Liability of the Board of Directors in a Company Facing Economic Difficulties

TRUST's Parties' getting Closer 12 November 2015

Splendid autumn for everyone! At Trust, everything is going well and our house-warming parties are getting closer. If you have not received an invitation, do not panic, just check all your mail bozes and if you still do not find it, send me an e-mail (jan.lindberg@thetrust.fi) and I will send to you an invitation. We have awesome artist playing like Anssi Kela,  Italian wines and good food - you do not want to miss this! 

To our real topic, as we have been advising some Boards lately in companies facing economic difficulties, I thought that I share a few words about this governance topic from director's liability point of few if it could also help others. Naturally this topic is requires further attention to details depending on the particular case, but at least this gives to you an overview of the different options. At the same time I must say that while my M&A blog has been on hold, but we have actually written a few additional posts so I will also publish those shortly.

Background

If a company is going through economical difficulties, it has, in practice, three options: 1) to file for restructuring 2) to file for bankruptcy or 3) to continue its business operations. If the company has lost its equity, the company must notify this to the trade register without undue delay, and the management of the company has an emphasized duty of care. Failure to file the notification has not been deemed a very significant matter in the court praxis regarding directors’ liability, but it is more important what actions the board takes, if the company is in economic difficulties and whether such actions lead to an increased debt burden or weaken the position of the creditors. Consequently, the management is under an obligation to take active measures to correct the situation or to improve the financial position of the company. If they fail to do so, they should generally file for insolvency proceedings. This is important, as continuing the business without corrective actions may lead to personal liability of the members of the Board of Directors of the company as well as that of its other management (including the CEO). Therefore, the management of a distressed company should be extremely alert in the event of loss of equity and other financial difficulties.

The purpose of this memorandum is to outline, at the general level, these possible liabilities under the Finnish law, and the different options a company not having adequate financing or capital could have, without providing an overall understanding of the matter or going too much into detail.

Liability of the Board

According to Section 23 of Chapter 20 of Limited Liability Companies Act (the “Act”), if the Board of Directors of a company notices that the company has negative equity, the Board shall at once make a register notification to the trade register on the loss of share capital. The purpose of such notification is to bring the economic situation of the company to the attention of the company’s debtors. If the Board neglects the notification, this might lead to the personal liability of the company’s Board of Directors and management under Section 1 of Chapter 22 of the Act, if a debtor or another contracting party suffering credit loss can show that it would not have given credit to the company had it known of the loss of equity. The referred Chapter stipulates the following:

“Liability of the management

(1) A Member of the Board of Directors, a Member of the Supervisory Board and the Managing Director shall be liable in damages for the loss that he or she, in violation of the duty of care referred to in chapter 1, section 8, has in office deliberately or negligently caused to the company.

(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.

(3) If the loss has been caused by a violation of this Act other than a violation merely of the principles referred to in chapter 1, or if the loss has been caused by a breach of the provisions of the Articles of Association, it shall be deemed to have been caused negligently, in so far as the person liable does not prove that he or she has acted with due care. The same provision applies to loss that has been caused by an act to the benefit of a related party, as referred to in chapter 8, section 6(2).”

Furthermore, in order to prevent inappropriate and damaging business and to maintain confidence in the business, among others, a person involved in the management of a company (for example as a member of its board) may be imposed a ban on business operations under the Finnish Act on Ban on Business Operations. This requires that the person in question has essentially failed in performing his statutory obligations related to the business, or if he is found guilty of criminal procedure that cannot be considered minor. It is also required that his activities as a whole are regarded as detrimental to the creditors, contractors, public finance, or sound and effective economic competition. The ban prevents its subject from, e.g., engaging in business activities for which the Accounting Act provides for an accounting obligation, being a partner of a general partner or a limited partnership's general partner or a member of the board of a company, as well as establishing a limited liability company, or otherwise to acting in a comparable business operations position. The duration of the ban varies between 3 to 7 years.

