The new UAE Bankruptcy Law (Federal Law No. 9 of 2016) has put a spotlight on the treatment of companies in financial difficulties in the United Arab Emirates. It comes into force on 29 December 2016. We set out a summary of the key points in the Law in our recent briefing.
The Bankruptcy Law brings more clarity to the processes available for companies whose financial condition is deteriorating. But what legal obligations does it impose on the directors and managers of these companies?
Good news - failure to file for bankruptcy is no longer criminalised
Under the provisions in Volume 5 of the Commercial Code (Federal Law No. 18 of 1993), which contains the current UAE law on bankruptcy of commercial businesses, it is an offence for a company to fail to petition for bankruptcy within 30 days of the date of suspension of payment of its debts (known as "bankruptcy by default"). Potentially, criminal proceedings may be taken against the directors of a failing company for a failure to take steps to apply for bankruptcy on behalf of the company they manage.
Under the Bankruptcy Law, whilst a company must petition to start a bankruptcy process after 30 business days from it either being unable to pay its debts when they fall due, or being balance sheet insolvent (by the company's debts being greater than its assets), there is no longer a specific offence for failure to file within this timeframe. In addition, the Bankruptcy Law has clarified that it is the responsibility of the company's shareholders to decide whether to commence a preventive composition or a bankruptcy process, by way of extraordinary resolution.
This is good news for directors and managers of companies in financial difficulties. The threat of criminal sanctions for bankruptcy by default was open to abuse by creditors seeking the best settlement of their outstanding debts. Directors also faced a difficult choice: filing for formal bankruptcy may not always be in the best interests of the company when the financial position may be recoverable, weighed against the protection of their personal interests and strict compliance with the law.
Trading through financial difficulties – the risks
The Bankruptcy Law provides a court sponsored process to allow a company in financial difficulties (before reaching either cash flow or balance sheet insolvency) to reach a binding agreement with its creditors, as an alternative to filing for bankruptcy. This is called a preventive composition. As with the removal of the offence of bankruptcy by default, this is a positive move to encourage companies and their directors to deal with declining financial performance as early as possible.
However, there is a relatively short window for the debtor company to apply for a preventive composition: up to 30 business days from the date on which it ceases to pay its debts (or less, if it is subject to regulation by a particular competent body). If a company has lost the opportunity to file for a preventive composition, directors should be aware of potential risks in managing the business through its financial downturn, particularly if it is placed into bankruptcy subsequently.
Specific offences on a winding-up
Under Article 201 of the Bankruptcy Law, there are a number of offences which may apply to directors and managers of companies which are later wound up by court order.
- Preferences – if the directors approve the repayment of one creditor to the detriment of others, or give special privileges to one or more particular creditors, this will constitute an offence if the preference was granted after the company ceased to pay its debts when they fell due. The offence will be committed even if the purpose is to pursue a preventive composition, or a financial restructuring. Therefore, directors must be cautious in paying off some but not all creditors, and in accelerating all or part of the company's debts in order to obtain agreement from key creditors to a repayment scheme, particularly once payments in the ordinary course of business have been missed.
- Sales at an undervalue – it is unlawful for a director to sell, in bad faith, any of the company's assets at a undervalue. Therefore, the directors of a company in financial difficulties should take care to ensure that they obtain market value for any asset disposal, particularly if the purpose of the sale is to delay the company entering either a preventive composition or bankruptcy, or seek an end to such a process. It may be wise to obtain a professional valuation of any such assets.
- Non-core, speculative business – there is a risk under the Bankruptcy Law that a director may be found liable for corporate activities undertaken by the company which were not core to the licensed business activities, particularly where such activities (even in hindsight) were speculative in nature and significant enough to have contributed to the company's financial difficulties. A director may be held liable at any time for poor management decisions (see the section below on the Commercial Companies Law), but the risk is heightened when the company is under financial stress.
For any of these offences, the Bankruptcy Law prescribes a penalty of imprisonment of up to two years for board directors and managers. In addition, it is clear from the Law that liability also rests with other individuals who play a role in the corporate decision making, even if they are not registered as the general manager on the trade licence, or as members of the board of directors. This extension of liability may affect people who undertake the management of a particular part of the company's business, to whom such responsibility is delegated by the board or general manager.
Any of these actions may also lead to personal financial liability for the directors – see below.
The offences outlined above are not the only relevant crimes. It is important to bear in mind that activities which are designed to deliberately conceal a company's financial position (such as fraudulent record keeping, or falsified accounting) or which dishonestly benefit certain parties over others (such as distributions of assets or profits in breach of the law) may also constitute criminal acts.
