Thursday, May 14, 2015

Frank Newman: Limited liability?

A recent High Court decision (December 2014) has important implications for property investors specifically and business people generally. The decision has shattered the rule that companies have limited liability. It is now clear that there are situations where shareholders do not have the protection of limited liability and may be pursued for recovery of a debt.

The case involves three  companies: Lewis Holdings Ltd; Steel & Tube Holdings Limited (STH), a public company listed on the stock exchange; and a subsidiary of STH called Stube Industries Limited (Stube). In June 2013 Stube was placed into liquidation by STH.

Stube did not trade, had no employees, no assets, no separate premises, no separate minute book, no bank account, no accounting system, no independent directors, and was wholly dependent on STH to maintain its solvency which was provided in the form of new share capital.

Stube's only transaction was a 21 year ground lease for land owned by Lewis Holdings. When Stube was liquidated by STH, it probably thought that would be the end of its ground lease obligations. Not so. Lawyers acting for Lewis Holdings successfully argued that the rarely used Section 271(1)(a) of the Companies Act should apply.

That section states:

"Pooling of assets of related companies
(1) On the application of the liquidator, or a creditor or shareholder, the court, if satisfied that it is just and equitable to do so, may order that—
(a) a company that is, or has been, related to the company in liquidation must pay to the liquidator the whole or part of any or all of the claims made in the liquidation:"

 Essentially the clause creates an exception to the principle that a company is a legal entity in its own right and the liability of shareholders is limited to their equity contributions. The key points to the exemption are that the companies must be related and the assets and liabilities of one may be pooled with another where the court believes it is just and equitable to do so.

The next section, Section 272 of the Act, gives the Court some guidelines for making an order. It says the Court should have regard to:

" (a) the extent to which the related company took part in the management of the company in liquidation:
(b) the conduct of the related company towards the creditors of the company in liquidation:
(c) the extent to which the circumstances that gave rise to the liquidation of the company are attributable to the actions of the related company:
(d) such other matters as the court thinks fit."

In this case Lewis successfully argued that STH is fully liable for the ground lease obligations of Stube.  

A key finding of the Judge was, " They [the directors] did not hold formal board meetings for Stube. Nor did they sit down together to discuss matters with a conscious appreciation that they were doing so with their Stube directors’ hats on...The STH group acted as a single unit. For the most part, the different trading activities of STH were carried on through divisions, rather than through subsidiaries. [The directors of STH] adopted the same approach in respect of their duties as directors of Stube. I do not find, in their evidence, any indication that they managed Stube any differently from the way they managed the divisions of STH."

Having established liability, the judge was left with the complex task of establishing the extent of the damages suffered by Lewis Holdings. On this matter the evidence provided by the expert valuers ranged from nil (those acting for STH) to $1.9m (those acting for Lewis). (Isn't it remarkable how professionals who are bound by their Code of Ethics to act independently and without bias can come up with such different valuations!) The evidence was so divergent that the judged ordered the parties to present further evidence at another hearing.

This ruling has important implications for property investors. It is not uncommon for high risk property speculators or developers to have multiple single property/development owning companies for the sole purposes of protecting a portfolio against the misfortune of one company.

If you operate a number of companies as a group you can not assume liability is absolutely quarantined to each. To remove doubt directors must be careful to ensure a subsidiary's interest are operated separately and not as a division. The subsidiary should have its own directors and meetings, it must maintain its own minute book and make decisions in the best interest of the subsidiary, it should have its own accounting records, and it should receive independent legal and accounting advice.


paul scott said...

Good show too, about the limitations on limited liability.
Cue in here people like the disgraceful David Henderson [ the Christchurch Henderson]
I would like to see tradesmen and self employed people favoured ahead of these vile liquidators, and distanced owners.

Glenn Webster said...

Limited liability was originally seen as a way for investors to reduce their risk and thus encourage economic development.
It has become a way of avoiding responsibility while taking unreasonable risks and facilitating sharp practice.
New Zealand should thoroughly overhaul the relevant legislation.