Duties of a director of an insolvent or distressed company
The Nigerian economy and the fate of domestic companies
Nigeria’s gloomy economic climate is increasingly taking its toll on businesses. Filings from eighty-five companies to the Nigerian Stock Exchange reveal that the total profit for the first half of 2016 plummeted by 26.6% in comparison with that of the first half of 2015. A combination of the protracted fall in oil prices, skyrocketing foreign exchange rate and unfavourable government policies have driven the economy into its worst recession in more than two decades. Figures from the National Bureau of Statistics (NBS) show that Nigeria’s Gross Domestic Product for the second quarter of 2016 declined by -2.06%, about 1.70% points lower than the growth rate of -0.36% in the first quarter of 2016.
NBS’ Consumer Price Index for August 2016 (which measures the rate of inflation in Nigeria) shows that inflation is at an 11-year high of 17.6%. This is a continuation of a seven-month upward trajectory (17.1% in July, 16.5% in June, 15.6% in May, 13.7% in April, 12.8% in March, 11.4% in February and 9.6% in January). In a bid to curb inflation, the Monetary Policy Committee of the Central Bank of Nigeria (CBN) last July increased the monetary policy rate by 200 basis points to 14% from 12%. This interest rate hike has put more pressure on domestic companies in an already sombre economic climate. Banks have repriced interest rates on existing loans to reflect the hike in the benchmark interest rate and this is bound to increase the cost of servicing existing loans, borrowing and doing business.
Against this background, the rate of default on existing loans is likely to increase as well as the number of companies going belly up. Augusto & Co has estimated that non-performing loans are expected to leap to 12.5% of total loans in 2016. This is well above CBN’s target of 5% back in December 2015. In the light of the foregoing and given that insolvencies are inevitable, it is imperative for directors to have a sound knowledge and understanding of their duties.
Duties to the insolvent or distressed company
The statutory duties of directors to a company under sections 279, 280, 282, 283 and 287 of CAMA do not cease when a company is insolvent. Accordingly, directors owe the company a fiduciary duty and must observe the utmost good faith towards the company in all transactions. Directors must act at in the best interest of the company, they must exercise their powers rightfully and must not to fetter their discretion to vote in a particular way. Directors must not delegate their powers improperly. Further, directors must not allow their personal interests to conflict with their duties. They must not make secret profit or unnecessary benefits and must not misuse corporate information, property or opportunity.
Directors owe their insolvent company the duty of care and skill. Directors must exercise their powers and discharge their duties honestly, in good faith and in the best interest of their companies. Directors must exercise the degree of care, diligence and skill which a reasonable prudent director would in comparable circumstance. The applicable test is an objective one and a director’s personal incapacities or limitations are immaterial.
Duties to the company – For whose benefit?
When a company is solvent, the above duties of directors are owed to the company for the benefit of shareholders. Nigerian law does not provide any guidance regarding whose benefit the duties are to be performed when a company is factually insolvent. English decisions suggest that the duties are owed for the benefit of creditors: HLC Environmental Projects Ltd v Carvalho (2014) BCC 337, 362; Colin Gwyer & Associates Ltd v London Wharf Ltd (2003) BCC 885, 906 [74]; West Mercia Safetywear Ltd v Dodd (1988) BCLC 250 at 253; Brady & Anor v Brady & Anor (1987) 3 BCC 535, 552. In contrast, Australian authorities such as Walker v Wimborne (1976) 137 CLR 1 and Bell Group Ltd v Westpac Banking Corp (2012) WASCA 157 and leading judicial authorities in New Zealand such as Nicholson v Permakraft Ltd (1985) 1 NZLR 242 at 250 and Sojourner v Robb (2006) 3 NZLR 808, [103] suggest that directors must consider both the interests of creditors and shareholders.
Requiring directors to balance the divergent interests of creditors and shareholders in the twilight zone will be an uphill task. When a company is in the twilight zone, directors are often anxious to engage in excessive risk taking so as to restore profitability. Shareholders will understandably be supportive of such high-risk transactions given that in the absence of such, they risk losing their equity investments in insolvency proceedings. In contrast, most unsecured creditors may be risk-averse in the twilight zone. First, there is no guarantee that excessive risk taking by directors will yield positive results. Second, in the event that the highly risky transactions are not successful, creditors will incur more losses in formal insolvency proceedings.
When a company is in the twilight zone, directors ought to act for the benefit of creditors. This position is underpinned by the fact that at this point (i) creditors become the real owners of the company and its residual value and, (ii) most commercial risks fall on creditors and not shareholders. Further, waiting till winding-up proceedings commence may amount to shutting the stable door after the horse has bolted, given the important operational and critical financial decisions often made at this point.
