Markus Dörig June 9 2008 Directors' Duties When a Corporation is in Financial Difficulties Badertscher Attorneys at Law | Corporate & Commercial - Switzerland Markus Dörig Corporate & Commercial IntroductionCapital Loss Over-indebtedness Introduction Directors of a Swiss corporation have a duty to manage the corporation with due care and to preserve the corporation's interests. They are personally liable for damages caused to the corporation, its creditors and shareholders by wilful or negligent breach of their duty of due care. The typical situation in which directors' liability might arise is when a corporation is over-indebted. Once a corporation is considered to be over-indebted, the directors risk becoming personally liable to anyone that suffers losses if the corporation subsequently goes bankrupt. The only way the directors can avoid personal liability is to comply strictly with their duties under Article 725 of the Swiss Code of Obligations.The concepts of capital loss and over-indebtedness are defined in Article 725, which imposes strict obligations on directors in either case.Capital LossArticle 725(1) protects the interests of shareholders. If the latest annual balance sheet shows that half of the share capital and the legal reserves are no longer covered by net assets, the board of directors must call a general meeting of shareholders without delay and propose adequate restructuring remedies.If the annual balance sheet shows a capital loss, the board of directors has a duty to convene a general meeting of shareholders without delay to inform them of the critical financial situation, to deliberate upon proposed restructuring remedies and to vote on the adoption of such remedies. The directors’ duty to monitor continuously the financial situation of the company requires that an interim balance sheet be prepared if concern of a capital loss arises during the business year.The most frequently used means of capital restructuring in Switzerland are: capital decrease; capital decrease with a simultaneous capital increase; and debt-for-equity swap.Over-indebtednessPursuant to Article 725(2) of the code, if there is a substantiated concern of over-indebtedness, then an interim balance sheet must be prepared and submitted to the auditors for examination. If the interim balance sheet shows that the liabilities of the company are not covered, whether the assets are appraised on a going-concern basis or at liquidation value, and the debts cannot be subordinated to overcome the deficiency, then the board of directors must notify the court by filing for bankruptcy.Over-indebtedness means that the liabilities of the company exceed its assets. In making this assessment, the method used to value assets is of fundamental importance. Once a company determines that its liabilities are not covered if its assets are appraised on a going-concern basis, it must re-value its assets at liquidation value. Ordinarily, this means that the company must take writedowns, particularly on goodwill, which will often render its balance sheet over-indebted. If the audited interim balance sheet shows that the liabilities of the company are not covered whether the assets are appraised on a going-concern basis or at liquidation value, the board of directors must immediately notify the court.Notification of the court may be avoided, however, if the debts can be subordinated to overcome the deficiency. This involves the conversion of existing debts into subordinated debts. The subordinated creditors undertake not to claim repayment of the subordinated part before all unsubordinated claims are satisfied.Notification of the court may also be avoided if there is a real prospect of financial reorganization. The Supreme Court has ruled that notification may be avoided only if the requirements set forth in Article 725a of the code regarding the postponement of bankruptcy are met. In other words, the directors bear the risk that a creditor may hold them accountable if restructuring measures fail and it turns out in hindsight that the requirements of Article 725a had not been met. This means that, in order to avoid personal liability upon a determination that the company is over-indebted, the directors must deposit the company balance sheet with the appropriate court even if there is a prospect of financial reorganization.On notification of the company's over-indebtedness in accordance with Article 725(2) of the code, the court is entitled to postpone the adjudication of bankruptcy at the request of the board of directors or a creditor, provided that there is a prospect of a financial reorganization.Courts have held directors liable where they failed to inform the court about the over-indebtedness of a corporation. Damages in such cases typically cover the increase in loss which occurred between the moment the directors should have known of the corporation's situation and the moment the bankruptcy was declared.For further information on this topic please contact Markus Dörig or Olivier Bauer at Badertscher Dörig Poledna by telephone (+41 1 266 20 66) or by fax (+41 1 266 20 70) or by email ([email protected] or [email protected]). The Badertscher Dörig Poledna website can be accessed at www.bdp.ch.