Name 8 instances when a director of a company may be held personally liable
Introduction
According to the CSSA May 2010 past paper the various reasons or conditions for the directors or director to be held liable include Directors may be personally liable in the following circumstances: Company’s name and registration number not being used in a negotiable document or other prescribed document; reckless carrying on of business; failure to exercise proper control; continuing to trade when the company is in financial difficulties, incurring debts which cannot be repaid; actions in conflict with the director’s fiduciary capacity; actions which exceed the company’s delegated limits of authority; contravening the provisions of legislation.
The new Companies Act No. 71 of 2008 (“the Act”) that came into effect on 1 May 2011, has a significant impact on directors’ liability in corporate South Africa. The provisions of the Act set the bar for competent directors at much higher levels than we have seen in the past.
Common law and fiduciary duties of directors
The fiduciary duties of directors are derived from our common law, which is created through the precedents set by our courts. While the Act attempts to codify many of these common law duties, it is a partial codification of the common law. In the circumstances, to the extent that the Act does not deal with a specific duty, or the consequence thereof, the common law will apply or will supplement such duty.
Section 76 addresses, to a very large extent, the standard of conduct expected from directors. Section 76(3) states that a director of a company, when acting in that capacity, must exercise the powers and perform the functions of a director – in good faith and for a proper purpose; in the best interests of the company; and with the degree of care, skill and diligence that may reasonably be expected of a person – carrying out the same functions in relation to the company as those carried out by that director; and having the general knowledge, skill and experience of that director.
Section 76(4) states that, in respect of any particular matter arising in the exercise of the powers or the performance of the functions of a director, a particular company director will have satisfied the obligations set out in section 76(3), if that director has taken reasonably diligent steps to become informed about the matter. This goes to the degree of knowledge that a particular director would have as to the financial status of the company.
A director would therefore be entitled to rely on the performance and information provided by persons who have received delegated powers or authority to perform one or more of the board’s functions. This includes the ability to rely on the veracity of the information provided, including financial statements and other financial data prepared by the employees of the company, accountants or any other professional person retained by the company, the board, or any committee constituted by the company.
Also included would be matters involving skills or expertise that the director could reasonably believe a particular person to have or to be within that person’s professional competence. For instance, if a director receives financial information from departmental managers, he or she would be entitled to rely on the veracity of such information provided such reliance is reasonable in the circumstances and when one considers the specific expertise of that particular manager. For example, the marketing director would not have the same level of insight into a set of management accounts as would the financial director.
Furthermore, in terms of section 76(4) of the Act, a director would have satisfied the obligations of section 76(3), if the director made a decision, or supported the decision of a committee or the board, with regard to that matter, and the director had a rational basis for believing, and did believe, that the decision was in the best interests of the company.
However, section 77(9) states that in any proceedings against a director, other than for wilful misconduct or wilful breach of trust, the court may relieve the director, either wholly or in part, from any liability set out in this section, or on any terms the court considers just, if it appears to the court that the director has acted honestly and reasonably, or having regard to all the circumstances of the case, including those connected with the appointment of the director, it would be fair to excuse the director.
Conditions that will make the director liable
The various conditions in which the directors of the company may be held liable will be discussed in the paragraphs to follow.
Reckless trading
Section 22(1) of the Act states that a company must not carry on its business recklessly, with gross negligence, with intent to defraud any person, or for any fraudulent purpose. Section 77(3)(b) in turn states that any director of a company is liable for any loss, damages or costs sustained by the company as a direct or indirect consequence of the director –
having agreed to 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; or
being party to an act or omission by the company despite knowing that the act or omission was calculated to defraud a company creditor, employee or shareholder, or had another fraudulent purpose.
Therefore, if a company continues to incur debts, where, in the opinion of a reasonable business person standing in the shoes of the company directors, there would be no reasonable prospect of the creditors receiving payment when due, it can be inferred that the business of the company is being carried on recklessly or negligently as contemplated by section 22(1) of the Act.
