Directors’ liability under French insolvency law and tools to prevent it

Directors of French companies can be exposed to personal liability in connection with insolvency proceedings pursuant to an ancient and relatively strict legal regime. Recent case law developments, however, show that this legal regime is mostly applied with a view to incenting directors to address difficulties as soon as possible, in line with the objectives of the French and European legislatures.

Historical legal framework

Directors of French companies are subject to a string of obligations and potential liability whenever their companies face financial difficulties.

First and foremost is the obligation to file for insolvency proceedings within 45 days of the occurrence of the so-called suspension of payments.^[1] Failing to file for insolvency within this deadline can result in liability for directors, including damages^[2] and injunctions prohibiting them from serving as directors or managing companies.^[3]

This obligation is sometimes difficult to meet because of the definition of the "suspension of payments." It corresponds to cash flow insolvency, i.e., the inability to repay debts as they fall due with available assets. This is somewhat a subjective matter. Indeed, whenever a company has both large receivables and trade debt, it may be particularly tricky to determine the extent of available assets and the due and payable debts at any given time.

Depending on how strictly this obligation to file a proceeding is interpreted, it could potentially result in systemic director liability in periods of crisis. At the outset of the COVID-19 pandemic, this issue was acknowledged by the French legislature, which relieved directors from their obligation to file for insolvency after the first lockdown.^[4] The obligation has since then been fully reinstated.

Common directors' duties are also worth mentioning as they may lead to liability in the event that management wrongdoing causes a liquidation. The law is particularly focused on accounting, inventory of the company's assets, and high-risk transactions (that may in hindsight be seen as potentially ruinous). 

Finally, once an insolvency proceeding (not liquidation) is commenced, the directors will remain in charge of the company under the supervision of the administrator and bankruptcy judge appointed by the court. This leads to a series of additional and new obligations, including the prohibition on paying pre-petition debts, entering into certain transactions for which prior judicial authorization is required, and agreeing claims on behalf of creditors.^[5]

Failures to respect those obligations can entail different types of liability and sanctions.

Civil liability, including a judgment to compensate for the shortfall of assets at the end of the liquidation, can be incurred by directors who have committed mismanagement that caused the insolvency.^[6] It should be noted that, since 2016, mere negligence is not sufficient to tag directors with civil liability.^[7] As revealed by the legislative debate when this change was introduced into the law, this exclusion was meant as a favor to directors, affirming a "right to make mistakes."

Criminal prosecution and administrative sanctions (in particular the prohibition to hold a directorship position) are also at stake when directors' duties have not been properly performed,^[8] although those types of sanctions are reserved for serious wrongdoing and fraudulent behavior.

However, it should be noted that certain sanctions have been removed from French law over time, in particular claims against directors to recover corporate debt^[9] or ordering their personal bankruptcy.^[10]

Those possible grounds for liability are similarly available against either registered or de facto directors and can even target companies holding a director's position when authorized by the law.

While the historically severe legal regime for directors' liability has evolved to align with a more relaxed global framework, it is important to note recent developments in case law, which show that directors are still under pressure when their companies face difficulties and must therefore be very diligent and quick to react in order to manage their risk.

Recent case law: pressure on directors remains high

Court decisions rendered over the past three years show that litigation against directors following an insolvent liquidation continue to generate an important flow of cases and that judges are working to find a balanced approach to distinguish between mere negligence and willful mismanagement.

One of the main insights is that judges are not obliged to base their decisions on a purely arithmetic approach as to profits and losses . For instance, abusively pursuing a loss-making activity has been recognized as willful mismanagement even if the company had some profitable years over a considered period of time^[11] and regardless of the fact that the company may not have been in suspension of payments.^[12] Generally, directors were found liable because they had not taken any steps to turn the situation around after the difficulties began.

This approach could cause issues for enterprises pursuing an activity despite suffering losses, even if the losses are eventually covered by shareholders loans. Should a French subsidiary end up in liquidation, the directors could still be at risk for pursuing a loss-making activity with an abnormal use of intragroup indebtedness.

With regard to the failure to comply with the obligation to file for insolvency within the 45 days of the suspension of payments, France's highest court seems to have established a construct that breaks free from automatically sanctioning directors for failing to initiate insolvency proceedings within 45 days of the suspension of payments.

It has indeed recognized in two different cases (with opposite outcomes) that knowledge by the director of the existence of the suspension of payments was irrelevant:

• The fact that the director knew about the suspension of payments but still failed to file for insolvency within the 45 day deadline was not considered to be willful mismanagement that would result in the director's liability,^[13]
• Where the company had already been unable to pay social contributions, taxes and salaries for several months, the director was found to have willfully breached the obligation to file for insolvency within 45 days of the suspension of payments, even though the director did not know the precise date on which the suspension occurred.^[14]

These differing rulings could potentially challenge the very nature of the deadline. Although directors would be less exposed to purely "technical" breaches, this leads to a great level of uncertainty, with a need to monitor the situation very closely.

On the other hand, business decisions taken by directors are more likely to be considered mere negligence and not willful mismanagement.

