Hong Kong Director Disqualification Orders: Managing Personal Liability in the Context of Corporate Insolvency

Directors of Hong Kong companies operate in an environment of personal liability – a liability that is brought into sharp focus where companies face financial difficulties or even insolvency. This liability may take not only the form of criminal or civil liability but also the form of a director disqualification order, meaning an order to bar that director from being involved in the management of a company in the future. In this article, we explore the basis for a director disqualification order and provide guidance for individual directors as to how they should conduct themselves in times of financial stress to avoid liability.

Company directors operate in an environment of personal liability. Nowhere is this more clear than in the case where their companies face financial difficulties or insolvency. In these circumstances, quite apart from potential criminal and civil liabilities, directors run the risk that if their conduct falls below the requisite standard, they may attract a director disqualification order, meaning an order that the director be barred from serving as a director or from being involved in the management of a company for a period of up to 15 years except with the approval of the court. A director disqualification order has far reaching consequences because it bars the individual from being a director not only of the company that has been wound up but also of other companies in the future.

Basis for Director Disqualification

The jurisdiction for disqualification orders arises under a number of different statutes, the most significant of which for insolvency purposes is the Companies (Winding Up and Miscellaneous Provisions) Ordinance (“CWUMPO”). Though the circumstances for disqualification under CWUMPO vary from being convicted of an indictable offence or an offence involving dishonesty to persistent breaches of company laws, in the insolvency context, a director of a company being wound up or which has been wound up may be disqualified if:

• Fraud – he has been guilty of fraudulent trading or any fraud;

• Breach of Duty – he has been guilty of any breach of directors' duties; or

• Lack of Fitness – he is otherwise unfit to be concerned in the management of a company.

As a broad principle, director disqualification proceedings generally take place at the behest of the Official Receiver on the basis of a lack of fitness. This type of disqualification proceeding is perhaps the most challenging type for directors as it need not involve a specific breach of a specific legislative provision. A disqualification order on this basis is justified because the court takes the view that a director's misconduct is sufficiently serious that a disqualification is warranted to override individual freedom so as to protect the general public. As one court put it:

In addressing the question of unfitness, the court is to decide whether the conduct of which complaint is made, viewed cumulatively and taking into account any extenuating circumstances, has fallen below the standards of probity and competence appropriate for persons fit to be directors of companies.…

Not every breach of duty or impropriety calls for a disqualification order. It would place directors of companies in an unfair and unrealistic position, and would involve going further than the applicable legislation or relative authorities contemplate, if every time a director was found to have failed in his duty, he was liable to be disqualified.

Process for Director Disqualification on the Basis of Lack of Fitness

Applications for director disqualification orders under CWUMPO on the basis of a lack of fitness are normally made by the Official Receiver. However, the role of the liquidator of a company being wound up is significant for it is the liquidator who, through his day-to-day responsibility for a winding-up a company, is likely to find fault with the conduct of a director and report it to the Official Receiver.

A complaint by a liquidator however, is not by itself sufficient. In determining whether to seek disqualification, the Official Receiver must take a view as to whether it would be in the public interest that a director (or former director) be disqualified. In this regard, the primary concern of the Official Receiver is whether a disqualification is desirable to protect the public from the future conduct of the director in managing a company.

Assessment of Fitness

Once the Official Receiver makes an application, the court will assess the director’s fitness, having regard to a number of different factors, including:

• whether the director has committed any misfeasance or breach of any directors' duties, fiduciary or otherwise, in relation to the company, or
• whether the director has misapplied or retained, or conducted himself in any way giving rise to an obligation to account for, any money or other property of the company.

In the insolvency context, for example, a court may have regard to whether a director was responsible for:

• the insolvency of the company
• any failure by the company to supply any goods or services which have been paid for (in whole or in part), or
• any unlawful disposal of the company’s property.

