What duties and liabilities should directors and officers be mindful of when managing a distressed debtor? What are the consequences of breach of duty? Is there any scope for other parties (e.g. director, partner, shareholder, lender) to incur liability for the debts of an insolvent debtor?
Restructuring & Insolvency (2nd Edition)
The Company Law in conjunction with the Indonesian Civil Code provisions on tort provides the possibility of a company or the Board of Directors / Commissioners of such company committing tort which cause losses to the third party. A director may be deemed as liable under tort if a contract is entered into on behalf of the debtor and the director of the debtor knows or should know that the company cannot, or cannot within a reasonable period of time, perform its obligations and the third party / creditor’s loss resulting from the breach of contract cannot be paid from the debtor’s assets.
The Company Law clearly states that every member of the Board of Directors / Commissioners of the debtor shall be jointly, severally and fully personally liable:
(a) for the losses of the debtor if the relevant director / commissioner is proven to be at fault or negligent in the performance of his/her duties in managing the Company with good faith and full responsibility for a director or in supervising and advising the Board of Directors for a commissioner, unless each of them can prove that:
i. for the Board of Directors:
- the losses do not result from his/her fault or negligence;
- he/she has conducted the management in good faith and prudence in the interest of the debtor and within the objectives and purposes of the debtor;
- he/she has conducted the management in good faith and prudence in the interest of the debtor and within the objectives and purposes of the debtor; and
- he/she has taken preventive measures against the arising or continuation of losses. [“Has taken preventive measures against the arising or continuation of losses” also includes steps to have access to information about the acts of management that result in losses, inter alia, through a forum of a meeting of the Board of Directors.]
ii. for the Board of Commissioners:
- he/she has made supervision in good faith and prudence in the interest of the
debtor and within the objectives and purposes of the debtor;
- he/she has no personal interest whether directly or indirectly in the acts of management of the Board of Directors that result in losses; and
- he/she has given advice to the Board of Directors to prevent the arising or continuation of losses.
i. if (i) the relevant director / commissioner is proven to be at fault or negligent which leads to the bankruptcy declaration of the debtor and the (ii) assets of the bankrupt debtor are not sufficient to settle the entire obligations of the debtor, for the unpaid claims of the bankrupt debtor’s creditors (This also applies to those holding director / commissioner position within 5 years prior to the bankruptcy declaration), unless each of them can prove that:
a. the bankruptcy is not due to his/her fault or negligence;
b. he/she has conducted the management (for director) / supervision (for commissioner) in good faith, prudence, and full responsibility in the interest of the Company and within the objectives and purposes of the Company;
c. he/she does not have conflict of interest either directly or indirectly over the management actions that have been performed (by the Board of Directors; and
d. he/she has taken measures to prevent the bankruptcy occurrence (for director) / advised the Board of Directors to prevent the bankruptcy (for commissioner).
In line with the Company Law, the scope for the shareholder of the debtor to incur liability for the debt of an insolvent debtor would be when it can be proven that when the debtor in its insolvent condition create debt:
a. The debtor has not yet acquired legal entity status.
b. The shareholder, in bad faith, uses the debtor solely for its own benefit.
c. The shareholder is involved in unlawful acts committed by the debtor.
d. The shareholder uses the assets of the debtor, causing the debtor to be unable to pay its debts.
e. The debtor has only 1 (one) shareholder for more than 6 (six) months.
Directors have both statutory and common law duties and may be held liable if their conduct falls below the requisite standard of care, including in circumstances related to a distressed debtor. These duties are not limited to the insolvency period but allegations that such duties were not met are more likely to arise when a company is insolvent. Important duties that directors need to consider are its fiduciary duty and duty of care.
Directors’ fiduciary duty is the duty directors owe to the company itself and not to its creditors, shareholders or other stakeholders. During an insolvency, the emphasis remains on the company’s best interests. In order to meet this duty, directors must act honestly and in good faith with a view to the company’s best interests. The interests of other stakeholders may be considered as part of the directors’ effort to satisfy their fiduciary duty to the company.
Duty of Care
Directors’ duty of care requires directors to exercise the care, diligence and skill that a reasonably prudent person would exercise in similar circumstances. In order to avoid liability in connection with directors’ duty of care, directors must be able to demonstrate, among other things, that they:
- kept themselves apprised of relevant information;
- sought expert opinions where necessary;
- considered reasonable alternatives; and
- made informed decisions.
Liability of Stakeholders
Generally, a director, corporate parent, or any other stakeholder will not be held liable for the debts of an insolvent company, subject to the exceptions described below.
Certain statutes impose personal liability on corporate directors. All Canadian provinces and territories (which have jurisdiction over matters concerning labour relations) and the federal government (in relation to federally regulated industries) impose personal liability on directors for unpaid wages, accrued vacation pay and termination and severance pay (in certain cases).
Directors are personally liable for payroll remittances for amounts deducted from employee’s wages on account of:
- income taxes;
- Canada Pension Plan (or Québec Pension Plan, as applicable) contributions; and
- employment insurance premiums.
The above amounts are deducted from the pay cheques of the company’s employees. They are considered to be similar in nature to trust funds. However, directors have a defence against liability if they can prove:
- they were duly diligent; and
- the failure to remit any required amounts in a timely manner was beyond their control.
Directors can be held personally liable in situations where a company defaults in payment of its goods and services tax or harmonized sales tax (“HST”) obligations. Canadian provinces which retain a separate retail sales tax (instead of HST) also impose personal liability on directors for failure to remit the required provincial sales tax.
Directors can also be personally liable for failure to remit certain pension contributions, particularly for amounts which were deducted from the employees’ pay. In addition to specific statutory liabilities, corporate directors can also be personally liable if the director acted improperly so as to cause loss to the company’s creditors.
