Jeffreys v Morgenstern [2014] NZHC 308 (27 February 2014)

Last Updated: 26 March 2014

IN THE HIGH COURT OF NEW ZEALAND AUCKLAND REGISTRY

CIV-2010-404-8432 [2014] NZHC 308

BETWEEN STEPHANIE BETH JEFFREYS AND TIMOTHY WILSON DOWNES Plaintiffs

AND ARTHUR SYLVAN MORGENSTERN First Defendant

TANYA MAY LAVAS Second Defendant

Hearing: 30 September and 1 - 4 October 2013

Counsel: N H Malarao and K Wakelin for Plaintiffs

C T Walker and A T B Joseph for Defendants

Judgment: 27 February 2014

_{JUDGMENT OF RODNEY HANSEN J}

This judgment was delivered by me on 27 February 2014 at 11.30 a.m., pursuant to Rule 11.5 of the High Court Rules.

Registrar/Deputy Registrar

Date: ...............................

Solicitors: Meredith Connell, Auckland

Gilbert Walker, Auckland

JEFFREYS v MORGENSTERN [2014] NZHC 308 [27 February 2014]

_{TABLE OF CONTENTS}

Introduction [1] The Axon House claims – background [4] Axon House – liquidators’ claims [19] The rental underwrite

When the duty arose [27] Solvency of companies [29] Knowledge when duty arose [46]

Carpark deed

Plaintiffs’ case [56] Defence response [61] Discussion [66]

Sale of shares in MS St Lukes

Background [71] Plaintiffs’ claim [76] Defence response [78]

Claim under s 298

Value of shares [81] Feasibility study [84] Whether consideration for shares exceeded their value [94]

Claims under s 301

Breach of s 131 – good faith [97] Breach of s 135 – reckless trading [111] Breach of s 137 – duty of care [113]

Relief [117] Summary and conclusions [121] Result [127]

Introduction

[1] The plaintiffs are the liquidators of Morningstar Enterprises Limited¹ (MSE), GS & LD Lease Limited² (GLL) and Kingdon Development Limited (KDL). They are among a group of companies engaged in property development operated by the first defendant, Arthur Morgenstern. He was at all times the sole director of the

companies. The second defendant is his partner, Tanya Lavas.

[2] Mr Morgenstern began his career as a property developer in California, coming to New Zealand in 1988. He has since undertaken a number of property developments in Auckland and elsewhere. Two of the major projects he undertook in recent years were the construction of a commercial building known as Axon House in Khyber Pass Road, Newmarket, and a mixed residential-commercial-retail development at St Lukes. The liquidation of the three companies was the result of problems that arose from the sale of Axon House and in the latter stages of the St Lukes development. The liquidators say transactions undertaken by the three companies at this time involved breaches by Mr Morgenstern of his duties under the Companies Act 1993 (the Act).

[3] In relation to the sale of Axon House, the liquidators say Mr Morgenstern caused or allowed the companies to enter into obligations which risked serious loss to creditors or which he should have known they would be unable to perform. The alleged breach in relation to the St Lukes development arose from the sale to MSE of the defendants’ shares in the company which undertook the development. The sale was for $3.5 million. The shares turned out to be worthless when the development was completed at a loss. In relation to all transactions, the liquidators seek compensation under s 301 of the Act and, in the case of the share sale, also under

_{s 298.}

¹ _{Now Kingdon Undertaking Limited (in liquidation).}

² Now Axon House Carparking Limited (in liquidation).

The Axon House claims - background

[4] The Axon House development was undertaken by KDL which was a subsidiary of MSE. KDL was incorporated in 2000 for the purpose of acquiring land on the corner of Khyber Pass Road and Kingdon Street, Newmarket, and undertaking the development there. Axon House - a five-storey building - was completed in 2005. It comprises a ground floor of retail units and five floors of offices. It was sold in 2005.

[5] Axon House was developed by a joint venture. Two of the joint venture partners, through a company, Vita Shoe Company Limited (Vita Shoe), contributed the land, valued at $2.8m. KDL and Vita Shoe agreed that, on the sale of Axon House, Vita Shoe would receive the $2.8m agreed value of the land plus 50 per cent of the profit on the development. The profit share was described as interest on a loan.

[6] The development was funded by Westpac Bank Corporation. The funding was arranged by Mr Martyn Reesby of Reesby & Co Limited and Structured Finance (NZ) Limited. Mr Morgenstern’s developments generally have been undertaken in association with Mr Reesby who has overseen their financial management and taken responsibility for providing regular reports to funders.

[7] A condition of the resource consent for the construction of Axon House was that 166 carparks in the Newmarket carpark on Khyber Pass Road, opposite Axon House, be reserved for users of Axon House. The carpark had been developed by companies associated with Mr Morgenstern. Some of the carparks were owned by GS & LD Investment and Management Services Limited (GLIMS), of which Mr Morgenstern was a 70 per cent shareholder. GLIMS leased the 166 carparks reserved for users of Axon House to its wholly owned subsidiary, GLL.

[8] Mr Morgenstern wanted to provide an incentive to the owner of Axon House to encourage tenants and users to lease the carparks. He decided to implement a scheme whereby the owner of Axon House would receive an incentive payment that would be payable provided a minimum number of carparks were leased by tenants

and users of Axon House. This would ensure that GLL would have the funds from which to pay the incentive fee.

[9] By April 2005, the building was almost completed and five and a half of the six floors had been leased. The joint venturers agreed to offer it for sale with a rental underwrite in respect of the unleased space and provision for the incentive payment of $100,000 for the lease of the carparks. A valuation for mortgage purposes, which took into account the rental underwrite and carparking incentive, valued the building at $17.95m.

[10] On 23 August 2005, KDL entered into an agreement for sale and purchase with SAITeysMcMahon Property Limited (SAI). The purchase price was $18m. The agreement for sale and purchase provided for KDL to provide a rental underwrite for two years in relation to the unlet space. The underwrite was for

$124,080 plus GST per annum and operating expenses. The sale and purchase agreement provided for a rental underwrite deed to be entered into before settlement.

[11] The agreement for sale and purchase also provided for KDL and GLL to enter into a carparking deed with SAI prior to settlement by which GLL would undertake to provide 166 carparks to tenants, owners and occupiers of Axon House at market rates.

[12] The agreement for sale and purchase was varied on 7 November 2005 to provide for the price to be adjusted to the extent that the rental and carpark income from the property was less than $1,462,500 per annum as at the date of settlement. When settlement finally took place, on 16 June 2006, the final purchase price was

$17,622,701.53.

[13] The underwrite deed, entered into before settlement, but dated 9 August

2006, provided that KDL would underwrite the rent and operating expenses in respect of the unlet space; the parties would cooperate and use their best endeavours to procure as soon as possible a lease of the unlet space; and the underwrite would be reduced to the extent that rental and operating expenses were paid under a new lease of the space. MSE undertook joint and several liability for KDL’s obligations.

[14] On the day of settlement, the carparking deed was entered into by SAI, GLL and KDL providing for GLL to lease the 166 carparks and for GLL to pay an annual fee of $100,000 to SAI which would be suspended, however, if the number of carparks leased or licensed to Axon House users fell below 50.

[15] Disputes arose in relation to both carparking and the rental underwrite. GLL declined to make the incentive payment as there were not 50 carparks rented at market rates. SAI claimed that the incentive payment was due because more than 50 carparks had been rented, albeit at below market rentals.

[16] KDL paid the instalments of the rental underwrite for four months but refused to make further payments because Mr Morgenstern considered that SAI was not cooperating in finding a tenant for the unlet space, in breach of its obligations under the lease.

