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Directorship during a liquidity shortage
7 April 2020

Directors of companies in financial distress are confronted with many different issues, including liability issues. More information about these liability issues is provided in this article.

Dividend distributions

The general meeting of shareholders in a private limited company (B.V.) is authorised to decide on the appropriation of the profits resulting from the adoption of the annual accounts and to decide to distribute dividend, when the equity capital exceeds the obligatory reserves. This is called the limited balance test. When the shareholders do not decide to distribute the dividend, then that is the end to the matter. The awareness amongst shareholders about the risks of the corona crisis is shown by recent appeals to companies from big investors in the media regarding suspension of the distribution of dividend.

The situation for the board becomes more complicated if the general meeting approves dividend distribution despite the risks, because the decision of the general meeting has no effect until the board grants its approval. In other words: the board has the final say. The board is obligated to refuse its approval when it knows or is ought to foresee that the company will be unable to keep up with its debt payments (also called: the liquidity test). If the board grants its approval even though it did not conduct the liquidity test correctly or it did not conduct the test at all, the consequences can be far-reaching. In that event, it follows from Dutch law that each board member is personally liable for the deficit resulting from the dividend distribution. Therefore, it is important that the board obtains insight in the financial situation of the company, before granting this approval.

In practice, the board member is mostly held liable after the company has gone bankrupt. Since the damage has already been caused at that point, the board member will have little means left to avert its personal liability. He/she faces the often-difficult task to prove that the dividend distribution is not due to his/her omission to take measures to avert the consequences. Therefore, we advise the board to seriously consider the liquidity in time and to always duly perform the liquidity test.

Selective payments during the corona crisis 

A good selective payment policy is key for companies to manage temporary liquidity issues. However, selective payment of creditors can in certain circumstances be unlawful when other creditors are left unpaid without any recourse for the damages resulting from the non-payment.

Selective payments
The starting point is that selective payments are not unlawful; a company is free to choose which due and payable debts it pays first. With this in mind, a company can make good use of this principle when (temporary) liquidity issues arise. 

But as so often, “there is no rule without an exception.” 

In general, a director of a company should take into account that he can be held liable for engaging in selective (preferential) payments of debts that are due and payable if, given the distressed financial situation of the company, he knows (or reasonably should know) that other creditors are left unpaid without sufficient recourse for the damages resulting from the non-payment and, with regard to the circumstances of the case, no adequate justification for the selective payments.

Justification for selective payments

Adequate justification for selective payments can be found in case the board of the company decides to pay certain creditors first so as to facilitate an attempt to rescue its business. Reference can be made to case law by a lower court in which a company in financial distress selectively paid creditors (non-related parties) following a predetermined list of creditors. The list was drawn up by the company with the help of an advisor to enable an honest rescue attempt of the business. The court held that:

“A director of a company in financial distress will have to stop trading if there is no reasonable option of continuing to trade. In the period preceding this moment, it can be expected of such a director to try to continue the business operations in some form. Part of such a rescue attempt will typically be to selectively pay the company’s creditors to a certain degree; those parties necessary to safeguard the continued existence of the business, will be paid preferentially out of the need to survive. If the business is saved, ultimately all creditors benefit from the selective payment. If the business fails, then it is not automatically given that the director acted negligently in making selective payments. When judging with hindsight, the criterion must be whether the director – given the situation the company was in – could reasonably decide to resort to selective payments or whether he should have stopped trading.”

Suspicious payments 
Selective payments to related parties are often unlawful. This includes selective payments to subsidiaries, director(s) or shareholder(s). Suspicious are also any selective payments – whether or not under pressure from the creditor – made on the basis of a personal interest of a subsidiary, the director or shareholder.

It is vital for directors to assess the viability of any rescue attempt (and to document this) before engaging in selective payments. If a claim for engaging in selective payments is brought against a director, he will not only have to be able to show that the company was involved in a serious rescue attempt, but also that the selective payments were necessary to make that attempt a success.

New commitments

As a result of the corona crisis, a company may find itself in distress and may, for example, have liquidity problems. In these difficult times, the board will in principle do everything in its power to save the company from collapsing in order to continue its business. In that situation, the directors of the company will have to be cautious when they conclude new agreements with third parties on behalf of the company. Such new obligations could include, for example, attracting new financing or concluding new contracts in an attempt to increase cash flow.

A poor financial position of the company may lead to its bankruptcy. If the company fails to meet its obligations and the damages resulting therefrom turn out to be non-recoverable because of the company’s bankruptcy, the other party is left with the damage. A director is personally liable for the loss suffered by the company’s creditor if the company enters into an agreement on behalf of the company while the director knows or should know that the company cannot fulfil its obligations thereunder and also has no recourse. Those damages may be substantial. For this reason, creditors of a bankrupt company often point their arrows at its directors. The trustee in bankruptcy will always investigate the director’s acts or omissions.

