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When a person becomes a director, one makes a great step forward on his/her corporate ladder. This person receives a new status and can now influence the whole company and the lives of its employees. Being appointed by the shareholders, the director is expected to bring the organization to success through the decisions one makes. Still, it may be that this person fails to cope with the duties and becomes liable for the issues that happen within the organization, including the acts of fraud and mismanagement. This situation attracts much attention because an insolvent company that continues trading can be a great problem for the creditors. Depending on their law system, different countries have various legal mechanisms made to cope with these issues. For now, they all seem to have particular advantages and disadvantages, and no effective treatment exists.
Lifting of Corporate Veil
In the middle of the 19th century, incorporation by registration was designed, and the doctrine of limited liability occurred right after it. Soon both acts were affected by the case Solomon v. Solomon & Company the House of Lords, and a legal person was distinguished from the organization and its members. Thus, the understanding of the company as a separate entity occurred. Still, in some cases the veil between it and its director can be lifted to prevent misuse of the corporate form:
- Fraud. To reveal the motives of the fraudulent individual, find out if a contractual or legal obligation is evaded, consider the timing of the incorporation.
- Group enterprises. To reveal the economic realities.
- Agency. To discuss the relationship with the agent and find out if the director is in charge of its acts.
- Trust. To reveal under what circumstances the trustee holds the shares.
- Tort. To discuss public nuisance and libel (used only in Canada).
- Enemy character. To evaluate the nature of shareholding (used in the wartime).
- Tax. To disclose tax evasions (Sadhu 21).
The lifting of the veil is supported in these cases by the UK Insolvency Act of 1986 that investigates the civil liability for fraudulent and wrongful trading along with other abuses.
Fraudulent trading – 213 – If in the course of the winding-up of a company Fraudulent it appears that any business of the company has been carried on trading with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose… the court, on the application of the liquidator, may declare that any persons who were knowingly parties to the carrying on of the business in the manner above mentioned are to be liable to make such contributions (if any) to the company’s assets as the court thinks proper (“Insolvency Act” 115).
Wrongful trading – 214 – …if in the course of wrongful the winding up of a company it appears that subsection of this section applies concerning a person who is or has been a director of the company, the court, on the application of the liquidator, may declare that that person is to be liable to make such contribution (if any) to the company’s assets as the court thinks proper (“Insolvency Act” 115).
Section 213 discusses the appearance of fraudulent. It is stated that if there was a fraudulent purpose, the court can say that the people who were aware of such intentions but continued to be involved in the business are in charge of the contributions considered to be appropriate in this particular situation proper (“Insolvency Act” 115). An example of the case that reveals the way, in which section 213 works, is the Court of Appeal in Morphites v Bernasconi. The directors of TMC Transport (UK) Ltd were suspected of not paying the rent to their landlord intentionally, as they created a new company, to which transferred everything except for liabilities. It was difficult to define if the avoidance of payment was enough to consider the case under the discussed section. Still, they were made to make a monetary contribution “to the company’s assets in its liquidation, as were solicitors involved in the scheme that resulted in non-payment of the rent” (“Morphitis v Bernasconi” para. 1).
Section 214 is focused on wrongful trading and has much in common with section 213. Provisions to it are similar, but there is a difference in the way it operates. As a rule, section 214 is used when insolvent liquidation and the declaration occur, and there are addressed to a particular person. This individual is to be a director of the company before it goes into liquidation and should be aware of the future unreasonable winding up.
The case is not treated according to this section only if it is proved that the director did one’s best to minimalize the losses. For example, at the beginning of the 1990s, one insurance company went into liquidation, and its directors got an opportunity to gain lots of money. The liquidators made an application against them and, as it turned out, there were no decent reasons for a sale and the directors had to know the true financial position of the organization. Moreover, they should have known that the organization is not able to meet the DTI’s margin of solvency. As a result, they were expected to contribute to company debts (“Wrongful Trading Insolvency Case Law” para. 16).
This case shows that breaching fiduciary obligations could lead to lifting the veil of incorporation. After all, when a company goes into insolvent liquidation, it is pertinent to consider whether directors have by failing to comply with their fiduciary obligations, contributed to the company’s liquidation. From the very beginning, the court was discussing the issue with eight directors who were both executive and non-executive. Thus, it turned out to be crucial to define what role each of them played and whether they were able to prevent insolvent liquidation.
