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Directors trading in insolvent circumstances

Directors trading in insolvent circumstances

Personal liability of directors is becoming an important issue in South Africa. The topic has been placed under the spotlight recently and directors need to be aware of their duties, responsibilities and the circumstances where they could be held personally liable for the debt of the company.

  1. Two types of insolvencies

Factual / technical solvency: Liabilities exceed the assets (fairly valued)

Commercial insolvency: State of illiquidity where an entity is unable to pay its debts even though the assets may exceed the liabilities

Factual insolvency doesn’t necessarily mean that a going concern problem exists but commercial insolvency is likely to indicate that a going concern problem does exist. The mere fact that an entity is trading whilst factually insolvent is not regarded as reckless or fraudulent trading.

Reckless trading is to conduct the company’s business in insolvent circumstances, with gross negligence or with the intention of defrauding a creditor or any person.

When a company continues to incur debt where there is no reasonable prospect of the creditors being paid when due, then it is considered that the business is being carried on recklessly.

  1. Directors duties

The directors have the responsibility to assess the effect of the insolvency of the company, the appropriate responses thereto, and whether the company should continue to trade in those circumstances.

  1. Actions and concequences

Directors’ responsibility is to ensure that when the warning signs become self-evident, they immediately take legal and financial advice and, if necessary, place their companies into liquidation or cease trading.

A response to factual insolvency is for the company to enter into a subordination agreement with a major creditor, where the creditor agrees not to demand or accept payment of amounts owing to them until such time as the company’s assets exceed its liabilities.

In the case of commercial insolvency, the directors must consider all the reasonable prospects to rescue the company. If a company continues to trade and incur debts, where, in the opinion of reasonable businessmen standing in the shoes of the directors, there would be no reasonable prospect of the creditors receiving payment when due, it will in general be a proper inference that the company’s business is being carried on recklessly or negligently.

A director has a duty to apply for business rescue or alternatively liquidate it as soon as they become aware that the company is financially distressed or is trading in insolvent circumstances.

In terms of the Companies Act, should a director fail to take the necessary action they may be held liable in accordance with the principles of the common law relating to the breach of a fiduciary duty, for any loss, damages or costs sustained by the company as a consequence of breach by the director of his duties.