4. LEGISLACIÓN COMPARADA
4.2 Colombia
The discontent with “fraudulent trading” statutes leaked in several directions. First, legis- latures presumed culpability of the board of directors whenever a firm incurred new debt while facing insolvency. Second, directors became liable on the obligation whether or not they participated, directly or indirectly, in the transaction. It is easy to understand the seductive logic of the transition from fraudulent trading to the new duty against insolvent trading.
We all know not to respect the broke gambler’s plea: “Loan me another hundred dol- lars, I can get it all back on this roll”. The gambler has nothing to lose and everything to gain. Since he is already broke, owing another hundred dollars that he cannot pay is costless. Yet, his chance of winning, even if small, an amount that will repay all his debts with some left over for his pockets has positive value. Since the gambler is desperate, he is likely to lie about his chances to secure the loan and since he is broke, his skills and judg- ment at the table are probably suspect as well. Recipients of his plea are better to save their hundred dollars or make their own bet on the next roll (for the same risk you get a higher expected return).
An insolvent company puts management in a position similar to our broke gambler. If the managers wind up the business they lose their jobs and the value of whatever equity investment they have in the company. On the other hand, if they can borrow to keep the business operational, perhaps they can “get lucky” and resuscitate the business, keep their positions and re-inflate the value of their stock. Fully informed creditors would be well
23. Harmer Report, supra n 21.
24. Creditors whom the managers could reasonably assume did not otherwise know their company’s true financial condition.
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Corporate Directors’ Personal Liability for “Insolvent Trading” in Australia
advised to demur. But managers in this position will be tempted to mislead creditors about the firm’s finances to secure the loan.25
If managers succumb to the temptation and lie about their company’s prospects and position, the principle of limited liability does not apply. The managers are personally liable for fraud. On this much all agree. The managers cannot contract away their duty not to mislead and the creditors cannot waive their rights against the managers for fraud. We presume conclusively that no-one would contract willingly to be defrauded. Any provision to the contrary must itself be part of the fraud.
With each new national financial crisis spawning multiple corporate insolvencies, leg- islatures, eager to appear to be doing something helpful, have reduced the burdens of proving fraud in such cases. The goal of the concerned lawmakers seems to be that, given the sizable temptations on managers to defraud creditors when their firms face insolvency, the law will conclusively presume it whenever a firm attempts to resuscitate itself outside of insolvency proceedings. Rather than require proof of a culpable state of mind, legisla- tures reduced the definition of culpable conduct in civil actions from intentional fraud or even reckless behaviour to something more akin to ordinary negligence.26 But the duty of care is not delineated by good custom and practice in the industry, as is the common law baseline, but out of the fertile minds of the drafters in high-sounding, opaque statutory lan- guage. The duty of care, so defined, means directors must act to stop their companies from incurring new debt when insolvency looms.
The lowest standard of liability, in Australia, requires only that a company incur a debt when there are “reasonable grounds for suspecting that the company is insolvent and the director is aware of this or ought reasonably to be aware of it”.27 In New Zealand, direc- tors must “not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so”.28 In England the test is stronger; the wrongful trading provi- sion applies if a director “knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation”.29
Legislatures also reduced the level of participation required for culpability. In Aus- tralia, directors no longer have to participate in the problematic loan transaction to be liable. They are liable if they did not act to stop the company from incurring debts when insolvency was suspected.30 In New Zealand a director is liable if he “allow[s] the
25. Some directors, worried about their personal reputations in the labour market, will not succumb to this temptation.
26. New Zealand redefined “reckless trading” to refer to something more akin to “negligent trading”.
27. Corporations Law s 588G (Australia). In a bizarre twist, however, a director has a defence if he “had reasonable grounds to expect that the company would have been able to pay its debts”. Corporations Law s 588H(1) (Australia).