[17] SAI issued proceedings in the District Court against KDL, GLL and MSE. It obtained summary judgment:

(a) Against KDL for $127,077.80 for unpaid rental and operating expenses to the date of judgment and costs of $5,701.00;

(b) Against MSE as guarantor of the rental underwrite for $127,077.80 plus $10,000 costs; and

(c) Against GLL for $111,540.44 for the carpark incentive payment plus

$1,900 in costs.

[18] GLL and KDL went into voluntary liquidation on 17 August 2007. MSE was put into liquidation by order of the High Court on 9 July 2008 on the petition of SAI. No part of the judgment debts had been paid when the companies went into liquidation.

Axon House - liquidators’ claims

[19] The liquidators claim that in procuring KDL to enter into the rental underwrite deed and MSE to guarantee KDL’s obligations under the deed, Mr Morgenstern was in breach of duties owed under, respectively, ss 135 and 136 of the Companies Act 1993 (the Act). Similarly, they allege that in causing GLL to enter into the carparking deed, Mr Morgenstern was in breach of duties owed under ss 135 and 136 of the Act. The liquidators seek orders under s 301 of the Act which gives the Court power to enquire into the conduct of a promoter, director, manager, liquidator or receiver and to order a person who has been guilty of negligence, default or breach of duty or trust to repay or restore money or property or contribute such sum to the assets of the company by way of compensation as the Court thinks just.

[20] Section 301 does not of itself impose duties on directors; rather, it is a means of enforcement against directors who have breached their duty to the company.³ It provides a procedural short cut by which a liquidator, creditor or shareholder may pursue the claims which a company in liquidation may have against its former directors.⁴ A claim under s 301 involves a two-step evaluation:

(a) To determine whether there has been a breach of duty or other default.

(b) To determine to what extent the director should be required to contribute to the losses.

[21] Section 138 provides an affirmative defence to a claim of breach of statutory duty by excusing a director who relies on information provided or advice given by an employee, professional advisor or fellow director and who acts in good faith, makes proper enquiry and has no knowledge that such reliance is unwarranted. The plaintiffs say Mr Morgenstern cannot rely on s 138 as it is an affirmative defence that has not been pleaded as required by r 5.48 of the High Court Rules. In Re Cellar

_{House Limited (in liquidation) Ellen France J said s 138 provided an affirmative}

³ Peace and Glory Society Ltd (in liq) v Samsa [2009] NZCA 396; [2010] 2 NZLR 57 (CA); at

_[47].

⁴ Robb v Sojourner [2007] NZCA 493; [2008] 1 NZLR 751 (CA) at [53].

defence, with the onus of proof on the director. ⁵ It may be that in order to avail himself specifically of the defence, Mr Morgenstern was required to plead s 138 but I think Mr Walker is right to say that for the purpose of considering whether or not there has been a breach of a relevant statutory duty, it must be necessary to consider whether Mr Morgenstern relied on information provided and advice given by others.

[22] Section 135 provides:

Reckless trading

A director or a company must not –

(a) Agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors; or

(b) Cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.

[23] Section 136 provides:

Duty in relation to obligations

A director of a company must not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so.

[24] Mr Walker submitted that s 135 more naturally applies to decisions to carry on trading while insolvent and decisions to incur individual obligations are usually addressed under s 136 which focuses on particular transactions rather than the general conduct of the company’s business.⁶ However, I agree with Lang J who said in Goatlands Limited (in liquidation) v Borrell that in principle there is nothing to prevent s 135 being applied to “one off” transactions. ⁷ In that case the expenditure of a substantial GST refund which the company was later required to repay was held

_{to fall within s 135. Section 135 was also applied to a single transaction in Re Wait}

⁵ _{Re Cellar House Limited (in liquidation) HC Nelson CP13/00, 18 March 2004 at [217].}

⁶ _{Peace and Glory Society Ltd (in liq) v Samsa, above n 3, at [44].}

⁷ Goatlands Ltd (in liq) v Borrell (2007) 23 NZTC 21,107 at [113].

Investments Ltd (in liquidation) where the directors committed the company to expenditure of $1.635 million dollars without having the necessary funding in place.⁸

[25] In my view, the rental underwrite and carpark commitment entered into in this case could potentially come within s 135. They were entered into as part of the sale of the building which was central to KDL’s business. In theory at least they could be regarded as transactions entered into as part of the normal business of the company.

[26] The point may be academic. As Clifford J said in Jordan v O’Sullivan it would be surprising if a director’s behaviour were to be assessed against a materially different standard, depending on whether an obligation was incurred as part of continuing series of transactions or as part of a stand-alone transaction. ⁹ Both are to be assessed broadly by reference to whether the decisions taken involved a legitimate or illegitimate business risk.¹⁰

The rental underwrite

When the duty arose

[27] A preliminary issue arises as to the time at which the breach should be considered in relation to the rental underwrite. Mr Campbell says it is when the agreement for sale and purchase was entered into as that created the obligation to enter into the underwrite deed. Mr Malarao says the breach occurred when Mr Morgenstern allowed the companies to enter into the deed at the time of settlement. He says that although KDL committed to the underwrite when the agreement for sale and purchase was entered into, the obligation did not accrue until settlement.

[28] I consider Mr Morgenstern’s conduct must be judged at the time the sale and

purchase agreement was entered into, that is 23 August 2005. From that point KDL

_{was under a legal obligation to provide the underwrite and would have been liable}

⁸ Re Wait Investments Ltd (in liq) [1997] 3 NZLR 96 (HC). See also Kings Wharf Coldstore Ltd

_{(in rec & in liq) v Wilson [2005] NZHC 283; (2005) 2 NZCCLR 1042 (HC).}

⁹ _{Jordan v O’Sullivan HC Wellington CIV-2004-485-2611, 13 May 2008 at [63].}

¹⁰ See also the discussion in Mason v Lewis [2006] 3 NZLR 225 (CA) at [49].

had it refused to enter into the deed. I do not see how Mr Morgenstern could be in breach of his obligations under the Act for procuring KDL and MSE to do something they were contractually bound to do. His conduct must be judged at the time he allowed KDL to make the legal commitment to provide the rental underwrite and for MSE to guarantee KDL’s obligation.¹¹

Solvency of companies

[29] The plaintiffs’ case is that at the time the sale and purchase agreement was entered into and subsequently Mr Morgenstern would or should have been aware that both KDL and MSE were insolvent and would not be in a position to honour the underwrite. They relied on the evidence of Mr Tim Downes, one of the liquidators, and two expert witnesses, Justin Bosley, a chartered accountant who gave evidence as to the insolvency of the companies, and James Sclater, also an accountant, who spoke of the standard of conduct which should be observed by a company director.

[30] Mr Sclater analysed the accounts of KDL as at 31 March 2005. He noted that liabilities exceeded assets by $1,017,778 and, after adjusting for related party assets which would not be readily realisable, concluded that the company had a negative cash working capital position of $1,304,929.

[31] Mr Sclater undertook a similar exercise with the financial statements of MSE as at 31 March 2005. He found that assets exceeded liabilities by $768,072. After excluding related party assets and liabilities as not readily realisable or repayable in cash, he calculated that the company had a negative cash working capital position of

$2,378,674 and a net liabilities position of a similar order.

[32] Mr Bosley analysed the solvency of KDL and MSE by reference to the tests in s 4(1) of the Act, namely whether the company is able to pay its debts as they become due in the normal course of business (the cash flow test) and whether the value of the company’s assets is greater than the value of its liabilities including contingent liabilities (the balance sheet test). Both tests must be met in order for a

_{company to be considered solvent.}

¹¹ Jordan v O’Sullivan, above n 9, at [60] referring to Ocean Boulevard Properties Ltd v Everest

[33] Mr Bosley said that, as at 31 March 2006, KDL did not satisfy the balance sheet test. Its liabilities exceeded its assets by $722,000. He attempted to “recreate” the financial position of KDL after making adjustments to reflect the position following settlement of the sale. Taking into account that MSE would not be in a position to repay its indebtedness to KDL of $678,000, he concluded that KDL’s liabilities exceeded its assets by $291,000, indicating that it was balance sheet insolvent.

