What is a Distressed Company? 2 1 6/5/20 Section 57 specifies - - PDF document

6/5/20 1

Directors' Duties in Financially Distressed Companies - Post Covid 19

• Chandaka Jayasundere

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What is a Distressed Company?

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Legally Insolvent Section 57 of the Companies Act

Section 57 specifies that a company shall be deemed to have satisfied the solvency test, if: a) it is able to pay its debts as they become due in the normal course

• f business; and

b) the value of the company’s assets is greater than: (i) the value of its liabilities; and (ii) the company’s stated capital

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Financially Insolvent

• ‘cash flow’ insolvency
• a company may be insolvent if it cannot meet the

debts as they fall due although having substantial assets over liabilities

• ‘balance sheet’ insolvency
• a company may be insolvent although it has no
• utstanding current debt, but the assets are not

sufficient to cover its present, future and contingent liabilities.

• The law is not concerned whether the

insolvency is balance sheet insolvency or cash flow insolvency. The law presumes and acts in a certain manner if the statutory requirements as contained in the Companies Act are met. 4

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Non-Legal Remedies for Companies in Distress

• The provisions discussed are only the legal remedies

available under the Companies Act and not other methods of riding out the distress.

• Before any decision is taken regarding insolvency or
• therwise there are other methods to overcome

difficulties such as:

• asset liquidation,
• fresh infusion of equity capital by shareholders
• r investors; or
• drawing down retained profits or other

reserves etc.; or

• Other financial recourses available which might

entail the restructuring of the capital, assets and

• wnership.

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Director’s Duties Fiduciary Duties

• A fiduciary is a person who acts for and on behalf of another in a relationship of trust

and confidence. A person thus acting in a fiduciary capacity owes a duty not to utilize his or her position in a way that is adverse to the interests of the person to whom the fiduciary is acting.

• The classic situation where this fiduciary duty arises is the relationship between a

trustee and his beneficiary.

• The relationship between a Company and its Directors are also inherently fiduciary. But

Directors are not trustees, although they occupy a fiduciary position towards the company whose board they form.

• Thus, directors of a Company must act bona fide in what they consider is in the interest
• f the Company and not for collateral purposes.

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Sections 187, 188 and 189

• f the Act
• Three fundamental duties that a director must adhere to and act upon.
• Section 187 provides that a person exercising powers or performing duties as a

di director of a company shall act in good d faith, in what that person believes to be in in the he in interests of the he company.

• Section 188 provides that a di

director of a company shall n ll not a act ct o

• r a

agree t ee to t the e co company a act cting, in a manner that co contraven venes es a any p provi visions o

• f t

the A e Act ct, or the provisions contained in the ar articles of f the compan any.

• Section 189 provides that a person exercising powers or performing duties as a

di director of a company: (a) shall not act in a manner which is reck eckles less o

• r g

grossly ly ne negli ligent nt; and (b) shall exercise the degree of skill and d care that may reasonably be expected of a person of his knowledge and experience. 7

Duty towards Creditors and other stakeholders

• A Director’s duty is not exclusively towards the company but is also towards the

shareholders, creditors and other stakeholders.

• The duty towards the creditors become more important in a situation where the

company is in financial distress and is either insolvent or about to be insolvent.

• In exercising their powers, the directors must take into consideration the interest of the

Company’s creditors.

• Thus, if a director acts in a situation of doubtful solvency the directors are not acting in

good faith when the Directors only act in the interest of the Company or its shareholders and not of its creditors. 8

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Duty of Directors on insolvency Section 219

• The fundamental duty of Directors in the case of insolvency is stipulated in section 219 of

the Companies Act.

• These provisions cast a duty to upon the directors or a director to take certain steps

regarding the possible insolvency of the Company.

• Section 219 states that a director of a company who believes that the company is unable to

pay its debts as they fall due, shall:

• forthwith call a meeting of the board;
• to consider whether the board should apply to court for the winding up of the

company; and

• the appointment of a liquidator or an administrator or carry on further the business of

the company. 9

Repercussions – Section 219 (2)

• Where the directors fail to comply with the above, they would be liable for any loss suffered

by creditors if the company is subsequently put into liquidation.

• Section 219(2), stipulates that:
• where a director fails to comply with the requirement of 219(1) and at the time of that

failure, the company was unable to pay its debts as they fell due, and the company is subsequently placed in liquidation, the court may on the application of the liquidator or

• f a creditor of the company, make and order that the director shall be liable for the

whole or any part of any loss suffered by creditors of the company as a result of the company continuing to carry on its business.

• Thus, if the Company is unable to pay its debts as they become due, and the Directors do not

comply with the provisions of section 219, and due to that act and the company goes into liquidation, the Directors will be personally liable for the entire or part of the loss suffered by creditors.

