Controlling entity's liability
Limitations of liability
Conditions and circumstances
Necessary and reasonably foreseeable steps
Under Czech law, a parent company, controlling entity or influential entity may be liable for the obligations of a bankrupt corporation under its control. Respective controlling entities' liability is a frequently discussed issue and closely related to the common law doctrine known as 'piercing the corporate veil'. The judiciary and legal academic community are torn when it comes to applying particular provisions of the Corporations Act in such situations.
Controlling entity's liability
The court may, on the basis of a petition from the insolvency trustee or a creditor of the corporation, find a member or former member of the corporation's statutory body liable for the fulfilment of all its obligations if:
- it has been decided that the corporation is insolvent; and
- the member or former member of the statutory body of the corporation:
- knew (or should or could have known) that the corporation was facing an imminent threat of bankruptcy; and
- in breach of the duty of due care, failed to take all necessary and reasonably foreseeable steps to prevent the bankruptcy (the so-called 'prevention rule').
The member of the statutory body need not succeed in preventing the bankruptcy of the corporation, but must be able to demonstrate that it took all necessary and reasonably foreseeable steps to prevent the bankruptcy. Notably, both individuals and legal entities can serve as members of the statutory body.
The prevention rule also applies to:
- anyone who uses their influence in a corporation in a decisive and significant manner to steer the behaviour of that corporation in a specific direction (this applies to shadow directors or de facto directors); or
- any entity which can directly or indirectly exercise decisive influence on a corporation (eg, a parent company toward its subsidiary), collectively referred to as a 'controlling entity'.
Under Czech law, the controlling entity has no duty of due care toward the corporation (unlike the corporation's own statutory body). Case law has established that shareholders have, at most, a duty of loyalty toward the corporation and its interests, but not the duty of due care.
Nevertheless, the Supreme Court recently ruled that in cases in which a shareholder holds 100% of shares of the corporation, the level of influence over the corporation (subsidiary) is self-evident, and the shareholder thus serves as a substitute for the statutory body of the corporation.
The definition and extent of the controlling entity's liability are crucial, because a thoughtless and automatic application of the prevention rule could potentially lead to legal uncertainty on the part of existing and former controlling entities.
Various stakeholder groups have discussed concerns regarding how the courts may construe the applicability of the prevention rule where:
- the controlling entity is found liable for the obligations of the bankrupt corporation because it should have invested additional capital into it during times when the corporation was facing an imminent threat of bankruptcy;
- even though the former controlling entity sold its share in the corporation to a third party, the former controlling entity is still liable for the obligations of the now bankrupt corporation; or
- investors whose shares in the corporation are being traded on the stock exchange are found liable.
Even major creditors of the bankrupt corporation (eg, banks or other financial institutions) could be considered controlling entities because they have significant leverage and influence over the decision-making process of the corporation, which could influence the behaviour of the corporation in a decisive and significant manner.
The court should always analyse the extent, impact and intensity of the influence (ie, level of activity) of the controlling entity toward the corporation and further relevant circumstances.
In particular, the following criteria should be satisfied before the prevention rule can be successfully applied against the controlling entity:
- The controlling entity should have actively interfered in the corporation's matters (eg, the shareholders put pressure on, or even made indirect threats to, the statutory body of the corporation), to make the corporation:
- distribute dividends, despite poor economic results;
- yield its own property or assets to the controlling entity (eg, through a donation agreement or lease agreement) without obtaining adequate compensation from the controlling entity;
- delay the filing of an insolvency petition, even though it has clearly been bankrupt; or
- enter into negotiations with a third party which are likely to exacerbate the financial problems of the corporation (hereinafter, collectively referred to as 'active interference').
- There should be unclear property, business and personal relations between the controlling entity and the corporation, including:
- uncertainty over which property and assets are owned by the corporation and which by the controlling entity;
- a failure to observe fundamental corporate governance duties (eg, keeping books and other corporate records);
- a deliberate undercapitalisation of the corporation (in contrast to the amount of the corporation's undertakings and commitments); or
- the absence of its own financial resources on the part of the corporation (ie, financial means are provided exclusively by the controlling entity) (collectively referred to as 'non-standard circumstances').
A combination of active interference and non-standard circumstances should alert the creditors or the insolvency trustee of the bankrupt corporation to the fact that the controlling entity may be potentially liable for the obligations of the bankrupt corporation.
Necessary and reasonably foreseeable steps
Should abovementioned be the case, the controlling entity should be able to prove to the court that it took all necessary and reasonably foreseeable steps to prevent the bankruptcy of the corporation. Unfortunately, what these steps may entail cannot be generalised, since the majority of bankrupt companies become insolvent due to a mixture of internal and external factors.
However, taking the following steps in particular (primarily through the statutory body), and doing so in time (ie, as soon as the corporation is facing an imminent threat of bankruptcy), could be considered necessary and reasonably foreseeable, and may persuade the court not to find the controlling entity liable for the obligations of the bankrupt corporation:
- appointing capable professional members to the statutory body and procuring qualified and professional economic and legal assistance;
- calling the general meeting (eg, should the economic results of the company indicate an imminent threat of bankruptcy or should the business objective pursued by the company be in jeopardy);
- regularly assessing and analysing the corporation's:
- business performance figures; and
- leverage ratio (ie, ratio of the external sources to the corporation's equity); and
- downsizing or winding up loss-making operations (eg, where a particular operation of the company continuously performs poorly and the company is regularly forced to cover its loss at the expense of the entire company; however, this does not apply in cases where a particular operation is essential to run the entire corporation).
The test of active interference combined with non-standard circumstances should always be carefully analysed and evaluated by the creditors or the insolvency trustee of the bankrupt corporation before filing a petition against the controlling entity.
The closer the relations between the controlling entity and bankrupt corporation (in terms of the assets forming the estate and in relation to business and personal relations), the higher the risk that the controlling entity may be found liable for the obligations of the corporation.
Lastly, no Czech case law exists concerning the controlling entity's liability for the bankrupt corporation's obligations. This is mainly due to the fact that judges are well aware of the potential adverse effects on the principle of legal certainty of any such rulings, if they were to establish liability on the part of existing and former controlling entities. Any such decision could potentially open Pandora's Box.
For further information on this topic please contact Petr Kuhn or Vladislav Klimeš at Badokh Kuhn Dostál Advokátní Kancelář by telephone (+420 222 937 515) or email ([email protected] or [email protected]). The Badokh Kuhn Dostál Advokátní Kancelář website can be accessed at www.badokh.com.