Beyond the balance sheet: Considering directors’ liability in financially distressed times

In the midst of the global concern of COVID-19 and the impact it has had, and continues to have, on the health and wellbeing of the population, a further concern is that of the effect the COVID-19 pandemic has had and shall have on businesses and the greater economy not only in South Africa, but worldwide.

7 Apr 2020 6 min read Business Rescue, Restructuring & Insolvency Newsletter Article

Since President Cyril Ramaphosa’s announcement of a national 21 day lockdown and the declaration of a national state of disaster, many businesses have found themselves in very uncertain times. One can only imagine the difficulties faced by directors and business officeholders during this period, as they endeavour to navigate their businesses and companies through these unprecedented times, finding themselves in very unfamiliar territory.

In advising businesses and companies in navigating through these unchartered waters, a starting point would be to try and manage the unavoidable in order to avoid the unmanageable - this was a quote by New York Times columnist, Tom Friedman. During this so-called Black Swan event, it is inevitable that many businesses will start to experience the effects in more ways than one, be it employee related issues, financial issues or market related issues.

It is unsurprising to hear that many businesses have already or may begin to experience financial distress during this time. While many of us obsess over our own health and symptoms over the next couple of weeks, as a director of company, it is equally as important to keep a finger on the pulse of the business during this time, so as to allow for swift and cautious action should the business start showing ‘symptoms’ of financial distress.

In identifying financial distress, the board and its directors would have to determine whether or not the company will be able to pay its debts as they fall due and payable within the immediately ensuing six months; or whether it appears to be reasonably likely that the company will become insolvent within the immediately ensuing six months.

These two factors would need to be carefully considered on a rational basis and technically speaking, one would have to consider if the company’s liabilities exceeds its assets; or if there are any realisable assets that can be realised in order to satisfy the company’s liabilities in the immediately ensuing six months.

Determining financial distress has far greater consequences for a director than a simple balance sheet consideration. In terms of section 129(7) of the Companies Act 71 of 2008 (the Act), there is an onerous obligation placed on a board of directors of a company wherein if the board determines that a business is in fact in financial distress, they are to either adopt a resolution to commence with business rescue proceedings, alternatively, deliver a written notice to each of its creditors, employees, trade unions and shareholders, setting out, inter alia, its reasons for not voluntarily commencing business rescue proceedings.

Failure to adhere to provisions as set out in the Act could result in a director being held personally liable for all the debts of a company. Section 77 of the Act speaks to this personal liability and explains that where a director knowingly carried on the business of the company recklessly or with the intent to defraud creditors or other stakeholders, he/she shall be held personally liable for any loss incurred by the company. Section 214 goes even further to provide for criminal liability for those directors at the steer of a company which is being traded recklessly.

In considering the above, one may surrender to the fact that in order to avoid personal liability in times of financial distress, a director is left with no choice but to either adopt a resolution for the commencement of business rescue or send a notice to all stakeholders, leaving the company in a worse off position and seemingly not acting in its bests interests.

However, in considering a directors’ freedom to exercise his/her fiduciary duties, the courts consider these instances on a case by case basis, and the enquiry is predominantly evidentiary based.

One of the main reasons that a director may elect not to send out a notice as provided for in section 129(7) (in the alternative to placing the company in business rescue), is for the sole reason of such notice seeming more like a ‘death notice’. This is because more often than not, the creditors may respond to such notice by applying to court for the company to be liquidated, as the notice contains an admission by the company of its commercial insolvency.

Therefore, should a director elect not to adhere to the provisions provided for in section 129(7) insofar as they believe that they would be acting in the best interests of the company, he/she would have to be able to prove that they acted honestly and in a reasonable manner in conducting business while the business was seemingly
in financial distress.

The defence provided for in section 77(9) of the Act is not unique to South Africa and is considered internationally as well. Commonly referred to as the Business Judgement Rule, the rule seeks to protect and promote the ability of directors to fully exercise their duties in the best interests of the company, without fear of personal liability arising from such decisions where such director acted honestly and reasonably.

Section 22 of the Act has also provided for the Companies and Intellectual Property Commission’s (CIPC) intervention, where the CIPC has the authority to issue notices where it reasonably believes that a company has been trading or carrying on business in a reckless, grossly negligent and fraudulent manner. However, in light of the COVID-19 pandemic and the state of national disaster in which South Africa finds itself, the CIPC has issued a practice note in terms whereof it acceded to not invoke its powers in terms of this section where a company is temporarily insolvent and still carrying on business or trading. This accession shall only be applicable insofar as the CIPC has reason to believe that the insolvency is due to the business conditions which were caused by the COVID-19 pandemic and shall only apply until such time that 60 days has lapsed after the declaration of a national disaster in South Africa has been lifted.

In considering the above, should your company run into financial difficulties during this time, while it is understandable to not readily concede that there may be problems, it would be unwise not to seek guidance in navigating through these uncertain times.

All directors should be asking themselves the following two important questions:

Is it reasonably unlikely that the company will be able to settle all its debts as they become due and payable in the ensuing six months?

Or, is it reasonably likely that the company will become insolvent within the immediately ensuing six months?

If the answer is yes to either of the above questions, we suggest that you make contact with us as soon as possible.

The Insolvency and Business Recue team at CDH is well equipped to guide you through the steps to be taken during early signs of financial distress and to identify various mechanisms available to companies to restructure such potential distressed financial affairs. Directors should take note that if they endeavour to take such pro-active steps to mitigate the distress, such would stand in good stead when considering as to whether or not the directors acted in a manner that was expected of them in the circumstances.

We can and want to help you during these trying times.

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