Liability of an Individual Acting as a Director of a Corporate Director under Czech Law: Another Country, Similar Issues

Ivo Trojan

1. Introduction

This article argues that s.154 of Act No. 89/2012 Sb., Civil Code[1] (the “Civil Code”), which, with effect from 1 January 2014, allows any limited liability company incorporated in the Czech Republic (the “subject company”) to appoint another Czech or foreign limited liability company as its sole director (the “corporate director”),[2] is fundamentally flawed and could be exploited to shield individuals from liability for their misconduct in relation to the affairs of the subject company.

In this context, the article points out the difficulties of establishing the liability of individuals acting as directors of corporate directors in the United Kingdom. Drawing upon the United Kingdom parallel, the article goes on to explore the possible ways of holding individuals acting as directors of corporate directors liable under Czech law. Finally, the article purports to outline what would be the right model for corporate directors in the Czech Republic.

2. A Company with No Accountable Human Face: A New Standard?

It is a well-established principle of company law that a limited liability company is a separate legal entity distinct both from its shareholders and directors[3], neither of which are, under standard circumstances, liable for the debts of the company.[4] It is acknowledged that limited liability is a legitimate tool to manage risks associated with business failure and to incentivise individuals to engage in economic activity.[5] On the other hand, limited liability may lead some individuals to undertake excessive risk to the detriment of the company’s creditors.[6] Therefore, narrow exceptions from the principle of separate legal personality (referred to as “piercing of the corporate veil”) are usually provided for in a statute to hold individuals who truly direct the company’s affairs accountable for their misconduct.[7]

By virtue of s.154 of the Civil Code, a company’s director, who could be required, as a last resort, to compensate the company’s creditors, may also be afforded the benefit of limited liability. Therefore, to enhance accountability and transparency in such structures, s.154 of the Civil Code requires the corporate director to appoint an individual as its proxy[8] to act on behalf of the corporate director in relation to the subject company. Such proxy owes fiduciary duties[9] to the subject company and may be held liable as if he or she alone were a director of the subject company.[10] Further, if an action is filed against the proxy, the proxy must plead and prove that he or she did not breach the fiduciary duties as a reverse burden of proof is placed on the proxy.[11]

However, where a corporate director fails to appoint its proxy, the corporate director (and ultimately the subject company) is represented by a director of the corporate director, whoever that may be.[12] And here comes the problem.

Surprisingly, there are no requirements indicating who the corporate director’s own directors should be.[13] The corporate director itself can have another corporate director as its sole director who, in turn, can also have another corporate director as its sole director and so on.[14] As a result, an accountable “human face” of the subject company could remain well hidden behind opaque multilevel chains of corporate directors.[15]

3. Lessons from the United Kingdom: Separate Legal Personality Prevails

Similarly to the Czech Republic, there were no restrictions on corporate directors in the United Kingdom prior to the Companies Act 2006. In attempts to hold individuals who acted as directors of corporate directors liable in court, claimants usually relied on the assertion that the defendant had acted in relation to the subject company as its de facto or shadow director. However, there appears to be a major evidential hurdle to clear[16] as all the actions brought against such individuals have been dismissed by courts.[17] The courts were ultimately called upon to adjudicate upon the conflict of two well-established company law principles: separate legal personality and accountability of individuals who truly direct a company’s affairs.[18] The leading authority in this regard is the Supreme Court’s decision in Revenue and Customs Commissioner v Holland and another[19], the facts of which can be summarised as follows.

Mr Holland devised a corporate scheme of 42 composite companies to administer business affairs of contractors who became both shareholders and employees of the composite companies. Each of the composite companies had the same sole corporate director of which Mr Holland was the only active director.[20] All the composite companies paid a fee for administrative services to the scheme’s holding company, owned by Mr Holland and his wife. Based on the decisions Mr Holland had made via the corporate director, the composite companies paid regular dividends to the contractors after tax provisions had been made.

However, due to a flaw in tax arrangements, the tax provisions turned out to be vastly insufficient, and the composite companies went into insolvent liquidation. The tax authority, being the composite companies’ only creditor, filed against Mr Holland an application under s.212 of the Insolvency Act 1986 for unlawful distribution of dividends pleading that Mr Holland had acted as a de facto director of the respective 42 companies and, thus, shall contribute GBP 3.5 million to their assets. The application was dismissed by a narrow majority of 3-2.

