Legal newsletter - April 2016 | KPMG | LV

Legal newsletter - April 2016

Legal newsletter - April 2016

In this article read about Liability of board members

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Liability of board members

The year 2015 brought a number of changes in laws relating to the management board, including additional liabilities in the Insolvency Law and the law On Taxes and Duties. The new regulation does not repeal the general liability of board members laid down in the Commercial Law. The Insolvency Law includes a new presumption of board member liability for losses. The personal liability of board members for tax liabilities of a company is laid down in the law On Taxes and Duties and is triggered when a number of conditions specified in the law materialise.

Since 1 January 2002, when the Commercial Law entered into force, the Latvian legal system has had the principle that a company is managed by the board jointly, each member of the board should act as a decent and diligent owner who at the same time bears joint liability with other members of the board.

Alongside the above laws, the activities and liabilities of the board are regulated by a number of other laws such as the Civil Law, the Administrative Violations Law, the Criminal Law, EU regulations and other sources of rules. Given that a legal person, either a limited liability or joint stock company, can operate only via their representatives then it is the operation of such representatives that makes the economic activities legal and successful. By its nature, the board is an agent appointed by the owners of the legal person to realise the shareholders’ interests, rather than its own interests. This is to emphasise that, on the one hand, the board bears general legal liability for its activities on behalf of the company and, on the other hand, the board is to manage the company in the interests of its shareholders, which means that board members are also accountable to the owners of the company.

Based on the regulation of the Commercial Law, the Insolvency Law, the Administrative Violations Law, the Criminal Law and other laws, a board member may find himself in a situation where he is simultaneously accountable to various parties such as shareholders, creditors and the court, each on different grounds, as well as for various breaches of rules and losses that may not be mutually exclusive. Several parallel processes may be in existence. For example, shareholders or a group of creditors may turn against a board member for compensation of losses while law enforcement authorities for committing a criminal offence.

Further we discuss the key principles of board liability under the Commercial Law, the new regulation of the Insolvency Law and the law On Taxes and Duties.

Overall regulation of board liability under the Commercial Law

The Commercial Law regulates the status of the board and board members, relationships between a board member (the board) and the company, the procedure for appointing and withdrawing a board member, the model according to which a board member discharges his responsibilities and liability of a board member. This regulation directly impacts the overall liability of a board member before the company and its creditors.

• Responsibilities of board members

A board member is the executive body of a company who manages and represents the company. This provision of Commercial Law states that board members have a wide scope of responsibilities. Section 221 of the Commercial Law refers to the basic responsibilities of board members of a limited liability company to inform the shareholders’ meeting on transactions concluded between the company and a shareholder, council member or board member, to report to the council on the company’s operations and financial position at least on a quarterly basis, and to inform the council immediately of any deterioration of the company’s financial position or other material circumstances connected with economic activities. It is laid down in Section 301 of the Commercial Law that board members of joint stock companies are obliged to have a good knowledge of and manage the company’s affairs, be accountable for the economic activities of the company and compliance of the accounting system with the law, manage the company’s assets and act with its funds according to the law, the articles of association and decisions of the shareholders’ meetings.

It is obvious from the above that the legislator has not provided an exhaustive list of responsibilities of a board member but has determined the model according to which board members should act. It is determined in Section 169 of Commercial Law that a member of the board and the council should discharge his duties as a decent and diligent owner. As part of case No. SKC-102/2014 the Supreme Court concluded that ““as a decent and diligent owner” is a general provision the content of which is left to be specified by the law enforcement authority. The openness of this provision makes it possible to seek the fairest solution of an individual case.” As part of case No. 2014-02-01 the Constitutional Court concluded that it is the above general provisions from which “the specific duties of a board member are derived based on, for example, the size of the company, the type of activity or the market situation. The features of a decent and diligent owner are made of a number of objective responsibilities, including, inter alia, the obligation to comply with laws, articles of association and decisions of the shareholders’ meeting, the obligation to be loyal and avoid making decisions in conflict-of-interests situations, and the obligation to make economically justified decisions based on well-considered information.” It therefore follows from the above that there are objective considerations for legislators that make it impossible to specify these responsibilities but it does not justify cases when some of the responsibilities that are not referred to in law are not carried out by a board member acting as a decent and diligent owner.