[34] Mr Bosley found that MSE satisfied the balance sheet solvency test at

31 March 2006 but after adjusting for the real or market value of work-in-progress and the equity investment in MS St Lukes, its liabilities exceeded its assets by $3.15 million. He concluded that MSE also failed the cashflow solvency test at that date.

[35] The defence challenges the views of Messrs Sclater and Bosley as to the solvency of KDL and MSE at 2005 and 2006. Mr Walker submits that their reliance on the accounts without regard to the underlying value of the assets led both witnesses into error and Mr Bosley’s adjustments to the 2006 accounts to reflect the sale of Axon House involved several mistakes.

[36] The main asset of KDL in the accounts for both 2005 and 2006 was the capitalised development costs of Axon House. These comprised the historical costs incurred totalling $11,271,094. Neither balance sheet reflected the sale value of Axon House as settlement did not occur until June 2006. Mr Bosley’s reconstructed balance sheet for KDL at 31 March 2006 took into account the sale of Axon. However, he concluded that even after factoring in the sale of Axon, liabilities exceeded assets by $291,000. He concluded that KDL was balance sheet insolvent even on a present value basis.

[37] Mr Walker argued that Mr Bosley’s calculation involved two errors. First, he treated the value of Axon House at settlement as $17,375,000 which was the net amount paid by the purchaser. However, its actual value was $17,622,701, or

$247,701 more than the value used by Mr Bosley. The amount paid on settlement was reduced to take account of rents paid in advance for June 2006, including the underwrite, tenant incentives and rates.

[38] Secondly, Mr Bosley proceeded on the basis that a payment of $3,500,000 to Vita Shoe was repayment of a loan and a further $200,000 was in respect of a “settlement creditor”. Mr Bosley was unaware that Vita Shoe was one of the joint venture partners and had contributed the land. The payment to Vita Shoe comprised the agreed value of the land of $2.8 million and $900,000 as its share of the profit.

[39] Readjusting Mr Bosley’s restatement for these two items, the assets of KDL

at 31 March 2006 would exceed liabilities by $856,000.

[40] Mr Bosley’s restatement also assumed that MSE would be unable to repay its debt to KDL of $678,000. On the basis of the balance sheet of 31 March 2006, MSE’s assets exceeded its liabilities by $604,000. However, Mr Bosley adjusted the balance sheet to delete work-in-progress of $1,436,299 in relation to a project at Otahuhu and the $3.465 million value of shares in Morning Star (St Lukes Garden Apartments) Limited (MS St Lukes), the company which had the carriage of the St

Lukes development.¹² He also included a contingent liability of $288,000 for MSE’s

guarantee of the rental underwrite. He concluded that, as at 31 March 2006, MSE’s

liabilities exceeded its assets by $3.149 million.

[41] The decision to write off work-in-progress on the Otahuhu project seems questionable. Mr Morgenstern acknowledged that it was a Housing New Zealand project which ultimately lost value because of the change in Housing New Zealand policy. However, it appears that this did not occur until after 31 March 2006.

[42] Mr Bosley contended that the shares in MS St Lukes had no value at 31

March 2006 because its balance sheet showed liabilities exceeding assets by $1.53 million. However, as will be discussed in greater detail later, the financial accounts for MS St Lukes show historical cost and not present value. As at 31 March 2006 it is arguable the value of $3.465 million could be supported, but that is of no consequence for present purposes. The accounts of MSE incorrectly recorded the shares in MS St Lukes as an asset. In fact, they were not acquired by MSE until the

_{following financial year. Reversing that transaction will reinstate Mr Morgenstern’s}

¹² The sale of the shares in MS St Lukes to MSE will be considered in detail later in this judgment

overdrawn current account, which was set off against the purchase price for the shares. As I discuss later, there is no reason why that account should not be regarded as recoverable.

[43] The rental underwrite was a contingent liability. Mr Bosley accepted in evidence that normally it would be shown as a note in the accounts rather than a liability in the balance sheet.

[44] If these adjustments are factored in, MSE was balance sheet solvent at

31 March 2006 even on an historical cost basis. Mr Bosley said it was cashflow insolvent at 31 March 2006. He acknowledged, however, that he had not investigated whether trade creditors were overdue or the terms of bank funding arrangements.

[45] The liquidators have not shown that KDL and MSE were insolvent at the time the rental underwrite commitment was made. However, that is not the end of the matter. The financial position of the companies is only one element of an enquiry which necessarily focuses on what Mr Morgenstern knew or believed at the relevant time.

Knowledge when duty arose

[46] The accounts for 31 March 2006, adjusted to reflect the sale of Axon House, provide an ex post facto guide to the ability of the two companies to meet the rental underwrite. In a perfectly predictable world that would reflect the information available to Mr Morgenstern at the time the agreement for sale and purchase was entered into. He was, however, reliant on projections and assumptions which would not necessarily be borne out or realised.

[47] At the time the agreement to sell Axon House was entered into and for some time afterwards, all the indications were that the development was profitable and that KDL would be solvent following settlement. The joint venture partners received regular reports from their accountants – BDO Spicers for KDL and Gosling Chapman for Vita Shoes. The first such calculation produced in evidence appears to have predated the sale and purchase agreement. Based on estimated proceeds of sale

of $17.5 million, it showed a profit of $2,544,491 or $1,272,245 for each joint venture partner.

[48] A further calculation prepared after the agreement for sale and purchase was entered into was based on expected sale proceeds of $17,622,701 with costs to

31 October 2005. The expected profit after taking into account the rental underwrite at $244,085 was $1,606,849.

[49] In an assessment prepared by BDO and sent to Gosling Chapman on 30 May

2006 (16 days before settlement), the expected profit was reduced to $1,390,274.12. A somewhat later assessment which appears also to precede settlement shows a slightly reduced profit of $1,304,355.

[50] On 15 June 2006, the day before settlement, Kensington Swan, acting for KDL, sent Hesketh Henry, for Vita Shoe, a draft trust account statement showing that, after a projected payment of $3,718,278 to Vita Shoe, a trust account balance of

$306,081 would remain. As previously noted, the payment to Vita Shoe comprised

$2.8 million as the value of the land and $900,000 as its share of the profit. The letter records that KDL is not prepared to provide the rental underwrite on its own; it wanted the guarantee, as it is termed in the letter, to be provided by the joint venture partners. It is not known how this issue was resolved.

[51] A statement sent to KDL on 31 July 2006 showed payments actually made from their trust account following settlement. That included $3.5 million to Vita Shoe for “repayment loan” and a further payment of $200,000 “as agreed”.¹³ The balance remaining in the trust account after these and other payments was $221.92

The payments to Vita Shoe, supported by the earlier profit calculations, indicate that the Axon House development project was indeed profitable. The evidence does not, however, show how the final settlement and payment of outstanding liabilities affected KDL’s financial position. There were no final accounts produced for the

_{project itself or accounts for KDL for the year ended 31 March 2007.}

¹³ The Vita Shoe loan was shown at $3.5 million in the 2005 and 2006 accounts of KDL but in the profit calculations the “agreed amount for land” was shown as $2.8 million. I was told that the difference of $700,000 was treated as a loan for tax purposes.

[52] Mr Malarao pointed to the fact that after payment of expenses and Vita Shoe’s profit share, the surplus in the trust account of the lawyers acting on the sale was only $221.92. He questioned how that could be reconciled with the surplus shown in the various projections and profit calculations prepared by the accountants.

