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Directors face fresh challenge
November 6, 2003
There is no distinction in the Companies Act between executive and non-executive directors insofar as fiduciary duties are concerned. Despite this, directors often look to escape culpability and argue their status as non-executives, as if to say that blame only lies with executive directors.
The well-known section 424 of the Companies Act deals with the liability of directors:
"When it appears ... that any business of a company was or is being carried on recklessly or with intent to defraud creditors ... or for any fraudulent purpose, the court may ... declare that any person, who is knowingly a party to the carrying on of the business in the manner aforesaid, shall be personally responsible ... for all or any of the debts or other liabilities of the company ..."
This section applies to any business of the company carried on in a reckless or fraudulent way and it is not limited to conduct in relation to its financial affairs.
The case of Philotex v Snyman in 1998 held that the language of the section should be given its full breadth in rendering liable persons who in effect have managed or are managing the business of a company recklessly or fraudulently.
This section thus applies to any person - even if he or she is neither a member nor a director nor an officer of the company - and also to a juristic person. The query is whether the person was knowingly a party to the fraudulent or reckless conduct of the business.
The section empowers the court to declare a respondent to be personally responsible for the debts or liabilities of the company.
This section was given a new leg to stand on in a recent decision handed down in the Johannesburg high court by Judge Claassen. This was the so-called Cellular Calls case of Kalinko v Nisbet.
Here a shareholder was given leave to sue directors for damages allegedly suffered by the diminution of shareholder wealth flowing from the directors' alleged wrongful conduct.
The application to executive and non-executive directors differs.
The case raised a number of important issues. The defendant's first exception dealt with subordinated debts. It was argued that a shareholder's loan had been subordinated by the shareholder's agreement against Cellular Calls and once Cellular Calls was liquidated, the debt became unenforceable.
It was argued that a subordinated debt dies a natural death on the debtor's insolvency.
The court distinguished two situations. The first was that upon liquidation of a company, the debt dies a natural death and cannot be proved against that company in insolvency. The second was whether or not the natural death of a subordinated debt upon liquidation precluded a claim for relief under section 424.
The court held that it would be patently incongruous for a creditor to be denied rights under section 424 in circumstances where the recklessness or fraud contemplated by this section were the very cause of the lapse of the creditor's contractual rights against the company.
If that were the case directors who were in control of a company could, by their own fraud and recklessness, engineer the company's liquidation and the consequent lapse of large loans by shareholders which have been subordinated. This would thwart the very intention of the legislature in the first place.
The court's view was that the subordinated claim should be considered to have died a natural death for purposes only of proving a claim against the company in liquidation. Such a claim should, however, be residually extant for purposes of unravelling the fraud or recklessness which had caused its demise, under the provisions of section 424. If it were otherwise, fraudulent directors and other officers of a company would benefit from their own fraud.
The plaintiff's further claims were premised on breach of the directors' fiduciary duty. The plaintiff alleged that the defendants owed the shareholders of Cellular Calls such a duty. He sued in his capacity as a shareholder and alleged that he had suffered damages due to the decrease in value of his shareholding in Cellular Calls which flowed from the defendants' wrongful conduct.
The defendants disputed this, arguing that they, as directors, owed a fiduciary duty to the company and not to its shareholders. They argued that at best if the conduct was proved, then it may show that Cellular Calls had a claim against the defendants.
The defendants argued that a company is a legal person with separate legal identity distinct from the directors or shareholders. Should it be defrauded by a wrongdoer, the company itself is the person to sue for such damage.
This concept was outlined in the well-known case of Foss v Harbottle, which is accepted in South African law. However, an exception is recognised in English and American law which allows for a derivative action being afforded to minority shareholders to be brought on behalf of the company against wrongdoers who are in control of the company on the footing that the minority shareholders are entitled to obtain redress on its behalf.
It has, however, been held that a shareholder cannot institute a derivative action where he or she complains that as a result of a wrong done to the company, their shares have diminished in value in circumstances where the company itself has a claim against the wrongdoer for the loss suffered by it. This would result in double recovery by both the shareholder and the company.
The judge did not expand on this issue and stated that the issue of double recovery was one for trial. He did say, however, that the Foss v Harbottle rule was not absolute and where there is no risk of double recovery and a shareholder does suffer diminished patrimony, the rule would inhibit justice and should not be applicable in such circumstances.
A shareholder may have no direct proprietary interest in the business of a company but he or she does have a financial interest in it, and the Foss v Harbottle rule can amount to an unwarranted and technical obstruction to the course of justice.
It will be interesting whether, if the matter proceeds to trial, the final judgment will open all sorts of doors for shareholders. What it has done already is amplify the need for directors to act with due care and diligence in running their companies.
Taryn Hirsch is an associate at Denys Reitz commercial law firm. This article appears in the latest Commercial Law Case Update
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