Legal Business DUTIES OF DIRECTORS WHEN INSOLVENCY SETS IN

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1 Memoranda on legal and business issues and concerns for multiple industry and business communities DUTIES OF DIRECTORS WHEN INSOLVENCY SETS IN 1 Rajah & Tann 4 Battery Road #15-01 Bank of China Building Singapore Tel: Fax: eoasis@sg.rajahandtann.com Website:

2 DUTIES OF DIRECTORS WHEN INSOLVENCY SETS IN This article discusses the duties of directors when insolvency sets in. It looks at the duties of a director prior to th e appointment as well as subsequent to the appointment of the liquidator. The offences that directors can be subjected to are also explored. Finally, some guidelines are provided as to how directors should act in the event of insolvency required of a director. Overview When a corporation becomes financially troubled, whether or not insolvency actually sets in, the fiduciary role of its directors modify and they take on additional duties including owing fiduciary duties to creditors. The nature of the additional obligations directors have to creditors in the wake of the financial distress of companies has not been well defined in existing statutory or case law. It is clear, however, that the problems directors face in these circumstances can be complex and daunting, often to the point of leading many who confront such situations, especially nonmanagement directors, to leave the corporation s service, perhaps depriving it at a critical time of an important part of management. This article identifies what potential liabilities a director may face when insolvency sets in into a company. With respect to an insolvent or nearly insolvent corporation, the director s fiduciary duties expand to make the director a fiduciary for creditors. For a claim to exist against directors under this theory, a condition of insolvency or near insolvency must exist at the time of the alleged breach of fiduciary duty (or as a consequence of it); it is insufficient that the corporation later becomes insolvent. Under section 254(1)(e) of the Singapore Companies Act, a court may order a company to be wound up if it is unable to pay its debts. This is the commonest ground on which a petition for winding up is presented. The Singapore High Court in Re Great Eastern Hotel (Pte) Ltd [1988] established two tests for what amounts to an inability to pay debts. These are an inability to pay debts as they fall due (the cash-flow test), and an excess of total liabilities over total assets (the balance sheet test). The change in the fiduciary duty of directors is sometimes explained as the application of a trust fund doctrine to the director s relationship to the corporations creditors. Directors must recognise that in managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may arise when the right course to follow for the company may diverge from the choice that the shareholders would make. Duties Of A Director Pre-Appointment Of Liquidator Once insolvency kicks in, a director should be aware of additional duties that become particularly pertinent on the onset of insolvency. Some of these duties are set out in the Companies Act, and Page 1

3 are intended to ensure that creditors interests in an insolvency are not compromised. Unfortunately the more difficult questions of the precise scope of the duty is not addressed. To illustrate, to what extent must a director make disclosure when a company is in financial difficulty? Providing too much disclosure could potentially mean that faith in the company is reduced, leading to further potential trouble. These issues are not statutorily dealt with nor documented anywhere Over and above the issues discussed above, there are specific liabilities that directors must concern themselves about. Firstly, a director of a company who is knowingly a party to the contracting of a debt, at the time the debt was contracted, had no reasonable or probable ground of expectation, after taking into consideration the other liabilities, if any, of the company at the time of the company being able to pay the debt, commits an offence under section 339(3) of the Companies Act. Breach of this provision has penal consequences. Next, it should be observed that where a company has gone into liquidation within six months of the creation of a floating charge, that charge is void except to cover the amount of cash advanced to the company at the time of creation or subsequently, together with interest at 5% per annum. This is not strictly a duty imposed on a director, but given the director s position in the company, a duty is placed on him to ensure that no charge is created when the company is on the verge of insolvency. Duties Of Directors On Appointment Of Liquidator On the appointment of a liquidator in a voluntary winding up (whether members or creditors ), sections 294(2) and 297(4) of the Companies Act provides that the powers of the directors cease except so far as is allowed by the liquidator or the members (or the committee of inspection or the creditors, in the case of a creditors voluntary winding up with the consent of the liquidator). Although there is no express provision in the Companies Act, powers of the directors cease when the court orders the winding up of the company. The court may, however, under section 282 of the Companies Act appoint the directors as special managers to assist the liquidator. However, directors should be aware that they may be required to furnish information to the liquidator to enable him to properly carry out his duties. This is essential in order to enable a liquidator to obtain an idea of the company s position, and there are several provisions in the Companies Act that deal with this. Section 336 of the Companies Act provide that the following acts of an officer (whether past of present) of a company which is being wound up committed within the 12 months next before the commencement of the winding up or at any time thereafter constitute an offence: Page 2

