What risks does a seat in the Board of Directors of a financially struggling company involve and ways to avoid and prepare for them.
Opening words
Seat in the Board of Directors in a limited liability company is no longer a mere position of trust. It involves statutory duties and responsibilities. These are particularly highlighted when the company is in financial difficulties. Seat in the Board of Directors should not only be regarded as a tribute or position of trust, but as a competence-requiring task, which includes a considerable responsibility, that may also concern the Board member personally.
The position of a board member in a limited liability company
Board members are a part of the company’s management. Limited Liability Companies Act requires that they diligently act to promote the company’s interest. In practice, this means both a duty of diligence and a loyalty obligation. The duty of diligence is assessed in accordance with the company’s objective in the light of Limited Liability Companies Act, namely, to generate profits for the shareholders of the company. The promotion of the company’s interest, in turn, is concretized as a loyalty obligation towards the company and all its shareholders. Management must promote the interests of all shareholders and treat them equally without favouring one group of owners. A member of the Board of Directors who is appointed by one of the owners is also obliged to promote the interests of the company and all shareholders.
The Board of Directors constitutes the top-level management of a limited company, and its membership is not risk-free, but requires diligence. The responsibilities of the Board of Directors include, inter alia, the proper organization of the management and operations of the company as well as accounting and financial control, representing the company and writing the business name, filing of commercial register reports, and the preparation of financial statements and other related obligations.
The responsibility of a member of the Board of Directors consists of negligence or negligent performance of the duties prescribed to the Board of Directors by the Companies Act, other law or articles of association. Thus, failure to perform the functions of the Board listed above may result in the liability of the Board members. For example, it may be a failure by the Board of Directors to monitor compliance with its decisions or to monitor the development of the company’s financial position appropriately. The liability of a Board member may also actualize from criminal activity.
The liability provisions set out in the Companies Act also apply to a deputy of the Board of Directors when they act as a member of the Board of Directors as a substitute of the actual member and take part in the decision-making process. In turn, a new member of the Board may be liable for a decision taken prior to their term of office if they participate in the implementation of the decision. In principle, a member of the Board of Directors avoids liability by performing their duties diligently and in the best interests of the company.
Duty of diligency
In order to fulfill their duty of diligence, a Board member must be active in their role. If the company’s best interests so require, the Board simply must take action. Otherwise, the result may be Board member’s liability to the company on the basis of passivity or negligence.
If a member of the Board causes damage in their actions, they may face personal liability. Liability against a company under the Companies Act may arise from intentional or negligent conduct if a member of the Board of Directors has acted in their role contrary to their duty of diligency.
In addition to the company, liability may also arise against another entity (e.g. a shareholder, creditor or a contractual partner of the company). In this case, the incursion of liability requires, along with negligence, a violation of a provision of the Companies Act or Articles of Association. This may include, for example, illegal allocation of funds or deficiencies in the company’s accounting.
The Companies Act contains a presumption of incidences, whereby a member of the Board of Directors is presumed liable for damages if the Companies Act is violated in respect of other than its general principles. It may also be a breach of a provision of the Articles of Association or damage caused by an action for the benefit of a related party. In this case, the Board member must demonstrate that they have been acting diligently to avoid liability for the damages. This situation is different from normal because usually the party claiming damages has to show the conditions of liability at hand.
How is diligence assessed?
In the assessment of duty of diligence and loyalty, the activities of a Board member are assessed on the one hand by their capacity as a member of the Board and, on the other hand, by their actual position. The assessment is therefore also influenced by what the Board member does in practice.
The evaluation of a Board member is objective and is based on how a diligent and competent person would act under similar circumstances. The Board member’s own abilities and competencies do not play any role in reducing liability. It is therefore considered a rule of thumb that a seat in the Board of Directors should be taken up only when one has the competence and knowledge for acting as a member of the Board. Ignorance does not save from liability.
When assessing diligence, it should be remembered that company management can make a loss-making decision even if it acts diligently. Making risky decisions is part of the business and management is forced to make risky decisions in often uncertain circumstances. As a member of the Board of Directors, you should not be held liable by an act which, after diligent consideration, you have judged to be in the best interests of the company, even if the assessment later turns out to be incorrect.
Sufficient diligence can generally be considered that appropriate information required by the situation has been obtained as a background to the resolution, a coherent decision or other action has been taken and the decision or other action has not been affected by conflicts of interest of the members of the Board. However, a Board member must understand that as the risk associated with a decision or action increases, the diligence required also increases and becomes more pronounced. If the action affects the company’s financial position, it must be in the best interests of the company and have a commercial reason.
How to act diligently in the board of directors
The liability of a Board member requires that they have contributed to the measure causing the liability. This assessment is made individually for each Board member. At least all members of the Board of Directors who supported the decision at the Board meeting are considered to have been involved. However, simply abstaining does not absolve a Board member of responsibility unless there is an acceptable reason to abstain (e.g., obstructionism or a dispute of interests).