Today, wrongful trading and fraudulent trading are considered apart from each other as they are used to describe connected but different notions. Considering the information gained from the Insolvency Act of 1986, it can be concluded that wrongful trading occurs when the directors are well aware of the problems that the company is facing but do nothing and let it trade as usual. They can be considered to be guilty even if they did not know about the actual condition but they should have been aware, which is also seen as a civil offense.
The directors whose guilt is proved in the court are claimed to be personally liable for the company’s problems or banned from holding their position. Fraudulent trading occurs when a company’s operations are conducted with the intent of deceiving, which is considered to be a criminal offense. The directors have fines/debt liabilities in this case.
‘Wrongful Trading’ and ‘Fraudulent Trading’ under the US Law
When a company is facing financial problems and turns out to not able to pay the debts, its director is expected to make reasonable decisions that will save the organization. One may need to gather all shareholders to let them know the current state of things and consider future steps. Fiduciary duties of directors are discussed under the United States of America (USA) Companies Law, but some variations may be found in different states.
In the USA, the directors have two main duties. They are to be as careful as any other reasonable person in the same situation and to do their best to act in the interests of the company and its shareholders, trying to omit any issues and conflicts of interest. In this way, the directors are not allowed to use the opportunities provided by the position in personal interests. It is also connected with the business judgment rule, which states that all decisions should be made to make the company operate decently and enhance its performance. Unfortunately, the directors do not always follow this rule and meet all expectations of the shareholders (Konstantinov 106).
The US corporate law indicates that if the company was mismanaged or defrauded, its directors are to hold personal liability. Still, when it comes to the bankruptcy and inability to pay the debts, the US law becomes rather friendly to the directors. Of course, the legal system tries to make them informed about the real state of things beforehand, but it cannot be denied that bankruptcy protection exists. Such cases are considered concerning the deepening insolvency, which is known as the damage made to the company by the director who wanted to let it operate longer and expanded fraudulent. This concept can be compared to the wrongful trading provided by UK law.
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Of course, these countries do not have the same legislation but directors’ liabilities turned out to be similar, and one will be liable for actions conducted to manage the company that is facing bankruptcy. In this way, the filing for it is presupposed but not obliged. Deepening insolvency developed from the tort law, and it is related to any misconduct. Thus, it can be used more often than wrongful trading and can be treated as fraudulent behaviors. Today it deals with both situations of wrongful and fraudulent trading and is referred to when he cases with negligent directors appear (Rubin 3). The difference between fraudulent and negligent deepening insolvency is distinguished, and it lies in the presence/absence of fraudulent behavior and failure to follow the business judgment rule.
Wrongful trading and deepening insolvency have different natures, and it is not necessary to prove the actual injury made to the company, considering wrongful trading. Only the intention of the director and one’s awareness of the real situation is discussed. The liquidator may insist on this issue if there is no evidence of the director’s economization, attempt to hide the actual state of things and worsen the situation.
So it can be said that no legislation prevents the directors from trading in case of financial insolvency. Mainly, the court considers it as fraudulent trading. Only when negligent action conducted by the directors is proved, wrongful trading can be approached. Still, even though the directors may be obliged to make a monetary contribution or imprisoned, wrongful and fraudulent trading is not seen as a punishment but as an attempt to help them to take a pause and reconsider the situation, trying to find some way out.
‘Wrongful Trading’ and ‘Fraudulent Trading’ under the UAE Law
Not so long ago the United Arabian Emirates (UAE) faced enormous changes and turned into a prosperous country that is known today as a leader in many industries. It continues to grow and tend to encourage its citizens to start their businesses. As a result, the concept of directors’ liabilities attracted much attention, and all companies became obliged to get to know the country’s Companies Law. In the UAE, the directors have six main duties: “duty to establish financial reporting procedures, duty to avoid conflict of interest, duty to disclose personal interests, duty to convene General Meetings of the company, duty to make a clear representation of the company to third parties, and duty of loyalty” (“Directors’ Duties in the UAE” para. 3-8). If the director fails to act according to the Companies Law and breaches one or several duties, one becomes personally liable for the occurred situation.
The UK Insolvency Act of 1986 was used by many other countries to develop their company laws, protection of assets in liquidation that was designed for the UAE has much in common with it. Articles 78 and 79 that can be found in the United Arab Emirates Company Laws and Regulations Handbook (20) describe the issues of wrongful trading and fraudulent trading almost in the same way.