4 concealing any part of the property of the company to the value of S$200 or upwards, or concealing any debt due to or from the company; fraudulently removing any part of the property of the company to the value of S$200 or upwards; concealing, destroying, mutilating or falsifying, or being privy to the concealment, destruction, mutilation or falsification of, any book or paper affecting or relating to the property or affairs of the company; making or being privy to the making of any false entry in any book or paper affecting or relating to the property or affairs of the company; fraudulently parting with, altering or making any omission in, or being privy to fraudulent parting with, altering or making any omission in, any document affecting or relating to the property or affairs of the company; by any false representation or other fraud, obtaining any property for or on behalf of the company on credit which the company has not subsequently paid for; obtaining on credit, for or on behalf of the company, under the false pretence that the company is carrying on its business, any property which the company has not subsequently paid for; pawning, pledging or disposing of any property of the company which has been obtained on credit and has not been paid for, unless such pawning, pledging or disposing was in the ordinary way of the business of the company; attempting to account for any part of the property of the company by fictitious losses or expenses; and making any false representation or other fraud for the purpose of obtaining the consent of the creditors of the company or any of them to an agreement with reference to the affairs of the company or to the winding up. Section 336 of the Companies Act further provides that the following acts of an officer (whether past of present) of a company which is being wound up constitute an offence: making any material omission in any statement relating to the affairs of the company; knowing or believing that a false debt has been proved by any person and failing for a period of one month to inform the liquidator of the same; and preventing the production of any book or paper affecting or relating to the property or affairs of the company. Page 3

5 Each of the above offences will render the officer liable to a fine not exceeding S$10,000 or to imprisonment for a term not exceeding two years. Under section 285 of the Companies Act, the court has the power to summon and examine on oath, among others, any officer of the company. Such a person may be required to produc e any books and papers in his custody relating to the company. The examination is generally conducted in private and may be held before a district judge. Public examinations may also be carried out. Under section 286 of the Companies Act, where the liquidator has reported that in his opinion, a fraud has been committed or some material fact has been concealed by any officer, or that some officer has failed to act honestly or diligently or has been guilty of some impropriety or recklessness, the court has the power to order the public examination of that person. The aim of the inquiry is to discover the facts, and therefore the person who is to be examined cannot have the order for a public examination discharged by alleging that the liquidator s report is false. The aim of a public examination is to elicit evidence that may be used against a miscreant in subsequent proceedings. The court s power to order examinations may also be invoked in a voluntary winding up upon the application of the liquidator or any creditor or contributory. The English Court of Appeal in R v McCredie and another [2000] upheld the convictions of the defendants, former directors of C Co, for inter alia fraudulently removing the company's property and for failure to deliver up books and papers (including floppy disks) of the company in response to requests from the liquidator. The facts of the case were briefly as follows: when the company failed and went into liquidation, the defendants had attempted to sell the name, goodwill and the customer database of the company. On the first day of the winding up, the liquidator had seized movable chattels including certain cabinets, and left behind the floppy disks and documents contained in them (which included valuable information on the customer database). The directors removed these from the company premises and subsequently failed to deliver them to the liquidator when asked to do so. The directors argued that since the documents and disks had been abandoned by the liquidator, they had removed them with the knowledge and consent of the liquidator. The English Court of Appeal held that pursuant to section 208 of the UK Insolvency Act 1986, the directors of a company under liquidation owe a continuing duty to the liquidator to co-operate with the liquidator actively in disclosing company property unknown to the liquidator. Thus, the directors had to hand over all books and documents relating to the company to the liquidator. The Court also noted that the term 'property' went further and included the fruits of the company's property, including any compilations prepared by an officer of a company from knowledge he acquired as a servant of the company and which added value. With respect to the defendant's defence of abandonment, the Court rejected this, holding that there had been no abandonment of the books and documents as the liquidator did not have the requisite knowledge of what was being abandoned. In this respect, the Court noted that the Page 4

