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A director may be placed on probation if, during any ten year period, two or more of his companies were unable to pay their debts in full

Orders of probation, coupled with an order for the payment of compensation, based on a company's inability to pay its debts in full

One of the significant innovations introduced by the Companies Act 2008 in pursuit of its declared objective of enhancing the quality of corporate governance is that a court may make an order that a director be placed under probation on any of several statutory grounds.

Unlike an order declaring a person a delinquent director, an order of probation does not disqualify that person from being a director, save to the extent that a restriction in this regard is made a condition of the order, as envisaged in section 162(9)(a). Nonetheless, the reputational damage caused by an order of probation is likely to be severe.

Being a director of more than one company that has been unable to pay its debts in full

In terms of section 162(7)(b)(iii) of the Act, a court may make an order placing a person under probation if –

"within any period of 10 years after the effective date—

(i) the person has been a director of more than one company, or a managing member of more than one close corporation, irrespective whether concurrently, sequentially or at unrelated times; and

(ii) during the time that the person was a director of each such company or managing member of each such close corporation, two or more of those companies or close corporations each failed to fully pay all of its creditors or meet all of its obligations, except in terms of—

(aa) a business rescue plan resulting from a resolution of the board in terms of section 129; or

(bb) a compromise with creditors in terms of section 155."

The following points are noteworthy in regard to this novel inclusion in the Companies Act –

  • This sub-section came into force immediately the Companies Act 2008 became effective (namely, 1 May 2011) and requires that account be taken of the events within the space of any ten-year period after that date.
  • The provision does not apply if the person in question had, during the given ten year period, been a director of only one commercially insolvent company, or had been a director of several companies but only one had failed to pay its debts or meet its liabilities in full.
  • A court order of probation in the given circumstances is not mandatory, but is within the discretion of the court; thus, even if all the facts envisaged in this provision are established, the court may nonetheless decide not to place the director in question under probation.
  • The order of probation may be made subject to such conditions as the court considers appropriate (section 162(9)(a)).
  • An order of probation may be imposed for a period not exceeding five years (section 162(9)(b)).
  • The person in respect of whom such an order was made can apply to court to have it set aside at any time more than two years after it was made (section 162(11)(b)(ii)).

The ground for making an order of probation, outlined above, must however be read with section 162(8)(b) which provides that a court may declare a person under probation on this basis only if the court is satisfied that –

"(i) the manner in which the company or close corporation was managed was wholly or partly responsible for it failing to meet its obligations; and

(ii) the declaration is justi?ed, having regard to the circumstances of the company’s or close corporation’s failure, and the person’s conduct in relation to the management, business or property of the company or close corporation at the time."

There have been no reported judgments to date in relation to these provisions

There has, to date, been no reported decision in which these provisions have been invoked or applied. There is consequently complete uncertainty as to the circumstances in which a court will invoke its discretionary powers to place a director under probation on the grounds outlined above.

In particular, there is uncertainty as to the circumstances in which a court will rule that an order of probation is –

"justi?ed, having regard to the circumstances of the company’s or close corporation’s failure, and the person’s conduct in relation to the management, business or property of the company or close corporation at the time."

The change in the law

Hitherto, the mere fact that a company turns out to be unable to pay its debts or meet its obligations in full, in and of itself has had no legal consequences for its directors.

It was only if the company's debts or obligations had been incurred in circumstances where the company was engaged in reckless or fraudulent trading that there could be consequences for its directors – namely, that a court could then declare those directors who had knowingly been party to such conduct to be personally liable for some or all of its debts or other liabilities in terms of section 424 of the Companies Act of 1973.

Significantly, since the coming into force of the Companies Act 2008, the transitional provisions of that Act provide that section 424 of the Companies Act 1973 continues to apply – but only where a company is being wound up on the grounds that it is insolvent (see Schedule 5, item 9(1) – (2)).

The underlying objectives of an order of probation in these circumstances

Prior to the coming into force of the Companies Act 2008, a person could, with impunity, be a director of any number of companies which turned out to be unable to pay their debts in full, and could walk away from the failed companies, financially unscathed, unless it was held that the company had carried on business recklessly or fraudulently and that he had been party to such conduct.

Sequential corporate failures of course give rise to a suspicion that managerial incompetence on the part of the director may be the common denominator. It was, therefore, not unreasonable for the new Companies Act of 2008 to contain a provision that would empower the court to order, in these circumstances, that a director "undertake a designated program of remedial education" as provided for in section 162(10)(a).

More controversially, however, where a court places a director under probation, it has the power to order, in terms of section 162(10(c), that the person in question –

"pay compensation to any person adversely affected by the person's conduct as a director, to the extent that such a victim does not otherwise have a legal basis to claim compensation".

To this extent, therefore, an order of probation may result in the imposition of civil liability on the director in question without any finding of reckless or fraudulent trading.

The likely impact of these provisions

Despite these new provisions of the Companies Act, it seems unlikely that, in practice, orders of probation will be made on the grounds outlined above, namely that the person in question was a director of two or more companies that, in a ten year period, were unable to pay their debts or fulfil their other obligations in full.

There are several reasons for scepticism as to whether courts will invoke their statutory powers to place a director under probation in these circumstances.

Firstly, there is a limited category of persons who can apply to court for an order declaring a person under probation, namely, the company itself, or a shareholder, director, company secretary or prescribed officer of the company, or a registered trade union that represents the company's employees. Notably absent from this list is the liquidator of the company or a creditor of the company.

It is also significant that, in the absence of an application by someone in these categories, the court has no power, of its own accord, to make an order of probation.

A second reason is that – in the absence of admissions by the director concerned – it will usually require a full-scale trial in its own right to establish the requisite factual basis for the court to make an order of probation, namely –

  • the circumstances of the company's or close corporation's conduct and the person's conduct in relation to the management of the company of the company and
  • that the manner in which the company was managed was wholly or partly responsible for its failing to meet its obligations and
  • that such a declaration is justified having regard to the person's conduct in relation to the management of the company at the time.

(As envisaged in section 162(8)(a) and section 162(8)(b)(i) – (ii)).)

Finally, the new Companies Act ostensibly holds out the possibility of compensation being awarded by the court to a person adversely affected by the conduct of a director in respect of whom an order of probation is made, but the Act radically qualifies this by providing that such compensation can be awarded only where the person so affected does not otherwise have a legal basis to claim compensation, as envisaged in section 162(10)(c).

Given that the conduct of the director in question will surely always have constituted a breach of his statutory duty of care and skill (as envisaged in section 76(3)(c)), the person who has been financially prejudiced by that conduct will, in principle, have a claim against that director for damages in terms of section 218(2), which accords a claim for damages to anyone who suffers damage as a result of any contravention of the Act. The mere availability of this alternative remedy (even if it is not pursued) will automatically disentitle the victim from being awarded compensation for that conduct as part of the order of probation.

Overview

It seems unlikely that, in practice, directors will be placed under probation on the grounds that they have been on the board of two or more failed companies during a ten-year period, and it seems even less likely that a director against whom such an order is made will be ordered to pay compensation to those persons who were adversely affected by the conduct that gave rise to the order of probation.

In short, it seems likely that these provisions of the new Companies Act will in practice be a dead letter and consequently no cause for concern for company directors engaged in high-risk entrepreneurial ventures.

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