!Корпоративное право 2023-2024 / 2013-study-analysis_en

According to Chapter 22, Section 1, Sub-section 2, A Member of the Board of Directors, a Member of the Supervisory Board and the Managing Director shall likewise be liable in damages for the loss that he or she, in violation of other provisions of this Act or the Articles of Association, has in office deliberately or negligently caused to the company, a shareholder or a third party.

As in scenario 4, but A resigns from his position as director of Bidder before Rival makes the competing offer.

Under Companies Act, the answer is unclear. After the resignation Director A has no fiduciary duty towards the Bidder. It is unclear, however, if non-disclosure of the facts before the resignation could be deemed to be such a neglect that it has causality with any damage suffered by the Bidder. Under the circumstances, especially if the resigning director has mentioned the conflict of interest as the cause of resignation, the remaining board members should take all reasonable efforts to base their decision on all relevant facts.

As in scenario 4, but after an initial expression of interest by Bidder in acquiring the assets and before Rival has taken any steps to make a competing offer, the Bidder board determines that an investment of that size is not advisable at the present time in light of Bidder’s weak financial position.

Under Companies Act, the answer is unclear. If the Bidder’s financial position is weak, the transaction might be too risky as it is not certain if the Bidder could sell the assets to the Rival with a profit. Thus it is not clear if the Bidder has been caused damage by Director A.

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302 Directors’ Duties and Liability in the EU

France

Hypothetical I: Liability of the parent and directors of the parent for breaches of duty at the level of the subsidiary

A pharmaceutical company is currently developing two new drugs. After assessing the potential liability risks associated with the future products, the directors of the pharmaceutical company decide to incorporate two separate private limited companies, each taking over the development, research and future marketing of one of the two drugs.

The directors of the pharmaceutical company appoint the two project managers as directors of the two subsidiary companies. The two subsidiary companies enter into an agreement allowing them access to the parent company's research facilities. According to the subsidiary's articles of association, all major strategic decisions regarding the research, development and marketing of the drugs are subject to approval by their sole shareholder, the pharmaceutical company. The employees working for the subsidiaries are formally still employed with the parent company, but are posted with the subsidiaries under an agreement entered into by the parent company and the two subsidiaries upon formation of the two companies.

When the directors of the parent company learn about competitors working on similar projects, they try to accelerate the development process of the two drugs. They award substantial bonuses to the subsidiary’s directors, contingent on the drugs receiving regulatory approval within the next 6 months. The original schedule provided for further tests, which would take at least 12 months.

Primarily because of the contingent bonus payment, the directors of the subsidiaries skip some of the planned tests and studies, and cover up this decision in their filings for regulatory approval.

The two drugs gain regulatory approval within the 6 month time span, and are successfully marketed shortly after that.

Two years after the initial marketing, independent studies reveal that one of the drugs causes a rare form of lethal cancer, exposing the relevant subsidiary to enormous product liability claims that far exceed its net assets. The drug developed by the other subsidiary proves to be safe and leads to substantial profits.

Is it possible that the parent company would be liable in circumstances comparable to the stylised facts above?

French case law is very restrictive to admit the possibility to hold the parent liable for instructions given to the subsidiary, such as in the current case.

The employees working for the subsidiaries are formally still employed with the parent company but are posted with the subsidiaries under an agreement entered into by the parent company, and the two subsidiaries is something common in groups. It would not lead the courts, as such, to consider that the subsidiary was not an independent entity.

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Under which circumstances would the directors of the parent company face a liability risk in those circumstances?

The parent company would have to be considered a shadow director or it would have to create a misleading appearance towards thirds parties that the parent was actually contracting (selling the drugs) with clients. Case law is becoming currently more restrictive as the latest decisions since 2004 require a misleading appearance and not just involvement in the business of the subsidiary.

Hypothetical II: Duties in the vicinity of insolvency

After making losses for three consecutive years, an oil trading company’s equity ratio (equity divided by total assets) has fallen below [1% - 5% - 10%]. On average, comparable companies in the same line of business have an equity ratio of about 25%.

The company still has substantial assets, but the thin equity cushion makes it hard for the company to pursue its core business, as trading partners demand higher prices to compensate them for the perceived higher risk of the company's operations.

The company's directors evaluate different possibilities to improve the business prospects of the company. They attribute past trading losses to the substantially higher volatility of oil prices following the financial crisis, and maintain the view that the company's business model is sustainable in the long run. After exploring the possibility to raise new equity to recapitalise the business, they conclude that current market conditions would force them to issue new shares at prohibitively low prices, which would lead to a substantial dilution of their current shareholders.