[53] The short answer is that it can’t. That is because what is shown in the solicitor’s trust account is a cash surplus following settlement which bears no direct relation to profitability overall or to the solvency of KDL. The profit share paid to Vita Shoes is compelling evidence that the project was profitable. Why this did not lead to a surplus in the books of KDL was not fully explained as no accounts were prepared after 31 March 2006.

[54] A contributing factor is likely to have been substantial “fees” Mr Morgenstern said had already been paid to MSE. Another is the professional fees incurred as the dispute with SAI flared up following settlement. There were funds available which enabled the rental underwrite to be paid for the first few months. And, I have no doubt that, had he been of a mind to do so, Mr Morgenstern could have ensured that KDL and/or MSE received shareholder support to the extent

necessary to enable payments of the rental underwrite to continue.¹⁴ He made a

deliberate decision not to do so because he regarded SAI as in breach of its legal obligations. By the time the position had been determined adversely to the Morgenstern interests, KDL had no funds. I accept that Mr Morgenstern could have chosen to support KDL and/or MSE at this point. I infer that he preferred to allow the companies to go into liquidation without satisfying the judgment.

[55] The rental underwrite was integral to the sale of Axon House, as was the carpark incentive arrangement. The commercial wisdom of the sale could not be questioned. The property sold for in excess of a registered valuation. The projections pointed to a surplus. There was nothing to indicate that there would be undue delay letting the remaining space. Notwithstanding the balance sheet position

_{of KDL and MSE, there simply is no basis to claim that the underwrite posed any}

¹⁴ In considering a company’s ability to meet its obligations, it is permissible for the directors to rely on an expectation that funding will be available, either from external sources or by way of shareholder contributions, provided the expectation is reasonable. See Jordan v O’Sullivan, above n 12, at [59] and Ocean Boulevard Properties Ltd v Everest, above n 9

risk of loss to company creditors. In my view, at the time Mr Morgenstern committed the companies to enter into the underwrite deed, there was no reason for him to be concerned that the commitment would create a substantial risk of serious loss or that the companies could not and would not meet their obligations to SAI if required to do so. The liquidators have not shown a breach of either ss 135 or 136 of the Act.

Carpark deed

Plaintiffs’ case

[56] The claims under ss 135 and 136 in relation to the carpark deed are against Mr Morgenstern in his capacity as director of GLL. As earlier mentioned, he and others had developed the Newmarket carpark which was situated in Kyber Pass Road, opposite Axon House. The resource consent for the construction of Axon House required 166 carparks to be reserved for users of Axon House. This was the subject of a covenant between GLIMS and KDL requiring the owners of the carparks to make them available to tenants of Axon House.

[57] On the sale of Axon House, KDL agreed to procure GLL to enter into a deed with SAI. Its terms included the incentive arrangement whereby GLL would pay an annual fee of $100,000 plus GST to SAI for the carparks. The obligation would be suspended if the number of carparks leased by Axon House fell below 50.

[58] The plaintiffs’ case is that at the time the carparking deed was entered into GLL was insolvent. It was reliant on the support of its shareholder, GLIMS, which was itself insolvent. The liquidators say Mr Morgenstern should have understood that GLL was committing to make an incentive payment that may not be covered by carpark rentals and was reckless in procuring GLL to enter into the deed.

[59] It is not in dispute that both GLIMS and GLL were insolvent when the carparking deed was entered into. As at 31 March 2005 and 31 March 2006, the liabilities of GLL exceeded its assets by $102,000 and $336,000 respectively, excluding provision for any contingent liability arising out of the carpark deed. At

31 March 2006, GLIMS’ liabilities exceeded its assets by $281,000, it had negative

working capital of $1.45 million and its current liabilities (excluding related party loans and advances) of $192,000 exceeded current assets by $171,000. GLL was reliant on the support of GLIMS which was itself reliant on ongoing support from its shareholders.

[60] Mr Sclater was of the view that a prudent director would have had concerns about GLL’s financial viability and its ability to meet its obligations under the carparking deed. He said Mr Morgenstern should have requested or prepared detailed budgets, cashflow statements and balance sheets setting out the projected future financial position of GLL. He considered that carparking projections relied on by Mr Morgenstern were inadequate.

Defence response

[61] Mr Morgenstern said that the plaintiffs’ case involves a misunderstanding of the nature of a carpark business and the reasonable expectations of GLIMS’ shareholders. He had previous experience of the ownership and leasing of carparks. He said it is normal in a start-up carpark business to run at a loss initially and to have to introduce capital to keep the business funded until a sufficient number of carparks are let at high enough rentals to begin producing a profit. He said this has been his experience on every carpark project he had undertaken. On that basis, GLL would be in debt to GLIMS in the early period because it was obliged to make lease payments to GLIMS but would not initially be receiving sufficient lease income to cover them. Mr Morgenstern said he expected this phase would be short-lived. In time GLL would become profitable and be able to meet its lease payments to GLIMS.

[62] Mr Morgenstern said he expected to be able to lease, through GLL, all 166 carparks to Axon House tenants within the first year. One of the anchor tenants had committed to taking 60 carparks and another to 16 carparks. He anticipated supplementing income from tenants by evening rentals on a casual basis to a tenant who was operating a pub and was required under its resource consent to have 60 carparks available.

[63] Mr Morgenstern’s evidence was that the concept of the carparking deed was to incentivise SAI to ensure that its tenants used the 166 carparks. In effect, SAI would receive a capped share of the profit produced by the reserved carparks. Under pressure from SAI, GLL agreed to a minimum threshold of 50 carparks. But, said Mr Morgenstern, that would still have been adequate to cover the incentive payment;

50 carparks leased at $45 per week would generate $117,000 in revenue. To this could be added up to $14,040 in casual evening revenue. Mr Morgenstern said he expected the minimum would be exceeded given that one of the tenants had committed to taking 60 carparks.

[64] Mr Morgenstern said the arrangement only made commercial sense if the 50 carparks were rented at market rates. This was contemplated by the agreement for sale and purchase which obliged KDL to procure GLL to enter into a carparking deed under which GLL would keep carparks available for Axon House tenants and would provide the carparks “at the then current market rate to tenants, owners and occupiers of the Property”.¹⁵ The carparking deed also contemplated the lease of carparks at current market rates.

[65] GLL’s difficulties stemmed from the terms of clause 2.9 of the carpark deed which relieved GLL of the obligation to make the incentive payment if the number of carparks leased fell below 50. It did not specify that in order to qualify for this purpose carparks should be leased at current market rates. After settlement, more than 50 carparks were leased to Axon House tenants but at substantially less than market rentals. GLL disputed liability for the incentive payment, contending that the carpark deed should be interpreted to require that at least 50 carparks were leased at market rates. GLL’s position was rejected and SAI was successful in obtaining judgment in the District Court.

Discussion

[66] In my view, Mr Morgenstern had good reason to expect that GLL would not be obliged to make an incentive payment unless there were more than 50 carparks leased at market rates. In a memorandum written to him on 13 May 2005,

Kensington Swan had explained the proposed carparking arrangements on the basis that GLL would provide carpark space at current market rentals. The agreement for sale and purchase and the carpark deed itself anticipated the lease of carparks at market rentals. The omission to qualify clause 2.9 may well have been a drafting error. It seems inherently unlikely that Mr Morgenstern would have committed GLL to making the incentive payment without receiving a corresponding benefit. It was the whole purpose of the incentive arrangement.

