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A director may escape accountability for reckless or fraudulent conduct where the company enters into a compromise with its creditors

Liability for reckless and fraudulent trading since the coming into force of the Companies Act 2008

The decision of the South Gauteng High Court in Freidlein Company (Pty) Ltd v Simaan and Others [2012] ZAGPJHC 16, handed down on 16 February 2012, concerns the important question whether a director's personal liability toward a creditor of the company in terms of s 424(1) of the Companies Act of 1973 for participating in reckless and fraudulent trading by the company is extinguished in circumstances where, in terms of an arrangement with creditors, all the company's creditors' claims are ceded to the proposer of the arrangement.

The continued application of section 424

It needs to be borne in mind that, although the Companies Act of 2008 repealed the Companies Act of 1973, the provisions of Chapter XIV of the latter Act remain temporarily in force. These provisions deal with the winding-up of insolvent companies and they remain in force, as an interim measure, until the proposed new Insolvency Act comes into force.

Consequently, section 424 of the Companies Act of 1973 continues to apply to insolvent companies, and the principles laid down in the above case, although it was decided in terms of the Companies Act of 1973, continue to be applicable to insolvent companies even though the Companies Act of 2008 is now in force.

The relevance of section 424 where there has been a compromise with creditors

In the Freidlein case, a company of that name had sought a court order that the directors of Furnex Stores (Pty) Ltd were personally liable for the latter's debts in terms of section 424 of the Companies Act of 1973 on the grounds that the business of the Furnex company had been carried on recklessly or fraudulently, and that they had been parties to this misconduct.

Section 424 of the Companies Act of 1973 provides that -

"When it appears, whether it be in a winding-up, judicial management or otherwise, that any business of the company was or is being carried on recklessly or with intent to defraud creditors of the company or creditors of any other person or for any fraudulent purpose, the Court may, on application of the member or contributory of the company, declare that any person who was knowingly a party to the carrying on of the business in the manner aforesaid, shall be personally responsible, without limitation of liability, for all or any of the debts or other liabilities of the company as the Court may direct."

The interest of the decision in the Freidlein case is that the directors in question argued that they could not be liable under this provision because the Furnex company had entered into an arrangement with its creditors, which had been sanctioned by the High Court, that this arrangement was binding on all the company's creditors, including Freidlein, and that the previous claim which Freidlein had against Furnex had been extinguished by that arrangement; consequently, the Furnex company no longer had any debts for which its erstwhile directors could be personally liable in terms of section 424.

The critical question of law was therefore whether the rights of creditors in terms of section 424(1) had been extinguished when the compromise with the creditors of Furnex was approved by the High Court or whether the creditors retained their claim under that provision of the Companies Act.

In Ex Parte De Villiers and Another NNO: In re Carbon Developments (Pty) Ltd (In Liquidation) 1992(2) SA 95 (WLD), Stegmann J had held that the existence of 'debts and liabilities' was a prerequisite for the operation and functioning of s 424(1) of the Companies Act of 1973, and the judge said in this regard that ?

For s 424(1) to be operable at all, the company must have 'debts or other liabilities'. If the company has no debts and liabilities an essential requirement is missing and s 424(1) cannot provide a remedy. In a case in which the creditors have all agreed in terms of s 311 to a compromise which specifically provides for the extinction of all the company's debts and liabilities, it seems to me to be obvious that s 424(1) cannot possibly function after the extinction of such debts and liabilities by the agreement of the creditors and sanction of the Court.

Stegmann J went on to say that, when a creditor of an insolvent company in liquidation is faced with a proposal under s 311 of the Companies Act of 1973 which involves an offer of compromise whereby he is invited to cede his claims against the company in liquidation in return for a payment under the compromise, the creditor should realise that, if the compromise is implemented, he will cease to be a creditor of the company and will also cease to qualify for any benefit he could have derived under section 424.

The intention of the legislature

It is however certainly arguable - and it was indeed argued in the present case ? that the intention of the legislature in enacting section 424(1) was that persons who knowingly participate in the fraudulent or reckless conduct of a company's business ought to be rendered personally liable for its debts, and that this purpose would be achieved if the personal liability of those persons was preserved, despite the implementation of a compromise with the company's creditors, and that parliament's purpose would be frustrated if such liability were to be extinguished by such a compromise.

Stegmann J said that there was no reason to doubt that, in providing for a compromise between a company and its creditors under section 311, the legislature intended to leave creditors free to deal with their rights as they saw fit, including their rights under section 424(1), and to compromise those rights or to extinguish them as they saw fit.

In the present case, the court found itself in agreement with the views of Stegmann J and ruled that the effect of the compromise with creditors was that section 424(1) could not function after the company's debts had been extinguished by the compromise agreed to by the creditors and sanctioned by the court.

Conclusion

It seems, therefore, that a director, who might otherwise have been faced with personal liability for a company's debts by reason of his being party to reckless or fraudulent trading, will escape accountability if a compromise is entered into between the company and its creditors in terms of which the company's debts are extinguished.

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