Discharging directors’ duties in times of financial distress

A recent decision of the New South Wales Court of Appeal[1] offers useful guidance for company directors of the importance of their directorial duties, in circumstances where the company over which they have stewardship is in a precarious financial position.

In this case the directors were found to have breached their duty to exercise reasonable care and diligence, by voting in favor of declaring a dividend which placed the company at risk of insolvency.

Facts

In early 2016 the retail business carried on under the name “Dick Smith” collapsed. A litany of litigation followed, including a claim by the receivers of company – Dick Smith Holdings Ltd (DSH) – against the former CEO and Managing Director (Mr Nicholas Abboud) and CFO, Company Secretary and Director (Mr Michael Potts).

The receivers alleged the directors breached their duty under section 180 of the Corporations Act 2001 (Cth) (Act) by voting in favour of declaring an interim dividend of $16.555 million in February 2015 and a final dividend of $11.826 million in August 2015. That was so, it was alleged, because DSH was experiencing cash flow difficulties at the time, which were exacerbated by payment of the dividends.

After a lengthy trial, the primary judge found that neither director contravened the duty by voting in favour of the interim dividend. The primary judge found Mr Potts (but not Mr Abboud) contravened his duty by voting in favour of the final dividend, but that DSH had not established it had suffered any damage as a result of the contravention.

Each of these findings was appealed.

Issues

The two issues considered on appeal were:

1. Whether either director contravened section 180 of the Act by voting in favor of declaring the interim or final dividend; and
2. Did any such contravention result in DSH suffering any damage for the purpose of section 1317H of the Act.

Decision

DSH had some measure of success on appeal, on both issues.

Contravention

Central to DSH’s arguments on contravention was section 254T of the Act, which (relevantly) prohibits a company from paying a dividend unless the payment “does not materially prejudice the company’s ability to pay its creditors.” DSH argued, and the Court readily accepted, that the prohibition encompasses not only prejudice to the company’s ability to pay creditors per se but also to its ability to pay debts as and when they fall due.

The provision requires a company to look forward to the time of payment of the dividend at the time of making the decision to declare the dividend, to ascertain what creditors or debts will be payable or might soon be.

Turning then to the alleged contraventions of section 180 of the Act, the question was whether at the time of voting in favour of declaring the dividends, the likelihood of non-compliance with section 254T was such that a director exercising reasonable care and diligence would not have made that decision.

When voting on the final dividend in August 2015, the board papers that were available to Mr Abboud included a forecast cash flow statement, which showed at the time the dividend would be paid DSH was expected to have a positive cash flow position (including facility financing) of around $64 million, that was sufficient to accommodate the dividend. The primary judge found Mr Abboud was entitled to rely on these forecasts.

The Court of Appeal disagreed. The evidence demonstrated that Mr Abboud understood from time to time that DSH was unable to pay the claims of creditors when due. The Court of Appeal considered that armed with that knowledge Mr Abboud ought to have asked Mr Potts for more detailed information about the cash flow projections before voting on the dividend, rather than simply rely on Mr Potts to raise any concerns, to properly consider and investigate whether a contravention of section 254T was likely or how it might be avoided.

The primary judge concluded that Mr Potts was in a different position. As CFO, he had access to more detailed daily and weekly cash flow forecasts, which painted a substantially different picture from that shown in the board papers, with DSH expected to exceed its facility limit by around $33 million.

The primary judge’s findings regarding Mr Potts were upheld on appeal. The Court was satisfied the more detailed cash flow forecasts indicated DSH would exceed its facility limit leading up to and following payment of the final dividend by a sizable margin, and so would not be able to pay its debts in full and on time at the date the dividend was to be paid.

The Court rejected Mr Potts’ argument that DSH had, consistent with industry practice, routinely deferred payment to creditors, commenting that:

1. It said was no answer to a failure to properly consider the discrete issue of whether payment of a dividend may prejudice a company’s ability to pay its creditors; and
2. The practice of pushing out creditors, in breach of DSH’s contractual obligations, had the real potential to detriment DSH’s interests in other ways.

The primary judge’s finding that neither director breached section 180 for voting in favour of the interim dividend in February 2015 was upheld on appeal. The key difference was that the detailed daily cash flow projection available at the time showed that DSH would be within its facility limit, and so would have access to sufficient cash reserves to cover the dividend at the date of payment.

Damage

Section 1317H of the Act allows a Court to award damages suffered as a result of a contravention of the Act.

The Court held, overturning the primary judge’s findings, that declaring and paying a dividend can itself constitute damage to a company. It found:

1. Declaring the dividend and consequently paying out the money, as a result of a contravention of section 180 of the Act, caused prejudice or disadvantage to DSH by diminishing its assets;
2. But for the contravention the decision to declare the final dividend would not have been made, the dividend would not have been paid, and DSH would have retained the money in question.

Damages were accordingly awarded in the sum of $11.826 million, the amount of the final dividend.

Lessons for Directors

Company directors, vested with great power to control the management and affairs of a company, necessarily bear great responsibility (so the adage goes). The decision reinforces the important role played by, and the high standards expected of, directors.

A number of practical tips emerge on the types of steps that should be taken by directors to discharge the duties owed in that capacity, in particular where a company is in financial difficulty. Directors should remain mindful to:

1. Keep the interests of the company front of mind when deciding on any particular transaction or course of action. That includes ensuring the transaction is both sufficiently beneficial to the company, and will not unduly expose it to adverse consequences or place it at financial peril.
2. Thoroughly and carefully investigate the pros and cons of any proposed transaction and seek guidance and advice both internally with the Board and management and (where appropriate) externally from professional advisers. Analise the information obtained during that process, to make a fully informed decision.
3. Not unnecessarily withhold information from the Board, or simply rely on others to bring raise pertinent issues that might be considered within their purview.

[1] DSHE Holdings Ltd (Receivers and Managers) (in liq) v Potts; HSBC Bank Ltd v Abboud; Potts v National Australia Bank Ltd [2022] NSWCA 165

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David brings more than 12 years’ experience in the areas of insurance and commercial litigation, with a particular focus on the specialty lines of professional indemnity, directors and officers, and management liability.

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