A rule in the bankruptcy act that had been in effect for over 10 years presented an impossible dilemma for the senior officers of companies under threat of insolvency. An amendment of the law that recently took effect, however, resolves the stalemate and opens the possibility for managers to make sound business decisions in crisis situations.

You’re damned if you do, and damned if you don’t...

There comes a time in the life of almost every business when it finds itself unable to meet all its due payment obligations at the same time. It’s often unclear, however, whether this inability to pay is just a temporary cashflow problem for the company, or indicative of a deeper problem that’s likely to lead to the company’s bankruptcy.

Until recently, this type of situation presented most managers with a serious dilemma. This is because under an amendment to the bankruptcy laws that took effect in 2006, a manager who, in a situation qualifying as a “threat of insolvency”, failed to take the creditors’ best interests into account was personally liable towards the creditors that remained unsatisfied after the liquidation. A manager was only exempt from this liability if he was able to prove that he had taken all the steps necessary to avoid or reduce the creditors’ losses.

The law, however, offered no guidance on what steps might be sufficient to meet this standard. And this put senior officers in a classic “catch 22” situation. If a manager decided to stop undertaking obligations on behalf of the company in order to avoid further losses, then it could have been blaimed to jeopardise the creditors’ interests by preventing the company’s continued operation. But if the manager undertook further obligations in the name of the company so as to ensure the company’s continued operation, but the company’s solvency was not successfully restored, then the obligations may have been considered to serve to further increase the creditors’ losses increasing, in turn, the manager’s personal liability. This meant that it was far from clear how a manager should proceed in such situations. The least risky option was to simply run away from the problem by resigning. And this certainly can’t have been the intention of the legislator

A way out of the dilemma

A bankruptcy law amendment that took effect in the summer, however, could point to a way out of this seemingly unsolvable dilemma. Based on the amendment, in future, managers can be exempted from their liability if they can prove that, following occurrence of the situation resulting in an imminent threat of insolvency, they did not take on risks that were unjustified given the company’s financial situation. In other words, in future, the manager will not have to wake up every day wondering how he or she will be able to minimise creditors’ losses.

The rule could allow the company’s manager to attempt to restore the company’s liquidity and satisfy the claims of its creditors without the risk of personal liability, provided that he or she does so without taking on any business risks that are unwarranted given the company’s financial situation. The new rule, therefore, won’t necessarily encourage managers to minimise losses and risks, but rather to make the best business decision they can under the given circumstances.

What needs to be done differently?

The question arises whether this new rule will lead to a change in the way senior officers act in situations where there’s an imminent threat of insolvency. The answer is: probably not. Those managers who previously took up the gauntlet, and undertook the management of companies under threat of bankruptcy even at the risk of their own liability, have probably acted in accordance with the new rule; in other words, they’ve already taken care not to undertake unjustified business risk anyway. The good news is that from now on the law – and hopefully judicial practice too – will help them in these efforts, so going forward they won’t have to feel that they’re “damned if they do, and damned if they don’t”.