What can directors of a company in financial distress or insolvency do?


By Ronald JJ Wong and Stacey Lopez

If you are a director or owner of a company in substantial debt, financial distress or becoming insolvent, you may want to do your best to resuscitate the company.

If the company is liquidated or wound up, a liquidator will investigate the affairs of the company and may hold you personally liable for debts or transactions of the company in certain circumstances.

If you seek to restructure debts, rationalise assets and reorganise the firm early, you may be able to avoid the company’s downfall.

Directors’ Duties and Liabilities

When a company is solvent, directors have a duty to promote the interests of shareholders.

When a company is insolvent or in a financially uncertain or parlous state, directors owe a duty to protect interests of the company’s creditors. A breach of this duty may result in directors being held personally liable.

The two common tests for insolvency applied by the law are

  • the cash flow test, i.e. company unable to pay its debts as it falls due; and
  • balance sheet test, i.e. total liabilities exceed assets.

A director who caused or permitted a transaction pre-insolvency or pre-liquidation which is an undervalue, unfair preference, extortionate credit, wrongful trading, or fraudulent trading transaction may be in breach of director’s or fiduciary duties.

Undervalue transactions are transactions where the company received no value for it or where the value received was much less than it should be. Transactions caught under the provision must have occurred within five years before the winding up application was presented and the company must have been wound up at the time of the transaction or was wound up as a result of the transaction.

Unfair preferences are transactions where a creditor gets special preference such that it is in a better position than it would have been if the company was liquidated. Transactions caught are those which took place within two years before the presentation of the winding up application if the recipient of the preference is an associate, and within six months in all other cases. This applies to floating charges as well subject to certain requirements.

Extortionate credit transactions are where the terms are exorbitant, unconscionable, or substantially unfair (s 228 of the Insolvency, Restructuring and Dissolution Act 2018 (“IRDA”), an act which has not yet, to date, come into force). Transactions within a period of three years before the presentation of the winding up or judicial management application are caught.

The new s 239 of the IRDA provides for wrongful trading. Wrongful trading is when an insolvent company incurs debts or other liabilities without reasonable prospect of meeting them in full, or the company incurs debts or other liabilities that it has no reasonable prospect of meeting in full; and that result in the company becoming insolvent. Any person who knew the company was trading wrongfully or as an officer ought to have known that it was trading wrongfully may be held personally liable for the company’s debt or liabilities.

Directors should therefore ensure that all transactions made by the company when it is financially parlous are commercially justified.

Neither restructuring nor insolvency proceedings will release directors from liability for previous actions or decisions.

Restructuring

Restructuring debts are essentially about two things: renegotiating debts and seeking new capital or cashflow.

The possible restructuring mechanisms are different ways to facilitate these two things. They are:

  • Informal workouts;
  • Scheme of Arrangement (“SOA”); and
  • Judicial management.

In the restructuring process, the company may sell assets or business lines to raise cash, borrow money at distressed loan terms, and/or look for investors to inject new capital or provide loans in exchange for security/collateral or equity on preferential terms.

The company may also work out salary reduction or leave arrangements with employees or retrench part of its workforce to reduce overheads. It should note any obligations to notify the Ministry of Manpower (“MOM”) of such scenarios under certain circumstances.

Informal Workouts

Under this approach, the company attempts to renegotiate debts and other obligations with creditors and other stakeholders without going to court. The idea is that if the creditors do not agree to the restructuring proposal, their position if the company is wound up would likely be much worse than if they were to hold out and give the company time or repayment terms.

Advantages:

  • Mutually beneficial for all stakeholders if implemented successfully, especially if the company practices open communication and transparency during the relevant period. The stakeholders, creditors, employees and suppliers of the company may regain confidence in the financial affairs of the company.
  • Flexibility in formulating the terms of the workout.
  • Gives the perception to customers and suppliers that the company is not doing that badly financially, and that it is still possible to salvage the business.

