This is the second article in a series on company directors’ duties and liabilities

The pari passu principle

A fundamental tenet of Maltese law is the principle of pari passu, in terms of which all the creditors of a company rank equally for their claims unless there is a lawful cause of preference. Accordingly, the property of a company must be applied in satisfaction of its liabilities pari passu, subject to the provisions of the Companies Act and of any other law as to preferential debts or payment.

In principle, until a company goes into liquidation and a liquidator is appointed, the directors should ensure that the principle of pari passu and preferential payments is strictly adhered to. Failure by the directors to abide by this principle may render the transaction “vulnerable” (under the rules outlined later on in this contribution) and will constitute a breach of duty potentially leading to personal liability.

Statutory duties

Directors of financially distressed or insolvent companies are subject to a number of duties, many of which are enshrined in the Companies Act. A breach of many of the duties that will be discussed hereunder could potentially lead to the imposition of personal civil and/or criminal liability.

Fraudulent trading

The Companies Act imposes personal liability on any person, including directors, who is a party to “fraudulent trading”. Fraudulent trading occurs where 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 fraudulent trading provision in our Companies Act is closely modelled on the corresponding provision found under the English Insolvency Act 1986.

The test of ‘fraud’ may be satisfied where directors allow a company to obtain credit when they have no reason to think that the creditors will ever be paid

In this regard, English commentators acknowledge the difficulty of demonstrating the requisite intention to defraud. By way of example, in a civil liability case decided under the pre-1986 law, 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.

Thus, it was 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.

It should, however, be noted that the fraudulent trading provision does not impose liability on directors only in classic cases of “fraud” but potentially also in situations where a company continues to incur credit when the directors have no reason to believe that funds will be available to pay creditors when their debts become due or shortly thereafter.

Thus directors need to be satisfied that services or goods supplied to the company can be paid on the relevant due date. In other words, the test of “fraud” may be satisfied where directors allow a company to obtain credit when they have no reason to think that the creditors will ever be paid or that funds will become available to pay the creditors when their debts become due or shortly thereafter.

Any person, including a de jure and de facto director, who is in breach of the fraudulent trading provision faces two types of sanctions which can be classified as civil and criminal respectively. By way of a civil sanction, any person who was knowingly party to the fraud may be made personally responsible, without any limitation of liability for all or any of the debts or other liabilities of the company as the court may direct.

A person found liable for fraudulent trading can also be found guilty of the criminal offence of fraudulent trading and subject to a fine of €233,000 and imprisonment for a term of five years.

Wrongful trading

The heavy onus of proving fraud to the required standard of proof in order to obtain a remedy under the fraudulent trading provision has, in practice, had a discouraging effect on the institution and prosecution of fraudulent trading cases.

Liability for wrongful trading may be imposed when a company is being wound up and is insolvent and it appears that a director of the company ought to have known that there was no reasonable prospect that a company would avoid being dissolved

This issue led the Maltese legislator, following the UK approach, to conclude that whilst proof of dishonesty should be required before a person could be found liable for fraudulent trading, different considerations should apply to the provision of a civil remedy where foreseeable loss is suffered as a result of unreasonable behaviour. The result was the introduction of the remedy of “wrongful trading” – arguably the most effective provision in the Companies Act imposing liability on irresponsible directors where a company is insolvent or approaching insolvency.

Liability for wrongful trading may 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. It is apparent that the essence of the activity consists of the company’s continuing 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 was inevitable or, at least, that it was a reasonable probability.

In such a scenario, the court may, on the application of the liquidator of the company, declare the directors liable to make a payment towards the company’s assets as the court thinks fit. A court will not, however, make such declaration 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 minimising the loss to creditors, the directors ought to give due regard to the general pool of creditors rather than to any particular creditor. Any action taken by the directors with respect to particular creditors could well be interpreted by a court as being preferential with respect to certain creditors and detrimental to the general pool of creditors.

In assessing the director’s behaviour, a 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). 

It is therefore clear that a court will hold directors of large, sophisticated companies to a higher “objective” standard that directors of small closely-held companies, although certain minimum standards must be met by all directors. Once liability is established, the court can order the director to personally make such contribution, if any, to the company’s assets as the court thinks proper.

The wrongful trading provisions apply not only to directors (and for this purpose there is no distinction in principle between executive and non-executive directors) but also to de facto and shadow directors. A de facto director is a person occupying the position of a director who has not however been formally appointed as such. A shadow director is a person or company in accordance with whose directions or instructions the directors of a company are accustomed to act.

A key concern for directors in the current COVID-19 climate has been whether, in the face of the wrongful trading provision, the company could avail itself of government support packages or take on further credit (thereby incurring additional liabilities) in circumstances where it was not clear whether or not the company would be able to repay those liabilities in the future. 

A further concern is that it is extremely difficult for directors to judge whether there is a reasonable prospect of avoiding insolvent liquidation given the unpredictable nature of the crisis, giving rise to the risk that they could be held liable when they simply, but honestly, made the wrong judgment call.

In response to similar concerns, on March 28, 2020, the UK government announced that there will be a temporary suspension of wrongful trading provisions for company directors, applied retrospectively from March 1, 2020.

The temporary suspension of the wrongful trading provisions in the UK should ease concern amongst directors of UK companies to some degree but could also give rise to a degree of abuse. While it appears that there have been calls for a similar relaxation of the wrongful trading regime in Malta, the Maltese government has not yet pronounced itself on the matter.

