Directors Duties in the UAE: Part 3 – Duties in times of Financial Uncertainty

Introduction

With global economies facing uncertain times as a result of the COVID-19 pandemic, and many businesses facing significant challenges to cash flow, revenue and bad debts, the possibility of insolvency will be very real for some companies in the UAE. In such circumstances it is important that directors fully appreciate how their duties and liabilities will be impacted and ensure decisions made in a financial distress situation are made in full consideration of these.

In ordinary conditions, directors generally focus on their duties to the company and manage it primarily for the best interests of its shareholders as a whole. Concerns relating to third parties (creditors etc) are relevant, however the focus in that regard is more often about managing those third party interests for the benefit of the company (and its shareholders) rather than as a result of any duties owed to those third parties. However, in situations where the company is in financial distress, the duties owed by the company’s directors take on a new dimension, where those duties extend towards those third parties directly. The actions and decisions of directors in these circumstances will be carefully reviewed, particularly if the company later finds itself in an insolvency situation, to confirm whether it has managed the company’s business correctly with a view to all relevant stakeholders, including its creditors.

On top of the day-to-day duties owed by directors, special duties and potential liabilities come into play when a company is potentially facing an insolvency situation. In current market conditions, directors should be focussed on maintaining cash/capital, keeping close control on their company’s obligations and keeping a clear overview on upcoming payment amounts and timelines to ensure they have enough liquidity to meet the short and medium term obligations of the company. In times of financial hardship where cash flow and reserves may be impacted, and in light of the common market practice of issuing post-dated cheques, directors must be wary of signing any current or post-dated cheques that may not be honoured. In addition, whenever possible, directors should engage in constructive dialogue with the payees of previously issued post-dated cheques and seek to replace those cheques with an alternative funding or payment arrangement which would not expose them to the risk of cheques not being honoured. All decisions taken by directors in managing the company should be taken with a view to ideally avoiding a potential cashflow insolvency scenario, or if that is unavoidable, to manage their business in a way which doesn’t expose the directors to claims of mismanagement and liability under applicable insolvency regimes.

This is the third note in a three-part series covering directors’ duties for companies operating in the UAE. Part 1 covers the basics of directors duties for “onshore” LLCs and PJSCs operating in the UAE (click here), while Part 2 examined how directors’ duties change in the context of group structures (including a look at ADGM and DIFC holding vehicles and related directors duties) (click here).

The Federal Bankruptcy Law

Federal Law No. 9/2016 (the “Bankruptcy Law”) applies to all companies established under the UAE Commercial Companies Law (Federal Law No. 2 of 2015 - the “CCL”) and most free zone companies (except free zones with their own insolvency regime such as the DIFC and ADGM), individuals that are defined as traders and certain civil companies. Bankruptcy under the Bankruptcy Law is assessed on a cashflow basis and on a net asset basis (the “Bankruptcy Test”) – has the company been unable to pay its debts when they fall due for more than thirty consecutive business days, or are its assets less than its liabilities?

Before discussing the duties owed by directors in these situations, it would be worthwhile setting out some basic information about how the Bankruptcy Law works. In brief, the Bankruptcy Law provides for two primary options for businesses in financial distress:

