DealMakers - Q2 2019
Ignorance is bliss, or is it?
by Lydia Shadrach-Razzino and Carine Pick
In terms of section 46 of the Companies Act, 71 of 2008 (Companies Act), a company may not make a proposed distribution to its shareholders unless (i) the distribution is pursuant to an existing legal obligation of the company, or a court order, or the board of that company has, by way of resolution, authorised such distribution; (ii) it reasonably appears that the company will satisfy the solvency and liquidity test immediately after completing the proposed distribution and; (iii) the board of the company, by resolution, has acknowledged that it has applied the solvency and liquidity test as set out in s4 of the Companies Act and reasonably concluded that the company will satisfy the solvency and liquidity test immediately after completing the proposed distribution.
The purpose behind the application of s46, read with s4 of the Companies Act, is to protect creditors and/or the minority shareholders of a company. The failure by the directors of the company to comply with the provisions of s46 will result in such directors incurring liability for the unlawful distribution, to the extent set out in s77(3)(e)(vi). In order to hold directors personally liable for the unlawful distribution, s46(6) of the Companies Act provides that the director/s of a company must have (i) been present at the meeting when the unlawful distribution was approved, or participated in terms thereof and (ii) failed to vote against the unlawful distribution, despite knowing that the distribution was contrary to the provisions of the Companies Act. On the reading of the provisions of s46(6), it is clear that all the requirements must be met in order to hold the director/s accountable for their actions to pass the unlawful distribution. This is confirmed by s46(6) and s77(3)(e)(vi), which section we note is where, pursuant to a company and/or director of a company having been (or likely to be) held liable, one would apply to court for an order setting aside the decision of a director, in order for a creditor and/or minority shareholder to find relief.
We note that the Companies Act expressly provides for a situation whereby the directors knowingly approved an unlawful distribution, and the liability that such directors will incur pursuant to non-compliance with the provisions of s46. However, with the influx of foreign investment and the rise of small and medium-sized enterprises in South Africa, many South African companies have taken to appointing foreign and/or local directors with limited knowledge of South African corporate governance and/or the Companies Act and, as such, it would appear that two further situations may arise from the passing of an unlawful distribution by the directors of a company that are not expressly provided for in the Companies Act, in relation to the attaching of liability to these directors.
The first situation that may arise is that director/s participated in the decision to approve the distribution without knowing that the distribution was unlawful. It is clear from the wording of s46(6) of the Companies Act that there are two requirements to be met by the director/s in order to attach liability for unlawfully passing a distribution. As such, mere participation in the decision to approve a distribution is not enough to attach liability to the director/s. The director/s are required to both have participated in the decision and failed to vote against the distribution, despite knowing that the distribution was unlawful. If there is a dispute as to whether the director/s "knowingly" contravened the provisions of s46, section 1 of the Companies Act provides guidance as to what "knowingly" means in the context of s46(6)(b), which definition we note is very wide. The definition of "knowing" goes beyond actual knowledge and provides for a person that was in a position in which such person "reasonably ought" to have (i) actual knowledge, (ii) investigated the matter to the extent that would have provided the person with actual knowledge or (iii) taken other measures which, if taken, would reasonably be expected to have provided that person with actual knowledge of the matter. It would then, at first glance, seem unfair to hold these directors personally liable if such directors acted honestly and reasonably in participating in the decision when they were unaware that the distribution was knowingly unlawful. Further, even if we wished to hold these director/s personally liable, it would seem that the application of s77(3)(e)(vi) does not allow for the director/s to be liable, as not all the requirements have been met to attach liability. However, at a second glance, our theory of unfairness shows weakness when we are dealing with a commercially-sophisticated director, being a director who has knowledge of South African corporate governance and the Companies Act, and/or previously served on boards of South African companies. We believe that the wording, "reasonably ought", does infer that a commercially-sophisticated director would, at the very least, acquaint themselves with the provisions of the Companies Act and/or have acquired knowledge by the exercise of reasonable due diligence prior to declaring a distribution to its shareholders. In such an instance, we believe that if a commercially-sophisticated director argued that he only participated but did not knowingly know that the distribution was unlawful, there would be justified grounds for a counter-argument on the basis that he/she "reasonably ought" to have known, in light of their circumstances as a commercially-sophisticated director, and we would likely be able to impute such knowledge to him/her in order to hold the director/s liable under the provisions of s77(3)(e)(vi).
The second situation that may arise is that director/s, by way of resolution, approved the distribution to their shareholders but did not participate in the decision to approve the distribution or know that the distribution was unlawful i.e. did not pass the solvency and liquidity test. In this case, it would again seem to an extent unfair to hold these directors liable, who acted honestly in approving the distribution when they were not even aware that the requirements of s46, read with s4 of the Companies Act, are required in order to approve a distribution to shareholders. Again, even if we wished to hold these director/s liable, the provisions of s77(3)(e)(vi) do not provide for the attaching of liability in such a case. This argument again may be futile for a commercially-sophisticated director claiming he/she was unaware that the solvency and liquidity test was required to be passed prior to declaring and paying a distribution. While the application of the solvency and liquidity test in such a scenario may not be visible on the resolution, we could still apply the theory of the provisions of s46(6) on the basis set out above, in that (i) he/she participated in the decision as they approved the unlawful distribution and (ii) despite claiming they were unaware of the application of the solvency and liquidity test, a commercially-sophisticated director "reasonably ought" to have known, or at the very least taken measures reasonably expected of a director in the circumstances, as a commercially-sophisticated director would do.