A diligently acting Board member must ensure that they have sufficient information to support their decision. In other words, decisions should not be made without sufficient information. In order to make decisions with sufficient information and to ensure that the information provided out to the outside world (e.g. financial statements and information provided to creditors) is correct, the Board member must be aware, for example, about the financial situation of the company.
If, on the basis of comprehensive information, it appears that the decision is detrimental to the company, the member of the Board of Directors must vote against it. If a member of the Board of Directors is absent when deciding, they should record a dissenting opinion when they are next present. On the other hand, simply voting against is not always enough to be relieved of responsibility. At least in cases of gross violation of the Companies Act or the Articles of Association, active action can be expected from a member of the Board of Directors to avoid liability. If necessary, this might require a resignation from the board.
Since compliance with the duty of diligence is assessed afterwards, it is done on the basis of drawn up documentation. Documentation should always be drafted diligently so that the later reader understands why a certain decision has been made in a particular situation. Reports, statements, calculations and other background material obtained in support of a risky decision should always be documented.
Discharge from liability of a board member
The General Meeting shall decide on discharge/release from liability to the members of the Board of Directors. The discharge from liability of Board members plays an important role when it comes to liability to the company. When the General Meeting grants a discharge from liability, an action may be brought against a member of the Board of Directors only if the discharge had been decided on incorrect information. This can occur in a situation where the Board of Directors has not reported at all about certain decisions or risks or has given a misleading statement to the General Meeting.
It is noteworthy that the discharge from liability covers only liability under the Companies Act and applies only to actions pursued on behalf of the company (not, for example, a contractual partner). It is also worth remembering that discharge does not always bind the company’s bankruptcy estate.
Membership of the board of directors of a company in financial difficulty
When a company is in financial difficulty, decisions should be considered especially diligently by a Board member. In this case, for example, a commercial basis is rarely found for lending company’s assets and is unlikely to be in the interests of the company as a business transaction. The provisions of the Companies Act and the provisions of the Articles of Association, which protect individual shareholders, creditors and other entities outside the company, require the attention of the Board member even in times of financial difficulties. For example, Board members need to consider creditors’ interests more when the company begins to face payment difficulties.
In order to avoid personal liability, a member of the Board of Directors should pay attention to at least the following issues when the company faces financial challenges:
- Related party arrangements in which business or assets are sought to be transferred to owners or another company prior to bankruptcy. Creditors suffer a loss and a lawsuit for damages or prosecutions for the debtor’s crimes may result.
- Debt taking when there is a risk of excessive indebtedness or permanent default. Continuing to do business in a financial situation that is unacceptable to the Company will easily lead to the liability of the members of the Board of Directors.
- The continuation of the operation of an insolvent company can fulfill the essential elements of dishonesty by the debtor which is punishable under the Criminal Code.
- Failure to report in the trade register when the share capital and reserves of a limited company is negative. In particular, the notice will inform creditors of the company’s financial condition. Personal liability for damages can follow when the creditor is able to demonstrate that it would not have relied on the company, knowing of the loss of equity.
- Failure to pay VAT to the State, withholding and contributions to the employer’s social security contributions when a member of the Board of Directors is aware of the company’s financial difficulties. The consequence may be a liability to the State for damages caused by negligence of the payments. This can also be creditor favoritism (the debtor’s dishonesty offence) in a situation where, during the failure to pay taxes, the debts of other creditors are paid.
- The company’s funds are used to buy its own shares or funds are loaned to related parties of the company. The result may be the liability of a member of the Board of Directors to the bankruptcy estate.
Liability insurance
It is good to keep in mind that the company can take out management liability insurance for the management. However, there are differences in the content of liability insurance policies and limitations on insurance companies, so it is worth comparing policies. In general, however, liability insurance policies do not cover clearly negligent activities.
How to be prepared for risks
A few pieces of advice on how to be prepared for risks;
- If you don’t understand the company’s business and its operating environment, don’t accept membership of the Board or resign from the company’s Board of Directors.
- Act diligently, familiarize yourself with the issues and require the necessary explanations and calculations of even more risky decisions, and archive the material (reports, statements and calculations made and acquired as a background for decisions).
- Vote against a risky decision if necessary and, also be prepared to resign from the Board of Directors if you consider the decision made to be contrary to the Companies Act or the best interests of the Company.
- Be sure to require clarification from management that accounting and legal obligations have been carried out in a lawful manner.
- What is essential in a crisis is that creditors are treated equally. For example, failure to pay taxes for several months while debts of other creditors are being paid may easily lead to a Board member being liable as well.
- Keep in mind that, in particular, actions that cannot be seen as the normal business of the Company, for example, various arrangements aimed at obtaining an advantage for someone related to the company, will easily trigger the liability of a member of the Board of Directors.
- Make sure that the General Meeting is informed of risky decisions and, in any case, correct information about the company’s activities is provided so that the discharge granted by the General Meeting is binding on the company.
- The company may take a liability insurance for the management. In general, however, liability insurance policies do not cover clearly negligent actions.