Finally, if a director provides a personal guarantee in favour of a lender as a condition of advancing credit, there is the possibility of the director being subject to contractual liability.
Notwithstanding the foregoing, directors may mitigate the financial burden of personal liability by seeking indemnification by the corporation, contractual indemnification and directors’ and officers’ insurance.
Parent Company Liabilities
Unless there is a contractual commitment stating otherwise, a parent company is not liable for an insolvent subsidiary’s debts.
However, there is an exception to this rule for certain employee claims. At common law, it is possible for a court to determine that the employees of the insolvent subsidiary were also employees of the parent company, meaning the parent is jointly liable for the debts of the insolvent subsidiary to the employees. This situation may arise if the parent company has exercised common control over the subsidiary. Additionally, in certain circumstances, employment legislation in most Canadian provinces and territories permits liability to be imposed on a related company (such as a parent company, subsidiary or company within the same corporate group).
Under tax legislation it is also possible for the parent to become liable for the insolvent subsidiary’s tax liabilities if the parent company has received assets from the subsidiary for less than fair market value.
Liability of managing directors
The management of (i) a company limited by shares (Kapitalgesellschaft) and/or (ii) a partnership (Personengesellschaft) without a partner who is a fully liable natural person must be very mindful in entity crisis situations. In particular, they should try to solve the crisis as soon as possible, and must monitor the entity’s financial situation and potential insolvency very carefully. Management has general fiduciary duties vis-à-vis the entity and its shareholders until it must file for insolvency due to illiquidity or over-indebtedness.
Among other responsibilities, the management is required to inform the entity’s shareholders in due course. If an annual or any interim balance sheet of a company limited by shares shows that 50% or more of the registered share capital has been lost, the managing directors must call an extraordinary shareholders’ meeting without undue delay. A violation of this duty can constitute a criminal offence and trigger a personal liability for management. In case of an impending illiquidity, a shareholder resolution is required on whether the managers should file for the opening of insolvency proceedings.
Once a company limited by shares or a partnership without a partner who is fully liable natural person becomes illiquid or over-indebted (see Question 3), management must not make any payments (or certain similar reductions of the estate) unless such payments are compatible at that point in time with the due care of a prudent businessperson. A breach of this obligation triggers a severe personal liability for managers, as they must compensate the entity for such payments.
When a company limited by shares or a partnership without a partner who is a fully liable natural person becomes illiquid or over-indebted, each manager must file for the opening of insolvency proceedings without undue delay, and at the latest within three weeks. Managing directors who negligently or intentionally breach this filing obligation commit a criminal offense and are personally liable for damages that can be asserted by (i) the insolvency administrator regarding the damages incurred by creditors of the entity whose claim originated prior to the obligation to file for insolvency, and (ii) by each creditor whose claim originated thereafter.
With regard to liability to social security authorities, the German Criminal Code imposes sanctions on directors who intentionally refuse to pay social security contributions or relevant taxes. In this context, the directors must distinguish between the different kinds of taxes and contributions. As a general rule, tax claims are not better ranked than any other claims. In practice, however, the managing director can be personally held liable if he or she will not pay the relevant claims for income tax and sales tax, as well as employee contributions, to the competent authorities.
Not paying the employee portion of social security contributions is punishable pursuant to Sec. 266a Criminal Code, as is any action by the debtor that diminishes the debtor’s main assets or obscures the actual development of the business in ways that clearly present a breach of business standards (no bookkeeping, dissipating money or squandering goods, falsifying balance sheets, etc.). If an entity is in a state of insolvency, or if such acts lead to bankruptcy, they are punishable by imprisonment up to five years.
Liability for fraud, especially crimes pertaining to insolvency, is allocated to directors who actually committed the crime or who were fully aware of the crime.
Liability of third parties
Other parties are not liable for the company’s debts—provided there are no guarantees, contractual assumptions of liability or domination agreements. Third parties may, however, be held liable for the company’s debts on grounds of tort. This applies, for example, to the shareholders of the debtor if they acted towards the company in a way that the German Federal Court calls exterminating interventions (Existenzvernichtender Eingriff), i.e., actions that eventually lead to the company failing the test for insolvency. The right of contestation also can lead to civil liabilities for third parties (see Question 6).
Directors have a duty not to trade in insolvent circumstances. See question 3 for directors’ duties and liabilities in this regard. Once the company is in liquidation, the directors’ duties, powers and rights cease and they no longer act in such capacity.
With business rescue, the management remains intact, subject to the authority and directions of the business rescue practitioner. Directors are thus not relieved of all their statutory and fiduciary duties (see question 10) and will have to comply, or face the consequences – see question 3.
Sureties and guarantors may incur liability for the debts of the debtor (subject to the release/non-release treatment of such security – see question 10). But generally shareholders and lenders will not incur liability for the debts of an insolvent debtor.
In principle, a company’s liquidation does not extend to its partners. Nevertheless, pursuant the Brazilian Civil Procedure Code, in cases of abuse of legal personality, characterized by the misuse of the legal entity’s distinct personality or confusion of assets between the legal entity and another person (whether natural or legal), the court can pierce the corporate veil in order to extend certain obligations to the personal property of the legal entity’s directors, officers, shareholders or partners.
Therefore, directors, officers, shareholders or partners of a limited liability company under liquidation can be subject to civil and penal liabilities. Their liability is restricted to acts that have caused loss or damage to the company while it was under their control or management, by reason of negligence, fraud or acts contrary to the law or the company’s by-laws or articles of association.
Moreover, if there is evidence that the administrators or controlling shareholders performed acts harmful to creditors’ interests, the creditors may bring an action for damages against them, even though they are no longer part of the bankrupt company.
