Canada: Directors Of A Corporation That May Be On The Path To Insolvency

1. Introduction

This paper is intended to give directors a better understanding of what is expected of them and what they can expect when the corporation is insolvent or on the path to insolvency.

There may be factors that destroy a business that cannot be anticipated, but generally, corporations do not suddenly become insolvent. Bellwether symptoms present themselves to directors that can and should be recognized.

Recent insolvencies show increased activism by affected stakeholders, such as shareholders, creditors, employees, pension funds and environmental authorities. When insolvency is a reality, these stakeholders often look to the directors, officers, advisors, lawyers and auditors to justify their actions- or inaction.

Directors must receive timely, reliable information from management and professional advisors. It is the directors' right and obligation to insist upon the provision of this information, but they should not merely receive the information (or ignore it) without question or challenge.

2. Where are the Gatekeepers?

I refer to a Delaware case where the court directed its comments to a corporation's lawyers and accountants. These comments have equal application to directors.

In Lincoln Savings and Loan Association v. Wall,1 the CEO of an insolvent corporation testified that he surrounded himself with scores of accountants and lawyers to make sure that all transactions were legal.

The Court asked:

Where were these professionals, a number of whom are now asserting their rights under the Fifth Amendment when these clearly improper transactions were being consummated?

Why didn't any of them speak up or disassociate themselves from the transactions?

Where also are the outside accountants and the attorneys when these transactions were effectuated?

What is difficult to understand is that with all the professional talent involved (both accounting and legal) why at least one professional could not have blown the whistle to stop the overreaching that took place in this case.

If financial statements provided to the directors are positive and encouraging, the normal reaction of the directors is to compliment themselves and management. Consider, however that the financial statements may be based on incorrect or incomplete information provided by management.

It is also possible that the financial statements, although accurate, are not fully understood by the directors. For instance, the indicated earnings may be significant, but these earnings may not represent realizable value. There may not be enough money available from the current assets to accommodate the operations of the corporation.

Financial statements show the financial position of the corporation at a given point in time on a going concern basis. Management should regularly provide the directors with statistics that highlight the corporation's key indicators and trends so that the directors have a clear understanding of these indicators and their historical trajectory, and can more easily project trends into the future.

As stated in Puda Coal Inc.,2 directors have a duty to think. When it is disclosed that the corporation is insolvent and had been on a path to insolvency for some time, the stakeholders will ask the directors what they did as gatekeepers to discharge their duties.

Directors will be held accountable, more so if affected stakeholders move to access the deep pockets of the directors' insurers. Quite often, the directors' and officers' insurance may not be available or be sufficient to cover the costs of the defence and any damages for which the directors may be found liable.

When a corporation is insolvent or is on the path to insolvency, the directors should act swiftly so as not to increase losses or incur new obligations. They should be very careful not to permit the corporation to incur new debts, or undertake new obligations, for which payment or satisfaction is not possible.

Not all corporations can be saved. If liquidation is the only available alternative, then this also must be addressed quickly to maximize recovery for the other stakeholders.

We will review in this paper how the courts examine the conduct of directors when the corporation is insolvent or approaching insolvency.

3. Duties of Directors

Subject to a unanimous shareholders agreement, directors are required to manage or supervise the management of the business and affairs of the corporation.3

Directors have two duties:

  1. a fiduciary duty to act honestly and in good faith with a view to the best interests of the corporation; and
  2. a duty to exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances;

All case law relating to directors' duties stems from these two principles.

In BCE Inc.,4the court considered these duties. Directors have a fiduciary duty to act in the best interests of the corporation. Often the interests of the shareholders and the other stakeholders coincide with the interests of the corporation. If, however, these interests conflict, the director's duty is to the corporation.

The court considered People's Department Stores Inc. v. Wise5 where at para 42 the court stated:

We accept as an accurate statement of law that in determining whether they are acting with a view to the best interests of the corporation it may be legitimate, given all the circumstances of a given case, for the board of directors to consider, inter alia the interest of shareholders, employees, suppliers, creditors, consumers, governments and the environment.

