Holding delinquent directors personally liable

July 1st, 2017
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By Emile Myburgh

One of the fears expressed on the new Companies Act 71 of 2008 (the new Act), before it entered into force on 1 May 2011, was about the increased responsibilities and liabilities for directors. At the time it was thought that the new Act would stifle entrepreneurship because fewer business people would be willing to subject themselves to these new risks. Section 424 of the Companies Act 61 of 1973 (the 1973 Act) balanced the need to protect directors and creditors perfectly well, so why start from scratch with something new and unknown?

It turns out that the new situation is not that different from the former situation. If anything, the rights of creditors and obligations of directors are now much clearer than they were under the 1973 Act. This article looks at how a creditor can hold a director personally liable for unpaid debts owed to them by a company in the light of the small but growing body of jurisprudence dealing with directors’ liability under the new Act.

The provisions of the new Act

Section 22(1) of the new Act prohibits reckless trading in the following words: ‘A company must not –

(a) carry on its business recklessly, with gross negligence, with intent to defraud any person or for any fraudulent purpose …’.

Section 218(2) of the new Act further provides that: ‘Any person who contravenes any provision of this Act is liable to any other person for any loss or damage suffered by that person as a result of that contravention.’

These two sections are the basis on which a director who contravenes the provisions of s 22(1) – by trading recklessly, with gross negligence, with intent to defraud any person or for any fraudulent purpose, and thereby causes loss or damage to any person – can be held liable for that loss or damage. It is easy to argue that a company who does not pay its creditors, in other words, that breaches its contract with the creditors, is, at the very least, defrauding its creditors and the long line of authorities on s 424 of the 1973 Act confirms that.

But it gets better when one brings the provisions of ss 76, 77 and 162 of the new Act into consideration. In terms of ss 77(2)(a), (3)(b) and (3)(c), a director may be held liable for breaching his or her common law and statutory fiduciary duties.

Section 77(2) states: ‘A director of a company may be held liable –

(a) in accordance with the principles of the common law relating to breach of a fiduciary duty, for any loss, damages or costs sustained by the company as a consequence of any breach by the director of a duty contemplated in section 75, 76(2) or 76(3)(a) or (b); …’

Section 77(3) states: ‘A director of a company is liable for any loss, damages or costs sustained by the company as a direct or indirect consequence of the director having –

(b) acquiesced in the carrying on of the company’s business despite knowing that it was being conducted in a manner prohibited by section 22(1);

(c) been a party to an act or omission by the company despite knowing that the act or omission was calculated to defraud a creditor, employee or shareholder of the company, or had another fraudulent purpose;’ (my italics).

Case law on the new Act

The words ‘sustained by the company’ in these two subsections have been interpreted by practitioners to mean that only the company has a claim against a director who breached any of the provisions mentioned in s 77(2) and (3) of the new Act. This argument was advanced in Rabinowitz v Van Graan And Others 2013 (5) SA 315 (GSJ) but was rejected by Du Plessis AJ at para 22 in the following words: ‘I … find that a third party can hold a director personally liable in terms of the Act for acquiescing in or knowing about conduct that falls within the ambit of s 22(1) thereof.’

Counsel for the defendant directors in the so far unreported case of Blue Farm Fashion Limited v Rapitrade 6 (Pty) Ltd and Others (WCC) (unreported case no 22288/2014, 1-4-2016) (Mantame J) tried the same argument to ward off the plaintiff’s attempt to hold them personally liable for the debts of the company. They took an exception to the plaintiff’s particulars of claim by arguing that s 77(3) of the new Act ‘does not grant a creditor of a company a statutory cause of action to claim the loss, damages and or costs it has suffered from a director of a company’ (para 7.2). Counsel for the defendants compared s 77(3) of the new Act with s 424 of the 1973 Act, which holds, inter alia, that a creditor can hold a director liable for all or any of the debts or other liabilities of the company when it is shown that the business of the company was or is being carried on recklessly or with intent to defraud creditors of the company. Section 424 still has a limited application in the event of liquidation proceedings against the company (s 9 of sch 5 of the new Act). It was argued that s 77(3) of the new Act was drafted differently from the provisions of s 424 of the 1973 Act and, ‘[h]ad the legislature wished to create a liability in the manner contemplated by Section 424, Section 77 would have been drafted in similar terms, but this was not done.’ It was further argued that, when directors are genuinely in breach of their obligations in terms of s 77, the creditor must institute action against the company, and not against the directors.

However, the court disagreed and resorted to how statutes must be interpreted. It quoted with approval the following excerpt from Natal Joint Municipal Pension Fund v Endumeni Municipality 2012 (4) SA 593 (SCA) at para 18: ‘Interpretation is the process of attributing meaning to the words used in a document … having regard to the context provided by reading the particular provision or provisions in the light of the document as a whole and the circumstances attendant upon its coming into existence. … Where more than one meaning is possible each possibility must be weighed in the light of all these factors. … A sensible meaning is to be preferred to one that leads to insensible or unbusinesslike results or undermines the apparent purpose of the document.’ By applying this reasoning, the court held that an interpretation, which favours holding directors personally liable in terms of s 77(3), leads to a sensible and businesslike result. It then cited the Rabinowitz decision with approval and dismissed the exception. Thus, a creditor that relies on s 77(3) to hold directors personally liable for the debts of a company to a creditor, discloses a cause of action in its particulars of claim that is not excipiable.