6 documents were allegedly abandoned on the first day of the winding up when the liquidator did not have the requisite knowledge of the business and hence of what was being abandoned. Accordingly, the defence having failed, the defendants were liable for inter alia fraudulent removal of company property. In Singapore, section 286 of the Companies Act gives the Court power to order the public examination of directors and other officers of a company under liquidation who are known or suspected to have any property of the company in their possession. While section 286 does not specify that the directors have to furnish all the documents of the company, whether or not the liquidator is aware of them, it is certainly arguable that such a duty should be owed to the liquidator. The liquidation of a company also brings with it a regime of offences that, if applicable, will result in the directors being subject to certain specified liabilities. Some of these specific duties are here discussed. Where a company has either bought property from or sold property to a person who was at the time of the transaction a director of the company for cash consideration and the transaction occurred within two years before the commencement of the winding up, the company may recover any amount by which the property was over valued or undervalued (as the case may be) from the director. This also applies to transactions with another company where that company had common directors with the company in liquidation. The liability to account seems to be strict, and there is no provi sion allowing the members to approve such a transaction. Arguably, the unanimity rule, ie shareholders unanimously agreeing to ratify the act, will also have no application, as the interest of creditors must be heeded in insolvency. Section 340(1) of the Companies Act allows a liquidator to apply to court to make any person who was party to carrying on the company s business in a fraudulent manner liable for the company s debts. If the officers of a company have breached their duties towards the company, the liquidator may apply to court to have these duties enforced in a summary way. Section 341 allows the court to assess damages against delinquent officers summarily by means of a misfeasance summons. The section creates no new rights but provides a sum mary mode of enforcing rights which apart from the section would have to be enforced by an ordinary action in the courts. Guidelines On Exercise Of Fiduciary Duties Of Directors Of Companies On The Verge Of Insolvency Compliance with fiduciary duties is very much dependent on the specific facts of the case. This calls into question a number of matters including, judgments of prudence, practicality and fairness in specific circumstances (including limitations on knowledge and time), through use of principles such as the business judgment rule and burdens of proof. Given this, it is helpful to set some guidelines as regards how a directors can or should act when a company is in financial difficulty. Firstly, directors must always bear in mind that the company s assets are owned by shareholders, or by creditors, as the case may be. Given this, adopting the approach that the shares are a trust Page 5

7 fund to be held in favour of creditors when insolvency sets in provides the director guidance in ascertaining what should be done in relation to the company s operations. The directors should also distinguish between core and non-core assets of the company by determining which assets and operations can be the basis of viable operations when the company is reorganised, and which retard the health of the company further. In addition, the directors should develop a business plan which contemplates prudent attainment of the greatest expenses and further liability exposure from the non-core assets. Such a plan can be put together in conjunction with the liquidator and even the auditors. Secondly, directors must pay particular attention to transactions as they are undertaken, particularly where the transactions are related party transactions. As stated, when a company is in financial trouble, the directors and officers fiduciary duties will expand to include creditors and other claimants. This will see an increase in the number of parties whose interest will intersect and conflict with those of insiders. Directors must therefore be prepared to handle these conflicts in conjunction with the liquidator. Finally, oversight practices that are perfectly adequate for financially healthy companies may become inadequate and imprudent in periods of financial distress. In particular, at such times there is greater than normal risk that the corporation s system of internal accounting controls can be overwhelmed or bypassed. This, therefore, calls for so special vigilance to deal with such matters. Conclusion It is evident that directors duties do not come to an end once insolvency sets in. The duties continue to remain onerous, with the added element that directors must be concern with how creditors are dealt with as well. Rajah & Tann is one of the largest law firms in Singapore. It is a full service firm and given its alliances, including US premier firm Weil, Gotshal & Manges, is able to tap into a number of countries. Rajah & Tann is firmly committed to the provision of high quality legal services. It places strong emphasis on promptness, accessibility and reliability in dealings with clients. At the same time, the firm strives towards a practical yet creative approach in dealing with business and commercial problems. The information contained in this newsletter is correct to the best of our knowledge and belief at the time of writing. Specific professional advice should be sought before any action is taken. In this regard, you may call the lawyer you normally deal with in Rajah & Tann or the Knowledge Management team at eoasis@sg.rajahandtann.com Rajah & Tann Knowledge Management. All rights reserved. Page 6