Consequently a director would have a duty to pass a resolution for a company’s business rescue or alternatively resolve to wind up or liquidate it as soon as he or she becomes knowingly aware that the company is either financially distressed or is trading in insolvent circumstances (both factually, in that its liabilities exceed its assets, or commercially, in that it cannot pay its debts to creditors as and when they fall due).
If a company is financially distressed and directors decide not to place it into business rescue, directors will be under a statutory obligation, in terms of section 129(7), to deliver a written notice to each affected person, confirming that the company is financially distressed and is not being placed into business rescue and providing reasons for such decision. On the other hand, if a company is trading in insolvent circumstances and there is no prospect for business rescue to succeed, the directors are obligated to fi le for liquidation.
Should a director not proceed in this manner, he or she may be held personally liable in terms of section 77(3)(b) as read with section 22(1) of the Act, subject of course to the court’s discretion to excuse such a director in terms of section 77(9) of the Act. In this regard, the detail of financial information available to a director, together with the veracity of such information, will be taken into account when the personal liability of such director is examined in terms of section 77 of the Act. If a director is, however, in charge of operations or marketing, he or she will not be expected to be privy to the same level of financial information as the financial director.
Directors who are knowingly a party to prohibited conduct
Furthermore, the Act defines what is meant by a person “knowing” of such prohibited conduct. “Knowing” when used with respect to a person, and in relation to a particular matter, means that the person either had actual knowledge, or such person reasonably ought to have had actual knowledge or acquired it by having investigated the matter or by having taken other measures which would reasonably be expected to have provided the person with actual knowledge of the matter.
As in all cases involving negligence, the test in South African law is essentially an objective one, in that it postulates the standard of conduct of the notionally reasonable director. It is subjective insofar as the said notional director is envisaged as conducting himself or herself with the same knowledge and access to financial information as the relevant director would have had in the circumstances. In this regard the court will have regard to, inter alia, the scope of operations of the company; the role, functions and powers of the directors; the amount of the corporate debt; the extent of the company’s financial difficulties; and the prospect, if any, of recovery.
Civil claims by the company against a director
Section 77(3)(b) of the Act, as read with section 22 of the Act, penalises and holds directors personally liable to the company for any loss incurred through knowingly carrying on the business of the company recklessly, with gross negligence, with intent to defraud any person or for any fraudulent purpose.
Receiving goods from creditors
Any director, who allows his company (the debtor company) to receive goods on credit from a creditor, knowing full well that the company is not in a position to make payment for such goods, opens himself/herself up to a personal liability claim. Such conduct would constitute reckless behaviour on the part of the director and may also include an intent to defraud the creditor who had supplied goods to the company on credit.
If the debtor company has more than one director, the company will have to pursue claims against all of those directors that had knowledge of the financial position of the debtor company, particularly to the fact that the debtor company, at the time that the company received the goods on credit, would be unable to pay for such goods as and when payment for such goods became due and payable (albeit due to lack of liquidity or because the company’s liabilities exceeded its assets). Knowledge is therefore an important element to prove and the onus will be on the company to prove such knowledge on the part of the director.
Additionally, in terms of section 77(2), a director of a company may be held liable in accordance with the principles of the common law relating to the breach of a fiduciary duty and relating to delict, for any loss, damages or costs sustained by the company as a consequence of any breach by the director of duties contemplated, inter alia, in section 76 discussed above.
It is important to note that the Act does not limit the application of section 77 only to directors as such. It applies to a director, an alternate director, a prescribed officer (as designated by the Minister), a person who is a member of a committee of a board of a company, or a member of the audit committee of a company irrespective of whether or not the person is also a member of the company’s board.
Section 77(6) states that –
“The liability of a person in terms of this section is joint and several with any other person who is or may be held liable for the same act”.
Section 77(6) thus allows the company to claim against more than one director and against any person who contravened the provisions of the Act.
Civil claims by creditors against a director
As is evident from the above, the company itself has a claim for loss/damage caused by the director to the company itself. The Act does not specifically mention the basis upon which a creditor can pursue a claim against the director who contravened the various sections referred to above.
Section 218(2) of the Act, however, states that any person who contravenes any provision of the Act is liable to any other person for any loss or damage suffered by that person as a result of that contravention.