As noted, directors have a duty to act as reasonably prudent persons would in comparable circumstances, which duty is not owed solely to the corporation. If the directors act in the best interests of the corporation, and in so doing exercise the care, diligence and skill of a reasonably prudent person in comparable circumstances as good corporate citizens, they will be meeting the reasonable expectation of other stakeholders.

The directors are also exposed to stakeholders' claims pursuant to section 248 of the Ontario Business Corporations Act ("OBCA") and section 241 of the Canada Business Corporations Act ("CBCA") with respect to oppression remedies, and as well to claims made via derivative actions.

BCE Inc. goes on to state that:

the corporation and shareholders are entitled to maximize profit and share value to be sure, but not by treating individual stakeholders unfairly.

Finlayson JA in Montreal Trust Co. of Canada v. Scotia MacLeod Inc.6 stated

a corporation may be liable for contracts that its directors or officers have caused it to sign, or for the representations those officers or directors have made in its name, but this is because a corporation can only operate through human agency, that is, through its "directing mind." Considering that a corporation is an inanimate piece of legal machinery incapable of thought or action, the court can only determine its legal liability by assessing the conduct of those who caused the company to act in the way that it did. This does not mean however, that if the actions of the directing minds are found wanting, that personal liability will flow through the corporation to those who caused it to act as it did.

In order for the directors to be liable, they must have done something that takes them out of the role of directing minds so that they "exhibit a separate identity or interest from that of the company so as to make the act or conduct complained of, their own."

If the directors cause the corporation to acquire goods or services on credit, knowing that the corporation cannot pay for them they would not be immune from attack by aggrieved persons, even if they were acting in what they thought was the best interests of the corporation.

In People's Department Store Ltd.,7the court stated that the director's fiduciary duty does not change when a corporation is in the "vicinity of insolvency."

If directors act honestly and in good faith, with the intent to improve the position of the stakeholders, even if they are not successful, they will not have breached their duties. The courts do not expect perfection from directors, only that they discharge their duties and act as a reasonable and prudent person would in comparable circumstances. This has given rise to what has been described as the business judgment rule.

As stated in People's:

many decisions made in the course of business, although ultimately unsuccessful, are reasonable and defensible at the time they are made. Business decisions must sometimes be made with high stakes and under considerable time pressure, in circumstances in which detailed information is not available. It might be tempting for some to see unsuccessful business decisions as unreasonable or imprudent in light of information that becomes available ex post facto. Because of this risk of hindsight bias, Canadian Courts have developed a rule of deference to business decisions called the business judgment rule, adopting the American name for the rule.

The directors' fiduciary duty does not change when a corporation is in the nebulous vicinity of insolvency. That phrase has not been defined; moreover, it is incapable of definition and has no legal meaning. What it is obviously intended to convey is a deterioration in the corporation's financial stability. In assessing the actions of directors, it is evident that any honest and good faith attempt to redress the corporation's financial problems will, if successful, both retain value for shareholders and improve the position of creditors. If unsuccessful, it will not qualify as a breach of the statutory fiduciary duty.

Perfection is not demanded. Courts are ill-suited to and should be reluctant to second guess the application of business expertise to the considerations that are involved in corporate decision making, but they are capable, on the facts of any case, of determining whether an appropriate degree of prudence and diligence was brought to bear in reaching what is claimed to be a reasonable business decision at the time it was made.

If directors act fairly when confronted with actual or impending insolvency with proper regard for the corporation and by extension for the welfare of other stakeholders, then they will have discharged their duty to the corporation and will have exercised the skill and judgment that is expected of them.

If, however, the directors act out of self-interest, or disregard the interests of other stakeholders, or act with willful neglect or without concern for the corporation's financial position, then they leave themselves open to attack, both by the corporation and by other stakeholders. This should not be misunderstood to mean that the interests of the corporation must be suborned to the interests of the other stakeholders.

