus Lower, was ordered by the High Court to pay $7 million to the company’s liquidators. Less than one month later, Donald Winton Allen, the managing director of Cellar House, was ordered to pay $1.75 million. Both directors were found guilty of reckless trading in breach of section 135 of the Companies Act 1993.
Then in November, the liquidator of Global Print Strategies, argued that the company’s director and former director should be found personally liable for the company’s debts also on the grounds of reckless trading. In December, the principal creditor of Petros Developments claimed that its loss was directly attributable to the reckless trading of the managing director. In contrast to the cases earlier in the year, both claims of reckless trading were rejected.
Directors could conclude from this spate of cases that they face greater risk of personal liability for outstanding company debts on the liquidation of company. But contrary to the ripples of media alarm, these cases should in fact be viewed as reassuring for directors. Whilst the actions of the defendants in the earlier cases were pretty extreme, the actual judgments endorse good business practice and suggest narrowed test for when courts find director liable for reckless trading. The later cases also seem to pick up on this trend toward narrowing the test for reckless trading and steering away from the literal interpretation of the law.

The law says
Some commentators suggest that under the current law, successfully suing for reckless trading is like “shooting fish in barrel”. It’s been suggested that the law wrongly imposes liability on directors for legitimate business risk taking. There is support for this view on literal interpretation of the relevant section.
Section 135 of the Companies Act 1993 provides that company must not “agree, cause or allow the business of company to be carried out in manner likely to create substantial risk of serious loss to the company’s creditors”.
The literal interpretation of this section seems particularly onerous for directors. The section uses the words ’cause’ and ‘allow’, which would appear to cover inactive directors as well as those directors who consciously ‘agree’ to the business of the company being carried out in reckless way.
In the Global Print Strategies case, Justice Salmon adopted practical approach to the potentially onerous implications of the word ‘allow’ in section 135. He said that reckless trading involved more than mere negligence and had to include conscious decision by the director to allow the business to be so conducted, or wilful or grossly negligent turning of blind eye to the situation.
Nonetheless, section 135 of the Companies Act still raises number of questions. What is “substantial risk”? What constitutes “serious loss”? The net result on literal interpretation appears to be section which imposes liability for carrying on business in way which contains real risks of not unimportant loss to creditors.
Fatupaito versus Bates, decided in the High Court in 2001, seemed to shed some light on how section 135 would be interpreted. Justice O’Regan thought the law appears to impose stringent duty on directors to avoid substantial risks of serious loss to creditors. The law does not allow the court to consider whether the risks which are being taken are reasonable in the circumstances, even when the potential for great rewards exists. Justice O’Regan concluded: “If the risk is substantial and it involves potentially serious loss, then, on the face of it, breach of section 135 occurs.”

South Pacific and Allen
The South Pacific case illustrates the courts interpreting reckless trading in pragmatic way. Justice Young said the law for reckless trading cannot be intended to penalise directors merely for taking risks. The law presupposes distinction between “legitimate business risks” and “illegitimate business risks”. The judge thought that it is only the taking of illegitimate business risks which warrants finding of reckless trading.
Justice France in the subsequent Allen case said that he would not resolve the exact reach of section 135, however he went on to apply the approach of Justice Young.
Directors should welcome this pragmatic approach. In the South Pacific case, the court recognised that the principal function of limited liability, and the function of company law in general, is to facilitate risk taking. It is function outlined in the preamble to the Companies Act 1993: “to reaffirm the value of the company as means of achieving economic and social benefits through the taking of business risks”.
It is difficult to reconcile this preamble with literal interpretation of section 135, which appears to penalise directors for taking any real risks that may cause loss to creditors.

What’s illegitimate risk?
In the South Pacific case, Justice Young identified two key questions for directors to ask themselves when deciding whether business risk is legitimate. First, do the creditors fully understand the risk being taken? The law will not give blanket protection to creditors against risks of which they are fully informed. Secondly, is the conduct of the director in question in accordance with orthodox commercial practice? Directors will not be saved by their own subjective assessment or intentions.
The key questions suggested in the South Pacific case were cited with approval in the Petros Developments case. The court pointed out that the principal creditor had full knowledge of the risks the company was taking and the company could not have continued to trade without the active support of the principal creditor.
Overall, it is difficult to determine in vacuum whether proposed business risk is legitimate or illegitimate. The South Pacific decision indicates that courts will assess the context in which the governance occurs, and if director’s behaviour departs markedly from orthodox business practice, so as to be characterised as unreasonable in those circumstances, then the court will find the director liable for reckless trading.
In today’s post-Enron environment where scrutiny of directors is more intense, directors should not be alarmed by the spate of cases involving reckless trading and the apparent trend of large personal fines ordered against directors.
Instead, it is the writers’ view that the law seems to be shifting towards more commercial interpretation of what constitutes reckless trading. But the shift is not concrete. The different approaches in Fatupaito versus Bates and the South Pacific and Allen cases will need to be resolved by the Court of Appeal before they can be relied upon with any certainty. Notably, in the Global Print Strategies case, Justice Salmon cited Fatupaito versus Bates, but failed to mention the South Pacific and Allen cases.
In the end, the law must be interpreted to find balance. Ensuring companies can still take legitimate business risks while penalising directors who take illegitimate risks achieves this balance, which in turn should spell good news for directors.

Rob Batty is solicitor and Peter Stubbs partner and head of the commercial department at law firm Simpson Grierson. Email [email protected]

Visited 7 times, 1 visit(s) today
Close Search Window