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April 21, 2020

Insolvency-related management liabilities: notable developments in Ukraine

Following introduction of the country’s first Insolvency Code, Ukraine has significantly moved towards an increase in insolvency-based liabilities of management and shareholders. Was such an approach reasonable and does it actually demonstrate effectiveness in increasing management prudence by using early-warning tools and other means of assistance for pre-insolvency estates? What experience regarding insolvency-based liabilities do neighbouring EU jurisdictions have? The answers are not particularly apparent.

A year of changes

The year 2019 was definitely a year of significantchange for Ukrainian insolvency legislation. While the country reached a pivotal point in reforming insolvency regulations in adopting its first Insolvency Code (the UIC), it also made significant progress in dealing with insolvency-related management liabilities. Management’s role in Ukrainian distressed companies has always involved sitting on the sidelines. Although potential civil, administrative or criminal liability for culpable insolvency/wrongful trade had existed in Ukraine for almost 20 years, it did not receive wide support by court practice until late 2018/2019 when Ukraine’s Supreme Court delivered a number of judgments against the management and shareholders of bankrupt estates. These court decisions marked a turning point in understanding whether and, most importantly, under which conditions, an insolvency estate’s management or shareholders may share the company’s debt burden.

Early-warning liabilities

It is a common understanding that a company’s management, and in a vast number of cases, its
directors, has direct obligations to oversee the business’s financial status. Any management decision including acquiring or selling assets or incurring new obligations/liabilities, has to be based on reasonable understanding of how this might influence the company’s solvency. The World Bank shares this view by directly stating that a country’s legislation should prescribe responsible corporate behaviour combined with reasonable risk-taking,1 especially in situations where a company is on the verge of distress and any management decision may be detrimental for its creditors. Should such decisions be harmful to creditors due to management’s wilful, reckless or negligent actions, then the management should pay for this and, by doing so, cover the creditors’ losses. 

Following this concept, most EU countries have already introduced two minimal insolvency-related duties for distressed company management: a duty of filing for insolvency; and a duty to notify shareholders of upcoming distress by convening a general meeting. As both duties arise to address financial difficulties immediately at pre-insolvency stage, they are classified as early-warning liabilities. Whether these measures increase the probability of avoiding the threat of insolvency or are aimed to increase cost-effectiveness balance for the insolvent estate, their practical importance is undoubtedly high.
From 21 October 2019, both duties have been fully applicable to Ukrainian management, at least to those governing limited liability companies (LLCs). These are Ukraine’s most idespread form of incorporation covering more than 50 per cent of all Ukrainian legal persons.

The duty of filing for insolvency

A key insolvency-related manager’s duty is to file for insolvency if the company passes a certain distress threshold. Before the UIC, this duty was only applicable to companies in non-court liquidation. In short, this meant a direct duty of a non-court liquidator to proceed with court insolvency immediately if a case of balance sheet insolvency had been established.

After the UIC was introduced, the concept of early filing became applicable to any Ukrainian legal entity which might be subject to insolvency procedures. The newly-introduced UIC’s article 34 forces a director to file for insolvency within 30 days of the date when the threat of insolvency became apparent. Failure to comply with this duty would lead to joint personal liability on the directors’ behalf for the company’s debts.
Since the concept itself is not new, it gives rise to the same issues already faced by other, primarily EU countries. 

The first difficulty relates to the definition of likelihood of insolvency: whether cashflow (unable
to pay debts as they become due) or balance sheet (liabilities outweighing assets) insolvency would be deemed as a trigger for managerial action? The same issue arises in different EU jurisdictions. For example, Germany, Austria and Bulgaria use an insolvency term for a company being either illiquid or over-indebted. At the same time, under German law, illiquidity fits with a concept of cashflow insolvency, while over-indebtedness (negative assets-to-liabilities ratio) is understood as balance sheet insolvency.As Austrian researchers suggest, a similar discussion on whether balance-sheet test might be equal to the liquidity test is expected to gain new momentum in Austria.3 

The UIC itself deals mainly with cashflow insolvency which, by definition in Ukrainian bylaws,4 is to be determined by dividing obligations as they fall due by highly liquid asset values. Obviously this approach does not cover any long-term perspective without which almost any trading Ukrainian company, whose cash and highly liquid assets are often being in a regular and well-controlled shortage as compared with immediate obligations, primarily intragroup ones.
Second, the 30-day term between the date when the likelihood of insolvency was, or should have been, determined and the date when a company actually files for insolvency might be practically impossible for Ukrainian companies. It is a widespread practice for different jurisdictions to set different timings for early filing. These range from 14 days in Poland to 60 days in Austria with a duty of immediate filing in the Czech Republic and Lithuania. However, these jurisdictions’ approaches do not contradict relevant domestic corporate legislation, thereby allowing companies to comply with all formalities while filing for insolvency to prevent such filings being dismissed without considering their merits.

