THE LEGAL OBLIGATIONS OF COMPANY DIRECTORS DURING FINANCIAL DISTRESS

Abstract

The aim of this paper is to study the duties and obligations of the company’s directors towards the company during financial distress. Directors are not just a position but a duty that needs to be carried out with responsibility. The role and responsibility of company directors both become crucial when a company faces insolvency. This paper explores the various obligations a company’s directors must carry out under different frameworks. This work highlights some specific duties and regulations of directors that they must follow to safeguard the best interests of their company and shareholders. This paper mentions the criterion that makes a company insolvent and how the board of directors are responsible to address the situation. Further this paper also mentions the consequences of not following the obligations. Whatever action a director takes must be in good faith with due diligence, skillful directors should take the company out of financial distress by striking a balance between the company, shareholders, and creditors. A nuanced understanding of companies’ financial position and the consequences of the actions must be known to the directors. The sole aim of this paper is to review the various obligations that company’s directors is liable to follow under the insolvency period of a company, and it is also to mention that under what criterion a company is considered insolvent and what will the direct consequences of non-fulfillment of the obligation upon the director. Finally, the readers of this paper will understand the intricate relationship a company and its board of directors share from the conclusion of all the findings.

Keywords

Legal obligations, directors, insolvency, distress, company law.

Introduction

Directors are an integral part of a company’s body; they take important decisions regarding the company. Apart from important decisions they have some fiduciary duties towards the company when it faces some backdrops. Under the proper framework their obligations are designed and well established and mention of consequences on non-fulfillment of duties. In India, the Companies Act 2013 has codified the duties and the Insolvency and Bankruptcy Code,2016 has codified duties of directors towards the creditors if insolvency arises. During financial distress, the duties of directors shift from shareholders to creditors, but maintenance of transparency is mandatory. There is a criterion for companies also as to when they are considered insolvent. The primary duties of the board of directors are to act in the best interest of the company and take the company out of distress with their effective decision-making skills and experience. It is important to appoint skilled directors to the board of directors who have a vision and are aware of the legal compliances they have towards their company, shareholders, and creditors. They should be held accountable for any mismanagement of a company’s finance, monitoring and maintaining accounts and establishing policies that act in bona fide. Government policies and corporate governance act have avoided many insolvencies which could have taken place. Directors should always seek legal advice during such conditions as legal experts are aware of all the charges and penalties that can put the director at risk of getting sued by the liquidators.

Directors’ duties and the company creditors (and other external stakeholders) relationships are crucial not only when a company is solvent but even more so when it is insolvent. This means that a board must also be adaptable to the kind of financial status dealing it with present and anticipated matters in connection therewith. It is beyond question that the original responsibilities of the directors to their shareholders in a phase of financial health for the firm are and should be paramount unless others than mere holders have contractually agreed dividend protection. As the shareholders are primary risk bearers for solvency contributing to any business loss of a company, therefore given their evident nature, the director’s actions intrinsically affect such stakes. Their main responsibilities change to those of creditors if they are in a formal insolvency process. The most curious divergences in the directors’ duties are seen when a company begins to have financial difficulty, and even more so when it is insolvent or closed. This is held as the duties of directors at this stage may differ between jurisdictions. Out-of-court Fraudulent Trading occurs when the company becomes insolvent but is not yet under a formal insolvency proceeding, and its shareholders or its directors acting on their behalf engage in any form of activity can be to siphon or destroy value at the expense of creditors. While there are some who disagree, the prevailing view (at least in common law jurisdictions) seems to be that when a company is on or about at the point of insolvency then duties towards creditors predominate over those owed towards shareholders should any exist. Therefore, the role of directors’ shifts is towards the creditors who are now residual risk-bearers, and they can be best heard by conserving what remains to attempt revival or facilitate repayment[1].

In the upcoming sections of this paper, we will see what the statutory duties are of directors and what is done to test the insolvency of a company. The legal obligations mention in India and what are the consequences faced by the directors on non-compliances of these duties like disqualification, defraud charge and other personal liability may also be put upon the director by the liquidator. This paper ends with the conclusion of all the findings.

Fiduciary Duties of Directors

Financial stress is a state whereby a firm or individual fails to generate enough revenues or income to enable him or her to discharge his or her debts. This is ordinarily attributable to extensive fixed costs, a high proportion of non-current assets, or revenues delicate to snapshot at a low economic stability. Causes of financial problems for the individuals include budgeting problems, excessive spending, elevated levels of indebtedness, litigation, and job loss.

