Tips for start-ups and scale-ups: directors' liability

Many start-ups - unfortunately - do not make it to scale-up and disappear within 5 years of their inception. This can be due to a host of circumstances, but often has to do with the lack of financial resources. Particularly for start-ups and scale-ups in the tech and manufacturing industries, large investments are often needed to develop products and methods before the market can be explored.

Even if the start-up does manage to emerge as a scale-up, money often remains an issue. 

Sometimes this leads to a situation where the start-up can no longer meet its obligations, resulting in the start-up being declared bankrupt.

The concept of bankruptcy is often associated with the concept of directors' liability; private liability for the debts of the limited liability company. Directors' liability comes in different forms. Consider (but not exclusively): liability due to accounting, founder's liability, liability for failure to perform obligations or evading recourse, and liability for selective payments.

In a series of articles, I am writing about directors' liability of directors of scale-ups and start-ups. This article is about directors' liability due to assumption of duties and selective payment.

Bankruptcy of Smart Business 4 Business

On May 19, 2020, the 's-Hertogenbosch Court of Appeal issued an interesting judgment. Smart Business 4 Business ("B4B") is a start-up founded on January 1, 2016. It did not last long. Its bankruptcy was declared on August 1, 2017. B4B developed a digital procurement platform for hospitality entrepreneurs.

The claim

In November 2016, Pay for People and B4B, after mediation by a third party, entered into a master agreement in which the parties agreed on the posting of employees to B4B. As of Jan. 2, 2017, one employee was seconded to B4B. While, as a rule, hiring employees seems to indicate growth, this was not the case with B4B. Invoices from Pay for People remained unpaid as early as February 2017. B4B appeared under the impression that it would not have to pay for the first until after April 2017, but even after April 2017, payment remained unpaid. In May 2017, B4B terminated the agreement because it would have to undertake major reorganization. Damages: €30,000.

Beklamel standard

Although the trustee was of the opinion that B4B's directors had not conducted improper management, Pay for People thought otherwise. According to Pay for People, B4B entered into obligations that the board knew or should have known it would not be able to fulfill. We call that a violation of the Beklamel standard.

It also believes that there has been selective (default) payment; according to Pay for People, B4B would have paid other creditors and Pay for People would not.  

Directors' liability for non-performance

The court dismissed the claim; it was not established that B4B knew between January and May 2017 that it would default on its agreement with Pay for People. Indeed, there was concrete visibility of a hefty crowdfunding in January 2017.

The Court also concludes that B4B's board is not liable for Pay for People's damages because Pay for People - through the intermediary - was aware that B4B was a startup and that a difficult financial situation is inherent in being a startup.

Selective payment

That the money raised through crowdfunding was not used to pay Pay for People was also not unlawful, according to the Court. The principle is that a debtor is free to decide which creditors to pay first. In this case, the available money was spent on the platform's development costs. The board had even deposited additional money to meet the salaries of its own staff.

From other case law, a different outcome also seems possible 

This case is unusual: in previous case law, the Supreme Court ruled the exact opposite where a newly established project company was concerned. That project company was virtually empty and the creditor was the principal who knew from the beginning that there was a project company. The directors of the project company did not deposit any money in that case and therefore the principal had no recourse. The Supreme Court ruled that the principal was entitled to trust that the director would provide sufficient funds and by leaving the project company "empty", he acted unlawfully towards the principal.

One might ask to what extent this differs substantially from the ruling on B4B. Isn't a project company also a start-up?   

Tips

What can a director learn from this case: the basic principle is that you may dare to undertake. This has been confirmed several times by the Supreme Court. Not everything leads directly to personal liability. That changes when you enter into an obligation which you knew or should have known that the company would not be able to fulfill and that the director can be personally blamed; a very high threshold.

Therefore, the most important tip to (young) business owners is: do not present the financial position of your company more rosy than it is, for example, in this case that - in my opinion - saved the directors.

You can remove the illegality - apparently - by actively informing the contracting party about the recourse position. You can also argue that it is your own fault if the contracting party then goes into business with you anyway. If things go wrong, at least you have a strong defense.

Want to know more about directors' liability? Then read this blog. For more information on selective payments see this blog.

Need a sparring session? I'd love to hear from you. Next time I'll write about incorporator liability and then about liability for frustrating recovery (Receiver/Roelofsen liability).