Duties arising from offences antecedent to or in the course of winding up
Sections 502 to 508 of CAMA provides for offences antecedent to or in the course of winding up. These offences give rise to and impose a number of duties on directors. Some of these duties are the duty not to make any material omission in the company’s statements; duty not to fraudulently induce a person to give credit to the company; duty not to make or cause any gift/transfer of a charge on the company’s property or levy/cause execution to be levied with intent to defraud creditors; duty not to conceal or remove company’s property within two months before the date of a judgement/order for payment of money obtained against the company. Directors must keep books of account explaining the company’s transactions and financial position throughout the period of two years prior to the commencement of winding-up proceedings.
Section 506 imposes a duty on directors not to engage in fraudulent trading. Within twelve months before the commencement of winding up proceedings, directors owe their companies the duty not to conceal or fraudulently remove any part of the company’s property; not to conceal, destroy, mutilate or falsify company’s documents; not to make or be privy to the making of false entry in a company’s document; not to fraudulently part with, alter or make any omission in a company’s document; not to fraudulently obtain property for or on behalf of the company which the company does not pay for; not to pawn, pledge or dispose of the company’s property obtained on credit and yet to be paid for unless such is done in the in the ordinary way of the company’s business.
Although directors are displaced by liquidators when winding up proceedings commence: section 422(9) of CAMA, they have a duty to cooperate with the liquidator. Directors must also deliver all the company’s property to the liquidator; they must not make any material omission in the statement of the company’s affairs; directors must inform the liquidator of any prove of false debt by a creditor; they must not prevent the production of any document relating to the company’s property or affairs.
Practical guide for directors
It is impossible to lay down a comprehensive guide on how directors of insolvent companies are to carry out their duties. However, below are some (and by no means exhaustive) practical guides.
Professional/expert advice: Professional advice should be promptly sought from legal, financial and insolvency experts at an early stage. External experts are often well-placed to offer dispassionate or objective opinions in times of internal uncertainty. Directors who honestly and reasonably rely and act on expert opinions may be shielded from certain liabilities.
Proper documentation: Directors should ensure that all critical transactions of the company are properly documented. All documents and paper trails showing what decisions were made, when they were made, the commercial basis for the decisions and implementation strategies must be securely preserved. Directors should also ensure strict compliance with all statutory or regulatory reporting/filing requirements and procedures.
Regular Board meetings: Regular board meetings should be held, with all board members endeavouring to attend. All critical issues relating to the affairs and financials of the company should be discussed in detail at the board meetings. Accurate minutes of the board meetings should be prepared showing the issues deliberated upon, decisions made, the commercial basis for the decisions and implementation strategies.
Communication with stakeholders: Gaining the support and cooperation of key stakeholders is important for insolvent or distressed companies. There should be regular communication and interaction with stakeholders such as creditors, essential service providers, key shareholders and shareholders’ associations, regulators, employees and employees’ associations etc. The stakeholders should be accurately informed of the state of the company’s affairs.
Transactions: Deciding whether or not to enter into transactions while distressed will depend on factors such as nature of the transaction, contractual obligations, benefits of the transaction, the length of time for recouping the benefits, the extent of the company’s distress, the potential level of risks etc. Generally, directors should engage in transactions which will maximise value for creditors.
A company which accepts pre-payments for services should set up a separate trust account for such pre-payments. Monies received from clients should only be transferred from the trust account to the company’s main account after the company has provided the pre-paid services. Where winding up proceedings has commenced prior to providing the services, the trust device will protect the clients from joining the company’s queue of unsecured creditors and directors against potential liabilities in relation to fraudulent trading.
To reduce a risk of fraudulent preference, directors must not treat any creditor more favourably than others. Directors who hold multiple directorships in different companies should scrutinize inter-company transfers to ensure that they do not constitute fraudulent preference. Generally, directors should avoid disposing company’s assets for less than the market value, incurring credit when it is apparent that the company will be unable to pay back when due or before the commencement of winding-up proceedings and topping-up the security collateral of a creditor without a contemporaneous consideration.
Uncooperative board: Where other directors of a company are uncooperative, a director should take proactive steps to minimise losses to creditors. The director may requisition board meetings, raise his concerns at the board meetings and with key shareholders of the company, make suggestions and useful recommendations at the board meetings and through memos. The director must ensure that his efforts are properly documented and well preserved. Resignation may be expedient after fruitless efforts.
Conclusion
Where directors of insolvent or distressed companies carry out their duties prudently and responsibly, the rate of restructuring and rescue of distressed companies will increase thus preserving value. Where the companies are moribund, they will be wound up in an orderly manner, minimising losses to creditors. The foregoing will boost investor confidence, incentivizing them to invest/re-invest in viable companies. Increased access to credit will promote growth of companies, which will in turn accelerate Nigeria’s economic growth.
Excerpt from a presentation by Dr Kubi Udofia at the international conference of the Business Recovery and Insolvency Practitioners Association of Nigeria (BRIPAN) held on 27 and 28 September 2016 in Lagos with the theme “Nigeria’s Changing Economy and Emerging issues in Restructuring and Insolvency.”
Dr Kubi Udofia