Director’s Duties and Liabilities in the Face of Corporation’s Insolvency
Insolvency occurs when a corporation is unable to pay its liabilities as they become due. In Canada, it may be possible for a corporation to continue its operation with the indulgence of its creditors for a period of time. Alternatively, the creditors may require the company to restructure under a private agreement or under the BIA or CCAA. Secured creditors may take steps to have a receiver appointed, to realize and liquidate the assets of the company.
a) Directors’ Duties
In Canada, it appears that directors have a duty to consider and act in the best interest of creditors when the corporation becomes insolvent or nears insolvency. If a receiver-manager is appointed by the creditors, the powers of the directors are suspended until the receiver is discharged. The receiver has the power to carry on the business in order to protect the security interest of those creditors who appointed them
Any action of the directors to move assets out of the corporation will be scrutinized by the receiver-manager to ensure that it did not precipitate the insolvency. Such actions include paying dividends and/or redeeming shareholder’s shares. If the receiver-manager can prove that the action precipitated insolvency, they have the authority to start an action holding the directors personally liable to return the funds to the corporation. Similarly, any payment to creditors will be reviewed to see if it constituted a fraudulent preference. A trustee in bankruptcy may also review certain non-arm’s length transactions in which the corporation was involved.
b) Personal Liability
Wages, Vacation Pay and Termination Pay
Both the Ontario and federal corporate statutes impose personal liability on directors for the payment of wages not exceeding 6 months, for services performed while the directors held office and up to 12 months of vacation pay under the Employment Standards Act. The Supreme Court of Canada ruled in Crabtree Estate that directors are not liable for termination pay in lieu of notice under the CBCA. Directors are not held liable for amounts owing to employees unless they are sued while a director or within 2 years after ceasing to be a director. Under the OBCA, the director must be sued while he or she is a director or within 6 months after ceasing to hold that position.
Directors are only liable for the amounts that accrued while the directors held office. Therefore, some directors have chosen to resign when it becomes obvious that the corporation will not be able to satisfy its obligations in the future.
It must be noted that directors are jointly and severally liable with all of the other directors for wages, however any director who has paid a claim is entitled to contribution from the other directors who were liable for the claim.
Various amounts are required to be deducted from employees’ wages and remitted to the government. Examples include income taxes and employees’ premiums for employment insurance and contributions to the Canada Pension Plan. If a corporation fails to deduct and remit these amounts, the directors at the time may be held jointly and severally liable for the amounts, including interest and penalties.
A possible defence for directors is that of due diligence. Directors must be able to show that they exercised the degree of care, diligence and skill and took positive steps to ensure that source deductions are being made and remitted that reasonably prudent persons would have exercised in comparable circumstances. One way is to implement a procedure requiring senior management to certify to the board on a regular basis that the source deductions have been paid to the government. This confirmation should be given more frequently when there are signs of financial instability.
Dividends/Redemption of Shares
A director may be personally liable for dividends paid, redemption or purchase of shares if these purchases were made while the corporation was insolvent during the 12 months preceding its bankruptcy under s. 101 of BIA. If the event occurred more than 12 months prior to the bankruptcy, the trustee or creditor would have to look to the relevant corporate statute instead. There is a due diligence defence available if the directors can show they had reasonable grounds to believe the company was solvent, or would not become insolvent as a result of the payment. The court will look to see if the directors acted as prudent, diligent persons would have acted in similar circumstances and whether they relied in good faith on financial statements or professional reports.
Directors should be aware that there are different solvency tests that must be satisfied if a corporation is paying a dividend, purchasing shares or redeeming shares. Under the Ontario and federal corporate statutes, the corporation cannot purchase shares or pay a dividend if there are reasonable grounds for believing that:
i) the corporation is, or after the payment would be, unable to pay its liabilities as they become due, or
ii) after the payment, the realizable value of the corporation’s assets would be less than the aggregate of its liabilities and its stated capital of all classes. (OBCA 30(1), CBCA 34(1)).
Directors who consent to a resolution authorizing payment in contravention of the section are jointly and severally liable to restore to the corporation any amounts paid out.
There are 5 exceptions that permit the purchase of shares after meeting a more lenient solvency test (OBCA 31(1), (2) & (3), CBCA 35(1), (2) & (3)):
Similarly, with the redemption of shares, under s. 32(2), there is a solvency test that must be met that is much like the test under OBCA s. 31(3).
We recommend that prior to becoming a corporate director you fully understand your duties and liabilities, including those arising in an insolvency situation. Similarly, if you are the director of a corporation that is facing insolvency you should review your duties and liabilities with a lawyer to ensure you continue to comply with your duties and you limit your personal liability to the extent possible.
Koby Smutylo – Business Law
236 Metcalfe Street, Ottawa, Ontario K2P 1R3 Canada
Telephone: 613 869 5440 • Facsimile: 613 691 0661 •email@example.com