28. Companies Act of 1993, s 136 (New Zealand). 29. Insolvency Act s 214(2) (UK).
30. Corporations Law s 588H(2) (Australia). A director must prove he “took all reasonable steps to prevent the company incurring the debt”.
business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors”.31
While one can understand how seductive the progression is to well-meaning legisla- tors, they went too far. They lost sight of a defining principle that distinguishes fraudulent trading from insolvent trading. There is a consensus that fraud in negotiating loan contracts is a condemnable practice. It is hard to imagine any exceptions. Insolvent trading blankets are not so uniform a group of situations. There are numerous situations in which insolvent trading is not a simple manifestation of our broke gambler’s scenario. I mention only a few below.
Scenario One: The High-Tech, Start-Up Company
An engineer has an idea for a new laser switch (drug or biotech marvel) and needs funds to build an operational prototype. Whatever equity he had put into his company to fund his research is exhausted. He now seeks first-stage financing in anticipation of creating an operating prototype, generating customers, and beginning manufacturing operations. His firm’s balance sheet shows negative equity and his best projections show negative earn- ings for at least another five years. Both he and his lenders understand that only one in five high-tech companies end up turning a profit and only one in ten end up a substantial suc- cess. But the lenders are willing to fund the company with convertible debt.32 The lenders calculate that they can diversify their lending over ten or more companies and ask for a rate of return on each that will leave them a profit when eight fail, one shows a profit, and one is a success.
Under the insolvency statutes, can the engineer borrow funds from a venture capitalist with limited personal liability? These creditors are surely not a pitiful group deserving of the government’s protection. Yet in Australia and New Zealand the answer has to be no.33 His company is technically insolvent and he has reasonable grounds to expect or believe that the company will not be able to pay off its debts when they become due. So, for our entrepreneur to enjoy limited liability, the venture capitalist must take some form of equity rather than debt.
Even if one can argue that the venture capitalist and the firm can waive any right to sue directors individually for insolvent trading on the first-stage funding,34 can the firm deal with trade creditors? Can it pay employees at the end of the week? Or must it pay cash in advance for all goods and services provided?
31. Companies Act of 1993, s 135 (New Zealand). A violation of s 136 by at least one directors would seem to trigger the obligations of s 135 for all non-participating directors. The interplay of the two provisions is not self-evident, however.
32. Each scenario assumes that the creditors are not able to waive their rights under the insolvent trading statutes, supra n 14.
33. England’s wrongful trading provision is more equivocal. 34. Supra n 14.
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Corporate Directors’ Personal Liability for “Insolvent Trading” in Australia
Scenario Two: Existing Lenders and the Over-Leveraged Company
A company has strong gross income, the revenue that it gathers from selling its goods far exceeds the cost of producing the goods, but in its past the firm has made poor capital side decisions. The interest on the firm’s long-term debt obligations equals the firm’s income. When principal repayments become due (some of which mature in the near future), the firm will not be able to make the payments. The managers of the firm decide to raise additional funds to expand production facilities in the hope of increasing profits sufficiently to make all their full principal repayments. The chances of success are less than fifty percent.35 The existing lenders, anxious to save their old debt, are willing to offer new loans.
Can the firm agree without subjecting the directors to personal liability if the firm fails? Again the answer appears to be no. The existing lenders must make an equity infusion for the board to continue to enjoy limited liability. Otherwise the firm must submit to whatever insolvency administration is available. If existing lenders and the firm can waive any claims under the insolvency trading provisions on the new debt, can the firm deal with trade creditors?
Assume the facts of scenario two with the following changes. A new lender is willing to make a high-risk loan to the troubled company only if all existing lenders agree that the new lender has priority in liquidation if the company fails. The existing lenders agree. Are the members of the board of directors personally liable on the new loan?
Scenario Three: Existing Lenders and the Company Suffering from Temporary Market Conditions
A company operating in a volatile market runs a tourist hotel and loses substantial revenue when an economic downturn changes dramatically the spending priorities of the citizenry. The company begins to lose money; revenues do not meet obligations. The company and its existing creditors believe that the downturn is temporary and the existing creditors are willing to offer new funds to keep the company operating until economic conditions ease. Will the directors be personally liable for the new loans?36
In scenarios two and three, why would the existing lenders or new lenders be willing to lend more money to an insolvent company? The lenders may want to avoid company
35. This is similar to the example in Mannolini, supra n 8 at 29. In Mannolini’s example a firm is committed to a single project and has no prospect of meeting its debts unless the project is profitable. The project has a positive net present value but a 60 percent chance of failure. Mannolini states that the directors would have an obligation under the insolvent trading provisions to abort the project.
