Measures to mitigate the risk of personal liability for company directors

The fifth and final article in a series on company directors’ duties and liabilities

1. Breach of general duties under the Companies Act

The risk of personal liability in this category is relatively limited and few situations have in practice led to personal liability. It is indeed not difficult to take measures to limit the risk of liability. The reason for this is that the duties that fall under this first category, the main duty being to act in the best interests of the company, depend exclusively on the director himself and it should not be hard for a director to determine what needs to be done.

What, therefore, should a director keep in mind? Three tips can be offered to a director:

act with integrity and with common sense;
give the company the time and the attention that the business deserves; and
if you think you do not have the necessary skills, resign or, if you have not yet been appointed, don’t accept the appointment.

What does it mean to act in the “best interests” of the company? The notion of “best interests” is usually clear enough. But directors also need to understand that if they are appointed by a particular class of shareholders or by a majority shareholder, their duty is to act in the interests of all the shareholders as a general body and not in the interest of the particular shareholder who appointed him. This principle is very relevant in the case of related-party transactions where the obligation is to ensure that any transaction is entered on an arms-length basis.

The most important measure is to implement a proper and well-thought-out management system

Liability for administrative fines under the Companies Act

The risk of liability under this category is also easy to mitigate.

A director should aim to adopt the following measures:

ensure that the Board engages a competent and diligent company secretary;
include a provision in the company secretary’s letter of engagement imposing liability on him for administrative penalties imposed through his negligence;
diarise and follow up with the company secretary on any necessary filings.

The above guidance is applicable to most filings (for example, filings of Form Ks, Form Ts, Form Hs and annual returns). In the case of financial statements, delays in filing are usually attributable not to the company secretary but to the company’s finance department.

3. Liability for administrative fines under specific legislation other than the Companies Act

Administrative duties are also imposed on directors, particularly in the financial services sector, by a variety of laws, including (but not limited to) the Prevention of Financial Markets Abuse Act, the Prevention of Money Laundering Act, the Insurance Business Act, the Investment Services Act and the Banking Act. A breach of these duties may lead to the imposition of an administrative fine personally on a director.

What can directors do to mitigate the risk of personal liability in relation to this category? The most important measure is to implement a proper and well-thought-out management system that assures, as far as possible, that the company is fully conversant with the myriad obligations imposed on it by the laws applicable to its sector and that the management system is manned by competent and dedicated personnel with proper training, reporting lines and accountability to the board of directors.

4. Liability in an insolvency scenario

The twin remedies of fraudulent trading and wrongful trading can be potent weapons that safeguard creditors’ interests against fraudulent and reckless behaviour by directors. What measures can directors adopt to eliminate, or at least significantly reduce, the risk of liability for fraudulent and wrongful trading?

Fraudulent trading

Identifying measures to not just minimize, but to entirely remove, the risk of fraudulent trading is easy. Indeed, there is just one thing to do: act with probity. The reason is that, as the name of the remedy itself suggests, fraudulent trading is premised on fraudulent conduct.

The operative wording of the legislative provision is “[i]f… it appears that any business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person or for any fraudulent purpose, the court… may… declare that any persons who were knowingly parties to the carrying on of the business in the manner aforesaid be personally responsible”.

Admittedly, in an action against a director for the civil remedy of fraudulent trading, the element of fraud may not need to be proved to the standard required in the criminal action for fraudulent trading, as “fraud” has a wider meaning in civil law than it does in criminal law, but ensuring that no fraud takes place, even in the civil law sense, should not be at all difficult for an honest person.

Perhaps because this provision may potentially involve criminal liability, an early English case had stated that the test of intent will only be satisfied if there is “actual dishonesty involving, according to current notions of fair trading among commercial men, real moral blame.”

It is true that some later English judgments indicated that the test will be satisfied where directors allow a company to incur credit when they have no reason to think that the creditors will ever be paid or where the directors obtain credit at a time when they have no good reason to believe that funds will become available to pay the creditors when their debts become due or shortly thereafter.

English commentators have nevertheless acknowledged the difficulty of demonstrating the requisite intention to defraud. In the civil liability case of Re Sarflex Ltd, it was held that where directors knew or had good grounds to suspect that there would not be sufficient assets to pay the creditors in full, the act of preferring one creditor over another did not amount to an intention to defraud other creditors destined to be left unpaid.