As for criminal liability, which is expressly provided for in Articles 168 et seq of the BRBL, the administrators, manag¬ers and liquidators of the company are equated to the debtor or bankrupt company for the purposes of the criminal provisions of the BRBL, each to the extent of his/her fault. The criminal sanctions are borne by the person or persons who managed the company and who committed the criminal act in the company’s name.
Although liquidation in itself is not a crime, certain acts committed prior to bankruptcy are considered by law to be criminal, such as:
- fraud against creditors;
- failure to record entries in accounting books;
- destruction or concealment of required accounting documents or accounting or business information;
- sham with respect to the composition of the company’s capital;
- falsification of required bookkeeping material;
- keeping a double set of books; and
- violation of confidential business information.
In the Judicial Reorganization officers and directors can be overthrown if (i) have been sentenced for a crime committed under previous judicial reorganization or bankruptcy or for a crime against property, public welfare or economic policy; (ii)demonstrates clear indications of having committed a bankruptcy crime; (iii) have acted with willful misconduct, simulation or fraud against creditor’s interests; (iv) have refused to provide information requested by the trustee or the committee; (v) have their dismissal provided for in the judicial reorganization plan; (vi) have been engaged in any of the following acts: (a) incurring in excessive expenditures in relation to its financial condition; (b)incurring expenses that cannot be justified by the business; (c) decapitalizing the company with no justification; (d) carry out transactions that impair the regular functioning of the company; (e)simulating or omitting claims on submitting the list of creditors.
Primarily, directors are obliged to promptly initiate insolvency proceedings with the competent court as soon as they learn of the insolvency (or should have learned of it, had they exercised due care).
Within reorganization proceedings the directors must exercise due professional care, and are liable for damage caused to creditors in violation of this duty. A director of a company that is being reorganized is held to a higher standard of care regarding their actions, compared to a company outside the insolvency regime. Among other things, directors must prioritize the common interest of the company’s creditors over the interests of the company, their own interest or the interest of any third parties. The reason for such shift in the person to whom fiduciary duties are owed is basically the fact that, under the pecking-order principle, creditors must be paid before the shareholders, secured creditors before unsecured creditors, and preferred creditors before any registered creditors.
Persons able to exercise control over the debtor (shadow directors, entities which can directly or indirectly exercise decisive influence on a debtor) might also be held liable (under certain circumstances) for liabilities of the debtor. Greater demand is placed on the controlling entity in terms of loyal and due performance of its obligations. Under certain circumstances, they may be found liable for the obligations of the bankrupt entity, for instance if they fail to appoint capable professionals to the statutory body of the entity.
See section 3 above.
Directors Duties and Liabilities
The Companies Act 1993 imposes high standards on directors to avoid reckless trading. The key duties that a director should most bear in mind when a company is in a position of financial difficulty are those in sections 135 and 136 of the Companies Act 1993 which are commonly referred to as the reckless trading or 'insolvent trading' provisions.
Under both sections 135 and 136 the duty owed by the director is to the company, and not to the shareholders or creditors. The liability of directors under these provisions is civil. Any damages or compensation awarded for breach of such duties must be paid by the directors to the company in insolvency for distribution to all creditors in accordance with their statutory priorities. The prospect of liability for reckless trading claims is a common catalyst for directors to place a company into voluntary administration or liquidation.
Section 135 states that a director has a duty to the company not to trade recklessly. It provides that a director must not:
- 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
- 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.
Section 135 is not intended to penalise directors merely for taking legitimate business risks. In fact, the preamble to the Companies Act 1993 reaffirms the economic and social value of a company “taking business risks”. It is only the taking of illegitimate business risks which will warrant a finding of reckless trading.
Section 136 sets out a director's duties to the company in relation to incurring obligations. It provides that a director of a company must not agree to the company incurring an obligation unless the director believes at the time on reasonable grounds that the company will be able to perform the obligation when it is required to do so. A director's belief under section 136 must be held on reasonable grounds. The director’s belief at the time is a subjective test, although the decision must be made on reasonable grounds, which is an objective test.
In a Court application relating to a breach of director's duties a shareholder or creditor cannot in the normal course obtain compensation payments directly. Remedy for a breach is to be sought by the company, or by a shareholder on behalf of the company (with the leave of the Court by a derivative action under section 165).
However, post-liquidation of a company, section 301 of the Companies Act 1993 allows a liquidator, a creditor or a shareholder of the company to bring actions against directors (and others) where, among other things, such directors (and/or others) have misapplied, retained, or become liable or accountable for money or property of the company, or been guilty of negligence, default, or breach of duty or trust in relation to the company.
The Court may grant relief directly against the directors in their personal capacity with the liability of the directors usually extending from the time that the company was in peril and the reckless actions were taken by the directors. The Court is given a wide discretion under section 301(1)(b)(ii) to order the director to “contribute such sum to the assets of the company by way of compensation as the Court thinks just”.
Section 126 of the Companies Act provides that a director includes (in addition to someone occupying the position of director, by whatever name called) a person in accordance with whose directions or instructions a director of the company may be required or is accustomed to act, and a person in accordance with whose directions or instructions the board of the company may be required or is accustomed to act.
However, a professional advisor will not be a shadow director if the person provides advice only in a professional capacity. A receiver is also excluded from the definition of a director.
Shadow directors will owe the same duties as are imposed by the Companies Act on directors, including the duties relating to reckless trading. Penalties associated with a breach of those duties will also apply.
Related company liability in liquidation
A liquidator may seek an order of the Court under section 271 of the Companies Act 1993 that a company related to a company in liquidation, but not itself in liquidation, pay all or part of the claims made in the liquidation (a contribution order). The definition of 'related company' is broad and includes majority shareholders, subsidiaries, companies which are both related to a third company or companies where the businesses of the two companies are carried on such that the separate businesses of each company are not readily identifiable.