36. Ibid. Mannolini notes, citing a 1907 case, that there is “authority for the proposition that temporary illiquidity must be distinguished from the situation in which a company faces an endemic shortage”. I do not find the distinction in the language of the statute. Moreover, whenever a board believes the situation is temporary and, in fact it is not, a court will second-guess the reasonableness of that belief. No director wants to assume that risk personally.
administration37 and its effects. If a board must apply for administration, the firm is put in the hands of a stranger, an administrator, who may not be as capable as the existing board and, in any event, must get up to speed on the firm’s situation. Moreover, administration has dramatic consequences for lenders, who lose their ability to enforce obligations (and control their renegotiation) and for the business’s reputation with other constituencies (em- ployees, customers and suppliers). Administration is a major, wrenching step that disrupts the continuity of the business at several levels. Many a savvy creditor is willing to take steps to avoid administration for companies that otherwise have their confidence.38 Why should we take away this option?
In sum, there are too many situations of insolvent trading in which the facts ought not to impose personal liability on a firm’s directors. Yet the insolvent trading provisions do not seem to have the flexibility to exempt such cases from the sections’ harsh coverage and attendant harsh consequences. A more specific factual inquiry is necessary for the direc- tors’ personal culpability. The traditional fraudulent trading statutes, better drafted and interpreted, perhaps permit such an inquiry, as does a doctrine of limited fiduciary duty to creditors when a firm is insolvent.39 Legislatures, to catch a few more wrongdoers,40 have erected bars to legitimate business judgments in recurring and significant situations.
As unfortunate as this is, the insolvent trading provisions have larger problems.
37. Australia and England use the term “administration” to refer to what in the United States is termed “bankruptcy reorganization” under Chapter 11. See A Campbell, “Company Rescue: The Legal Response to the Potential Rescue of Insolvent Companies” (1994) 1 International Company and Commercial Law Review 16. The procedure for putting a company in administration is much slower and more expensive and cumbersome in England than in Australia. See R Goode, “Insolvent Trading Under English and Australian Law” (1998) 16 Company and Securities Law Journal 170. This may explain why the Australian insolvent trading provisions are designed to encourage directors to use administration much earlier than the English provisions. An administrator is personally liable on debts incurred for services rendered, goods bought, or property leased during the administration with indemnification rights against the firm. See Corporations Law s 443A(1)(Australia).
38. In England, for example, administration procedures produce much lower returns for creditors than do voluntary arrangements negotiated outside of administration. See Goode, supra n 37 at 1745.
39. The insolvent trading rule needs also to be distinguished from case law on directors’ fiduciary duties that shifts those duties from shareholders to creditors on insolvency. See S McDonnell, “Geyer v Ingersoll: Insolvency Shifts Directors Burden from Shareholders to Creditors” (1994) 19 Delaware Journal of Corporate Law 177 (discussing developments in the United States); R Rao, D Sokolow and D White, “Fiduciary Duty a la Lyonnais: An Economic Perspective on Corporate Governance in a Financially Distressed Firm: (1996) 22 Journal of
Corporation Law 53 (same). The theory of the shift is that shareholders are no longer the residual claimants of
the firm’s assets when a firm is insolvent, creditors are. The character of the duty does not change. The directors are obliged to act with reasonable care and in good faith. Under even the most robust applications of the doctrine, there is no absolute prohibition on the incurring of new debts when a company is insolvent, although the activity may, under a given set of facts, constitute director misbehaviour.
40. We will catch a few more intentional wrongdoers because it is easier to prove a case against an intentional wrongdoer under insolvent trading provisions than under fraudulent trading provisions even though the later statutes apply. And insolvent trading provisions will catch a few somnolent directors for their lack of attention to their firm’s financial affairs, situations in which fraudulent trading provisions do not apply.
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Corporate Directors’ Personal Liability for “Insolvent Trading” in Australia