Section 76 of the new Act is an additional ground on which a creditor can hold a director personally liable. Section 76(3)(a) and (b) read as follows:

‘(3) Subject to subsections (4) and (5), a director of a company, when acting in that capacity, must exercise the powers and perform the functions of director –

(a) in good faith and for a proper purpose;

(b) in the best interests of the company; …’.

Subsections (4) and (5) provides defences that a director can use to ward off liability in terms of s 76. However, it is difficult to see how a director of a company that breaches a contract by not paying its creditors is acting in good faith, for a proper purpose and in the best interests of the company. The case law cited support this argument.

Section 77(3), quoted above, expressly provides that a director is liable for any loss, damages or costs contemplated in s 76(3)(a) or (b).

This argument was analysed in the Blue Farm Fashions case, as well as in Sanlam Capital Markets (Pty) Ltd v Mettle Manco (Pty) Ltd and Others [2014] 3 All SA 454 (GJ), from para 40 onwards. The Sanlam case was once again an exception against a claim attempting to hold directors personally liable for the debts of a company towards a creditor. The claim was based on the directors allegedly acting recklessly by their participation in the affairs of the company when it was commercially and legally insolvent. The plaintiff based its claim on s 424 of the 1973 Act and in the alternative on s 77(3)(b) of the new Act. The plaintiff alleged that the defendant directors were personally liable for the debts of the company in terms of s 77(3)(b) due to their breach of the provisions of s 76. The court agreed that it discloses a cause of action and dismissed the exception.

Delinquency and criminal liability

Whenever a court finds that a person contravened s 77(3)(a), (b) or (c), a court must make an order declaring such a person delinquent in terms of s 162(5)(c)(iv). This section is worded in peremptory terms, in other words, there is no alternative. This means that such a person, in addition to being personally liable for the company’s debts, will not be allowed to act as director of any company again for a period of at least seven years, subject to certain conditions imposed by the court (such as limiting the delinquency to a particular category of companies (s 162(6)(b)).

In Gihwala and Others v Grancy Property Ltd And Others 2017 (2) SA 337 (SCA), the directors tried to attack the constitutionality of s 162(5)(c) on the grounds that it infringed s 22 of the Constitution because, they argued, it limited their constitutional right to choose their trade, occupation or profession freely. The court rejected this argument noting, among other things, that s 162(5)(c) serves ‘to protect the investing public against the type of conduct that leads to an order of delinquency, and to protect those who deal with companies against the harm caused by the misconduct of delinquent directors. Section 162 was an appropriate and proportionate means to achieve such a purpose.’ The court also held that conduct covered by s 162 committed before the new Act came into effect, could also lead to a director being declared delinquent.

In addition, s 214(1)(c) criminalises the conduct described in s 22(1):

‘(1) A person is guilty of an offence if the person –

(c) was knowingly a party to –

(ii) an act or omission by a business calculated to defraud a creditor, employee or security holder of the company, or with another fraudulent purpose; … .’

The penalty for the offence created in s 214(1)(c) is, in terms of s 216(a), a fine or imprisonment for a period not exceeding ten years, or both a fine and imprisonment.

Conclusion

From the above court cases, a clear pattern can be seen emerging to hold directors personally liable in terms of the 2008 Act, even in the absence of liquidation proceedings and without the need first to institute proceedings against the company concerned. The directors may even end up in prison.

The legal position of directors’ personal liability in terms of the new Act can thus be summarised as follows: When not paying a creditor without a valid reason, it can be argued that a director contravenes the provisions of s 22(1) by trading recklessly, with gross negligence, with intent to defraud any person or for a fraudulent purpose. By contravening
s 22(1) a director also contravenes their fiduciary duties as set out in s 76, which in turn, is a contravention of s 77, which further renders a director personally liable for the debts of the company. Section 218(2) makes any person liable to any other person for any loss or damages suffered by that person as a result of a contravention of the Act, and not paying a creditor can result in the contravention of various sections of the Act. Wrongfulness is not required (Piet Delport and Quintus Vorster Henochsberg on the Companies Act 71 of 2008 vol 1 (Durban: LexisNexis 2011) on s 218).  The contravention of s 77 will, in addition, necessarily result in the director being declared delinquent in terms of s 162(5)(c), while the contravention of s 22(1) is criminalised by s 214.

These provisions are a powerful tool in the hands of creditors and the Supreme Court of Appeal has shown in the Gihwala case that it clearly favours this new dispensation. The consequences for directors when a company, in breach of contract, does not pay its creditors can be severe. Considering that companies who operate in contravention of s 22(1) are often insolvent, creditors should not hesitate to go after the directors of companies who do not pay them, without first resorting to liquidation proceedings. After all, it is the directors who defraud the creditors and such directors should not be allowed to hide behind the legal personality of the company.

Emile Myburgh BCom LLB LLM (Stell) is an attorney at Emile Myburgh Attorneys in Johannesburg.

This article was first published in De Rebus in 2017 (July) DR 29.

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