[67] Leaving to one side the unexpected difficulty over the incentive payment, the Newmarket carpark appears to have been operated in a commercial and businesslike way. I was referred to revenue and expense budgets for the 2003 2005 period which showed continuing growth in revenue and profitability for the overall operation. It is true, as Mr Sclater pointed out, that these budgets covered the whole operation of which the GLL business was just a part, they were for an earlier period and did not include actual figures. However, I have no reason to doubt that they reflected the pattern of growth which could reasonably be anticipated and which Mr Morgenstern said was being achieved. The plaintiffs’ experts did not dispute his evidence that a carpark operation could expect to incur losses in its early years of operation and only gradually build towards profitability.

[68] It was inevitable then that both GLIMS and GLL, as GLIMS’ wholly owned subsidiary, would be reliant on the continuing support of GLIMS’ shareholders. Indeed, a note to the GLIMS accounts records the agreement of shareholders to continue to support the company and ensure that debts are paid when they fall due. Both Mr Bosley and Mr Sclater accepted that the continuation of this support was critical to the survival of both companies. As previously noted, if such support can reasonably be anticipated if required to meet an obligation, a director will not be in breach of s 136 or guilty of the illegitimate risk-taking which would also found

liability under s 135. ¹⁶

[69] As I have already said, I take the view that Mr Morgenstern had reasonable grounds for believing that income from the carpark would be sufficient to cover the incentive payment. Further, he appears to have had no reason to think that

shareholder support would not continue and extend, if need be, in the event that GLL required assistance to meet its obligations under the carpark deed. I do not think the turn of events which led to the judgment against GLL was reasonably forseeable. I consider Mr Morgenstern had reasonable grounds for believing that income from the carpark would be sufficient to cover the incentive payment. However, in the event that support was required, Mr Morgenstern was entitled to anticipate that GLIMS would continue to support GLL as it moved towards profitability. Indeed, it is clear that GLIMS’ shareholders decision to withdraw support from GLL stemmed from their belief that the incentive payment was not payable.

[70] On this basis, I am satisfied that Mr Morgenstern’s decision to allow GLL to

enter into the carpark deed did not involve a breach of duty under either s 135 or

136.

Sale of shares in MS St Lukes

Background

[71] As earlier mentioned,¹⁷ the St Lukes development was carried out by Morning Star (St Lukes Garden Apartments) Limited (MS St Lukes). It acquired approximately eight acres of land in St Lukes from Westfield NZ Limited in January

2003. The completed project comprised 382 residential apartments approximately

500 m² of retail units and a commercial building. Mr Morgenstern owned 99 of the shares in MS St Lukes. Ms Lavas owned one share. The shares of both were transferred to MSE on 30 March 2007 at what the liquidators of MSE claim to have been an excessive consideration.

[72] The St Lukes development was financed by the Bank of New Zealand (BNZ) as first mortgage lender and Structured Finance as second mortgage lender. As with the Axon House development, Mr Reesby managed the financial side of the development. All payments had to be made or approved by Structured Finance. Mr Reesby regularly prepared financial reports and feasibility studies reporting on the projected returns from the project.

[73] By 2005 MS St Lukes had completed the construction of 241 apartments and associated retail units in Buildings A to F. This was known as stage one. It remained to complete Buildings G and H, comprising 53 apartments and six commercial units, together with a two-storey commercial building intended to house a branch of the BNZ. This was known as stage two.

[74] Stage two required a variation to the existing resource consent and a new resource consent for the BNZ building. MS St Lukes had engaged a planning consultant to look after this side of the development. When building consents were issued for Buildings G and H, it was assumed that the necessary resource consents had already been obtained. In early 2006, it emerged that this was not the case. A variation to the resource consent had not been obtained. Work on stage two stopped. For various reasons, including objections raised by a group of owners of stage one apartments, there were unexpected delays and a retrospective resource consent was not granted until March 2008. The conditions of consent were much more restrictive than had been sought. There was an appeal which was not resolved until 2010. The delay and the modified terms of consent substantially impacted on the profitability of the project.

[75] In late 2006 or early 2007, Mr Morgenstern was advised that he should reduce his overdrawn current account with MSE. As at 31 March 2005, he had an overdrawn balance of $1,776,336. There were drawings during the year ended 31

March 2006 which further increased the balance.¹⁸ Mr Morgenstern said at that time

his only significant asset was his interest in the St Lukes development which had ground to a halt and was no longer producing income. His accountants, BDO Spicers, proposed that he sell his shares in MS St Lukes to MSE, crediting his current account in payment. He said he was advised that he needed to establish a market value for the shares, otherwise the transaction would be open to challenge and any difference between the transaction value and actual value of the shares would be deemed a dividend. It was agreed that Mr Reesby would be asked to

_{assess the current value of the St Lukes project. He prepared a feasibility study or}

¹⁸ The accounts for the year ended 31 March 2006 show Mr Morgenstern to have a credit balance of $145,296 but that is acknowledged to be incorrect as it wrongly included at least two major transactions including the share sale itself.

“profit summary” as at 28 February 2007 which showed an assessed profit of

$4,429,000. On the advice of BDO, the assessed value was discounted by 20 per cent and the shares transferred for $3,465,000.

Plaintiffs’ claim

[76] The liquidators say the sale of shares in MS St Lukes (including the one share owned by Ms Lavas) was for an excessive consideration. They claim the shares were worthless. They seek compensation under s 298 of the Act which provides that where, within a period of three years before the date of commencement of the liquidation, a company has acquired property from a director (including a nominee or relative of a director), the liquidator may recover any amount by which the value of the consideration given for the property exceeded its value at the time of the acquisition. The liquidators also seek orders under s 301. They say the sale involved breaches of the duties under s 131 (of good faith), s 135 (not to trade recklessly) and s 137 (of care). In addition to the alleged sale at an undervalue, the plaintiffs rely for these causes of action on irregularities in the sale process and Mr Morgenstern’s alleged purpose of avoiding personal liability for his indebtedness to MSE.

[77] The liquidators say that when the transaction took place in March 2007, the shares were worthless and Mr Morgenstern’s overdrawn current account which, by way of set-off provided the consideration, was worth its face value. They say that Mr Morgenstern engaged in a self-interested transaction, without a contemporaneous

independent valuation which was a minimum requirement.¹⁹

Defence response

[78] As mentioned, Mr Morgenstern’s position is that he acted on the advice of BDO Spicers. He said Mr Iain Craig advised him that he needed to pay down his current account in order to bring capital into MSE and avoid incurring interest on the overdraft which would give rise to a deemed dividend. He continued:

MSE was my main trading company and, among other obligations, guaranteed the obligations for the St Lukes Garden Apartments project.

¹⁹ Robb v Sojourner, above n 4, at [25].

Given that that project has stalled, I had no ability to repay the current account from cashflow. I therefore needed to transfer assets into MSE.

[79] Mr Morgenstern said his only significant asset at the time was his interest in the St Lukes Garden Apartments development, held through MS St Lukes. Mr Craig suggested that he sell his shares in MS St Lukes to MSE, crediting the current account in payment, in order to capitalise MSE. Mr Morgenstern was adamant there was no element of asset protection in the transaction. As he was the owner of the shares in MSE, he claimed it made no difference whether the shares in MS St Lukes were held by him directly or by MSE.

[80] Mr Morgenstern also maintained there was no suggestion that the transaction would enable him to avoid personal liability to MSE in respect of his overdrawn current account in the event of its liquidation. He did not anticipate that MSE would go into liquidation. His interest was to transfer to MSE his only substantial asset in order to pay off a current account that he had no other means of meeting. Mr Morgenstern said he proposed that Martin Reesby assess the current value of the St Lukes Garden Apartments project as he had extensive knowledge of the project and was in the best position to provide an accurate assessment.

Claim under s 298

Value of shares

[81] It is convenient first to consider the evidence bearing on the value of the shares. The liquidators say they were worthless when acquired by MSE. Mr Downes said that MS St Lukes was insolvent. As at 31 March 2007, its liabilities exceeded its assets by $1,515,012. It’s assets included a debt due by MSE of

$1,268,640.