Whether a director could, in the given circumstances, allow the company to enter into new obligations depends on all the circumstances of the case. It is important to note that the director is an entrepreneur and is allowed to take certain risks. If the possibility of a refinancing or takeover is still realistic, the director may allow the continuity of the business operations to prevail. A relevant circumstance may be whether the envisaged new agreement fits in with the normal business operations of the company.

Although serious personal blame of a management board member is required to hold him personally liable, the management board member should proceed with due care. He should be aware that his actions may affect him personally. At some point he will have to put the interests of creditors before the interests of the company. A director of a company in distress should act prudently and carefully document his decision-making process to ensure that his reasons for entering into new commitments are clearly laid down in writing.

Corona crisis: think (also) about notice of inability to pay taxes and pension contributions

To limit the adverse economic consequences of the corona virus, various (fiscal) measures have been announced to support businesses with (temporary) liquidity issues. If a company cannot pay its taxes and/or (pension) contributions on time, it is possible to submit a request for special deferral of payment of taxes. In addition, it is important to also notify the Dutch tax authorities of the inability to pay taxes and/or (pension) contributions (“melding betalingsonmacht”). If the company fails to do so in time, the managing directors risk personal liability for the unpaid taxes and contributions.

Obligation to report in ability to pay
In the event that a company cannot meet its obligation to pay taxes and/or (pension) contributions, the managing directors must notify the Dutch tax authorities and the relevant industry pension fund. This notification must be made “without delay”. This means that the notice must be made no later than two weeks after the day on which payment is due. The notice must be made in writing and must provide insight into the circumstances that have led to the inability to pay.

Director’s liability 
The sanction for not or not timely reporting the inability to pay is far-reaching: the director(s) are jointly and severally liable for the unpaid taxes and/or (pension) contributions of the company. It is therefore important to notify the Dutch tax authorities and/or pension fund in time. When notice is given in time, director’s liability is still possible, but only if the non-payment of the taxes and/or (pension) contributions is the result of improper management. In that case the burden of proof rest on the Dutch tax authorities and/or the industry pension fund.

The corona crisis 
In light of the Corona crisis and the far-reaching (fiscal) measures for businesses, the question arises whether the statutory regulation of the notice of inability to pay and the associated directors’ liability will be strictly enforced.

In response to questions of the Dutch Order of Tax Advisers, the Dutch tax authorities has announced on their website (in Dutch) that it will (in principle) consider a request for special deferment of payment of taxes made by a company that is subject to corporate income tax, also as a notice of inability to pay such taxes in the event the company cannot pay VAT and wage taxes. This notice is legally valid for periods as of February 2020 insofar as the inability to pay has actually arisen due to the corona crisis.

It remains unclear how the various industry pension funds are dealing with this subject. We advise to contact the Corona desk of your industry pension fund.

To avoid problems, it is still advisable to notify in ability to pay in addition to the request for special deferral of payment of taxes and/or (pension) contributions. 

When should you file for a suspension of payments or bankruptcy?

The board of a company that has ceased to pay its debts can be declared bankrupt at its own petition (and at the petition of creditors). If this situation is not yet inevitable, it can be useful to apply for a suspension of payments, so the company can get a little ‘breather’.

No matter the financial difficulties of the company, the board is not legally obliged to file for its own bankruptcy or suspension of payments. Nevertheless, the board must watch that the enterprise of the company is unnecessarily long continued while it is no longer viable. If a board member of the company does this, the risk comes into existence that he can be accused of accumulating the debtors position and tax debts in an irresponsible manner, or that he has otherwise allowed to unnecessarily weaken the financial positions o the company.

The latter can, for example, also be the case if, in times of crisis, (significant) debtors of the company cannot or will not pay, that trade creditors which have been paid in advance are declared bankrupt, the board does not perform the necessary acts to collect payment of outstanding bills or to otherwise secure the creditors position of the company. If the board does not take timely measures to address such risks and nevertheless continues the enterprise, this increases the risks of non-performance towards creditors, which risk will materialise in the event of bankruptcy. Following a bankruptcy, this can lead to the board member(s) being held personally liable by the insolvency trustee or by creditors of the company.

Examples of grounds for personal liability are the performance of selective payments and the entering into new obligations, as discussed above. As a result, the board has to constantly consider if bankruptcy has become inevitable or, for example, if a possible restructuring/relaunch of the company has a chance of success. All things considered, filing for suspension of payments or bankruptcy can sometimes be the only sensible board decision.

The board is always authorised to file for a suspension of payments. This is not the case with filing for bankruptcy: the law provides that the board cannot file for the company’s own bankruptcy without the consent of the general meeting of shareholders (unless the articles of association provide otherwise). If the board files for its own bankruptcy without the required consent, each of the board member(s) can also be held personally liable. Should filing for bankruptcy be your last resort, please make sure to prepare this bankruptcy petition with care.

Please do not hesitate to contact us if you have any questions.