Bankruptcy

If a company’s financial difficulties turn into permanent insolvency, then the company should file for bankruptcy. Some pressure to make the appropriate filings is created by the fact that continuing to run the business of an insolvent company may be deemed as debtor’s dishonesty under Section 1 of Chapter 39 of the Criminal Code, in relation to which the punishment varies between a fine and 2 years of imprisonment. Therefore, it is not recommended to wait that a creditor files for the bankruptcy of the debtor company – at least not for a very long time. The decision on filing for bankruptcy is made by the Board of Directors with simple majority.

Also, according to Section 12 of Chapter 4 of the Credit Data Act, which is applied to registers to which credit data companies enter credit data, which they then provide to others (usually against payment), the credit data registers are entitled to enter information regarding a person’s participation in companies, as well as these companies’ payment default situation, bankruptcy, and similar economic situations. The entry regarding bankruptcy may be in the register for a period of five years. Furthermore, as stipulated in Section 27 of Chapter 6 of the same act, this information may, subject to the fulfillment of specified requirements, be used in the credit rating of a company in which that person is involved. It is our estimation, however, that these requirements would not be fulfilled in the case at hand with the assumption that the company has been up and running for several years and its accounting has been made and filed appropriately. On another note, it is possible that this information be used also in other relations, such as when establishing a new company, or when applying for a personal loan, etc. as the information is publicly available to any interested party.

Restructuring of Enterprises

To the extent the company is in a position to be rehabilitated and it fulfills the requirements under the Restructuring of Enterprises Act, the company could, instead of bankruptcy, file for restructuring. This could be recommended if the debtor company’s business is profitable, but it has so much debt that it cannot pay them in the agreed schedule. The restructuring proceedings creates costs, and thus is not recommended if the company is for example very small.

Conclusions

A member of the Board of Directors of a company going through economical difficulties should pay special attention to the company making the appropriate filings an taking the necessary actions in accordance with the above and also otherwise actively act with due care in fulfilling his or her obligations as outlined above. Continuing the business without corrective actions and/or otherwise not acting as required by the law may lead to personal liability of the members of the Board of Directors of the company as well as that of its other management (including the CEO). Next we continue with M&A themes, but hopefully we meet in our parties so see you there!

Regards,

Limppu

UPC Ratification Progresses in Finland

Greetings everyone, I just thought that I share this if someone has missed this important piece of European patent law reform and advancements in Finland!

In February this year, the Ministry of Employment and Economy of Finland set up a Working Group to make preparations for the ratification of the Unified Patent Court Agreement (“UPC Agreement”). The resulting memorandum has now been published, including a draft for a Government Proposal, which covers actions to be taken for its implementation in Finland, as well as clarification as to how national legislation would need to be changed to make it compatible with the provisions of the UPC Agreement. It was proposed in the memorandum that the Parliament would ratify the Agreement. Following this, ratification is expected to take place by the end of 2015. The below quote is from the press release published by the Ministry of Employment and Economics on the matter:

“According to the proposal — provisions of the agreement that are of legislative nature shall be brought into force by an Act of the Finnish Parliament. The working group has also drafted necessary amendments to the Finnish legislation on patents, including the necessary measures for implementing the regulations governing the European patent with unitary effect. According to the proposal a new chapter would be added to the Patents Act. This chapter would include provisions on the European patent with unitary effect.”

The Agreement contains provisions on the scope and limitations to the exclusive right conferred by a patent. The relevant provisions in the Patents Act would be amended with a view on achieving uniformity with the provisions of the  Agreement. The proposal also includes amendments to procedural legislation that clarify the division of competence between national courts and the Unified Patent Court as well as the necessary amendments to legislation on enforcement and criminal sanctions.”

The proposal of the Working Group can be found from: here, worth checking out!

Should interim injunction decisions for utility models follow patents? (MAO:434/15, 18 June 2015)?

Inspired by several Finnish companies, like many other interest groups, having expressed their concern regarding the level of renewal fees of the Unitary Patent, I thought of writing about a slightly different protection regime that provides not only fast but also low-cost protection for technical inventions, namely, utility models. First I have a question for all of you interested in IP enforcement and interim injunctions: do you think that interim injunctions in cases involving utility models should be granted on grounds and standards different to those applicable to patents? If you do not have a view on this, see what the Finnish Market Court considers and as we will see the main emphasis is on the so-called ‘claim requirement’:

http://kluwerpatentblog.com/2015/06/30/finland-should-interim-injunction-decisions-for-utility-models-follow-patents-mao43415-18-june-2015/

Hope you like it and and now until next time!

