High cost of directors’ failure to consider creditors’ interests
A Federal Court’s decision against directors of a failed mining company operating in SA’s far north who didn’t show required consideration for creditors’ interests, is an alert to all company directors of the likely high personal cost for neglecting this responsibility.
The Court ruled that directors of Termite Resources NL (Termite), when faced with the company’s financial collapse, breached their duties to creditors by failing to conduct a proper analysis of cash reserves. They were ordered to pay Termite $7m in compensation for their collective breach.
The background story
Termite was established as a wholly owned subsidiary of Outback Iron Pty Ltd (Outback), mining at Cairn Hill, SA. Outback was an incorporated joint venture between IMX Resources Ltd (IMX) and Taifeng Yuanchuang International Development (Taifeng).
IMX and Taifeng advanced $48.9m through Outback to Termite, which pursuant to a Distribution Policy accepted by the directors, distributed $46.1m of its mining proceeds back up the chain of companies before being placed into voluntary administration two years later.
The Court had to consider whether the Distribution Policy had a binding affect on the parties and whether directors’ acceptance of it breached their duties to Termite.
Clauses in the policy ruled to be binding
The Judge said that while the description of the document as a “policy” document would seem to suggest it should have no binding effect, he was persuaded that two clauses concerning the agreed character of contemplated distributions were indeed binding – although the others were not.
His Honour reasoned:
- Relevant clauses appeared in a section of the document headed “Procedure” to distinguish them from other sections.
- Both subject matter and declaratory expression of these relevant clauses were indications of a binding agreement, and.....
- It was clear IMX’s auditor was pressing for formal documentation to ensure IMX would receive distributions from Termite, necessary for continuing solvency. It was the auditor’s opinion this had to be done for IMX to be regarded as a going concern, all of which in context was not only understandable, but when objectively considered, indicated the companies wished to be bound.
Central to the Judge’s eventual ruling was the Distribution Policy’s significant requirement that Termite maintain a $3m cash reserve and distribute all surplus mining proceeds to Outback.
Directors’ duties when insolvency is foreseeable
The Court examined directors’ actions relative to requirements of sections 180 and 181 of the Corporations Act 2001 (Cth), and in common law.
Directors must take into account matters bearing on a company’s solvency at the time they act, and as a result of their action. The judge found there were foreseeable risks to Termite’s solvency.
He said there was obvious volatility in markets for iron ore indicated by price fluctuations. There were also rate fluctuations in USD/AUD exchange rates.
Forecasts of quantity and grade of Cairn Hill ore were apparently unreliable and were concurrent with project uncertainties at the mine.
The Court held that the law required directors to consider the interests of creditors when acting in the face of real (as distinct from remote) risk to a company’s solvency.
It was found Termite’s directors knew of, and had considered the effect of, various risks to the company’s solvency.
Specifics of directors’ collective failure
Evidence produced at trial established that a $3m cash reserve was insufficient for Termite to cover contingencies and liabilities in the event that one or more of foreseeable risks, known to directors, materialised so as to put an end to mining at Cairn Hill.
The Court’s view was that reasonably diligent directors, in Termite’s circumstances, would have approved a Distribution Policy with a cash reserve of at least $10m. Anything less could not rationally be considered as being in the company’s best interests.
The judge said it was plain the Policy was undertaken in the interests of IMX and Taifeng and at no stage had consideration been given to what was best for Termite.
Accordingly, total disregard by Termite directors for the welfare of the company, meant a defence against liability provided by the Business Judgement Rule in section 180(2) of the Corporations Act was not available to them.
One director had drafted the Distribution policy using the obviously inappropriate figure of $3m. Because Termite’s board had never addressed the deficiency of such a cash reserve, members breached their duties. The Court found directors had not conducted an initial review of the adequacy of the reserve and had failed to keep themselves informed of ongoing effects of the reserve’s inadequacy.
Thus Termite’s directors were ordered by the Court to pay $7m to the company as compensation for loss suffered as a result of breaching their duties.
There’s a twist to the case’s conclusion
Termite Resources NL (In Liq) v Meadows, in the matter of Termite Resources NL (In Liq) (No2)  FCA 354, while serving as a salutary lesson for directors unaware of the law’s requirement for them to consider creditors in their decision making – or for those unwilling to meet this responsibility – also has an interesting aspect.
Termite, by focusing its claim against directors for failure to maintain sufficient cash reserves, rather than the imprudence of distributions, thereby restricted the Court in the amount of money it could order be paid to the company as compensation.
The way Termite’s claim was structured limited the company’s ability to recover money from its former directors to the difference in value between cash reserves actually maintained, and cash reserves that would have been maintained by directors exercising required care and diligence.