In determining whether to grant a contribution order the Court will have regard to the extent to which the related company took part of the management of the company in liquidation, the conduct of the related company towards creditors of the company in liquidation, and the extent to which the circumstances that gave rise to the liquidation are attributable to the actions of the related company.
There is no specific provision of law that places enhanced duties on directors of a distressed debtor. However, directors owe obligations under general provisions of the Companies Act, such as the duty of diligence and duty of loyalty. Thus, directors could, for example, be held liable for damages to the company or creditors if they have acted in breach of their duty of diligence. In addition, certain acts (such as a gratuitous act) by an insolvent company are vulnerable to being set aside.
In addition, if a director or officer has engaged in fraudulent conduct before filing of a company’s bankruptcy proceedings, he/she may be held liable for such a conduct under criminal law and/or tort law.
Under Japanese law, parties other than the debtor are not liable for the debts of an insolvent debtor except under limited circumstances where, for example, they have expressly guaranteed such debts.
As explained at Question 3 above, directors should be mindful of their duty to a company’s creditors once a company is insolvent – a breach of this duty may result in personal liability being imposed.
In addition, directors should also be careful of the antecedent transactions described at Question 6 above – case law in Singapore has held that a director that permits an antecedent transaction to be carried out is prima facie in breach of his duties. Directors should thus ensure that all transactions leading up to the insolvency of a company can be commercially justified. If there is a fair likelihood of a potential transaction being challenged, directors may wish to consider implementing the transaction through a scheme or judicial management instead.
British Virgin Islands
Directors in the BVI owe a range of fiduciary and common-law duties to their companies, and these duties do not terminate with the appointment of a liquidator, though directors cease to have any role in the management of the company save to the extent permitted by the IA and/or the liquidator.
As stated above, when a company nears insolvency, the focus of the directors’ duty to act in the company’s best interests shifts from the members to the creditors. As such, the directors must be mindful of the effect their conduct of the company’s affairs may have on creditors’ likelihood of being repaid what they are owed. Directors are sometimes given indemnities for liability they may incur for negligence, default, breach of duty, or breach of trust.
Part IX of the IA deals with malpractice and the principal ways in which a director may be ordered to contribute assets to an insolvent company, including liability for misfeasance, fraudulent trading and insolvent trading. An application pursuant to Part IX can only be brought by a liquidator, but the provisions are not limited territorially.
In the event that a director or officer of the company has misapplied or retained or become accountable for any money of the company, or if the director could be described as being ‘guilty of any misfeasance or breach of any fiduciary or other duty in relation to the company’, then the court has broad powers to make an order that such director or officer repays, restores, or accounts for money or assets or any part of it to the company as compensation for the misfeasance or breach of duty. The IA misfeasance action merely puts the powers at common law on a statutory footing, but this statutory provision does not preclude any parallel liability arising under general directors’ duties at common law or otherwise.
The court can make an order against a company’s directors if it is satisfied that, at any time before the commencement of the liquidation of the company, any of its business has been carried on ‘with the intent to defraud creditors of the company or creditors of any other person; or for any fraudulent purpose’. In such cases, the court can declare that the director is liable to make a contribution that the court considers proper towards the company’s assets. This is not limited to directors and officers, but applies to anyone who has been involved in carrying on the business in a fraudulent manner. There is no statutory defence to fraudulent trading, but it is necessary that actual dishonesty be proved.
Directors’ liability for insolvent trading has been summarised above, and as stated in that context any contribution that the court orders under Part IX is compensatory and not penal, and will be used to swell the assets available for distribution to the company’s general body of creditors. The section 81 Conveyancing Ordinance claim is also a relevant consideration.
Other than claims against directors and other officers in respect of misfeasance, fraudulent trading, or insolvent trading, or other general grounds on which personal liability may be incurred, such as assisting in a breach of fiduciary duty or fraud, there are no routes by which other parties connected to the liquidation of a company may be liable for the debts of an insolvent debtor. In relation to misfeasance, fraudulent trading, and insolvent trading, it should be noted that the liability is to the company to make good losses that have been suffered, and not to provide any third party with an additional person against whom they may seek a remedy.
At present, there is no regime applicable to insolvent partnerships, though the bankruptcy of a partner will trigger the dissolution of the partnership in the absence of agreement to the contrary. The court has jurisdiction to order the dissolution of a partnership where its business can only be carried on at a loss, but only the partners can apply for such an order, and creditors have no recourse. There is no specific regime relating to voidable transactions (though section 81 of the Conveyancing Act remains available). If the partnership is a limited partnership, only the general partner may be sued personally, and commonly limited liability companies are used as sole general partners, effectively removing the risk of personal liability for partnership debts.
Only if there is a specific contractual provision will parent or group companies become liable for the debts of a related company, unless it is possible to pierce the corporate veil and identify the parent with the subsidiary.
The directors, supervisors or officers of an enterprise bear duties of loyalty and care to the enterprise during its business operation. If any of them breaches the foregoing duties, resulting in the bankruptcy of the enterprise, he/she should bear civil liability under law and, in addition, may not hold any position as director, supervisor or officer of any enterprise within three years following the end of the bankruptcy proceedings. When an enterprise is in a deadlock situation, its shareholders, if the enterprise is a limited liability company, or its directors and the controlling shareholder, if it is a joint stock limited company, have an obligation to liquidate the enterprise in a timely fashion, which is a natural extension of the duties of loyalty and care. If their failure to fulfill such duties results in the loss of any major assets, books, important documents, etc. of the enterprise, which renders the liquidation of the enterprise unfeasible, they will be held jointly and severally liable for the enterprise's debts.
Directors owe a number of general and specific law duties to the company, its shareholders and creditors, including:
- duties of good faith, care and diligence;
- to not improperly use the positon, or information obtained by virtue of the position, to gain personal advantage or cause detriment to the company;
- to keep adequate financial records;
- to take into account the interests of creditors; and
- to prevent insolvent trading.