For instance, the arguably reckless behavior of the director not diversifying its client portfolio and relying on a single customer, which eventually terminated the business relationship, was considered mere negligence and not willful mismanagement.^[15]

On a different note, the payment of dividends has recently been subject of scrutiny by the courts, particularly in the context of a leveraged buy-out when the target subsequently becomes insolvent and is eventually liquidated.

The payment of dividends to the holding company in order to repay the acquisition loan, without consideration of the cash position of the target, can amount to willful mismanagement by the directors.^[16] Indeed, even though the decision rests with the shareholders, directors can propose and induce the distribution of dividends.^[17]

This same result was also found in the context of intercompany advances from the subsidiary to the holding company, with the court noting that the interest of the group as a whole does not exonerate the director from their liability.^[18]

In summary, the assessment of the elements that could lead judges to characterize liability for willful mismanagement on the part of the director remains highly dependent on the facts. Generally, the underlying message of these decisions is that directors should act with caution and take the appropriate measures as early as possible to avoid aggravating the situation.

The need for anticipation and early action resonates with the different reforms undertaken by the French legislature in order to foster the resolution of difficulties through amicable frameworks.

Protection for directors arising out of the use of amicable restructuring frameworks

French law provides for two different amicable frameworks for the resolution of difficulties: the ad hoc mandate and the conciliation. They are deemed amicable as there is no general and automatic stay on claims and creditors called to participate cannot be compelled to waive or reschedule their debts.

The ad hoc mandate is a very light touch legal process with minimal court supervision, virtually no effect on third parties, and very little legal protection for the debtor. The conciliation, on the other hand, has been developed by the legislature and utilized by practitioners to become the preferred tool in France to successfully implement restructuring agreements.

It should be noted that French courts have refused to grant directors any kind of safe harbor in relation to the ad hoc mandate, notably by stating that it does not preclude the subsequent liability of the director if the opening of the ad hoc mandate was not appropriate considering the seriousness of the company's situation.^[19] On the other hand, the conciliation provides a much more secure framework for directors.

The main objective of a conciliation is to encourage participants to reach an agreement without imposing restructuring measures on creditors as part of a judicial proceeding. By pursuing this objective, the conciliation will de facto protect the directors from incurring liability in certain cases.

In particular:

• The opening of a conciliation will effectively satisfy the obligation to file for insolvency within 45 days of the suspension of payments and therefore prevents director liability on this ground,^[20]
• The conciliation is confidential.^[21] Its existence or content cannot be disclosed by any of the participants (debtor, creditors called to participate, conciliator) or by third-parties^[22] that may have obtained non-public information about the conciliation. This principle has been affirmed several times in very strict terms by France's highest court, including by dismissing the ability of the debtor to use elements of the conciliation as part of subsequent and distinct judicial proceedings.^[23] This confidentiality protects directors, since the limited circumstances in which the conciliator's report may be disclosed should not permit its use for the purpose of lawsuits against the directors,^[24]
• As a consequence of the approval of the conciliation agreement by the commercial court, which can be requested by the debtor company, the company is deemed not to be in suspension of payments at the date of the judgment^[25]. This once again prevents any subsequent criticism against directors for not filing for insolvency in due time.

Incentives for directors to use amicable frameworks to prevent insolvency proceedings

In addition to those protections, the conciliation is without a doubt the less dispute focused tool in reaching a restructuring agreement and is therefore a very effective mechanism to avoid any ulterior legal actions that may target directors in the context of formal insolvency proceedings.

This aspect has been reinforced with the last reform of French insolvency law in 2021.

Among the amendments introduced to the conciliation, the company, assisted by the conciliator, can now try and obtain orders from the judge supervising the conciliation staying claims against it.^[26] This is meant to prevent non-cooperative creditors from disrupting negotiations conducted with other creditors.

Also, when a restructuring plan has been negotiated as part of a conciliation, but is not agreed to by a minority of creditors, the debtor can request the opening of an accelerated safeguard process in order to have the plan voted on and adopted by creditors^[27] and imposed on the dissenting creditors – akin to a cram down.

This tool has been available since 2014 for large companies and specific cases of complex financial indebtedness but has now been extended to small and medium sized enterprises and improved to fulfil the objectives set by European law.^[28]

Quite significantly, therefore, the introduction of classes of affected parties for the purpose of voting on the restructuring plan includes the ability to impose a plan -- which has been agreed upon by the main parties involved -- on minority dissenting creditors or classes of creditors.

This bridge between conciliation and safeguard acts as a powerful mechanism for the debtor company and prevents creditors from adopting intractable positions that would otherwise prevent the implementation of a restructuring agreement supported by a large majority of claims as part of a conciliation.

Conclusion

The latest statistics on the number of conciliations, which continues to grow and has been used in many high profile and complex restructuring matters confirms that the legislature's objectives, usefully seconded by judges, have been achieved in significant part.

The incentives for directors to use these additional mechanisms as a way to manage their risk by offering some protection and flexibility, and by ensuring the effectiveness of these tools, are now strongly established. Yet, they should always be used in accordance with their credo: as an early intervention tool to prevent financial illness rather than a cure after the collapse.