1. Preventive Composition: A preventative composition is a process initiated by the company in times of financial hardship to ask for the court’s assistance in settling debts with its creditors with the aim of working through the existing financial hardship to recover the business. As the name suggests, this is a process only available for companies that do not meet the formal Bankruptcy tests, but where the directors of the company feel that they will be unable to trade out of their existing indebtedness.In a preventative composition, the company would make an application to the court supported by a detailed overview of its trading position and net assets (and various other information) and their plan for how the preventative composition plan should proceed to enable them to settle their debts to a position where they can exit the plan and begin business as usual again. If the court accepts the application, the company’s debt obligations will be suspended, during which time the court will appoint a trustee to supervise the directors’ management of the company. The trustee would seek to agree a plan for the company to trade out of its existing position, which plan would require the approval of a majority of its creditors holding not less than two thirds of the value of the total outstanding debts of the company. The trustee, with assistance of the court, would then oversee implementation of the preventative composition plan over a period of up to three years. During the term of the plan, the company is restricted from taking certain measures (such as settling claims that arose prior to commencement of the plan, taking on new debt or disposing of its assets etc) and must generally manage the business in accordance with the terms of the court-approved plan and under the supervision of the trustee and the court. If at any time during the implementation of the plan, the company fails the Bankruptcy Test or the court determines that the plan is impossible to implement, it may terminate the plan and convert it into a declaration of bankruptcy, described below;
2. Bankruptcy: The second main option is a formal bankruptcy process. A bankruptcy process can involve either a rescue procedure, or a liquidation. Under the Bankruptcy Law, directors of the company must file for bankruptcy where the company fails the Bankruptcy Test. A creditor with a debt in excess of AED100,000, and which has not been paid for thirty business days after final demand, may also petition the court for bankruptcy to recover the debt due to it. The initial view to be taken by the court is to assess whether the company can be restructured, settle its debts, and become profitable again. So, similar to the preventative composition, an expert and trustee are appointed to determine the company’s financial position, compile a complete list of creditors, and assess whether the company can be restructured in order to become profitable once more. Any such plan presented to the court requires the approval of the company and the approval of a majority of its creditors holding not less than two thirds of the value of the total outstanding debts of the company. The trustee and company then implement the restructuring plan, in a similar way to the preventative composition plan.If a restructuring is not possible, the court shall issue a judgment to declare the company bankrupt and order liquidation of its assets. A declaration of bankruptcy and liquidation could also be issued in a range of other scenarios, including if the required majority approval of creditors is not reached for the restructuring plan, or if the company applied for bankruptcy and is deemed to have acted in bad faith or applied in order to delay or evade payment to a creditor. Once bankruptcy is declared, the trustee shall arrange to liquidate the company and its assets and distribute the proceeds to the creditors in order of priority, and the balance back to the company for distribution among its shareholders.

This illustrates how, in times of financial distress, the law redirects the obligations of the company, and therefore the directors of the company, towards its creditors. This puts a different and very important spin on the obligations directors owe under law in these circumstances.

Directors and managers may face personal liability for taking certain actions in these situations. This will be of key concern to directors and managers and should be of concern to anyone who is actively involved in the management of the relevant company as a result of the wide definition of manager used in the Bankruptcy Law. Any person working at the company and playing an active role in the decision-making process is to be considered as a manager for the purposes of the penalties applicable under the Bankruptcy Law, this includes any person under whose directives and instructions the managers operate. Therefore, this could extend to parent company directors or those who are not listed as a manager on the licence or appointed a director but nevertheless play as active role in the management. The Bankruptcy Law has not yet been fully tested and claims under the Bankruptcy Law provisions are only recently starting to come through the courts so it remains to be seen how these provisions will be interpreted in practice. Nevertheless, we would expect more cases to come out of the current financial situation and would advise directors, managers and anyone else involved in the decision-making process to take a cautious approach in this regard.

Actions which can result in potential personal financial liability for directors include:

1. where the court determines that the company’s assets cover less than 20% of its debts and the directors or managers are proved to be liable for the company’s losses due to a breach of their duties under the CCL (see Part 1 of this series, link above). In this situation, the court has the authority to declare each director and manager jointly and severally liable to pay all or any of the company’s debts. For service-based companies, software platforms and so on, this may be of more relevance than a more asset-heavy business (for example a real estate developer or manufacturer), but given the potentially severe consequences of a breach, keeping careful control over a company’s balance sheet should be kept firmly in mind by all directors and managers; and
2. in the period of two years prior to a declaration of bankruptcy, if the directors or managers, or any one of them, is found to have disposed assets at an undervalue, given preferential treatment to creditors or used commercial methods “without considering their risks” (such as commercial deals which are not on arm’s length terms entered into to avoid or delay bankruptcy). In this case, again, the directors or managers (or any of them) can be jointly and severally liable to pay any or all of the company’s debts, save for any director or manager who voted against taking the relevant action. The directors and managers have a defence in this case if they can prove that they have taken all precautionary measures to minimise potential losses in relation to their assets and the company’s creditors

Directors and managers can also be found criminally liable under the Bankruptcy Law in situations involving:

1. impropriety to cover up the company’s financial position;
2. a failure to supply information requested to a court or trustee;
3. selling assets at an undervalue to delay the suspension of debt payments or declaring the company bankrupt;
4. hiding company property from creditors; and/or
5. paying, or providing benefits to one creditor at the detriment to the others.