Regards,

Jan

Do you think that set-off and netting are important for the effective functioning of the international finance?

I found this old article from my files and thought that I share this as it brigs to my mind good memories from Oxford times and lectures with amazing Philip Wood of Allen & Overy. I had fun writing this and hope you enjoy (reading with your own discretion and no guarantees on substance, and mistakes are all attributable to the undersigned).

There are three general types of set-off and netting. To begin with, there is insolvency set-off in which case the party sets-off his claim against his insolvent counter party. The second type is close-out netting in which case the parties cancel and set-off open executory contracts. Finally, in settlement netting debts or fungible claims under executory contracts are set-off provided that they fall due or are delivered during the same day. I first focus on general policies underlying set-off and netting in different jurisdictions and then analyse these different aspects in connection with the above-mentioned classification. I then turn to the question whether or not set-off and netting are important for functioning of the international finance.

One of the most fundamental distinctions in this question can be illustrated with reference to different approaches to ‘cherry-picking’. Term cherry-picking itself means the question whether or not the solvent party has the right to cancel and set-off the losses and gains in its open executory contracts or whether the insolvency administrator may choose selective performance. Jurisdictions can be roughly divided into two categories on the basis of how they approach this issue in other words to those which consider cherry-picking as unjust and those which think that it is justified. The former approach can be classified as pro-creditor, which allows insolvency set-off, or like in the case of England, it even mandatory. In addition, pro-creditor view considers rescission clauses valid in the event of insolvency. The latter approach on the other hand tries to maximise the debtor’s estate by allowing selective performance. Rescission clauses having an effect on insolvency are usually expressly nullified. This latter approach could be said to apply in Napoleonic countries while the former in Anglo-American and Roman-Germanic legal families.

As already mentioned above, in insolvency set-off the parties may set-off mutual claims. If the solvent party is not allowed to set-off, his exposure to insolvent party will increase. Naturally this risk is taken into account in the risk assessment of the bank increasing the cost of credit. Controversially, it could be argued that set-off itself make rehabilitations process more difficult because it diminishes the debtor’s assets generally, which may be needed not only for future business but also as a security in the process itself. At least in some circumstances, the rehabilitation process might maximise the creditor income and in addition to that provide some other positive externalities like saved jobs. In financial terms this issue is extremely difficult whether pro-creditor or pro-debtor approach should be preferred and it will become even more difficult if the effects of set-off on systemic risk are taken into consideration.

On the other hand, it can be argued that set-off violates creditor equality, because only one creditor is paid at the expense of the others. From this respect this is a question whether creditors should be treated pari passu. The Napoleonic pro-debtor system sees this issue from the perspective of quasi-security and deems set-off as an unpublished security interest. At the end of the day the question of equality issue turns to the issue what is considered as just. Should the creditor have the right to set-off or should the debtor or her successor have the right to selective performance for example in close-out netting depends on moral value-judgements connected with the socio-economical culture of the legal system in question.

In the third type, the parties agree that monetary obligations in the same currency or the same type are netted provided that they fall due or delivery on the same day in order to reduce settlement risk. The actual conflicting policies are already explained above, but it should be borne in mind that in this case both approaches purport to protect the same underlying interest: reduce transaction costs not only trough legislation and carve-out arrangement but also trough voluntary agreement-based system like ISDA.

Set-off and netting are important especially due to their financial effects, but what is the best way to implement and organise the whole system remains to be the key question. When comparing these two categories one faces with the problem of finding appropriate measures for measuring the financial effects of insolvency set-off in pro-debtor and pro-creditor systems or to prioritise different values behind these financial choices. This distinction is however merely a question of effectiveness since it is conceivable to argue that both systems facilitate the objectives of the international finance.

