There have been a number of high profile corporate nose-dives recently (Tollgate, Leisurenet and Fidentia), with hefty jail time being handed out to directors or officials who have run their business recklessly or fraudulently. These big cases has caught the attention of the media, but what about smaller companies that are run into the ground by the recklessness or fraud of their owners?

Holding directors personally liable for company debts

Source: Nicci Ferguson Attorneys

There have been a number of high profile corporate nose-dives recently (Tollgate, Leisurenet and Fidentia), with hefty jail time being handed out to directors or officials who have run their business recklessly or fraudulently. These big cases have caught the attention of the media, but what about smaller companies that are run into the ground by the recklessness or fraud of their owners? A holiday in Polsmoor for the culprits may sweeten the taste but it doesn’t get your money back.

The Companies Act allows a court to declare directors personally liable for debts and losses where they have carried on the business of the company recklessly or fraudulently. Unfortunately, the courts do not enforce these provisions lightly as the 2006 Supreme Court of Appeal case of Heneways Freight Services v Klaus Grogor highlights.

Mr Grogor was the sole director and manager of The House of Sports Cars, a company that imported exotic cars like Rolls Royce, Lamborghini, Aston Martin, Bugatti and Bentley into SA. Heneways were clearing and forwarding agents contracted by Grogor. In August 2000, Grogor applied to Heneways for credit, which was granted, and ran up a debt of R309 734.36 for services rendered.

Grogor gave Heneways a post-dated cheque for the amount owing but when the date for payment arrived, he stopped the cheque. The House of Sports Cars was subsequently liquidated, leaving Heneways to sing for their supper. Being a tenacious bunch, Heneways then sued Grogor personally for reckless and/or fraudulent trading under section 424(1) of the Companies Act. Section 424(1) reads:

“Where it appears that the business of the company is being carried on recklessly or with the intent to defraud creditors of the company, the Court may, on application, 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 limitation of liability for all or any of the debts or other liabilities of the company as the Court may direct”.

In support of their application, Heneways led evidence that Grogor had, for the past year, followed a practice of issuing cheques on behalf of the company which were subsequently stopped after the date for payment arrived. They alleged that Grogor had acted fraudulently and recklessly in terms of section 424(1). They also alleged that Grogor was fully aware of the company’s precarious financial position when he applied for credit with them, and that he knew that the company wouldn’t be able to pay its debts when they became due. They argued that this also fraudulent and/or reckless.

In deciding the case, the court applied the million dollar question:

Would the reasonable businessman in Grogor’s position, with his knowledge, have no reason to believe, when the debt in question was incurred, that there would be funds available to pay the debt when it became due?   

In his evidence, Grogor admitted that the company was experiencing financial difficulties and that he had followed a practice where more pressing debts were paid first and arrangements were made for the others. He also gave evidence that the company was due to be bought out by a large partner shortly after the Heneways debt was incurred and that all amounts owing would be paid from the proceeds of that deal. He also believed that, even if this deal did not come through, the company would be able to settle all its debts given time. The company only had to sell one or two cars in stock to revive the company’s cash flow.

The court accepted Grogor’s explanations and held that a reasonable businessman in his position would have acted in the same way. His conduct was not found to be reckless or fraudulent and Heneways, having lost in the lower court, lost the case on appeal.

Our R0.02:

There is a lot of uncertainty around these applications. Firstly you need to have as much information as possible on the company’s affairs, including its current and past financial position and future prospects. Then you need to speculate as to what the director’s state of mind was at the time he or she incurred the debt with you. Finally, you will be reliant on the court’s attitude to whether the director acted as a reasonable businessman would in the same circumstances.

As the Heneway decision shows, the courts will not make a finding of recklessness lightly. If there is an adequate explanation given for the director’s optimism about the future prospects of the company, and that explanation is found to be reasonable, the court will not declare the director personally liable under this section. Even where it is apparent that a director is negligent when incurring further debts on behalf of a company already experiencing cash flow problems, and putting further creditors at risk, he will not be personally liable.

To succeed in an application under s424, you must convince the court that the director, knowing that the company was in financial trouble, did not genuinely believe that“the clouds would roll away and the sunshine of prosperity would shine upon him again and disperse the fog of his depression”.