by Dirk Kotze
It is trite that the ultimate fate of a financially distressed company, unable to pay it creditors, are liquidation. Once in liquidation and should creditors elect to proceed with an insolvency enquiry, the directors of the company might, in appropriate circumstances, be faced with the uncomfortable question, “why did the board not timeously inform the stakeholders and creditors of the fact that the company was financially distressed and why did you not resolve to place the company under business rescue”.
Why would this be a relevant question? The relevance of this question is found in the duty imposed on the board of directors in section 129 (7) of the Companies Act 71/2008 (“the Act”), which states that, “if the board of directors of a company has reasonable grounds to believe that the company is financially distressed, but the board has not adopted a resolution contemplated in this section (referring to a resolution to place the company in business rescue proceedings), the board must deliver a written notice to each affected person, setting out the criteria referred to in section 128 (1)(f) that are applicable [i.e. choose and explain the financially distressed scenarios as per the definition provided in section 128 (1)(f)] to the company, and its reasons for not adopting a resolution. Simply stated, if a company is in financial distress and it has not filed for business rescue, their is a positive duty on its board of directors (“the board”) to advise the affected persons being the creditors, shareholders and employees of the company that it is financially distressed, and also advance reasons why they have elected not to file for business rescue.
The language used in this section is not directory, but peremptory and it suggest that once the definition of financial distress in section 128 (de facto and commercial insolvency foreseen in the ensueing 6 months) of the Act are met, the board has a positive duty to act. Not only must they inform stakeholders of the fact that the company is in financial distress, but they must also advance reasons why they have not adopted a resolution and filed for business rescue.
A further question that arises automatically is whether a failure of the board of directors to comply with this duty in terms of section 129 (7) (hereinafter referred to as “this duty”) will have adverse consequences for the board, especially in circumstances where the company is eventually liquidated and creditors suffer huge losses as a result of unpaid claims, which losses could have been lessened if this duty had been complied with
The answer to this question is by no means staightforward. At the outset, section 129(7) does not contain any sanction if the board fails to comply with this duty, nor does the Act provide any specified time limits within which such compliance must occur. The main and obvious reason for the absence of a sanction, is the fact that such notice to creditors will in all likelihood be tantamount to commercial suicide by a company, as its creditors may no longer be willing to supply goods and services on favourable credit terms, if any at all. Banks and financial institutions will, in all likelihood, withdraw all credit facilities or at least substantially reduce such facilities.
Does this mean that the board could simply ignore this duty if they have reason to believe that the company is financially distressed? The answer should be a clear NO.
Although I do not propose that that a failure to comply with this duty will automatically lead to the directors being liable for the losses suffered by creditors in a liquidation, the following should be kept in mind.
Firstly, the Act, via section 218(2), makes it clear that, “any person who contravenes any provision of this Act is liable to any other person for any loss or damage suffered by that person as a result of that contravention”. Thus for instance, an aggrieved shareholder (who continued to invest his money into a financially distressed company whilst not having been informed of its financially distressed status), and a creditor (who continues to supply goods and/or services to a financially distressed company whilst being blissfully unaware of its financially distressed status) might well choose to claim their losses from the directors of the company should the company end up in liquidation.
Secondly, a failure to comply with this duty, in conjuction with other relevant evidence, may lead to a conclusion that the directors of the company acted recklessly and with gross negligence. Section 424 of the old Companies Act (which still applies under our new company law regime) and the judicial pronouncements thereon [see Philotex (Pty)Ltd and Others v Snyman and Others 1998 (2) SA 138 (SCA)] makes it clear that directors will be held personally liable for the debts of a company if they traded recklessly. When the Philotex judgement was handed down, this duty did not exist and under our new company laws it could well be argued that a failure to comply with this duty is an important factor from which an inference of “recklessness” can be made in event of a company continueing to trade and incurring huge debts in a financially distressed scenario. Filing for busines rescue could certainly and in appropriate circumstances be regarded as a reasonable step that a board of directors could and should have taken to prevent the losses being uncurred by creditors and shareholders.
Thirdly, the failure to act in terms of section 129(7) of the Act could also impact on an inference that a director acquiesced in the carrying on of the company’s business despite knowing that it was being conducted in a manner prohibited by section 22(1) of the Act (i.e. recklessly, with gross negligence, with intent to defraud or for any fraudulent purpose). This may lead to personal liability for any loss, damage or costs sustained by the company [see section 77(3)(b) of the Act].
Taking into account the risks involved, directors of companies should at least take note that a failure to comply with section 129(7) may in appropriate circumstances lead to personal liability for the debts of the company. The real conundrum is however that you are, in no way, “damned if you do and damned if you don’t.”
It will be interesting how the Courts will interpret this provision, which, due to its possible adverse commmercial consequences, will not in isolation lead to personal liability, but will most certainly in appropriate circumstances be an important factor when considering reckless trading.
Dirk Kotze LLB (Stell) LLM (Unisa) is an attorney who practices for his own account in Stellenbosch. www.dirkkotze.co.za
This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your legal adviser for specific and detailed advice.