Where a company is declared bankrupt, the directors and managers may be punished by imprisonment for up to two years if they committed any of the following acts:

1. used their power improperly;
2. failed to maintain commercial books that are sufficient to reveal the company’s financial position or failed to conduct inventory-taking as imposed by law;
3. failed to provide data required by the appointed trustee or intentionally provided incorrect data;
4. disposed of the company’s assets after cessation of payment with the intent to keep them away from the creditors;
5. paid a creditor’s debt after cessation of payments by the company, to the detriment of the other creditors, or gave preferential treatment to one creditor over the rest, even with the intention to achieve preventive composition or restructuring;
6. disposed of the company’s assets for less than market value, or resorted to any methods that are detrimental to the interest of the creditors with the intention of obtaining money to avoid or delay cessation of payment, adjudication of bankruptcy or termination of the preventive composition or restructuring;
7. spent large sums gambling or speculating when not required by the company’s activities; and/or
8. made serious financial commitments relative to its financial position at the time for the benefit of parties other than the company and without compensation.

Given the potential personal liabilities of directors and managers under UAE law, it is imperative that directors and managers pay close attention to their duties and obligations and the remit of their powers (both under law and those granted by the shareholders) when making decisions in respect of a company, and even more so where there is potential for the company to find itself in an insolvent position or bankruptcy. Importantly, a director may be found liable even where the intention was to try to prevent or delay cash flow insolvency. For example, directors will need to carefully consider their duties and obligations when taking out additional corporate loans or deciding to dispose of assets or settle the debts of related parties or specific creditors.

In addition to the above, directors and managers can be liable to imprisonment for a period of up to five years and a fine up to AED 1,000,000, if they commit any of the following acts after the issue of a decision to open proceedings against the company:

1. hide, destroy or amend all or some of the company’s books with intent to cause prejudice to the creditors;
2. embezzle or hide part of the company’s assets;
3. declare debts not due from the company while aware of them, whether the declaration was in writing, verbal or in the budget, or refrain from submitting papers or clarifications while being aware of the outcome;
4. obtain preventive composition or restructuring for the company through fraud; and/or
5. make false declarations about the subscribed or paid-up capital, distribute fictitious or seized bonuses exceeding the amount set out in law, the company’s memorandum of association or articles of association.

These penalties do not apply to a director or manager who is either: (a) proven to not be involved in criminal activity; or (b) established reservations over the decision leading to the activity. As a result, directors must maintain detailed minutes of all board minutes so that all decisions relating to the financial aspects (including the acquisition and disposal of assets, entry into commercial contracts or any important decisions taken on behalf of the company) are carefully recorded. If the directors do not agree on a specific matter, the minutes should specifically note each directors’ opinion and therefore any reservations over the decision leading to the activity.

Additionally, it is worth noting that there is relief provided under the Bankruptcy Law, allowing for a stay of criminal proceedings where bounced cheques were issued prior to the commencement of a scheme of composition or restructure. All judicial proceedings are suspended once a court decides to proceed with an application for a preventive composition or rescue/rehabilitation procedure. Bankruptcy proceedings take precedence over criminal proceedings preventing criminal courts from considering such claims and proceedings. The recipient of a cheque which was not honoured will be considered an unsecured creditor for the purpose of the bankruptcy proceedings.

DIFC/ADGM Insolvency Regime

The DIFC Insolvency Law (Law No. 1 of 2019) applies to companies established in the DIFC and provides for a range of options from company voluntary arrangements, rehabilitation and restructuring, to administration, receivership and liquidation (voluntarily or court ordered). Similar provisions apply in the ADGM under the ADGM Insolvency Regulations 2015.

The DIFC Insolvency Law and ADGM Insolvency regulations contain broadly similar acts for which directors or officers may be held liable in the event of winding up or administration of the company, including:

1. various acts of fraud in anticipation of winding up which took place within the twelve months preceding winding up or administration;
2. falsification of company books;
3. material omissions from statements relating to company’s affairs;
4. false representations to creditors;
5. fraudulent trading;
6. wrongful trading (see below); and
7. misconduct in the course of winding-up.

Where a director or officer has been found to have carried out one of the above acts, the court may (in response to an action by any aggrieved person including an administrator, liquidator, administrative receiver, creditor, shareholder or other person liable to contribute to the assets of the company (e.g. a guarantor)), make any order it sees fit against such person. These orders may include requiring the director or officer to:

1. repay or account for any funds misapplied or retained (with interest);
2. pay compensation for any breach of duties; and/or
3. contribute to the company’s assets.

It is therefore important that directors and officers play close attention to their duties and potential liabilities as they go about making decisions for a company in financial distress as these decisions will be closely by any administration, liquidator, receiver or other stakeholder in the event the company finds itself in an insolvency process down the line.

