Although the COVID-19 crisis could certainly be a catalyst for the deterioration of a company's financial situation, each company faces a different level of hardship, with the associated legal characterisation and procedures. This section outlines three types of measures: (a) internal measures in the event of a capital impairment, (b) controlled management (gestion contrôlée) in the event of a temporary inability to face payment obligations, and (c) bankruptcy (faillite) should the company's financial situation be irremediably compromised. All of these measures are aimed at dealing with various levels of financial distress (in view of remediation or realisation of the company's assets) and discusses certain risks for directors in terms of liability.
1 July 2021
Suspension of the one-month deadline to declare bankruptcy until 31 December 2021
Pursuant to the Act of 30 June 2021 amending the Act of 19 December 2020 on the temporary adaptation of certain procedural provisions in civil and commercial matters, the one-month deadline to declare bankruptcy (Art. 440 Commercial Code) has been suspended until 31 December 2021.
2 July 2020
Capital impairment and related director's liability
Following the diagnosis of the company's financial health, e.g. after review of the company's interim financial statements based on the most recent developments, the directors will be able to assess the company's net asset position and determine whether capital impairment has occurred (i.e. if, pursuant to losses incurred, the value of the company's net assets has fallen below half or a quarter of its share capital), in which case the directors shall launch the so-called alarm bell procedure.
The directors are obliged to regularly assess the proper keeping of the company's books and accounts. Moreover, the knowledge of a capital impairment is not affected by prior approval by shareholders of the financial statements (annual accounts). As a result, the directors must be able to assess the financial situation (and potential capital impairment) of the company on a continuous basis.
It should be noted that the alarm bell procedure should be initiated as soon as the directors learn of the capital impairment (e.g. based on invoice(s) received or payment requests), regardless of the preparation of formal interim accounts.
In the context of the alarm bell procedure, the board of directors must prepare a special report to explain the reasons for the company's financial situation and justify its proposals (be it the winding-up of the company or its continuation). Any proposal to continue the activity of the company should be supported by a description of the measures to be adopted in order to remedy the company's financial situation.
Failure by the directors to prepare such a special report for consideration by the company's shareholders will render any decision taken by the shareholders with respect to the winding-up or continuation of the company null and void, unless the shareholders have unanimously waived this requirement. In addition, the directors will be personally and jointly and severally liable to the company for all or part of the increase in the losses suffered.
Needless to say, in the context of the current COVID-19 crisis, directors should closely monitor the company's net asset position (in particular in terms of potential value impairment, which could lead to a sudden drop in the company's net asset value) and keep a close eye on the abovementioned thresholds.
Controlled management - an attempt to cure a compromised financial situation
A debtor may apply for controlled management if it is unable to obtain credit (ébranlement du credit) or temporarily unable to face its payments obligations but, despite this situation, (i) still has a chance of resolving its financial problems or (ii) controlled management would improve the likelihood of the debtor's assets being realised in the interest of its creditors.
Controlled management will result in either a reorganisation of the debtor and a remediation of its liabilities or the realisation of the debtor's assets to satisfy its creditors, i.e. a winding-up scenario. However, in practice, a successful application for controlled management may prove difficult, as many debtors applying for such relief cannot evidence that they would benefit from it. Rather, a declaration of bankruptcy will be the only available option should the company's financial situation be definitively compromised.
Bankruptcy and related director's liability
A director may manage a company with care, seek advice from financial and legal advisors when difficulties arise, monitor and assess on a regular basis the company's financial situation and even try to restructure the company, should the need arise, and yet still be faced with the company's bankruptcy.
Any company that ceases making payments and whose credit is in jeopardy shall be considered to be in a state of bankruptcy.
In the context of the current COVID-19 crisis, it should be stressed that the origin of the suspension of payments is irrelevant (e.g., it does not matter if it results from the fault of the debtor or from an event of force majeure).
If cash flows are insufficient and trust breaks down, the company will be deemed bankrupt. In such cir-cumstances, the directors of the company shall, within one month from the date of the suspension of payments, file for bankruptcy with the clerk of the district court of the place where the company has its registered office. If the directors fail to act as described above, they may be sued, under certain circumstances, for negligent or fraudulent bankruptcy, both of which constitute criminal offences under Luxembourg law.
In the context of the COVID-19 crisis, the Luxembourg government issued a Grand Ducal Decree on 25 March 2020, as amended by a Grand Ducal Decree dated 29 April 2020, in order inter alia to suspend the deadline for filing for bankruptcy for up to two months following the end of the state of emergency in Luxembourg. A further Act passed on 20 June 2020 expressly provides under its article 9.3° that the deadline for filing for bankruptcy is suspended for a period of 6 months following the end of the state of emergency, which formally ended on 24 June 2020. This new piece of legislation entered into force on 25 June 2020.
