SHAREHOLDERS: PERSONAL LIABILITY UNDER SECTION 424 OF THE COMPANIES ACT?

Monday, June 07, 2004
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Everyone in business is familiar with section 424 of the Companies Act 61 of 1973 (“the Companies Act”) which is used by aggrieved and unpaid creditors to vest personal liability on the directors of a company for “reckless trading”.  It is the one section in the Companies Act that could contribute more to the introduction of a culture of good corporate governance than the King 1 and King 2 Reports – utilising the “stick” as opposed to the “carrot” method of persuasion.
 
Human nature being what it is, this has inevitably resulted in canny shareholders or the alter-egos of corporate shareholders, deliberately not seeking appointment as directors of the company, content to remain on the sidelines and in the shadows, but controlling and even manipulating the management of the company, free of fiduciary duties, through the simple mechanism of holding the purse strings in terms of shareholder funding – safe in the knowledge that they are unlikely ever to called to account for this.  After all, it is trite that, unlike directors, shareholders do not owe a fiduciary duty to the company.  But what of a liability under section 424?
 
Section 424 (1) of the Companies Act states:
 
When it appears, whether it be in a winding-up, judicial management or otherwise, that any business of the company was or is being carried on recklessly or with intent to defraud creditors of the company or creditors of any other person or for any fraudulent purpose, the Court may, on the application of the Master, the liquidator, the judicial manager, any creditor or member or contributory of the company, declare that any person who was knowingly a party to the carrying on of the business in the manner aforesaid, shall be personally responsible, without any limitation of liability, for all or any of the debts or other liabilities of the company as the Court may direct.
[our emphasis]
 
Section 424 imposes a statutory liability not linked to the usual elements of a delictual claim for damages:  it is not necessary to show a causal link between the reckless conduct of the directors or other parties, and the losses suffered by the creditors and the company.
 
What most people forget is that section 424 is not limited to directors of the company but applies to “any person”, including an ordinary employee such as a financial manager, even if he is neither a shareholder nor a director nor officer of the company.  Although there is no case law on the point, a strong argument could be made that the personal liability could equally apply to a shareholder – provided that the shareholder was a party to the reckless or fraudulent activity.  The liability can also attach to a juristic person, such as a company, provided it can be demonstrated that the so-called “controlling mind” of the company, its board of directors, was aware of the activities (Cooper NNO v S A Mutual Life Assurance Company 2001(1) SA 967 SCA).
 
Section 424 however only applies to those persons who are “knowingly a party” to the carrying on of the business of the company recklessly or fraudulently.  To be “party” to the company’s business as contemplated by section 424 requires joining with the company in a common pursuit of the company’s business, not of the person’s own private ends.  Thus the company’s auditor can never be a “party” to the carrying on of the company’s business, even if his negligence enabled the business to be carried out in a fraudulent or reckless manner (Powertech Industries v Mayberry 1996 (2) 742 W).  Similarly, the liquidators in the Cooper NNO case referred to above, who sought to hold Old Mutual Life Assurance personally liable for the debts incurred by investors in a failed investment scheme on the basis that their brokers “sold” the investment to the investors and it was thus a “party” to the reckless trading of the scheme, lost the action as the court found that brokers employed by Old Mutual were, in selling the investment, pursuing their own business ends.  The court observed:
 
“Clearly the section is aimed only at conduct which attracts liability to the company, as it is only that conduct which constitutes the mischief against which the section is aimed. The section does not extend to those who, while carrying on their own business, incidentally enable the company to carry on its business. No matter that a landlord, for example, may by letting premises to the company enable the company to carry on its business, and even enable it to do so recklessly, the landlord is not carrying on the company’s business and he is not a party thereto.”
 
“Knowingly” means, as set out by the court in the case of Philotex (Pty) Ltd and others v Snyman and others; Braitex (Pty) Ltd and others v Snyman and others 1998 (2) SA 138 SCA:
 
“having knowledge of the facts from which the conclusion is properly to be drawn that the business of the company was or is being carried on recklessly; it does not entail knowledge of the legal consequences of those facts. It follows that `knowingly’ does not necessarily mean consciousness of recklessness. Being a party to the conduct of the company’s business does not have to involve the taking of positive steps in the carrying on of the business; it may be enough to support or concur in the conduct of the business.”
 