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“unable to pay its debts” - section 271

A company shall be deemed to be unable to pay its debts where-

(a) a creditor by assignment or otherwise, to whom the company is indebted in a sum exceeding fifty thousand rupees then due, has served on the company, a demand under his hand requiring the company to pay the sum so due and the company has for three weeks from the date of so leaving, neglected to pay the sum or to secure or compound for it to the reasonable satisfaction of the creditor; or (b) execution or other process issued on a judgment, decree or order of any court in favour of a creditor of the company, is returned unsatisfied in whole or in part; or (c) it is proved to the satisfaction of the court that the company is unable to pay its debts, and in determining whether a company is unable to pay its debts, the court shall take into account the contingent and prospective liabilities

• f

the company.

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Liquidation is not mandatory under section 219

• Section 219 does not mandatorily require that the

company should proceed to liquidation.

• The Section clearly states that at the meeting of

the board of directors that is to be called in terms

• f section 219 the directors must decide either:

(a) to apply to court for the winding up of the company; (b) to appointment of a liquidator or an administrator; or (c) carry on further the business of the company. 12

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Duty of Directors on serious loss of capital – Section 220

• Section 220 provides that:
• if at any time it appears to a director of a company that the net assets of the company are less than half of

its stated capital,

• the board shall within twenty working days of that fact becoming known to the director,
• call an extraordinary general meeting of shareholders of the company for the purposes of the section
• The notice calling a meeting under this section shall be accompanied by a report prepared by the board, which

advises shareholders of: (a) the nature and extent of the losses incurred by the company; (b) the cause or causes

• f the losses incurred by the company; (c) the steps, if any, which are being taken by the board to prevent further

such losses or to recoup the losses incurred.

• Where the board of a company fails to comply with these provisions, every director who knowingly and wilfully

authorises or permits the failure or permits the failure to continue, shall be guilty of an offence and be liable on conviction to a fine not exceeding two hundred thousand rupees.

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Repercussions of not complying with the provisions of section 219 are monetary in that the Directors would have to recompense the damage suffered by Creditors in the event of liquidation Repercussions of not complying with the provisions of section 220 are penal and would entail committing an offence and thereby exposing oneself to a fine.

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Ot Other remedies s available while continuing g to tr trad ade

PART VIII - COMPROMISE PART IX – COURT APPROVED ARRANGEMENTS, AND COMPROMISE PART XIII - ADMINISTRATION

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• in all these provisions, th

the majority ty of th the class of person to whom the provisions will apply, may by such majority co compel mi minority dissenting person to to be bound by the arrangement

• r compromise.
• For example, if the compromise is in respect of a particular

class of creditors (say: non-secured creditors) then if a majority of such creditors agree to such a compromise, the minority of such creditors although dissenting will be bound by the compromise.

• The majority needed to successfully push through an

arrangement or compromise is specified by Court.

• These provisions necessarily involve a compromise – a give

and take. The creditors may have to agree for a restructuring

• f the debt, a moratorium on repayment and interest waiver
• etc. The Company may have to agree to fresh infusion of

equity, transfer of assets, sale and liquidation of assets and provision of fresh security as collateral.

• Th

There is no gain without pain!

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Arrangement

• Arrangement is defined widely in section 255 to include a re-
• rganisation of the share and stated capital of the Company.
• UK Insolvency Act - ‘Arrangement’ is stipulated as a proposal

that is a composition (that is the word they use in the UK for

• ur ‘Compromise’) in satisfaction of its debts or a scheme of

arrangement of its affairs.

• The IA Act also provides for the Directors to include in a

proposal for arrangement to obtain a moratorium for the Company

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Compromise

• A ‘compromise’ is defined in section 247 of the Companies Act s

compromise between a company and its creditors, including a compromise:

• (a) cancelling all or part of any debt of the company;
• (b) varying the rights of its creditors or the terms of a debt;
• (c) relating to an alteration of a company’s articles that affects the likelihood of

the company’s ability to pay a debt; 18

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Administrator

• The Administrator can be appointed before attempting an

arrangement or compromise. The Administrator can, as a part

• f his proposal propose a compromise or arrangement as

stipulated in the Act.

• Where the board of a company considers that:
• (a) the company is or is likely to become unable to pay its

debts as they fall due; and

• (b) the appointment of an administrator will be likely for:
• (a) the survival of the company and the whole or any

part of its undertaking as a viable concern;

• (b) the preparation and approval of a compromise

under Part IX or a compromise or arrangement under Part X; or

• (c) a more advantageous realisation of the company’s

assets than would be likely on a winding up, the board may resolve to appoint an administrator of a company. 19

From and after the appointment of an administrator, until the end of the initial period (defined in section 400): (a) no resolution may be passed or order made for the liquidation of the company ; (b) subject to 402(2), no steps can be taken to enforce any security over any property

• f the company or to repossess any goods in the company’s use or possession

under any hire-purchase agreement, except with the consent of the administrator

• r with the leave of the court and subject to such terms as the court may impose;

(c) (c) no other proceedings and no execution or other legal process may be commenced or continued and no distress may be levied against the company or its property, except with the consent of the administrator or with the leave of the court and subject to such terms as the court may impose. However, this does not stop any person from filing a Petition to wind up the company.

