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 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.