It has been argued that in the absence of reasonably clear indications that the requisite intent to defraud was present at the time of the conduct in question, there remains a degree of uncertainty whether civil or criminal proceedings for fraudulent trading will prove to be successful in a given case. Even where liability for fraudulent trading was imposed, the element of sheer recklessness present in those cases clearly amounted to moral blameworthiness – such that no director of probity and integrity would knowingly act in that manner.

It is in this sense that it is easy for a director to know what to do to exclude the risk of liability for fraudulent trading altogether. The judgments in the Price Club saga, in particular Dr. Andrew Borg Cardona noe vs Victor Zammit et, constitute case-studies of what directors ought not to do if they want to avoid liability for fraudulent trading.

Directors should not assume that the safest course of action is to stop trading.

Wrongful trading

What to do to avoid liability for wrongful trading is more difficult to determine. The reason for this is that the wording of the wrongful trading provision is relatively wide and the courts are afforded considerable discretion in granting the remedy. The difficulty of determining what to do to avoid liability is not helped by the absence of clear guidance from the courts (though admittedly it is not their function to do so).

The main principle underlying the wrongful trading remedy is that when a company is insolvent or facing impending insolvency the directors are bound to consider the interests of the creditors ahead of the interests of the company.

Liability may in fact be imposed when a company is being wound up and is insolvent and it appears that a person who was a director of the company knew, or ought to have known, prior to the dissolution of the company, that there was no reasonable prospect that a company would avoid being dissolved due to its insolvency.

In such a scenario, the court may declare the directors liable to make a payment towards the company’s assets as the court thinks fit. However, the court will not grant an application for wrongful trading if it is shown that the directors took every step they ought to have taken with a view to minimising the potential loss to the company’s creditors.

In assessing the director’s behaviour, the court takes into account both (i) the knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by or entrusted to that director in relation to the company (the objective test); and (ii) the knowledge, skill and experience that the director has (the subjective test). Once liability is established, the court can order the director to make such contribution, if any, to the company’s assets as it thinks proper.

A few suggestions can however be attempted as to measures that can be taken by directors to minimize the risk of liability when the company is insolvent or approaching insolvency. As a preliminary general point, it should be emphasized that in deciding what steps to take “with a view to minimising the potential loss to the company’s creditors”, the directors ought to give due attention to the need to minimise the loss for the benefit of the general pool of creditors and not for the benefit of individual creditors.

Another preliminary general point that needs to be emphasized is that it appears to be generally recognized that wrongful trading takes place where the company continues to trade and incur liabilities after the time when it was known, or ought to have been realised by the directors that an insolvent liquidation is inevitable or, at least, that it was a reasonable probability.

Two observations need to be made about this view. First, that wrongful trading may occur despite the company ceasing to trade and incur liabilities when it is insolvent or there is a reasonable probability of insolvency. The reason for this is that even if the company ceases to trade, it may still not be taking every step to minimize the potential loss to creditors (for example, if it allows valuable stock to deteriorate).

Second, that it is not in every situation that a company has to stop trading if insolvency occurs or is probable. The reason for this is that continuing to trade for a short period of time (for example to sell products at a good margin) may actually be in the best interests of the creditors.

Apart from the above considerations, what can directors do in practice to avoid liability for wrongful trading? Much of course will depend on the particular circumstances – including, the size of the company, the nature of its activities, the number and remuneration of its directors and employees, the quantum and type of stock it holds, and the causes that led to the failure of the business.

Some general recommendations can however be made. The following is a list of recommendations of practical steps and measures that should be adopted by directors, particularly in light of the on-going COVID-19 scenario, with a view to minimising the risk of being found responsible for wrongful trading:

1. Directors must ensure that they have a clear picture of the company’s affairs and, so as far as possible, all directors should agree on what needs to be done.
2. Directors should not assume that the safest course of action is to stop trading. A director ought to take every step that can properly be expected to minimise loss to creditors. A director can be faulted just as much for a premature cessation of trading as for continuing to trade while insolvent. This makes it essential to obtain competent outside advice as to whether to stop trading or continue.
3. Directors must carefully consider, together with the other directors, whether the business is viable. If it is, a director should insist on the preparation of (a) a business review; and (b) a sensible and constructive programme to reduce expenditure, increase income, ensure an adequate cash flow and restore the company to profitable trading, disposing of unprofitable or marginal parts of the business and dismissing staff who are surplus to the company’s needs or are not doing their job.
4. Directors should monitor the risks of customer/client defaults as early as possible and the impact on cashflow spanning several months ahead. Cashflow projections should be re-evaluated pessimistically (a significant drop in tourism will have a knock-on effect and negatively impact GDP).
5. Directors should identify all expenses that can be curtailed, for example, retainers, rents, subscriptions and insurances.
6. Directors should identify any actual or potential breaches of covenants or event of default in relevant agreements.
7. Directors should review current policies and procedures to accommodate the pandemic challenges and should consider changing business priorities.
8. Directors must insist on regular board meetings (virtual or otherwise).
9. A full paper trail and sets of minutes is important to show that directors have assessed the situation properly, taken appropriate advice on a regular basis and, insofar as they consider it appropriate, acted in accordance with such advice in order to fulfil their duties to the company and its creditors.
10. Directors must make sure that there is a proper distribution of responsibility within the company.
11. Directors must make sure that the accounts are being properly kept and up to date or, if not, ensure that prompt steps are being taken to do so, with outside help being brought in as and when necessary.
12. Directors must ensure that the board regularly receives an updated budgeted and a full, accurate and up-to-date picture of the company’s trading, financial and cash flow position.
13. A director must try to persuade other directors to take appropriate professional advice on suitable remedial measures. For example, where contractual obligations oblige the company to deliver a service or product, the directors should consult the company’s lawyers on whether it is possible to declare force majeure on non-delivery. The company’s advisors should attend board meetings.
14. Directors must keep creditors regularly informed and enlist their support for the continued operation of the company where this is likely to be of benefit to the general body of creditors. In this connection it is just as important to have the support of major unsecured creditors as of secured creditors, for it is the former who are most likely to suffer loss and whose support makes it easier for directors to show subsequently that they took every step they could have taken to minimise the loss to creditors.
15. Directors should identify any assets that can be used as security with banks to consider taking out additional loans as early as possible for any secured bank lending. Directors should contact the company’s bankers for any special temporary facilities.
16. Directors should consider applying for a moratorium in terms of applicable regulatory-imposed moratoria.
17. Avoid incurring additional obligations or taking on new debt unless the board has a reasonable degree of confidence that the company will be able to pay it back. Creditors will clearly be extremely upset if the directors allow the company to enter into a transaction where it will receive a benefit, but there is no real expectation that it will perform its own obligations in respect of that transaction.
18. Directors should seek renegotiation, even if temporary, of any fixed costs, such as rent and insurance.
19. Directors must consider the possibility of applying to the court for a compromise, arrangement or reconstruction or a company recovery procedure or putting the company into liquidation.
20. A director must insist that all recommendations for remedial action made by other directors and by that particular director who is making the recommendation or any dissention from any unwise actions or inactivity advocated by other directors are properly and fully minuted or otherwise placed on record.
21. If the director who is making certain proposals is in the minority and his recommendations are repeatedly rejected, causing the company to sink deeper into the mire, such director should resign and should state his reasons in a letter. However, resignation must be the last resort. A director who simply resigns without having taken every step he should have taken to minimise the potential loss to creditors will not of itself evade liability. Hence a director should not resign unless such director has done his utmost to put things in place.

It is also critical, for a director to mitigate against the risk of personal liability for wrongful trading, to ensure that at very regular intervals (that is not just when the financial position of the company deteriorates) he keeps tabs on the financial position of the company by insisting that management accounts are presented to the board on a sufficiently frequent basis.

The highest level of risk is posed by the threat of personal criminal liability

In this way, a director would be able to determine whether the company is facing financial difficulties and the obligations incumbent upon him to take all steps to avoid the potential loss to the company’s creditors are triggered. The director needs to be aware that the aforesaid obligations are triggered even if he should have known that the company is facing insolvent liquidation. A court will not be favourably impressed by a director who says that he only realised in April 2020 (when the final accounts for the year ended 31 December 2019 were completed and ready for audit) that the company had been in dire financial straits during 2019.

5. Criminal Liability

The highest level of risk is posed by the threat of personal criminal liability. Criminal liability constitutes this level of risk not only because of the severity of the punishment (nobody wants to spend time in prison or to include a criminal record on his CV) but also because, at least in the case of vicarious criminal liability, the offence may be committed without any direct involvement of the director and in scenarios where it may not be easy for the director to ensure that the company does not breach the criminal law.