In practice, this would give directors additional time to (i) resume the company's activities and restore cash flow, thereby allowing a clearer assessment to be made of the potential evolution of the company's liquidity situation over the next few months and its ability to face its liabilities, and (ii) negotiate with the company's creditors and banks with a view to remedying liquidity shortages or reducing liabilities (e.g. through refinancing or a debt-to-equity swap). However, directors should not misinterpret these favourable provisions as a blank cheque from the government to pursue the activities of a business that is already compromised, thereby increasing its losses, and should remain aware of their potential liability should the company ultimately be declared bankrupt.
Director's liability in the context of bankruptcy
Directors should refrain from distributing interim dividends or other amounts to the company's shareholders in the current context if the financial situation of the company does not permit this possibility. While the distribution may be regular (i.e., it complies with the legal requirements), if the amount thereof places the company in financial jeopardy (meaning the company may not be able to face its liabilities due to a shortfall in liquidity or available reserves following the dividend distribution), the directors could be held civilly liable to creditors in tort.
Besides, in the event of bankruptcy, the Commercial Code provides for three grounds on the basis of which the (former) directors of a company may be held personally bankrupt, ordered to contribute to the company's debts, or prohibited from engaging in commercial activities or serving as a company's representative or auditor. It should be noted that these additional grounds do not preclude action on the basis of the general liability rules.
Most of these sanctions require gross misconduct on the part of the directors. Gross misconduct is defined in the case law as a serious wrongdoing that a reasonably prudent director (bon père de famille) would not have committed under the same circumstances, with reference to the director's discretionary authority and the facts known to him or her at the time the wrongdoing was committed. The characterisation of gross misconduct is a question of fact.
Mitigation of director's liability
If a company is declared bankrupt, the court will decide whether to hold the directors liable for the company's outstanding debts, to declare the directors personally bankrupt or to prohibit them from engaging in certain activities, after having performed a marginal review to determine if the bankruptcy was caused by serious wrongdoing on the part of the directors which can be considered gross misconduct on their part.
As the characterisation of gross misconduct is a question of fact, the court will consider, whilst taking into account the current exceptional circumstances of the COVID-19 crisis, whether the directors took measures to prevent the bankruptcy.
In this regard, whether the directors have taken the necessary steps to assess if the company was vulnerable and to mitigate the financial risks for the company (i.e. negotiation with business partners and banks, actively seeking ways to benefit from initiatives and measures that have been put in place in relation to the COVID-19 crisis) will play a primary role in the court's review.
1. It goes without saying that failure by the directors to take any of the abovementioned steps to mitigate the risk of bankruptcy for the company will qualify as gross misconduct on their part, and the court could be justified in holding the directors personally liable (at least in part) for the company's outstanding debts.
2. In addition to the foregoing and in general, the directors must:
- always act in the company's best interest, i.e. place the company's interest first when taking decisions;
- when defining corporate strategy, act as a reasonably prudent person (bon père de famille) and (i) manage the company's business in good faith and with due care, in a competent, diligent, prudent and active manner, in the company's interest, (ii) respect the duties imposed by law and the company's articles of association, and (iii) do nothing that falls outside the company's corporate interest;
- actively scrutinise the financial position of the company in order to identify any liquidity risks as well as any risk of capital impairment and initiate the alarm bell procedure in a timely fashion, so as to limit their liability to the company for any increase in losses;
- when in doubt, the directors could seek external financial advice in order to obtain additional comfort on the short-term prognosis of the company's cash position and thus mitigate their potential liability;
- actively supervise and review the preparation of the company's financial statements, to ensure that they provide an accurate view of the company's accounting position. This is also required in order for the directors to be released from liability to the company for acts recorded in the company's books of account at the time discharge is granted to the board by the annual general meeting. It should be recalled that discharge is valid for the period covered by the accounts presented to and approved by the meeting only if the accounts do not contain any errors, omissions or false statements.
Considering the current exceptional situation, directors are expected to act exceptionally. For this purpose, if a weakness is identified early on when assessing the company's current and contingent obligations, it is highly recommended that the directors hold regular meetings to monitor the evolution of the company's financial situation as well as that of its subsidiaries, especially if the company has agreed to act as guarantor for the satisfaction of monetary obligations by its subsidiaries (e.g. in order to avoid cross-default).
Although this will not resolve existing financial problems, real-time monitoring and quick, transparent communication with the company's legal and financial advisors will facilitate a more efficient response and mitigate the exposure of the company and that of its directors.