Introduction
Termite Resources NL v Meadows is another reminder for directors of their duties. Although the Federal Court held that the liquidators had failed to establish causation for broader losses arising from its decision not to have a greater cash reserve for operations, the court awarded lesser damages of $7m for the inadequate cash reserve.
Background
The case against the directors concerned the amount of money kept in reserve for the company to meet its liabilities, including Termite’s Distribution Policy, where Termite borrowed money from Taifeng and IMX to continue its operations. On 12 March 2013, Termite designated $3million as its retaining reserve. In early 2014, there was a sudden decline in the spot price for iron ore, falling from about $130 per tonne to around $100 per tonne. This resulted in Termite incurring tail liabilities of around $25m, which crystallized upon reducing production of iron ore due to falling iron ore prices. On 18 June 2014, this amount was later found to be inadequate and Termite was placed into voluntary administration. During the administration, the spot price continued to decline to $80 per tonne and, in September 2014, the creditors of Termite resolved to wind up the company.
The Decision
The liquidators argued the cash reserve should have been $10m to account for a volatile iron ore mine market price at the time. By entering into the Distributions Policy and failing to review, revoke or vary the policy, the directors were alleged to have caused Termite to become insolvent. The liquidators argued also that the directors had failed to consider the interests of the company and instead had advanced the interests of Outback, Taifeng and IMX by using Termite as fodder. The liquidators alleged that two non-directors, Mr Sun and Mr Pang, were shadow directors of Termite, as the directors were accustomed to act in accordance with their wishes.
Directors are required to be fully informed of all activities of the company and to act with due care and diligence to avoid harm and risk. The test to determine breach is whether an ordinary person in their position would have acted as they did at the relevant times in the interests of the company. They are also required to consider the interests of shareholders and creditors.
The court found that the directors were all aware of the risks of a volatile iron ore price, including the consequence of insolvency. The directors had considered ring-fencing Termite to protect IMX and Outback from liabilities from the mining project. Concerning the directors’ decision to provide the $3m reserve amount, the court found that they had given minimal consideration to the adequacy of the reserve amount. In applying Grimaldi v Chameleon, the court found that Mr Sun and Mr Pang were in fact directors of Termite.
Justice White found that the liquidators of Termite NL failed to establish that the reserve amount would not have been distributed if the directors had complied with their duties. Even if there was a breach, the liquidators could not establish what position Termite would have been in without the breach.
Justice White held that the $3m reserve amount was inadequate in the circumstances. He observed that:
- the reserve did not sufficiently cover Termite’s monthly expenses;
- the reserve would not sufficiently cover losses if the iron ore price fell more than $20 per tonne below Termite’s breakeven point;
- the Cairn Hill mine operation was costly and the directors were aware of the risk of insolvency;
- the directors knew the iron ore price was volatile;
- the company had a “near death experience” in September 2012 when the iron ore price fell below Termite’s breakeven price for 44 days. It should have been on the directors’ minds if Termite experienced a longer period of trading below the breakeven price;
- the directors held an unrealistic view of the prospects of finding capital from the other entities in the joint venture; and
- management of Termite had advised the directors that the reserve amount was inadequate and the directors ignored this.
The court considered that a $10m reserve amount was appropriate because it would have covered 66% of Termite’s monthly expenses and Termite would be adequately covered in situations when the iron ore price fall about $33.30 per tonne below the breakeven price for 2 months or $22.30 per tonne for 3 months. This meant that the liquidators could only establish a loss of $7m. The court held that the defendants could not rely on the business judgment rule because their decision was not for a proper purpose and it was not in Termite’s best interests.
Conclusion
The decision highlights the need for directors to adopt a conservative and rigorous approach in calculating cash reserves, particularly in volatile market conditions.
Chris Goddard
chris.goddard@chrisgoddardsolicitors.com.au
Paul Goddard