Liabilities arising out of bounced cheques
Under the Penal Code, criminal liability attaches to a person who writes a cheque in favour of a third party without sufficient funds to honour the payment, as well as for withdrawing funds resulting in a cheque being dishonoured. In the context of a company, this liability generally attaches to the individual writing the cheques on behalf of the corporate entity. However, the offence may be remedied by payment of the debt at any time, including after the criminal court has passed its judgment.
Under the Bankruptcy Law, criminal proceedings for such an offence will be suspended if the cheque was written in the period before the company enters a preventive composition or a court ordered financial restructuring. After the terms of the repayment scheme have been approved by the court and creditors, the debt which is the subject of the cheque may be settled under those terms, and the consequent criminal offence remedied.
However, it is important to note that the potential criminal liability has not been removed entirely by the Bankruptcy Law: if the company's financial situation deteriorates to the extent that the company is wound up in a bankruptcy process, criminal proceedings may not be suspended. In other words, the directors of companies in the most severe financial trouble remain at risk of penal sanctions for dishonoured cheques. In practice, directors may find it difficult to assess, when writing cheques early on in a company's decline, the likelihood of a winding up being ordered by the court in the future. So, although the new Law is helpful and incentivises directors to pursue a preventive composition, cash flow management and careful record keeping of post-dated cheques is still recommended.
Personal financial liability for directors
In 2015, the UAE introduced the new Commercial Companies Law (Law No. 2 of 2015). Directors and managers of UAE incorporated companies should read this and the new Bankruptcy Law together to have a full understanding of the risks of personal liability for financial loss suffered by the companies which they manage, or by third parties such as shareholders and creditors.
Examples of some of the relevant provisions are as follows:
- General directors' duties - The Commercial Companies Law sets out express duties owed by individuals authorised to manage a company to that company. These duties include a requirement to exercise a standard of care and diligence in performing a managerial role that a "prudent person" in a similar position would exercise. This is an objective test against which to measure a director's conduct and quality of decision making. A director of a company in financial difficulties may find that their decisions in the period leading up to a preventive composition or bankruptcy process are scrutinised closely against this standard.
- LLC manager liability - A manager of a Limited Liability Company may held liable to the company, its partners and other third parties (which may include creditors) for a number of acts, including "gross error". A "gross error" may be constituted by a failure to meet the standard of care required of such a manager under the objective test outlined above. In addition, it may be easier for a creditor to pin-point decisions taken by a manager, with the benefit of hindsight, which led to loss later on, if the company is ultimately subject to one of the processes in the Bankruptcy Law.
- Low recoveries – under the Bankruptcy Law (as was the case under the Commercial Code), in a winding-up, if the company's assets are insufficient to cover at least 20% of its liabilities, the directors may be required to pay a contribution to all or part of the company's debts, by court order.
- Liability for certain management acts after a winding-up order – at any time within two years of the commencement of a bankruptcy process, the directors or manager may be held liable for the debts of the company if they have undertaken certain actions in the management of the company, if the company is wound-up later on. These actions include sales of assets at an undervalue, entering into new commitments at less than market value or which are unaffordable in the context of the company's resources, and creating preferences in favour of certain creditors. However, if the directors are able to prove that the acts were taken with a view to minimising the loss incurred by the company and its creditors, they will not be held liable. Furthermore, any director who objected to the acts, or was not involved in any of the relevant actions, will also not be held liable for them. Fully documenting decision making at a board level is therefore likely to be helpful, including the board's considerations and reasoning for the resolutions passed.
As the UAE ushers in new business laws for its modern economy, accountability for corporate actions appears to be high on the government agenda. Strengthening corporate governance was one of the stated aims of the new Commercial Companies Law and it is clear that the new Bankruptcy Law progresses that further. The Bankruptcy Law also incentivises a prompt response to financial difficulties. So, directors and managers of UAE companies in the current economic climate are well advised to plan ahead their response to any financial decline and seek professional advice early - not only to take advantage of new options under the legislation, but to also ensure that they understand their own risks.
Minimising liability for directors and managers
- Good corporate governance –
- regular board meetings
- full minutes of decision making
- seek early consultation with the owners/LLC partners
- Market valuation of assets to be sold
- Diligent financial record keeping
- Documentation of all post-dated cheques and guarantees
- Caution over paying some creditors over others once financial difficulties encountered
- Assessment of any new terms agreed in the ordinary course, to ensure not onerous in the financial context of the company
- D&O insurance to assist with financial liability (although not usually criminal fines)
- Seeking professional help earlier, rather than later, to advise on options