• Joint liability and presumption of guilt of the board

As board members manage the company only jointly, they are jointly accountable for losses incurred by the company. So, a company or creditors are entitled to raise claims against each board member individually or all of them collectively. The principle of joint liability is not revoked or limited by different representation rights, namely, regardless of whether one board member has the right to sign documents only together with other board members and another board member has the right to represent the company individually, both of them will bear joint liability.

The provisions of the Commercial Law include a presumption of fault of a board member – where losses have been incurred and there is a causal relationship with actions/inaction of the board, the board bears liability for these losses regardless of fault. A member of the board (council) may release himself from liability if he proves he has acted as a decent and diligent owner and in good faith within a lawful decision made by the shareholders’ meeting (the condition does not apply to the creditors’ right to raise claims) and has not committed even the slightest act of carelessness. Approval of the council for the board’s action does not rule out the board members’ liability towards the company and its creditors.

A claim against a board member may be raised on behalf of the shareholders by the council, representatives appointed by the shareholders’ meeting who can also be a newly appointed board or by creditors (on behalf of the company). A company is obliged to raise a claim against a board member also if it is requested by minority shareholders (1/20 of share capital or a holding of at least EUR 71,100).

A claim should be raised within three months from the date when the shareholders’ meeting made the decision to raise the claim or when a request was received from the minority shareholders.

If the shareholders’ meeting or the council has released the board from liability by a decision then such a release applies to a specific action and it cannot be considered as an overall release of the board from liability. However, this kind of decision to release the board from liability or reach a settlement does not limit the rights of minority shareholders, and those of creditors and the administrator to raise claims against the board.

In the understanding of the Commercial Law, any internal agreement concerning the areas of responsibility for specific board members will not be the grounds for releasing the particular board members from liability. As concerns legitimate grounds for releasing from liability, it could be the inability of the board member, for objective reasons, to impact the actions of the board due to being suspended, for example.

• Time period for a board member’s liability

Board members are liable for their actions performed from the date they are appointed to the date of the decision by which the respective board member is removed or resigns. It is worthremembering that entries concerning board members made in the commercial register have declarative power, and regardless of what entries are made a board member is accountable for the actions taken from the date of appointment to the date of removal or resignation. A former board member of a company can also be held accountable when he no longer holds the position unless the time limit has been reached. Lawyers are not unanimous as to the interpretation of the time limit for claims arising from unlawful activities of a board member, i.e. whether it is five years as for the creditor claims or is ten years as stipulated in the Civil Law.

Board liability under the Insolvency Law

The Insolvency Law includes a number of special obligations of board members, including submission of insolvency applications, transfer of the company’s assets, provision of information to the insolvency administrator etc.

It is clearly stated in the law that board members are obliged to file an insolvency application if the company has failed to settle its due debt liabilities for more than two months. This provision applies to all debt regardless of the amount. An alternative option to filing an insolvency application is reaching a settlement with creditors on the extension of the deadline for payments or on commencing a legal protection procedure.

If the insolvency application is filed in due time, it will reduce losses of creditors and the company itself. The discussion on how to motivate board members to discharge their duties was launched back in 2013. The initial recommendations concerning ‘additional’ liability of board members under insolvency proceedings were notably more extensive. The current wording of the Insolvency Law discussing board members’ liability refers only to one significant violation in the discharge of the board members’ duties - failure to keep or inadequate keeping of accounts. This is another presumption of board members’ fault – if the board member has not provided the insolvency administrator with accounting records of the company or these records are in a condition that does not give a fair view of the company’s property status or transactions during the last three years an amount equal to the primary debt under creditor claims that is impossible to cover under the insolvency proceedings may be claimed from the respective board member. In contrast to claims based on Commercial Law, the amount of loss in a claim raised against the board under Insolvency Law is easier to calculate as the method to establish the amount is provided in the law.

Given that the percentage of satisfied creditor claims in Latvia is low the amount of losses under claims raised on this basis may be considerable; however, the legislator has limited in which cases a board member may be held accountable for losses of this size and the decisive element for establishing the fault is whether or not proper accounting records were kept.

Consequently, to release himself from liability in a matter like this a board member should rebut his individual presumption of fault by proving that he objectively cannot be held liable for not providing accounting documents. Such cases could be for example when these documents were not provided to the board member when he assumed the position or these documents have been destroyed by any other person. In any case, it is permitted for the court to release a board member from liability or reduce the amount of compensation in view of the level of influence that the respective board member exercised on the conditions that caused losses.