Duty where a company is unable to pay its debts

The Companies Act imposes another positive duty on the directors where the company is close to insolvency. If the directors become aware that the company is unable to pay its debts or is imminently likely to become unable to pay its debts, they are required to forthwith, and not later than 30 days from when they become so aware, duly convene a general meeting of the company for a date not later than 40 days from the date of the notice.

The purpose of the general meeting would be to review the company’s position and to determine what steps should be taken to deal with the situation, including consideration whether the company should be dissolved or, where applicable, whether the company should make a “company recovery” application. This duty to call a general meeting applies to directors of both private and public companies.

Duty when there is a serious loss of capital of public companies

The Act also imposes an additional positive duty on the directors of a public company when there is a serious loss of capital. Where the net assets of a public company are half or less of its called up issued share capital, the directors are required, not later than thirty 30 days from the earliest day on which that fact is known to any director, to duly convene a general meeting for a date not later than 40 days from the date of the notice for the purpose of considering whether any, and if so, what steps should be taken to deal with the situation, including consideration as to whether the company should be dissolved. A breach of this duty renders each of the directors in default liable to a penalty, and, for every day during which the default continues to a further penalty.

Criminal offences under the Companies Act

Apart from the above duties, which are primarily of a civil or administrative nature, the Companies Act also sets out a number of criminal offences that may be committed by directors of a company before it is dissolved or in the course of the winding up.

Considering the increased risk of certain companies being placed into liquidation as a result of the COVID-19 pandemic, these criminal offences and their corresponding punishments also merit further discussion.

Misapplication or retention of company’s property

A director who has misapplied or retained or becomes accountable for, any money or other property of the company or been guilty of any improper performance or breach of duty in relation to the company may be compelled by the court to (i) repay, restore or account for the money or property or any part of it, with interest at such rate as the court thinks fit or (ii) contribute such sum to the company’s assets by way of compensation in respect of the improper performance or breach of duty as the court thinks fit.

Concealing company’s property; falsifying records

A director commits a criminal offence if, within the 12 months immediately preceding the deemed date of winding up (typically being the date on which a winding up application is filed or the shareholders resolve to wind up a company), he conceals any part of the company’s property or falsified any records of the company.

However, it shall be a defence for a person who is charged to prove that he had no intention to defraud or conceal the affairs of the company. A director found guilty is subject to a fine of not more that €233,000 or imprisonment not exceeding five years or both.

Fraud by officers of companies being wound up

A director would also commit an offence, and be subject to a fine of not more that €233,000 or imprisonment not exceeding five years or both, if when the company is being wound up he has made or caused to be made any gift or transfer of, or charge on, or has caused or connived at the enforcement of any executive title against the company’s property or has concealed or removed any part of the company’s property since or within two months before the date of any unsatisfied judgment or order for payment of money against the company.

A director will not, however, be guilty if he proves that at the time of the conduct constituting the offence, he had no intent to defraud the company’s creditors.

Other offences by officers of companies being wound up

The Act sets out a further list of offences which may be committed by a director of a company that is being up by the court or voluntary, or if, subsequent to the commission of the alleged offence, the company is wound up. This list includes offences relating to the failure of directors to disclose all information and to assist the liquidator. Any such offence also subjects the director to a fine of not more that €233,000 or imprisonment not exceeding five years or both.

Fraud by officers of companies subsequently wound up

A director commits an offence if (i) by false pretences or by means of any other fraud he has induced any person to give credit to the company, or (ii) with intent to defraud creditors of the company, he has made or caused to be made any gift or transfer of or charge on, or has caused or connived at the enforcement of any executive title against, the property of the company, or (iii) with intent to defraud creditors of the company, he has concealed or removed any part of the property of the company since, or within two months before, the date of any unsatisfied judgment or order for payment of the money obtained against the company. The penalty is fine of not more that €233,000 or imprisonment not exceeding five years or both.

Failure by an insolvent company to keep proper accounting records

A director is also bound to ensure that proper accounting records are kept by the company. If it is shown that proper accounting records were not kept throughout the period of two years immediately preceding the winding up or the period between the registration of the company and the winding up, whichever is the shorter, and it is further shown that the company was insolvent at the moment of the commencement of its winding up, every director who is in default is guilty of an offence unless he shows that he acted diligently and that in the circumstances in which the business of the company was carried on the default was excusable. A director found guilty of this offence would liable to a fine of not more than €47,000 or imprisonment for a term not exceeding three years or both.

Criminal offence under the Criminal Code

Article 192(d) of the Criminal Code imposes criminal liability on a bankrupt trader which “after having stopped payments… has paid or given any undue preference to any creditor to the prejudice of the general body of creditors”. Given that the reference to “bankrupt trader” in the Criminal Code extends to an insolvent company, it is arguable that criminal vicarious liability may well be attributed to a director of an insolvent company that has paid or given any undue preference as contemplated in article 192(d) of the Criminal Code.

The liability of the director is vicarious because he is essentially being made liable for an offence committed by someone else – that is, the company of which he is a director. The prosecution would need to prove that the offence has been committed (by the company). To escape liability, the director must then prove that the offence was committed (i) without his knowledge and that (ii) he exercised all due diligence to prevent the commission of the offence. The offence is punishable with imprisonment for a term from seven months to a year.

The next article in this series will tackle, among others, the disqualification of directors, vulnerable transactions, groups of companies, EU regulation on insolvency proceedings, and shareholder liability.

Professor Andrew Muscat is a partner at Mamo TCV Advocates.