Direct criminal liability

Certain wrongs on the part of directors may also give rise to a criminal offence punishable by a fine and/or imprisonment. It would then be the duty of the police to prosecute the offenders before the judicial authorities. Several such wrongs are set out in the Companies Act (for example under the section “Offences antecedent to dissolution or in the course of winding up”). Direct criminal liability on the part of directors could also arise under a number of other laws, including the Banking Act and the Social Security Act.

Mitigating against the risk of direct criminal liability is generally relatively easy because the nature of the offence is usually such that it involves real moral blameworthiness and a person of integrity who acts with probity should not fall foul of the criminal law. In certain cases, for example to avoid the risk of criminal liability under the Social Security Act, the director should also insist (and regularly double-check) that all relevant social security payments are effected in a timely fashion.

Vicarious criminal liability

Several laws create criminal offences for breach of some of their provisions – including the Employment and Industrial Relations Act, the Value Added Tax Act, the Occupational Health and Safety Act and Prevention of Money Laundering Act. While the offence will notionally have been “committed” by the company, liability is effectively imposed not on the company but “vicariously” on the director. And the liability on the director is personal: a personal criminal liability.

Reducing the risk of vicarious criminal liability is much trickier that reducing the risk of direct criminal liability. The reason is that where vicarious criminal liability is imposed on the director, article 13 of the Interpretation Act (and replicas of it in various laws) essentially lays down that where any offence is committed by a company every person who, at the time of the commission of the offence, was a director (or manager or company secretary) is presumed to be guilty of that offence unless he proves (i) that the offence was committed without his knowledge and (ii) that he exercised all due diligence to prevent the commission of the offence. Significantly, the director must proved both limbs of the defence to be exonerated from liability. The onus is on him.

The question is: what can a director do to mitigate the risk of vicarious criminal liability? It is impossible to determine with any degree of precision what measures directors should take to minimise, or ideally eliminate, the risk of vicarious criminal liability. But the essential goal is to have a proper and well-thought-out management system that assures, as far as possible, that the company is fully conversant with the myriad obligations imposed on it by the laws applicable to its sector and that the management system is manned by competent and dedicated personnel with proper training, reporting lines and accountability to the board of directors.

By taking appropriate measures to ensure compliance, companies will also indirectly be guarding against the personal liability of their own directors

By way of a practical example, let us briefly set out some measures that should be adopted to lessen the risk of vicarious criminal liability under applicable occupational health and safety legislation. It must of course be said that the precise measures to be taken will of course depend on a variety of factors, including the size of the company, its organisational structure, the number of employees, the nature of their work, the place of work and the inherent risks associated with the work carried out by the different employees.

Depending on the extent to which the foregoing factors are relevant, a rigorous implementation of the following measures should, however, go a long way to mitigating the risk of liability:

1. setting up a Health and Safety Committee and ensuring that competent and well-trained personnel are involved;
2. appointing a competent and well-trained Health & Safety Officer;
3. ensuring that the Committee and the Health and Safety Officer are given appropriate on-going training on a regular basis;
4. providing regular training to employees as befits their work;
5. implementing any health and safety measures required by OHSA and OHSA Regulations or by any another statutory provision;
6. regularly reviewing and monitoring health and safety measures;
7. having proper and open channels of communication between employees and the personnel responsible for health and safety;
8. organizing regular reports and updates to the board of directors;
9. putting in place an established system for escalating any matter of concern to the board of directors;
10. acting immediately should health or safety measure needs to be taken;
11. seeking professional advice on the measures that need to be taken and to their proper implementation;
12. regularly placing health and safety issues on the agenda of meetings of the board of directors;
13. ensuring that an adequate self-policing mechanism is in place;
14. keeping of proper and accurate records of all measures aimed at securing health and safety; and
15. eradicating complacency.

Conclusion

As noted earlier in this series, the measures required to mitigate against the risk of personal liability on directors depends on a number of factors, including the nature of the business of the company, its size and number of employees.

Few measures, for example, may need to be implemented in respect of a small family holding company that simply owns immovable property used by family members. It is however a different matter entirely for directors of a regulated entity or a listed company.

A regulated company, such as a bank or an insurance company is subject to a plethora of complex legislation, in particular to do with capital adequacy and solvency and prevention of money laundering. Similarly, listed companies are regulated by specific sets of laws, such as the Listing Rules and the capital markets legislation.

Very significant measures need to be adopted by such companies to ensure that they comply with their legal obligations. By taking appropriate measures to ensure such compliance, companies will also indirectly be guarding against the personal liability of their own directors.

Professor Andrew Muscat is a partner at Mamo TCV Advocates.