[82] Mr Downes accepted that he based his opinion solely on the accounts as at

31 March 2007. He conceded that he had not enquired into the present value of the assets or investigated Mr Morgenstern’s capacity to repay his current account. He accepted, however, that the solvency of MS St Lukes should not be assessed solely on the accounts.

[83] Mr Bosley also relied on the 2007 accounts in concluding that the shares of MS St Lukes had no value when they were acquired by MSE. He acknowledged that he had not undertaken any other assessment of the underlying value of the development project. He agreed, however, that the solvency of MS St Lukes could not be assessed solely by reference to the accounts.

Feasibility study

[84] Mr Reesby said the so-called feasibility study was a revised budget and profit assessment prepared for the purpose of giving the development’s funders a view of their security position. He said he set out to provide a fair, accurate and reliable picture. He did not know the study would be used for the purpose of a sale of the shares.

[85] The evidence of Mr Bosley highlighted major concerns about the use of the feasibility study for the purpose of valuing the shares. Its primary deficiency is that it was not a valuation of the shares. It was an assessment of the profitability of the development project. The project was, of course, the major asset of MS St Lukes. Its value would necessarily be an important component of any share valuation. But a share valuation involved much more than a valuation of the company’s main asset. As Mr Bosley said in his evidence in chief:

The feasibility study purports to calculate a share value by deducting “Existing Debt” of $17.1 million from the total of the Project Components. This calculation highlights the ambiguity of the valuation methodology. A correctly developed income based approach would add surplus assets and deduct any creditors that were not included in the net cash flows and this analysis has not occurred. Potential surplus assets at 31 March 2007 include intercompany balances and related party balances. Trade and other creditor balances also exist. In a similar manner, a correctly developed asset based approach would account for all balance sheet items at 31 March 2007 to obtain an equity value but the intercompany and related party assets and the creditor balances do not appear to have been accounted for.

[86] The feasibility study may have been acceptable for the purpose of reporting to the project’s funders, but it was a wholly unsatisfactory basis for founding a related party transaction. The evidence of Mr Bosley also exposed further important shortcomings in its fitness for that purpose.

[87] Property values used exceeded valuations (which themselves did not meet formal reporting standards) and in the case of the residential apartments, did not appear to be supported by “actual sales of comparable units in the same complex” as Mr Reesby claimed.

[88] The allowance made by Mr Reesby for interest of $600,000 was demonstrably inadequate on total debt of $16.5 million at 28 February 2007. In cross-examination Mr Reesby was unable to explain his calculation. Mr Bosley’s calculation of $2.55 million seems much closer to the mark though he was obliged to concede that he had not enquired into the likely debt profile of the project. What is clear is that, even after expected realisations, substantial debt levels would persist

until completion.²⁰

[89] The feasibility study itself made no allowance for risks and contingencies. They were allowed for in the 20 per cent discount recommended by BDO Spicers. That was never explained or justified and appears to have had insufficient regard for the risk that the project would not resume and be completed in a timely way.

[90] Mr Morgenstern was inclined to minimise the uncertainties associated with the resource consents required before the St Lukes project could be completed. He said that in March 2007 he understood consents would be granted within a relatively short timeframe. Yet the potential pitfalls were significant. Before the project could be progressed, four separate applications for resource consents had to be processed. The retrospective application required to regularise issues arising from earlier works had to be dealt with first and three applications to vary conditions of the underlying consent and to erect the bank premises would then be reactivated. While Mr Morgenstern was able to point to projections from the project manager which indicated that works could be recommenced at an early stage, the delays and disruptions that had prevented the resumption of work over the previous year showed that considerable caution was required. On 22 December 2006, the project manager referred to the time taken as “hugely unexpected” and “very upsetting”. He referred to earlier expectations of recommencement by the middle of 2006 but, as a

_{result of “continually changing requirements”, the best estimate of recommencement}

²⁰ I do not overlook that interest was separately allowed for on the costs of stage 2 itself.

was late in the first quarter of 2007. However, by 29 March 2007 (one day before the share transaction took place), the project manager was again referring to “continually changing requirements from Council” and to a “best estimate for recommencement” as the end of June, or early July 2007.

[91] Mr Morgenstern said he followed the advice of Ms Gina Hull of BDO Spicers in applying a discount of 20 per cent for the profit estimate. There is nothing to support or explain its adoption. Having regard to the uncertainties associated with the grant of the resource consent alone, it was clearly grossly inadequate, as subsequent events were to show.

[92] The hearing of the retrospective consent application did not take place until

31 October 2007. A further day of hearing was required in November 2007. The retrospective consent was not granted until 25 March 2008 and was subject to unacceptable conditions. Among other things, it did not allow the development of 15 further apartment units or the BNZ building, the sale of two future development units and required substantial additional works. There was an appeal to the Environment Court which was not resolved until 2010. Construction of the second stage did not recommence until late 2010.

[93] I am led inexorably to the conclusion that Mr Reesby’s feasibility study (as adjusted) is of no assistance in determining the value of the shares. The defendants have not shown they were worth $3.5 million at 30 March 2007. In order to succeed under s 298, however, the liquidators must go further and show that the consideration provided for the shares exceeded their value.

Whether consideration for shares exceeded their value

[94] The consideration for the shares was the setoff of their assessed value against Mr Morgenstern’s current account in MSE. Mr Morgenstern said his only significant personal asset at the time was his shares in MS St Lukes. Therefore, his ability to repay his current account – and therefore its worth as an asset of MSE – was dependent on his shares in MS St Lukes having at least the equivalent value. He provided no details of his personal financial position to substantiate this claim. He should have done so if he wanted to persuade me that his only significant personal

asset was his shares in MS St Lukes. I do not think there is sufficient basis for me to conclude that his current account ought not have been fully recoverable regardless of the value of his shares in MS St Lukes. I proceed on the basis that the consideration for the shares was the amount by which his current account was reduced. The key issue then is whether the plaintiffs have shown that the shares were worth less than their assessed value of $3.465m.

[95] In concluding that the shares had no value, Mr Bosley essentially relied on the past performance of MS St Lukes to conclude that work-in-progress at 31 March

2007 would not have generated a future profit. He conceded that he had not himself made the enquiries and did not have the expertise that would have enabled him to value the assets of MS St Lukes at 31 March 2007. He accepted that in reaching his conclusion that the shares were of no value, he relied on the financial accounts alone. That is insufficient. The exposé of the deficiencies in the Reesby-based valuation has gone a long way to showing that work-in-progress had no value but I was not provided with the evidential foundation which would have enabled me to conclude that to be the case.

[96] I am left then with two bases for valuation of the shares, both deficient. Mr Reesby’s feasibility study could not support the valuation adopted for the purpose of sale. On the other hand, the valuation put forward by the liquidators failed to make provision for the fair value of the St Lukes development as at March

2007. I am satisfied the consideration paid by MSE was excessive but I have no reliable means of determining by how much. The liquidators have not made out a case for recovery under s 298.

Claims under s 301

Breach of s 131 – good faith

[97] I pass to consider the alternative causes of action beginning with the

liquidators’ claim of breach of s 131 of the Act. Section 131(1) requires that:

A director of a company, when exercising powers or performing duties, must act in good faith and in what director believes to be the best interests of the company.