Disadvantages:

  • There is no court moratorium against legal proceedings continuing or commencing against the company, appointment of receivers, realisation of securities over assets, execution, distress or enforcement process against assets. So, creditors may in the meantime sue the company or apply to wind up the company.
  • Difficulty in achieving consensus among creditors since they have diverse expectation – e.g. some may want a quick exit from the company while others would not mind staying on for the long-term recovery.
  • May fail due to divergent interests of all the creditors, minority creditor troubles, unreasonable terms of creditors’ proposal, and lack of communication and transparency.

Scheme of Arrangement (SOA)

An SOA is a court-ordered process where the company is given time to engage its creditors or contributories on a proposed compromise or arrangement relating to debt restructuring.

Possible proposals include writing off a percentage of creditors’ debts, a longer timeline for repayment, asset sale, deleveraging through debt repurchase (shareholders repurchase company’s debt at a discount and then cancel it for more equity), debt for debt exchange (new debt to have a lower principal, lower interest rate, longer maturity for priority over old debt), and debt for equity swap.

New legal provisions introduced in 2017 allow for rescue financing (also known as debtor-in-possession financing adapted from the Chapter 11 process in the United States) where an investor lends money on a priority or super-secured basis which has priority over existing secured debts (s 211E, CA; s 67, IRDA). However, before the court will approve such rescue financing, the company must show that it has made reasonable efforts to obtain rescue financing on a non-super priority basis.

An SOA may also be used by the company to reorganise the share capital of the company, propose a buyout of shareholders of the company, take a listed company private, and/or reconstruction or merger of a group of companies.

The company, or its creditors, shareholders, judicial manager or liquidator (if the company is being wound up) can apply to court to order a meeting of creditors to approve the proposed SOA.

Typically, if the company is the applicant for an SOA, it will apply to court for a moratorium against legal proceedings for as long as it intends to propose the SOA. An automatic 30-day moratorium applies from the date of the company’s application or until the application is decided by the court (whichever earlier). The moratorium may then be extended as appropriate. The moratorium may apply even to persons outside Singapore. Related companies may also apply for such a moratorium.

In the meantime, the directors of the company would usually remain in control of the company.

The applicant must disclose all material information to the court, including the background to the company’s financial state, the proposed SOA, an explanation on why the proposed scheme is necessary, classification of creditors (depending on the nature of their rights, e.g. secured, preferential, unsecured), the appointment of the scheme manager, proposal on the conduct of the meeting, and any facts which may render the SOA unlikely to succeed. The SOA must not be sought in bad faith for some collateral purpose.

The court must be satisfied that the statutory requirements are complied with, attendees at the meeting to be called would be fairly representative of the class of creditors, and the scheme is one that a man of business or an intelligent and honest man, being a member of the class concerned acting in respect of his interest, would reasonably approve. There is a possible need to hold separate meetings for different classes of creditors.

For the scheme to be approved, it must be approved by a majority (>50%) in number present and voting (in person or proxy), and this majority represents ¾ in value of the creditors or class of creditors, or members or class of members. The scheme must then also be sanctioned by the court. Every class of creditors or members must have the requisite threshold approve the scheme.

Amendments to the law made in 2017 allow companies to apply to the court for an order to ‘cram-down’ a class of creditors or members who voted against the scheme (dissenting class); if this happens, the scheme will still be approved. The scheme must not unfairly discriminate between classes of creditors; it must be fair and equitable to every dissenting class.

Further, the IRDA, when applicable, will only require existing members or shareholders not to receive or retain assets of the company under the scheme to cram-down on an unsecured class of creditors. In contrast, under the current law, existing members or shareholders cannot retain any asset on account of their interests in the company unless all unsecured creditors are paid in full (the absolute priority rule).

After the court approves the application to summon a creditors meeting, a date and time will be fixed for the meeting. Creditors will have to submit proof of debts before the meeting to attend and vote at the meeting. The chairperson of the meeting (who usually is the proposed scheme manager) will adjudicate the proof of debts.

If the creditors approve the proposed scheme, the applicant will then go back to court to seek an order to sanction the scheme. If the scheme is approved, it will be administered by a scheme manager according to the terms of the scheme.

