Increased Threshold to Trigger Directors' Liability in Insolvency Scenario?

Introduction

The Sapin II Act of November 8 2016 amended the regime governing directors' liability in an insolvency scenario in order to encourage the recovery of honest directors of failed businesses.

Article L.651-2 of the Commercial Code now states that mere negligence is not a form of mismanagement that can serve as the basis of an action by the court-appointed liquidator against the director of a company in liquidation proceedings: "in case of mere negligence by the officially-appointed or de facto director in the management of the company, the director cannot incur liability for the shortage of assets."

The reform creates a new inadmissibility ground by which a claim made against directors on the grounds of mere negligence must be dismissed immediately without being examined on the merit.

This reform is in keeping with the European Commission's objectives to promote the rescue culture and give a second chance to honest directors, as set out in its November 22 2016 proposal for a directive on preventative frameworks, second chances and measures to increase the efficiency of restructuring, insolvency and discharge procedures.(1)

Background

In principle, directors of a company that becomes the subject of insolvency proceedings incur no liability as a result of this situation.

The only exception to this principle is in the context of liquidation proceedings.

The liquidator appointed by the insolvency court in the liquidation proceedings of a company may bring an action for mismanagement against one or more officially appointed or de facto directors when it is established that such mismanagement contributed to the shortage of the company's assets (defined as the negative difference between the total assets and the total liabilities of the company).

Liability for mismanagement therefore requires evidence that the defendant:

• was an officially appointed director of the company or acted as a de facto director;
• in such capacity, mismanaged the company; and
• contributed to the shortage of the company's assets.

The court-appointed liquidator has a statutory monopoly to bring this action against the directors on behalf and in the common interest of creditors. This means that once liquidation proceedings are ongoing, a creditor acting alone has no standing to bring an action against the directors of the debtor company, except if the creditor can allege that it suffered a loss that is personal and distinct from that which was suffered by all other creditors.

If they are found to have mismanaged the company, officially appointed and de facto directors and their permanent representatives may be held liable on their own assets for all or part of the shortage of assets suffered by the company.

In this case, the insolvency court has a quasi-discretionary power to determine the amount to be paid by the defendants. Such amount can therefore be a token sum or a portion of the total liabilities.

Alternatively, the court can decide that the directors must bear the total debt of the company even though their behaviour is only one of many factors that contributed to the shortage of the company's assets.

Mismanagement

There is no legal definition of 'mismanagement'. As a result, this concept is established by the courts on a case-by-case basis.

Decisions rendered by the courts show that actions against mismanagement cover more than punishing genuine abuses of managers, such as the misuse of corporate funds for personal purposes.

In fact, case law shows that such actions are sometimes used by the courts to examine closely the strategic choices made by the directors of the company in order to determine whether these choices would have been made by a normal director concerned about the continuation of the activity and the mitigation of the damage suffered by the company's creditors.

The courts have deemed a wide range of decisions to be acts of mismanagement, including:

• making excessive investments in relation to the expected revenues of the company;
• not taking the necessary measures to solve the company's financial difficulties;
• imposing expenses on a company that exceed its financial capacities, without any consideration and in the interest of another company of the same group;(2) and
• failing to file for reorganisation or liquidation proceedings within the statutory period of 45 days from the occurrence of the company's cash-flow insolvency.(3)

Negligence

Cases of negligence can be qualified by the courts as mismanagement in situations where the directors' passiveness in the management and oversight of the company's operations showed a lack of interest for the company's finances and operations.

The following cases of negligence have been deemed by the courts to be mismanagement:

• in the case of a company that owned an industrial site that was subject to environmental laws and regulations, the chief executive officer's (CEO's) lack of interest in the company's compliance with such regulations, including the company's obligation to restore the site after ceasing operations there;(4)
• a case in which the CEO failed to monitor the collection of significant clients' receivables and demand clients' guarantees to secure the payment of certain work orders;(5)
• a case in which the CEO's passivity during several months while the company was making losses led to a significant increase in the company's shortage of assets;(6)
• a case in which the CEO visited the headquarters only twice a month and left the whole of the management of the company's operations and strategy to an incompetent member of staff;(7) and
• board members' negligence in their duties to supervise the company's operations, including to monitor the company's accounting adequately.(8)

By contrast, the courts have showed discernment and considered that instances of one-off negligence do not amount to mismanagement, such as a two-month delay in communicating cash and activity forecasts to statutory auditors.(9)

Comment

The legislature's motives for stating that mere negligence is not a case of mismanagement must be approved, insofar as they aim to promote entrepreneurship and second chances for honest entrepreneurs.

However, in light of the existing case law on the concept of mismanagement applied to cases of negligence, past decisions have shown that one-off instances of negligence are unlikely to trigger directors' liability – in particular, when they did not contribute to the shortage of assets – as opposed to patterns of negligence that established directors' lack of interest for the company's affairs.

Therefore, the reform seems to bring a purely cosmetic addition to the law, with no change to the existing and well-settled principles governing directors' liability in an insolvency scenario.

On the other hand, the poor drafting of the reform is likely to prompt an unforeseen debate before the courts on how to interpret the concept of 'mere negligence':

• Should it be read as exonerating all types of negligence, as opposed to other torts such as positive acts of mismanagement and imprudence?
• Or should it be interpreted as distinguishing between several degrees of negligence, with the adjective mere being used to oppose one-off negligence against more serious instances of directors' inertia?

The impact study on the basis of which the bill was drafted seems to indicate that the former interpretation should prevail.

However, if this were the case, it would be an unwelcomed change to the liability regime, as it would exonerate negligent directors in instances where their apathy amounted to a total loss of interest in the company's management and should undoubtedly be punished when it resulted in an increase of the company's unpaid liabilities. It would also defeat the legislature's intentions to give second chances to honest directors while penalising reckless ones.

It remains to be seen how courts will apply this provision.

Finally, arguably, the Sapin II Act takes the wrong approach to providing predictability for honest directors in an insolvency scenario. To achieve this objective, a more ambitious reform is necessary. It could be based on reducing the discretionary power of the courts to determine the portion of the shortage of assets to be borne by the director in case of mismanagement. Why not apply the rules applicable to creditors' liability in case of excessive support under which creditors can be held liable only for shortages that they are directly responsible for?

Endnotes

(1) COM/2016/0723 final – 2016/0359 (COD).

(2) Supreme Court, Commercial Section, March 30 1999, 95-17905.

(3) Supreme Court, Commercial Section, May 28 1991: Bull IV 187; Supreme Court, Commercial Section, November 4 2014, 13-23070.

(4) Bordeaux Court of Appeals, June 20 2014, 11/05234.

(5) Douai Court of Appeals, September 14 2011, 10/05395.

(6) Supreme Court, Commercial Section, January 9 1996, 93-12576.

(7) Supreme Court, Commercial Section, October 24 1995.

(8) Supreme Court, Commercial Section, January 2 2002.

(9) Paris Court of Appeals, April 8 2014, 13/03626.

This article was first published by the International Law Office and can also be found here.

This post comes to us from Bird & Bird and has been co-authored by Nicolas Morelli and Céline Nézet.