Getting rid of the rot that can come with distress

Robin Nicholson
Director: Corporate-911

Throughout my career in business rescue, and my previous career where I held top management positions at companies, one thing became apparent: mismanagement is one of the biggest contributors to financial distress.

This was an issue in a rescue that I recently completed. It was a major issue at South African Airways, and is a challenge at Eskom which the parastatal is desperately trying to resolve.

I recently read a publication by Werksmans Attorneys that discusses this issue, and I feel that it is worthwhile reminding ourselves about some obvious examples of mismanagement. We also need to look at how the Companies Act tries to regulate this, and the impact of mismanagement on companies.

Reckless trading
The Werksmans editorial points out that 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.

The Werksmans editorial adds that, 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.

The Werksmans editorial points out that, 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
The Werksmans editorial points out that, 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.

The Werksmans editorial adds that, 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.

Directors can do serious damage to a company
Photo By: Canva

Civil claims by the company against a director
The Werksmans editorial points out that 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.

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.

The Werksmans editorial adds that 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.

If the director indeed had such knowledge, the Act will allow the debtor company to pursue a civil claim for loss/damages against the relevant director.

The Werksmans editorial points out that, 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 contravenedthe provisions of the Act.

It is often difficult to go into a company and make sweeping changes
Photo By: Canva

Civil claims by creditors against a director
The Werksmans editorial points out that, 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 because of that contravention.

The Werksmans editorial adds that 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 because of a contravention of the Act, and the abovementioned 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.

The role of BRPs
It is often difficult to go into a company and make sweeping changes without addressing the mismanagement issue. This often delays the progress of a business rescue because there is significant pushback from managers who are earning a princely sum of money.

At the end of the day, while BRPs are making sweeping changes, these changes are in the company’s best interest and are being done to bring a company back to a profitable core. This cannot be done with management that are acting recklessly or are delinquent directors. Cut out the rot and the company will be saved.