Mortuary construction as a measure of restructuring
In a death structure, the healthy parts of the business are transferred out of a company, leaving the loss-making parts in the company. In this way, the profitable parts can continue to be utilized and are not sucked into a bankruptcy. The healthy parts are transferred by, for example, an asset transaction or a legal split of the company takes place. In principle, this is allowed, yet it regularly goes wrong.
In 2020, for example, the Court of Appeal of The Hague (Jan. 7, 2020; JOR 2020/111) ruled against a contractor for abusing a mortuary construction. Earlier, our colleague Joost van Dongen wrote this article about that.
What was the case?
The contractor had structured its business in a corporate group structure. All fixed assets were housed in a holding company and were leased on a contract basis (intra-group) to operating companies.
Operating company "A" had accepted an order. At some point it became apparent that an engaged subcontractor had made a mistake in the installation of facade panels. Although initially this did not have any major consequences, there was a chance that the plates could crack over time. The operating company could not take care of the repair itself nor recover the costs from the liable subcontractor. The director of the operating company foresaw that the client would want to recover its damages from the operating company, which would probably bankrupt it in the long run.
The question arises how the director in such a case is still doing well in the Rhineland stakeholder model. After all, he not only has to serve the interests of his client, but he also has a responsibility to employees and other creditors. It seems irresponsible to place new activities in the same operating company if it is foreseeable that they could be dragged into an impending bankruptcy. What is more: it can also result in directors' liability towards new clients if you take on a job while the bankruptcy of the company is already foreseeable, so that the job cannot be completed.
Restructuring
The director chooses to restructure and decides to create a new operating company "B". New orders are taken and executed 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 was left holding the bag: it could find no recourse. This is a classic example of a mortuary construction.
Use or abuse
The dividing line between lawful use and unlawful abuse of a mortuary construction is thin. With the mortuary construction, the principal is not necessarily worse off. There was not much recoverable capital in operating company A anyway. After all, only assignments were accepted in that company and the claims arising therefrom against the principals of earlier assignments had already been paid and that income had also already been used to pay running costs of the operating company.
From the contractor's perspective, it is simply isolating a risk, to ensure that other projects can go ahead, jobs and the business can be maintained and the group does not go under due to a single claim whose liability, note, was not with the contractor itself, but with a subcontractor. Broadly speaking, therefore, abuse only occurs when assets are diverted from recovery.
Directors' liability due to mortuary structure
This then leads to directors' liability towards the creditor if the director can be seriously blamed for putting the operating company in a situation where it can no longer fulfill obligations previously entered into (or incurred). This is also referred to as "emptying the BV". Insolvency law specialists call this liability under Ontvanger/Roelofsen, after a standard Supreme Court ruling.
In a Directors' Liability course I once gave for the Order of attorneys Gelderland, I devoted 12 sheets to this topic, so that quickly goes beyond the scope of a blog, but if, as a creditor, you feel that your means of redress have been actively taken away, that there is recourse frustration and/or unwillingness to pay, then that is a basis for bringing a claim against the director of the company in question, in private.
Conclusion: mortuary construction is allowed, but has risks
So too in this case: director does not get away with it. He was blamed for not arranging a purchase price within operating company A for the goodwill of the orders he suddenly took on in operating company B. This allowed it to get off to a flying start, using the name and reputation of the construction company. According to the Court of Appeal, that value had accrued in operating company A, so assets had indeed been withdrawn from recovery by continuing the business in a new operating company B.
From a real purchase price for that goodwill, the principal's damages could have been paid, or at least partially. Because that is still a point of attention with this form of director's liability: the damage resulting from the "emptying of the BV" (= the mortuary construction: the value of the extracted goodwill) is not by definition equal to the damage suffered by the principal as a result of the breach of contract with respect to the facade plates: that damage may be greater or lesser.
Thus, a mortuary construction is per se allowed, but the director must ensure that the creditors (or shareholders) are not disadvantaged as a result. In such cases, the aggrieved parties can hold the director liable individually, or the trustee on behalf of the joint creditors.
The bankruptcy pauliana
Closely related to a mortuary construction is the bankruptcy pauliana. As I outlined above, a creditor or a trustee can hold a company director liable for emptying the limited liability company, for frustrating recourse, for extracting recourse from the debtor company.
But in bankruptcy, a trustee (just as outside bankruptcy an individual creditor can, for that matter) cannot only hold the director liable. The trustee can also choose to recover the recourses, the assets, that have been removed from the BV, back into the company. For this purpose, the trustee has the pauliana in his "toolbox."
Thus, the trustee can (pursuant to Article 42 Bankruptcy Act) under circumstances destroy (reverse) unobligatory legal acts of the subsequent bankrupt if they are detrimental to the creditors of that bankrupt.
The purpose of the pauliana is to reverse (conscious) favoritism of certain creditors at the expense of the other creditors (who are thus disadvantaged). This goal is achieved by granting the trustee the power to annul certain non-obligatory legal acts if they result in favoritism of selectively certain creditors.
Destruction means that the act legally never took place and its consequences must be reversed. The trustee can use this power only if the following three requirements are met:
- there must be an unobligatory legal act; An unobligatory legal act is a legal act that is not required by law or a (previous) agreement.
- Resulting in prejudice to creditors; and
- while the debtor knew or should have known of that prejudice. When it comes to legal acts with consideration (other than for no consideration), the latter requirement also applies to the other party.
A practical example
The pauliana has many manifestations. A common one is payment in lieu or sale combined with set-off: the company can no longer pay salaries, but still owns a nice car. The director decides to sell the car to his holding company and not to pay the purchase price to the operating company, but to have the holding company offset the management fee claim the holding company was still owed.
At first glance one would think that this would be allowed, especially if the car was properly valued by an independent expert and the purchase price was also invoiced. There is no question of emptying the BV, as in the mortuary construction.
But because the holding company suddenly obtained a netting position, the holding company was still able to collect its management fee, while there was then no more money to pay the salaries to the staff. And the staff could also no longer seize the car to recover on it. So the staff is disadvantaged and the trustee can reclaim the car from the holding company. Legion of these examples are conceivable.
Mandatory legal acts
A trustee can even reverse mandatory legal acts under Article 47 Fw. If the director of a company pays a payable invoice to a creditor, while the creditor knew about the bankruptcy petition against the company or that the payment was the result of consultation between the debtor and the creditor, the purpose of which was to favor the latter over other creditors by that payment, the trustee can reclaim that paid money from the creditor.
Conclusion
So how do you get it right as a director? Try to avoid being accused of favoring certain creditors over others. This obviously plays out especially if you favor "friends and family," both in the human and corporate contexts, i.e. literally family members, but also parent or sister companies.
If, in times when bankruptcy is foreseeable, an asset leaves the company (e.g. by sale), make sure that in return there is a cash-in of the actual value of that asset. And then make sure that that cash-in is then distributed fairly among the joint creditors or remains available to the (later) bankruptcy trustee. Because what is a "fair distribution" of the proceeds? You could write a whole new blog series about that... Therefore: when in doubt: sound the alarm or register for our free webinar'do and don'ts with an impending bankruptcy'.
