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Deepening an insolvency: director liability

09 February 2009

This is the third in a series of articles written by Philip Wood, Allen & Overy's Special Global Counsel, on the financial crisis and the global slowdown from a legal perspective.

Now that the financial crisis has spread its tentacles to ordinary corporations, is there a risk for directors of these corporations of liability for deepening the insolvency? Is it possible to untangle the mess and keep out of trouble?

The liability for deepening an insolvency is a different shade from the general liability to govern in accordance with good governance standards and the statute.

Things used to be different. In 1892 in England a director of the Cardiff Savings Bank was appointed to the board at the age of six months and attended only one board meeting in 38 years. He was held by the court not to be liable for a negligent mismanagement that had occurred.

In those days, the law believed in companies, the new creation. Sure, companies were thought of long before the 1800s – for example, the Roman societas, the English and Dutch East India companies. But companies really took off in the 1800s as a means of enterprise.

"Time does not synthesise the law. Time accumulates the law. It piles it up."

Large groups have subsidiaries all over the world. They have local companies because of the desire to insulate the local business and the rest of the group as a whole, because the host government insists, because management is easier, because it is a joint venture, because they might want to sell, because they want central treasury functions. All these and other good reasons. Some groups have thousands of subsidiaries. The consolation is that there is a maximum of only about 320 jurisdictions to cope with.

These jurisdictions do not have the same view about director liability in the twilight. The law of a subsidiary’s jurisdiction could be different from the law of the parent’s jurisdiction so that common directors could be held to different standards. The rules have been built on successive bouts of failures so that now, after a century or so, the hubbub of menacing strictures is deafening.  Time does not synthesise the law. Time accumulates the law. It piles it up. 

Broadly, where we have got to is that there are around seven classes of liability risk for directors in the context of insolvency :

1. Unpaid tax. Failure to pay over to the authorities tax collected at source and social security payments and instead using the moneys to ward off creditors.  Directors are personally liable for this practically everywhere – from the U.S. to Australia, from Norway to Switzerland. Governments with their hands on the levers of legislative power have ways of getting paid – in the public interest, of course.

2. Fraudulent trading. This is incurring debts when the directors know for sure that there is no hope of paying them. Successful cases are few internationally, because of the silver lining test, the sunshine behind the storm clouds, the light at the end of the tunnel.

3. Unreasonable trading deepening the insolvency. This is not doing the right thing towards creditors, measured by an objective reasonableness standard, when the company is in trouble and instead deepening the insolvency. This is a feature of one herd group – Britain, Ireland, Australia, Singapore and New Zealand.  In Britain it is called wrongful trading. Hungary has joined this group. Case law elsewhere has arrived at similar results, e.g. the Netherlands. In England at least, the approach has been indulgent. It also suggests that it can sometimes be reasonable to carry on.

4. Duty to file for insolvency proceedings. This duty kicks in if, say, the company is unable to pay its debts as they fall due, or the company is balance-sheet insolvent, or the company has lost half or some other proportion of its capital. Variations of these rules are widespread – France, Belgium, Chile, Italy, Russia, Taiwan, even Saudi Arabia, but not Britain, the U.S., Japan or China. Germany has reconsidered this duty.

One problem for the balance-sheet test is whether the value of the company is its liquidation value or its rescue value. How can one predict what will happen?

The impact of the rule is illustrated by a recent case where the banks promoting a work-out (which was going well) woke up one morning to discover that the directors of a major subsidiary had filed for insolvency. That scuppered the work-out. The managing director of the subsidiary explained, "I've got a wife and kids, too".

So if you are a director of a big industrial company in trouble in these jurisdictions, give up.  Just file a piece of paper straightaway and go on a long vacation.

5. Negligent management, deepening the insolvency. Examples are failing to shut down some loss-making business (never mind that it had a chance), or over-borrowing, or embarking on a risky venture. Countries adopting this approach do not have a business judgement rule. In some countries it can be routinely the case that the bankruptcy of the corporation results in the bankruptcy of the directors. In France the law has recently moderated this draconian result.

6. Breach of company law, prejudicing creditors in the twilight, e.g. paying dividends out of capital, self-dealing, faulty accounts, preferential transfers.

7. Violation of listing rules, e.g. failing to tell markets that things are bad, notwithstanding that this information at once makes things worse.   

These liabilities can spread to the so-called de facto or shadow directors – said to be puppet-masters, string-pullers, interlopers, usurpers. This is seen by some as a useful way to have a go at banks and controlling holding companies and shareholders on big pocket principles. In Austria even the government as shareholder has been held liable for interference in management. Also, insolvency is not a good time to be a company doctor. Just when the doctor is needed because the patient is sick, the law punishes the doctor. Ireland has a specific exemption.

This map for Director liability for deepening insolvency shows a tentative grading of legal systems on some of these issues. This map is broadbrush, but one has to start somewhere.

"The U.S., and Canada as well, firmly reject the idea that directors should be liable for deepening the insolvency."

A remarkable aspect of this map is that the U.S. – and Canada as well – firmly reject the idea that directors should be liable for deepening the insolvency – an approach recently confirmed in the U.S. in the Parmalat case in New Jersey, following ample precedent. They reject the policy that directors should be aggressively disciplined in this way, that they should be incentivised to stop early. That is why companies in the U.S. can carry on much longer than they can in many other countries. They uphold the view that directors should not be chilled into premature closure, that wrong business judgements should not effectively be criminalised. They appear to think that people should be encouraged to be directors, and that the veil of incorporation should be honoured. Plain crazy, or plain common-sense?

What practical advice can one give if things are gloomy? The directors should make sure that financial information is up-to-date and increase its frequency and detail. Directors' duties to creditors intensify. The board should get independent advice from doomsday experts – advice on what the local duties are (especially duties to file), on what practical steps to take, on what the disclosure duties are to markets.

Boards of companies which are vulnerable to a credit cut-off should be thinking about Plan B. They should recognise in particular how the law protects pensioners and employees. The finance staff should ensure that tax and social security contributions are paid over promptly. Banks can inform the company of their intentions, but not deliver instructions or take over management. 

Treat group companies at arm's length. There should be an absolute ban on self-interested transactions and self-dealing of any kind. Check directors' and officers' insurance – for what it is worth. Record decision-making – although some U.S. litigators discourage this.  Foreign directors may have a duty to supervise local management. In many countries boards are collectively responsible. If the company is actually insolvent, then, amongst other things, preferential payments outside the ordinary course could be dangerous.

In addition, work 48 hours a day, do this, do that, know everything, predict the future.

The bright side is that the financial crisis is an external event, obviously not brought on by the fault of the directors of ordinary corporates.  If the past is clear, then there is only the future to think about.

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Further information

If you have any queries relating to this article, please email Philip Wood,  philip.wood@allenovery.com, or tel: +44 20 3088 2552.