Breach of Fiduciary Duty

Directors' Duty to Creditors

Where a company enters the insolvency zone, a director’s fiduciary duty requires him to take into account the interests of the creditors as a whole. A failure to do so may subject him to a disqualification order. For example, a director may be liable to be disqualified if:

• he causes the company to give an unfair preference to a particular creditor including a payment to the creditor made with the desire to put that creditor in a better position than other creditors in the event that the company goes into liquidation (e.g. making a loan repayment to a particular creditor at a time when the company owes outstanding wages to its employees and other payments to its general creditors);
• despite the company’s financial difficulties and without lawful reason, he withdraws funds from the company for personal use and with no benefit to the company; or
• he draws and tenders cheques for payment to the company’s creditors knowing that the company has insufficient funds in its bank accounts to honour those cheques.

Director Liability for Continuance of Insolvent Business

One area of difficulty is the extent to which a director may be subject to disqualification if he continues the company’s business in the face of insolvency or so-called "insolvent trading". There have been cases of director disqualification where:

• the directors had caused the company to make large purchases of stock at a time when they knew the company had ceased to be viable; or
• the director caused the company to take deposits from customers for sale transactions knowing that the company could no longer fulfil those transactions.

Statutory Breaches of Director Duties

As there is some uncertainty as to whether a director’s conduct warrants a disqualification order in the absence of a breach of a specific statutory provision, it is common for disqualification proceedings on the basis of lack of fitness to include allegations of breaches of specific statutory duties to strengthen the case for director disqualification.

This is particularly so where, in the insolvency context, such statutory breaches speak to a disregard for the interests of creditors or an obstruction of the winding-up and liquidation process. For example, the court may make a disqualification order if:

• a director fails to cause proper accounting records to be kept such as to hamper the director’s ability to understand the financial status of the company and make decisions accordingly and, in the event of company liquidation, the liquidators’ ability to identify and recover the assets of the company;
• a director fails to ensure that a company pays its employee’s wages or its contributions to the Mandatory Provident Fund, or renews its employee compensation insurance,
• a director fails to maintain proper corporate records and to make proper filings with the Companies Registry.

Breach of Directors' Duty of Care

A director’s breach of his duty of care may provide the basis for a disqualification order. However, where the case for a disqualification order is based solely on allegations of incompetence, the court must be satisfied that either the conduct complained of demonstrates incompetence of such a high degree that allowing the individual to act as a director would endanger the public or the conduct fails to meet standards of commercial morality.

Director Liability for Commercial Misjudgement

It follows that mere commercial misjudgement is insufficient to justify a disqualification order. Thus, for example, where a director causes a company to pursue a line of business which ultimately fails, without more, it would be unlikely that the director could be subject to a disqualification order.

On the other hand, for example, a director could be liable to disqualification if he habitually approves transactions without understanding the substance or ascertaining the purpose of these transactions or he fails to make enquiries or exercise independent judgment as to whether these transactions are in the interest of the company.

Director Liability Following Delegation of Responsibility

One area that may concern a director is whether he could be liable to disqualification on the basis that those to whom he has delegated management responsibility fail to meet the requisite standard of conduct.

In this respect, a court will have regard to the role which a director was assigned (or which he in fact assumed) in the management of a company in determining whether he has been unfit.

Non-Executive Director Liability

However, non-executive directors should not, however, draw too much comfort from the court's approach above because this approach does not absolve them to act prudently.

So, for example, a non-executive director may be liable to disqualification if he approves a transaction knowing that the transaction would have a long-term substantial impact on the company’s financial position without making sufficient enquiries about the transaction and simply deferring to the executive directors without exercising his own independent judgment to question the commercial viability of the transaction.

MANAGING THE RISK OF A DIRECTOR'S PERSONAL LIABILITY

The pressure from financial difficulties faced by companies can impair the ability of the directors of those companies to make sound judgments that comply with the law, especially where the company is on the verge of corporate insolvency.

The temptation to cut compliance corners to save costs, the desire to move quickly to ensure corporate survival and an undue optimism as to the probability of the success of life saving strategies are factors that can increase the risk of a director’s personal liability and result in a liquidator's complaint and director disqualification proceedings.

In these circumstances, whenever there is doubt, directors should consider the need for objective and professional external advice to ensure they remain on the right side of the law. They may also consider company restructuring options to overcome a liquidity crunch and avoid insolvency.