Compliance with these duties means that directors should place a company into external administration at such time that the company is cash flow insolvent or there exists a less than reasonable prospect that the company will remain cash flow solvent.
Australia’s new safe harbour provisions could, in certain circumstances, enable a company to delay a formal insolvency appointment where it seeks to pursue a turnaround plan with a “better outcome” for the company. If such a plan is being developed, the company must ensure it meets the criteria to enliven the protection, because as a matter of practice, if the turnaround plan is unsuccessful and a formal insolvency follows, the safe harbour protection will only be a defence to an insolvent trading claim rather than a positive exception to liability.
The directors of a debtor should respect the duty of due care and diligence in the performance of their tasks (criterion: a reasonable, cautious and diligent director), and act in the corporate interest of the debtor. Besides the contractual, tort and criminal liability, there are also specific grounds for director’s liability in case of bankruptcy:
- Any (former) (shadow) director can be held liable for all or part of the company’s debts up to the shortfall if that person committed a gross and manifest negligence that contributed to the bankruptcy.
- Any (former) (shadow) director may be held liable for (part of) the social security contributions and related costs due at the time of the bankruptcy if (i) he committed a gross fault which caused the bankruptcy, or (ii) during the period of five years before the bankruptcy, he was involved in at least two bankruptcies, settlements or similar operations, with debts towards the Social Security Institute.
- Directors of companies are jointly liable for failure to pay the company tax prepayments or VAT if this is due to a fault in the performance of their management tasks. Not only the managing director, but also other (shadow) directors may be held liable if it is proven that they committed a fault that contributed to the failure.
- Under the new bankruptcy law, directors can also be held liable if it is established that they have continued a loss-making operation, whereas bankruptcy should have been filed.
Shareholders of limited liability companies are only held liable for the specific contribution they have undertaken to make (exception: shadow directors or on the basis of tort). If the debtor is an NV/SA (public limited liability company) and all shares are held by a single shareholder for a period that exceeds one year, the shareholder is deemed to guarantee all obligations of the debtor.
Founders can be held liable if the debtor becomes bankrupt within three years following its incorporation, and if the debtor’s capital on incorporation was manifestly insufficient for the normal conduct of the intended business activity over at least a two-year period.
A lender may be held liable if by granting or maintaining a loan it created a wrongful appearance of solvency of the debtor, which incentivised third parties to contract with the insolvent debtor (criterion: a normal, prudent and reasonable lender, placed in the same circumstances). Untimely/abruptly withdrawing a loan may also lead to liability.
Directors and officers of a company must act in the company’s best interest (taking into account stakeholder interest). If a company enters into a state of financial distress, its directors should attach more importance to the interests of the creditors with a view to ensure the availability of recourse of their claims.
The starting point is that only the company is liable for its obligations. However, there are various grounds on which a director can be held (personally) liable (see below).
- Liability towards company – In general, a director is liable for improper performance of his duties only in case of serious negligence. Improper performance of duties can consist of (refraining from) acting in violation of statutory provisions, the articles of association or if he has acted in a way which is obviously unreasonable/improper;
- Liability towards third parties – A director can be held liable on the basis of tort if it can be held he has acted seriously negligent and in particular if he has prejudiced creditors of the company;
- Liability in bankruptcy – Each director is jointly and severally liable for the shortfall of the bankruptcy estate if the management board has evidently improperly performed its duties and the improper management was an important cause of the bankruptcy. Special importance is attached to the duty of bookkeeping and the duty to timely publish the annual accounts.
The main rule under Dutch law is that a shareholder of a company is not personally liable for the obligations of the company since the company has legal personality. However, a shareholder can under exceptional circumstances be held liable on the basis of for instance tort (e.g. in the event a shareholder commits a tort with regard to creditors by infringing a duty of care).
A party (such as a controlling shareholder) who has acted as de facto director, could be held liable on the same grounds as a managing director.
Lender liability is relatively rare but cannot be excluded depending on the circumstances.
As noted above, directors and officers generally only have fiduciary duties to their shareholders and the corporation, not to creditors. Only when the company is insolvent do some states expand a director or officer’s duty of loyalty to include creditors.
Depending on the state law where the corporation is incorporated, directors and officers generally also have a duty of care and a duty of loyalty. The duty of loyalty requires that directors and officers act in good faith in the best interests of the corporation, prohibiting directors from taking actions that are self-interested or to engage in self-dealing transactions. The duty of care requires that directors adhere to a reasonable standard of care and exercise the reasonable amount of caution, watchfulness and attention in conducting the affairs of the company. Regardless of whether the company is solvent or insolvent, the business judgment rule generally applies, which assumes that in making decisions for the company, the directors and officers are operating rationally, in good faith and for the best interests of the company.
While the board of directors in most cases continues to run the company post-petition, the U.S. Trustee is charged with overseeing the administration of the bankruptcy proceeding. While the board remains in position and continues to have the authority to make decisions on behalf of the company, the U.S. Trustee does have the authority to examine actions of the board and object to the court.
It is presumed that directors, partners, parent entities, shareholders (including parent companies) and lenders will not be held liable for the liabilities of a corporation. However, directors, partners, parent entities and/or lenders may be held liable for a number of reasons.
It is possible for other parties to incur liabilities if a court disregards the corporate forum and “pierces the corporate veil.” All courts analyze the doctrine of “piercing the corporate veil” differently, but generally the common considerations are 1) whether there was a fraud or injustice perpetuated in the use of the corporate forum and 2) whether evidence of complete domination and control exist such that the corporation is regarded to be a shell, instrumentality or alter ego of the parent corporation. Courts consider many factors when determining whether the veil can be pierced, but do so on a case by case basis. Generally courts look for evidence of (i) the failure to observe corporate formalities; (ii) the undercapitalization of the corporation; (iii) intermingling of corporate funds; (iv) shared corporate directors, officers, personnel, office spaces and services; (v) common use of property and assets; (vi) the corporation’s ability to make decisions for itself; (vii) the arm’s length nature of interactions and transactions between the parent and company; (viii) whether the corporation is profitable by itself; and/or (ix) guarantees granted by the parent to the subsidiary. The presence of one factor or more does not indicate the veil should be pierced in itself.