Lack of awareness of the bad management signs before the problem gets out of hand is very hazardous. It may occasionally reach a state beyond which indebtedness cannot be addressed since the company or person has amassed debt that is beyond their capability to pay. In this case, desperately, people board the bankruptcy train as the only way out of the quagmire[2]. There are diverse levels of financial conditions of a company before they become insolvent because financial distress is not a sudden accident but a gradual collapse. Director should take careful steps when addressing financial situation of their company like maintaining accurate books and records all the financial information should be up to date which will help board of directors to make precise decision based on current financial condition of the company, latest cash flow position of the company, management accounts, trading projects, creditors balance, update on progress with funding also should be looked after. The business plan for the next 12 months should be prepared, close working of capital position of the company and can be improved by collecting debtors quickly, more appropriate level of stock and credit term management. Quick steps should be taken to cut the cost and minimize the exposure to creditors, monitoring the projections and adjusting for current and future trades. The need for strong governance is felt in these tough situations faced by the company, an informed decision must be taken by the board of directors and creditors’ interest should be put first. Only payments that will preserve the value of the business should be allowed. Board meetings should take place frequently to discuss the business situation and keep a record of the business updates. Documentation of decision and what information was relied upon, what professional advice was taken are all key points that should be taken into consideration. Expert guidance should be taken when dealing with insolvency period, there are many insolvency experts in the legal field that can be consultants. An expert’s advice mitigates the risk and errors because it is not possible for the board of directors alone to know all the legalities of corporate law and what decision the best in the creditors interest will be[3].

These are some common fiduciary steps that a director or board of directors should take when mitigating the financial situation and it is always advisory to take advice from legal experts. Corporate laws are overly complex and cannot be easily understood. Legal experts and professionals will help you understand your obligations and liabilities better, which will eliminate the risk of getting into any sort of legal trouble.

Insolvency Test of Companies

There are two tests to determine the insolvency of companies. They are cash flow test and balance sheet test although there is no definite method to test the insolvency, if we talk about the insolvency check through cash flow test, you need to check your company’s day to day financial situation whether the company can pay the liabilities and when it will fall due. Make plans according to the company’s current and future dues. Directors need to prioritize the company’s future dues and seek expert advice before the situation accelerates to the next level. Another method is the balance sheet test which examines all your company’s owned properties such as stock, receivables, liquid cash, and even any property, cars, and machinery that is not leased or rented out. Such assets then counter any liabilities that the company bears from the bank, other financial institutions, HMRC, staff, provisioners and other business creditors. The balance sheet test will finally address ‘what is more for your company, assets or liabilities’ Should the outcome of the balance sheet test indicate that your company has more liabilities than the assets, then you are economically insolvent, and it is imperative that steps are taken to correct the situation. Insolvency practitioners are the best people who can advise on the correct course of action for your company[4]. These are two tests to examine the current situation of a corporation which could help directors to negotiate the condition and plan the improvement of the company. Directors need to seek professional advice and prioritize the interest of the creditors to avoid any future troubles.

Legal Frameworks of Director’s Duty

In this section we will see the different frameworks regarding directors’ liabilities around the globe which include US, Australia, and India.

The Model Business Corporation Act of 2002, which is a federal statute that applies to US businesses, dictates the basic requirements for the management of corporations. This law specifically states that directors have a duty of good faith, care, and loyalty. How far these duties would be recognized were left to the State law provisions Of, these states which made the law. US courts have also at times held that the directors are presented with the duty of care, and they owe a fiduciary duty primarily to the shareholders and not usually directly to bondholders or creditors. Lyonnaies in NACEP v The Delaware Supreme Court over ruled Credit Lyonnaies in NACEP v Gheewala matter where the Court in the case noted that words “solvents company operating in borderline stage” held that are legal representatives of the corporation and its shareholders and should exercise their business as to be modified by reference to fairness to the corporate party concerned and exercised for the exclusive benefit of the shareholder/owners of the corporation.” Thus, Gheewala relied on reasoning for other earlier extant cures regarding creditors which simply permitted the use of derivative actions claims in extraordinary situations only. This meant that the stage of borderline was to be not as a reason to perform the change of duties. The safe harbor of business judgment rule was applicable upon companies. In effect, in the US, as of now, directors have no direct legal obligations toward creditors by the virtue of being members of the company as is in the case of the borderline stage being.

In Australia, the Corporation Act,2001 framed that it is the responsibility of the directors other directing officers to exercise their power based on good faith where the exercise of that power will be for the benefit of the company. Creditors are not expressly stated with reference to the law, but the Australian court have determined that in situations where a company is facing insolvency, the company’s identity aligns with the interest of the creditors. Additionally, section 588G of the act puts a responsibility on the directors to avoid insolvent trading[5].