The court will give appropriate deference to the application of the business judgment rule. See also Pente Investments Management Ltd. v. Schneider Corp.8

Corporations are not obliged to avoid all ventures that involve an element of risk. The conscience of the corporation, as well as its management, is consigned to directors who must properly administer the property so that it is not dissipated or exploited for the benefit of the directors themselves to the prejudice of the creditors: Winkworth v. Edward Baron Development Co. Limited et al.9

In Unique Broadband Systems Inc.,10a corporate director argued that there was no breach of a fiduciary duty because the director was removed from office before an intended impugned payment could be made. Accordingly, the director argued that no damages had been suffered.

The Court of Appeal rejected this submission and relied on a statement made by Mark Ellis in his text Fiduciary Duties in Canada (Carswell, Toronto 2014 Ch. 1 at 5).

Entering into a potential conflict of interest is a breach whether or not the conflict is operative; once such a conflict becomes operative to jeopardize the beneficiary or his property, the fiduciary breach would then give rise to the remedies available at law. The point is important: to wait until damages or prejudice actually occurs is to prejudice the beneficiary's right to utmost loyalty and avoidance of conflict. If such a schism in theory is allowed, the law would be encouraging a finding that the duty "piggy-backs" the damage caused rather than premising damages on the basis of duty.

The conduct of directors may very well be investigated in insolvency proceedings where it is the mandate of the Trustee, Receiver, and possibly a Monitor to examine possible degradation of corporate assets.

In ADGA Systems International Ltd. v. Valcom Ltd.,11 the court had to consider a claim made against a corporation and its directors claiming they induced a breach of fiduciary duty, and a breach of contract. The Ontario Court of Appeal recognized the concerns of the lower court regarding the proliferation of claims against officers and directors of corporations in circumstances which indicate the desire by the claimants for leverage in the litigation process. This is of concern to the courts, because business cannot function efficiently if corporate officers and directors are inhibited in carrying on the business of the corporation for fear of being exposed to ill-founded ligation.

The Court recognized the application of Said v. Butt,12 which held that there is an independent cause of action against directors that looks through the corporation to the directors in what is known as piercing or lifting the corporate veil. The Said case is authority for the proposition that there is a distinction between the corporation and the directors, if it is established that the directors acted bona fide for the protection of the interests of the corporation. This anticipates that the director had not acted fraudulently or improperly, so that it could be said that he acted bona fide in the best interests of the corporation.

Officers and directors are however responsible for their tortious conduct, even though that conduct was meant to be in the best interests of the corporation. Fraud committed by a director to increase the revenue of the corporation cannot be said to be bona fide and in the best interests of the corporation. See Kepic v. Tecumseh Road Builders.13

Where a corporate veil has been pierced, it usually involves transactions where the use of the corporate structure was a sham from the outset: See Montreal Trust and Scotia MacLeod.14

To read this Paper in full, please click here.

Footnotes

1. (1990) 743, F. Supp 901 District of Columbia.

2. Puda Cole Inc., Court of Chancery of the State of Delaware, (2013) Consolidated C.A. No. 6476 – CS (Del Ch.)

3. Section 115(1) OBCA; s.102(1) CBCA.

4. (2008) 301 D.L.R. (4th) 80 (SCC).

5. (2004) 244 D.L.R. (4th) 564 (SCC).

6. (1996) 129 D.L.R. (4th) 711 (ONCA). Leave to Appeal refused.

7. (2004) 244 D.L.R. (4th) 564 (SCC).

8. (1998) 42 O.R. (3rd) (177) Ont. (CA) and Kerr v. Danier Leather Inc. (2007) 2 SCR 331.

9. [1987] 1 All E.R. 114.

10. (2014) ONCA 538.

11. (1999) 168 D.L.R. (4th) 351.

12. [1920] 3 K.B. 497.

13. (1987) 18 C.C.E.I. 218 (Ont. C.A).

14. (1995) 129 D.L.R.(4th) 711.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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