A director’s failure to ensure certain taxes, such as payroll taxes, are being paid may also impute liability to them under federal or state law. Corporations are required to withhold employee taxes and pay them directly to the government. Not doing so could lead to personal liability on those responsible for this misuse.
As for lenders, typically there are no fiduciary duties imputed in a debtor-creditor relationship. Nevertheless, if the debtor’s operations, finances, corporate policy and/or disposition of assets are being controlled or dominated by the lender, it could lead to the lender’s liability. In these cases lenders’ claims have been equitably subordinated, recharacterized or avoided. At worst, a lender could be found to be liable for damages to the debtor.
Directors, while managing the distressed business, need to act in the ordinary course of business.
As a matter of corporate law, directors have fiduciary duties towards the company first and as such need to preserve it as a going concern and act in accordance with its corporate interest.
Within the scope of a liquidation proceeding, directors may be personally liable in committing an act of mismanagement that would contribute to an insufficiency of assets in accordance with Article L. 651-2 of the French Commercial Code. Therefore, the liability of directors is only retained for having increased the financial difficulties of the company.
Directors may also incur criminal liability for criminal bankruptcy (“banqueroute”) or other criminal offences set out in Articles L. 654-8 et seq. of the French Commercial Code.
Under French law, the concept of shadow directorship or de facto mangers (gestion de fait) targets any person who interferes or has interfered with the management decisions of the company and which has contributed to an inefficiency of assets. Creditors, but also shareholders or more generally anyone, can become a shadow director. A de facto manger has the same responsibilities as a de jure manager of the company.
In limited cases, creditors may also incur liabilities for abusive support in cases of fraud, indisputable interference in the management of the debtor or if the guarantees obtained for the loans or credits are disproportionate.
Under Luxembourg law, the directors of a company may generally be liable for (i) the non-execution of their mandate, (ii) any misconduct in the management of the company's affair and (iii) any damages caused by their fault or negligence (torts).
Not filing for bankruptcy within this timeframe constitutes serious misconduct, which could lead the court to recognize the director’s civil or criminal liability and to order the directors to bear all or part of the debts of the company.
- In addition to the general grounds of civil liability for breach of fiduciary duties, a director can be held liable for the company's debts. Legal and de facto directors/managers of a bankrupt company can be held personally liable for the company's outstanding debts if the bankruptcy results from serious and blatant faults for which they are accountable, such as entering into transactions completely out of proportion to the company's financial capabilities and which lead to its bankruptcy. Such claims can only be brought by the company's bankruptcy receiver(s) within three years following the court judgment establishing all outstanding receivables.
- The parent entity (domestic or foreign) of a commercial company can be held liable to fully pay-up shares which it has subscribed for. It can also be exposed to liability if it has acted as a de facto manager or if the creditors can successfully demonstrate that the parent entity and the bankrupt company should be considered as one and the same party, in particular because of a co-mingling of assets.
- Subsidiaries of a bankrupt group company might also bear exceptional or additional liabilities where the court considers that the group company would bear excessive risks disproportionate to its net assets and financial position and takes the view that such company would never have taken such risk as a fully independent entity. For such additional liabilities to be incurred by the subsidiaries it would have to be shown that those subsidiaries were compensated by present or future financial benefits.
- A bankruptcy receiver can seek general tort damages from certain third parties that committed a fault that lead to the bankruptcy or damage to the bankruptcy estate. Courts have recognised the validity of such actions against banks, accountants and auditors. A bank can, for instance, be held liable where it has misleadingly maintained the appearance of solvency of the debtor or where it has abruptly rescinded a credit facility.
Any person who has contributed to the occurrence, creation or development of the state of insolvency of a company by the commission of certain deed expressly provided by the insolvency law may be held liable civilly by being obliged by the syndic judge to cover a part of or even all the liabilities of the insolvent company, without exceeding the damage caused by such deed. Thus, the liability for a company becoming insolvent is not limited only to the members of the company’s management bodies, but it may be entailed against any person proven to have committed at least one of the deeds that the law indicates as causing insolvency. Obviously, in certain situations and for certain deeds, the law institutes even criminal liability.
Under Swiss corporate law the highest executive body of a company is responsible for, inter alia, the overall management and strategic positioning of the company, the financial accounting and control, the overall supervision of the management and compliance with laws and regulations generally. Such duties become particularly relevant in a distress scenario in which case a certain shift of responsibilities from management to the highest executive body occurs. Duties and obligations will have to be interpreted in the light of the financial status of the company. In addition, the overarching duties (duty of care, fiduciary duty, equal treatment of shareholders) and certain specific obligations apply in a distress situation:
- If the latest annual financial statement shows that half of the share capital and the legal reserves of a company are no longer covered by its assets, the directors, inter alia, have to convene an extraordinary shareholders' meeting to which adequate restructuring measures must be proposed.
- If the board of directors of a Swiss corporate has reason to believe that the company is over-indebted, it must draw up an interim balance sheet without delay, which must be audited by the company's statutory auditors. Such interim balance sheet will have to be prepared on a stand-alone basis and the statutory accounting rules are pertinent.
- If such interim balance sheet shows that the company is over-indebted at both going concern values and liquidation values, the board of directors of the company must, as a rule, file for bankruptcy without delay.