SPA Series Part 8: How To Negotiate M&A Deals In Finland - Earn-Outs

Dear All,

I know it would be interesting to read a bit about bulletproof earn-out clauses but I first have to tell some news from our firm. These days, we have a new website that we are very proud of (see here). In addition, another issue is that we are nominated among the noted M&A firms in Chambers Europe 2015 for the first time. I first of all would like to thank all of you who have voted for us. It is an honour to be in the same category with the leading heavyweight transaction law firms. Already this year we have represented clients in several deals, such as acquisition of Sports Tracking Technologies Oy by Amer Sports Corporation (link to press release) or divestment of private cloud business of F-Secure to Synchronoss Technologies for 60MEUR (link to press release), not to mention energy sector deals with Vapo relating to acquisition of district heating systems (link to press release). Anyway, we have been very fortunate and blessed with great team, which is now expanding with a new member joining to our ranks by the end of summer. The name I will still keep as a secret but this way we ensure that we are able to serve our growing clientele even better. But to the real thing, do you know how to write bullet-proof earn-out clauses? If your answer is no, then you came to the right place!

An earn-out clause is a payment structure, which means that part of the purchase price is connected with the future performance. So typically there is an initial payment on completion of the acquisition and a number of subsequent deferred payments, which are spread over an agreed period post-completion. In a sense this mechanism is contingent for certain events taking place, which creates a challenge for the drafter. One example could be the following: 

“The Purchaser shall pay the Purchase Price in a following manner: ….Provided that the agreed financial targets are reached in the Company, the Seller shall be entitled to an additional payment for the Shares of the amount of EUR____________ (Earn-Out). The Earn-Out shall be calculated in accordance with Appendix X.

The calculation of the Earn-Out shall be based on the annual accounts of the Company for the financial year X, which accounts shall be prepared in accordance with the Accounting Principles. The Earn-Out shall be paid by the Purchaser to the Seller in euros in immediately available funds within X days following the date when the determination of the Earn-Out is deemed final and binding.” 

And naturally there should also be a mechanism to solve disputes if there are disagreements.

What are the advantages and disadvantages of an earn-out? The main point probably is that earn-out enables more precise valuation of the target. This comes with the prices as the control that buyer can exercise during the earn-out period is typically limited. So there is an interesting balancing exercise to be made between the short and long term plans of the Company but for the seller this mechanism might enable higher price even in a situation when there are doubts as to the actual profitability and performance by the contemplated buyer.

Some points on drafting these clauses:

• The Earn-Out is most often calculated by reference to EBIT, but turnover or net assets could also be used. Not very common though;
• If you are using several purchase price mechanics simultaneously, see that there is no overlap, e.g., if the project closing is delayed (like overlap between adjustments and earn-out);
• Profits should be carefully calculated and considered and one issue that relates to this is that accounting principles should be precisely defined. This is a point that the seller and buyer see differently and, as an example, the buyer may want the one-time so-called windfall profits to be taken out; 
• For the seller, it is preferable to have a model in which there is no "all or nothing" approach but carry-forwards and backs between years if there is a longer period;
• The responsibility as to who prepares the accounts is also relevant and here we refer to a price adjustment blog that we already discussed;
• There almost certainly must be provisions relating to the management of the business during the earn-out period and some typical vetoes could include, for example, the right to hire new employees, the right to use subcontractors, board structure, remunerations, the right to promote employees according to the Company’s performance evaluation process. On the other hand, the buyer typically wishes to ensure that capital expenditure is not deferred to drive short-term performance;
• How synergies are treated is also an important and difficult issue, such as more affordable access to capital, insurances. Buyers may resist these due to the fact that these are difficult to quantify;
• The relationship with the overall structure of the representations and warranties and indemnities should be defined. So what happens if an event is a warranty claim, indemnification and affects an earn-out in the same time. A point worth considering whether there is a possibility for double-recovery;
• Also set-off criteria is worth considering and whether there is a need to have withholding rights to expand the scope of set-off that would be ordinarily available under law; and
• Taxation is something that should always be considered and in particular if you connect the earn-out with employment condition to avoid unpleasant employer payment surprises.

Hope this gives you a head start if you have been unfamiliar with these earn-outs in the past. Next I will focus on escrow payments and new posting coming by the end of this month. We have also started a book project around these M&A themes which will be released in the autumn, but more information on that to follow.

Lovely beginning for your spring week and hope to be in touch with you soon,

            Jan