Claims on the basis of Insolvency Law are raised on behalf of the pool of creditors by the insolvency administrator. If the administrator has not raised such a claim it can be done by the creditor himself within one year after the process has been completed in the amount of his recognised and outstanding claim.

Unlike the Commercial Law, Section 72.1(4) of the Insolvency Law refers to determining the individual level of fault of a board member. Determining the individual fault of each board member is a precondition for administrative and criminal liability, for example, failure to file an insolvency application (S 166.55 of the Code of Administrative Violations), bringing the company to bankruptcy (S 213 of Criminal Law), delaying the insolvency proceedings (S 215 of Criminal Law).

Board member’s liability for tax debts of a legal person

Amendments to the law “On Taxes and Duties” entered into force on 1 January 2015 and stipulate a board member’s personal liability for overdue tax payments of a legal person. The aim of these amendments was also to motivate board members as the executive body of the company to discharge their duties as decent and diligent owners, namely, to treat the company debt liabilities with due respect. At the same time, these amendments were drafted to secure effective collection of tax payments as it is often the case that it proves impossible to collect tax from a company as it has neither cash nor property that can be used by the State Revenue Service for collection.

In light of this, the law “On Taxes and Duties” was supplemented with a new chapter XI “Compensation of overdue tax payments of a legal person” which lists criteria under which the State Revenue Service commences the process of recovering overdue tax payments directly from a natural person who was a board member at the time when the overdue tax payments in question accumulated.

According to Section 60(1) of the law “On Taxes and Duties” liability for overdue tax payments of a company is transferred to the relevant board member when all of the below criteria are met.

These criteria need to be considered in connection with the Insolvency Law. It must be pointed out that these references are general by nature and it is therefore unclear what the legislator actually meant, i.e. which of the definitions of a stakeholder given in the Insolvency Law is applicable. In light of the overall regulation on board member liability laid down in the Commercial Law, board members bear joint liability for tax debts. Namely, tax debts may be claimed from any board member (or all of them together).

The procedure that the State Revenue Service will use to make the decision to recover overdue tax payments of a legal person from its board member is specified in Section 61 of the law “On Taxes and Duties”. The law specifies a three month period from the date of establishing the fact that collection is not possible during which the State Revenue Service would warn the company and board members about commencing a recovery process of tax debt.

Board members may submit documents and evidence to defend themselves. If board members no longer have access to the company’s documents the State Revenue Service will obtain the required documents and evidence from the company. After reviewing these documents the State Revenue Service will make the decision to recover the overdue tax payments or inform the board member on terminating the process.

If the recovery process is not terminated, the board member is required to pay the company’s tax debt within 30 days of the date when the decision of the State Revenue Service entered into force. The decision made by the State Revenue Service may be appealed to the Director General of the SRS, and any decision by the Director General may be appealed in a court according to the procedure laid down in Administrative Process Law. The appeal would suspend the decision of the SRS from the date of receipt of the application to the date when the decision made by the SRS official becomes incontestable or non-appealable.

Currently, there is a case under preparation in the Constitutional Court regarding conformity of the new chapter XI of the law “On Taxes and Duties”, “Compensation of overdue tax payments of a legal person”, with Section 91, paragraph 1, Section 92 and Section 105 of the Latvian Constitution. The application was filed to the Constitutional Court by members of the Parliamentwho believed these requirements disproportionately restricted the right to property, did not conform to the principle of equality, and disproportionately infringed the principle of presumption of innocence. It is too early to judge what the potential outcome of this process will be; however, it is likely that the new regulation on board member liability for overdue tax payments of a legal person will soon undergo its first amendments.

In summary, a board member’s liability cannot be limited by contract or any other act of private law. This liability is to the company’s shareholders, its creditors and the state, for conducting economic activities according to law. Hence, board members are accountable to themselves. Before assuming a position on the board, one should evaluate the condition of the company, including its operations to date, the condition the company’s accounting records are in, whether tax payments have been made on time and other aspects. A board member shall act in the company in the shareholders’ interests but not by executing illegal decisions. When you act as a board member together with other board members be aware of what they are doing. Also, when a board member resigns from the position it is advisable to obtain documentary evidence on the company’s condition as at that date, for example, by drafting an act of transfer and receipt of property and documents. Responsible action reduces the risk of claims being raised against the board member.

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