Indian Companies Act,2013 lays down the framework of corporate governance in India. Section 166 of the act gave guidance about the duties of company directors during insolvency. Good faith, due care and diligence and the company’s interest are the core duties of directors mentioned in the act. Independent judgement, the best interest of the company and the avoidance of conflict should be the priority of the directors. Specific duties like to act by the articles of the company, Article of Association (AOA) of the company should have the duties of directors according to the laws mention in CA 2013[6]. There are approx. 700 applications pending worth Rs. 2 lakh crores in India. Inspite of stringiest laws in India breach of duties happen one the striking example is the case of the Satyam scam is a striking example of violations on fiduciary duties by directors. In 2009, the chairperson of Satyam Computer Services Ltd., Ramalinga Raju confessed to a monumental overstatement in profits and revenues with wrongly stated financial statements. The scandal rocked the Indian corporate world and triggered alarm bells over standards of corporate governance and regulatory oversight. The matter of Satyam brought to the limelight, once again in bold relief that no monetary measure can replace a sense of duty which is inherent upon human race and a stronger more bruising arm all too rudely articulated by findings emanating from investigations; barely possible without prompt corrective measures being put into effect. There are many such example present in India like IL&FS crisis, Kingfisher Airlines limited etc[7].

Laws Regarding the Duties of Directors in Financial Distress

As we have discussed above the duties of directors regarding the financial distress of a company are embedded in the Companies Act. But there is another regulatory body as well, like the Insolvency and Bankruptcy Code which frames the duties of directors. Section 166 of the act specifies the director’s primary duties towards the shareholders. Section 166(7) of the act specifies the crucial role of the directors during financial distress. Section 337 of the act chastened directors and other officials for frauds if company is nearing towards insolvency. This section holds the directors criminally accountable for their misconduct. Section 339 significantly enhances the deterrent effect by making the directors personally responsible during the Twilight Zone when actions taken by the director may affect the ability of creditors to reclaim their dues in the event of bankruptcy. This subsection provides that the Tribunal may make an order holding that any director who has been knowingly engaged in the carrying on of a business with intent to defraud creditors, or for any other fraudulent purpose, is personally liable for the whole or any part of the debts of the company. Criminal liabilities under Section 447 also hang over such directors if there are any established cases of individual fraud, the consequences of which extend to imprisonment and fines of up to 200,000 rupees. Section 340 assigns the Tribunal the additional power to order payments to be made by directors for, or to make good the assets of the company, from any piratical activities or wrongful acts committed as the company is nearing insolvency and is in the process of being wound up. Also, Section 338 deals with the keeping of up-to-date books of accounts of the company that are relevant before winding up commences. When such records are not kept by the directors, they can be liable unless they prove that they cannot help it. The punishment for this offense is imprisonment for a term of one to three years and a fine between sixty thousand rupees and two hundred thousand rupees. Section 286 is aimed at the former directors and managers of the company who left within one year prior to the petitioning for insolvency filing on the assumption that such people might have played a role in the deterioration of the company. In the Insolvency and Bankruptcy Code (IBC) section 17(1) (b) states that the power of the directors is suspended when interim resolution professional is appointed. Under section 19, the staff of the company in liquidation together with its board of directors are required to furnish whatever assistance and support the interim resolution professional may need. Non-cooperation in this regard may have adverse consequences, as it may be treated as an impediment to the process in the event that the IRP applies to the Adjudicator to order such cooperation. On the other hand, section 65 makes it an offense for any individual, including directors, to take steps or do any act that would bring about any insolvency resolution process or bankruptcy order for purposes of revenge or with dishonest intention or for any other reasons than seeking to resolve the insolvency or the liquidation process. Where the individual is convicted, criminal sanctions will be imposed[8].

These are some of the laws related to the duties of the directors during financial distress of the company. In the next section we will be investigating the consequences of non-compliance of these obligations by the company’s director.

Consequences of Breach of Duties

Section 337 of Companies Act,2013 imposes penal liabilities on directors for fraudulent activities which includes criminal penalties, fines, imprisonment for their immoral conduct. Section 339 of CA 2013 establishes personal liabilities and sets up tribunals which could decide whether the directors have defrauded the creditors or not and impose fines and penalties holding them personally liable for the fraud and under Section 447 they can be put to imprisonment and fines. Section 340 holds directors personally liable to repay and restore the company’s assets or compensation for any misfeasance as the company is undergoing insolvency. Section 338 mandates the maintaining of account books and directors failing to do so may result in penalties imprisonment for one to three years and fine up to one to three lakhs. Section 286 targets the ex-directors and executives for their former action which might have led the company to insolvency[9]. These are the consequences that a director must undergo if they fail to fulfill their duties. There are some common grounds across the districts over which the action of directors is held liable like: –

Wrongful trading: when the director knows that company might go to insolvency but did not take necessary steps to avoid the potential loss of the creditors.