Wrongful trading

Of particular concern to directors attempting to trade out of a situation of financial distress will be the potential liability for wrongful trading. It is a defence under both the DIFC and the ADGM insolvency regulation for the director show that after he/she first knew (or ought to have concluded) that there was no reasonable prospect of the company avoiding going into insolvent liquidation, he/she took every step with a view to minimising the potential loss to the company's creditors as he/she ought to have taken and which a reasonably diligent person (being someone with the actual general knowledge, skill and experience of the director and the knowledge and skills expected of someone in his/her position) would have done.

Some additional relief for DIFC directors and officers will come from the suspension of wrongful trading provisions and related liability for an emergency period from 21 April 2020 to 31 July 2020 (as may be extend) under the DIFC’s Presidential Directive No. 4 of 2020 in Respect of COVID-19 Emergency Measures (the “DIFC COVID-19 Directive”). The DIFC COVID-19 Directive states that the suspension of the wrongful trading rules “is intended to ensure that directors of DIFC companies in the current uncertain environment are able to take decisions to continue to trade, incur new credit and make decisions which may otherwise cause directors concern about the potential for personal liability under the wrongful trading regime set out in Articles 113 and 115 of the Insolvency Law”. This should give directors comfort that the DIFC Authority is encouraging businesses to continue to trade, to maintain cashflow and protect the medium-term. At the time of writing no equivalent exemption had been issued in the ADGM. However, in light of the incorporation of and reliance on English law in the ADGM, it may be relevant and encouraging that wrongful trading provisions in England and Wales have been suspended in response to the COVID-19 pandemic.

Other group companies

We have also reported on a recent decision on directors’ duties on company insolvency in the UK which will be of interest to groups which include an entity registered in England and Wales, please see our Law-Now here. Given the heavy influence of English law in the DIFC and indeed, incorporation of English common law in the ADGM, this finding is also likely to be relevant to companies established in those financial free zones.

GUIDANCE FOR DIRECTORS

In light of the duties and potential liabilities of directors in the UAE, in carrying out their functions and making decisions, all directors should:

1. remember that if they act in breach of duty, it is possible that they could be liable to pay money to the company even if it suffers no loss or in certain circumstances face criminal liability;

1. make sure they have access to sufficient information about the business, activities and financial position and prospects of the company to make an informed decision about what is in its best interests. In particular, they will need to know about any commitments or events that could threaten the company’s ability to continue trading on a solvent basis;
2. be particularly cautious about approving any course of action that seems to provide little or no benefit to the company, either directly or indirectly – e.g. where the company is being asked to assume or guarantee a liability of its parent or a sister company - or where the consideration or other quid pro quo to be provided by the counterparty in return for a transfer of the company’s assets may not be worth its face value – e.g. where the consideration is in the form of securities or other assets that are illiquid and/or difficult to value;
3. remember that it is not just where the company goes insolvent that a director could be at risk of a claim being made against them. If the company is sold, and the new owner considers that, for example, the company’s position or prospects were worsened by transactions that the director approved, they could cause the company to bring claims against the director. And, depending on the company’s activities, a regulator might be able to bring criminal or civil proceedings against the director – e.g. where the company or its subsidiaries have been involved in breaching legislation relating to bribery or anti-competitive practices;
4. record in the board minutes or related documents the reasons why the director believes a course of action is in the best interests of the company. They may also consider obtaining confirmation or advice from an independent third party – e.g. to value illiquid assets. Any objection by a director to a decision by the board should also be clearly recorded in the minutes;
5. ensure their decisions as to whether the company should follow a course of action is based on their own independent view of what is in the best interests of your company. A director may take into account the interests of their appointing shareholder and may be able to decide that the course of action preferred by their appointing shareholder is also in the company’s best interests. But where the best interests of the company differs from those of the director’s appointing shareholder or another group company, the director must do what is in the best interests of the company he/she is acting for - even where that means the director will risk incurring the wrath of their appointor, losing their appointment and/or damaging their career prospects;
6. where there is in any doubt, ask the company’s shareholders to approve the relevant course of action. Such an approval is unlikely to completely protect a director against personal liability, particularly if the course of action is plainly not in the company’s best interests and/or the company is or may be insolvent, but in some circumstances it may help. Taking legal advice on the particular circumstances is of course also a good idea.

Please do get in touch if you would like advice on your duties and potential liabilities in the current climate or in your specific circumstances