The closest parlance to both wrongful trading and fraudulent trading under the Emirati law are offenses in bankruptcy: negligent bankruptcy and fraudulent bankruptcy. The difference between them is that these two bankruptcies under the Emirati commercial code occur after the company files for bankruptcy. Such issues are discussed in the Commercial Transactions Law that focuses on the individuals who do not pay the debts. According to Article 645, bankruptcy occurs when the director/company is not able to pay debts or is not willing to pay them due to financial problems faced by the organization. Still, even in this case, bankruptcy cannot be declared automatically. Only the order of the court can change the situation. Thus, if the director uses illegal money to pay the debts, one’s case will not be discussed under this law until a bankruptcy order is issued.
If the organization fails to pay the debts because of other expenditures or because much money is spent on some speculations, negligent bankruptcy is claimed to be faced by the company. If it is proved that this situation is the director’s fault, one will be punished by two years’ imprisonment or will be obliged to pay compensation, as it is stated in Article 880. The fine may be different by no more than AED 2,000.
Except for that, it is critical for the organization that operates in the UAE to file for bankruptcy as soon as possible. If the director is not paying debts for more than thirty days and keeps his/her own counsel, one will be considered guilty of this offense. Such an approach is described in Article 649. Fraudulent bankruptcy is treated more seriously. It can lead to imprisonment for up to five years. Such kind of bankruptcy occurs when the director spoils business records, used for one’s purposes or just concealed some money from the creditors, acknowledged undue debts or conducted fraudulent actions to reach the creditors (Nagar para. 21).
Both personal and criminal liability of the directors is discussed in the Insolvency Law. It includes detailed information about the things for which one will be considered liable but fails to give a decent description of the fines and imprisonment period. Only their maximums are pointed out so that it would be impossible to extend the prison sentence or increase the fine. As a result, it depends on the court hearing what punishment a director will receive.
According to the Commercial Companies Law, the directors can be personally liable for being negligent if they committed the negligent act or omission, such as fraud, abuse of authority, etc. As a result, the issue of mismanagement can be discussed according to Article 148. It states that the directors can be considered liable for “all acts of cheating (fraud), abuse of authority as well as for any violation of the law or of the Articles of Association and for fault in management” (Abaza para. 5).
Articles 301 and 302 states that if the company faces financial issues, the losses increase greatly and reach half of the capital, the director is expected to notice this situation and discuss it with the shareholders instead of not paying the debts. In this way, all the mentioned information supports more general Articles 84 and 162. They state that the director is liable for frauds, losses, and gross errors, so if one allows the company to operate further knowing what happens in the organization, he/she will be subject to a fine or prison sentence.
So it can be concluded that even though both wrongful trading and fraudulent trading do not exist per se in the Emirati law, they are notionally existent under Article 84 and 162-1 of the new Company Law, 2015. Article 111 of the old Company Law also considered the director’s liability towards the company in case of maladministration, but this issue was not discussed so widely then (“Federal Law No. (8) of 1984” 35).
Both the USA and the UAE are highly concerned about their businesses. The countries provide various legislations that can be used by the companies as guidelines to avoid possible issues. Legal mechanisms created to deal with wrongful trading and fraudulent trading in these countries seem to be based on the UK Insolvency Act of 1986, as they have much in common with it. In both countries, the director and the company are considered as a whole until the moment the conflict of interests occurs, and the director conducts actions that are harmful for the organization and its creditors.
Even though the USA tends to be more patient and friendly to the cases of wrongful trading than the UAE, they apply the punishment to the directors whose intent to defraud the creditors was proved or awareness of a poor business situation. The liquidator investigates to find out whether the directors performed their duties as they were expected to. If no, the accusation to the court is presented to see if they are liable for what has happened.
Abaza, Islam. Liability of Directors on Mismanagement and Bankruptcy, 2011. Web.
Directors’ Duties in the UAE 2012. Web.
Federal Law No. (8) of 1984. n.d. Web.
Insolvency Act. n.d. Web.
Konstantinov, Dmitry. “Wrongful Trading: Comparative Approach.” BRICS LJ 2.1 (2015): 100-124. Print.
Morphitis v Bernasconi 2003. Web.
Nagar, Saifedin. Bankruptcy in the Context of UAE Law, 2015. Web.
Rubin, Paul. New Liability under Deepening Insolvency: The Search for Deep Pockets, 2015. Web.
Sadhu, Anusuya. Lifting the Corporate Veil, 2012. Web.
United Arab Emirates Company Laws and Regulations Handbook. Washington, DC: International Business Publications, 2008. Print.
Wrongful Trading Insolvency Case Law. n.d. Web.