After analysing the market conditions, the directors come to the conclusion that the market price for crude oil is bound to rise significantly over the next year, particularly due to high anticipated demand from emerging market economies. In an attempt to recapitalise the company the directors decide to invest heavily in crude oil futures. They expect that the anticipated increase in oil prices will lead to substantial gains from this transaction, bringing the equity ratio back in line with the industry average, and thus allowing the company to resume their trading operations at more sustainable conditions.

The directors are aware that a sudden substantial fall in oil prices could potentially wipe out the remaining equity of the firm, but they consider the likelihood of this happening to be very low.

Shortly after entering into the forward sale agreement, worries about a sovereign debt crisis lead to a revision of worldwide economic growth forecasts. The price of crude oil falls more than 10% on a single day, the worst one day performance in many years. As the company cannot fulfil the margin calls on its forward sales contracts, the positions are closed by the counterparty. The closed positions have a negative value exceeding the company’s equity, leading to the company’s over-indebtedness. Trading partners refuse to enter into transactions with the company due to its financial position, and banks close all existing credit lines of the company.

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Do fiduciary duties prevent directors from entering into particularly risky transactions?

Under French law, directors and managers are not prohibited from entering into risky transactions. However, in the case at hand, since the company will have to file for bankruptcy because of the transaction, it is almost certain that it will be held liable for breach of its duty of care.

At which point in time does the law provide for additional duties of directors or the change of existing duties in situations of financial distress? (i.e. how is ‘vicinity of insolvency’ defined?)

Once the company has filed for bankruptcy, any management mistake that was committed before the bankruptcy may lead to liability.

What is the legal response to below situation?

The directors would almost certainly be held liable for management mistakes.

Hypothetical III: Duty of care

A large banking institution is engaged in retail as well as investment banking. In 2000, a new CEO was appointed, who also sits on the board of directors. The CEO made the decision to invest heavily in collateralised debt obligations (CDOs) backed by residential mortgage-backed securities, including lower-rated securities that pooled subprime mortgages to borrowers with weak credit history. The investments were initially successful, generating high profits for the company. However, beginning in 2005, house prices, particularly in the United States, began to decrease. Defaults and foreclosures increased and the income from residential mortgages fell rapidly.

As early as May 2005, economist Paul Krugman had warned of signs that the US housing market was approaching the final stages of a speculative bubble. Early in 2007, a large US subprime lender filed for bankruptcy protection and a number of investors announced write downs of several billion dollars on their structured finance commitments. In July, 2007, Standard and Poor’s and Moody’s downgraded bonds backed by subprime mortgages. At the end of 2007, two hedge funds that had invested heavily in subprime mortgages declared bankruptcy. In spite of these warning signs, the CEO had continued to invest in CDOs until shortly before the Lehman bankruptcy in September 2008, accumulating a total exposure of more than 20 billion Euro/Pounds/… . The subprime mortgage crisis necessitated massive write downs, leading to an annual loss of eight billion in 2008, which can be attributed in equal measure to the CDO transactions undertaken in 2005-2008.

The CEO resigned in October 2008. As part of the resignation, the CEO entered into an agreement with the company providing that he would receive 50 million Euro/Pounds/… upon his departure, including bonus and stock options, and in addition an office, administrative assistant, car and driver until he would commence full time employment with another employer. In exchange, the CEO signed a non-compete agreement and a release of claims against the company. The agreement with the CEO was approved by all directors (the CEO abstaining from voting), acting on behalf of the company.

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After the CEO’s departure and with a new management team in place, it transpires that the old CEO had used a number of ostensibly arms-length transactions with investment firms that were, however, controlled by the CEO’s nominees, to transfer assets at an undervalue to a company owned by the

CEO on the Cayman Islands. When the true nature of these transactions becomes known, the assets are no longer recoverable.

Questions:

Is the CEO liable for annual loss suffered by the company in 2008?

The BJR, as known in the US, does not apply in France, but French courts do not tend to secondguess business decisions as long as the company does not become insolvent. If it does, they easily find a management mistake. In the current case, the company has not become insolvent. This situation is similar to a few situations of French banks. No suit has been filed and I doubt that a judge would find a management mistake. Suits are more likely to be filed (but not necessary to be successful) on the ground that the company, when listed, did not disclose with accuracy the relevant facts.

It cannot be said generally when warning signs (‘red flags’) become so obvious that initially permissible risk-taking constitutes a violation of the duty of care. This is decided by courts on a case-by-case basis. They will usually hold that the situation must have been so desperate that there would have been no hope to save the company.