Nevertheless, in scenarios where knowledge cannot be imputed to directors or such directors acted honestly and reasonably, it surely cannot be said that these director/s would escape liability simply by claiming they did not know. If this were the case, then no director of a company would take the initiative to acquaint themselves with the provisions of the Companies Act and South African corporate governance, and it would seem that ignorance is truly bliss when approving a distribution unknowingly in contravention of the Companies Act.
We believe that in order to understand the extent to which a director may be held personally liable for approving an unlawful distribution, we would have to understand the consequences and implications of the unlawful distribution on the company. If a distribution was declared in contravention of s46, read with s4 of the Companies Act, the result would be one of the following: (i) the company remains solvent and liquid pursuant to the unlawful distribution and able to continue to, inter alia, pay its creditors or (ii) the company is, or within a period of 12 months from declaring and paying the unlawful distribution will be, insolvent and illiquid, and unable to pay its creditors.
If the company remains solvent and liquid pursuant to the unlawful distribution, it cannot be said that the director/s should incur personal liability in this instance, whether such director/s knowingly or unknowingly authorised the distribution. This is made clear by s77(4)(a)(i) which stipulates that liability for a director may only arise if the company, as a result of the unlawful distribution, is insolvent and illiquid. However, we note that the distribution still remains in contravention of s46 of the Companies Act. Section 46 of the Companies Act does not expressly provide that non-compliance with the provisions of the section will result in such distribution being void, whereas in other sections such as s45 of the Companies Act, it does expressly provide that non-compliance will result in the financial assistance being declared void. Accordingly, we believe that it would be up to the company to decide how to handle this discrepancy. It may apply to the court in terms of s218(1) of the Companies Act when the remedies available under s77(5)(a) are not available to declare the unlawful distribution void, and then remedy the situation by making good with the requirements of s46 by declaring the distribution again to its shareholders.
If the company, as a result of the unlawful distribution, is insolvent and illiquid this would, inter alia, result in the creditors having a claim for damages (including penalties, fines and interest, to the extent applicable) against the company for payment of the debts due and owing, due to the non-compliance with s46 of the Companies Act. Outstanding claims by the creditors against the company may lead to (i) the company being declared insolvent and leading to the institution of insolvency proceedings, in which case the liquidator would likely use s218(1) to declare the unlawful distribution void, or (ii) the company applying to the court in terms of s77(5)(a) for an order to set aside the decision of the board and reverse the distribution. However, we have already concluded that s77(5)(a) would not be applicable in the instance that not all the requirements of s77(3)(e)(vi) have been met. Whatever the outcome, it still remains unclear in terms of s46 where the liability of the director/s, if any, exists in situations where the director/s did not knowingly contravene the provisions, or did not apply the solvency and liquidity test, pursuant to the unlawful distribution and as a result, the company is now insolvent and illiquid.
We believe that despite the failure of the drafters to expressly provide for the liability of the director/s in these situations, these directors should not be absolved of liability completely, simply on the basis of not knowing. Upon becoming a director of a company, a director is required for the duration of their service to the company to abide by their duties, common law and statutory, as directors of a company. These duties are fundamental to the success of a company as in many instances the shareholders rely on these directors to make decisions and run the company in good order. The authorising of a distribution in terms of s46 of the Companies Act is an unalterable provision of the Companies Act, and for good reason. The failure of directors to comply with these provisions, whether intentionally or unknowingly, may result in disastrous consequences for a company.
As such, we believe that the failure of directors to acquaint themselves with the provisions of the Companies Act and South African corporate governance, would undoubtedly amount to a breach of their duty of care and skill to the company. However, the nuance here is where we are dealing with a commercially-sophisticated director as opposed to a director who is not commercially sophisticated, as it would, in the circumstances, be unfair to hold a director who is not commercially sophisticated liable for breach of his/her duties, and it is likely that a court would find in favour of the director who could not be held to standards of imputed knowledge as contemplated in the definition of "knowing". Furthermore, as mentioned above, it would be the creditors of a company who would have a claim against the company, but it is possible for creditors to institute action against the directors in question in terms of s218(2), which provides that any person who has contravened the provisions of the Companies Act may be liable to another person for any loss or damage suffered by that person as a result of the contravention. Again, the claim by a creditor in terms of s218(2) against a director who is not commercially-sophisticated may serve to be an ineffective solution.
Where knowledge is imputed to a director, allowing a claim under s77(3)(e)(vi), a director is found liable as a result of a breach of its common law and/or statutory duties, and/or a claim is made against a director in terms of s218(2) due to the non-compliance with the provisions of s46 of the Companies Act, it would seem that claiming ignorance by a commercially-sophisticated director would not be adequate grounds for circumventing liability, provided that the company, as a consequence of the unlawful distribution, is now insolvent and illiquid. However, in the case of directors who are not commercially-sophisticated, it would seem that ignorance is bliss.
Shadrach-Razzino is an Executive and
Pick a Senior Associate | Corporate Commercial | ENSAfrica.