This section would accordingly allow a creditor to claim against the company as well as against a director(s) or any person who caused loss/damage to such creditor as a result of a contravention of the Act, and the above mentioned sections in particular. For instance, this section would allow a creditor to institute an action against the directors for the cost of the goods supplied on credit to the debtor company which ultimately remained unpaid, if the business of the company was carried on recklessly at the time the goods were procured by the debtor company on credit.
Section 424 of the COMPANIES ACT 61 OF 1973 (“the 1973 Act”)
As set out above, the standards of conduct, and liability of directors under the Act are dealt with principally in sections 76 and 77. However, nowhere in those sections or anywhere else in the Act are there provisions identical to sections 423 and 424 of the 1973 Act, which gave creditors’ rights as against directors of debtor companies.
Schedule 5 of the Act delineates the transitional arrangements. That is, those provisions of the 1973 Act which continue to apply despite the repeal of the 1973 Act. Item 9 of Schedule 5 of the Act provides that despite the repeal of the 1973 Act, Chapter 14 of the 1973 Act continues to apply with respect to the winding-up and liquidation of companies under the Act.
In light of item 9(1) of Schedule 5, it would therefore appear that sections 423 and 424 of the 1973 Act (which are part of Chapter 14) will continue to be used by aggrieved creditors (whose claims arose either before or after 1 May 2011) against directors of companies in circumstances where such companies have been wound up or liquidated, and when such conduct has caused losses to creditors. Whether or not the reference to “winding-up and liquidation” in item 9 is limited to purely procedural aspects of this process, and thus not to matters related therewith, is something that will need to be deliberated on by our courts.
Charging directors criminally
Section 214 of the Act provides for criminal liability if an act of fraud has been perpetrated by any person in relation to a company, its creditors or employees. Additionally, in terms of section 34 of the Prevention and Combating of Corrupt Activities Act 12 of 2004 (“POCA”), any person who holds a position of authority and who knows or ought reasonably to have known or (reasonably) suspected that any other person has committed fraud involving an amount of R100 000 or more must report such knowledge or suspicion or cause such knowledge or suspicion to be reported to any police official. A failure to do so is a criminal offence.
Accordingly, if a creditor (or fellow director) suspects that the business of a company is being carried on with the intent to defraud any person or for any fraudulent purpose, then such creditor (or fellow director) is under a statutory obligation to report his/her suspicions to the police.
As a result, the directors of debtor companies may not only be held personally liable towards to the company and its creditors for losses incurred, but may also be charged criminally.
Delinquent directors
In terms of section 162 of Act, the Companies and Intellectual Property Commission (“the Commission”) or the Panel set up by the Act, may apply to a court for an order declaring a director delinquent (or under probation) if such a director continues to grossly abuse his/her position, or acted in a manner which constituted a contravention of section 77(3) (b) of the Act. Such contravention would occur as a result of a director acquiescing in the carrying on of a company’s business despite knowing it was being conducted in a manner prohibited by section 22(1).
Further, a director may be declared to be a delinquent, if he/she has been a party to an act or omission by a company despite knowing that the act or omission was calculated to defraud a creditor of the company or had another fraudulent purpose.
A director may also be declared a delinquent, in terms of section 162(7)(b)(ii) of the Act, if during the time that he/she was a director of more than two companies, and such companies failed to pay all of its creditors in full or meet all of its obligations (except in terms of a Business rescue Plan resulting from a resolution of the board in terms of section 129 or a compromise of creditors in terms of section 155). Therefore if a director consistently allowed his/her companies to be placed into liquidation resulting in creditors not being paid in full, an application may be made to court via the Commission or the Panel to declare such person to be delinquent.
Where a declaration of delinquency occurs, the director concerned may be ordered to pay compensation to any person adversely affected by that person’s conduct as a director, even if such a victim does not otherwise have a legal basis to claim compensation or in the case of an order of probation (similar to a suspended sentence) be forced to be supervised by a mentor in any future participation as a director while the order remains in force or be limited to serve as a director of a private company or of a company of which that person is a sole shareholder.