Have the directors (other than the CEO) breached their fiduciary duties by approving the agreement in conjunction with the resignation of the outgoing CEO?

The decision belongs to the board of directors (or supervisory board), but if the transaction is signed before and without authorisation, it is simply voidable in case of prejudice to the company.

Have the members of the company’s internal audit committee (of which the CEO was not a member) breached their fiduciary duties by not identifying the true nature of the ostensibly armslength transactions and are they, accordingly, liable for the loss suffered by the company as a consequence of the transactions? Have the other directors (except the CEO) breached their duties?

Theoretically, members of the audit committee are not subject to specific liability rules or a separate standard of care in light of their position and/or expertise, especially in suits by shareholders. However, if the board of directors is held liable for having approved the transaction, members of the audit committee will face a secondary action by other members of the board in order to share a larger portion of the damages by arguing that they are more liable.

Directors are generally not required to monitor their colleagues. If a director lies to them, they will probably not be held liable for not having identified the problem, unless it was obvious.

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Assuming that the company has a claim against the CEO or another director pursuant to one or more of the above questions, can a minority shareholder enforce the claim?

-Who can bring a claim on behalf of the company?

Any shareholder.

-What is the threshold to bring a derivative action?

One share.

-Do conditions exist that must be satisfied before a court will allow a derivative action to proceed (for example, will the court review whether the action is in the interest of the company or frivolous)?

No.

Hypothetical IV: Duty of loyalty

A mining company (‘Bidder’) considers expanding business operations. The board identifies assets held by another company (‘Target’) as a possible acquisition. The following scenarios ask you to consider the liability of a director (‘A’) on the board of Bidder.

Director A is also majority shareholder in Target, holding 60 percent of the outstanding share capital of the company. As majority shareholder of Target, he is interested in an acquisition that is beneficial to Target. He proposes that Bidder purchase the assets for 10 million

Euro/Pounds/…, knowing that the value ranges between 7 and 8 million. Director A does not disclose his interest in Target to the board of Bidder. A majority of the directors approves the acquisition. A’s vote was not decisive for the positive vote.

The law requires directors to disclose their interest. This duty is laid down in the Code de Commerce. The transaction is void because the director took part in the vote, regardless of the fact that his vote was not essential, and even if the operation would have been beneficial to the company. However, the nullity is not opposable to good faith third parties.

As in scenario 1, but Director A discloses his interest in Target to the board of Bidder, and a majority of the uninterested directors approves the acquisition.

The conflicted director must abstain from voting. As long as he abstains and the board approves the transaction, it is valid.

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As in scenario 1, but when the shareholders of Bidder learn of A’s interest in Target, they ratify the transaction, believing that it is in the company’s interests.

Shareholders cannot authorise the transaction. They can only approve it, with no legal effect. Under French law, the rule is that each organ of the company receives its powers from the Companies Act and modifications are limited.

A minority shareholder can appeal to the court and claim that the transaction was not in the company’s interest even if the transaction was approved by the majority of the shareholders.

Director A is majority shareholder and managing director in a competitor of bidder (‘Rival’), which is also active in the mining business. The assets held by Target that Bidder seeks to acquire consist in claims near Rival’s own mining territories. Director A is of the opinion that the assets are more valuable for Rival than for Bidder. He therefore arranges for Rival to make a competing and higher offer than Bidder, and Target accordingly decides to sell the assets to the former company.

The body of case law on the corporate opportunities doctrine is not very developed. Directors (but not managers of Limited - SARL) are allowed to run competing businesses. However, this case law is evolving. It cannot be ruled out that a French court would hold that there was a breach of the duty of loyalty, since the exact extent of this duty is still not fully clear.

As in scenario 4, but A resigns from his position as director of Bidder before Rival makes the competing offer.

There could be a case for liability, but again this is not certain.

As in scenario 4, but after an initial expression of interest by Bidder in acquiring the assets and before Rival has taken any steps to make a competing offer, the Bidder board determines that an investment of that size is not advisable at the present time in light of Bidder’s weak financial position.

There is no prejudice, so that there would be no liability.

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Germany

Hypothetical I: Liability of the parent and directors of the parent for breaches of duty at the level of the subsidiary3

A pharmaceutical company is currently developing two new drugs. After assessing the potential liability risks associated with the future products, the directors of the pharmaceutical company decide to incorporate two separate private limited companies, each taking over the development, research and future marketing of one of the two drugs.

