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Avoiding Insolvency – the Role of Good Governance

The rise in the number of companies facing severe financial distress is an unavoidable fact of today’s economic market. The underlying causes of this distress are several and include the unresolved debt overhang from the last debt crisis, the slash in petroleum prices that began in 2015, and of course, the devastating effects of the Covid pandemic and its resulting shutdowns which cast a gloom over worldwide commerce.

This article discusses how proper corporate governance process can help lessen the risk that your company end up in such a situation and also lessens the risk to the company’s directors and managers in the event that insolvency is unavoidable.

The Bankruptcy Law

In late 2016, the UAE enacted a new Bankruptcy Law – Federal Law No. 9 of 2016 - which has provided new avenues whereby distressed companies can remediate an insolvency scenario. The new law seeks to enable a paradigm shift as to the treatment of indebted entities to a “rescue culture”, in line with the practices of other international commercially prominent jurisdictions such as the US and UK. Accordingly, the law provides for a process in which the injection of new capital can be arranged, while at the same time claims based on existing debt can be both managed and mitigated, using a set legal process.

The Bankruptcy Law was also amended in late 2020 in response to the Covid pandemic to provide for various forms of enhanced debtor protections, including suspension of the requirement to file in cases of insolvency, expedited claims relief and settlement procedures, and a suspension of any bankruptcy proceedings filed by a creditor, if an “Emergency Financial Crisis” has been declared, which is defined as “a general condition affecting trade or investment in the country, such as an epidemic, natural or environmental crisis, war, etc…. determined by a decision of the Council of Ministers”. A Ministerial decision was thereupon issued declaring such a financial crisis, effective from 1 April 2020 through 31 July 2021.

Mitigation of Risk

Of course, one would rather not be faced with the drastic choice of whether to seek shelter under the Bankruptcy Law in the first place. While many factors causing economic distress are beyond a company’s control, certain key risks can be significantly mitigated, if not eliminated entirely, through adherence to prudent corporate governance processes.

Firstly, deployment of good governance practices will allow the company to better foresee impending risks and plan accordingly, as such create a framework for sound business practices, sustained growth and better risk management. Good governance practices are also often associated with improved operational efficiency and lower costs of capital.

Secondly, at least regarding company directors and managers, such practices are to some extent implicitly codified in the UAE Commercial Companies Law (the ‘CCL’), and it is thus imperative that directors and managers follow the requirements of law, lest they face legal risk should their company tip into insolvency as a result of their failure to adhere to the law.

Consequently, prudent corporate governance processes should ensure that the company’s directors and managers follow the applicable provisions of the CCL and other relevant laws. The CCL generally provides that, “A person authorized to manage the company shall preserve its rights and extend such care as a diligent person.” Regarding limited liability companies, the CCL provides that company managers shall be “liable for any losses or expenses incurred due to improper use of the power or the contravention of the provisions of any applicable Law, the MOA of the company or the contract appointing the Manager or for any gross error by the Manager.”

Regarding an LLC’s insolvency, the company’s managers are required to refer the issue of whether the company should be dissolved to its shareholders, if its losses reach half of its share capital. The failure to refer this matter to the shareholders accordingly can lead to substantial fines.

The directors of publicly traded companies have somewhat similar duties of care that are actually more stringent. Adhering to the statutory duties is therefore imperative, whatever the form of the company’s establishment.

Risks in Bankruptcy

Should a company be placed in bankruptcy, the failure to follow good governance practices – particularly when this implies a breach of the CCL provisions – can create personal risk to the company’s directors and managers. Importantly, pursuant to the Bankruptcy Law, if the debtor’s assets are insufficient to satisfy at least 20% of its debts, the Court may obligate members of the board or managers to pay these debts, in cases where their responsibility for the company’s loss is evident, pursuant to the provisions of the CCL.

Also note that the directors or managers may face criminal prosecution in the event of a host of improper actions, all of which might be avoided if a proper governance protocol is instituted. In some circumstances, liability may even extend to the shareholders themselves, if they have been found to have been involved in improper actions related to the debtor company’s management.

In conclusion, a company’s directors should thus always follow good corporate governance practices. Failure to do such may not only place the company solvency in danger but cause significant risk to the responsible individuals on a personal level.

Authored by Barry Greenberg, Of Counsel
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