Fraudulent trading: this claim can be brought against any member of the company, not just the directors where the intent was to defraud the company.

Misfeasance: in this conduct the director gave personal guarantees to the creditors and if they face loss can file a case against the director.

Defenses for Directors

There are basically two legal doctrines to protect directors from liabilities, but they churn up few questions at the end. These are as follows:

Business judgement rule: It’s this legal thing that came out of Delaware courts and then spread like wildfire to most commonwealth countries. Here’s the deal: it basically assumes that when company directors are making big decisions, they’re doing it in good faith, with all the info they need, and honestly believing it’s the best move for the company. But it imposes a million-dollar question: does this rule give directors too much leeway? Or is it unavoidable in the cutthroat world of business[10]?

Trust fund doctrine: Basically, it’s saying that company directors can’t just do whatever they want with the company’s stuff. They’ve got to be careful not to mess things up for the company or its stakeholders. It’s like they’re holding all the company’s assets in a big piggy bank for the creditors. The consequences for breaking these rules can be different depending on where the company’s at in its life cycle and what kind of protections are already in place for shareholders and other groups. Is all this legal red tape actually helping to keep companies in line, or is it just making things more complicated?

Conclusion

This paper concludes with the findings that financial distress is not a sudden process but a gradual fall that can stipulate many challenges for a corporation. Directors are the responsible entity of a company and are accountable for any mishap that occurs. Director position is not a position of ultimate advantages but needs very visionary skill to hold the credibility of the company within the creditors. The liabilities of directors shift towards the creditors from shareholders because they hold the burden of debt and are more affected party of all the downfall. Any wrong or fraudulent tended activity of directors will cause them penalties under various jurisdiction, talking about the jurisdiction the various government laws and policies have provided safe harbor to the liquidators against any fraud done to them. Directors should seek professional advice from experts as it is impossible to be aware of all the legal provisions related to corporate laws, it will avoid getting penalties and liabilities. Directors are an integral part of a company, and their decision should be uniform and in the best interest of the company. There are many ways in which insolvency can be avoided. The two tests mentioned above, like cash flow and balance sheet should be considered. Annual meetings should be held to discuss the progress of the company and important decisions must be taken under the supervision of an expert’s team. This paper has mentioned all the duties of directors and their consequences for non-compliance.

References

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[1] INSOLVENCY AND BANKRUPTCY BOARD OF INDIA, https://www.ibbi.gov.in/

(last visited Oct. 22, 2024).

[2] Adam Hayes, Financial Distress: definition, signs, and Remedies, INVESTOPEDIA (Oct. 24, 2024, 8:32 PM), https://www.investopedia.com/terms/f/financial_distress.asp.

[3] Ian Barrett, Director’s duties and Obligations- Business in Financial Difficulty, KPMG (Oct.25,2024,10:43 PM), https://assets.kpmg.com/content/dam/kpmg/ie/pdf/2023/01/ie-directors-duties-and-obligations.pdf.

[4] REAL BUSINESS RESCUE, https://www.realbusinessrescue.co.uk/company-insolvency/balance-sheet-test-and-cash-flow-test-for-a-uk-company (Oct. 25, 2024).

[5] IBBI,e8e306852963ae62b5fe59c298edb97d.pdf (last visited Oct. 25, 2024).

[6] INDIAN CODE, India Code: Section Details (last visited Oct. 25, 2024).

[7] Tushar Rana, Directors’ duties and Liabilities in Indian Companies: A Comparative Analysis, Directors’ Duties and Liabilities in Indian Companies (last visited Oct. 26, 2024).

[8] Dimple Khotele, Director liability during financial distress- An interplay of the IBC, 2016 and the Companies Act, 2013, IBCLAW. BLOG (Oct 26, 2024, 1:38 PM), https://ibclaw.blog/director-liability-during-financial-distress-an-interplay-of-the-ibc-2016-and-the-companies-act-2013-by-dimpal-khotele/#:~:text=Section%20340%20further%20empowers%20the,their%20actions%20during%20their%20tenure.

[9] Dimple Khotele, Director liabilities during financial distress- An interplay of the IBC,2016 and the Companies Act, 2013, IBC LAW BLOG (Oct. 26, 2024 1:38 pm), https://ibclaw.blog/director-liability-during-financial-distress-an-interplay-of-the-ibc-2016-and-the-companies-act-2013-by-dimpal-khotele/.

[10] Bharat Vasani, The Business Judgement Rule: The Indian Context, CYRIL AMARCHAND BLOGS (Oct. 27, 2024 2:48 PM), https://corporate.cyrilamarchandblogs.com/2023/12/the-business-judgment-rule-the-indian-context/.

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