Where is director’s liability for corporate misfeasance?

State-owned enterprises

By Aditya Narayan

The financial crash of Air Mauritius (due to a shortfall of revenue over costs over two years) and the extremely low profitability of State Bank of Mauritius (net profit after tax of Rs 15 million in 2009 due to a credit loss of Rs 3 billion) are undoubtedly the results of bad business decisions. They have nothing to do with Covid-19. There is no denying that past and present enablers of bad governance bear responsibility for the predicament of both entities.  Where is director’s liability for misfeasance in theory and practice?

In principle, directors have a fiduciary duty to the corporation and its shareholders to manage the affairs of the corporation in a manner consistent with their interests. In the typical business model, shareholders are concerned about profit maximization as measured by profitability ratios (Profit Margin, Return on Investment and Return on Equity) and shareholder value. Beyond these narrow indicators, corporate citizens are expected to be fair to other stakeholders, namely employees, creditors and customers.

Corporate misfeasance

While Covid-19 is an exogenous factor that has grounded all airline companies, in general the performance of a company is usually determined by endogenous factors, assuming there is no disruption in markets. One factor that accounts for poor financial results is corporate misfeasance, which is legally defined as the improper performance of a lawful act. Misfeasance implies that directors use their lawful authority to make business decisions in a “wrongful or injurious manner”. That is true for both Air Mauritius and SBM, where directors have the general authority to contract, except in exceptional cases where they need board approval.

In the case of Air Mauritius, no amount of rationalization could warrant the ill-advised hedging contracts (hedging fuel supply at a higher price than subsequent market prices), the overstaffing at all levels, the humongous compensation for a few and the leasing contracts for expensive aircraft. It is obvious that for both an operating lease (a straight rental of aircraft that is expensed yearly) and a capital lease (acquisition of a depreciable asset with a long-term lease obligation), the company failed to do a sound cost-benefit analysis to predict cash inflows and outflows over a time period. Or if the analysis was done, it relied on faulty assumptions of cost and revenue.

It is mind-boggling that some genius would have signed off on the financial analysis relating to leasing contracts signed by the company.  Anyone in business would not acquire expensive capital equipment for use if the net cash inflows over time are not positive.

Similarly, in the case of SBM, no reasonable person would have approved large loans to foreigners without securing adequate collateral. It is a fact that the bank took excessive risks in lending over three years that accumulated credit losses of Rs 7 billion. It’s unconscionable that senior management would write off bad debts as an accounting exercise without questioning the credit risk management procedures and the approval process.

Director’s liability

So who is responsible and accountable for bad business decisions? It is not enough to get rid of people who made the wrong decisions and let them go scot-free with golden handshakes. There is a principle of corporate governance that is called director’s liability. It is fairly simple but never applied in public companies controlled by the State. Corporate law in most countries provides for director’s liability to hold directors to account for decisions that they made without due diligence. Before going into voluntary administration or filing for bankruptcy, a company should be able to go to the bottom of things to understand who is responsible for what and when.

Over the years, in developed countries, there has been a general trend towards holding directors liable for the consequences of their actions that bring hardship to employees, shareholders and third parties. Penalty or liability provisions in statutes are directed not only at the corporation but at the directors as well. For example, where insolvency occurs, governments hold directors personally liable for taxes collected (e.g. VAT) but not remitted on time or for corporate taxes payable but not paid.

In the USA, directors of ex-Enron, who created Special Purpose Vehicles to hide significant transactions off-balance sheet, were prosecuted and fined. In some jurisdictions, a special liability is imposed on directors with respect to employee wages in the event of the bankruptcy of the corporation.

Companies Act

Section 160 of the Companies Act, 2001 (Standard of care and civil liability of officers) provides that:

(1) Every officer of a company shall exercise –

(a)       the powers and discharge the duties of his office honestly, in good faith and in the best interests of the company; and 

(b)       the degree of care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. 

(2) Where a director of a public company also holds office as an executive, the director shall exercise that degree of care, diligence and skill which a reasonably prudent and competent executive in that position would exercise. 

(3) Subject to section 149 and without limiting any liability of a director under section 143, where an officer commits a breach of any duty under this Part –

(a)       the officer and every person who knowingly participated in the breach shall be liable to compensate the company for any loss it suffers as a result of the breach; 

(b)       the officer shall be liable to account to the company for any profit made by the officer as a result of such breach; and 

(c)        any contract or other transaction entered into between the officer and the company in breach of those duties may be rescinded by the company. 

The provisions above are clear: where a director has breached the duty stated in subsection 160(1) of the Act, the director is liable for the loss resulting from the breach. It might be argued that the directors of the Air Mauritius and SBM did not breach their duty and acted in good faith. That’s something for a court of law to determine upon application from aggrieved shareholders. Since the majority shareholder is the State, and in the absence of any action on her part, it was up to minority shareholders to be proactive before they were pre-empted by voluntary administration or otherwise. How to enforce director’s liability is an issue that needs careful thinking from shareholders and employee unions.

Enforcement

With regard to Air Mauritius, we understand that the trade unions have staked a claim for past wages or benefits not paid with the insolvency administrators. However, we know from previous cases that employees have always got the short end of the stick when proceeds from a liquidation of assets are distributed as secured creditors always come ahead. While creditors might take a haircut this time, it is likely that employees would be the losers. Moreover, as the company’s pension fund had a deficit of Rs 2,4 billion for the fiscal year ending March 31, 2019, it is clear that the pension plan was underfunded, due either to insufficient contributions from the employer or to the employer’s default on payment of contributions. Who is responsible for the unfunded liabilities?

The potential or actual collapse of a national airline is a tragedy in the life of any nation that depends on its carrier to connect to the world and carry passengers. Also, the write-off of large loans with a negative impact on the bank’s bottom line is an irrecoverable loss. Those two events are harmful to employees (now on the brink of unemployment) and to shareholders (losing income on investment). While there is no deus ex machina to save badly managed companies from insolvency or bankruptcy, it’s time for employees and shareholders to act in order to get director’s liability enforced where it is warranted.

---

* Published in print edition on 15 May 2020

Tags:Aditya Narayan, Air Mauritius, Companies Act 2001, Corporate Misfeasance, COVID-19, Director’s Liability, Enron, Financial Crash, Profit Maximization, SBM