[98] Section 131 enacts the longstanding common law principle that directors must act in good faith and in what they believe to be the best interests of the company. There are extensive discussions of the nature of the duty in the judgments of Fogarty J in Sojourner v Robb ²¹ and of the Court of Appeal on appeal.²² In Sojourner v Robb the directors of a company in financial difficulties responded by transferring its undertakings and the bulk of its assets to a phoenix company. The

transferor company then went into liquidation. Creditors sued the directors under s

301 alleging a breach of s 131 on the basis that the sale was for the purpose of defeating the (indigent) creditors of the company and was not at arm’s length and at an undervalue. On appeal the Court of Appeal said:²³

Directors ... should take care to ensure that the value paid by the phoenix company is fair. This is likely to involve, at the very least, a contemporaneous independent valuation of the assets being acquired. In terms of both the process adopted and the price which is eventually fixed, directors would be well advised to err on the side of caution as if the sale is later held to have been at an undervalue, the liability of directors may well exceed the discrepancy between the contract price and fair value. This is because, if the sale is not for fair value, ss 139 – 149 of the Companies Act will be of no assistance to the directors and there will thus be no limitation on the application of the usual equitable principles as to relief (which extend to compulsory disgorging of gains).

[99] It is helpful to begin by considering the circumstances that confronted Mr Morgenstern in March 2007. The St Lukes development had been halted in March 2006. MS St Lukes was carrying substantial debt which had been guaranteed by Mr Morgenstern personally. While there were indications that the project was getting back on track, there were significant hurdles to be cleared before construction could resume. There could be no assurance as to when this would be. MSE itself was coming under financial pressure. It was balance sheet insolvent. It was being sued by SAI as guarantor of the rental underwrite deed.

[100] While Mr Morgenstern’s position is that the sale of MS St Lukes shares was first mooted at this time, there are clear indications that the issue had been previously considered. The share transfer and related Board resolution were originally dated 10

_{March 2006. The consideration shown in the resolution was $3.5 million. The date}

²¹ _{Sojourner v Robb [2006] 3 NZLR 808 at [100] – [102].}

²² _{Robb v Sojourner, above n 4.}

²³ At [31].

of both was amended to 30 March 2007 and the consideration in the resolution amended to $3.465 million. To add to the confusion, the accounts of MSE showed the sale as taking place during the year ended 31 March 2006.²⁴

[101] Mr Morgenstern conceded that there may have been a discussion in March

2006 about a transfer of the shares but had no recollection of it. The documents clearly point to sale having been contemplated at that time, then resurrected in March

2007. If the price of Ms Lavas’ single share is added back, the consideration is exactly the same. That is an extraordinary coincidence when regard is had to the apparent change in the prospects for the St Lukes development over the intervening year. There is no suggestion that the earlier proposed transaction was supported by a valuation. It is remarkable then that the later valuation was anticipated with such uncanny accuracy.

[102] Be that as it may, there is support for the valuation in the form of Mr Reesby’s feasibility study. For the reasons already discussed, however, it falls well short of meeting the requirement for a contemporaneous independent valuation. It is not independent. It is not a valuation of the shares. It is so plainly deficient that I simply do not accept that Mr Morgenstern was advised that the valuation was adequate for the purpose. If he had been so advised, I would have expected the accountants concerned to be called to defend and explain their advice. The failure to

do so supports a contrary view.²⁵

[103] I am also not persuaded that Mr Morgenstern honestly believed the sale to be in the best interests of MSE. I believe his dominant purpose was to avoid exposure to a claim for recovery of his current account and to shift the risk of the St Lukes project to MSE and, through MSE, to its creditors.

[104] A previously noted, Mr Morgenstern said he was advised by Mr Craig of BDO Spicers that he needed to pay down the current account in order to bring capital into MSE and to avoid incurring interest on the overdraft, which would give rise to a

_{deemed dividend. The benefit of the current account ceasing to incur interest and the}

²⁴ _{These accounts were not prepared until after March 2007.}

²⁵ Applying the so-called rule in Jones v Dunkel [1959] HCA 8; (1959) 101 CLR 298 (HC). See the discussion in

Perry Corporation v Ithaca (Custodians) Ltd [2004] 1 NZLR 731 at [146] – [155].

tax savings that would follow would, of course, accrue to Mr Morgenstern personally. Arguably, the company was advantaged by deriving income from the overdrawn account. That said, as Mr Sclater accepted, the advice was orthodox enough. It is standard for accountants to encourage clients to draw down their current accounts. What is said to be objectionable in this case is the means used to achieve that end.

[105] In cross-examination Mr Morgenstern explained what he understood to be meant by “bringing capital” into MSE. He said the company needed to be capitalised:

Because it had a shareholders’ account I couldn’t pay back.

I understand his position to be that the sale would be in the interests of the company because it would replace a current account that could not be repaid with a valuable asset.

[106] As I have already said, I do not necessarily accept that Mr Morgenstern could not have repaid his current account. I was given no details of his personal financial position. What he did say, however, is that he was in a position to support MSE by capitalising it as and when necessary. He said that although he had limited personal financial wealth, he still had the ability to earn the funds and raise capital from banks, finance companies and investors to inject into his companies as and when required to meet financial obligations. I believe Mr Morgenstern could and would avail himself of these resources if his personal financial standing were threatened.

[107] Leaving that to one side there is, however, as Mr Malarao pointed out, a central fallacy in the proposition that the acquisition of the shares would “capitalise” MSE. The “capitalisation” of MSE would be dependent on the success of the St Lukes development. The acquisition of the shares would only “capitalise” MSE in any real sense if the development were profitable. In that event, Mr Morgenstern’s ability to repay his current account, contingent (on his evidence) on the success of the St Lukes development, would be restored. The acquisition of the shares achieved nothing for MSE while Mr Morgenstern was able to shed his personal liability and acquire an asset (the balance of the purchase price) which would be repayable if the

St Lukes development were profitable. In a very real sense, MSE surrendered a bird in the hand for one in the bush.

[108] Mr Morgenstern acknowledged in cross-examination just how important the transaction was to him in the counterfactual of MSE going into liquidation. He was asked about an email in which he had said that MSE was not ready to go into liquidation at the date of the email (23 August 2007) but would be at the year end. He was asked “why at year end?”. His reply was:

Because a trigger for MSE to go into liquidation right then would have bankrupted me on the spot because I hadn’t got my St Lukes Garden Apartments on track, I had contingent liabilities to the Bank of New Zealand, I had contingent liabilities to 282 purchasers that I agreed to finish the development for and it was important for me not to let anything broadside me until I had paid back those loans and came good to those people I made representations to.

[109] Mr Morgenstern’s exposure in March 2007 was no different. The St Lukes project was still some distance from getting back on track. There was optimism but there were also danger signals. Mr Morgenstern’s personal exposure was significant. The liquidation of MSE would have had disastrous consequences for him. The proposed transaction put his personal interests and those of MSE in direct opposition. In circumstances in which he was bound to act with the greatest circumspection to ensure that he could not be accused of placing his interests before those of the company, he acted in what can only be described as a cavalier fashion. Instead of an independent share valuation, he made do with an exercise carried out for a completely different purpose by an associate who himself had a direct interest in the subject matter.

[110] Mr Morgenstern said the sale of his shares, including his reliance on the Reesby feasibility study, was endorsed by his advisors at BDO Spicers. If so, as I have previously commented, they should have been called to explain and defend their advice. With only Mr Morgenstern’s evidence to rely on, I am quite satisfied that he was aware of the essential shortcomings of the valuation. He proceeded with the sale regardless as best serving his personal interests. He was clearly in breach of s 131.

Breach of s 135 – reckless trading

[111] Unlike the rental underwrite and carpark commitments, the purchase of MSE shares was a transaction which went to the heart of the company’s business enterprise. MSE’s primary function was to operate as an investment or holding company for the Morgenstern property development interests. The transaction came into the category identified by Lang J in Goatlands of one that had the potential to

cause the company’s demise. He said, with reference to a single transaction: ²⁶

If, as in the present case, the directors are considering whether the company should enter into a single transaction that has the potential to cause its complete demise, they must reach their decision after a “sober assessment” of the level of risk that the transaction entailed for the company and its creditors. They should only proceed to commit the company to the transaction if, objectively viewed, the risk of failure is sufficiently small to warrant the company taking it. If the risk of failure is substantial, in the sense of real and significant, it should not be taken.