The majority in Holland did not find that Mr Holland had been the composite companies’ de facto director.[21] It was held that the question was one of law and the principle expressed as follows:

So long as the relevant acts are done by the individual entirely within the ambit of discharge of his duties and responsibilities as a director of the corporate director, it is to that capacity that his acts must be attributed.[22]

To hold otherwise would mean to “ignore or bypass the separate legal personality of the corporate director.[23] S. Griffin observes the majority was looking for any of the exceptional circumstances accepted by courts to pierce the corporate veil of a company.[24]

Given the then valid legal framework, it is submitted that the decision in Holland was a correct one as it promotes legal certainty and predictability, values much appreciated by the business community. However, the outcome could have been much different for Mr Holland had the scheme been set up under s.155 of the Companies Act 2006 as it requires any company to have at least one director who is an individual. [25]

Furthermore, an outright ban is to be imposed on corporate directors[26] in the United Kingdom unless an exception applies under the forthcoming legislation,[27] and even if an exception applies, the subject company will still be required to have at least one individual as its director.[28]

4. The Czech Way: An Untrodden Path

In the Czech Republic, a situation may arise where an individual who directs affairs of the subject company via its corporate director is not entered in the commercial register as the corporate director’s proxy or director. In such case, it is submitted that the claimant must plead and prove that the defendant acted in relation to the subject company in either of the following positions: (i) a director of the corporate director, (ii) a person in a similar position as director or (iii) an influential person. Neither of the arguments, however, has been tested in court yet.

First, by virtue of s.46(4) of the Companies Act, an (ultimate)[29] director of the corporate director, the same as the corporate director’s proxy, owes fiduciary duties to the subject company and may be held liable as if he (or she) were a director of the subject company. Accordingly, s.46(4) of the Companies Act effectively disregards a corporate director’s separate legal personality.

Secondly, s.69(2) of the Companies Act imposes potential liability for wrongful trading[30] upon any “person in a similar position as director”, such as, typically, a company’s liquidator.[31] In addition, S. Černá argues that any person who assumes the duty of due managerial care in relation to a company by acting as its director, although not being formally appointed as such, becomes a person in a similar position as director.[32]

Accordingly, the concept of “a person in a similar position as director” resembles the concept of de facto director as developed by courts in the United Kingdom to hold accountable persons whose appointment as director was invalid, who ceased to be a director or have actually never been appointed as director but nevertheless acted as such.[33] It was also later conceded[34] that the concept of de facto director may overlap with the concept of shadow director, defined as “a person in accordance with whose directions or instructions the directors of the company are accustomed to act.”[35] It is submitted that the case law[36] and theory relating both to a de facto and shadow director could be a valuable source of inspiration for Czech courts and legal scholars.

However, s.69(2) of the Companies Act does not constitute per se a clear statutory authority to disregard the corporate director’s separate legal personality.

Thirdly, where an individual exerts his or her legal or effective influence over the subject company to affect its affairs, he or she may become an influential person within the meaning of s.71(1) of the Companies Act. As such, the respective individual could be held liable for the debts which the subject company is unable to pay to its creditors[37] or for wrongful trading.[38]

Nevertheless, it is argued that, despite the explicit statutory wording,[39] the liability for wrongful trading cannot be, under standard circumstances, imposed upon an influential person.[40] The reason is that an influential person (such as a controlling shareholder) generally does not owe the duty of due managerial care to the subject company while the liability for wrongful trading may arise only as a result of one’s breach of the duty of due managerial care.[41]

An individual, although being an influential person, thus can be held liable for wrongful trading only where he or she assumes the duty of due managerial care[42], for example, by regularly and intensely intervening in the (subject) company’s day-to-day management.[43] Accordingly, an influential person could be held liable for wrongful trading only where such influential person becomes, at the same time, a person in a similar position as director (see above).[44]

Since s.71(4) of the Companies Act explicitly stipulates that an individual may become an influential person (and, with regard to the above conclusions, also a person in a similar position as director) by exercising its influence via another person (such as the corporate director), it is submitted that it provides a sufficient statutory authority to disregard the corporate director’s separate legal personality.

5. Conclusion

Czech law provides courts with sufficient authority to disregard the corporate director’s separate legal personality and hold liable individuals who direct affairs of the subject company. Yet, in practice, many claimants will be effectively prohibited from pursuing their claim against such individuals as they will be either unable to establish the identity of the potential defendant or have no plausible information as to the defendant’s alleged misconduct or the defendant’s position in relation to the subject company.

It is suggested that enforceable registration requirements be enacted to ensure that there will always be at least one individual entered in the commercial register in relation to the subject company[45] upon whom the same fiduciary duties and reverse burden of proof are imposed as if he or she was a director.

