Reckless Trading

The Companies Act 1993 (“the Act”) provides the framework that applies in respect of directors’ duties and reckless trading. The Act prohibits a director from allowing the business to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors. Any director who fails to exercise necessary care or prudence may be found personally liable for reckless trading.

New Zealand’s largest award against a director for reckless trading was made out in the Lower v Traveller [2005] NZSC 79 case. The High Court in this particular case (and subsequently the Court of Appeal) determined that the director was responsible for $8.4 million in damages.

Reckless trading refers to a director taking illegitimate business risks. In determining the legitimacy of such risks, an objective assessment is undertaken, with focus on the way the business is done, and whether the director’s methods have created a substantial risk of serious loss.

The courts have stipulated that a director’s “sober” assessment of the ongoing character of the company and its likely future income prospects is required when a company hits troubled waters.

A two pronged approach to determine a director’s liability has been adopted, firstly whether there should be liability, and if required, what relief is appropriate.

Material factors to assess that a business risk is legitimate include whether:

1. The risk was fully understood by those whose funds were at risk;
2. The company was insolvent and continued to trade over an extended period;
3. The director’s conduct was normal, in its ordinary course of business; and
4. The primary persons interested in the insolvent company are the creditors rather than the shareholders.

Liability for reckless trading can relate to an isolated transaction. The company does not need to be in liquidation and no knowledge of the reckless trading is required.

There are limitations to the Act.  The courts have found that recklessness requires more than mere negligence; and a director must either be willfully negligent or make a conscious decision to allow the business to be conducted in a manner that causes substantial risk of serious loss to the company’s creditors. A director may also avoid liability where a director has the full support of the creditors and the creditors were fully aware of risks which were incidentally substantial.

One of the criticisms of reckless trading is that it does not allow for high risk company trade where there are prospects of large profit margins. Some do not consider this point well founded, as arguably a risk of loss is reasonably balanced by a prospect of gain. It appears this point is yet to be decisively settled at common law. The wording of the Act does not leave room for a balancing exercise, however the Courts have acknowledged certain academic articles which analyse the duties of directors under the Companies Act 1993, proposing their preparedness to apply such an assessment to balance risk and reward.