It is currently being proposed within the context of a general revision of Swiss corporate law to amend certain of these obligations so as to force the directors to take action at an earlier stage. Such rules are not currently expected to enter into force before 2020.
Sound management may require the initiation of composition proceedings before an over-indebtedness situation exists in case the company is in the state of (looming) illiquidity. Such action may be warranted where an out-of-court restructuring does not appear to be viable and/or where creditor action is expected which may frustrate the attempts for an out-of-court restructuring.
If such duties are not complied with, executive bodies may be exposed to civil law director's liability where the wilful or negligent breach of the director's duties has caused damages to the company or, in certain constellations, the creditors and where there was a causal nexus between the breach and the damage. Where executive bodies failed to notify the court of an over-indebtedness situation, damages typically cover the increase of loss that occurred between the date the executive bodies failed to act and submit a notification of over-indebtedness with the competent court and the date bankruptcy proceedings were effectively opened. Further liability risks may arise in the context of transactions that are subject to avoidance (see section 6 above).
In addition, executive bodies may be exposed to the risk of criminal liability if they fail to adhere to their statutory duties and obligations. In particular, such risks exist in case of failure to properly keep corporate books and accounts, mismanagement, where bankruptcy proceedings were caused fraudulently, in case of a fraudulent reduction of assets to the detriment of creditors or in case of creditor preference.
Finally, executive bodies of a Swiss corporate debtor may become liable for certain social security contributions and withholding tax obligations which were not paid prior to the initiation of insolvency proceedings. Furthermore, the parent company of an insolvent corporate debtor may become liable for claims of creditors of the latter in exceptional circumstances, namely under the theories of piercing the corporate veil and/or based on a trust based liability. Requirements established in court precedents and legal doctrine are fairly strict, though.
Partners and lenders are not typically exposed to the risk of incurring a liability for the debts of an insolvent debtor unless they have assumed the role of a de facto shadow executive of a Swiss corporate debtor in which case they may become exposed to the risk of director's liability (see above). That said, recent court precedents hold that it is generally not sufficient to be qualified as a shadow director where a contracting party or lender merely acts to protect its contractual position.
While they do not directly incur a liability for the debts of an insolvent debtor, the company's statutory auditors may become liable for damages similar to a company's director if they do not notify the court if the company is over-indebted and the board of directors fails to notify the court itself (see above).
As set forth in Section 3 above there are currently no specific provisions relating to the duties and liabilities of the management of a distressed debtor.
However, under the Companies Law the officers and directors of a company has a fiduciary duty and duty of loyalty towards the company. In situation of insolvency and distress, such duties applies under the Israeli practice and ruling to the creditors, becoming the most significant stakeholders of the company.
Under the Companies Law, the consequences of breach of the duty of care by directors and officers are treated as a damages claim whereas the breach of the duty of loyalty is treated as a breach of agreement with the company.
The new Insolvency Law imposes specific liabilities on directors and officers that knew or should have known that the company is insolvent and did not took reasonable measures to reduce the scope of insolvency. A presumption of taking reasonable measures exists where such directors and officers acted in order to get consultation from insolvency experts, negotiated a debt arrangements with the company creditors or commenced insolvency proceedings.
The court may determine that any officer or director of an insolvent company (and any person acting in such capacity informally) that was involved in fraudulent conduct shall be personally liable without limitations to all the company's debt. Additionally, any member, shareholder, officer, director or court officer who misused any of the company's funds or assets, or acted wrongfully with respect to the company, may be ordered to remit such funds or assets or be forced to pay compensation as the court will see fit. Such provisions were replaced with certain revisions in the new Insolvency Law.
The court may order the "piercing of the corporate veil" and attribute the debt of the company to its shareholders if it is found they used the company in order to deceive any person or discriminate a creditor, in a way, which is harmful to the company's purpose, or by unreasonable risk to its ability to repay its debt. An example of such behavior is the use of unreasonable financial leveraging.
The duties of the directors of an insolvent, or potentially insolvent, company are primarily owed to the company’s creditors. Where the directors are aware of the insolvency they are deemed to hold the assets on trust for the creditors of the company and are obliged to preserve the assets for the benefit of the creditors.
A director of an insolvent company that acts in breach of his or her fiduciary duties to the creditors can be sued for damages, and a purchaser with knowledge of the insolvency that attempts to acquire assets at an undervalue can be required to return or compensate the company and its creditors.
Directors that are found by the Court to have knowingly engaged in reckless trading (i.e. allowing a company to incur liabilities that the director knows the company cannot or is unlikely to be able to discharge) can become personally liable for the debts of the company, in whole or in part, and without limitation in amount. A director is deemed to have acted knowingly where he or she (a) ought to have known that their actions or those of the company would cause loss to creditors or (b) allowed a company to contract a debt without honestly believing on reasonable grounds that the company would be able to discharge that debt.
The Court may relieve an officer of personal liability for the debts of the company where it is satisfied that the officer acted honestly and responsibly in relation to the conduct of the affairs of the company.
Directors can be found guilty of fraudulent trading if, in the course of an examinership or the winding up of a company, it is proven that the director was knowingly a party to the carrying on of any business of the company with intent to defraud creditors of the company or creditors of any other person or for any fraudulent purpose. A person found guilty of fraudulent trading may be exposed to criminal liability as well as personal liability for all or any part of the debts or other liabilities of the company.
Duty to keep adequate accounting records
Directors are responsible for the company’s due administration, including keeping proper accounting records, minutes of meetings and filing information at the Companies Registration Office.
Where a company is wound up, and was unable to pay all of its debts, and it is shown that the failure to keep adequate accounting records contributed to this, or resulted in substantial uncertainty concerning its assets and liabilities, or substantially impeded its orderly winding-up, the company and every director or other officer in default shall be guilty of a criminal offence and moreover a court may declare that any such director or other officer in default shall be personally liable for all or any part of the liabilities of the company.