Further, it is submitted that the United Kingdom’s model requiring the subject company to appoint at least one director who is an individual is more convenient than the Czech one as the responsibility for appointment of a director-individual lies solely with the subject company, whereas under Czech law, it is the subject company’s corporate director who appoints an individual as its proxy (or director).

In the first place, however, the Czech Government should, based on empiric data and following public consultation, reconsider[46] whether there is even a case for allowing corporate directors in the Czech Republic or whether corporate directors should be banned as in other developed jurisdictions.[47]

Ivo Trojan graduated from Charles University in Prague, Faculty of Law, in 2014 and commenced his Ph.D. studies at the same university in 2016. He also studied at Lancaster University Law School in the United Kingdom as part of the Erasmus Exchange Programme in 2012 – 2013. At present, Ivo is a junior associate at Weil, Gotshal & Manges in Prague where he focuses on company law, capital markets, and insolvency & restructuring.

[1] Zákon č. 89/2012 Sb., občanský zákoník.

[2] Although s.154 of the Civil Code applies generally to all legal entities (save for explicit statutory exceptions) and all elected corporate bodies, it will be analysed only in the context of limited liability companies and their directors. In terms of Czech law, the term “limited liability company” used in this article refers both to a limited liability company (in Czech: společnost s ručením omezeným) and a joint-stock company (in Czech: akciová společnost), as both of these companies utilise the principle of limited liability.

[3] See Pelikánová, I. in Černá, S., Štenglová, I., Pelikánová, I. a kol. (2015) Právo obchodních korporací. 1st Ed. Prague: Wolters Kluwer, pp. 40–41; or French, D., Mayson, S., Ryan, C. (2012) Company Law, 29th Edition, Oxford: Oxford University Press, pp. 122–127.

[4] Pelikánová, I., op. cit., note 3, or D. French, op. cit., note 3, pp. 49–52.

[5] Griffin, S. (2004) ‘Limited liability: a necessary revolution?’ Company Lawyer 25(44), p. 99.

[6] See Ireland, P. (2010) ‘Limited liability, shareholder rights and the problem of corporate irresponsibility’, Cambridge Journal of Economics 34.

[7] Courts are generally reluctant to extend these exceptions save for the most abrupt cases of abuse of corporate structures; See Lokajíček, J. (2016) Prolomení majetkové samostatnosti kapitálových společností. 1st Ed. Prague: C. H. Beck, pp. 138-139; or Griffin, S. (2013) ‘Establishing the liability of a director: issues relevant to disturbing corporate personality’. Company Lawyer 34(5), pp. 138–140.

[8] Such an individual must comply with eligibility requirements prescribed for members of corporate bodies in s.152 to 153 of the Civil Code and s.46(1)(2) of Act No. 90/2012 Sb., on companies and cooperatives (zákon č. 90/2012 Sb., o obchodních společnostech a družstvech (zákon o obchodních korporacích); the “Companies Act”).

[9] Duty of due managerial care and loyalty under s.159 of the Civil Code in conjunction with s.51 et seq. of the Companies Act

[10] Section 46(4) of the Companies Act.

[11] Section 52(2) in conjunction with s.46(4) of the Companies Act.

[12] Section 154 of the Civil Code.

[13] Lasák, J. in Lavický, P. a kol. (2014) Občanský zákoník I. Obecná část (§ 1−654). 1st Ed. Prague: C. H. Beck, p. 795.

[14] Dvořák, T. in Švestka, J., Dvořák, J., Fiala, J. a kol. (2014) Občanský zákoník. Komentář. Svazek I. 1st Ed. Prague: Wolters Kluwer, a. s., p. 523.

[15] The practice of courts and public notaries who are responsible for administrating the Czech commercial register is yet to be settled as to whether individuals directing the affairs of the subject companies must always be entered in the commercial register; see also Lála, D. (2015) Právnická osoba jako člen voleného orgánu kapitálové obchodní korporace. Právní rádce 6, p. 33.

[16] Ellis, J. (2016) ‘The continued appointment of corporate directors: an examination of the effect of s.87 of the Small Business, Enterprise and Employment Act 2015.’ Company Lawyer 37(7), p. 204.

[17] Ibid. See also Griffin, S., op. cit., note 7, pp. 135–136.

[18] L. J. Yap, ‘De facto directors and corporate directorships.’ (2012) Journal of Business Law 7, p. 579; Ellis, J., op. cit., note 16, p. 206.