[112] For the reasons already canvassed, I consider the transaction involved an unacceptable level of risk that could not be justified. It involved the company surrendering a valuable asset (the debt recoverable from Mr Morgenstern) in exchange for shares in a stalled property development that had a long way to go before offering any prospect of a return. Mr Morgenstern failed to take even the most elementary steps to protect the interests of the company. The risk of serious loss to company creditors was palpable. It was a proposal that could not have survived a sober assessment. I am satisfied that Mr Morgenstern was in breach of s 135.

Breach of s 137 – duty of care

[113] Section 137 states:

A director of a company, when exercising powers or performing duties as a director, must exercise the care, diligence, and skill that a reasonable director would exercise in the same circumstances taking into account, but without limitation,—

(a) The nature of the company; and

_{(b) The nature of the decision; and}

²⁶ Goatlands Ltd (in liq) v Borrell, above n 7, at [46].

(c) The position of the director and the nature of the responsibilities undertaken by him or her.

[114] The standard for assessing a director’s skill and care is the objective standard of a ‘reasonable’ director. This requires an objective assessment not giving credit for a particular director’s lack of any requisite experience or knowledge, but being tested by the requisite skill set required of a reasonable director in the same position as the defendant.²⁷ Although subsections (a) and (b) require a factual analysis of the circumstances, this does not alter the objective test required. Subsection (c) allows the Court to consider the executive or non-executive nature of the appointment.

[115] Commentary on this section distinguishes s 137 from s 131:²⁸

It is possible there is an overlap between the duty in s 131 to act in what the director believes are the best interests of the company (see CA131.04) and the duty in s 137 to exercise the care, skill, and diligence of a reasonable director. However, the standard expected under s 131 may well be significantly lower given the subjective test in that section of “what the director believes”. Therefore, cases involving only negligence are likely to be brought under s 137. See H Rennie QC and P Watts, Directors’ Duties and Shareholders’ Rights, New Zealand Law Society seminar, Wellington, August-September 1996, pp 12-13.

[116] In the circumstances that existed at the time of the share sale, I am satisfied that Mr Morgenstern’s actions fell well short of the standard to be expected of a reasonable director. Mr Sclater drew my attention to a number of respects in which the company’s recordkeeping was deficient. These included the failure to produce timely accounts; the failure to keep and interests register; and the omission to ratify the share sale, as a major transaction, by special resolution as required by s 129 of the Act. However, the most egregious omission was Mr Morgenstern’s failure to obtain an independent share valuation by a suitably qualified person. I am satisfied that a reasonable director in Mr Morgenstern’s position would have done so. He is

_{accordingly in breach of s 137 of the Act.}

²⁷ Boutique Tanneries Ltd (in liquidation) v Handley HC Auckland CIV-2006-404-2713, 24 July

_{2008, at [31].}

²⁸ Brookers Insolvency Law and Practice (online looseleaf ed, Thomson Reuters) at CA137.03.

Relief

[117] Where a breach is found, the Court may make orders under s 301(1)(b)

requiring the person in breach:

(i) To repay or restore the money or property or any part of it with interest at a rate the Court thinks just; or

(ii) To contribute such sum to the assets of the company by way of compensation as the Court thinks just.

[118] Relief may be calculated on a restitutionary or compensatory basis. ²⁹ In cases of reckless trading, what has been described as the standard approach is to consider the deterioration in the company’s financial position between the breach date and the date of liquidation and make an order which has regard to causation, duration of the trading and culpability.³⁰ Cases such as the present demonstrate the practical difficulty of determining the extent of deterioration. Further, such an approach does not really respond to the essential nature of the breach which lies, not in the decision to carry on trading past 30 March 2007, but in the decision to sell the shares.³¹ The focus must be on the implications of the transaction itself.

[119] This is recognised by the liquidators who seek, not an account of profits, but orders which would, in effect, restore MSE as nearly as possible to the position it was in before the share sale. In the circumstances, that would be equivalent to requiring Mr Morgenstern and Ms Lavas to disgorge the benefits which flowed to them from the breach. That benefit was, of course, the elimination of

Mr Morgenstern’s current account and a credit to him for the balance.³²

[120] An order is sought that Mr Morgenstern restore to MSE the sum of

$3,465,000 and Ms Lavas restore the sum of $35,000. It is not apparent to me that there is any basis on which I could make an order against Ms Lavas. No relief

_{against her is pleaded. She was not a director and therefore not in breach of duties}

²⁹ _{Robb v Sojourner, above n 4, at [53].}

³⁰ Re Bennett, Keane & White Ltd (in liq) (No 2) (1988) 4 NZCLC 64,317 (HC) and Lower v

Traveller [2005] 3 NZLR 479 (CA) cited in Mason v Lewis HC Auckland CIV-2003-404-936, 1

_{October 2008 at [62].}

³¹ _{See also the discussion in Robb v Sojourner, above n 4, at [72] – [74].}

³² The credit balance appears to have been largely offset by a debt of $1, 612,220 owed by Hamina

Enterprises Ltd.

under the Act. The breaches have been by Mr Morgenstern and, as they led to all shares being transferred, the resultant loss to the company was $3.5 million dollars. I conclude that is the sum that he should be ordered to pay, less $1 being the price at which the shares were subsequently sold to St Lukes Holding Limited.

Summary and conclusions

[121] The rental underwrite and carpark indemnity were integral to the sale of Axon House. The commercial wisdom of that transaction has not been questioned. The sale price was in excess of a registered valuation of the property. It yielded a profit on the development.

[122] Both commitments were contingent in nature and at the time they were entered into Mr Morgenstern had good reason to expect that neither would give rise to a liability. In the event that they did, it was reasonable for him to expect that the companies concerned would be in a position to honour them. Their inability to do so was not something he could reasonably have foreseen.

[123] Neither commitment involved illegitimate risk-taking. There are no grounds for Mr Morgenstern to be required to contribute to or make good the losses that ensued.

[124] The sale to MSE of the shares of Mr Morgenstern and Ms Lavas in MS St Lukes is a horse of a very different colour. By the time of the sale the financial position and prospects of MSE had deteriorated. The St Lukes development had been dogged by delays and there were major questionmarks over when it would resume. Its profitability was uncertain. The sale of the shares gave rise to a direct conflict of interest. Prudence, care and transparency was required. An independent expert’s valuation of the shares was a minimum requirement.

[125] The valuation obtained by Mr Morgenstern fell well short of that standard. It could not be relied on to justify the sale price. However, the evidence to support the liquidators’ opinion that the shares had no value is itself deficient. They had not been able to prove the extent by which the sale price exceeded the consideration. The claim under s 298 of the Act accordingly fails.

[126] However, the way in which the sale was transacted constituted clear breaches of Mr Morgenstern’s duties as a director to act in good faith, not to carry on the business of MSE in a manner likely to create a substantial risk of serious loss to the company’s creditors and to act with reasonable care. He is required to make good the loss suffered by MSE as a result of these breaches.

Result

[127] The claims against Mr Morgenstern for breaches in relation to the share underwrite and the carpark deed are dismissed.

[128] The claim for orders under s 298 of the Act are dismissed.

[129] I make declarations that the sale of the defendant’s shares in MS St Lukes involved breaches by Mr Morgenstern of duties under s 131, 135 and 137 of the Act, by reason of which I order him to contribute to Morningstar Enterprises Limited (in liquidation) the sum of $3,499,999.

[130] The plaintiffs are entitled to costs. If the parties are unable to agree, they may file memoranda.