The directors of the pharmaceutical company appoint the two project managers as directors of the two subsidiary companies. The two subsidiary companies enter into an agreement allowing them access to the parent company's research facilities. According to the subsidiary's articles of association, all major strategic decisions regarding the research, development and marketing of the drugs are subject to approval by their sole shareholder, the pharmaceutical company. The employees working for the subsidiaries are formally still employed with the parent company, but are posted with the subsidiaries under an agreement entered into by the parent company and the two subsidiaries upon formation of the two companies.

When the directors of the parent company learn about competitors working on similar projects, they try to accelerate the development process of the two drugs. They award substantial bonuses to the subsidiary’s directors, contingent on the drugs receiving regulatory approval within the next 6 months. The original schedule provided for further tests, which would take at least 12 months.

Primarily because of the contingent bonus payment, the directors of the subsidiaries skip some of the planned tests and studies, and cover up this decision in their filings for regulatory approval.

The two drugs gain regulatory approval within the 6 month time span, and are successfully marketed shortly after that.

Two years after the initial marketing, independent studies reveal that one of the drugs causes a rare form of lethal cancer, exposing the relevant subsidiary to enormous product liability claims that far exceed its net assets. The drug developed by the other subsidiary proves to be safe and leads to substantial profits.

1.Is it possible that the parent company would be liable in circumstances comparable to the stylised facts above? Under which circumstances would the directors of the parent company face a liability risk in those circumstances?

Under German law the liability of a parent company could in these circumstances arise out of the principle of liability for an intervention destroying the economical existence of the company (existenzvernichtender Eingriff), general stock corporation law, as well as group law regulations.

3 Answers on German law kindly provided by Niklas Bielefeld.

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a)Intervention destroying the economic existence of the company (existenzvernichtender Eingriff)

The limited liability of shareholders and the separation of liabilities and assets between shareholders and company – as laid down in s. 1(1), sent. 2 of the German Stock Corporation Act (Aktiengesetz, AktG) for the German stock corporation (Aktiengesellschaft, AG) and in s. 13(2) of the German Limited Liability Company Act (Gesetz betreffend die Gesellschaften mit beschränkter Haftung, GmbHG) for limited liability companies (Gesellschaft mit beschränkter Haftung, GmbH), respectively – have always been emphasised and enforced by German courts as two of the core principles of company law. The German Federal Court of Justice (Bundesgerichtshof, BGH) has over the years established a rule that the shareholders in a limited liability company may be subject to personal liability towards the company in case of a conscious intervention or interference destroying the economic existence of the company. This case group is not quite clear-cut, however, from a dogmatic point of view and has undergone several changes and alterations over the years. According to recent decisions by the BGH the personal liability of the shareholders for this particular form of misuse and abuse of the corporate form is derived from s. 826 of the German Civil Code (Bürgerliches Gesetzbuch, BGB), a rule of tort law. It applies only in very narrow circumstances, where the shareholders consciously and abusively diminish the assets of the company, causing the company to become insolvent in the process. The actions of the shareholders leading to the insolvency must be of an unethical and immoral nature. In an authoritative decision from 2008 the BGH stated:4

“The liability for intervention destroying the economic existence of the company (remark: as a case group of s. 826 BGB) shall have the effect of an enforced prohibition of the withdrawal of company assets which endorses – but also goes noticeably beyond – the general statutory rules on capital maintenance by compensating for the unethical self-serving behaviour of shareholders to the detriment of the creditors of the company and thereby causing or deepening the company’s insolvency through the establishment of a rigid liability for damages to the impaired assets of the company.”

According to the BGH, the actions of the shareholders have to aim at giving preference to their financial interests over the legally protected interests of the creditors through a conscious impairment of the assets of the company. Since the courts have always been reluctant to interpret this case group broadly, the personal liability of shareholders is limited to this type of behaviour.

While not being undisputed, it is argued by most legal authors that this concept of liability, which was developed for private limited companies (GmbH’s), shall also apply to public companies (AG’s).5

In the above case, German courts would almost with certainty conclude that the parent company was not liable according to s. 826 BGB for causing the insolvency of one of its subsidiaries, because the relevant actions, i.e. the setting-up of the bonus scheme – although probably unethical and reckless towards the general public – were not aimed at impairing the subsidiary’s assets in favour of the parent company’s self-interest and to the detriment of the creditors’ interests.

4BGH, Judgement of 28 April 2008 - II ZR 264/06 (“Gamma”, NJW 2008, 2437, 2438); see also BGH, Judgement of 9 February 2009 - II ZR 292/07 (“Sanitary”, NJW 2009, 2127).

5Hüffer, Aktiengesetz, 10th edition, 2012, § 117, sec. 14; Spindler, in Münchener Kommentar zum Aktiengesetz, 3rd edition, 2008, § 117, sec. 87-88.

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