Disqualification- and D&O Liability cases

Is there a link between Disqualification cases and Directors and Officers Liability cases?

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During the summer there have been a lot of media coverage on the increase in the number of Disqualification cases. An article in the Danish newspaper “Berlingske” in June 2021 included a table showing the number of imposed Disqualifications between 2014-2020:

The article also informed about The Danish Eastern High Court, the Danish Maritime and Commercial Court, the Danish National Board of Justice and the Danish trade association “Danske Advokater” giving warning about the number of Disqualification cases significantly exceeding the number of cases, the Danish Bankruptcy Council believed would be imposed yearly upon implementation in 2014.

To be subject to Disqualification means that you are prohibited from participating in the management of a business with limited personal liability (in Denmark either an “ApS” or an ”A/S”). Anyone who is subject to Disqualification is likely to suffer severe financial consequences as they no longer can be a Board Member or Executive Director. Especially if this is their the primary profession or vocation. There are no immediate financial consequences, in the shape of fines or claims, of a Disqualification case. And yet, there can be. A Disqualification case might be used as leverage to a Directors and Officers Liability case – maybe even in relation to management members who themselves have not been imposed with Disqualification.

The purpose of this article is to investigate and analyse the link between Disqualification cases and Directors and Officers Liability cases. The link is relevant for management- and board members and the insurance companies, who provide Directors and officers Liability insurances.

Who makes the decision

The Danish Bankruptcy Act determines the frame work for a Disqualification case. The case is initiated by the bankruptcy court upon recommendation of the Trustee. Neither the creditors nor the bankruptcy court can impose the Trustee to recommend the initiation of a Disqualification case, but the bankruptcy court can request the Trustee to initiate further investigation before the bankruptcy court makes further decisions hereof. The decision to initiate a Disqualification case cannot be appealed.

The bankruptcy court decides if a Disqualification case should be initiated, but do not undertake a further, in depth test at the initiating stage. The bankruptcy court solely has to assess if the recommendation of the Trustee gives a reasonable basis to initiate a Disqualification case and only reject the recommendation if it is apparently wrong.

The Trustee’s fee is paid by the Danish national treasury and the court determines the fee. The Board member or Executive Director in question can request a public defence lawyer assigned, also paid by the Danish state. However, the State is entitled to reimbursement of the fees.

The formalities

As a first requirement, the Board member or Executive Director in question shall have participated in the executive management of the bankrupt company no more than 1 year prior to the date of the bankruptcy order. Both listed Executive Directors, Board Members and unlisted de facto directors can be imposed Disqualification.

It is no excuse to have been listed as Executive Director for formal reasons only with no influence on the management of the company, just as it is no excuse not to have been listed as Executive Director if one exercised the relevant authorities of a Director or a Board Member. The participation in the management of several bankrupt companies can lead to multiple Disqualification cases each imposing up to 3 years quarantine with maximum of 10 years in the aggregate.

Grossly unjustifiable conduct of business

Disqualification requires proof that it is likely that the person is unsuitable to participate in the management of a company on the basis of grossly unjustifiable conduct of business. There has to be evidence of abuse or similar misconduct in connection with the management of the company.

Disqualification can only be applied in circumstances that in both objective and subjective respects can be regarded as gross. Included in the assessment will be i) if the bankruptcy has led to significant loss for the creditors, ii) if the bankruptcy is caused by the management taking unacceptable risks or iii) if the bankruptcy is more likely to have been caused by circumstances beyond the control of the management.

According to the bankruptcy court, the conduct not only has to be actionable but also include the characteristics of a criminal offence. The court will include and assess all aspects of the case. The court will acknowledge the management’s prerogative to do business based on a business judgment rule and depending on the company’s size and complexity.

Fairness

The bankruptcy court must also exercise due care as to the reasonableness of imposing Disqualification on the person in question. This gives the bankruptcy court the opportunity to weigh characteristics of the matter such as the nature and consequences of the person's grossly unjustifiable conduct, and what consequences it will have for the person in question to be imposed Disqualification.

The intention of the regulation

The Disqualification regulation is based on the Danish Bankruptcy Council's report from 2011, and the purpose was to put an end to “bankruptcy riding”. From a consumer protection point of view the Danish Bankruptcy Council found that there was a need for regulation and in addition a need for protection of the business community against unfair competition.

Directors and Officers Liability cases (D&O Liability cases)

In recent years we have seen and still see and increased number of liability claims against Executive Directors or Board Members of bankrupt companies. It is part of the Trustee's duty to investigate whether there are circumstances that may give rise to a claim for damages against management or board members - or against the bankrupt company's auditor or other advisers. Consequently, it is often the Trustee who initiates claims for damages, but the claim can also be initiated by a creditor.

In order for the Trustee to conduct such cases, which are often quite difficult and document-heavy, there must be sufficient funds in the bankruptcy estate and the creditors must agree to use part of the estate's funds in a lawsuit and thus risk a smaller dividend if the case is lost.

The Trustee has to prove that the management acted negligently and caused a loss on the company or its creditors. The management of a company is granted a certain margin to make wrong decisions that result in losses. This is known as "the business judgment rule". The courts are reluctant to override business and strategic decisions if they are reasoned and documented, regardless of whether or not they later prove to be unwise. When the courts finds in favour of the claimants, it is often because the management’s decisions have been poorly or not at all substantiated - or based only on considerations irrelevant to the company or because such management decisions have benefited individual owners or creditors, but not the company. Court ruling on liability may also be based on findings that a company continued its business operations beyond the point of hopelessness. This is the point in time where management should have realised that it was not feasible to continue the business and that further operations would simply lead to more and greater losses.

Is it then an advantage for the Trustee and the creditors to initiate a Disqualification case prior to a liability case? Not necessarily. It takes more to impose Disqualification than to find someone liable. In the case of Disqualification, the requirement is that the act has been grossly unjustifiable, whereas liability for damages only presupposes simple negligence - in combination with the admission of a certain margin to make mistakes.

Conversely, the way seems to be paved for a claim for damages if Disqualification is imposed. Provided, of course, that there is a tort law-related loss and that there is the necessary causal link between the negligence and the loss.

What still speaks in favour of going the Disqualification route first is that the creditors do not have to approve the decision. It is taken solely by the bankruptcy court, and the bankruptcy estate's funds are not used to review the claim. Unlike a claim for damages, there is thus no financial risk for the creditors associated with conducting a Disqualification case.

The management's liability may be covered by a D&O insurance. However, such insurance typically exclude losses due to intentional and criminal acts and improper/dishonest misconducts. Consequently, the D&O insurance oftentimes does not cover individual insureds who have been disqualified as Executive Managers and Board members. They will have to pay any claims for damages out of their own pockets. The bankruptcy estate will thus not be able to receive funds via the D&O Liability insurance, as far as the members of the management who are subject to Disqualification are concerned.

However, it is conceivable that there are members of the management in a bankrupt company who are not subject to Disqualification, but who may incur liability for damages. It is also conceivable that a Disqualification case can be used as leverage for a compensation case. It depends on the specific circumstances and on whether there is a coincidence between the circumstances that justified Disqualification and the circumstances that the Trustee believes may justify a claim for damages against these members of the management and their roles in general.

Be aware

Executive Directors and Board Members, not directly involved in a Disqualification case against their former colleagues, should nevertheless be interested in such lawsuits. Moreover, insurance companies that offer D&O Liability insurance should sport an interested in Disqualification cases, regardless of the coverage position in such case because such case may impact a later D&O liability case.