Contractor builds a death house (and it doesn't stay up)

The Hague Court of Appeal[1 ] this year slammed a contractor for using a so-called mortuary construction.

What was the case?

The contractor had structured its business in a corporate group structure. All assets sat high and dry in a holding company and were lent on a contract basis (intra-group) to operating companies, which thus had little fat on their own bones. Group company "A" had accepted a contract. At some point it turned out that an engaged subcontractor had made a mistake in the assembly of facade panels. Although this did not initially have any major consequences, there was a chance that the plates could crack over time. The group company could not take care of the repair itself, nor could it recover the costs from its subcontractor. Thus, the damage could no longer be prevented or repaired. At that point, there was not much the director could do about it. The client was left empty-handed and the group company was also likely to go bankrupt in the long run.

The question arises as to how the director is still doing well in such a case. After all, not only does he have to serve the interests of his principal, but he also has a responsibility to employees and other creditors. It seems irresponsible to place new activities in the same group company if it is foreseeable that these could be dragged into an impending bankruptcy.

Restructuring

The director opts for a restructuring and decides to create a new group company "B". New assignments are carried out in the new operating company and activities within A dried up. As mentioned, the company was already undercapitalized. Therefore, when the claim finally landed for the damage to the cladding panels, the client had lost out. This is a classic example of a mortuary construction, which is frequently used at home and abroad.

Use or abuse

The dividing line between lawful use and unlawful abuse is interesting here. While it is of course unfortunate for the principal that he is left empty-handed, one should also not lose sight of the fact that he probably would not have been able to recover his damages from the (technically bankrupt) group company anyway. Thus, with the mortuary construction, the principal is not necessarily worse off. From the contractor's perspective, it simply isolates a risk to ensure that other projects can go ahead. Broadly speaking, therefore, abuse only occurs if assets are diverted from recovery, or if obligations are later incurred that should be expected to be impossible to meet.

Conclusion

In this case, the contractor does not get away with it. He is blamed for not securing a purchase price for goodwill within group company A during the restructuring. Group company B had got off to a flying start by using the name and fame of the construction company. According to the Court of Appeal, that value had accrued in group company A, so assets had indeed been removed from recourse by continuing the business in a new group company. The damages could have been paid from a real purchase price.

Thus, the judgment of the Court of Appeals can be followed. However, the question arises whether a mortuary construction is still possible after this judgment. Once again it is clear how not to do it. But would the director have gotten away with it if he had been a bit more skilful?

Incidentally, both parties could easily have avoided the problems by being a little more astute beforehand. For example, the principal would have been better off finding out first who he was contracting with. It seems a missed opportunity that he did not require a 403 declaration, CAR insurance or other form of security. Even from a director of a practically empty company, however, one may wonder whether he did not give a bit too much weight to the interests of the shareholder.

[1] Hague Court of Appeal January 7, 2020; JOR 2020/111