On how new Civil Code affects liability

Issues

From the Budapest Business Journal print edition: The new Civil Code of Hungary came into effect on March 15 this year. BBJ asked a legal expert in the field, Balázs Sanin-Tóth, in what ways the new Civil Code affects directors’ liability, and how court practices could change as a result.

BBJ: How did the previous legal regulation look like and how did courts rely on it?
Sanin-Tóth: Under the Civil Code in force before 15 March 2014 and the separate Companies Act, directors were normally not liable for the company’s debts to its creditors. The court practice made it clear that any damage caused by a director when acting on behalf of a company was attributable to the company only. In other words, the creditors could not ‘pierce the corporate veil’ and sue the directors.

So what has changed?
Directors were and remain liable vis-à-vis the company if they cause losses to the company by a breach of their management duties.

As a notable exception to the norm that creditors could not sue the directors, the directors were and remain liable for ‘wrongful trading’. If there is an event of ‘threatening insolvency’, directors must take into account the interests of the creditors too. In practice this requirement means that from the moment a director foresaw or reasonably could have foreseen that the company would not be able to pay off its debts on their maturity, if the director continues business and as a result the company’s financial position worsens, he can be liable for all unsettled debts at the end of the insolvency proceedings. A director may escape from this liability if he or she proves that he made all generally expected measures in order to limit the creditors’ potential losses. The practical test is whether in troubled times the director continues any loss-making business.

As far as the new Civil Code is concerned, does it resemble any West European regulation in particular?
In all established market economies it is a normal risk of business that managers take business decisions. By definition these decisions imply a certain level of risk and can potentially cause damage to the company or third party creditors. However, such risk-taking is a key element to any properly functioning market. Sound business decisions which are taken in accordance with a standard of how a commercially reasonable person would act, should not lead to personal liability.

Fraud of course remains an exception. For example, in the United States if there is an IPO (initial public offering) of securities and subsequently the share price plummets, shareholders will probably sue the management for misleading information in the prospectus. But similar litigations are partly caused by shareholder activism and the litigation culture, e.g. that losing parties do not have to pay the litigation costs of the winning party, so there is not much to lose; courts may award punitive damages. I think that the laws regarding directors’ liability are not that different in the United States. What is different is the broader context.

So what size of penalties should top executives expect in Hungary?
Under a provision of the new Civil Code there appears to be a possibility for creditors to sue the directors who caused damages when acting in the name of a company. The meaning and future application of this new rule is unclear as we speak. Respectful professors argue that the new norm is not intended to change the law and it only says that if a director causes losses in connection with but acting beyond the scope of his mandate, the company may be jointly and severally liable for his wrongdoing. An example by Prof. Vékás is when a director goes to a business meeting where he steals some assets of the counterparty.

Others believe that the director and his company may be jointly and severally liable if both of them caused the damage out of contract. The broadest commentary is that a director may be liable for non-contractual damages even where the company is liable for the same amount based on contract.

One thing appears to be certain. Lawyers will probably try and sue both the company and their directors if a creditor has any problem with them. If nothing else, this will work as litigation tactics. If a director is potentially also on the hook he will feel more inclined to settle the dispute and pay some amount on behalf of the company.

What do you think top executives should do in order to minimize losses? Will directors and officers (D&O) liability insurance become a solution?
Insurance companies cherish the new rule for directors’ liability as a very nice business possibility for the insurers. Before March 15, 2014 Hungarian D&O insurance was a practically non-existent product, apart from a very few exceptions. It was mainly big corporates that took out such insurance; multinational companies often in the form of group insurance, typically outside of Hungary, in the country of their main operations.

This is now obviously a lucrative possibility for insurers. In addition, directors should take out such insurance because insurance it designed to cover a future uncertainty and the future scope of application of the liability rule is clearly an uncertainty.

As other ways of protecting directors, we also suggest that they obtain an indemnity from the appointing shareholder who guarantees to step in financially and otherwise when a creditor sues the director. Such an indemnity can be given in the company’s deed of foundation or in a separate contract.

Yet another possibility that we often use is that a contract between the company and its counterparty providers for a waiver by the counterparty of its damages and other claims it may have against a director. The weakness of this waiver is that it can only work with a creditor who has a contract with the company. Non-contractual claims from third parties may not be covered in such a prior waiver.

Our advice remains that directors skating on thin ice should give deliberation to the interests of creditors and should document that they acted with due care. For example, they have asked for legal or other specialist opinion and considered various options as to how to proceed. If a director acts in a fraudulent way or in bad faith, creditors will have an increased chance to catch them.

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