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Obtaining the approval of Court

• Compromises and arrangements.
• Notwithstanding the provisions of the Act or

the provisions contained in the articles of a company, the court may on the application of a company; an administrator; or (with the leave of the court), any shareholder or creditor of a company, order that an arrangement or compromise shall be binding

• n the company and on such other persons or

classes of persons as the court may specify. Any such order may be made on such terms and conditions as the court thinks fit.

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• Before making such an order the court

may, make among others:

• an order that notice of the application to such persons or classes of

persons as the court may specify;

• an order directing the holding of a meeting or meetings of shareholders
• r any class of shareholders or creditors or any class of creditors of a

company, to consider and if determined fit, to approve in such manner as the court may specify, the proposed arrangement or compromise.

• The court may for that purpose determine the shareholders or creditors

that constitute a class of shareholders or creditors of a company;

• an order requiring that report on the proposed arrangement or

amalgamation or compromise be prepared for the court by a person specified by the court, and

• if the court thinks fit, be supplied to the shareholders or any class of

shareholders or creditors or any class of creditors of a company or to any

• ther person who appears to the court to be interested;

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• The court may also for the purpose of giving effect to any arrangement or compromise

approved:

• provide for and prescribe terms and conditions relating to –
• the transfer or vesting of movable or immovable property, assets, rights, powers,

interests, liabilities, contracts and engagements;

• the issue of shares, securities or policies of any kind;
• the continuation of legal proceedings;
• the liquidation or the removal from the Register without liquidation, name and

particulars of any company;

• make provision for persons who voted against the arrangement or compromise at any

meeting or who appeared before the court in opposition to the application, to approve the arrangement or amalgamation or compromise; 23

Ot Other consequence ces of co continue to trade The malpractices -section 374

• Section 374 in respect of fraud in anticipation of winding up stipulates

that:

• when a company is wound up, a person who is a past or present
• fficer of the company is deemed to have committed an of
• ffence

if,

• within the two
• years pr

preceding the commencement of the winding up,

• he has done the acts specified in the section which includes the

con

• ncealment of
• f pr

prope

• perty or debt, fr

fraudulent removal of

• f

com

• mpa

pany’s pr prope

• perty.
• Section 374(2) however stipulates that it is a defence that a

person so charged to prove that he had no intent to defraud; to prove that he had no intent to conceal the state of affairs of the company or to defeat the law.

• A person who commits an offence under section 374(1) shall be

liable on conviction to a fine not exceeding one million rupees or to imprisonment for a term not exceeding five years or to both such fine and imprisonment.

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The malpractices - section 375

• Section 375 of the Act in respect of Fraudulent Trading specifies that
• where any business of a company that has been wound up has been

carried on

• n with intent to
• defr

fraud creditors of the company or creditors

• f any other person or for
• r any fr

fraudulent pu purpos pose, every person who was knowingly a party to the carrying on of the business in that manner, shall be deemed to have committed an of

• ffence and shall be

liable on conviction to a fine not exceeding one million rupees or to imprisonment for a term not exceeding five years or to both such fine and imprisonment.

• Subsection (2) provides that where in the course of the winding up of

a company it appears that any business of the company has been carried on with intent to

• defr

fraud creditors of the company or creditors

• f any other person or for
• r any fr

fraudulent pu purpos pose, the court may, declare that any persons who were knowingly parties to the carrying on

• f the business in that manner, shall be: (a) liable to make such

con

• ntribu

bution

• n to
• the com
• mpa

pany’s assets; or (b) personally respon ponsibl ble for

• r

such debt bts or

• r ot
• ther liabi

bilities of the company, as the court may think fit.

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The malpractices - section 376

• Section 376 stipulates that
• where in the course of the winding up of a company it

appears to the court that a person who has taken part in the formation or promotion of the company or a past or present director, manager, liquidator or receiver of the company, ha has misapplied d or retaine ned d

• r
• r bec

ecom

• me

e liable e or

• r accou
• untable

e for for mon

• ney or
• r

pr prope perty of the compa pany, or be been guilty of ne negligenc nce, de default or breach h of du duty or trust in n re relation to the company, the court may order that person:

• (a) to re

repay or re restore re the money or pro roperty or any pa part of it with interest at a rate the court thinks just;

• r
• (b) to co

contribute such sum to the assets of the co company by way of co compensation as the court thinks just; or

• (c) to pa

pay or transfer the money or pr prope perty or any pa part of it with interest at a rate the court thinks just, to the creditor. 26

6/5/20 14 Thank you

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