UK: Directors & Officers In An Era Of Insolvency

Last Updated: 17 June 2016
Article by Roderic McLauchlan

The rapid downturn in the price of oil and gas and decline in the price of commodities has sent ripples through the Canadian economy. It is therefore timely to consider the exposures directors and officers of Canadian companies can face, especially if their companies are in the vicinity of insolvency.

Distressed companies may either file for bankruptcy protection under the Bankruptcy and Insolvency Act ("BIA") or seek protection from creditors while they seek to rearrange their businesses under the Companies Creditors Arrangements Acts ("CCAA"). The BIA provides for both reconstructuring through proposals and liquidations through bankruptcy proceedings. The CCAA is used primarily for the restructuring of more complex corporate businesses, although it can be used for a sale or liquidation.

Officers and directors face substantial responsibilities under Canadian corporate law. Leading Canadian decisions, including from the Supreme Court of Canada in People's Department Store v. Wise and BCE v. 1976 Debentureholders, established that an honest and good faith but unsuccessful attempt to address a company's financial problems does not constitute a breach of those duties. The duty of a director is owed to the corporation, as opposed to shareholders or creditors. While the company is solvent, the interests of shareholders and creditors are usually aligned with that of the corporation. However, such interests can diverge when a company is in financial difficulty, with creditors seeking repayment of their debts while the company and shareholders may be more focussed on maintaining economic operations. This will require careful assessment of the impact of any particular decision on the corporation's creditors.

Under Canadian corporate governance legislation, most notably the Canadian Business Corporations Act ("CBCA"), directors owe both a statutory fiduciary duty and duty of loyalty to the corporation to avoid conflicts of interest in self-dealing as well as a duty of care to exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. Other statutes impose liability on directors and officers in insolvency, securities, tax, employment and environmental matters. The following are types of conduct that may lead to exposure:

  • Failure to take reasonable steps to minimize losses to creditors - where insolvency is inevitable would be a breach of duty leading to claims by creditors, or insolvency practitioners, for the added debts and damages incurred. However, where there are diverging interests between groups of stakeholders, such failure may not be a breach of duty
  • Misappropriation of corporate assets - may trigger both civil and criminal liability
  • Directors and officers can be liable for preferential transfers at undervalue (usually for the difference between the value of the consideration received and the fair market value of the assets at the date of disposition). Paying out of dividends while the company is unable to meet its obligations is problematic. Directors and officers should be aware of the "solvency test", namely, whether there are reasonable grounds to believe that the company would, after a particular action, be unable to pay its liabilities as they become due ("going concern test") or if the asset value of the company is less than its liabilities ("balance sheet insolvency"). With volatile commodity prices, many resource companies need to pay particular attention to these issues
  • If directors and officers know the company is on a verge of insolvency but do not take steps to mitigate losses and inform creditors, they may face a statutory "oppression" claim
  • Preferential payments to one creditor as opposed to another when insufficient monies are available to pay both can be attacked by the trustee in bankruptcy if it took place within three months (if made at arm's length) or within a year of bankruptcy if made to a related person
  • Continuing to trade where there is little prospect of being able to pay debts when due

Other statutory liabilities

Besides causes of action under the various insolvency and corporate statutes, directors and officers face numerous statutory liabilities during insolvency situations:

(a) Liabilities to the employees of the company

Under various statutes directors can be personally liable for unpaid claims of employees (e.g., CBCA section 119 and the Employment Standards Act, section 81(7)). These claims are very common against directors and officers of insolvent companies. It can be brought individually by the employees or on their behalf by provincial employment agencies. If many employees are involved, the liabilities can be significant. Increasingly, insolvency practitioners and government agencies are aware of D&O insurance and expect that it will respond.

(b) Personal liability for failure to remit sales tax or to withhold at source deductions

Claims include payroll (Income Tax Act, section 227.1) and sales tax deductions. These generally impose joint and several liability on directors and officers, and any one executive may face the entire claim with the right to sue the other directors.

(c)Environmental liabilities

This is an important recent development in terms of liability for directors. Notably, the Directors of insolvent companies can be personally liable for remediation orders issued by the Ministry of the Environment, even if the pollution occured prior to their involvement. Recent cases have led to D&O coverage becoming a major topic in the D&O market leading to expanded attempts to include that coverage.

(d) Statutory construction liens liabilities

These are claims where subcontractors' fees are unpaid, monies have not been kept in a separate statutory trust by the insolvent building company, and the subcontractors sue the directors and officers personally for the amounts outstanding if the executives have acquiesced in the dissipation of these monies.

(e) Liabilities under the Pensions Benefits Act

This is for failure to take steps to prevent the corporation from acting in a way that breaches the duties it usually owes as administrator of a pension plan.

Generally, the statutes above allow directors and officers a defence if they establish that they exercised due diligence to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances. Historically, this is a high hurdle to meet. Furthermore, the government agencies are notoriously aggressive in prosecuting employee and tax liability related claims.

Outside directors and the de-facto directors

It is not only appointed directors who face liability but also those who perform these functions. As seen in Hatrell v Canada, 2008, FCJ No. 228 (FCA) de-facto directors may be liable for the corporation's failure to remit income taxes.

Can these exposures be minimized?

In order to set up possible due diligence defences, executives need to attend all board meetings and take steps to try to ensure that the financial reporting and payment systems are timely and effective.

Expert advice should be sought about any significant transactions or decisions. Indemnity agreements with the corporation should be reviewed. Security arrangements to support the indemnities, such by means of a segregated trust, can be considered under expert advice.

Resignation can be appropriate, especially if the executive is in disagreement with proposed courses of action. If they continue to manage the business affairs of the corporation, liability for unpaid taxes or wages may accrue. Furthermore, if a corporation is dissolved but subsequently revived, the liability remains.

Depending on the size of the company, consideration should be given to the benefits of a restructuring under the CCAA. Plans approved by the Court and creditors usually include a release of claims against directors.

Other considerations

Besides these exposures, directors face significant claims under securities laws in connection with misrepresentations or other conduct issues related to the capital markets. One area to consider is the exposure to privacy claims, especially if there are any issues dealing with sensitive information that might be affected by the insolvency. Steps need to be taken to continue to preserve personal and private information. The Office of the Privacy Commissioner of Canada is currently examining the standards applicable to directors and officers in connection with such matters, and will be issuing commentary and guidelines in due course. Watch this space.

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Roderic McLauchlan
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