The 2017 amendments also introduce procedures for pre-packaged schemes which do not require creditors’ meetings (s 211I, CA; s 71, IRDA). This is where the scheme has already been pre-approved by creditors on certain requirements being fulfilled. The company must (i) provide creditors with a statement, accompanied by certain material information, (ii) publish advertisements of a notice of the application, (iii) send notice and a copy of the application to each creditor, and (iv) satisfy the court that had a meeting of creditors been summons, the scheme would have been approved by the required thresholds at the meetings.

Advantages:

  • Allows for flexible terms and solutions.
  • Legally binding on all stakeholders once the scheme is approved.
  • There is no insolvency threshold requirement.
  • Less stigma and negative publicity on company.

Disadvantages:

  • There is usually a tight timeline to engage creditors to approve the scheme.
  • It may be difficult to achieve the requisite threshold approvals if there are a multitude of classes of creditors.
  • If the company is hopelessly insolvent or there are no reasonable prospects, it is unlikely that the scheme will be approved or succeed.

Judicial Management

A judicial management (“JM”) is a court-ordered process to rehabilitate an insolvent company.

A company or its creditors may apply if the company is insolvent or likely to become insolvent. Similar to SOA, a moratorium against legal proceedings against the company will apply upon an application.

An appointed judicial manager will take control of management of the company and make a proposal to restructure or compromise debts and liabilities. The company’s directors will thus lose their functions and powers to the judicial manager.

Typically, if the application is made by a creditor, an interim judicial management (“IJM”) will be sought. This will place the company under JM pending the hearing of the actual JM application.

A judicial management order remains in force for 180 days but may be extended by the court upon the judicial manager’s application.

Judicial managers, like liquidators, have powers to investigate past transactions and apply to set aside transactions for being unfair preference, undervalue, etc.

The judicial manager must prepare a statement of proposals to restructure the company and seek approval from a majority of the creditors in number and value. If approved, the judicial manager would then have to implement the plan according to the terms approved. Judicial managers can also make an SOA or apply for the company to be wound up.

Under the JM regime post-2017, rescue financing provisions are available as well.

Advantages:

  • Allows the company time to reorganise its affairs to try to restructure the company, its operations and debts.
  • Moratorium against legal proceedings against the company available.
  • Does not require creditors’ approval for the JM itself.
  • The judicial manager, being neutral and independent, may receive more confidence from creditors in terms of working out a reasonable proposal to resuscitate the company.

Disadvantages:

  • Control of the company will be ceded from directors to the judicial manager.
  • There is generally a stigma regarding companies under JM. Shareholders may be perceived as using JM to delay and avoid winding up.
  • The cost of implementing the JM may is significant and may ultimately deplete the company’s remaining assets which otherwise would have been available for distribution in a winding up.

Insolvency Termination Clauses

Directors of insolvent or financially parlous companies should note insolvency termination clauses in the company’s contracts with third parties.

These common clauses would allow the counterparty to terminate, modify and/or accelerate obligations under the contract immediately upon certain scenarios, including suspension of payment, negotiation or making of proposals with creditors for compromise or rearrangement of debts, application, petition, resolution or order made in relation to winding up, judicial management, scheme of arrangement, or appointment of an administrator.

However, under section 440 of the IRDA which has yet to come into force, such ‘ipso facto’ clauses may have limited effect. A party who wishes to enforce such clauses would have to seek the leave of court and prove significant financial hardship if required to continue to perform the contract.

Winding Up / Liquidation

If an SOA or JM plan fails, the company will invariably be wound up.

A liquidator will be appointed who will investigate the affairs of the company, call in and liquidate assets, make claims against third parties including debtors and former directors, and prepare the asset pool for distribution of dividends to creditors.

Liquidators may disclaim certain property or contracts if they are onerous, unprofitable or unsaleable subject to the approval from the court or a committee of inspection (comprising creditors and contributories who supervise the liquidator).


Information as at 16 July 20


Corporate & Commercial Corporate Finance Corporate Insolvency & Restructuring