This series of articles examines the duties and liabilities under Maltese law of directors of private and public companies where the company on whose board they sit is experiencing financial difficulties. This subject is particularly relevant these days when several companies are finding themselves in a difficult position as a result of the COVID-19 worldwide pandemic.
As a result of the stringent measures imposed worldwide to help contain the virus, industries are being paralysed across the globe and many of the world’s economies are plunging into a sharp slowdown and heading into recession, in what is shaping up to be the worst global economic crisis since the Great Depression of the 1930s.
Flights have been significantly reduced and shops, offices, restaurants and factories have been closed in many parts of the world, including Malta. The path for many businesses is precarious, with wary consumers, an efficiency-sapping stop-start rhythm and new health protocols.
In this scenario, directors of Maltese companies are having to make difficult decisions without knowing how long the crisis will last, what further measures the government might impose to slow the spread of the virus, what further financial support will be offered by the government and without being able to predict how developments around the globe will impact supply chains or customer demands.
In particular, the impact of the crisis on businesses has made it difficult for directors to determine whether there is a realistic prospect that their company would be able to ride out the storm and emerge from the current crisis intact or whether insolvency proceedings are inevitable.
This determination is critical because on it depends the course of action that directors will need to take if they consider that the company may not be able to ride out the storm.
Indeed, directors can face personal liability if they make the wrong call and this is leading to concerns that directors may feel constrained to file for insolvency proceedings without perhaps giving due consideration to other possible rehabilitative alternatives, thereby driving what might still be viable businesses down the path of liquidation.
To allay such concerns may require legislative intervention (by, for example, suspending or at least relaxing the rules on wrongful trading thereby allowing directors the breathing space required to continue trading for longer and thereby save companies’ and people’s livelihoods).
An overview of the issue
In terms of the Companies Act and general principles of law, directors owe certain duties to the company on whose board they sit irrespective of whether or not the company is experiencing financial difficulties.
These duties include the duty to act in good faith in the best interests of the company, the duty to act within their powers, the duty to promote the success of the company, the duty to exercise reasonable care, skill and diligence, the duty to avoid conflicts of interests, the duty to declare personal interests in transactions or arrangements with the company and the duty not to act in competition with the company.
Where a company is solvent, the duties are owed to the company for the benefit of its shareholders. It is assumed that in generating profits for the benefit of the company and its shareholders, sufficient funds will be available, allowing the company to satisfy all of its liabilities as and when they fall due.
However, once the company becomes insolvent or is approaching insolvency, an additional set of duties comes into play. Essentially, at this juncture, directors become bound to have regard to the interests of creditors, who would, at such stage, have a primary interest in the proper application of the company’s assets. A breach of these duties can lead to personal liability and even disqualification from acting as a director of any other company.
The notion of insolvency
Prior to setting out the specific duties on directors of financially distressed or insolvent companies, a few words need to be said about the notion of insolvency under Maltese Law and one of its most central principles, the pari passu principle.
The notion of insolvency under Maltese law is rather wide. Indeed, a broad spectrum of financially distressed scenarios can fall under the notion of insolvency with significant repercussions on the affected companies and their directors.
Directors can face personal liability if they make the wrong call and may feel constrained to file for insolvency proceedings without giving due consideration to other possible rehabilitative alternatives
A company and its directors would be deemed to fall under the legal insolvency regime in any of the following scenarios: (i) where the company is technically insolvent having failed either the “cash-flow” test or the “balance sheet” test; (ii) where the company is imminently likely to become insolvent; (iii) where there is no reasonable prospect that the company could avoid going into insolvent liquidation; (iv) where the company is “doubtfully solvent”; (v) where the company is “nearly insolvent”; and (vi) if a contemplated payment or other course of action would jeopardise the company’s solvency.
Of these scenarios, only the “cash-flow” test and the “balance sheet” test are defined in the Companies Act and therefore merit further consideration.
A company is deemed to be insolvent under the “cash-flow” test if a debt due by the company has remained unsatisfied in whole or in part after twenty-four weeks from the enforcement of an “executive title” against the company by any of the “executive acts” specified in the Code of Organisation and Civil Procedure.
The mere fact that a creditor has been demanding payment from a company for a number of years and has not received payment does not necessarily imply that a company is “unable to pay its debts.” An executive title is required. Usually, the executive title is a court judgment. The judgment must be a res judicata (final and definite judgment with no possibility of appeal).
With a final judgment in his favour, a creditor may issue one or more executive acts against the debtor to enforce his executive title (the judgment). However, it is only when a period of 24 weeks has elapsed after the issue of any of these executive warrants and payment in full has not been effected that it could be said that the company has failed the “cash-flow” test.
A company will fail the “balance sheet” test if it is shown to the satisfaction of the court that the company is unable to pay its debts, account being taken also of contingent and prospective liabilities of the company.
A court is given a discretion to ignore the “cash-flow” test and apply instead the “balance sheet” test by determining whether, in the long term, the company will be able to satisfy its obligations towards its creditors, after taking into account also the company’s contingent and prospective liabilities.
It is generally accepted that for the purposes of this test, accounts should be prepared on a going concern basis as it is likely that many companies would be balance sheet insolvent if the accounts were prepared on a break-up basis. In practice, problems may become apparent before a company fails the cash-flow or balance sheet tests.
For example, the company may be in breach of a borrowing or other undertaking in its loan documentation with creditors. Breach of these undertakings may indicate that the company is experiencing financial difficulties and may entitle a creditor to enforce certain rights against the company, resulting in the company becoming insolvent if it was not so already.
The creditor might however decide against exercising its rights, choosing instead to discuss with the company how the situation can possibly be remedied.
If a company is financially distressed or insolvent as described above, directors become bound to have regard to the interests of creditors and additional duties on directors come into play. A breach of these duties may lead to personal civil and/or criminal liability of directors.
Personal civil liability would typically follow an action by the company’s creditors or the liquidator leading the court to order the directors either to contribute to the assets available for distribution to the general pool of the company’s creditors or to be directly and personally liable for all or some of the debts of the company as the court may determine.
The next article in this series will explore further the pari passu principle and the statutory duties of companies, along with criminal offences in relation to companies under the Companies Act and the Civil Code.
Professor Andrew Muscat is a partner at Mamo TCV Advocates.