However, for Ukrainian LLCs which constitute the majority of the country’s legal persons, a 30-day term might not be sufficient. In particular, the UIC rules clearly require the company to file for insolvency in the absence of a shareholders’ decision approving such filing. In turn, should an LLC’s articles of association establish minimal 45-day (or longer) period for shareholders’ notification, there would clearly be no decision for filing made within 30 days. That might make an early filing impossible, as the filing not supported by the debtor’s shareholders decision will be rejected in court on technical grounds with no further action.
Moreover, in light of the EU Directive on restructuring and insolvency, Ukraine should focus not only on a real and serious threat to a debtor’s actual viability as of the present date, but also on their prospective ability to pay debts as they fall due. This, as the Directive says, may extend to a period of several months or even longer, clearly longer than the 30-day period prescribed by
the UIC.
Both these issues might make this strong tool excessively inquisitorial for directors with no actual insolvency protection given. 

Convening a general meeting of shareholders

Reflecting article 19 of the Second Directive 2012/30 (EU), Ukraine introduced an obligation on an LLC’s director to convene a shareholders’ general meeting if the company’s net asset value decreased by 50 per cent when compared with a previous financial year. Failure by the director (or a board if it exists) to do so causes vicarious liability for debts not covered by the company itself in the event of bankruptcy.
This Directive’s provision has already been effectively implemented by most countries in the EU. Some, including Germany, implemented article 19 in part by switching from net assets value criteria to statutory capital decrease.
In Ukraine this implementation appears to be very successful. In the authors’ opinion, the clear and precise wording of current Ukrainian legislation on LLCs should be extended to: all legal persons (not to solely LLCs); and near-insolvent situations as described above. This would make the pre-insolvency approach more flexible and integrated.

Culpable insolvency 

Being among a few jurisdictions such as Romania and Spain,providing non-culpable/fortuitous, culpable or fraudulent insolvency, Ukraine still has much room for improvement in this regard. Notwithstanding the concept coexisting on the boundary of both civil and criminal liability, neither has shown any remedial effectiveness.

First, any claim arising from the fraudulent insolvency may be brought against directors, shareholders or stakeholders in the event of bankruptcy eg, during the distribution between creditors phase; and must be by a liquidator, not creditors. In our opinion, such an approach does not provide creditors with necessary protection as they are potential victims of such fraudulent/culpable insolvency. It is therefore of crucial importance that creditors should be able to claim damages arising from management’s potential fraud and/or wrongful or reckless trade either in the insolvency case or via separate proceedings.
Second, the criteria for determining fraudulent insolvency in Ukraine have not been updated for almost six years and require an extensive review. This is mostly based on the switch of accounting from domestic to international standards. The review should cover such basic indicators as owned-asset coverage ratio and determining of net assets value, both of which are of absolute importance for any economically-based conclusions about a business’s viability.

Conclusions

The importance of the developments made by Ukraine in the field of insolvency-related management liability is hard to overestimate. They reflect recent EU insolvency reform and constitute a logical continuance of the country’s forthright intent to transform a post-Soviet insolvency system to a more modern one.

At the same time, as recent EU members’ experience shows, Ukraine does require additional measures for making insolvency-based liabilities less inquisitorial and more creditor-oriented – primarily by not depending on a liquidator’s lack of incentive. These add-ons should especially include:

  • the introduction of precise terms for both ‘likelihood of insolvency’ and ‘forecast-based insolvency’;
  • a switch in focus from civil liability of management to that of ultimate beneficial owners being directly liable for a company’s financial struggles; and
  • the further development of disqualification penalties against management misconduct.

 

A milestone of these developments does remain apparent, despite being responsible for either delay in action or wrongful trading, managements’ objective ability to cover all potential creditor loss might be little to none. Such impoverished state of management would surely outweigh effort/cost in favour of creditors, thereby making any action against management more ‘witch hunt’-like rather than a reasonable claim possessing true remedial power.

 

Notes
1. From a study on a new approach to business failure and insolvency.Comparative legal analysis of the Member States’ relevant provisions and practices Tender No JUST/2014/JCOO/PR/CIVI/0075, January 2016.
2. Gerard McCormack, Andrew Keay, Sarah Brown and Judith Dahlgreen, Study on a new approach to business failure and insolvency, European Commission/University of Leeds, 2016, pages 48-49.
3. Gottfried Gassner and Georg Wabl ‘The new EU Directive on restructuring and insolvency and its implications for Austria’, Insolvency and Restructuring International, Vol 13 No 2, September 2019.
4 Ministry of Economy of Ukraine, Guidelines for identifying signs of companies’ insolvency and signs of action to hiding bankruptcy, fictitious bankruptcy or deliberate bankruptcy No 14, 19 January 2006.
5 Gerard McCormack et al, (note 2 above), page 58.

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