During times of crisis, where there is no chance of refinancing a company’s debt, the board of directors must initiate insolvency proceedings.
We are going to focus on the duties of directors of an insolvent company. Directors of a company have a duty to act with honesty, diligence and prudence, the so-called duty of care. Directors will be held liable if they fail to comply with their obligations, not only to the company itself, but also to the creditors. This liability can be civil and/or criminal.
Insolvency: Effects of insolvency proceedings on directors
There are two types of insolvency proceedings in Spain:
- Voluntary insolvency proceedings: when the board of directors voluntarily requests the initiation of insolvency proceedings
- Necessary insolvency proceedings: when a third party requests the initiation of insolvency proceedings.
In voluntary proceedings the board of directors maintains its powers of management and control over the assets of the company, although they are under the surveillance of insolvency administrators from whom they may require authorization to carry out certain actions.
In necessary proceedings, the management powers of the board of directors are suspended. The powers previously held by the directors are transferred to the insolvency administrators.
Therefore, if the board of directors wants to keep its powers, it should be aware of the company´s situation in order to know whether insolvency proceedings are obligatory or not, so they can voluntary request the initiation of insolvency proceedings.
Should the insolvency proceedings result in the liquidation of the company the judicial resolution initiating such liquidation includes the declaration of the dissolution of the company and the cessation of the directorships. Insolvency administrators will be substituted for the directors.
Once the liquidation begins, the insolvency administrators must file a plan to sell assets and rights of the company. This plan will be on the public record and directors and creditors will be allowed to review it in the corresponding commercial court. Both are entitled to file petitions for the modification of its content if appropriate.
Insolvency: Duties of the Board of Directors
The board of directors must request the initiation of insolvency proceedings when the company cannot regularly comply with its financial obligations. Upon learning of the insolvency situation, the board of directors must request the initiation of the insolvency proceedings within two months.
The law provides that the board of directors is presumed to be aware of the situation of insolvency, iuris tantum, when one of the following situations occurs:
- Obligations of the company are regularly unpaid
- Company assets have been seized that affect generally the company’s assets
- Hasty liquidation of the assets of the company
- General failure to comply with the following obligations: tax payments, social security payments, salaries, severance payments and similar during the three months prior to the initiation of insolvency proceedings.
Directors are duty-bound to be aware of these situations and, if appropriate, request the initiation of the insolvency proceedings as soon as possible. Upon such request, the directors must personally appear before the relevant commercial court and the insolvency administrators as many times as required in order to cooperate and provide all necessary information requested.
Directors cannot wind up the company until authorized by the court. Directors cannot place burdens upon the assets and rights of the company until they have the relevant authorization. They can, however, perform what it is necessary for the continuation of the regular activities of the company.
Directors must also provide the insolvency administrators with all accounts regarding the assets and equity of the company. The obligation of preparing and auditing the annual accounts remains with the directors. There is, however, an exception for the audit of the annual accounts when the insolvency administrators have been appointed. This exemption does not apply when the company has securities in secondary markets or when it is under public surveillance by the Bank of Spain, the General Directorate of Insurances and Pensions or by the National Commission of the Spanish Stock Markets.
Thus, the preparation of the annual accounts is a responsibility of the directors during the insolvency proceedings, overseen by the insolvency administrators, and is the responsibility of the insolvency administrators when the powers of the board of directors are suspended.
Classification of insolvency proceedings and directors’ liability
In order to know whether a director can be held liable for the insolvency of a company, we look to the classification of the insolvency proceedings made by the courts. Insolvency proceedings can be classified either as accidental or fraudulent
If the report of the insolvency administrators or, where appropriate, the public prosecutor, classify the insolvency as accidental, the judge will immediately order the termination of the proceedings against the directors.
Directors’ liability in fraudulent insolvencies
Where the insolvency is classified as fraudulent, the company is entitled to a hearing within ten days and the court will summon all persons affected by such classification, so they can appear before the court within five days if they have not previously appeared.
The insolvency of a company can be deemed fraudulent where there is a failure of the duty of care of the directors, i.e., that the behavior of these individuals has produced or aggravated the insolvency of the company.
Also, when one of the following events takes place the insolvency is automatically deemed fraudulent:
- Failure to comply with accounting obligations
- Filing of inaccurate or fake documentation within the framework of the insolvency proceedings
- When the liquidation is initiated by order of the State
- When the company sells all or part of its assets in a way that is prejudicial for the creditors or prevents a seizure from being effected
- Fraudulent use of goods and/or benefits within two years prior to the declaration of insolvency
- Prior to the declaration of insolvency carrying out a legal action to simulate a fictitious financial position.
The judgment of the commercial court holding that the insolvency is fraudulent will set out the reasoning behind such classification and also refer to the following matters:
- Persons affected by the classification
- The court can bar these persons from the management of assets of natural or legal third parties from two to fifteen years. They will not be allowed to represent any person during that period of time. The penalty will vary according to the seriousness of the particular facts
- These persons can lose any rights with regard to the insolvency proceedings and they may have to reimburse all assets and rights that have been inappropriately acquired. They may also have to pay the corresponding damages
- These persons may also be held responsible for all or part of deficit of the liquidation.
In addition, the Insolvency Law provides that seizures of personal assets of current and former directors (that held office up to two years before the bankruptcy) can be carried out. This preliminary injunction can only be ordered when there is enough evidence for the bankruptcy to be classified as fraudulent and the equity of the company is not enough to pay all its debts. The judge will determine the amount of the seizure. This can be replaced by a bank guarantee if preferred by the directors.
The current Insolvency Law in Spain increases the level of liability of directors of a company. Therefore, directors must pay attention not only to the accounting and management aspects of the company, but also to the legal issues relating to their business and agreements, in order to avoid liability within the framework of a insolvency proceedings.
This article is not considered as legal advice