Director liability when a Lithuanian company goes bankrupt

Written by attorney-at-law Tadas Ugintas.

A company’s insolvency does not in itself mean that its director must personally pay the company’s unpaid debts. A legal person and its director are separate legal subjects, so creditors’ claims are satisfied first of all from the company’s assets.

A director’s personal liability can arise where it is established that he or she failed to perform duties set by law, or caused damage to the company or its creditors by specific decisions. The fact of insolvency, or a large amount of unpaid debt, is not enough on its own to support such a claim.

A director’s duties arise before insolvency proceedings are opened.

Where insolvency is likely, the director must inform the company’s members of its financial position, propose ways of dealing with the financial difficulties and avoid actions that would endanger the company’s viability.

Once the company becomes insolvent, the director must start insolvency proceedings without delay. This duty is set out in the Law on Insolvency of Legal Entities (in Lithuanian).

In practice, the main dispute is often not about the duty itself but about the moment when the director understood, or should have understood, that the company’s difficulties were no longer temporary.

Poor results, a cash flow shortfall or a single overdue payment do not necessarily mean insolvency. The whole financial position is assessed: the ratio of assets to liabilities, the ability to meet obligations as they fall due, the company’s prospects, its sources of financing and whether there was a real chance of restoring solvency.

No. Even where it is established that the director started insolvency proceedings too late, he or she cannot automatically be ordered to pay the full amount of creditors’ claims left unpaid in the insolvency case.

The claimant must show what specific damage resulted from the director’s delay. This usually means comparing the company’s financial position at the time when insolvency proceedings should have been started with its position when they actually began.

The damage may consist of liabilities that grew during the delay, a reduction in the company’s assets or some other objectively proven loss of creditors’ chances of being paid. But a causal link must be established: the damage must result from the director’s failure to act, not from earlier business failures, market changes or other circumstances.

Once insolvency proceedings are opened, the insolvency administrator examines the company’s business, accounts, transactions, movements of assets and the conduct of its directors before the proceedings began.

A claim against a former director may be based on allegations that he or she:

• did not start insolvency proceedings in time;
• entered into transactions that were clearly disadvantageous to the company;
• transferred the company’s assets without justification;
• made payments in breach of other creditors’ interests;
• used the company’s funds for purposes unrelated to its business;
• did not keep or hand over the accounting records;
• did not hand over the company’s assets to the insolvency administrator;
• breached the duties of loyalty, care or good faith;
• contributed to an intentional bankruptcy by acts or omissions.

Each of these grounds has to be assessed separately. The fact that a transaction later proved to be loss-making does not prove that the director who entered into it acted unlawfully.

As a rule, a director’s civil liability requires:

1. unlawful acts or omissions by the director;
2. damage to the company or its creditors;
3. a causal link between the director’s conduct and the damage.

It is not enough to say in general terms that the company went bankrupt and creditors were left unpaid. The claimant must establish which specific duty the director breached, when it happened and what financial consequences resulted from that particular breach.

Lithuanian courts take the view that directors must be left reasonable room for business judgement. Business always involves risk, so an unsuccessful decision is not unlawful in itself. Decisions that are clearly unreasonable, dishonest, affected by a conflict of interest or contrary to the interests of the company and its creditors are treated differently.

A company in financial difficulty often cannot pay all its creditors at once. Payments made during this period are frequently examined by the insolvency administrator.

However, the mere fact that one creditor was paid while others were left unpaid does not establish the director’s civil liability.

The court has to assess:

• what was paid for;
• whether the company actually received the goods or services;
• whether the payment was needed to keep the business going;
• whether the terms matched market terms;
• whether the payment was a way of stripping assets;
• whether the recipient was related to the director or shareholders;
• whether the payment actually reduced the value of the company’s assets.

In one case, the insolvency administrator claimed more than EUR 101,000 from a former director, challenging 42 payments made by the company. The court dismissed the claim because the facts of insolvency and the payments themselves did not prove unlawful conduct by the director or damage. The case is described here (in Lithuanian).

The director must ensure that the company’s accounts are properly kept and that its transactions are supported by documents. Once insolvency proceedings are opened, the company’s assets, documents and information must be handed over to the insolvency administrator.

Missing documents make it harder to establish what assets the company has, to check its transactions and to assess the causes of insolvency. Failing to hand them over may therefore lead not only to a fine but also to a claim for damages or a restriction on acting as the head of a legal person.

When the administrator asks for documents, the handover should not be left to informal correspondence. It should be recorded exactly which documents and assets were handed over, what the company objectively does not have and where any remaining accounting information may be.

Declaring a bankruptcy intentional is a separate question. Such a ruling does not mean that every person who served as director at different times caused an intentional bankruptcy.

The court has to identify the specific person, his or her actions and how they are linked to the company’s insolvency or to a substantial deterioration of its financial position. Official status as director may be relevant, but it does not replace an examination of who actually took the decisions.

In some cases courts find that the company’s financial decisions were in fact taken not by the director named in the register but by someone else. In one such case the registered former director was cleared (in Lithuanian), because the court found the person who actually ran the company responsible for the intentional bankruptcy.

The defence should not begin with a general explanation that the director acted in good faith. It should begin by testing how the claim is built.

First, establish:

• which specific duty is said to have been breached;
• what date of insolvency is relied on;
• how the damage has been calculated;
• whether the damage has simply been equated with the total of creditors’ claims;
• what the causal link is based on;
• whether the company’s real business prospects were assessed;
• whether the person named as defendant actually took the decisions during the period in question;
• whether the administrator took account of the value the company received;
• whether all relevant accounting and bank records have been obtained.

Relevant evidence may include board or shareholder decisions, financial statements, cash flow forecasts, creditors’ proposals, agreements to defer debts, banks’ responses, statements from accountants and employees, and documents showing real attempts to restore the company’s solvency.

In another case we handled, a former director faced a claim of EUR 814,415. The case ended in a settlement: the director paid EUR 1,000 and the company dropped the rest of its claims. The case is described here (in Lithuanian).

The biggest mistake is to wait until the insolvency administrator assesses the financial position in detail for the first time.

When serious solvency problems appear, a director should:

• regularly review obligations that have fallen due and the assets available;
• document decisions to continue trading;
• inform shareholders of the financial position in writing;
• prepare realistic cash flow forecasts;
• avoid unjustified payments to related parties;
• not sell assets below market value;
• keep accounting records and contracts;
• assess whether the financial difficulties are still temporary;
• start insolvency proceedings without delay once the company becomes insolvent.

A timely legal and financial assessment will not always prevent the company’s insolvency. But it can protect the director against an unfounded allegation that he or she ignored the financial position or knowingly increased creditors’ losses.

If the insolvency administrator has already brought a claim, demanded documents or raised the question of personal liability, the situation should be assessed on the basis of the specific grounds of the claim and the evidence. A director’s liability is not presumed, but a late and poorly reasoned defence can make it much harder to have the claim dismissed.

For an assessment of your situation, contact an insolvency lawyer.