Generally speaking, wrongful trading is the special form of liability where a director of a company is liable for damages towards the creditors for the mismanagement of an insolvent company.
A special feature of the wrongful trading concept is that it may give rise not only to the liability of the director of the company but also to the liability of the director, management, employee of the parent company or even of the grandparent company (so called shadow director).
The pandemic and the related measures taken to restrict social contacts are challenging many businesses. In this summary we would like to draw your attention to the above special aspect of the situation: executives of foreign parent companies can potentially be held liable under the laws of Baltic/CEE/SEE countries for certain acts and decisions relating to their Baltic/CEE/SEE subsidiaries.
Please see below an overview of Estonian laws on this matter.
The principal rule of the liability of the directors
In Estonia the principal liability lies with the members of management board. Private limited companies and public limited companies are represented and managed by the management board according to the Estonian Commercial Code (ECC) § 180 (1) and § 306 (1). The management board may have one member (a manager) or several members, stipulated by the ECC § 180 (2). Some private limited companies may have a supervisory board as well, for public limited companies having a supervisory board is compulsory, according to the ECC § 180 (4) and § 316 (1). The supervisory board shall plan the activities of a company, organise the management of a company and supervise the activities of the management board, ECC § 316 (1). If a company has a supervisory board the management board must adhere to the lawful orders of the supervisory board, according to ECC § 180 (4) and § 306 (2). Therefore, in certain cases the question about the liability of the supervisory board might arise.
The general rule of liability for a member of a management board (i.e. a director) is that a director must perform his or her duties with due diligence according to Estonian Commercial Code (ECC) § 187 (1), § 315 (1).
More specifically, the director must perform his or her obligations arising from law or the articles of association with the diligence normally expected from a member of a management body and must be loyal to the legal person according to Estonian General Part of the Civil Code Act (CCA) § 35.
Diligence that is normally expected from a member of management body is determined on case-by-case basis depending of knowledge, skill and characteristics of a specific director by the courts of law. The actions of a director are compared to the actions of a diligent director who is performing his or her tasks under similar circumstances.
Special liability regime for directors in threatening insolvency
Under the circumstances of threatening insolvency the general rule of performing one’s duties with due diligence still applies, however the management board member must adapt his or her actions accordingly to the economic state of the company.
This means mainly two things:
1) the management board member must consider submitting bankruptcy declaration, and the potential damage to the company and to its creditors caused by the omission of bankruptcy declaration;
2) the management board member must consider whether or not there is a cause to refrain from making payments on behalf of the company, and the potential damage to the company and its creditors caused by making the named payments according to ECC § 180 (5), § 306 (3).
The first and foremost obligation in case of insolvency is submitting bankruptcy declaration in orderly time. The second most important obligation is to withhold making payments on behalf of the company.
The law specifically prohibits making payments by the management board members on behalf of the company when the insolvency has become evident according to ECC § 180 (5), § 306 (31).
The law does not provide an exhaustive list of prohibited payments. This generally means that prohibited are payments satisfying the claims of some creditors, and therefore, not leaving enough assets to satisfy the claims of other creditors, resulting in the unequal treatment of creditors.
Payments to shareholders are also prohibited if the company’s net assets are less than or would be less than the total of share capital and the reserves which pursuant to law or the articles of association shall not be paid out to shareholders according to ECC § 157 (3).
When will a threatening insolvency situation occur?
If the net assets of a company are less than one-half of the share capital, or less than the minimum amount of share capital provided by law, the shareholders shall decide on:
- a reduction or increase of share capital on the condition that the net assets would thereby form at least one-half of the share capital and at least the minimum amount of share capital; or
- the implementation of other measures as a result of which the net assets of the company would form at least one-half of the minimum share capital provided by law; or
- dissolution, merger, division or transformation of the company; or
- submission of a bankruptcy petition. – According to § 176 and § 301 of ECC.
Insolvency is deemed as a state of a company in which the company is unable to satisfy the claims of the creditors and such inability, due to debtor’s financial situation, is not temporary according to the Estonian Bankruptcy Act (EBA) § 1 (2). Also if the assets of the debtor are insufficient for covering the obligations thereof and due to the debtor’s financial situation, such insufficiency is not temporary according to the EBA § 1 (3).
In order to objectively determine, whether a company is in a threatening insolvency, multiple factors must be considered – in addition to analysing net assets, other accounting data and prosperity of the business plan must be considered.