Restriction and Disqualification orders
A liquidator of an insolvent company is obliged to make an application to the Court for an Order restricting the directors from acting as directors of another company for a period of up to five years, unless the liquidator directed otherwise by the Director of Corporate Enforcement (the “ODCE”). A defence to such an order exists where the director can demonstrate that he or she acted honestly and reasonably in the conduct of the affairs of the company. In addition the directors must demonstrate that they have when requested to do by the liquidator, cooperated as far as could reasonably be expected in relation to the conduct of the winding up. A restricted director can only act be appointed or act in any way, whether directly or indirectly, as a director or secretary or be concerned or take part in the promotion or formation of any company where the company has a paid up share capital of €500,000 in the case of a PLC or €100,000 in the case of a private company.
An application can also be brought by a wide range of parties including shareholders, directors, employees, receivers, liquidators, examiners and creditors, for a disqualification order in respect of a director who has been guilty of fraud, a breach of his duties, reckless or fraudulent trading or conduct which makes him unfit to be concerned in the management of a company. A disqualification order will prevent the offender from acting as an auditor, director, receiver, liquidator or examiner or other officer of a company for a period of five years, or such other period as the court may order.
Disqualification and restriction orders can be obtained against any person who is a director of a company on the date of, or within 12 months of, the commencement of the winding up.
As explained in more detail in our response to Question 11 above, a director of an insolvent can become personally liable for personally liable (without limitation of liability) for all or any part of the debts or other liabilities of the company where he or she is found to have (a) knowingly engaged in reckless trading (b) engaged in fraudulent trading or (c) failed to ensure that the company keeps adequate records.
Where a party (including a lender, parent entity or other party) is found to be a shadow director of an insolvent company (i.e. a person in accordance with whose instructions the company was accustomed to act), then it could also be treated as a director and become personally liable in the circumstances outlined above.
Liquidators, creditors and contributories of a company that is being wound up have the power to apply to court to have related companies contribute to the debts and liabilities of the company which is being wound up by means of a contribution order. In any such application the Court will have regard to (a) the extent to which the related company took part in the management of the company being wound up, (b) the conduct of the related company towards the creditors of the company being wound up and (c) the effect that such order would be likely to have on the creditors of the related company.
Shareholders of an unlimited liability company that is being wound up on an insolvent basis are liable, without limit, to make a contribution of an amount equal to the deficit on its balance sheet after its assets have been realised.
Directors of an English company owe fiduciary duties to the company itself (which, in good times, means its shareholders, but in the zone of insolvency, this shifts to the creditors or potential creditors of the company).
The main heads of liability for directors in the zone of insolvency are wrongful trading and misfeasance. Note that other forms of liability may be found in relation to publicly traded companies. Misfeasance relates to the breach of fiduciary duties and, specifically, the misapplication of the debtor’s funds.
Directors are generally most cognisant of the wrongful trading offence, which is designed to force directors to take all steps to minimise losses to creditors. Wrongful trading is established where a director knew or ought to have known that there was no reasonable prospect that the company would avoid insolvent liquidation and the director failed to take every step to minimise potential losses for creditors.
Apart from financial penalties, any one of these offences can lead to a disqualification order for future directorships or criminal penalties including fines.
Liability may extend to third parties in certain limited circumstances. TUPE regulations may apply when assets are purchased out of an administration: where the business is being carried on is substantially the same as before, all liabilities of employment transfer to the purchaser. This will include redundancy costs and unfair dismissal claims. The Pensions Regulator can exercise moral hazard powers over a connected third party that has acted in a way that has been materially detrimental to a defined benefit pension scheme of the debtor. The Regulator can issue a contribution notice against employers and their connected persons where relevant, demanding payment to remedy any shortfall in the scheme. Further, the European Commission and the Competition and Markets Authority have the power to reach behind the corporate veil when fines they have issued are left unpaid by an insolvent debtor and where there is a structural link with an economic successor entity.
Pursuant to the Insolvency Law, the managers and relevant employees shall be liable for damages and lost profits (daños y perjuicios) caused to the insolvent entity in certain specific cases provided by the Insolvency Law. In addition, they would be liable when acting in breach of their duties of care and loyalty, and when acting with willful misconduct (dolosamente), bad faith (mala fe) or illegally. The Insolvency Law also contemplates that Directors could be criminally liable.
Except for guarantors, joint obligors, co-borrowers, or similar parties, third parties are not liable for the Recognized Claims of an insolvent entity. Partners and shareholders are generally limited to the value of their equity contributions.
Under Portuguese insolvency law, directors can face civil and criminal penalties for breaching their legal duties. When managing a distressed company, directors should be mindful of the circumstance that an insolvency may be qualified as culpable if it is created or aggravated as a result of intentional fault or serious misconduct on the directors, in the three years preceding the commencement of the insolvency proceedings.
Portuguese insolvency law foresees an irrebuttable presumption of fault concerning the acts of directors that affect, in whole or in a significant part, the assets of the debtor, (such as destruction, damage, render useless, concealment or disappearance, etc.) or that harm the economic situation of the debtor and simultaneously bring benefits to the directors, when they do not comply with certain legal obligation (eg. duty to keep organized accounts). The non-fulfillment of the duty to file for the declaration of insolvency can also create a presumption of fault (although this can be set aside).
The qualification of the insolvency as culpable, having been caused or aggravated by directors actions, triggers several effects, such as: the inhibition of the directors persons to manage third-party assets, to trade, to hold office in any corporate body of a company, association, foundation, public company and cooperative; the loss of any credits over the insolvency or the insolvency estate; an obligation to compensate the creditors of the debtor which was declared insolvent in the amount of the unpaid credits (for unfunded liabilities), up to the value of their respective assets.
Directors can also be held personally liable for the company’s tax or social security debt.