The same case also considered the requirement of “recklessness” as connoting more than mere negligence:  at the very least, gross negligence.
 
In looking at the question of holding a shareholder liable under section 424, consider the example of company X, which has two shareholders.  In terms of a shareholder’s agreement, the shareholders agreed to unconditionally provide funding or working capital needed by company X, in proportion to their shareholding, upon request from company X, for the first 5 years of the company’s trading.  Company X’s ability to continue trading as a going concern is solely reliant upon the unconditional continued financial support from its shareholders.  One of the shareholders refuses to provide the necessary funding, either because it has financial difficulties of its own or because it wants to leverage some advantage from the company.
 
The refusal by a shareholder to lend monies to the company when there is no obligation to do so, does not constitute being “party” to the running of the company’s business (Klerk No v SA Metal and Machinery Co (Pty) Ltd [2001] 4 All SA 27 E).  In that case, two companies (“the DKW Group”) carried on the business of a scrap metal dealership, purchasing scrap metal and selling it to larger dealers.  The DKW Group began to experience cash flow problems and accordingly the defendant SA Metal granted the DKW Group a rolling credit facility.  In order to protect the interests of SA Metal, its CE was appointed as sole manager of the DKW Group.  Due to an erroneous credit, the facility went beyond its limit.  SA Metal was not prepared to fund the additional amount, giving rise to the bank calling up the overdraft and the DKW Group was subsequently liquidated.  The liquidators sought to hold SA Metal and its CE liable for the debts of the DKW Group in terms of section 424, on the basis, amongst others, that by withdrawing support from the DKW Group, they were a party to reckless trading.  The court noted:
 
“The so-called withdrawal was not a withdrawal by … [SA Metal] as participant in the running of the Group: it was a refusal by [SA Metal] to loan more money to the Group.  ….  [SA Metal] was under no obligation to provide more money to the Group.  Its refusal to do did not constitute participation in the running of the Group’s business.”
 
Similarly in the case of Simon No and Others V Mitsui and Co Ltd and Others 1997 (2) SA 475 (W), the court with approval the author Gore-Browne on Companies 44th ed at 35.014—15, in discussing an equivalent section under English law:
 
“If, for example, it is alleged that a controlling company has promised support for its subsidiary which has been withdrawn, this allegation cannot be used as the basis of an inference of fraud unless it can be shown that the promise was false when made or constituted a continuing representation falsified by a subsequent change of mind uncommunicated to the [subsidiary] or its suppliers (Re August Barnett & Sons Ltd (1986) BCLC 170 at 175.)”
 
There is regrettably no case law on the converse:  when there is a binding obligation to fund the company.  In our example, the shareholders agreement imposes an unconditional obligation on the shareholders provide working capital to company X, provided certain criteria are met.  It could be argued by an aggrieved creditor or a liquidator of company X that the shareholders’ failure or refusal to provide the funding, in circumstances where its directors were aware that:
 
·        Company X was solely reliant on shareholder funding to continue trading, and
·        Company X was continuing to trade and incur debts, and 
·        Company X would not be able to pay its creditors on due date without such funding, and
·        It (the shareholder) had an obligation to provide such funding and was unlawfully breaching that obligation.
 
Constituted being “knowingly a party” to the reckless trading of the business of company X.  Often such funding clauses are inserted so that the company can rely on guaranteed funding to tide it over the first difficult few years of its trading.  Moreover it is possible that the shareholders’ agreement was furnished to third parties and in particular creditors, who would regard the funding clause as form of letter of comfort.   The shareholder’s action in breaching its obligation to fund company X, knowing that creditors may be advancing credit to company X or failing to call for security on the strength of the comfort of knowing that company X has an absolute right to call for funding when cash flow is tight, and failing at least to advise all creditors of its intention to breach the funding provisions, could be construed as “reckless”.  This may also form the basis of a common law delictual action by creditors on the basis of negligent misrepresentation.
 
It must be stressed that shareholder liability under section 424 of the Companies Act on this basis is still untested in our law.  While there is a prima facie basis for such a claim, the facts of each case would need to be investigated.
 
 
 
 
 
 
 
 
In the next issue of The Nature of Law, we will consider the potential liability of the directors of the beleaguered company X under section 424, given the fact that the company is technically insolvent and reliant on shareholder loans to achieve “going concern” status – a fairly common scenario in the South African economy