If a company is insolvent and the insolvency, due to the company’s economic situation, is not temporary, the management board shall promptly but not later than within twenty days after the date on which the insolvency became evident, submit the bankruptcy petition of the company to a court. After insolvency has become evident, the members of the management board shall no longer make payments on behalf of the company, except in the case where making the payments in the situation of insolvency conforms to the due diligence requirements, according to ECC § 180 (5) and § 306 (3).
If a company is clearly permanently insolvent, the members of the management board are obligated to submit a bankruptcy notice according to CCA § 36.
If the threatening insolvency is of temporary nature, the insolvency is usually surmountable. The distinction of temporary and permanent insolvency is, however, complex. Certain aspects must be taken into account, such as the volatility of market, flaws in the management of the company, the insolvency of the company’s own debtors, or other factors causing the company to fail to perform its obligations. Therefore, recognising a threatening insolvency lies with the obligations of the managing director. Moreover, a diligent director must recognise a threat of insolvency and act accordingly.
With regard to prohibition of payments, a question arises at what point does the prohibition take effect? The prohibition takes effect with certainty in case the insolvency is permanent.
What are the legal consequences if the director breaches the special duty described in section 2?
In case the director breaches the aforementioned prohibition and damage is incurred by the creditors, the director shall compensate to the company for any payments made behalf of the company after the insolvency of the company became evident and which, under the specific circumstances were not in line with the principle of due diligence according to ECC § 180 (5), § 187 and § 306 (3), § 315. In case of management board, i.e multiple directors, the directors will jointly and severally compensate.
With regard to payments made to shareholders, upon receipt of a dividend, a claim for return of the payment can be submitted by the creditor of the company if the assets of the company are not sufficient to satisfy the claims of the creditor. In such case the shareholder must return the dividend according to ECC § 158 (1), (3).
The damage from prohibited payments is mainly caused by untimely bankruptcy declaration by the managing board. In such case the creditors and the bankruptcy trustee can submit a civil law action against the member of managing board for the omission of submitting a timely bankruptcy declaration according to the ECC § 180 (5), § 306 (31).
The management board’s obligation to submit a timely bankruptcy declaration is set out to hold creditors harmless from kinds of damage:
1) a timely bankruptcy declaration protects the assets of the company and therefore secures the claims of the creditors,
2) a timely bankruptcy declaration secures that an insolvent company does not engage in economic activities and acquiring obligations.
During insolvency proceedings a trustee can apply on behalf of the creditors that the court revoke the transactions of the company which were concluded or performed by the company before the declaration of bankruptcy and which damaged the interests of the creditors according to the EBA § 109-114.
Does this wrongful trading liability apply to persons other than the directors?
This liability applies to first and foremost to the members of the management board. Certain liability lies also with the members of supervisory board. Similarly to the management board, the supervisory board must perform its duties with due diligence. Therefore, if a company has supervisory board, that fails to detect a prohibited payment by the management board or approves a prohibited transaction, the supervisory board is jointly and severally liable for the damage incurred by the creditors according to ECC § 327.
Additionally, a “shadow director” is liable for damaging private limited company by influencing activity of private limited company according to ECC § 167.
This liability does not apply to the employees of the company, the employees are only liable to their employer or to the company, but the tasks and the liability of an employee does not extend to creditors outside of the company.
Who is a shadow director?
The law does not stipulate a definition of a shadow director. Even though a concept of shadow director is not defined, the law does stipulate the liability of a person who, by misusing his or her influence, influences a member of the management board or supervisory board to act contrary to the interests of the company. This person is liable to compensate any damage incurred to the company. In the event the management board or supervisory board member breaches his or her obligations, he or she is jointly and severally liable with this (shadow) person. A claim against this (shadow) person ca be submitted by the company or by creditors. In the case of declaration of bankruptcy of a private limited company, only a trustee in bankruptcy may file a claim on behalf of the private limited company according to ECC § 167 (5).
How to determine if the company is in a threating insolvency?
Same answer as under question No 3.
The creditors have multiple legal remedies for protecting their claims with insolvent companies, before and during bankruptcy proceedings. Creditors can submit claims for damage against the management board or supervisory board member for carrying out prohibited payments, also against persons influencing management board or supervisory board members to such actions.
In addition, creditors can submit a claim for compensation in case of an untimely bankruptcy declaration. During bankruptcy proceedings the legal remedy for creditors is revoking transactions of the company which were concluded or performed by the company before the declaration of bankruptcy and which damaged the interests of the creditors.
This overview was prepared by our senior associate Mari Karja and legal assistant Karmel Kristin Einberg who are happy to help you in case of any additional questions. Our regional COVID-19 task force is also at your disposal.