Picture: 123RF/KASTO
Picture: 123RF/KASTO

An economy undergoing severe distress poses very specific challenges to directors and senior managers.

Perhaps the most important of these challenges is the necessity to avoid trading recklessly — which threatens to expose these directors to claims of personal liability.

It’s an imperative grounded in section 22(1) of the Companies Act, which says that "a company must not carry on its business recklessly, with gross negligence, with intent to defraud any person or for any fraudulent purpose".

Any director or manager who breaches this can be held liable for any loss, damage or costs sustained by the company

But this liability extends further. If a company goes into liquidation, directors also face personal liability should it be found that it was trading recklessly before it was liquidated. And this is a strict liability, in that there needn’t be any direct link between the reckless trading and the loss.

As many companies battle to keep their heads above water in the pandemic, it’s critical that director and managers learn exactly what constitutes reckless trading. Helpfully, a number of cases have pinned it down for us.

In Fourie v Newton, a 2010 case which revolved around directors’ responsibilities in the collapse of newsagent CNA, the court restated the principles of reckless trading. It is this:

Gross negligence is necessary, rather than just mere negligence;

  • An honest but mistaken view that a company wasn’t trading recklessly won’t negate liability, if a reasonable person wouldn’t have had that view;

Acting recklessly consists of a failure to give consideration to the consequences of your actions.

It’s quite clear there are many minefields around reckless trading which directors have to avoid

In the Philotex case, dating back to 1997, the directors of a company called Wolnit were held to be reckless where they carried on trading without the assurance of support from their parent company, the Rentmeester Group.

Directors can also be held personally liable if they take out credit for the company without a reasonable expectation it will be able to repay that loan.

With credit, there’s another critical point. Normally, directors owe a fiduciary duty of care, skill, and diligence to shareholders. But when it comes to financially distressed companies, they owe that duty to their creditors too.

During Covid-19, we’ve seen many companies suspend their dividend. Legally, this is a wise move, partly because of the way the Companies Act obliges companies to apply the twin test of solvency and liquidity.

These tests must be applied when a company plans certain corporate transactions including, importantly, dividend payments and other distributions.

Here, directors must exercise their judgment in assessing whether their company will be solvent and liquid immediately after making the payment. The standard of care is both subjective and objective: would a reasonable person have thought the company would pass this twin test? Get it wrong, and you face personal liability under the Companies Act.

Boards must also be vigilant to ensure that covenants in loan contracts aren’t breached, and that there isn’t a default due to a company not meeting the requirement of being a going concern.

If all that sounds tricky enough, consider that if you’re the director of a JSE-listed company, you also have a duty to make a prompt disclosure of any circumstance that could be seen as "price sensitive", like a liquidity shortage.

Disclosure, in fact, is vital. Under section 129 of the Companies Act, directors who believe a company is in financial distress but have not placed the company in business rescue must inform those affected — including shareholders, creditors and employees. And here, the interpretation is complex.

It’s quite clear there are many minefields around reckless trading which directors have to avoid. As Covid-19 ravages our corporate sector, you can expect many of these provisions to be aired in court in the next few months.

  • Katz is chair of ENSafrica

 

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