[19] Revenue and Customs Commissioner v Holland and another, [2010] UKSC 51.

[20] The other was Mr Holland’s wife who, upon evidence, performed only secretarial work.

[21] The majority relied heavily on the High Court’s decision in Re Hydrodam (Corby) Ltd [1994] B.C.C. 161, where, on p. 164, Millet J, as he then was, expressed the following view: “Attendance at board meetings and voting, with others, may in certain limited circumstances expose a director to personal liability to the company of which he is a director or its creditors. But it does not, without more, constitute him a director of any company of which his company is a director.

[22] Holland and another, [2010] UKSC 51, at 42.

[23] Ibid, at 98.

[24] Griffin, S., op. cit., note 7, p. 145.

[25] The aim of the restriction was to strike a right balance between preserving flexibility and preventing abuse of corporate directorships; see Department of Trade and Industry (March 2005), White Paper “Company Law Reform”, Cm.6456, p. 24.

[26] Section 87 of the Small Business, Enterprise and Employment Act 2015, new s.156A of the Companies Act 2006.

[27] As of the date of this article, the draft of the statutory instruments had not been published. It is being contemplated that, for example, only such corporate director whose directors are all individuals could be allowed in limited circumstances; see Department for Business Innovation & Skills (November 2014), Consultation Paper “Corporate Directors: Scope of exception to the prohibition of corporate directors”, BIS/14/1017, pp. 8–11.

[28] Section 87 of the Small Business, Enterprise and Employment Act 2015, new s.156B (4) of the Companies Act 2006.

[29] Section 46(4) of the Companies Act applies also to an individual who is an (ultimate) director of the corporate director’s corporate director; see Lasák, J., op. cit., note 13.

[30] Section 68 of the Companies Act.

[31] Havel, B. (2013) Svoboda a zájem: Viktor Knapp v tenatech komercionalistiky. Právník 12, p. 1203.

[32] Černá, S. (2013) Ještě k ručení vlivné a ovládající osoby za porušení povinnosti odvracet hrozící úpadek. Obchodněprávní revue 6. S. Černá also refers to such person as a “de facto director”. For a different view, see Havel, B., op. cit., note 31.

[33] See Holland and another, [2010] UKSC 51, at 58-93, for the development of case law relating to a de facto director.

[34] Holland and another, [2010] UKSC 51, at 91.

[35] Section 251 of the Companies Act 2006.

[36] For example, see Re Mumtaz Properties [2011] EWCA Civ 610, in respect of a de facto director and Secretary of State for Trade and Industry v Deverell [2000] 2 W.L.R. 907, in respect of a shadow director.

[37] Section 71(3) of the Companies Act.

[38] Section 68 in conjunction with s.76(3) of the Companies Act.

[39] Section 76(3) of the Companies Act.

[40] Čech, P. (2012) Nad několika rekodifikačními nejasnostmi. Obchodněprávní revue 11-12, and Černá, S., op. cit., note 30.

[41] By failing to do everything that is necessary and reasonably foreseeable to avert the subject company’s impending insolvency; see s.68 of the Companies Act.

[42] Havel, B. (2013) O kogentnosti, vypořádání újmy a ručení vlivné osoby ve světle nového soukromého práva. Obchodněprávní revue 1, p. 16, and Havel, B. op cit., note 30, pp. 1202–1204. Again, also the concept of assuming the duty of due managerial care by a person who is not an appointed director is quite novel in Czech law and is yet to be tested in court.

[43] Černá, S., op. cit., note 32

[44] Ibid. Accordingly, “persons in a similar position as director” can be perceived as a narrow subcategory of “influential persons”. For a different view, see Havel, B., op. cit., note 31.

[45] It is suggested that, for example, the following penalty could be enacted: if the subject company after prior notice fails within the prescribed period to appoint and enter in the commercial register an individual as its director, it could be put into liquidation by the court on application of the subject company’s creditor or another relevant third party.

[46] No policy reasons for introducing corporate directors into Czech law were stated in the explanatory reports to the Civil Code and the Companies Act, or elsewhere.

[47] See, for example, s.201B of the Australia Corporations Act, s.105(1)(c) of the Canada Business Corporations Act, s.141(b) of the Delaware General Corporate Law, s.76(3) of the Germany Aktiengesetz, s.701 of the New York Business Corporation Law. See also Lála, D., op. cit., note 15, p. 36, for a contemplated amendment to s.154 of the Civil Code inspired by French legislation.